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The case for Michelin
Posted by: batbeer2 (IP Logged)
Date: December 31, 2011 09:47AM

SUMMARY

Compagnie Generale des Etablissements Michelin (Michelin) can be purchased for $ 10B (5x pre-tax earnings). This is remarkable in light of the following:

1) The company is the most profitable of its peer group.

2) The company has the best balance sheet of its peer group.

Shares trade on the NYSE Euronext in Paris at a 20%-30% discount to my estimate of intrinsic value. For US investors there's an OTC ADR. Five ADRs represent one common share.

Michelin's superior profitability is a result of the companies better product mix. The company simply generates more cash per tyre sold than its close comps. This key advantage is likely to persist due to Michelin's control of its ditribution network.

BUSINESS & HISTORY

Michelin does today what it set out to do in the nineties… of the nineteenth century ! The company produces, distributes and sells tyres for passenger cars, trucks, buses, motorcycles, construction and mining vehicles, aircraft, etc. Operations range from raw material production (rubber plantations) to retail & services (Euromaster in Europe & TCI in the US).

Michelin’s mission is to enhance mobility by putting into practice its core values of respect for customers, respect for people, respect for shareholders, respect for the environment and respect for facts.

Michelin has 115k employees working in three divisions.

1) Passenger car tyre division with:
- the largest European passenger tyre operation
- a significant position in the US and
- a significant position in Asia (#1 in China).

2) Truck tyre division; the company is the world leader in truck tyres, (retreading) services and truck-side support services.

3) Distribution & specialty tyres (earthmovers, aircraft, etc).

This structure is as simple as it is unique. At the highest level, other major tyre companies such as Bridgestone and Goodyear are regionally organised (US, EMEA, …. etc.).


MARKET & COMPETITION

The global tyre market is roughly $ 155B. Cars and light commercial vehicles account for $ 95B and truck tyres are a $ 45B market leaving $ 8B for tractors, earthmovers and motorbikes and $ 7B for planes.

For many decades, three companies have accounted for about 50% of global tyre production.

• From France: Michelin (Michelin, Uniroyal, and BF Goodrich brands).
• From the US: Goodyear (Goodyear, Kelly-Springfield, Lee, and Douglas brands).
• From Japan: Bridgestone (Bridgestone and Firestone brands).



The tyre industry serves two distinct markets:

Original Equipment Manufacturers

OEM tyres are sold directly to automobile (and aircraft, earthmover, truck…) manufacturers. This is a capital-intensive, cyclical, business with high customer concentration. The attitude of automobile manufacturers towards tyres is:

"Tyres should be black, round and cheap and and we don't care much about black or round!"

Replacement

Replacement tyres account for about 70% of the passenger car tyre unit volume, 85% of truck tyre unit volume and 95% of aircraft tyre unit volume. Trucks, planes and to a lesser extent cars use up multiple sets of tyres over their lifetime.

Operators of trucks, busses and planes are very conscious of fuel consumption and will gladly pay a premium for tyres that shave a few percentage points off their fuel expense.

COMPETITIVE ADVANTAGES

In general, tyre companies invest in production facilities for the local OEM market and subsequently dominate the local replacement market. Pirelli (FIAT) dominates Italy, Goodyear (GM) dominates the US, Bridgestone (Toyota) has a lock on Japan and Michelin (Citroën) has its home base in Europe. Bridgestone, as a relative latecomer (1935) to the business has grown in lockstep with the Japanese automotive industry.

Once capacity has been established to supply local OE manufacturers, the production facilities generate profits by also serving the profitable local replacement market. Pricing power comes from cheap, local, distribution.

Operators of large fleets of trucks require efficient (roll resistance) tyres and “truck side” services. This requires an efficient service & distribution network. There are obvious barriers to entry favouring the incumbent.

The aviation industry requires tyres that are light (fuel !), durable (multiple landings !) and certified for use on a particular aircraft. Tyres may last dozens or hundreds of (landing) cycles depending on many factors. Importantly, tyres are replaced on the spot, as needed. Every airport served must have the capacity to replace some or all tyres on a given plane. This requires an efficient distribution network. There are many, highly profitable companies (dealers networks) that specialise in the distribution of aircraft tyres.

There’s a lot of overhead involved to get (light) tyres certified. Unsurprisingly, Bridgestone, Goodyear and Michelin have >> 90% of this market.



In unit terms, 85% of tyres sold are for cars and vans and 11% of tyres sold are for trucks. Trucks account for 11% of unit volume and 40% of revenue. Selling truck tyres is a MUCH better business. Asset turnover is higher which is important in a capital-intensive business.

At Michelin, roughly 50% of revenue comes from trucks, earthmovers and planes.

Michelin dominates this profitable niche through global control of its distribution networks like TCI in the US and Euromaster in Europe. Goodyear and to a lesser extent Bridgestone rely more heavily on dealers and third-party distributors/wholesalers.

Here’s how this works in practice:

The US Navy just exercised a second five-year option to extend its tyre supply contract with Michelin. Under the contract, Michelin is required to deliver 100% of all Navy aircraft tyres anywhere on the continental United States within 48 hours or less, and anywhere in the world, including deployed aircraft carriers, in 96 hours or less. Michelin is currently exceeding the Navy’s delivery requirements, averaging over 98 percent on-time delivery with zero backorders.
The Navy no longer manages its own inventory like it used to. Michelin has a similar contract with the Defense Logistics Agency, to supply aircraft tyres to the US Air force, the US Army, and some allied foreign militaries.


BALANCE SHEET & PROFITABILITY

With a Hat-tip to McFlipp ! We compare Long-term debt, Cash at dec. 2010 and FCF.



Not only does Michelin generate more cash, there's less debt to service with it.

Bridgestone has significant debt to service. Corporate interest rates in japan are low. Bridgestone has an important advantage there. This advantage is not within management’s span of control. In any case, Bridgestone has more debt and generates less cash in total or per tyre sold.

Goodyear has the worst balance sheet and does not generate cash to do anything about it. Management is weeding out unprofitable production capacity hoping to turn this juggernaut.

Since 2005, Bridgestone and Michelin have maintained unit volume and market share. Goodyear is shrinking and has clearly not been spending enough to maintain its business. This implies Goodyear’s earnings are overstated. Goodyear, in its current state is no match for its Bridgestone or Michelin.


MANAGEMENT

Michelin’s strategy and operations are aligned with customer needs. This has been recognised by J. D. Power with 66 awards since 1989. Fortune magazine lists Michelin is the world’s most admired company in the Motor Vehicle Parts industry.

Michelin is structured so the (Michelin) family doesn’t need to own half the shares to retain control of the company. Nevertheless, they own roughly 30% of equity. The Michelin family act like owners; they are. Since the untimely death of Edouard Michelin (drowned in 2006, aged 42) after leading the company for seven years, they leave the management of the company to "hired hands".

This year, mr. Senard took over from mr. Rollier for a four year stint as managing partner. This is a company where the boss gets a four year contract.

Mr. Senard is paid $ 2m per annum plus options priced at EUR 65; a 40% premium.

Bridgestone has a stated strategy of becoming the world’s undisputed #1 tyre company. I find it interesting that this strategy is NOT focused on customers and/or shareholders. Bridgestone is focussed on competition. Bridgestone’s strategy is a recipe for disaster in this capital-intensive, cyclical business.

Management proudly claims Bridgestone is taking market share (revenue). The numbers show unit volume has been flattish and profitability is mediocre. Bridgestone sells most of its tyres in Japan. We know the Yen has appreciated meaningfully against the dollar. The rise of the Yen and not the improvement of the business is the main cause of revenue growth as reported in dollar terms.

Goodyear is led by Mr. Kramer, an accountant. He gets $ 10m per annum. Goodyear is clearly fighting for survival. Goodyear is quite transparent and management seems rational and competent. This may be a case of an excellent jockey riding a lame horse.

VALUE & PRICE

Michelin has 180m shares outstanding. Shares trade at EUR 45 => $60 for a market cap of $ 10B.

Replacement value

Michelin is spending $2B per annum for 4 years to increase production volume 25%. This implies current production capacity is worth $8B x 4 = $32B. With zero value assigned to the distribution business, we get a per share value of EUR 70 => $90

Owner earnings

Michelin reports about EUR 1B of earnings. An investor requiring a long term 9% (index) return should de willing to pay 11 x EUR 1B. We get a per-share value of EUR 60 => $ 80

For some reason, taxmen don’t rely on reported GAAP earnings. They have their own system. Michelin pays about EUR 300m of taxes per annum which checks out with our estimate of owner earnings.

Relative value

On average, Bridgestone generates about $ 2B of EBIT, Michelin generates $ 2.5B and Goodyear $ 0.8B. The market cap of Michelin is roughly $ 10B, that's 4x EBIT. Goodyear trades at 4.5x and Bridgestone at 9x for a market cap of $ 18B.

Although there is no margin of safety in relative value, this serves to prove the market doesn't price Michelin rationally. The company generates more income before interest, has less debt to deal with and has the lowest multiple.


Private market value

Schaeffler group bid $18B for Continental AG. Continental does more than tyres; nevertheless, by adjusting for EBIT contribution, we use this data point to estimate the value of Continental’s tyre division at $ 8B. Continental produces less than half the number of tyres Michelin does. This implies Michelin is worth at least $16B. We get a per-share value of EUR 60 => $ 80

We use multiple approaches (no extrapolation here !) to get an estimate of fair value of EUR 60 - 70 per share. Importantly, there is none of the approaches gets us a value less than the current share price of EUR 45. We conclude that this is a rare opportunity to buy a great company at a clear discount.

CATALYSTS

1) The venerable tyre manufacturer is cranking up production with an annual budget of $2 billion till 2015. "Our ambition is to grow production volume by 25% by 2015 and by 50% by 2020. " Mr. Senard says.

2) Continental's $ 13B tyre division may come up for sale. In the short term this may cause some fireworks. In the long run this just signals further consolidation of the tyre business (especially in Europe) which is a good thing for Michelin.


SPECIFIC RISK

There are a couple of notable risks specific to this industry.

Low cost imports. Imports are now 15% of North American passenger tyre market. It’s 10% in Europe. In 2005, imports were only 2-3%.

This certainly puts pressure on prices. I believe the imports are a result of an |”OEM boom” in China. Excess capacity has been built while the local replacement market doesn’t soak up local production (yet). This is not a sustainable strategy. Not surprisingly, the companies involved have been accused of dumping practices. This is a capital (not labour) intensive business and in the long term, the low-cost producer is likely to be found where the cost of capital is lowest (Japan).

Rising raw material cost. Raw materials are 35% of COGS and rubber (including synthetic) is half of that. This is why Bridgestone and Michelin own some rubber plantations. Having said that, Goodyear, Bridgestone et al. have seen the price of natural and synthetic rubber rise a hundredfold. This time is not different. Demand for tyres is fairly inelastic and prices will be passed on.

Collusion The three dominant companies could be (rightly or not) accused of fixing prices. This is a popular passtime for the European commission. Michelin may or may not be involved in this practice, I have no way of knowing. The mere accusation would probably drive shares lower.


WHY IS THIS CHEAP ?

1) The economic outlook is bad.

2) Michelin is French. Well, France does not have its fair share of governance scandals. The US has Enron, Japan has Olympus, Italy has Parmalat and France has…. ehm.

3) A couple of years ago, Michelin issued shares without clear purpose.

What is not generally understood is that this coincided with Schaeffler's bid to take rival Continental AG private. For obvious reasons, Michelin doesn’t want Continental’s tyre operation to go to Bridgestone or Goodyear cheap. Maintaining a healthy balance sheet enables Michelin to place a decent bid for Continental’s tyre division if it should come "in play".

This is one possible and rational explanation why management shored up the balance sheet with a rights issue without publicly stating their intentions. In any case the shares were issued at higher prices.

4) The consensus view is that Michelin is losing market share to Bridgestone. There’s a lot of noise in the news about Bridgestone taking the #1 spot. The only metric supporting this “fact" is revenue. No one seems to notice Bridgestone’s revenue in dollar terms is tied to the rising Yen.


Disclosure

This is not a recommendation to buy or sell anything. I had no position in any of the stocks mentioned at the time of writing.

Any and all questions welcome as usual.


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The case for Michelin
Posted by: McFlipp (IP Logged)
Date: January 2, 2012 04:25AM

Looking at the balance sheet at the end of H1 2011 I see €728 million of cash and cash equivalents and €3.8 billion in debt, so where exactly do you get the numbers that they have $2.5 billion in cash and no debt?


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The case for Michelin
Posted by: batbeer2 (IP Logged)
Date: January 2, 2012 08:51AM

Hi McFlipp

Thanks for your comment; good catch !

My numbers are the annual reports, including the last one for FY 2010. More than EUR 2B of cash and investments. [www.michelin.com]

Michelin of course does have liabilities. Some current and some of it non-current. AFAIK, no bonds though.
[quicktake.morningstar.com]

In any case, thanks for the heads-up. I'll check the H1 report.


- EDIT -

Checked it out. You'll notice cash is down by about EUR 1B and inventories are up by a similar amount. They've obviously spent some cash building up inventories. I presume this is a sesonal thing (winter tyres in Europe !?). I'll go through the years see if there's a similar pattern for other years.

- EDIT2 - There is. It's a seasonal issue.


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The case for Michelin
Posted by: McFlipp (IP Logged)
Date: January 2, 2012 09:35AM

Yeah, the €3.8 billion is "financial liabilities", in the H1 2011 report it wasn't split out into what this exactly was, but I assumed it was debts/bonds. In the slides that come with the 2010 annual results they classify financial liabilities as "debt" and use it in their calculation for "net debt", which is about €1.6 billion at the end of 2010. So I think your cash amount is OK, but you missed the €3.8 billion in debt.

On the Michelin website there is a page about their debt (http://www.michelin.com/corporate/EN/finance/share-debt/debt?selectTab=debt) where it claims that 50% of their debt is in bonds btw.


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Re: The case for Michelin
Posted by: batbeer2 (IP Logged)
Date: January 2, 2012 09:43AM

Right..... thanks for looking into it. I changed the article.
I'm simply using LT debt now to get an apples-to-apples for all three.


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The case for Michelin
Posted by: Adib Motiwala (IP Logged)
Date: January 2, 2012 11:51AM

So then what is EV? Is it attractive now after accounting for the large debt?


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The case for Michelin
Posted by: graemew (IP Logged)
Date: January 2, 2012 12:35PM

I am always looking for good European companies to invest in...I can't find many that I really like. I think Michelin is a very interesting idea ....there is great growth potential in emerging markets and tyres represent an almost essential ongoing purchase...something that can be put off, but eventually new tyres have to be bought. The company has reduced debt and has plans to expand production in China, India and Brazil where there is huge potential. At only around 6 or 7 times earnings and priced around net asset value the stock does seem attractive. I'm currently researching more...the only thing that worries me a bit is the irregular cyclical nature of earnings and the pension liabilities...I normally only buy companies with steady growing earnings that aren't affected much by recessionary periods. Thanks for drawing attention to this idea.


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The case for Michelin
Posted by: batbeer2 (IP Logged)
Date: January 3, 2012 04:23AM

Hi Adib

>> So then what is EV?

Depending on how you like to do the math, EV would be $ 12 B to $ 16 B which is less than the EV of close comps. Whether it's attractive is a matter of opinion. I personally have a pretty high hurdle rate.


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The case for Michelin
Posted by: JeanPierreSarti (IP Logged)
Date: January 3, 2012 01:52PM

This is a minor point but I think you are wrong about OEM attitudes about tires. Today, many tires are made specifically for one particular car or type of car. Case in point, the Prius could wear almost any kind of rubber but for Toyota to back up the MPG claims you must use the Michelin tires designed more for fuel efficiency and less for road noise. The converse is true for the Lexus which will come with a quiet tire while sacrificing tread life.

Anyway I am probably strengthen your argument which is fine, I just wanted to point out that OEMs are much more particular about the tires then you imply. Infact it probably means that when looking at companies like NTB or Discount Tire Co. it is imperative that you take into account that Dealers are trying to muscle in that market by claiming they only carry tires meant for their specific cars with a healthy mark up of course.


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The case for Michelin
Posted by: batbeer2 (IP Logged)
Date: January 4, 2012 02:12AM

Hi JeanPierreSarti

Thanks for the comment. OEMs, Particularly the ones with a focus on quality (toyota, porsche...) are indeed a bit more picky about their tyres than I imply. What would really change this business is if airless tyres become commonplace (google "tweel"). In any case, that's a good thing for the incumbents due to the R&D overhead.



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