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Cooper Tire & Rubber Company: Wait For A Pullback Before Considering A Buy (NYSE:CTB)

About Cooper Tire & Rubber Co.

Cooper Tire & Rubber Company (NYSE:CTB) (“CTB” or the “Company”), together with its subsidiaries, designs, manufactures, markets, and sells replacement tires in North America, Latin America, Europe, and Asia. The company operates through two segments: Americas Tire Operations (~80% of sales) and International Tire Operations (~20% of sales). In 2019, the Americas segment had approximately 10% market share in the US. CTB operates in a highly competitive industry, which includes Bridgestone Corporation, Goodyear Tire & Rubber Company (GT), Groupe Michelin, and other low-cost producers. These competitors are substantially larger than the Company.

CTB offers passenger car, light truck, truck and bus radial (TBR), motorcycle, and racing tires, as well as tire retread materials; and markets and distributes racing, TBR, and motorcycle tires. The company sells its products to independent tire dealers, wholesale distributors, regional and national retail tire chains, large retail chains, and other tire and automotive product retail chains, mass merchandisers, and digital channels as well as original equipment manufacturers; and directly to end users through three owned retail stores. Cooper Tire & Rubber Company was founded in 1914 and is headquartered in Findlay, Ohio. (Sources: Finviz, Annual Report 2019)

Our View

We believe that the recent strategic initiatives at CTB may prove valuable in the near term, leading to margin expansion and earnings (free cash flow) on the higher end relative to recent years.

Over time, the Company still operates in a highly competitive industry where the fundamental economics will prevail and cause earnings to normalize.

The record-breaking results for Q3 2020 are thus unlikely to be very sustainable going forward – seasonality and already rising raw material prices will be a drawback in first half of 2021, while competitive forces will continue to be strong over the longer term.

Coming quarters will still be important to gauge the sustainability of the margin expansion and how well the business is likely to fare over the next years.

At the current market price ($40/share), the stock is modestly attractive, but given the sharp and significant rise since April to near-record highs reached in 2015-2017 – largely reflecting recent results – we believe it is prudent to rather wait for a pullback (likely in Q1 ’21, possibly in Q4 ’20 if raw material prices continue to rise) before considering a buy.

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Basis for Opinion

Strategic initiatives

Since 2018, the Company has focused on increasing its retail presence and expanding its global manufacturing footprint. This has been in response to steadily declining revenues in recent years due to strong US dollar and competition from low-cost producers (in Asia) that was especially hurtful for American tiremakers (incl. Goodyear Tire & Rubber Company and CTB).

“…these initiatives include increasing our retail presence, by making Cooper products available at a greater number of retail points where consumers want to shop for tires. This effort is going extremely well. Not only have we entered into relationships with many new retailers, but Cooper has also been able to expand and continue to grow our business with existing customers. As stated previously, Cooper tires are available in all of the top five tire retailers in the U.S., a direct result of our retail expansion efforts. Additionally, we have seen strong growth on e-commerce platforms.”

“Another key strategic initiative is evaluating and upgrading our global manufacturing footprint, with a goal to have the right technology and capabilities, with the right production capacity in the right locations, with a competitive cost structure.” (Source)

In line with that, the Company closed its high-cost factory in the UK and enhanced its use of the plant in Mexico. (Source) The Company is still subject to tariffs but has moved some manufacturing to Vietnam to counter those effects. By setting up manufacturing operations in Asia, CTB will also position itself to benefit from growing demand in Asia and compete more successfully globally – something that the Company should actively consider, since 80% of its sales come from North America.

Another thing the Company has done is focusing more on higher value-added products. This is particularly good since it will likely be beneficial in terms of margins (evident in Q3 2020). Overall, management seems to be on point in its actions and well aware of what measures need to be taken in order to sustain the competitiveness of CTB.

Strong Financial Position

CTB has a relatively strong balance sheet. As of September 30, 2020, it had roughly $1.2 billion in tangible equity of which nearly $500 million was in cash & cash equivalents. Long-term debt to equity ratio was only 0.24, current ratio 2.4 and quick ratio at 1.75.

The second largest asset category is Property, Plant & Equipment. At the end of 2019, it consisted of the following (according to Annual Report 2019):

Property, Plant & Equipment ($000)

Dec 31, 2019

Land and Land Improvements

53,516

Buildings

344,142

Machinery and Equipment

2,042,578

Molds, Cores and Rings

262,444

Total Property, Plant & Equipment

2,702,680

Less: Accumulated Depreciation

1,655,438

Property, Plant & Equipment, Net

1,047,242

Properties – Type of Facility

Total

Manufacturing

10

Distribution Centers

21

Retail Stores

3

Technical Centers and Offices

20

Total

54

Earlier this year, the Company had to temporarily close some of its plants due to the pandemic. This has caused inventory levels to be unusually low. As this is likely to have been the case for other tiremakers, there exists the possibility of supply-demand mismatch that might put upward pressure on prices. if that persists and coupled with growing demand as economic recovery takes hold, it might possibly have a positive benefit on the Company’s results. This is still very uncertain and may not be significant at all.

While the balance sheet is strong, it is worth noting that CTB has experienced rising cash conversion cycle since at least 2010, taking twice as long to make a sale and collect receivables in the trailing twelve months compared to 2010. Although this may be in part due to the more costly manufacturing and less attractive value proposition due to the ever stronger dollar, it is worth keeping an eye on. A change in that trend would be very favorable, whereas continued rise would be concerning, given the strategic changes currently underway.

Near-term Outlook

We view the near-term outlook for CTB as quite favorable. Improved gross margin due to lower-cost manufacturing and higher-value added products, coupled with likely uptick in economic activity, should positively impact CTB’s earnings.

According to Moody’s ratings review of CTB in late June 2020:

“Moody’s believes that consumers are likely to use their vehicles more as social distancing policies are eased, rather than travel in planes, trains, and busses. This trend should be supportive of aftermarket tire demand. The drop in petroleum and related raw material costs is expected to be reflected in the company’s cost of goods sold. [This lower cost was evident in Q3 2020 results.] Cooper Tire’s strong cash balances support operating flexibility enabling the company to manage operations as consumer demand for aftermarket tires gradually recovers along with increasing production at Cooper Tire’s manufacturing operations.” (Source)

This will likely continue into 2021, except for raw material costs. For example, the price of rubber has risen quite sharply in recent months (after Q3 ’20). This is one reason why the exceptional results in Q3 2020 will likely be short-lived (some restructuring costs due to the changes in manufacturing may also be a factor). And since first- and second-quarter results are generally on the lower end (due to business seasonality – sales volumes tend to be stronger in Q3 and Q4, but weak in Q1 and Q2), we might expect to see the stock price rise put to a pause and pull back a little as results come in relatively weak compared to the latest quarter.

global-price-of-rubber

(Source: FRED)

But, barring any significant setbacks (e.g. delayed economic recovery, sustained negative input price effects, non-realized supposed benefits from strategic initiatives), results for 2021 should be on the higher end relative to recent years, making the stock potentially attractive with the above discussion in mind.

Valuation

While CTB has generated return on equity (ROE) of roughly 22% annually since 2010 (according to Morningstar), it does not have a wide moat (durable competitive advantage) is largely influenced by external factors (such as price of rubber, oil and other inputs, currency fluctuations, and activities of larger competitors (which have more say in market prices)). The Company is the 5th largest tire company in North America (one of only two global tire manufacturers headquartered in the US) and the 13th largest in the world (source). As such, the general competitive nature of the business and lack of significant durable competitive advantage will be reflected in the results of CTB over time.

In terms of valuation, we consider three scenarios (based on data from Morningstar):

(1) Neutral: Future earnings will on average be similar to previous 10 years.

In the last 10 years, gross margin has averaged 16%, operating margin roughly 8%, sales nearly $3.3 billion and capital expenditures have been 5.5% of sales. Free cash flow has averaged $94 million or $1.9/share. At the current market price ($40/share), this would give 4.75% in earnings yield and make the stock relatively fairly valued compared to the S&P 500, which yields approximately 4% (source).

(2) Positive: Margin expansion sustained, revenue rebound.

Here, we assume that gross margin will average 20% with operating margin at 10% (quite similar to the trailing twelve months, which include both record-high results and relatively low first half – this would also be on the high end of management’s expected operating margin for second half of 2020 (expected 10-14%)). If we assume sales to reach the high end of last 10 years (approximately $3.6 billion) and capital expenditures to be 5.5% of those ($198 million), then free cash flow will be roughly $160 million ($3.2/share). This will yield 8% in earnings, making the stock quite attractive relative to the S&P 500.

(3) Negative: Sales and margins will remain relatively depressed at recent levels.

Here, we essentially assume that recent initiatives will not lead to sustained changes with sales and margins at the low end relative to the last 10 years. Gross margin is then 14%, operating margin nearly 7%, and sales at approximately $2.8 billion. Capital expenditures will average $154 million, giving free cash flow of around $42 million ($0.84/share), resulting in 2.1% earnings yield and an unattractive stock.

Our belief is that a combination of (1) and (2) is the most likely scenario. Specifically, since CTB does not have a durable competitive advantage and operates in a highly competitive market, we would expect the positive scenario (2) to occur for the near future and gradually head towards the neutral scenario (1). In a rough estimate, this might be one-third of the period in scenario (2) and two-third of the period in scenario (1), approximately resulting in free cash flow of $116 million ($2.3/share) and earnings yield of 5.75%.

While this would make the stock modestly attractive relative to the S&P 500, it does not offer a large margin of safety. And given our earlier discussion on potentially lower earnings in the next few quarters and already sharp rise in the stock to date, we would recommend waiting for a near-term pullback before considering a buy.

Summary

Overall, CTB’s strategic initiatives to focus on lower-cost manufacturing and high-value added products may prove lucrative in the coming years. Strong balance sheet gives the Company flexibility and opportunity to take advantage of opportunities and align its operations to the market. Economic recovery may also give boost to the business, while opportunities for international growth remain. Rising raw material prices should, though, be considered in the near term since they might make the margin improvement less beneficial if they remain elevated for long.

Over the long term, strong competitive forces and lack of durable competitive advantage will dominate the results causing earnings to gradually normalize to 5-6% in free cash flow yield.

Recommendation: Wait for a pullback before considering a buy.

Fair Value: Approximately $45-$55/share.

Factors to Consider: Economic recovery (revenue growth), raw material prices (and possibly short-term currency fluctuations), cash conversion cycle, margin improvements, tariffs, actions of larger competitors.

Timeframe: Q4 2020 and first half of 2021.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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