The Financial Experts’ Favourite – Michelin

Reports from financial and industry analysts generally agree that the tyre industry, among others, is facing a difficult time with market conditions having worsened recently. Despite this, the Deutsche Bank AG, London is recommending Michelin shares as a “buy”, even though the organisation is downgrading its 2001 profits forecast for the French manufacturer by 3%. The reason for this seemingly contradictory attitude is that Deutsche Bank believes that there are a number of positive developments awaiting Michelin in the second half of the year, and the reason for downgrading profit expectation at all is entirely attributable to the difficulties posed by the market in the first half of the year.

So what are these positive developments? Looking at the US market for passenger car tyres, both OE and replacement are expected to be, at best, flat. However, despite the anticipated fall in volume, price increases of around 3.8% introduced by the manufacturers have stuck.

The main reason for this is the effect of the Firestone recall, which Deutsche Bank says is responsible for structural positive changes in the tyre industry, which it says is heading towards “an ideal oligopoly”. The dictionary defines oligopoly as “a market situation in which control over the supply of a commodity is held by a small number of producers, each of whom is able to influence prices and thus directly affect the position of competitors.” A new set of price increases of around 4% has been announced by Goodyear, Bridgestone/Firestone and Michelin.

The scene for US truck tyres is less encouraging, with recent price increases being given back to customers. More of a worry for Michelin, though, was a fall in sales of truck tyres in Europe, where the brand enjoys a significant margin. Outlook There is no doubt that Michelin’s expected slice of new business following the Firestone recall – estimated at four million tyres, based on market share of the last recall – is responsible to a great extent for the analysts’ bullish attitude.

Deutsche Bank reckons that the second recall could benefit Michelin’s top line by 200 million Euro and pre-tax profit by anything from 60 to 80 million Euro. Should the latest 4% price increase on US passenger replacement tyres stick, then this will add another 60 to 80 million Euro to annual earnings. However, one cannot bank on a tyre recall happening every year and the US light truck replacement tyre market could fall by up to 5% in 2002, affecting all manufacturers.

One positive factor not mentioned so far is that of raw material costs, particularly the price of oil, as oil derivative products represent 40% of raw material costs. At the beginning of 1999, a barrel of Brent crude cost $11.6 and by the end of 2000, it had risen to $29.

In the first quarter this year, the price had dropped to $26.3 and the estimate by the Deutsche Bank’s oil team is for the price to fall to $23 by the year end. Earlier, we said that the trend for most tyre markets worldwide was flat, but even so there is opportunity for financial growth, even if no great increase in unit sales.

Take, for example, a mature tyre market such as that for replacement tyres in Europe; Figure 1 compares the current market mix with an estimate for four years hence. It can be seen that the greatest growth, in volume terms, is in the high performance sector, where traditionally prices and margins have been higher. This is also the sector where brand names, particularly premium brand names, are of more significance to the motorist, as performance is an important factor in the purchase decision.

Thus, any growth in this sector is likely to favour premium brand manufacturers such as Michelin, allowing the company to increase its operating margin. Deutsche Bank AG London is predicting that the company is on course to achieve a 10% operating margin by 2005, compared to 7.5% in 2000.