Description

Cooper Tire & Rubber (CTB) is a cyclical business that is over-earning. I expect normalized EPS well below what the Street assumes and think downside is 30-45%, and potentially more.

Cooper is not a new story. Folks have been bearish on the tire companies forever and I could have made the same argument last year or the year before. In fact, I did! The VIC boards will reflect that I was expressing my distaste for Cooper all the way back to December of 2015.

So why now? While it may seem counterintuitive (the stock is down ~30% from earlier this year), I’d argue that now is an opportune time. Confronted with weak sell out at retail, excess inventory in the channel and new supply coming online, the tire industry is becoming increasingly competitive in an environment where raw materials are on the rise. That’s a very bad recipe for Cooper. Complicating matters is that Cooper benefited from a number of 1-time items this past year that may become headwinds over the coming quarters.

In my view though, Cooper is not just a cyclical short. It’s a high cost player in a commodity industry; has been losing share to structurally advantaged competitors for years; doesn’t have a brand and under-invests in R&D. Moreover, the extent of Cooper’s issues have been obfuscated by tariffs that have propped up its earnings and inflated its margins. After years of no new supply, the North American market is seeing an influx of new capacity, which could create a dangerous imbalance of supply and demand.

The normal warnings apply: Cooper screens cheap, is heavily shorted and stands to benefit from tax reform. In addition, it may (erroneously) be perceived to be a winner from increased protectionism.

Background

Cooper is a tier 3 tire manufacturer. The company was founded in 1914 and it’s the 11th largest tire company globally and the 4th largest in North America. The long-time CEO, Roy Armes, stepped down in FY16 (and sold a good amount of stock at the time). This also just so happened to be Cooper’s most profitable year on record. Cooper’s current CFO, Ginger Jones, announced earlier this week that she would be stepping down later in the year. She had been in the role for only about 3 years.   

Importantly, Cooper derives virtually all of its EBIT from the Americas (97% of segment earnings in FY17). This is key for the short case as the over-earning phenomena I’ll discuss is most prevalent in North America and Cooper is the most exposed to this region among its peers. Within the Americas, Cooper sells mainly replacement tires for passenger cars and, relative to its competitors, has a greater mix of low-value-add or LVA tires.

Cooper is a challenged business

While most tire companies aren’t particularly good businesses, I would argue that Cooper is uniquely disadvantaged. Its bread and butter for most of its history has been unbranded, private label tires. However, as cheaper tires have found their way to the US, Cooper has had to pivot away from its heritage. This has been problematic because Cooper doesn’t have a strong brand and under-invests in R&D and marketing relative to peers. To put this into perspective, Cooper invested $60m in R&D this past year vs $400/$180m for GT/Hankook. To its credit, Cooper has been slowly boosting its R&D investment (now at ~2% of revs) but this is still industry-low (peers are at 2.6% to 3%). I’d contend that it’s too little, too late.

More importantly though, Cooper doesn’t have a low cost position as it’s burdened by union contracts and a legacy manufacturing footprint that is outdated and inefficient. Its 4 US facilities were built on average in the mid 1900s. By contrast, Hankook, one of the primary share gainers in the US, operates with fewer, larger, more modern and more automated plants and thus enjoys far greater scale and margins. As result, Hankook does ~$1b in sales and $200m in EBITDA per plant or 5x what Cooper achieves. Hankook just opened its first plant in the US this past October.

As a result, Cooper has been a long-term share loser. It’s been ceding market share on the low-end to cheaper Asian imports and on the mid-end to companies like Hankook and Nexen that make better quality tires at lower prices thanks to greater scale and automation. You can see this quite clearly from the market share numbers that Cooper provides in its 10-K. As shown below, Cooper’s market share has declined from 17% in the early 2000s to 11% today.

CTB Historical Market Share

Source: CTB SEC Filings

In addition, we know that sales to Cooper’s main customer, TBC/Treadways, is in sharp decline. Sales to TBC were $485m in FY15 and ended FY17 at $305m, a 40% decline over only 2 years. Despite this drop, TBC still represents 13% of Cooper’s Americas sales. Bulls might argue this is a good sign because TBC was employing Cooper for lower margin, less desirable private label business. While this may be true, such LVA business is critical for Cooper because it helps to cover a significant fixed overhead base.

Bulls believe that Cooper will be able to make up for this lost business by pivoting to high value add or HVA tires, which are currently all the rage in the industry. In layman's terms, these are simply tires for larger rim diameters. The problem is that HVA is where a wave of new supply is focused and peers are investing far greater dollars here than Cooper.

Now this may all seem obvious and you must think that everyone already knows all of this. In reality, I think a lot of investors, including the Street analysts, are still asleep at the wheel. There’s been a lot of noise in Cooper’s numbers over the past few years, which I believe has partially masked both the long-term structural issues and the near-term profitability erosion.

So what’s been happening?

First and foremost, there have been a slew of tariffs. The US government imposed significant tariffs on Chinese tires from 2009-2012 and then again (rather unexpectedly) in late 2014. This was a windfall for Cooper as these cheap tires were the main competition on the low-end (and remember, Cooper has historically been a low-end manufacturer). To put this into perspective, consumer tire imports from China have declined 80% over the past few years! From 61m units before the reintroduction of tariffs to just over 12m units for 2017.

What amplified this air pocket of competition was a sharp drop in raw material prices that occurred at the same time. Cooper’s own raw material index peaked at 259 in FY11 and subsequently declined for 19 straight quarters, bottoming in the 130s in mid 2016 or down a whopping 50%. Normally, this wouldn’t really matter - tire companies tend to lower prices when raw mats are falling and hike prices when they are rising. However, with an absence of competition, pricing during this period was uncharacteristically resilient, especially in FY15 and FY16 when raw materials registered their steepest declines. This is a huge deal for Cooper since raw materials comprise roughly 60% of its total costs (COGS are 90% of total costs and raw materials are 65% of COGS).

As you might imagine, this created a perfect storm and Cooper’s margin blew out. This is clear when you look at Cooper’s historical EBIT margins in its Americas segment:

Americas Segment EBIT Margin %

Source: CTB SEC Filings

As you can see, Cooper’s EBIT margin averaged just under 2% from FY05-FY11, jumped to 10% from FY12-FY14 and advanced even further to 16% in FY15-FY16. Margins peaked at an astounding 18.3% in Q1’16. As noted at the start, FY16 was Cooper’s most profitable year on record, going all the way back 100 years. This past year, the Americas EBIT margin registered 13.4%, a slight dip but still the third highest result on record and well ahead of the 8-10% goal that management articulated. Mind you, that 8-10% goal was introduced at Cooper’s last investor day in May 2014 when times were very different.

While this margin bump impacted all tire companies, it was most pronounced in North America and particularly impacted the LVA segment due to the aforementioned Chinese tariffs. As a result, Cooper was the biggest beneficiary and, of course, is the most exposed to a normalization going forward.

Obviously, “tariffs” and “China” are both dirty words at the moment. However, I would note that the tariffs on Chinese tires remain intact. It’s very unlikely that new or stiffer tariffs are enacted and, even if they are, imports of passenger tires from China are now minimal. In fact, the most recent news (from last month actually) was that the US Dept of Commerce was lowering certain tariffs on Chinese passenger and light truck tires. If this proves true, it’s actually quite negative for Cooper.

Government Lowers Tariffs on Chinese PLT Tires

The other thing that has been helping Cooper is that there hasn’t been any new supply in years. If you go back in time, the North American tire market was struggling in the mid-2000s from overcapacity and, as a result, from 2006-2009 almost 70m units of capacity were taken out of the industry. Since then little-to-no new capacity has been added until recently. As I’ll cover below, that’s all about to change as there’s a significant amount of new supply soon to come online.

The final thing I’d note is that Cooper (in a rather ugly disagreement) lost its main international JV (CCT in China) in 2015. This makes the historical numbers a bit deceiving. At one point, international, and particularly China, was almost 60% of EBIT and the main bright spot going forward (fun fact: at Cooper’s investor day in 2014, the word “China” was called out 46x). Cooper no longer has much of a Chinese presence. It is now trying to rebuild its international business and sell-siders will talk favorably about the recent growth but it’s still an insignificant portion of profits ($9m on $334m in total segment EBIT). North America is ultimately what matters.

Where does this leave us today?

I’d argue that Cooper today is in secular decline and over-earning by a wide margin. What makes this interesting is there are real reasons for this to change over the coming year. What makes this even more interesting is that it’s already playing out in the results but not clearly evident due a host of 1-timers. These non-recurring item, in my view, made this past year (which was already dismal) look much better than it actually was and make modeling this upcoming year a tricky affair.

Let’s first talk about what’s changing. The major change is new supply. At last check, there were 8 different international tire companies adding greenfield capacity in the US, most of which are set to open right about now. This represents ~50m units of incremental supply or a 10-15% bump. Looking at it another way, this is almost equivalent to the same number of units that came out of the industry from 2006-2009. It’s the most pronounced capacity expansion in over 15 years. Modern Tire Dealer puts out an annual fact book and the past two years have run the headlines: “Wow, a 4.6% rise in capacity!” and “62 plants, with more to come!” According to MTD, capacity increased by 4.6% in 2016 and 4.9% in 2017. There’s more to come.

The largest of these new facilities is Hankook’s plant in Clarksville, TN. This facility had its grand opening just a few months ago in October 2017. This one plant alone is expected to produce about 12 million tires once fully ramped. Cooper, by comparison, produces about 30 million tires (and declining) across 4 plants in the US.

The party line according to bulls is that supply additions will be met by new demand. And, Cooper reassures investors by stating in its presentation, “tire supply & demand to remain balanced through 2020.” However, a closer read of that very slide reveals a glaring inconsistency: capacity additions and expected demand increases are only balanced on a global basis. In Cooper’s own slide, capacity additions in North America total 3x the expected demand increase!

Cooper Investor Presentation Slide on Supply & Demand

Source: CTB January 2017 Investor Presentation from the Deutsche Bank Global Auto Industry Conference, page 11

The additional wrinkle here is that most of this new supply is being directed to HVA tires, which is precisely where Cooper is trying to reposition its business without a brand, technology or cost advantage. On the LVA side, while Chinese tires are now nearly non-existent, customers like TBC have found new, low cost substitutes from countries like Vietnam, Thailand and Indonesia. Imports from these countries are up. It’s only recently though that import supply has recovered to pre-tariff levels. So this leaves Cooper between a rock and a hard place; cheap LVA substitutes are re-entering the US market at the same time that significant new HVA capacity is being added, potentially disrupting supply and demand.

If this wasn’t bad enough, raw material prices are now on the rise. Cooper’s raw material index ended FY17 at 158, up 14% for the year and up 20% off the lows in early 2016. That said, it’s still well below the 259 level reached in 2011. This is also evident when you look at Cooper’s LIFO reserve, which was historically 25-35% of gross inventory yet ended FY17 at a new low of 14.7%. As you can see below, the change in Cooper’s LIFO reserve meaningfully benefited its earnings for 4 straight years (from FY12 through FY15) before leaving off more recently. In total, the change in the LIFO reserve added $1.59 to EPS over the past 6 years. With raw materials now seeing inflation, this could turn the other way and become a headwind.

CTB’s Historical Change in its LIFO Reserve

Source: CTB SEC Filings and my estimates

The issue for Cooper is that raw materials are expected to continue their ascent in FY18. The company guided to a modest increase in each quarter of 2018; however, this may prove conservative.

On that note, the analyst at Longbow (who was formerly a bull) put out a report last month downgrading Cooper, citing the current raw material environment as one of the reasons. He makes the argument that Cooper’s peers are forecasting greater raw mat inflation and that rubber and oil have already shown low double-digit sequential increases in Q1’18. He goes on to say, “the worst thing that can happen for 2018 earnings is a greater than expected rise in raw material costs.” If the peer estimates are right, he claims that there could be as much as $140m in incremental raw material costs in 2018. That’s relative to Street EBIT estimate of $252m! If you get the report, it’s worth a read. The fellow at Longbow initiated with a buy in late January and a little over a month later has already lowered his FY18 EPS by 23%. Wow.

In a normal environment, Cooper and its peers would simply increase prices to reflect the rising cost of raw materials. However, much like 2015 and 2016 proved to be abnormal (in a good way), 2018 is shaping up to be abnormal (in a bad way). Attempts to take pricing last year backfired epically. GT went first. Cooper followed. Uncharacteristically though, peers didn’t get in line. If they did, it was later, less aggressively or not at all. A big part of this unexpected behavior is new supply and competitors eager to gain share. Hankook, for example, is on the record saying that they plan to grow their US business 15%. Remember, the market is more or less flat. As a result, both Cooper and GT lost significant share in 2017. Cooper’s light vehicle volume in the Americas declined 10% vs an industry decline of 0.4%.

The other thing going on is that tires sales at retail have been weak, resulting in inventory build up in the channel. Confronted with this headwind, tire companies have been especially promotional to make the next sale. Simply wordsearch “promotion” and you’ll find that it was mentioned 38x in Cooper’s last 4 earnings calls vs 9x in the 4 calls from 2016.

This creates a challenge for Cooper as we enter 2018 because it needs to remain “market facing” and regain share in an increasingly competitive environment. This means that Cooper is unlikely to take meaningful price increases despite ongoing raw material inflation. This could have a significant impact on the business as the net of raw materials and pricing is the biggest swing factor for EBIT. Keep in mind that going back to 2010 (and likely much longer), Cooper has never had a year where both pricing and raws were negative contributors. 2018 might have a fighting chance of breaking that streak.

How bad has it already been?

It’s been bad. 2017 could be rightly viewed as a debacle. But you wouldn’t realize how much of a debacle it really was if you only consume Street research and Bloomberg numbers. By my math, normalized earnings were down 50% in FY17 and 20% lower than what you see in Bloomberg. While the outlook is getting worse, Street estimates, somewhat astoundingly, imply results that are unchanged for the current year.

To appreciate how bad the recent results have been, start with volume. Cooper’s light vehicle unit growth in the Americas has now declined for 8 straight quarters. Total Americas unit growth (inclusive of commercial truck tires) was down 6.3% in FY17 after falling 0.2% in FY16. What’s startling about this is that Cooper has had declining unit growth in the Americas for most of the past 14 years. The only 5 years where unit growth was positive were periods of tariff tailwinds (2010-2012 and 2014-2015). That’s a pretty remarkable statement and supports my argument that Cooper is more than just a cyclical short.

CTB Americas Segment Y/Y Unit Growth

(shaded areas = tariff periods)

Source: CTB SEC Filings

In addition to weak volumes, FY17 saw the beginnings of increased competition and rising raw materials. This seems apparent when you look at the numbers: EBIT of $272m declined 31% on sales that were largely unchanged. The Americas segment, which had been so profitable, saw reported margins decline 350 bps.

It was really much worse though. In Q1’17, Cooper benefited $22m from a reversal of TBR tariffs. In Q3’17, Cooper benefited $39m from lower product liability expense (due to changes in its internal estimates). Both of these items artificially lowered Cooper’s COGS. Offsetting these benefits were $5m in costs from a Tornado and $3m from an ERP write-off. In total, these items benefited Cooper by $53m, suggesting that underlying EBIT was really $219m (down 45%) and EPS was really $2.42. Street models don’t make these adjustments.

We can take this a step further because Cooper also reduced SBC by $10m, pension expense by $3m and cash incentive comp by another $12m. That totals $25m in additional non-recurring benefits, suggesting underlying EBIT of $194m (down 52%) and EPS of $2.11.

Bulls believe that Cooper earned EBIT of $272m and a margin of 9.5%, right in-line with the management guidance of “the high-end of 8-10%.” They gave that guidance though at the end of 2016, before they knew about these 1-time gifts, which they conveniently did not adjust out as results got increasingly worse. In reality, the adjustments above suggest that Cooper missed its own guidance by a wide mark with an underlying EBIT margin somewhere close to 6.8% to 7.7%.

These non-recurring items also point to a broader question about earnings quality. Product liability expense, pension expense and SBC have all been down in each of the past 2 years, flattering the income statement. In addition, DSOs have risen for the past 4 years and increased significantly over the past year. DSIs have shown a similar pattern and it isn’t because of raw materials (the DSI on finished goods has risen y/y for the past 8 quarters). The increases in Q2 and Q3 of 2017 are particularly noteworthy. As you might expect, FCF has soured with Cooper burning $20m in FY17, the first negative number since FY11.

CTB’s Recent Working Capital Metrics

Source: CTB SEC Filings and my estimates

As we head into 2018, things seem to be getting worse for all the reasons I’ve already discussed (competition is increasing, new supply is entering, raw materials are rising, inventory levels are high and sell-out is weak). Despite this, Cooper is guiding to an FY18 margin at “the low-end of 9-11%” (the company doesn’t guide revs or EPS). Bear in mind that due to a change in pension accounting this year, Cooper gets a 100 bps benefit as $28m of expense moves out of EBIT and into other income. So on a like-for-like basis the margin guidance for 2018 is 8-10%...the same as it was last year...and the year before...and...you get the idea. That 8-10% goal was the same target introduced at the investor day in May of 2014. Unsurprisingly, Street is calling for EBIT of $252m in 2018, right inline with guidance and implying a margin of 8.7%.

Meanwhile, if you take the midpoint of the two estimates I offered above, you’ll arrive at $207m in underlying EBIT for FY17. Included in that number is pension expense of $38m, which is now reclassified into other income. So let’s move that pension expense out and call the apples-to-apples number $245m. The punchline is that Street is modeling $250m, essentially flat y/y. This suggests a significant improvement in the trajectory of fundamentals, which should seem unrealistic if you’ve been following along.

A better guess might be an outcome that sees a similar decline to that experienced in FY17. If you exclude the benefits noted above, the underlying Americas segment EBIT margin was really more like 10-11% in FY17, down from 16.9% the year before. My bet would be that the Americas margin contracts even further to something like 8-9% on revs down low-to-mid single digits. This in fact may be generous if the environment gets much more competitive. Recall from the earlier chart that the Americas rarely achieved margins above 8% prior to FY14 and has recorded many more years in the sub 5% column.

In any event, let’s use an 8-9% margin and assume the international business continues to grow. To be more precise, I estimate Americas EBIT of $185-$210m, International EBIT of $20m (up from $9m in FY17) and Corporate of ~$60m. These estimates are apples-to-apples with the old reporting format so we now need to adjust for the upcoming change in pension accounting - this boosts EBIT by ~$30m and reduces other income by the same amount. This should get you to consolidated EBIT of $170-$200m, 20-30% below the Street. Interest and pension expense are each ~$30m. Note that Cooper will benefit (yet again) from lower pension expense in 2018; this is expected to decline another $10m or $0.15/share...don’t get me started (we’ll ignore this for now). Finally, Cooper’s tax rate should be ~25% (down from 32% previously). All in all, this points me to underlying EPS of approximately $1.70-$2.10, well below what the Street is currently modeling at $3.12.

Goodyear, Cooper’s closet peer, currently trades at 7x FY18 EPS and 6x FY19. These are multiples that Cooper has often seen in the past, if not lower at times when it has fallen out of favor. On current Street estimates, Cooper currently trades at 9x this year and 8x next year. Unlike GT, Cooper has slight net cash not counting its underfunded pension. I’m not going to argue for 6x earnings but I think the multiple here is less relevant if you believe that normalized earnings are below $2. Even at 10x EPS you would get a stock price of $17-$21, down 30-45%. A more draconian case of 6-8x would suggest a stock price as low as $10-$14, down 50-70%.

Disclaimer

This report (the “Report”) with respect to Cooper Tire & Rubber (the “Issuer”) has been prepared by the author (the “Author”) for informational purposes only. The Report contains certain forward-looking statements and opinions which are based on the Author’s analysis of publicly available information believed to be accurate and reliable. While the Author believes that such forward-looking statements and opinions are reasonable, they are subject to unknown risks, uncertainties and other factors that could cause actual results to differ materially from those projected. The Author has no obligation to inform readers of changes in such forward-looking statements and opinions and no warranty is made with respect to the accuracy or completeness of any of the information set forth herein.

As of the date the Report is published, the Author and/or certain entities (the “Entities”) affiliated with the Author hold a short position in the securities of the Issuer and therefore have a financial interest based on changes in the price of the Issuer’s securities. The Entities may increase, decrease or otherwise change their position in the securities of the Issuer based on changes in market conditions or other analysis. Neither the Author nor the Entities undertake any responsibility to inform readers of changes in such position.

Nothing in this Report constitutes investment advice.  Readers should conduct their own due diligence and research and make their own investment decisions.

Catalyst

New supply

Increasing promotional activity

Earnings misses and estimate revision