Summary
- A decrease in replacement tire volumes indicates a weakness in consumer discretionary spending.
- High debt is a worry, especially if sales deteriorate further.
- The stock's volatility may offer a better, lower entry point.
- An investment in Goodyear should be considered speculative until the debt burden is reduced.
Goodyear Tire & Rubber Co. (GT) is an iconic American company facing short-term headwinds due to weakness in the replacement market. Consumers have started pulling back on their discretionary spending, which may pressure the company's sales, profit margins, and cash flows in the coming quarters. The company trades at a cheap valuation, and its high debt load may be the primary reason behind it. It may be best for investors to wait for a pullback in the share price to below $10. Investors should not chase this market rally pushing up high-beta stocks such as Goodyear.
Watch growth in sales volumes
The company issued a profit warning on January 27 due to industry-wide weakness, particularly in Europe. The company pointed out that raw material and input costs have declined while wage inflation remained. The company's GAAP gross margins averaged 22.19% (Exhibit 1) over the past decade but, in 2021 but have dropped to 19.8% in the past twelve months. In the September 2022 quarter, the gross margin decreased to 18.9%, a 329 basis points erosion in margins (Exhibit 2) .
Exhibit 1:
Exhibit 2:
In Q3 2022, unit volumes declined by 3% compared to 2021 due to weakness in the replacement market. Price/mix contributed to a $742 million increase in revenue and far exceeded the increases in raw material costs of $204 million. Consumers have become more cautious about their spending as inflation and dwindling savings have taken their toll on spending. The company may have limited success in increasing prices further or selling higher-priced tires since consumers have cut back on discretionary spending. Given the profit warning, the pressure on the consumer, and the weakness in volume growth, the company's revenue growth and margins should come under pressure in Q4 2022.
Many companies in my coverage universe saw lower price elasticities in the past year, where price increases outpaced volume declines. The lower price elasticity surprised the companies and may have emboldened them to institute more double-digit price increases. But, the muted volume declines may be a lagging indicator, with more consumers pulling back on their spending in the wake of sticker shock . In short, the consumer revolt is beginning.
High carrying cost of inventory
The increase in raw material and labor costs over the past year may have substantially increased the carrying cost of inventory for the company. The company carried $4.8 billion in inventory based on the Q3 2022 report (Exhibit 3) , which amounted to 108 days' worth of sales, compared to an average of 81 over the past decade with a standard deviation of 10. This substantial increase in inventory carrying cost may pressure margins in the coming quarters if the company resorts to discounts to sell its products. Similarly, outstanding receivables have also increased over the past year (Exhibit 4) . The increased inventory and receivables have contributed to a substantial decrease in operating cash flow.
Exhibit 3:
Exhibit 4:
Debt is a concern
At the end of Q3 2022, the company had total debt of $8.3 billion and net debt of $7.1 billion (Exhibit 5) , which amounted to a debt-to-EBITDA ratio of 3.7x.
Exhibit 5:
Existing shareholders should understand that Goodyear Tire & Rubber co. is a speculative investment, and any deterioration in sales will have an enormous impact on its ability to meet debt covenants and pay its debt. The company is paying high-interest rates on its debt, with the interest rate as high as 9.5% on Notes due 2025 (Exhibit 6) . The company's debt is rated "BB-" by Fitch, indicating the speculative nature of the investment. But, Fitch says the company's outlook is stable, so that is a positive. New investors should avoid the stock until it gets to $10 or below in price, given the high debt load, lower cash flows, and economic uncertainty.
Exhibit 6:
The stock looks cheap for a reason.
The stock is trading at a forward GAAP PE of 8.3x compared to the sector median of 15x and the company's five-year average of 9.6x. The company is trading at a price-to-sales of 0.15x, an ultra-cheap valuation.
A discounted cash flow model yields a per-share equity value of $7.96 (Exhibit 7) . This model assumes a free cash flow margin (Operating Cash Flow - CapEx) of 3.6%. The free cash flow margin assumption is at the high end, given its standard deviation of 2.5% and an average margin of 1.13% (Exhibit 8) . This model used a conservative revenue growth rate of 2%. The company may grow much faster in the future. An assumption of a 2% growth rate between 2023 and 2027 and a long-term growth rate of 3% yields a per-share equity value of $11.4. Given the high debt load, acquiring shares closer to $10 or below might give investors some margin of safety. The stock is trading at $11.34.
Exhibit 7:
Exhibit 8:
Dividends have become a vital income and return generation tool for investors in this low-growth, high-inflationary environment. But, the company does not pay a dividend at this time, and given its high debt load, it may not be able to pay a dividend soon. The global economy may be entering a period of slow growth for the rest of the decade, and inflation may continue to be a problem.
Astonishing volatility of Goodyear's stock
A linear regression model of the monthly returns of the Vanguard S&P 500 Index ETF ( VOO ) and Goodyear between June 2019 and January 2023 yielded a beta of 1.86. Yahoo Finance has calculated a beta of 1.85 . The company operates in consumer discretionary, a highly volatile sector. The Vanguard Consumer Discretionary ETF ( VCR ) has lost 17.7% over the past year, while Goodyear has 45.7%. The Vanguard S&P 500 Index ETF lost 9.7% over the past year and just recorded one of its most vital months in January 2023 with a 6.4% return.
The positive outlook delivered by General Motors on January 31 lifted the auto OEM sector, with Goodyear rising 5.3% in one day compared to the 1.4% return for the Vanguard S&P 500 Index ETF. The beta of 1.86 indicates that, on average, for every 1% change in the monthly return of the Vanguard S&P 500 ETF, Goodyear is expected to change by 1.85%. The stock's volatility can be understood from the monthly return statistics (Exhibit 9) . In February 2021, the stock returned a mammoth 59%, while at the beginning of the pandemic, March 2020, the stock dropped 39%. The stock has a high standard deviation of 17%, compared to the 5.7% standard deviation of the Vanguard S&P 500 Index ETF (Exhibit 10) .
Exhibit 9:
Exhibit 10:
Much may depend on the strength of the consumer in the coming months. Investors should pay attention to the management's comments about demand trends during the earnings call on Wednesday, February 8 . Goodyear Tire & Rubber Co. may exceed performance expectations if manufacturers produce more cars compared to 2021, consumers return to buying them, and an improvement in tire demand in the replacement market. Investors should be cautious when investing in Goodyear Tire & Rubber Co. Building a small stake when the stock approaches its 52-week low of $9.66 may be more appropriate. It is better not to chase a rally in Goodyear. Given the high volatility of the stock, it may give investors multiple opportunities to buy at a price that offers some margin of safety.
For further details see:
The Goodyear Tire: An Icon In Trouble