India Ratings and Research (Ind-Ra) expects that the incremental tyre demand generated over FY21-FY24 could be insufficient to absorb the new capacities created in the current capex cycle. The overall capacities could be unutilised to the extent of 20%. The agency expects that segment-wise, two-wheeler/three-wheeler tyre capacities will be utilised 70%-75% and passenger car radials 80%-85% by FY24, after factoring in the additional capacities under set-up/ramp-up.

The truck and bus (T&B) segment capacities are expected to be utilised 65%-70% by FY24. While the segment has seen a weak demand from original equipment manufacturers, the more resilient replacement market is likely to provide support.

Ind-Ra's analysis is based on the capacities of the top five listed tyre industry companies, namely Apollo Tyres ('IND AA+'/Stable), CEAT ('IND AA'/Stable), JK Tyre & Industries ('IND A-'/Negative), MRF and TVS Srichakra ('IND AA-'/Stable).

Ind-Ra believes that successful implementation of the scrappage policy would benefit the tyre sector, particularly the T&B segment. Given the shorter replacement cycle for T&B tyres, fleet owners could be encouraged to scrap older vehicles, which would increase the utilisation of existing vehicles, as well as lead to the subsequent purchases of new vehicles, thereby supplementing the replacement demand.

However, structural changes such as work from home, even after the COVID-19 outbreak is settled, and significant push towards public transport spending for managing pollution levels could dent the replacement demand, particularly in passenger car radials and two-wheeler tyres. As over 50% of the demand comes from the replacement market in these segments, the utilisation of the additional capacities could take longer than expected. The industry is operating with an all-time low asset turnover and return on capital employed ratios, which could sustain for some time in this scenario. Lower profitability on account of constrained operating leverage could extend the deleveraging process, and hence, impact the credit ratings.

The tyre companies have undertaken an aggressive capex cycle over FY16-FY20. As a large part of the capex is debt funded, their leverage metrics moderated in FY20. Ind-Ra expects the leverage ratio to remain elevated around 2.5x over FY21-FY22 as the ramp-up of these facilities would still take time and due to lower profitability amid subdued demand conditions over FY20-FY21 and lower operating leverage. However, as a large part of the capex cycle has been completed, the metrics should start improving from FY23. While some players have deferred part of the capex by one to two years due to a demand slowdown, the overall capex intensity is likely to remain low in forecasted years.

The tyre industry is insulated to an extent from the cyclicality observed in auto sales due to its reliance on the more stable replacement market. While sales to original equipment manufacturers declined 16.3% year on year in FY20, in line with the decline in auto industry volumes, the replacement market sales declined by a modest 2.6% over the same period. The replacement market share also increased to 58% of the overall domestic tyre sales volumes in FY20 on the back of the decline in OEM sales.

Ind-Ra expects a mid-single digit decline in the tyre industry volumes, despite a sharper decline of 20%-25% in OEM volumes as the replacement market, would continue to support the industry. The overall industry could also benefit from any further restriction/duties on imported tyres.

Ind-Ra expects the tyre sector revenue to recover in FY22, supported by a better demand from both OEM and replacement markets.

In 2QFY21, the top five tyre companies recorded exceptional EBITDA margins, aggregating about 16%, on the back of stable rubber prices as well as crude oil prices and related derivatives tracking below a year ago levels. However, natural rubber and carbon black prices have started increasing from September, and hence, the profitability is unlikely to recover to the levels seen in 2QFY21 in the following quarters.

Overall, Ind-Ra expects EBITDA margins to moderate year on year in FY21, due to an inflationary trend in raw material prices in 2H as well as the lower profitability recorded in 1QFY21.

In the medium-to-long-term, however, Ind-Ra expects the margins to benefit from the economies of scale, product diversification, and increasing share of radial tyres, though the extent of the benefit would be subject to the volatility in raw material prices.