Balkrishna Industries – Can The Compounding Machine Continue? – The Curious Investor

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Summary 

  • BKT has been a phenomenal wealth creator (36% CAGR i.e. 22x over last 10 years)
  • It operates in the Off-Highway Tyre (OHT) segment, which has low growth prospects but is a moderately attractive industry to be in because of the high entry barriers 
  • The company has delivered strong operational performance over the last decade with good growth in revenues and profits, stable and improving margins, strong returns on capital. 
  • At the same time it has increased its market share in the global OHT market from 3.5% to 6% over the last decade   
  • Its moats include low cost manufacturing (in a very labour intensive industry) and a strong distribution network 
  • The management has shown restraint with capital allocation, has never stretched the balance sheet with too much debt, has engaged in timely capacity expansion and engaged in capex to deepen its competitive advantage
  • The risks to BKT include sustained low global growth and commodity price risk 

Introduction 

Balkrishna industries (BKT) is a producer of “Off-Highway tyres” (OHT) that are used in sectors such as agriculture, construction and mining. The company has four manufacturing units in India with a production capacity of 300,000 MT. It is a primarily export oriented business, with 80% of its sales being generated through exports (51% from Europe and 17% from North America in FY20). Its key strength is its low cost manufacturing capabilities that has allowed it to capture a market share of 5-6% in the global OHT market.  

Industry analysis 

OHT demand is cyclical and linked with global economic growth 

The global tyre industry is valued at ~$150bn. OHT is a subsegment of the overall tyre market and generates sales of $13-$15bn annually. Whereas most of the tyre demand comes from passenger vehicles (2-wheelers, 4-wheelers) and commercial vehicles (eg. trucks), OHT is a niche segment that constitutes tyres used in agriculture, construction, mining and earthmoving. The tyres are characterised by their large size, rugged nature and requirement of having to operate on uneven terrains. OHT demand is cyclical and linked with global economic growth. For instance the demand contracted in 2009 and between 2012-2016 when global GDP growth was poor. However, over longer periods of time OHT demand has grown 2-5% per annum, driven by growth in agriculture, construction and mining activities.  

The market can be divided into Agri vs OTR segments and OEM vs Replacement segments 

Agriculture tyres account for ~30% of the global OHT market where as Off-The-Road (OTR) tyres (which comprises industrial, construction and mining applications) comprises ~70% of the market. The agriculture market is less cyclical and more correlated with crop prices, farm incomes and weather conditions. The OTR segment is more cyclical and is impacted by construction and mining activity. 

The market can also be divided between OEM (Original Equipment Manufacturers) and replacement sales. OEM constitutes sales directly to manufacturers of equipment for the agriculture, construction, mining sectors. Replacement sales constitutes sales to end users that purchase tyres after their original tyres get worn out. OEM sales for OHT manufacturers are a function of relationships with OEMs, product approvals and sales of equipment. Replacement sales are driven by replacement cycles of the tyres (typically 2-3 years), distribution reach of OHT manufacturers and brand building efforts. Typically there is a 50-50 split between OEM and replacement for large OHT manufacturers 

The Industry is fairly consolidated with the top 8 players accounting for ~85% of the global market share

The largest players in the OHT industry are Michelin, Bridgestone and Titan International, which together account for ~54% of the market. BKT has a ~6% share of the market, making it the sixth largest player (as of 2018). Small unorganised players constitute 15% of the market. 

Structural attractiveness – The industry is moderately attractive (relatively high barriers to entry but increasing competitive intensity) as assessed by the Porter’s five forces framework

Company analysis 

BKT has delivered robust operating performance over the last decade 

Colours indicate whether I think the metrics are strong, average or weak; Abbreviations: CAGR= Compounded Annual Growth Rate; EBITDA= Earnings before Interest Tax, Depreciation, Amortisation; PAT= Profit After Tax; EPS= Earnings Per Share; CFO= Cashflow From Operations; ROTCE = Return on Tangible Capital Employed; ROE= Return on Equity
Source: S&P CAPITAL IQ
  • Revenues have been cyclical but have grown faster than the industry and shown a healthy 12% CAGR over the last decade 
  • This has allowed BKT to increase its market share in the OHT market from ~3.5% in FY11 to ~6% in FY19. The management is targeting a market share of 10% in 3-4 years. 
  • EBITDA margins reflect the underlying volatility in commodity prices. Yet, they have been steady and gradually improving caused by lower commodity prices, backward integration efforts and improving operating efficiencies.  
  • CFO/EBITDA ratio has averaged >70% for the last decade and >80% for the last 5 years, indicating that a large part of BKT’s profits are being converted to Cashflow 
  • ROTCE and ROE have averaged 20% over the last decade and have remained fairly stable, which is comfortably above the cost of capital. This is an indicator of the capital efficiency of the business and its high quality. 
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BKT’s moats are its low-cost manufacturing setup and wide distribution network 

  • Low-cost manufacturing setup: OHT is a labour-intensive industry and labour costs constitute 25-30% of revenue for leading players like Michelin and Continental. For BKT, this is just 5% given that its manufacturing facilities are in India. This allows it to price its products lower than competitors and still maintain its margins. 
  • Wide distribution network: The company’s distribution network is spread across 160 countries. It has a wide product range of 2,700+ SKUs to cater to the diverse needs of different markets. A well-functioning, wide distribution network along with after sales service is something that will be difficult for a new entrant to replicate. 

BKT should be able to grow revenues and profits by 10-15% CAGR over the next 10 years

Given BKT’s strong historical performance, I believe there are likely to be four drivers of revenue growth for BKT over the next 10 years:

  1. Moderate growth in market size (likely to grow volumes by 2-4% CAGR)
  2. Market Share growth (likely to add additional 3-4% CAGR to volumes): I am expecting BKT to increase its market share from 6% to 8-9% in 10 years, which is lower than management’s target of achieving 10% market share in 3-4 years
  3. Price hikes (likely to add 2-3% CAGR to revenues): Price hikes would be in line with global inflation. BKT is also steadily reducing the price differential between itself and competition, which could allow moderate price hikes
  4. Depreciation of India’s currency (likely to add 2-3% CAGR to revenues in rupee terms)

Adding all these sources of revenue growth, BKT should be able to grow revenues by 10-15% CAGR over a period of 10 years. I believe this is a reasonable base case scenario with potential risks to the upside (for instance if BKT is able to capture a higher market share or if India’s currency depreciates more significantly). While the near future looks uncertain because of the global slowdown, I believe that over a decade, we should see at least one cyclical upturn and hence, we should be able to see 10-15% CAGR revenue growth over a longer period of time. 

For the last couple of decades, BKT was largely focused on the Agriculture segment and the replacement market. BKTs market share in Agriculture is estimated at 10% and in OTR at 2%. In 2018 and 2019, it had become the leading player in the agriculture replacement market in the US (>20% market share). It has recently started focusing on the OTR segment and deeper penetration into OEMs, which are likely to be growth drivers for the company going ahead. A substantial part of the recent capacity expansion has been dedicated to the OTR segment and it has introduced new products in the segment. 

On margins, I think there are risks to both sides. A rise in commodity (rubber, crude) prices over the medium-long term are likely to erode margins. But here, BKT’s backward integration is likely to hold it in good stead, exposing it less to commodity cycles. Further, BKT is currently operating at <70% capacity utilisation and over the medium term as volumes grow and utilisation improves, operating leverage is likely to help improve margins (i.e. costs are unlikely to increase as fast as revenues because some costs are fixed). Hence I don’t find any strong reasons to project margin increases or decreases. 

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Management analysis 

The management has a good capital allocation record

Source: S&P CAPITAL IQ

The management has engaged in timely capex to increase capacity (when utilisation levels have crossed 70%). They have never stretched their balance sheet by taking on too much debt. They have funded capex through internal accruals and manageable levels of debt. 

The company has a history of taking only moderate levels of debt for capital expenditures and promptly repaying them with internal accruals. After taking on debt to fund the FY12-15 capex cycle to increase capacity, the company promptly brought down net debt levels to ~0. In fact, the current capex cycle (FY19-21) has largely been funded through internal accruals (with no net debt). I view the conservative approach towards debt in a cyclical industry as a positive as it will help the company survive any protracted downturn in the global economy.

The capital expenditure has been done to 1) increase capacity to keep up with demand and 2) backward integration (carbon black plant), which will help it improve margins.  The company has not moved out of its strong areas (there have been no unrelated acquisitions/expansions). It has grown organically and capex has been aimed at deepening its moats (low cost production).  As its capex cycle comes to an end, it will be important to look out for how management chooses to deploy the cash flows the business generates. The strong track record of the business is also indicative of management’s competence. The promoters are a part of the company’s leadership and own >58% of the company. They have not decreased their shareholding for over a decade, indicating that the interests of the management/promoters is likely to be aligned with that of minority shareholders.  

Source: S&P CAPITAL IQ

Valuation 

I haven’t done any detailed financial modelling but have used more of a back of the envelope calculation to assess what returns an investor could potentially expect entering at the current levels (at INR 1308 per share on 7 July 2020)

Source: S&P CAPITAL IQ

We can see the following trend from the BKT P/E ratio over the last 15 years

  • Hit a high of 38.2 in Jan 2006. It steadily decreased thereafter to hit an all-time low of 2.2 in March 2009. 
  • It largely stayed between 5 and 15 from May 2009 to Sept 2016
  • After breaching 15 in Sept 2016, it went up to a high of 37.4 in Aug 2018 and subsequently fell to 15.3 in March 2020
  • On July 7 2020 it was 26.5
  • The 10-year average has been 15.6 and the 5-year average has been 21.3

The below table shows the sensitivity of the stock price after 10 years to the EPS CAGR over 10 years and the exit P/E multiple:

The above table suggests that depending on BKT’s earnings growth over the next decade and the exit multiple, in 10 years BKT’s share price could be anywhere between INR 1,067 and INR 11,067 – an incredibly wide range. Based on my assumptions, INR 2,060 – INR 4,417 might be a more reasonable range to expect.

Assumptions

  • EPS CAGR of 10-14% is reasonable
  • An exit multiple of 16-24 is reasonable. This is at a slight premium to the historical multiple that global tyre companies and BKT has traded at

This means that the stock price would be INR 2,060 – INR 4,147 in 10 years. From the Current Market Price of INR 1,308, this translates into a 4.6% – 12.9% per annum share price appreciation over 10 years. The current dividend yield is 1.5%, which can potentially increase to 2-2.5% as profits rise, the company’s capex program comes to an end and it decides to release its Free Cashflows as dividends. Hence, under reasonable circumstances an investor could earn 6.5%-14.5% returns per annum over a decade. However, do note the wide range of possibilities that exist.  

  • Commodity price risk: Increase in prices of key raw materials (rubber and crude oil derivatives) poses a major risk to profitability.  
  • Sustained low global growth: In the short term, global growth is likely to remain slow and OHTs are likely to see slow volume growth and limited pricing power. Rising fixed costs due to completed capex could be a drag on BKT’s financials (margins and return ratios) in the near term. A major risk to BKT is sustained low global growth, if the world takes much longer to recover from the pandemic and its after effects. 
  • Potential saturation in market share: BKT is already a market leader in the agri replacement market in the US and Europe. It is unlikely that it will be able to substantially grow its market share further in this space. The company is now focusing on improving its share in the OEM and OTR segments. While initial trends have been positive, investors need to watch out for whether BKT is able to replicate its success in the agri replacement market.
  • Increased competitive intensity (entry of Indian players and acquisition of emerging market players by global tyre companies)
  • De-globalisation and protectionism (moves by US and European countries to prevent imports) 
  • Inflation in India and erosion of moat of low cost of production 
  • Deviation from core strategy: Any expansion that erodes BKT’s moat or a move into an area where management doesn’t have demonstrated competence could be a risk. The management had announced plans to launch a production facility in the USA, which has been put on hold. Starting production facilities in the US may erode BKT’s core competitive advantage of low cost manufacturing. 
  • Strong de-rating of the stock: If one or more of these risks plays out together, it is possible that the stock is pushed back down to single digit P/E multiples (like it has in the past), which would cause significant capital erosion for an investor. 
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Conclusion

There is little doubt about the fact that BKT has had a phenomenal run over the last decade. It has achieved good growth, stable/improving margins, shown good return ratios while maintaining its moat of low cost production. This has been reflected in its share price appreciation. Although investors must ask themselves whether this has already been priced into the current share price and what expectations are implicit in the current price.

Key Questions for Investors

Below are some key questions that are difficult to answer but one that investors should try forming an opinion about as it is likely to affect the long term prospects of BKT:

  • How long will the Covid-19 induced global economic slowdown last and what will be its impact on the demand for OHT tyres?
  • Will BKT be able to replicate its success in the Agri replacement market and grow market share in the OEM and OTR segments?
  • How will the increased competitive intensity in the market play out? Will it erode BKT’s moat?
  • What is likely to be the trend in commodity prices and how will it impact BKT’s margins?

Here is my excel sheet with the calculations I’ve done to get the metrics & charts above:

Please note that this is not investment advice. I am not a financial advisor. Please do your own research or consult a financial advisor before making any investment decision. Please assume that I have a position in any stock that I write about. 



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Purav Shah
Purav analyses a company/sector and ends by asking the key questions that are likely to determine the success of the investment. He tries to answer these questions and decides that they should go (in the words of Charlie Munger) in the “too hard (to answer) pile”.
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