Management Speak: Apollo Tyres (Neutral) - R&D thrust – key advantage; spends to rise

We present key takeaways from our visit to Apollo Tyres’ (APTY) global R&D centre in Chennai. This is the company’s second R&D centre (the other  in Netherlands focusses on the passenger car segment). We see APTYs R&D thrust as a key advantage but also expect R&D spends to rise, going forward (R&D spend rose at a CAGR of 23% over the past 5 years).

• Regulations in Europe and India to tighten: Tyre-related regulations in Europe are getting more challenging, with norms related to rolling resistance, wet grip and noise levels gradually tightening (Exhibit 1).While these regulations are currently being applied only in Europe, the company believes these norms will soon be followed in India too. Further, BSVI norms will require low resistance tyres suited to Indian conditions. The challenge is in meeting these norms at minimal cost.
• Focus on electronics and new compounds: The role of electronics in tyres has been gradually increasing. If autonomous vehicles were to become popular, electronics would play a meaningfully increasing role. While APTY is slowly raising capabilities here, for example the company is developing a tyre, which calculates and relays pressure on real-time basis (likely launch in Sep 2019), it is also focussing on developing new, greener (less of oil-based components) materials. For instance, it is looking at Silica to replace/combine with carbon black.
• R&D expenses too could rise apart from the above factors: APTY's R&D process require it to balance various conflicting criteria. For example, the company has to match fuel economy requirements while meeting performance standards. Shortening product cycles and experiments with new materials add to the complications. As a result, absolute R&D expenses could continue to rise, going forward (Consolidated R&D spends rose from 0.9% to 2.1% of sales during FY13 -18).   

Maintain Neutral with a target price of Rs220: APTY is admirably gaining market share in the TBR segment, but faces pressures from a downturn (Q4 India volume growth likely in single digits, while Europe could decline) at a time when it is ramping up capacity. FCF will likely remain negative, as capex remains high with the company expanding capacities in Europe and India. APTY’s pricing power in the increasingly important European market could be tested. Maintain Neutral. TP of Rs220.