Tires and the Trade War

 
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Asian Markets

A Glance Back at Asian Markets

The trade conflict between the United States and China has been at the forefront of a year of global financial volatility. As most Asian nations are export-focused economies, trade disputes between key players strongly affect the performance of markets.

An example of this volatility can be seen in the MSCI Asia Pacific, which since March 22, 2018 has decreased by 4.7 percent, compared to the 6.7 percent increase of the MSCI World Index, an index that represents the world’s most developed economies.

 
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Considering the current trade war circumstances, it appears to be difficult to uncover profitable opportunities, with poor returns for Asian investments in the last few previous quarters. This stagnant marketplace has raised many concerns for investors, who are unsure of how to move forward with investments in the region.

Despite this, our proprietary Capital Deployment Index — which tracks the allocation of capital across the Asian region between various countries and industries — has shown massive return opportunities in the past, allowing us to find opportunities when there seemingly are none...

South Korean semiconductor manufacturer SK Hynix (South Korea; ticker: 002350), our January 2019 stock pick, exhibits just this. They have been able to successfully increase their exposure in the US market as a result of the US-China trade war.

SK Hynix has strongly outperformed the South Korea Stock Exchange Index in the three months since publishing our recommendation. As of April 9, 2019, SK Hynix’s price has increased by 26.6 percent, compared with the 8.1 percent growth of the South Korea Stock Exchange Index.

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Our March Findings

We began by asking ourselves one simple hypothetical: "If the trade war were to end in favor of the United States, which country would benefit most from a reduction of Chinese imports to the U.S".

Based on the raising of capital over time, we believe that South Korea is an interesting option and can strongly benefit from the potential of a changing paradigm, followed by Japan.

Over the previous four quarters, South Korea has made strong efforts to raise capital, amounting to a total of KRW43 trillion (US$38 billion).

This capital increase in South Korea has highlighted many South Korean industries that are experiencing a period of debt increase. It is these industries that we believe are poised to benefit over the next few years.

Our proprietary CDI model has signaled that the Consumer Discretionary sector, led by the automobile industry group, has been strongly benefiting from this increase flow of debt.

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Based on AmCham’s China survey, this sector has seen strong blow-backs from the U.S.-China Trade War, with an initial US$50 billion of tariffs on automobiles levied from both China and the U.S. However, South Korean companies have been positioning themselves to capture the opportunities that this division has provided.

The tire industry, a leading group in this sector which has been increasingly raising capital, intends to expand their share of the U.S market. Considering that South Korea is one of the top largest exporters of tires to the U.S, they already have the infrastructure and market share in place to capture the ongoing market shift.

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South Korea and Japan have leading tire manufacturing companies in this industry, despite less abundant raw materials than competitors such as Thailand and China. Instead, the development of the tire industry in these two countries is attributed to a robust auto industry, which exports more than 50% of manufactured automobiles.

We believe that South Korean tire companies are positioning themselves to further ramp-up their tire exports. We found that the majority of listed tire stocks in South Korea have strongly increased their long-term debt in 2018, yet their counterparts in China and Japan have significantly decreased.

The decrease in long-term debt has demonstrated their corporate expectations about the future.

Industry Macro

Why this Industry Matters

In the context of the trade war, Chinese tire products will be among the items receiving the harshest tariffs from the United States, if the U.S. wants to ramp up their current tariffs on China. History has shown that tire imports are often one of the top priorities for the U.S. to consider for new tariffs.

Before the announcement of a temporary hold on tariff increases in late February 2019, the U.S. had planned on increasing Chinese tire import tariffs from 10% to 25%. If this were to be put in place, this high tariff will force U.S. dealers to seek out other suppliers in order to sustain their price competitiveness.

History has shown that South Korean tire manufacturers will stand to benefit the most from additional U.S. tariffs on China.

 
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President Obama’s 2009 decision to levy a tariff of up to 35% on Chinese tire imports resulted in Chinese tire imports significantly decreasing.

In response to a potentially strong levy from the Trump administration on Chinese tire exports, many Chinese tire manufacturers have cut their expansion plans for the years to come. This has been reflected by a reduction in long-term lending in domestic Chinese companies.

This is also traced in the Japanese tire industry, with a pessimistic expectation being displayed by manufacturers. Yet despite this, South Korean manufacturers have strongly increased their expansion.

It is therefore a good time to purchase South Korean tire stocks and, coupled with a strong decline last year, these stocks will be in a good position for pricing.

The Advantages of the South Korean Tire Industry

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According to data from the Korean Tire Manufacturers Association, Kumho Tire ranked No.1 with sales of 6.52 million tires in 2018, accounting for 40.6 percent of locally produced tires sold in the country.

This was followed by Hankook Tire and Nexen Tire with 35.3 percent and 24.1 percent, respectively. These top three tire manufacturers account for more than 90% of the domestic market.

Most tire manufacturers in South Korea have been expanding their business abroad, spurred on by fierce local competition. By diversifying geographical distribution, companies can better mitigate global demand risk. An effective way they’ve found for entering markets is by partnering with leading automobile producers locally, allowing South Korean manufactures to establish strong foothold in new frontiers.

An important review factor is the breakdown the revenue of companies that play a key role in the tire industry. Hankook, has only 15% of revenue drawn from domestics, as opposed to Europe’s 32% and North America’s 28%. Nexen has a diversified revenue stream as well, with South Korea’s domestic market accounting for only 12%, while pulling in 22% from Europe and 21% from North America.

Another strength of the industry is the capacity for scaling and high-quality production. Given the fierce competition in the local tire market and the need to supply tire products for local auto manufacturers, the three main tire companies must produce high quality and advanced technology tires in order to stay current and competitive.

This allows the operating margin for South Korean tire companies to be higher than those of other global competitors.

 
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Our Stock This Month

Nexen Tire Corporation

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Nexen Tire (002350 KS Equity) is the third largest tire producer in South Korea. Established in 1942, the company operates three manufacturing plants — two in Korea and one in Qingdao, China. A new plant in Zatec, Czech Republic will begin initial operations during the first half of 2019.

Nexen Tire’s Changnyeong, South Korea plant has been recognized as one of the most advanced, state-of-the-art tire manufacturing plants in the world with an annual output of 12 million units. Plans are in progress for a tire plant in North America with a production start-up goal of 2021.

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Nexen currently exports tires to about 150 countries through approximately 500 global dealers, allowing a deeper and more sustainable global market penetration. In the past five years, they have sustained a stable income stream year-on-year.

Among all tire companies in South Korea, Nexen has demonstrated a strong increase in debt deployment in 2018, with a nearly 50% increase in long-term debt when compared to 2017.

Nexen has sparingly deployed its capital in the past five years. Yet every time they have done so, we have seen an improvement in return on capital. In 3Q2014, they successfully increased capital by KRW224 billion, with return on invested capital in that time reaching 7.3%. In the next 2 years, they increased quarter-on-quarter basic to 12.3%.

After reviewing the price announcement for tire manufacturers, we discovered that most of the firms have increased their selling price since September 2018. For Nexen, this is an increase of 6 percent for passenger and light truck tires to the United States.

One note is that most of the increase happens to be in North America, which is bearing a strong brunt of the new tariff regime’s ramifications on prices. Provided that Chinese tire products have had a 25% import tariff since early 2018, the price increase from other manufacturers are still quite minimal.

With China as the top tire exporter to U.S. market, this strong tax imposition is creating increased opportunities for manufactures from other nations in terms of market share and profit margin.

The local tire industry in the U.S. can’t make up for the shortfall of Chinese imports, as local production is already at near-full operational capacity, which opens further opportunities for competitors from countries that are unaffected by the trade war.

 
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Recent tire price increase announcements

 
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Competitive Advantage

Nexen Tire has enjoyed sales growth in major markets including the United States and Europe, while refining product competitiveness thanks to continued R&D investment. All of this has happened despite the global economic downturn, the shrinking of the automobile market and fiercer competition among tire manufacturers.

 
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At the same time, the company has increased its efforts to ramp up exports, while employing various marketing strategies based on region.

In the meantime, Nexen Tire integrated and transferred its R&D center and sales division to Germany in September, and plans to continue to boost its sales by strengthening its global competitiveness by building a large new R&D center in the U.S., and a slated mid-2019 opening of a factory in the Czech Republic, which will give them direct open market access to the EU.

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Morever, Nexen has maintained a stable cash flow for many years, which allows them to better serve their debt obligations. Debt service ratio has been also kept at a very safe level.

Nexen can control its ability to payback debt as well. The relationship of total debt to the debt to EBITDA indicators shows a range from 1.5 to 5, which are positive indications of its debt payback capacity.

 Compared to its two main domestic competitors, Nexen has grown at a much faster pace in the past 10 years. As you can see in the below chart, Nexen’s assets growth is always higher than its peers, remaining stable when others have been volatile.

Investment Case

Czech plan’s operation is a turning point

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Coming online this year, the Czech plant is expected to boost Nexen’s long-term growth potential by increasing the firm’s production capacity and strengthening its foothold in Europe.

Since its latest update, Nexen tire Europe is awaiting permission from “appropriate authorities” to start trial production at its greenfield manufacturing plant in the Czech Republic.

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The diversification across geographical locations could help Nexen mitigate the macro uncertainty stemming from a possible slowdown in global tire demand. Output and sales at the plant are expected to reach 2.5 million units for 2019.

The successful ramp-up of their Czech plant will generate similar levels of OPM to that of Hankook Tire's Hungary plant.

Strong exposure from the demand shift in the North America market

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Sales in North America surged 19.3% YoY in 3Q2018, while domestic sales slid -10% due to fierce competition and declined car production volume. The European market maintained a steady growth of 3%. Given this prospect, North America is expected to be a new growth engine in years to come provided that Chinese tire items are still in the top tariff category.

Supported by the rubber price

The rubber price has a big effect on the price of tires. After a long period of price decline, tire production prices have steadily recovered since early 2017. This allows key players to mitigate price increase problems, while simultaneously allowing flexibility on international sales prices.

Attractive valuation

Nexen has been trading much below its competitor Hankook Tire, as well as the top three global tire companies. Provided its stable cash flow model, Nexen is quite under-priced, with one of the lowest P/E ratios in the industry globally – around 8 compared to the global average of 11.6.

Since the release of its last financial statement in March, Nexen’s stock price has surged compared to its peer companies in the industry such as Hankook and Kumho.

How to Invest

Key risks

Prolonged Competition in the Domestic Tire Market Could Cool

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The South Korean tire market is considered to be an oligopolistic market, dominated by the top three companies mentioned earlier. This competition is quite heavy, as they compete with each other for the same local market.

However, as we have seen, competition will be less intense following the forecast expansion plan being enacted by several South Korea automobile manufacturers. This could mitigate some risk incurred when investing in Nexen tire stocks.

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FX volatility could affect the top line

Given more than 70% of revenue of Nexen comes from export sources, the reliance of the Korean won against foreign currencies could negatively affect the bottom line, if volatility occurs.

The chart below shows how FX movements have affected the stock movement of tire manufacturers in the past.

Given the recent stability displaced by the KWON currency over the last few we years, we can safely say that FX risk is unlikely to be a significant factor in the upcoming period.


Target Price

The financial burden driven by increased debt, however, appears priced in, while the diversification of production and sales will help Nexen reduce regional demand risks in the long-run. Its solid expansion in the European market reduces capacity ramp-up concerns. The company’s long-term growth prospects remains intact, which leads us to propose a buying recommendation.

We recommended NEXEN TIRE CORPORATION (South Korea; ticker: 002350 KS Equity) for the next three months.

Based on the company’ growth prospects after the launch of their Czech plant in 2019, we estimate the target price for Nexen to be around KRW14,000, offering an upside of around 27% of the current price of KRW11,000 as of 12th April.

 
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Guidelines for Purchasing

  • Symbol: KRX: 002350

  • How to buy: Local broker required

  • Exchange: Korea Stock Exchange

  • Dual listing: None

 
Peter Pham