Termination of Cooper deal a positive: Our negative stance on the Cooper Tire acquisition was the primary driver of our Sell stance on Apollo Tyres. We believed this acquisition to be overleveraged (the combined entitys debt level would have increased by nearly 9x to $2.8 bn) and aggressive (acquisition EVenterprise value--of Cooper Tire >2x that of Apollos). Even one bad year of operations could have severely hampered Apollos ability to service the interest as well as the principal repayments.
Benign rubber prices to aid margin: Rubber prices remain benign (prices down 10% in the last six months). As a result, we expect margin to remain strong (consolidated Ebitda margin at 12.7% in FY14 and 12.5% in FY15 vs 11.4% in FY13). As a result, despite muted top-line growth (4% over FY13-15), we expect healthy net earnings CAGR (compound annual growth rate) of 16% over FY13-15.
Significant capex/acquisition remains the key negative risk: We expect Apollos existing operations to generate FCF (free cash flow) of R18 bn over FY14- 15, due to strong CFO (cash flow from operations) generation (R26 bn) and limited capex. This is likely to result in net debt-equity coming down from 0.7x (end-FY13) to 0.2x (end-FY15). However, any management action to substitute the Cooper deal with significant capex/acquisitions remains a key risk to our stance/valuation.
Valuation: Our revised DCF (discounted cash flow) model yields a fair valuation of R125/share, (using a WACCweighted average cost of capitalof 14% and terminal year growth rate of 3%), implying 7.5x (times) one-year forward net earnings and an upside of 23% from the current market price. The implied P/E (price-earnings ratio) is at around 20% discount to that commanded by MRF but in line with the historical average P/E commanded by Apollo Tyres.
Cooper Tires indicated it will pursue breakup fees ($112.5m) and other damages against Apollo Tyres. Given the partial ruling in favour of Apollo Tyres by the Delaware Court of Chancery in October 2013, we believe Apollo Tyres is on a stronger footing in its dispute against Cooper Tires. As a result, we have not factored in the break-up fees/damages to be paid by Apollo. In case Apollo Tyres is liable to pay break-up fees of $112.5m, the fair valuation per share drops to R111/share, implying 10% upside to the current market price.