Tire dealer watch list for 2014
While tire prices remained calm, there were enough elements stirring the waters to keep the tire industry rocking in 2013.
First, there was the proposed purchase of Cooper Tire & Rubber Co. by Apollo Tyres Ltd. Then there was the flood of tires from China following the removal of Tariff 421 in late 2012 (and their effect on the market). And there was anticipation on whether or not customers would finally release the pent-up demand for tires and auto service while continuing to recover from the recession.
For insights into what happened in the tire and automotive service industries in 2013 and what to expect in 2014, Modern Tire Dealer turned again to tire industry analyst Nick Mitchell.
Mitchell works for institutional equity research firm Northcoast Research Holdings LLC in Cleveland, Ohio. He joined the company in April 2009 as a senior vice president and equity research analyst. He now covers several segments, including the tire and automotive aftermarket.
He has received awards from the Wall Street Journal and Financial Times that recognize the performance of his investment recommendations.
Mitchell began his financial career at McDonald Investments Inc. in Cleveland, where he was an investment consultant within the firm’s brokerage division. He holds the Chartered Financial Analyst and Chartered Market Technician designations.
MTD: What do you see as the defining moments in the tire industry in 2013?
Mitchell: Besides the ongoing drama between Cooper Tire and Apollo, the most notable trend in 2013 was definitely the flood of tires from China. This phenomenon clearly drove the improving trend in Rubber Manufacturers Association (RMA) shipments and pressured unit volumes of manufacturers that concentrate on the bottom half of the Tier Two category.
MTD: Through your conversations with tire dealers, what is their attitude about business going forward?
Mitchell: Most of the retail players who I have spoken with over the last two months noted that they expect light passenger unit volumes to increase 1% to 3% in 2014, which would be a modest step up from the consensus opinion that volumes were flat to up 2% in 2013. Interestingly enough, the dealers who I spoke with at the end of 2012 indicated that volumes would likely range from a 1% decline to a 1% gain in 2013. That means the collective mood among the installer community was a little brighter heading into the holidays in 2013, and I can assure you that everyone has their fingers crossed in hopes that Old Man Winter will bring cold temperatures and lots of snow this year.
MTD: In 2013, we continued to see wholesalers getting larger by buying up smaller wholesalers. Will that trend continue?
Mitchell: Absolutely. As long as there are folks willing to sell their distribution businesses, there will be a short list of buyers eager to bid on those assets. Large synergies can be gained through scale when it comes to distribution, and fitment proliferation is a growing problem for the smaller, and often less well financially capitalized, distributors. As a result, I see no end in sight for the consolidation trend.
MTD: What were the U.S. replacement shipment highlights in 2013 vs. 2012 for passenger tires?
Mitchell: There was a nice recovery in shipment trends in 2013 with volumes up 3% to 4% through the first 11 months of the year. The recovery was led by stronger import trends, largely from China.
MTD: How about replacement shipment highlights for light truck tires?
Mitchell: Light truck tires were fairly stable in 2013, with volumes approximately flat through November.
MTD: And for medium truck tires?
Mitchell: Demand for medium truck tires performed the worst, as volumes were flat to down 1% headed into the final month of 2013.
MTD: There was a lot of pent-up demand for tire purchases in 2013. Are consumers still putting off buying tires?
Mitchell: Despite the modest improvement in volumes in 2013, consumers are still reluctant to spend money on tires unless they need to. Similar to last year, dealers continue to say that their internal data suggests that the average tire coming off the road today only has 2/32-inch of tread, which is well below the historical average of 4/32 to 5/32. As a result, dealers continue to note that they expect to see some of the pent-up demand to make its way back to the market over the next 12 months.
The one caveat is that the enthusiasm behind this thesis has been tempered slightly over the past 12 to 18 months as some folks think that the recovery will be very gradual without the market ever really experiencing that one-time snap back in volumes that everyone has hoped for since the onset of the Great Recession.
MTD: What is the state of dealers’ and manufacturers’ inventory levels?
Mitchell: Sell-in to the channel has significantly outpaced sell-out in 2013, which means inventory levels are much healthier among wholesalers and installers relative to this time last year. I estimate that units at these two stages in the supply chain are probably up 3% to 4%. I do not get the sense that inventory at the manufacturing level has changed much over the past year as all the players are focused on limiting working capital investments.
MTD: What are the lasting effects of the elimination of the Chinese tire tariff on Sept. 26, 2012?
Mitchell: This is an interesting question as it naturally assumes that we will not see another tariff implemented in the next decade, which I think is a risky bet for these retailers that are shifting more of their product offering toward Chinese manufacturers. I can say without a doubt that the greatest lasting impact has been the rude awakening it provided to select high-cost manufacturers that compete in the bottom half of the Tier Two segment and in the Tier Three category. The increased supply from China has definitely forced these manufacturers to accept the reality that they were pricing their product higher than the brand and product quality would support in the long-run. The question is how will these manufacturers adjust to the more competitive environment and, unfortunately, I am not sure that they all have found a productive answer to this real problem.
MTD: How are premium tire brands, the broad-line brands, and value brands doing in the market?
Mitchell: The strength of the market resembles a barbell right now, with brands at both ends of the market performing much better than those that constitute the middle. Going forward, I expect that demand trends over the next year will continue to be segmented, with relative strength expected in the Tier One and Tier Three categories, and relative weakness to continue in the Tier Two bucket. Installers continue to suggest that an aging car parc will continue to place downward pressure on the mix in the coming quarters as more light vehicles are entering the final replacement cycle, which typically occurs in year 11 or 12 of the vehicle life cycle. This trend clearly plays to the strengths of Tier Three/opening price point product. However, these same operators believe that the value propositions of Tier One suppliers are strong enough to insulate them from being share donors in the coming years, especially given the fact that the market is shifting to high value-added (HVA) tires at the front-end of the vehicle life cycle. This outlook naturally means that Tier Two suppliers as a group are expected to lose share.
MTD: What economic factors affected tire sales in 2013, and what do you see affecting the replacement tire market this year?
Mitchell: There were three main economic factors at play that affected the behavior of consumer demand in 2013: 1) income tax refunds were disbursed later than normal; 2) a return to normalized payroll tax rates; and 3) tires became more affordable. The first two items pressured the market at the start of the year, but as we moved into April and May, the lower prices at retail trumped the other headwinds. I expect job growth will have the biggest impact on tire volumes in 2014. While we have seen gradual improvements in labor markets over the past two years, I think we could see better-than-expected sellout trends at retail this year if job growth accelerates and if gas prices and tire affordability do not move against the consumer.
MTD: What is going on in the OE tire market segment? Do you see car manufacturers demanding anything different?
Mitchell: The OE channel is clearly a bright spot for the tire manufacturers right now. The new vehicle market continues to recover, and auto makers continue to turn to the Tier One and Tier Two tire manufacturers for help improving the ride quality and fuel efficiency of the cars and light trucks that are being built today. Given the fact the automobile manufacturers can gain decent benefits in these two areas for a marginal cost by leveraging the technology of their tire suppliers, I expect this area of the market will continue to trend favorably for those manufacturers with significant OE exposure.
MTD: What is happening with raw material prices?
Mitchell: I expect the raw material cost component of building the average passenger tire will remain flat through the first six months of the year before starting a gradual ascent in the back-half of the year. I think the move higher will be slow enough to allow the manufacturers to effectively recover the higher costs in a timely manner. I do not expect to see a lot of pressure on price/mix-to-raw spreads among the manufacturing community, especially Tier One players.
MTD: What predictions do you have for the Big Three — Goodyear Tire & Rubber Co., Bridgestone Americas Inc. and Michelin North America Inc. — this year?
Mitchell: I do not think that the Big Three will make any acquisitions in 2014, but I would not be surprised to see consolidation or strategic alliances — platforms to share technology, gain purchasing capital, and capital alliances — formed among some of the manufacturers in the Tier Two or Tier Three segments.
MTD: How about any of the smaller companies?
Mitchell: Hankook is doing an excellent job gaining traction in the OE market, with notable wins on some high profile luxury vehicles, including the BMW X5; BMW 1.3 and 5 series; and Mercedes-Benz S-Class. Ongoing support by these premium brands should help Hankook further strengthen its image, which ultimately increases its long-term potential in the replacement market.
MTD: What impact on the U.S. replacement market will Chinese tire companies have going forward?
Mitchell: You definitely cannot ignore the fact that the Chinese manufacturers are growing their presence at SEMA and in the North American replacement market. Most of the players in the North American tire industry that I have spoken with in recent months noted that they were surprised by the strong impact the influx of Chinese tires had on volumes and pricing in 2013. I think the Tier One and Tier Two manufacturers underestimated the consumer acceptance of Chinese products. I also believe the manufacturers that use a portion of their production capacity for entry level private label product realized that the increased supply of opening price point tires from overseas exposed deficiencies in the breadth of their product offerings that will clearly need to be addressed if these branded producers want to continue to make value/opening price point tires. Some manufacturers delayed price investments due to the fact that they misread the strength of their relationship with distributors and underestimated the need to lead with price in this segment of the market. This, combined with a smaller product offering of opening price point tires — fewer fitments/SKUs, was the primary reason some Tier One and Tier Two manufacturers lost share with their opening price point/private label offering. I think we are still 10 or more years away from a point in time when these producers will have a product that would be deemed an HVA/premium tire that consumers would seriously consider purchasing. In other words, for now I expect the Chinese manufacturers will only be a noticeable competitor in the Tier Three/opening price point segment of the market.
MTD: Auto service remained a bright spot for tire dealers throughout 2013. What will happen in this segment in 2014?
Mitchell: I think business trends will be a little more balanced in 2014. I do not expect you will see a huge acceleration in demand for light service and maintenance work, but I do expect tire unit volume trends will be a little healthier, which should help return the sales mix to more normalized levels.
MTD: What are the demand trends for the do-it-for-me (DIFM) channel?
Mitchell: I have definitely seen demand trends pick up nicely in the DIFM channel over the last six months following a string of lackluster quarters stretching back to the second quarter of 2012. Taking a long-term perspective, I continue to expect the commercial channel will yield growth rates 1% to 2% higher than the do-it-yourself (DIY) channel.
MTD: What are the trends in the average repair order?
Mitchell: It really depends on the type of service that the tire dealer offers. For those shops that specialize in light service — brake work, oil changes, batteries, tune-ups, etc. — the average ticket has likely been flat over the past 12 months. However, operators who offer a wide assortment of services, including medium- and heavy-duty repair work, are seeing a nice lift in their average ticket. Indeed, as a car moves from the eight- to 11-year-old bucket to the 12-plus-year-old bucket, the amount of regular maintenance and light service performed declines in certain key categories, while there is a noticeable lift in the volume of more complicated repairs. Interestingly, the sharpest drop off in demand trends are in the categories that generate the most traffic.
MTD: Have wallets been opened for preventive maintenance?
Mitchell: In the commercial channel there has been a nice pick up in the amount of preventive maintenance being done in 2013 relative to 2012, when many garage owners were reporting a lot of consumers were deferring non-essential repairs and routine maintenance. Demand for routine maintenance supplies has been somewhat lackluster in the DIY channel during 2013. However, I expect trends will improve somewhat in 2014 as we cycle the headwind from the higher payroll tax rate at a time when fuel prices are projected to fall.
MTD: What changes have there been in the demand trends of the light vehicle fleet?
Mitchell: There is an ongoing shift toward more medium- and heavy-duty repair work given the average age of a light vehicle is over 11 years old. We are also seeing more professional installers and DIYers trading down to lower quality and/or private label products to lower the cost of the average repair.
MTD: What’s next for the big automotive parts chains?
Mitchell: I expect Advance Auto Parts, AutoZone, O’Reilly Automotive, and Genuine Parts will have share gains in the coming years, especially in the DIFM channel. I expect Monro Muffler will more or less hold its share in its existing markets, while expanding share in new markets via its aggressive acquisition strategy. I expect Pep Boys will continue to lose market share in the DIY and commercial delivery segments, but I do think that the company can increase its scale in the tire and service market through organic growth and acquisitions. Industry stakeholders will be watching Advance Auto Parts closely to see how well it can integrate the assets of General Parts International, including managing the relationships with the independent CARQUEST network.
MTD: What economic factors do you see affecting automotive service profits during 2014?
Mitchell: At the end of the day, the level of profits will be driven largely by the strength of consumer demand. Job growth, trends in gas prices, and consumers’ desire to replace their existing automobiles will be key determinants of how much consumers will invest in their vehicles in 2014. In short, we expect the operating environment will be up 1% to 3% in 2014.
MTD: Thanks for your insights, Nick. ■