Pirelli's bigger is better

Pirelli is a simple proposition in terms of both marketing and the equity story: high value tyres with superior margins are selling like hotcakes, including and notably for those placid SUVs which helpfully grind through them quickly thanks to their ridiculous weight. Pirelli is making a fortune as it caters for the “ungreen” side of the car market. Shareholders are unlikely to be concerned for a while anyway as cash flows will put to rest any environmental questions.

Reservations, if any, relate to the fact that the delisting (2015)- relisting (2017) with a new reference shareholder in Chinese CNRC was a case of some shareholders (Camfin/Tronchetti Provera) being more equal than others as they extracted the fruits of a de facto LBO. This left an aftertaste and suspicions on the liability side of the balance sheet while the assets are good to have. The stock has lost a third vs. its relisting price and offers 24% upside. It is a Buy and is worth going for after losing 15% ytd. Below we address Pirelli’s operational singularities

Pay offs

Management’s focus on the premium tyre segment is paying off. On a yoy basis to H1-2109, the delivery number in the premium segment was up by 3.9% whereas standard tyres experienced a collapse of 13.9%. Consequently, the total was down by 5.0%. These numbers suggest that delivery volumes in the two segments, which had been equal in size in H1 18, stood at 55% to 45% in H1 19.

This strategy has paid off in recent years as high-value tyres (i.e. large diameter wheels at 18 inches and rising) are needed for SUVs and sports cars. To attract aficionados of these vehicles, Pirelli is one of the most well-known sponsors of Formula 1. Although we are certain that equipping all these racing cars is a costly exercise, Formula 1 still attracts huge crowds around the world and, thus, clients for its tyres.

Replacement profits

These clients are needed in the replacement market. In fact, shipments for replacements of high-value tyres were up by 13% in H1 19 while those to OEM production lines were down by 3.4% as premium car production fell in Europe and China. The US market shows that the SUV market segment is doing considerably better than regular sedans. While sales of sedans were down by 8.9% to slightly less than 2.60m vehicles in H1 19, sales of pick-up trucks and SUVs were up by 1.4% to 5.84m. As the trend has been similar albeit less pronounced in other regions, the sheer volume of premium cars on the roads bodes well for replacement demand. Even if the number of electric vehicle sales will rise disproportionately in the years to come at the expense of these ‘conventional’ vehicles, replacement demand will remain strong for many years.

The price per tyre is very different between the two segments. As noted above, the volume was 55% high value and 45% standard in H1 19, but the respective revenue numbers were 67.3% to 32.7%. These ratios suggest that the price (ex factory) for a high value tyre is about 80% higher than the price for a standard model.

Not so superior profits though

This would suggest that Pirelli generates profit margins at the top end of the tyre industry, but this is not the case. Unfortunately, the company does not split its operating profits and only gives consolidated numbers. In recent years, Pirelli’s operating margin increased from 12.0% in 2016 to 13.5% in 2018. The stated EBIT margin was 16.0% in H1 19, but this included a €72m benefit from a Brazilian tax credit settlement. Excluding this, the margin was 13.3%, which is higher than Michelin’s (12.2%) although Continental and Nokian Renkaat have both achieved considerably higher numbers in the past. One explanation might be Pirelli’s disproportionate dependence on LatAm. It generates about 11% of turnover there whereas the others show revenue shares of about 4% for that region (Nokian Renkaat is not active there at all). The economic ups and downs in that region (Argentina is the worst of all these countries) may lead to extra-low sales prices and, hence, to below-industry-standard margins.

However, this gives management ample room for efficiency improvements. The company currently operates 19 factories in 12 countries and, if we assume that its ASP is comparable to Continental’s (about €75 per tyre), it produces some 70m tyres annually. This translates into a volume of less than 4m tyres per factory which seems very low. Consequently, the closure of one or the other factory might well be on the agenda, in particular if tyre demand (for standard tyres) continues to fall in future.

In short, Pirelli could be managed as a tighter ship.

Governance questions 

As mentioned from the get go not all shareholders are equal. At 71, the CEO has made good money while giving de facto control to CNRC/ChemChina . The same CEO is also tied up reshaping Italian capitalism with successful Italian entrepreneurs of … his generation. Governance as per AlphaValue’s scoring is subpar while succession plans are hardly mentioned.

Pirelli is only worth €4.7bn those days while CNRC paid €7.5bn for full control in 2015 and subsequently added its own mediocre tyre business to Pirelli’s. It also bought from Pirelli the less profitable side (industrial businesses). The Chinese party is thus far from breaking even on that deal even if we agree to the view that its ambitions are far more long term that a quick buck. This does, however, raise the question of what is to be left to minorities once the Chinese owner decides to exercise its legitimate rights. Remember that ChemChina is an SOE so minorities may not be their priority.

Valuation

Leaving aside the governance issue, Pirelli is good value after its recent share price correction and adjustments to our projections post the H1 report which highlighted higher-than-anticipated net debt