Worrisome Headwinds at Goodyear Tire
Price Target $28.00

Link to SI News Release
  

March 29, 2017

Charles Goodyear:  “Life should not be estimated exclusively by the standard of dollars and cents.  I am not disposed to complain that I have planted and others have gathered the fruits.  A man has cause for regret only when he sows and no one reaps.”

  
From an intra-day low of $27.50 on November 1st of this past year, The Goodyear Tire & Rubber Company (NASDAQ:GT) has risen a staggering 33% as of yesterday’s close of $36.51.  What’s causing this euphoric rise, and more importantly is it sustainable?  After looking at the numbers a bit closer, we think not.  Goodyear Tire is sowing, but what exactly are the shareholders reaping?  In this report, we give a summary of troubling trends and headwinds we see with Goodyear Tire that should give shareholders pause.
 
First and perhaps foremost, the company reported a net profit of $561 million in the fourth quarter of 2016 compared to a net loss of $380 million in the fourth quarter of 2015.  On the surface, that appears to be just rosy, but when we adjust the numbers by removing extraordinary items, the company’s net income is actually 16% less in 2016-Q4!  See chart below. 
  
In the fourth quarter of 2015, the company took a $646 million charge for the deconsolidation of its Venezuelan subsidiary.  According to the company’s 2016 annual report:  “Effective December 31, 2015, we concluded that we did not meet the accounting criteria for control over our Venezuelan subsidiary. We deconsolidated the operations of our Venezuelan subsidiary and began reporting their results using the cost method of accounting. Our financial results for 2016 do not include the operating results of our Venezuelan subsidiary.”  Were it not for this one-time charge, the company would have booked a profit of $266 million for 2015-Q4.

In the fourth quarter of 2016, the company reported an income tax benefit of $238 million.  The company’s average tax rate is roughly 30%.  Were it not for the tax benefit, the company would have reported income tax expense for the quarter of approximately $99 million, with a resulting profit of $224 million.  By removing the aforementioned extraordinary items, Goodyear Tire’s profit is $266 million for 2015-Q4 and only $224 million for 2016-Q4, a nearly 16% decline.

Going forward, the company expects some additional income tax benefits.  In 2016, the company saw a net income tax benefit of $77 million on income before income taxes of $1,207 million.  For 2015, income tax expense was $232 million on income before income taxes of $608 million.  According to the company’s 2016 Annual Report, the decrease in income taxes for 2016 compared to 2015 was “primarily due to net discrete adjustments of $458 million, due primarily to a tax benefit of $331 million from the December 31, 2016 release of the valuation allowances on certain subsidiaries in England, France, Luxembourg and New Zealand…As of December 31, 2016, these subsidiaries, on which we have previously maintained a full valuation allowance, are located in jurisdictions with unlimited carry-forward periods for utilization of tax losses and have achieved earnings of a duration and magnitude that they are now in a position of cumulative profits for the most recent three-year period.  As a consequence of this profitability in recent periods and our business plans for 2017 and beyond forecasting sustainable profitability, we now conclude that it is more likely than not that our deferred tax assets in these entities will be realized… At December 31, 2016, our valuation allowance on certain of our U.S. Federal, state and local deferred tax assets was $139 million primarily related to our investment in our deconsolidated subsidiary in Venezuela, and our valuation allowance on our foreign deferred tax assets was $187 million.”

While the company may stand to realize tax benefits from the carry-forward of losses, we are more concerned about the decline in sales from the company’s main operating segment.  During 2016, the company operated its business through three operating segments:          (1) Americas, (2) Europe, Middle East and Africa (“EMEA”), and (3) Asia Pacific.  Both net sales and tire units sold declined in the Americas, the company’s largest operating segment, primarily from weakening demand for commercial truck tires in the United States and continuing recessionary economic conditions in Brazil.  In 2016, the America’s contributed 54% of the company’s sales.  Even though tire units remained constant in the EMEA segment, net sales declined.  This was due to heavy discounting resulting from increased competition, particularly with respect to smaller rim diameter consumer tires in EMEA.  Net sales and tire units did manage to improve somewhat in the company’s smallest operating segment, the Asia Pacific region.  See chart below.
  
  
The overall decline in net sales this past year is consistent with the company’s trend for the past 12 quarters.  Net sales have declined QOQ for the past 12 quarters! (see chart below). 
  
  
On top of that, annual net sales have been steadily eroding for the past 5 years.  See chart below.
  
  
Looking ahead, can we expect any improvements in sales?  The simple answer is no.  A primary reason is that going forward, the company will continue to be impacted by the persistent strengthening of the U.S. dollar against most foreign currencies.  Additionally, the company’s tires are sold under highly competitive conditions throughout the world.  On a worldwide basis, it has two major competitors: Bridgestone (based in Japan) and Michelin (based in France). Other significant competitors include Continental, Cooper, Hankook, Kumho, Pirelli, SRI, Toyo, Yokohama and various regional tire manufacturers.  Both Bridgestone and Michelin have large shares of the markets of the countries in which they are based and are aggressively seeking to maintain or improve their worldwide market share.  The company’s competitors produce significant numbers of tires in low-cost countries, and have announced plans to further increase their production capacity.

What about improvements in margins from aggressive cost control?  Not likely.  The company is expecting raw material cost to be approximately 27% higher this year than it was in 2016.  According to the company’s last annual report:  “Raw material costs have historically been volatile, and we may experience increases in the prices of natural and synthetic rubber, carbon black and petrochemical-based commodities. Market conditions or contractual obligations may prevent us from passing any such increased costs on to our customers through timely price increases.  Additionally, higher raw material and energy costs around the world may offset our efforts to reduce our cost structure.  As a result, higher raw material and energy costs could result in declining margins and operating results and adversely affect our financial condition. The volatility of raw material costs may cause our margins, operating results and liquidity to fluctuate. In addition, lower raw material costs may put downward pressure on the price of tires, which could ultimately reduce our margins and adversely affect our results of operations.”

Falling sales and increasing costs is resulting in decreasing cash flows.  Net cash provided by operating activities was $1,504 million in 2016, compared to $1,687 million in 2015.  According to the company, “Net cash provided by operating activities in 2016 decreased $183 million compared to 2015 primarily due to an increased use of cash for working capital of $75 million and lower segment operating income of $35 million.”

What about that dreaded Border Adjustment Tax or BAT being proposed by the current administration? The company responds to this overhang best in its last annual report:  “The imposition of tariffs on certain tires imported from China or other countries may reduce our flexibility to utilize our global manufacturing footprint to meet demand for our tires around the world. In addition, the imposition of tariffs in the United States may result in the tires subject to such tariffs being diverted to other regions of the world, such as Europe, Latin America or Asia, which could materially adversely affect our results of operations, financial condition and liquidity in those regions.”

Can we expect any relief from increasing new vehicle sales?  Not really.  According to Autodata, overall new vehicle sales fell 1.1% for the month of February compared to a year earlier.  Ford (NYSE:F) posted a 4% decline, Fiat Chrysler (NYSE:FCAU) posted a 10.1% decline, and Toyota (NYSE:TM) posted a 7.2% decline.  GM’s (NYSE:GM) and Nissan’s 4.1% and 3.7% increases for the month were not enough to bump overall sales into positive territory.  Rising inventory levels is another worrisome trend in the new car sales category.  Inventory levels at dealerships rose from 70 days’ supply last February to 78 days this February.  This means factories will need to slow their pace of production going forward, hence lowering demand for tires.

Earlier this month, the company announced the pricing of $700 million of new unsecured 10-year senior notes to replace $700 million of notes coming due in 2022.  It did a similar offering in 2015.  The company has a very substantial debt load of $5.5 billion.  While the debt load remains persistently high, the company paid $82 million in cash dividends last year, even increasing the quarterly dividend from $.07 to $.10 during the last quarter and announced common stock dividends and share repurchases of $3.5 billion to $4.0 billion for the next four fiscal years.  Why not take that $3.5 to $4.0 billion to reduce debt and strengthen the balance sheet?

We’re not the smartest cookies in the cookie jar, but the company’s strategy rather seems like a bit of bribery.  Our sales and profits are going down, but we’re going to pay you dividends and increase share repurchases to “enhance shareholder value.”  Hmmm.  The company even admits to this strategy in its annual report:  “Cash and cash equivalents decreased by $344 million from December 31, 2015 due primarily to capital expenditures of $996 million, common stock repurchases of $500 million, net debt repayments of $256 million and dividends paid on our common stock of $82 million.”  That strategy will only go so far because the company’s ability to borrow is decreasing.  At the end of 2016, the company had total credit arrangements of less than $8.5 billion.  At the end of the prior year, the company had total credit arrangements of nearly $8.7 billion.

Looking forward, we are not optimistic that Goodyear Tire can turn its fortunes around.  We see continued pressure on sales and margins.  We see 2017 earnings per share of $3.00 to $3.50 (net of extraordinary items), and consequently we assign a price target of $28.00.