Are Tiremakers Gaining Traction?

Few industries have felt the bite of the recession as acutely as tire manufacturing. However, we believe the short-term outlook for tire manufacturers is brightening given the potential release of pent-up replacement tire demand as drivers notch up more miles, drastic capacity cuts across the industry, and easing raw-material costs. Also to be considered is the proposed tariff on imported Chinese tires, which is a wild card. If approved, this tariff could have mixed effects on the U.S. tiremakers, such as  Goodyear (GT) and  Cooper , which we will cover in more detail shortly. Although we expect North America to be a tough battleground for both tiremakers going forward, we find Goodyear's position in this important market to be more tenable than Cooper's.

Adverse Conditions
In response to the presently dismal demand environment, tiremakers across the industry have pared capacity, with Goodyear and Cooper proving no exception. Goodyear is planning to take down 15 million-25 million units of capacity during the next few years, or almost 10% of its global capacity. Cooper has also been active on this front as the firm will shutter its Albany, Ga., plant in late 2009, eliminating 9.5 million units of capacity, more than 20% of its North American potential production.

Meanwhile, we think an imminent resurgence in replacement-tire demand is quite likely. Replacement-tire demand is typically dictated by vehicle miles-driven figures, as balding tires must eventually be replaced. However, even though declines in U.S. miles driven have decelerated in 2009, and actually posted year-over-year gains in April and May, U.S. replacement tire demand in 2009 is forecast to decline by nearly 9%, according to the Rubber Manufacturers Association. We view this disparity as evidence that beleaguered U.S. consumers are deferring tire replacements, and we believe that this pent-up replacement-tire demand will be released in the near future, likely in 2010 and 2011. We believe this confluence of contracting supply and rebounding demand for replacement tires will provide a temporary spike in profitability for Cooper and Goodyear by raising plant-utilization rates and tightening tire availability, thereby supporting pricing. In addition, falling raw-material costs could provide an additional boost to industry bottom lines. However, we believe that incremental benefits from lower raw-material costs will subside in the coming quarters as rubber and oil prices have recovered from their nadir in early 2009.

Tariff Would Put Brakes on Imports
A huge uncertainty looming over the U.S. tire industry is the International Trade Commission's recommendation to impose a three-year tariff on Chinese tire imports. Although the proposed tariff's effects on tiremakers are still unclear, we believe that the tariff, if passed, could benefit Cooper and harm Goodyear. Cooper competes with low-cost Chinese import tires in its North American private-label tire business, while Goodyear exited many segments of the private-label tire market in 2006 and focuses more on premium-branded tires, which are less susceptible to Chinese competition. Also, the bulk of Cooper's sales are made in the U.S., which would be protected from Chinese competition under the tariff, and we believe the firm's Chinese joint ventures could easily redirect their output to other markets outside the U.S. given their relatively small footprint.

Goodyear, on the other hand, generates most of its sales outside the U.S., in markets which could be flooded by cheap Chinese tires rerouted from the U.S. if the tariff were enforced. However, we caution that any potential benefits accruing to Cooper because of the passage of the tariff will likely be temporary, as low-cost tire production can easily shift to other countries outside China. Indeed, we have anecdotal evidence that tire production in India is ramping up in anticipation of the tariff being enacted. That being said, President Obama still has not approved the ITC's tariff recommendation. The deadline for the decision is mid-September, and we will continue to monitor this issue closely.

The Better Tire for the Road Ahead
Although we are now more bullish on the short-term outlook for both Cooper and Goodyear, we are much more inclined to bet on Goodyear over the long haul than Cooper. Goodyear boasts stronger and more diverse distribution channels than Cooper, which has traditionally relied on small independent retailers, which are slowly losing market share to larger national chains. Cooper is now scrambling to secure retail space with the larger retailers, and recently reached an agreement with  Sears  to sell its tires. However, the Sears agreement notwithstanding, we believe that securing distribution agreements with other large retailers will not be easy, and this could also pressure Cooper's margins given these larger players' stronger pricing power versus the company's traditional customer base.

In addition to its distribution advantage, Goodyear is already strongly entrenched within the premium-branded tire market, which commands more attractive margins and is better protected from the onslaught of cheap imports. Cooper, on the other hand, still generates about half of its sales from private-label tires, which has steadily lost market share to cheap imports. Moreover, its branded tires are not as well-recognized as Goodyear's, which boast a strong lineup of innovative offerings. As competition intensifies within the important North American market, we believe Goodyear's advantage over Cooper in distribution channels and premium tires will shine through.