Monday, May 29, 2006

GoodYear Tires: Don't Count on a Recovery

Sure, GoodYear (GT) may have a blimp as its marketing prop, but don't mistake that a sign that its stock is flying high. On the contrary: Good Year is so burdened with debt, the company may be celebrating this Christmas in a funeral home. That is, unless, either private equity comes to the rescue or the company does a secondary offering, raises some much-needed mula, and pays off hungry creditors. Let's review Good Year's dire predicament:

Description Good Year is a global manufacturer of tires and rubber products. It markets several lines of power transmission belts, hoses and other rubber products for the transportation industry and various industrial and chemical markets, and operates commercial truck service, tire retreading, and auto service center outlets where it offers products for retail sale. Good Year has 80,000 employees, posted $20 billion in sales last year, and currently supports a $2.3 billion market cap.

Thesis Goodyear finds itself in the middle of a "must restructure or die" scenario. Without sufficient cash flows from US operations, Good Year could end going under because of its high debt levels (debt/total capitalization ratio is 70%, way above our 50% preference threshold). Having mutilated its brand, the company is now attempting to turn things around in the US, its largest and worst-performing segment. Management plans to do this by selling noncore business assets, instigating new product launches, tightening distribution, and marketing more effectively. So far, sales have picked up, although a large chunk of that has come from one time gains. Tires is a low margin, cutthroat business (GT's net margins at a 700 bps discount to S&P's); besides the abrasive competitive milieu, Good Year must also deal with the bane of looming pension payouts. Goodyear claims 40% of the market for original equipment tires, but because rivalry is thick, price wars ensue among tire companies, leaving customers with high buying power. Lastly, Good Year is currently fighting some legal messes whose outcomes remain unknown.

Risks The possibility that Good Year will have trouble covering interest expenses over the next year is likely; additionally, a secondary offering (whose proceeds will presumably be used to retire debt) will dilute current shareholders and make any future earnings streams less meaningful. Moreover, we're vexed by how little stock insiders at Good Year own, less than 1% of the 177M shares outstanding. Without stock-based motivation, a successful restructuring appears less likely and the risk/reward becomes far less attractive. Others agree: the short interest ratio on GT shares is 12%, an increase from the previous month.

Valuation Because of its debt load, tarnished brand image, and questionable management motivation levels, Good Year stock is trading at a basement level valuation. On a price/sales ratio, Good Year trades at a discount to both its industry and the S&P; on a forward PEG basis, GT trades at a 55% discount to its estimated 16% EPS growth for 2007 (9.2 forward multiple/16). Nonetheless, investors must take into consideration the firm’s highly leveraged capital structure. Our back-of-the-envelope DCF valuation model (using an aggressive 13% cost of capital) yields a price target of $11, representing a 15% haircut from Friday's closing price. We think holding onto this stock is like lighting a cigarette in a dynamite factory -- you might live, but you're still an idiot.

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