Taking advantage of market volatility
We took advantage of the market volatility in October by initiating a position in Michelin, a stock that we know very well and have already owned in the past. In addition, we added meaningfully to existing positions whose stock prices we thought were unjustifiably hit (down c.10% or more month-to-date at one point) by the broad-based sell-off we saw in the first half of last month. We note that low portfolio turnover is not a goal for us, but rather a result of our investment process and philosophy. In practice, this means that when attractive stock prices are presented to us by the market, we should take advantage of them. As a result, we bought a total of 4.9% of AUM in October, which by our standard, is quite active.STOCK OF THE MONTH: MICHELIN
Michelin, a stock in our corporate events bucket, produces tyres for passenger cars, trucks and agricultural vehicles as well as aircraft and earthmoving equipment. Sales go through their own specialist stores or third party distributors.
Of the USD 185bn tyre market, Michelin has approximately 15% market share similar to the other market leader, Bridgestone. The market is relatively consolidated, with the top 10 players comprising around two-thirds of the market.
Replacement tyres account for around 80% of sales while the remaining 20% is derived from original equipment sales.
40% of sales come from Europe, 36% from North America and 24% from the rest of the world; around one-third of revenues are from emerging markets.
WHY WE LIKE THE STOCK...
We think that the market is meaningfully underestimating the strong free cash flow that the company is likely to generate over the coming years. We expect the high levels of free cash flow to benefit shareholders via a significant return of cash through higher dividends and, potentially, share buybacks.
Michelin has invested heavily in growth-related capital expenditure (i.e. building new factories in China, India, US, Indonesia, etc.) over the past five years at close to 2x the level of depreciation. This spend will peak this year at EUR c.2bn, which compares to the company’s maintenance capex of EUR c.700mn. This means that normalising capex alone (i.e. without accounting for lower manufacturing costs due to capacity cuts in Europe and improved efficiency in emerging markets given the new factories) adds over EUR 1bn to FCF per year or c.8% of current market cap. At that level, we have a company with well over 10% FCF yield even assuming little to no growth in revenues; FCF yield based on 2013 FCF is c.6% including growth capex.
In addition, despite the high capex over the past few years, Michelin has managed to de-lever and is close to running a net cash position on its balance sheet, highlighting its cash generative characteristics. From a net debt position of EUR 2.6bn at the end of 2010, the company ended 2013 with a net debt of EUR 740mn.
We appreciate investors’ skeptical views on the company given currently weak growth trends for the market. We saw similar stock price reactions in the past when market volumes were poor. In the end, the company sells a mundane product – the round, rubber things that people use to drive around in their vehicles. End users can defer buying them, as they did in 2009, but in the end they have to replace their old tyres, as they did in 2010 and 2011. Incidentally, despite weak demand in 2009, the company still generated solid FCF.
At 6x 2014 EBIT and high free cash flow yield, we see good downside protection while we wait for surplus cash returns to arrive. In the meantime, we will collect the 4% dividend yield on the stock.
Cyrill Marquaire, LOF-Europe High Conviction