Now that we have looked at a great, wide moat companies, See’s, let’s take a look at company with no moat, Goodyear. The contrast is informative and helps us to understand the appeal of the wide moat business from an investment perspective. As we shall see, when returns are inadequate or capital is allocated recklessly, equity value is usually destroyed.
Goodyear Tire & Rubber (GT) is the largest U.S. manufacturer of tires, and one of the largest worldwide. Operations also include rubber and plastic products and chemicals. GT holds the leading market share in North America.
About three-quarters of the tire shipments for the automotive industry are for replacement tires, with one-quarter for new vehicles. Margins on replacement tires are typically higher than for original equipment tires, as automakers receive discounts for buying in high volume. Manufacturers are willing to make less on OEM tires because it is believed that car buyers are likely to stick with the OEM brand.
The auto tire industry is a lousy, capital-intensive industry characterized by cut-throat competition, low margins, low returns on capital and high debt levels. Even in good times, it is difficult to turn a profit. The entire industry suffers from over-supply. The companies have high fixed costs and require large annual capital expenditures, making volume the key profit driver.
The auto tire industry exhibits all of the characteristics of an industry with poor fundamental economics:
- Absence of Any Brand-Name Loyalty. Automobile tires are a commodity. Tires are just a black piece of rubber for most buyers. Customers largely buy on the basis of price rather than quality or brand loyatly. Perceived differentiation between tires of an equivalent grade is minimal and brand substitution is very common.
Attempts to drive differentiation through innovation have gone nowhere. Consumers generally lack the information, expertise or ability to test and evaluate different tires independently. In addition, with few exceptions, tire manufacturers have proven adept at copying and incorporating technological innovations introduced by competitors. To make payback from innovation even more difficult, when one manufacturer introduces a truly unique feature or design, the OEMs are reluctant to accept it unless it is available from at least one other source.
Similarly, attempts to drive brand loyalty through brand advertising have not resulted in higher earnings for a sustained period. According to a May 3, 2011 article in Modern Tire Dealer, 52.5% of retail customers do not specify a brand preference when entering a dealership. An additional 25% do specify a brand but are convinced by the dealer to switch. Thus, three-quarters of actual tire purchasers demonstrate no brand loyalty.
Another method to drive brand loyalty (or at least inertia) is by being on newly purchased cars. Under this theory, the consumer will be reluctant to switch brands when the tires need to be replaced. Yet, XX% of consumers in the US replace their original equipment tires with a different brand when the time comes to replace them.
- Multiple Producers. As we saw with Moody’s, the best business to be in is a monopoly and the next best business is an oligopoly. As the number of competitors increases, the attractiveness of the business decreases. The more competitors there are in a field, the less likely it is to be rational. It heightens the odds of destructive price wars and battles for market share. The tire industry has over a hundred participants making it a nightmare. On a worldwide basis, GT has two major competitors, Bridgestone (based in Japan) and Michelin (based in France), that 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. Other significant competitors include Continental, Cooper, Hankook, Kumho, Pirelli, Toyo, Yokohama and various regional tire manufacturers. The competitors produce significant numbers of tires in low-cost countries, and have announced plans to further increase their production capacity in low-cost countries.
The presence of multiple competitors is further evidence that there are no moats in the tire industry. In markets where all of the competitors have equal access to customers and common cost structures, and in which entrants and incumbents offer similar products on similar terms, market share should divide more or less evenly among competitors. Such is the case in the tire industry.
- Over-Capacity. Another characteristic of a no moat company is the existence of substantial excess capacity in the industry. Because there are no moats in the tire industry, excess profits can only be derived by reducing costs. Management regularly invests in new equipment in an attempt to be more efficient and, thereby, lower costs. Annual productivity improvements are seen as essential but this in turn leads to a surplus of plant and equipment. Because of high fixed costs, tire manufacturers with excess capacity are invariably the instigators of downward price movements as they attempt to recoup some of the cost. Greenwald describes this dynamic in Competition Demystified, “It takes a long time for an industry with excess capacity and below-average returns to eliminate unnecessary assets. The problem is compounded by the longevity of new plants and products. Part of the poor performance of commodity businesses stems from their durability, even after they are no longer earning their keep. Competitors with patient capital and an emotional commitment to the business can impair the profitability of efficient competitors for years.”
- No Intangible Assets. For the no-moat company, profitability is almost entirely dependent upon management’s abilities to efficiently utilize tangible assets. There is no goodwill in this business and no valuable trade names. There are no valuable patents as consumers do not assign any particular value to tire innovations. The only tool left to management to improve profits is operational efficiency.
- No Pricing Power. We have previously seen that See’s was able to raise prices each year because of the emotional ties consumers had with their chocolate. Similarly, Moody’s is free to raise prices because prospective debt issuers simply have no choice but to get a Moody’s rating or face higher interest rates. By contrast, because tires are just a black piece of rubber, tire manufacturers have no pricing power. The price of tires simply moves with the price of raw materials. When the price of rubber increases, the industry increases prices to keep up. When the price of rubber decreases, tire prices drop as there is increased price competition. “Relative to raw materials the extended period of decreased global volumes has contributed to lower raw material costs, resulting in a higher level of price competition.” Q1 2013 conference call
Quantitative Evidence of a Moat (or lack thereof)
GT exhibits all of the characteristics typical of the no moat company.
- Low Profit Margins
- Low Returns on Invested Capital: Goodyear is a poorly performing, capital-intensive company. Capex has averaged 4% of sales over the past 20 years – compared to just X% for MCO. As expected, ROIC is poor as well. ROIC in 2012 was just 10%.
5-year average 7%
10-year average 7%
20-year average 9%
- Erratic Profits: Being a cyclical business with no durable competitive advantages, GT has very erratic profits. This makes projecting forward earnings an impossible task. One wonders how purchasers of shares are valuing the business.
- Little FCF: As poor as the accounting earnings are, after capex and pension contributions are taken into account there is little in the way of Free Cash Flow for the owners to pocket:
Qualitative Evidence of a Moat
The qualitative analysis correlates with the quantitative analysis: there is no qualitative evidence of a moat. We follow the framework for analysis presented by Bruce Greenwald and Judd Kahn in Competition Demystified. The authors identify three types of demand-side moats: (1) brand loyalty, (2) switching costs and (3) network effects. Lets examine each in turn.
- Brand Loyalty – As discussed above, there is little brand loyalty in the tire industry. GT has tried to develop brand loyalty or at least its cousin habit by making tires available to automakers at a steep discount. The theory being that if consumers bought a new car with GT tires on them, they would be more likely to purchase GT tires when the time came to replace them. Unfortunately, this approach didn’t work and GT has eliminated such deep discounts.
- Switching Costs – There are no switching costs in moving from one brand of tire to another. Consumers simply don’t invest enough time in understanding tire performance to appreciate the costs of switching from one brand to another. Fair or not, tires are viewed as largely interchangeable.
- Network Effects – Not applicable.
The authors also identify two supply-side sources of competitive advantage: (1) low-cost producer and (2) economies of scale.
- Low-Cost Producer- Cost advantages that allow a company to produce and deliver its products or services more cheaply than its competitors (privileged access to resources like oil or proprietary technologies). GT would have a durable competitive advantage if it somehow secured a cheap, stable source of raw materials. With this pipeline, it could undercut the prices charged by its competitors. Unfortunately, this has not occurred and GT is buffeted by the whims of the commodities markets like its competitors. Similarly, there is no proprietary technology in the tire industry.
- Economies of Scale – Costs per unit decline as volume increases because fixed costs make up a large share of total costs. It is quite possible that GT enjoys economies of scale. This is a high fixed cost business and GT has spent billions on its infrastructure. But, GT is not the dominant player in the tire market. Without a sizable gap in market share, there is no benefit from economies of scale.
Management & Capital Allocation
In a no moat situation, management’s job is to focus on operational excellence and divert any cash flows generated by the business into more profitable activities. Historically, GT management showed absolutely no awareness of the no moat situation in which they found themselves with predictably disastrous results.
In 1993, GT had sales of $11.6 billion. Its stock sold for $35.22 on a split-adjusted basis at the end of 1993. Twenty years later, GT had sales of $20.9 billion. During the period 1993-2012, the company made capital expenditures of about $14 billion.
What did GT accomplish with that $14 billion? Not a whole lot. GT has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years. The stock sold for $14.60 at the end of 2012 – less than half its 1993 value. Meanwhile, the CPI has gone up 61% over this time period. That $14 billion would have done much more for its shareholders if it had been allocated to other uses. One wonders how each day during this period many people convinced themselves to buy shares of GT.
There are some signs that current management understands their situation and pursuing a sounder strategy. Return on equity and return on invested capital are up fairly dramatically the past 2 years.
The management team has actually executed quite well and has done a nice job reshaping the enterprise to be smaller and focused on higher value, more profitable segments of the tire market. The company had net income of $183 million in 2012 – its second consecutive year of positive accounting earnings. The company has gone from 29 plants to 16, and from selling 40% of its product at the low end of the market for about $60/tire, to 75% at the high end of the market for more than $130/tire. The company has executed this transition through asset sales and negotiations of union labor agreements. The company sold its North American farm tire business in 2005 and its European and Latin American farm tire business in 2010, both to Titan, and sold its Engineered Products business to the Carlyle Group in 2007. The company has also taken the opportunity to use labor contract negotiations with the USW to remove plants from protected status and thus allow them to be closed. In 2003 they closed the Huntsville, Alabama plant, in 2006 they closed they Tyler, Texas plant, and in 2011 they closed the Union City, Tennessee plant. (A side note: Titan Tire bought the Union City plant from Goodyear. Titan has carved out an interesting niche as a manufacturer of off-the-road tires by buying tire plants from bigger companies Pirelli, Continental and Goodyear.) Full closure of the Amiens, France plant, which reportedly lost $80 million per year, was announced earlier this year.
The company is also riding the bounceback in new auto sales.
Nevertheless, the company continues to generate negative FCF. As a result, the perpetually cash hungry company was forced to issue common shares in 2007 and pref erred shares in 2011. Its debt to equity ratio has jumped from 1.58 in 2007 to 7.97 in 2012. This doesn’t include uncapitalized leases and unfunded pension obligations. Meanwhile, the company hasn’t been able to pay a dividend is 2002.
Current management has declared GT a company of limited resources. It will no longer participate actively in every element of the tire business throughout America and the world. Now, the strategy is to eliminate the profitable aspects of the company and focus on the most attractive products. This begs the question: With no moat, how will GT protect these niches? Competitors will be attracted to these high margin products like bees to honey. What barriers to entry stand in their way?
Similarly, it is not hard to imagine the low cost producers who now concentrate on the lower end of the market will work their way up the value chain. The model I have in mind is Honda slowly working its way up the value chain until it could introduce the Acura luxury car.
When we think of mitigating some of our exposure to the potential risk of inflation, our response is to own a great business with pricing power. Such business can raise prices to keep up with inflation. We also prefer to own a business that only needs modest additional capital to maintain its competitive advantage or to engender growth. This is because the price of the fixed assets it needs to maintain its business keep going up with inflation. The fact that much of See’s value or MCO’s value is intellectual property, and not fixed assets, is an attribute we value.
GT shows the other side of this issue. Left unchallenged, the high costs associated with maintaining fixed assets tend to grow with inflation. In the current low inflation environment, the industry needs to achieve annual revenue growth of 3-4% just to maintain its existing margins. In a highly inflationary environment, it is highly unlikely that GT will have the pricing power to pass along the increased costs of maintaining its fixed asset base.
In general, we like to steer clear of companies with a unionized work force. Unions can cut profits through increased compensation and retiree benefits. They also limit management’s flexibility in reducing excess capacity by closing factories and laying off workers. GT is a party to collective bargaining contracts with labor unions, which represent a significant number of its employees. The master collective bargaining agreement with the United Steel Workers covers approximately 8,000 employees in the United States at December 31, 2012, and expires July 27, 2013. In addition, approximately 23,000 employees outside of the United States are covered by union contracts that have expired or are expiring in 2013, primarily in Germany, France, Poland, Brazil, China and Venezuela.
With the backdrop of an uncertain economy, shrinking unions and company cost-cutting, Goodyear and the Steelworkers are negotiating on a new national contract covering 8,000 tire workers at six plants. The chastened union is merely hoping to hang on to what they have rather than trying to win any concessions from management.
The problems outside the US are worse where unions have reacted to the economic downturn by becoming more militant rather than chastened. As mentioned above, GT is scheduled to close a plant in France after the union workers there refused to agree to new working conditions, which they argued were too harsh and benefited only the company. The union is resisting and the Socialist government has gotten involved with unpredictable results.
As noted above, from 1993 to 2012 the company spent approximately $14 billion on capital expenditures. During this same period, GT earned approximately $2 billion in accounting profits and paid out $51 million in preferred dividends. Where did the extra $12 billion or some come from to fund these capital expenditures? From the beginning of 1993 to the end of 2012, the company added about $3 billion in debt. The company also issued 96 million shares of its common stock – an increase in shares outstanding of 64%. In 2011, the company was forced to issue preferred stock which pays a regular dividend and is substantially similar to debt. As a result, GT’s book value per share of common stock dropped dramatically – falling from $18.56 in 1994 to $1.50 at the end of 2012. This is another measure of just how badly GT management has screwed the shareholder.
During this period, the cash –hungry company let its huge pension obligations badly languish. The pension funds are now significantly underfunded and another drag on cash. Although GT has frozen a number of pension plans globally, including the U.S. salaried pension plans, and closed participation in the primary U.S. hourly pension plan, many of employees participate in, and many of our former employees are entitled to benefits under, defined benefit pension plans.. The unfunded amount of the projected benefit obligation for U.S. and non-U.S. pension plans was $2,656 million and $866 million, respectively, at December 31, 2012, and management estimates that they will be required to make contributions to funded U.S. pension plans of approximately $175 million to $200 million in 2013, and $375 million to $425 million in 2014.
What does this all add up to? At best it means that very little money is left over for the common equity holders after all of the debt obligations are met. At worst, it means that this company is in a very precarious spot and a downturn in the economy combined with a tightening of credit standards could force the company into bankruptcy. This is not a terribly difficult scenario to imagine.
Valuation & Conclusion
Generally, commoditized industries with high capital costs and low variable costs tend to earn poor shareholder returns over time (i.e. airlines, grocery stores, unregulated power plants commodity manufacturing, etc.) . Goodyear is no exception. A company like this is worth the reproduction value of its assets. Perhaps a skilled investor could time a purchase when the stock is low and sell it on a subsequent uptick. But it is certainly not a buy and hold compounding machine.
Let us close with a much quoted passage from the 1980 Berkshire Hathaway annual letter on the folly of investing in no moat companies in notorious industries:
We have written in past reports about the disappointments that usually result from purchase and operation of “turnaround” businesses. Literally hundreds of turnaround possibilities in dozens of industries have been described to us over the years and, either as participants or as observers, we have tracked performance against expectations. Our conclusion is that, with few exceptions, when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.