The last time I looked at Michelin (OTCPK:MGDDF) (OTCPK:MGDDY) was before COVID hit. In January 2020, I liked what I saw as the company traded at a A 7.5% free cash flow yield and a 3.6% dividend yield, but then that kind of slipped off my radar during COVID as the business had to deal with a lower amount of cars new and a decline in the replacement market as cars and semi-finished cars were completed with fewer miles. The stock price rebounded nicely as economies reopened, but the stock price is now down about 40% from its January high. It’s time to take another look and maybe consider starting some bottom fishing.
Michelin is part of the CAC 40 index on Euronext Paris and it is obviously the most liquid trading place for investors interested in Michelin. The the stock symbol in Paris is ML and with an average daily volume of approximately 1.6 million shares, the Paris listing is significantly higher than all secondary listings. Michelin currently has a market capitalization of around €17 billion based on the current share price of around €24 per share.
MGDDF represents one underlying stock, MGDDY represents ½ share. I will refer to the betting list and use the EUR as the base currency throughout this article. All the relevant information I refer to in this article can be found here.
The first half was not so bad, despite a continued decline in new vehicle tires
The auto industry’s problems have been going on for a few years now and tire suppliers like Michelin are certainly not immune. The image below shows estimated tire volume in the OE (read: new car) division, and Michelin is seeing a very sharp decline in its European and North American markets.
And although fewer cars have been built, resulting in less demand for Michelin tires to fit under new builds, the number of car uses has continued to increase over the past 2 to 2.5 years since the initial outbreak of COVID. Indeed, replacement tire volumes for cars and light trucks are now higher than in 2019.
Michelin recorded total sales of just under 13.3 billion euros in the first half of this year, but due to the increase in COGS, gross income increased by less than 10% to 3.64 billion euros. A pretty decent result, but unfortunately most other expenses also increased at a rate of around 10%, which resulted in an increase in operating profit from 1.42 billion euros to “only” 1, 53 billion euros. A good result, but perhaps a little disappointing.
After deducting the 273 million euros of “other” operating expenses (according to the footnotes, this is mainly related to the Russian asset impairment charge with a few other non-recurring items contributing to the total, such as you can see below), operating expenses reported revenues were slightly lower at 1.26 billion euros.
As net interest expense increases and Michelin was able to post a positive result attributable to equity accounted investments, it was able to limit the “damages” and the net result amounted to 843 million euros, of which 841 million euros or 1.18 million euros. EUR per share is attributable to ordinary shareholders of Michelin. The average tax rate is expected to decrease in the future as the tax bill was higher than it should be due to certain non-deductible expenses.
As I usually focus on the cash flow generated by a business, I wanted to make sure that Michelin always generates a good level of free cash flow. As you can see below, the reported operating cash flow was only €7 million, but that was obviously the direct result of the €1.72 billion investment in the working capital. In addition, the company paid 396 million euros in taxes when only 313 million euros were due. Adjusting for these two items, operating cash flow was just over $1.8 billion.
We also need to deduct approximately €130 million of rent (which is included in the €781 million of cash flow from financial liabilities) to arrive at an adjusted operating cash flow of €1.67 billion. euros. A little less than in H1 2021 but a very correct result all the same.
The total capex of 980 million euros is quite high, especially if we also take into account the lease payments, the total amounts to approximately 1.1 billion euros, which is approximately 20% more than the 909 million euros in amortization charges. That being said, looking at the breakdown of capital expenditures, we see that the company has allocated €273 million to “debt variations”. The “pure” capex was only €709 million.
Full-year investments will be 1.9 billion euros this year, but that’s also because Michelin is making up for the lower investments spent in 2020 and 2021 when it reduced its cash outflows during the COVID crisis.
I think it is fair to assume that normalized capital expenditure will be around 1.7-1.8 billion euros (similar to the amounts incurred during the pre-COVID years). Maintenance investments are expected to be even lower than that, but Michelin is reluctant to give a breakdown of maintenance investments versus growth investments. I think normalized sustaining capital (even after taking into account the impact of current inflation figures) is around 1.5 billion euros per year.
Applying that to a projected full year operating cash flow of around 3.3 billion, I expect full year sustaining free cash flow to be around 1.8 billion euros. This translates to approximately EUR 2.5 per share.
And that makes Michelin quite attractive at current levels. Of course, an economic downturn will also impact demand for new tires and a volatile rubber price will also have to be managed by Michelin. But from a fundamental perspective with net debt below €4.5 billion (including cash management assets) and around €4.9 billion in EBITDA, the leverage ratio ( 1.1) and the EV/EBITDA ratio (less than 5) are attractive. In addition, Michelin continues to generate healthy free cash flow and with an anticipated payout rate of 50% of recurring income, shareholders can expect a dividend of EUR 1.2-1.4 per share, which would represent a yield of 5 to 6% (subject to the French withholding tax of 12.8%).
I don’t currently have a position at Michelin, but I would be interested in going further. I will probably write put options with a strike price just out of the money.