Sumitomo Rubber: the worst might be over

For many analysts, tire demand has bottomed out for a few months now. The recovery is only gradual but demand for replacement tire will lead to solid growth in volumes in FY12/10 following a double digit decline in FY12/09.

Sumitomo Rubber’s stock price has lagged the ones of its peers and for that reason I believe the stock could overperform in its sector the next 6 months. On August 11, 2009 Sumitomo Rubber industries (SRI) has released its first half results. Revenues fell by almost 20% lead bv its sports product segment (-22% yoy) and followed by its tire segment (-19% yoy). Even though it might look bad it is still a recovery from the 25% decline of first quarter revenues.

If I recall, last August SRI management had revised up its first half forecast, including the better visibility of earnings in the ast six months of 2009. As a result analysts do not seem surprise by the recovery of the earnings and revenues seen this quarter. However, SRI just announced a plan to cut its fixed cost by ¥4.7 billion, which might please analysts overall. I am not sure if these cost cuts will be permanent since the better part comes from cuts in wages, bonuses and overtime hours paid.

A few analysts bring up the theory about low capacity utilization. The idea being that when a company has low capacity utilization for a long period of time that gives managers an opportunity to think about changes and improvements instead of being rushed by production needs. Thus, analysts who believe in this theory expect SRI to imrove its productivity in the coming quarter given that it has run at 70% capacity for quite a while now.

What about SRI’s golf segment?

New golf clubs are scheduled for launch in 2010, which should drive a healthy increase in revenue, while the 2008 acquisition of Cleveland Golf with its distribution network has increased SRI’s share of the US golf ball market.

What are the risks to SRI’s earnings recovery?

Demand for replacement tire has been well below trend for a while. It is the result of the many government subsidies to buy new cars (Japan, Germany, France and US). Governments have already announced subsidies would be stopped in December at the latest. However if it is not the case then demand for replacement tire might continue to suffer.

SRI is not different than many exporters and its earnings are tied to foreign exchange rate. A return of the yen below the 90¥/$ would add more pressure to SRI’s earning recovery. Macquarie assumes in its forecast that a ¥5 move in the ¥/$ exchange rate changes operating profit by ¥750 million (approximately 4% of total OP).

Finally raw material prices are the last concerns I would have to SRI’s earnings recovery. So far the low level experienced for natural rubber and synthetic rubber prices have been a positive factor in SRI’s strong performance recently. However, in the case of a sharp increase in prices in 2010, profit margins could be negatively affected. Now the question remains: do prices can increase while the economy is still in slow recovery? My opinion is “No” but with China’s stimulus still in place everything is possible.

I think Sumitomo Rubber could be a good company to invest in the short to medium term. The stock price has underperformed its peers and could be preferred by many investors if the stock market keep its pace toward the 10000 or the 11000 points on the Nikkei225.