Inter Market Perspective

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ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 17 & 18

Research Entity Number – REP-085

6 March 2018

Ahmed Raza ahmed.raza@imsecurities.com.pk +92-21-37131600 Ext. 101

..

We initiate coverage on GTYR, the largest tyre manufacturer in Pakistan, with a TP of PRs210/sh and a Neutral rating. Penetration in the replacement market and impetus from the truck segment (sponsors own GHNI and GHNL) underpin our 3yr sales CAGR of 15%. However, this is balanced by premium valuations and risk of incumbent OEMs shifting to imported tyres going forward.

GTYR’s products are used by all Auto OEMs but market share in the large replacement market is estimated at just 7%. We believe this is set to increase due to (i) PKR weakness / higher customs valuation making imported tyres more expensive, and (ii) increased capacity to meet growing replacement demand. Potential restoration of Regulatory Duty on imported tyres can act as a strong catalyst.

GTYR trades at a FY18/19F P/E of 12.7x/11.7x, at a premium of 28% to the Auto OEMs. We believe this is largely justified due to higher medium-term growth prospects for GTYR where P/E compresses to < 10x on FY20F earnings. We like potential for GTYR to explore contracts with new entrants in Pakistan’s auto space while also considering possibility of expanding into radial truck tyres, which can unlock more upside.

Replacement market sales growth to offset OEM slowdown We initiate coverage on The General Tyre and Rubber Co. (GTYR), the only tyre manufacturer in Pakistan which caters to all vehicle segments, with a Neutral stance and Jun’18 TP of PRs210/sh. Three key developments will likely enable GTYR to increase its share in the lucrative and large replacement market (1-2% higher margins vs. OEM sales; 80%+ of tyre sales): (i) PKR depreciation making imports expensive, (ii) upward revision in custom valuation of imported tyres (on which duties/taxes are calculated) and (iii) increased capacity to meet replacement market demand. These offset limited near-term room for volumetric growth in passenger cars (incumbent OEMs) and the loss of a popular variant, Corolla Altis (15% est. share in passenger cars), to imported tyres.

Rising raw material prices but margins should sustain Better prospects for global growth, rally in international oil prices and attempts to limit exports by the top 3 natural rubber producers have increased raw material prices for GTYR, a trend which may continue. While this has manifested in recent volatility in GMs, at 9% in 4QFY17 and 17% in 2QFY18, we expect GMs to normalize at 20% where eventual cost pass-through is a feature of the Pakistan auto parts market. Risks emanate from substitution with imported tyres but the pricing gap (prices of GTYR’s products are 30%-60% lower than premium imported tyres) is a mitigating factor.

What could trigger a rally? Restoration of Regulatory duty (removed in Feb’18 on court’s order) on imported tyres will be a key positive. We think duty restoration is likely; with trade deficit impinging on FX reserves, the GoP may be left with few choices to curb imports. Secondly, pending entry of manufacturers such as Kia, Hyundai and Nissan in the next 2-3 years can lead to fresh contracts which can lock-in a new demand stream. Finally, the company is mulling to buy additional land to expand capacity by another c.1mn tyres from existing 3.4mn. GTYR will likely manufacture high-margin radial truck tyres, which are currently imported. As BoD approval is pending, this is not part of our estimates.

Growth prospects justify some valuation premium GTYR trades at a FY18F P/E of 12.7x vs. 10.1x for main auto OEMs and 9.2x for KSE-100. In our view, higher valuations for GTYR are justified by its promising growth trajectory (3yr projected profit CAGR: 10%) where prospects of supplying to the new players in the Pakistan auto manufacturing space, as well as possible expansion, can add to growth.

Risks: Capacity constraints for OEMs, imported competition & higher raw material prices.

Growth triggers awaited; initiate with Neutral

The General Tyre & Rubber Co

Initiation of Coverage

The General Tyre & Rubber Co. of Pakistan Limited

Price (PRs/sh) 194.14

TP (PRs/sh) 210.00

Stance Neutral

Upside 8.17%

Fwd D/Y 3.09%

Total Return 11.26%

Bloomberg / Reuters GTYR PA / GNTY.KA

Mkt Cap (US$mn) 105.0

52wk Hi-Low (PRs/sh) 345.51/177.69

3m Avg. Daily Vol ('000 shrs) 102

3m Avg. Traded Val (US$mn) 0.20

GTYR- Valuation Snapshot

Key Ratios FY17A FY18F FY19F FY20F

EPS (PkR) 14.75 15.25 16.67 19.48

EPS Growth (%) -15% 3% 9% 17%

PER (x) 13.17 12.73 11.65 9.96

P/S (x) 1.2 1.0 0.9 0.8

PBV (x) 3.1 2.7 2.4 2.1

D/ Equity (x) 1.3 1.3 1.2 1.0

DPS (PRs) 15.00 6.00 8.00 10.00

DY (%) 7.7% 3.1% 4.1% 5.2% Source: IMS Research

GTYR- Price performance

Absolute Rel. Index Index Abs.

1M -17% -16% -1%

3M 3% -7% 10%

6M -8% -13% 5%

12M -29% -17% -12%

FYTD -36% -30% -6%

CYTD 3% -5% 8% Source: IMS Research

2 | P a g e

Perspective

*

Rep. market sales declined due to capacity issues and cheap imports

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-10%

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12

FY11 FY12 FY13 FY14 FY15 FY16 FY17

PRsbn

OEM Sales -Lhs RM Sales- LhsOEM - YoY RM - YoY

Source: Company Accounts

GTYR is manufacturing all types of tyres

1.02

0.320.04

0.17

0.15

0.60

Sales (mn Tyres)

Passenger Car

Light Truck

Truck Bus

Farm front

Farm rear

Motorcycle

Source: Company Accounts

OEM sales may decelerate due to capacity constraints…

0%

20%

40%

60%

80%

100%

120%

0

50

100

150

200

250

300

FY11 FY12 FY13 FY14 FY15 FY16 FY17 1HFY18

Utilization - Rhs Capacity ('000 Units)*

Source: IMS Research, PAMA *calculated on name-plate capacity

…while raw material costs are rising

25

%

19

%

-3%

1%

-33

%

-44

%

18

%

36

%

-55%

-40%

-25%

-10%

5%

20%

35%

50%

65%

80%

FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18TD

Natural Rubber Synthetic Rubber* Carbon Black Arab Light

Source: Bloomberg *Price available from FY13

GTYR can take share in HCV tyre imports if it expands

0

50

100

150

200

250

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

400

800

1,200

1,600

Volume '000 - Lhs* Value in US$mn*

Source: IMS Research, PBS * HCV Tyre imports only

Restoration of Regulatory Duty can unlock massive upside 0% 5% 10% 15% 20% 25% 30% 35% 40%

Other

Construction

Motorcycles

Tractors

Bus/Truck*

Light Trucks

Motor Cars

CD Prev. RD RD applied earlier

Source: IMS Research, FBR

'000 US$mn

3 | P a g e

Perspective

About the Company The General Tyre and Rubber Company of Pakistan Limited (GTYR) started commerical production in 1964 on a 25 acres plot at Landhi, Karachi with an initial capacity to produce 120,000 tyres per annum. The company was established by General Tire International Corporation (GTIC) of USA, but then 90% of its shares were sold to the present owners, Bibojee Services Ltd in 1977. Continental AG, the current owner of GITC sold the remaining shares to the sponsors in Jan’17. The company has a Technical Services Agreement with Continental AG and has been using its brand of ‘General’.

Bibojee Group has diverse business stakes in several industries including textiles, insurance, construction and automobiles. The group has 62% stake in Ghandhara Nissan (GHNL) and 39% ownership in Ghandhara Industries (GHNI); both assemble different brands of trucks/buses.

Pak Kuwait Investment Company (PKIC) which is the largest shareholder of GTYR, acquired 28% shareholding (current: 30%) when the company completed a major expansion, taking the capacity to 600,000 tyres per annum. PKIC, a Development Finance Institution is a 50:50 joint venture between the governments of Pakistan and Kuwait. PKIC also has a 30% stake in Meezan Bank (MEBL), the largest islamic bank in Pakistan.

Capacity Breakup

Est Rev

Shareholding Pattern

Bibojee Services 27.79%

Pak Kuwait Investment Co. 30.00%

Banks/ DFIs 9.18%

General Public 16.85%

Foreign Cos. 2.08%

Others 14.11% Source: Company Accounts

Investment Thesis

GTYR manufactures tyres for all vehicle segments and has a capacity to produce 3.4mn tyres p.a. It is also the sole local supplier to most of the OEMs in Pakistan. Robust demand outlook leads us to project a 15% sales CAGR over next 3yrs.

Share in the lucrative replacement market has come off since FY14 but is set to increase going forward, in our view, given that imported tyres have become more expensive after PKR weakness & upward revision in customs valuations.

Eventual cost pass-through ability should enable GTYR to maintain GMs in the 20% vicinity in the medium-term. As a result, revenue growth should largely filter through to the bottom-line; 3yr EPS CAGR is conservatively projected at 10%.

GTYR trades at a FY19F P/E of 13.2x but this compresses to 8.8x on FY20F earnings. We think high growth prospects, amidst multiple triggers justify premium valuations.

Triggers include:

- Restoration of 20% Regulatory Duty on imported tyres (ex-tractors & 2/3 wheelers)

- Possible expansion to enter the radial truck tyres segment, thereby fully leveraging group synergies (sponsors own GHNI and GHNL as well).

- Award of brownfield license to GHNL to assemble passenger cars of Datsun brand, where we think GTYR can lock-in another OEM.

- Possible contracts with incoming Auto OEMs such as Kia, Hyundai, Renault etc.

4 | P a g e

Perspective

Replacement market sales growth to offset OEM slowdown We initiate coverage on The General Tyre and Rubber Co. (GTYR), the only tyre manufacturer in Pakistan which caters to all vehicle segments, with a Neutral stance and Jun’18 TP of PRs210/sh. Three key developments will likely enable GTYR to increase its share in the lucrative and large replacement market (1-2% higher margins vs. OEM sales; 80%+ of tyre sales): (i) PKR depreciation making imports expensive, (ii) upward revision in custom valuation of imported tyres (on which duties/taxes are calculated) and (iii) increased capacity to meet replacement market demand. These offset limited near-term room for volumetric growth in passenger cars (incumbent OEMs) and the loss of a popular variant, Corolla Altis (15% est. share in passenger cars), to imported tyres.

GTYR caters to all product segments There are eight tyre & tube manufacturers in Pakistan but most cater to the two-wheeler market. GTYR is the only company catering to all vehicle segments while a few other companies are producing tractor/commercial vehicle tyres in limited quantity. Automotive sales in Pakistan have historically been cyclical, but GTYR has depicted consistently increasing revenue (10yr sales CAGR is almost 10%). This appears a function of product diversification which guards against a downturn in any particular segment.

Major tyre manufacturers in Pakistan

Motorcars Light Trucks Rickshaw Truck/Bus Motorcycles Tractors

General Tyre √ √ √ √ √ √

Servis √

Mian Tyre (Panther) √ √ √

United Rubber √ √ √

Ghauri Tyre √

Diamond Tyre √ √

Source: IMS Research

Replacement Market is 80% of tyre demand Excluding two wheelers, we place the current size of Pakistan’s tyre market at c.9mn units, of which about 80% emanates from replacement market demand of more than 7mn registered vehicles. GTYR’s overall market share is c.18%, but this drops to just c.7% in the replacement market where imports and smuggled tyres majorly dominate. This is partly due to (i) structural issues such as porous border / transit trade with Afghanistan that facilitates smuggling and (ii) GTYR’s own capacity constraints amidst lack of radial truck tyres in its product suite. However, GTYR is now looking to address the factors under its control by exploring possibility of expanding and entering the radial truck tyres segment.

GTYR has about 20% overall market share (excluding 2 wheelers)…

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12

0%

20%

40%

60%

80%

100%

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

mn Units

GTYR Imports Smuggled Tyre Mkt Size* - Rhs

Source: IMS Research *Estimated size excluding 2 wheelers

…but the company is missing out in the large replacement market

0%

20%

40%

60%

80%

100%

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

GTYR Imports Smuggled RM as % of total market

Source: IMS Research

Autos sales are cyclical but GTYR’s revenues have increased in each of the last 10yrs. This may be due to a diversified product portfolio.

GTYR is expected to increase its market share in replacement market from current c.7%. We estimate replacement market size to be 10.6mn tyres (excl. 2-wheelers)

Registered vehicles in Pakistan by type

1.5

0.6

12.7

1.4

0.2

0.3

3.0

Other

3 wheelers

2 wheelers

Tractors

Buses

Trucks

Cars (inc taxis)

mn Units

Source: Pakistan Economic Survey 2016-17

5 | P a g e

Perspective

Imported tyres dominate the replacement market

In FY17, Pakistan imported rubber tyre and tubes worth US$350mn, meeting nearly half of country’s demand, where most imports pertain to commercial and passenger vehicle tyres. While GTYR has a good brand in tractor tyres, the company’s inability to make radial truck tyres at present and tough competition from cheaper Chinese tyres, as per our understanding, are the main reasons behind high tyre imports. Most of Pakistan’s tyre imports emanate from China while global tyre brands such as Bridgestone, Michelin, Dunlop occupy limited market shares partly due to their premium pricing.

Smuggled tyres are also a problem According to our estimates, smuggled tyres account for c.30% of the total volume, (excluding 2-wheelers), where we understand truck/bus tyres occupy a significant share. Smuggling takes place primarily across the land border with Afghanistan, aided by a porous border and high duties on formal imports. That said, recent moves to tighten movement across the border may help to curb smuggling to some extent.

Nothwithstanding the above, three key developments should help GTYR in building market share in the replacement market:

(i) PKR depreciation making imports expensive,

(ii) Upward revision in custom valuation of imported tyres (on which duties/taxes are calculated) and,

(iii) Increased capacity to meet replacement market demand.

Share of imports has grown considerably, particularly in Truck/Bus segment

0.0

1.0

2.0

3.0

4.0

5.0

6.0

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

mn Tyres

Motor Cars Light Truck Truck Bus Tractor

IMPORTS GTYR

Source: IMS Research, PBS, Company Accounts

China has the highest share in imports

53%58% 58%61% 59% 62%

70%

79%

69%

19% 21%16%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

FY15 FY16 FY17Motor Cars Light truck Truck Bus Tractor

Source: IMS Research, PBS

Imported tyres meet approx. half of Pakistan’s tyre demand (excl. 2-wheelers) with 60% of the imports originating from China.

Pakistan is a highly price sensitive market. Demand for imported Chinese tyres may come off – thereby favoring GTYR – in case of higher duties / PKR weakness.

6 | P a g e

Perspective

Moderate PKR depreciation to benefit GTYR In Dec’17, PKR depreciated by c.5% against US$. Moderate PKR depreciation benefits GTYR, as it will be full reflected in prices of imported tyres (including taxes/duties which are based on import value). On the other hand, raw materials (which are majorly imported) make up only 40% of GTYR’s net sales. We expect the PKR to depreciate further across the course of 2018 which should further make imported tyres dearer compared to GTYR.

Taxes/Duties on imported tyres

Tax/Duty Rate Basis

Custom Duty (CD) 20% Assessed Value

Sales Tax (ST) 17% Assessed Value + CD

Withholding Tax (WHT) 6% Assessed Value + CD + ST

Source: FBR, Pakistan Customs Tariff

Upward revision in customs values will limit underinvoicing On 15th Dec.’17, custom authorities revised up the minimum assessed values of imported tyres in the range of 5-14%. To curb underinvoicing, imported tyres are assessed at the higher of declared value by importers or pre-determined rates by customs authorities for various types of tyres (also referred to as import trade prices). This reflects in final tyre price such that all follow-up duties/taxes are calculated on the underlying assessed customs values. However, efficacy of this measure may erode in case the customs floor value is below the actual product cost.

Revised pre-determined customs assessed value

Increased capacity to meet replacement market demand Historically, GTYR has been upgrading its capacity with increasing demand. However, higher offtake by OEMs in recent years resulted in decreased replacement market sales. With commisioning of new mixing plant in May’17 and continued investment in downstream production process, GTYR can focus more on replacement share, especially in passenger car and tractor segment (as the company does not manufacture preferred ‘radial’ tyres for heavy commercial segment).

Rim Size (Inches)

End Use Japan India China All Other Origins

US$/unit Change US$/unit Change US$/unit Change US$/unit Change

13 Passenger Car 21.2 5% 19.08 5% 14.84 5% 18.02 5%

14 Passenger Car 30.5 5% 27.45 5% 21.35 5% 25.93 5%

16 Light Truck 54.6 5% 49.14 5% 38.22 5% 46.41 5%

20 Truck/Bus 209.0 7% 188.1 6% 146.3 7% 177.65 6%

28 Agriculture 167 15% 149.5 15% 116.9 15% 142 11%

30 Agriculture 275 14% 248.75 15% 192.5 14% 236 16% Source: Pakistan customs * change calculated from previous valuation on 30th Nov,’16

Radial tyres use steel cords compared to nylon polyester used in bias tyres. Radials command higher margins due to superior performance and durability.

GTYR underwent expansion during FY16-17

1.5

1.7

1.9

2.1

2.3

2.5

-100

150

400

650

900

1,150

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

mn Tyresmn PRs

Plant & Machinery* Boilers* Moulds* Capacity (excl. 2-wheeler)-Rhs

Source: IMS Research * Net additions

Per unit tyre prices of various brands

0 5 10 15 20

Bridgestone (Thailand)

Dunlop (Thailand)

General

Ling Long (China)

PRs'000

Source: IMS Research

PKR depreciation, along with upward revision in custom assessment have made imported tyres dearer

7 | P a g e

Perspective

But existing OEM demand is facing challenges While Pakistan’s auto sales are at record highs, limited medium-term growth prospects from existing OEMs, due to their capacity constraints and loss of a popular variant, Corolla Altis (c.15% share in passenger cars) to imported tyres – means GTYR has to look at the replacement market or new product segments, e.g. radial truck tyres to sustain sales growth.

Pakistan’s Auto Sales are currently at record highs driven by low interest rates (cheap auto financing), soft commodity prices (lower cost of production) and recovery in farmer income (agricultural growth of 3.5% in FY17 vs 0.3% in FY16). Total auto sales for local OEMs (including Cars/LCVs/Pickups) reached 213k units in FY17, posting a CAGR of 12% during FY13-17, while 1HFY18 sales are up by massive 27% YoY.

As a result of this strong growth, OEMs are now operating near maximum utilization levels. None of the passenger vehicle OEMs have planned a major expansion for the near future despite strong demand at present, and only INDU is adding c.10,000 units via a debottlenecking exercise (expected to come online in 4QFY18). Changing macroeconomic dynamics (rising inflation and interest rates; weaker PKR) and new upcoming competition may be some reasons holding back expansion, in our view.

That said, to some extent the expected slowdown in sales geared towards incumbent passenger OEMs can be countered by robust demand in other categories:

Incumbent Passenger Car OEMs are running at full capacity

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FY11 FY12 FY13 FY14 FY15 FY16 FY17 1HFY18

Utilization - Rhs Capacity ('000 Units)*

Source: IMS Research, PAMA *Calculated on name-plate capacity

Passenger Car OEMs including INDU, HCAR and PSMC are facing capacity constraints

Incumbent OEMs are operating at near-maximum capacities, offering limited growth opportunities. INDU is increasing its capacity by another 10k units p.a. but GTYR may be the sole supplier for additional units.

News reports are suggesting that GHNL, an associate, will receive brown-field status to assemble passenger cars of Datsun brand, where GTYR can lock in another OEM.

Truck/Bus capacity stands at only c.50% while strong infrastructure activity will likely sustain double digit growth in the next few years (FY15-17 sales CAGR of 44%).

Dewan Motors (DFML), a client of GTYR, has resumed production of Shehzore truck in Feb’18 after getting brown-field status. GHNI, another associate, is introducing JAC light truck and D-max pickup (launch expected at the start of FY19).

Another buying spree can be observed during 2HFY18 on account of (i) upcoming harvesting season and (ii) subsidy on 6.2k tractors by Sindh government.

Post general elections in 2018, GoP can increase GST on tractors from current 5% to rationalize fiscal expenditures, especially if the country goes for another IMF program. Therefore, we have incorporated a decline in FY19 with growth picking ahead of election years.

Competition by locally established players will keep a check on both market share and pricing power, in our view.

GTYR is the only local manufacturer of tubeless motorcycle tyres (introduced in Apr’17); contract with OEMs for 125cc and above bikes (this segment can afford 3x expensive tubeless) will be a catalyst.

Passenger Cars Commercial Vehicles Tractor Motorcycle

8 | P a g e

Perspective

Rising raw material prices but margins should sustain Better prospects for global growth, rally in international oil prices and attempts to limit exports by the top 3 natural rubber producers have increased raw material prices for GTYR, a trend which may continue. While this has manifested in recent volatility in GMs, at 9% in 4QFY17 and 17% in 2QFY18, we expect GMs to normalize at 20% where eventual cost pass-through is a feature of the Pakistan auto parts market. Risks emanate from substitution with imported tyres but the pricing gap (prices of GTYR’s products are 30%-60% lower than premium imported tyres) is a mitigating factor.

Cost pressures will remain

Demand side pressure on raw materials will likely continue due to better prospects of world economy (IMF is estimating 3.9% GDP growth in 2018/19 vs earlier projections of 3.7% and 3.5% average over the past 5 years). At the same time, Indonesia, Malaysia and Thailand have also started a cut in natural rubber exports, in order to fetch better prices. For GTYR, Natural Rubber (TSR) is c.25% of the raw material cost while the rest is mainly accounted for oil-based derivatives (synthetic rubber, carbon black and nylon). Rise of crude oil prices (up 36% in FY18TD), and its petrochemical derivatives will also stretch the price of natural rubber due to its close substitution with synthetic rubber.

Rubber is the most important material for tyre manufacturing with natural and synthetic rubber making up c.45% of the raw material cost. Other major materials include Carbon Black (20%) and Nylon Fabric (20%) while the rest includes the cost of steel cords and certain accelerators. More than 90% of the raw materials are imported by the company; therefore, it is signficantly exposed to gyrations in commodity prices and exchange rate.

Steep PKR depreciation can create problems According to management, more than 90% of the raw materials are currently imported, exposing company to exchange rate volatility. We understand that the company has to renegotiate price increases with OEMs; therefore, margins can take a quarter to revert back to normal levels.

In a scenario of steep change in the exchange rate or raw material prices, margins can come off significantly within a quarter and may take until the next quarter to normalize. In the replacement market, the company can pass on prices, but a price shock can affect demand resulting in lower sales. In the case of the Dec’17 c.5% weakness in the PKR, however, we feel that the impact is not large enough to significantly affect 3QFY18 performance for GTYR.

Raw material cost breakup (on average)

20%

25%

20%

20%

15%TSR*

SBR*

Carbon Black

Nylon Polyester

Others

Source: Company management

Oil can lead recovery to in raw material prices

25

%

19

%

-3%

1%

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%

-44

%

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%

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%

-60%

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FY11 FY12 FY13 FY14 FY15 FY16 FY17 FY18TD

Natural Rubber Arab Light Gross Margins

Source: Bloomberg, Company Accounts

Natural Rubber production is highly concentrated in South East Asia with three countries – Indonesia, Malaysia and Thailand – accounting for 70% of the world production.

Styrene Butadiene Rubber (SBR) is a commonly used synthetic rubber with Naphtha (derivative of crude oil) as the main feedstock.

Carbon Black, used as a reinforcer, is also a petrochemical. Recently, environmental concerns in China and US has created problems on supply side.

9 | P a g e

Perspective

Sensitivity to PKR/US$ exchange rate

FY19F FY20F FY21F

Base Case US$-PKR 114 117 122

change 4% 5% 3%

EPS (PRs) 16.67 19.48 20.12

Bull Case US$-PKR 111 111 111

change 1% 0% 0%

EPS (PRs) 17.08 20.46 22.35

Bear Case US$-PKR 120 132 146

change 10% 10% 10%

EPS (PRs) 14.78 14.03 10.99 Source: IMS Research

Margins have lately been volatile… GTYR GMs varied from 9% in 4QFY17 and 17% in 2QFY18 (against 25%/21% during FY16/17). These were a function of sudden spikes in raw material prices and production issues. According to management, migration to newly implemented SAP system during 4QFY17 affected sales, resulting in higher overhead costs per unit while significant rise in carbon black prices led to a below-expected result in 2QFY18.

…but GMs should normalize around the 20% mark going forward The company has now addressed its production bottelnecks, while carbon black prices have been declining (after peaking from US$ 1,527/MT on 31st Jan’18). We expect improved margins for the rest of year as cost increases (raw material and PKR depreciation) are gradually being passed on to customers. Since eventual cost pass-on is industry practice for auto parts, we expect margins to normailze at 20% in the long term, but sudden swings in raw material prices can depress a quarter’s performance, due to lag in price re-adjustment.

Margins by tyre type

End Use Margins

Motor Car 21%

Light Trucks 20%

Bus/Truck 17%

Tractor Rear 25%

Motorcycles 2% Source: Company Management

Quarterly GMs and Raw Material Snapshot

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-20%

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1Q

FY1

6

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6

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6

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6

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7

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FY1

7

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8

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FY1

8

Natural Rubber* Synthetic Rubber* Carbon Black* Gross Margins - Rhs

Source: IMS Research **QoQ change

Although pass-on of cost increases is a feature for most auto part manufacturers, sudden gyration can erode a quarter’s margin

10 | P a g e

Perspective

What could trigger a rally? Restoration of Regulatory Duty (removed in Feb’18 on court’s order) on imported tyres will be a key positive. We think duty restoration is likely; with trade deficit impinging on fx reserves, the GoP may be left with few choices to curb imports. Secondly, pending entry of manufacturers such as Kia, Hyundai and Nissan in the next 2-3 years can lead to fresh contracts which can lock-in a new demand stream. Finally, the company is mulling to buy additional land to expand capacity potentially by another 1mn tyres from existing 3.4mn, where GTYR will likely manufacture high-margin radial truck tyres, which are currently imported. As BoD approval on this project is pending, this is not part of our estimates.

Restoration of regulatory duty will change our investment case!

On 8th Feb’18, Sindh High Court (SHC) ordered against the additional regulatory duty imposed on non-essential imports including tyres, which were placed in Oct’17. To recall, FBR imposed RD through SRO 1037 to curb the rising import bill; but according to SHC, such authority does not lie with FBR/Finance Minister, terming the move illegal (the authority lies with Federal Cabinet). As the GoP wants to curb the import bill, we believe restoration of RD seems likely. For that, the Federal Cabinet will have to reinstate the additional RD, as per our understanding.

In case of passenger cars, imposition of 20% regulatory duty will increase the cost of import by 17% (83bps increase in cost for every 100bps increase in RD) as additional taxes are calculated in percentage terms after adding duties to the import cost.

Impact of RD on imported tyres (motor cars) - simplified example Account US$ Value

Assessed/Declared Value 10.00

CD @ 20% 2.00

RD @ 20% 2.00

ST @ 17% 2.38

WHT @ 6% 0.98

Total Taxes 7.36

Final Cost 17.36

Without RD US$ Value

CD @ 20% 2.00

ST @ 17% 2.04

WHT 0.84

Total Taxes 4.88

Final Cost 14.88

Additional amount due to RD 2.48 Increase in cost 16.7%

Source: IMS research, FBR

All eyes on new players! With several greenfield licenses awarded in OEM space under Auto Policy 2016-21, we estimate capacity additions of over 100k vehicles (both passenger and commercial) over FY20-21 period. Furthmermore, it is likely that GoP will make it harder to import CBUs by introducing measures like decreased depreciation allowance, ban on sale of cars for 1-2 years imported by overseas Pakistan. In addition, concessionary duty structure enjoyed by hybrid vehicles (50% of the prevailing duty structure) can be withdrawn as oil was US$108/bbl when this relief was allowed, and current economics are different. In such a scenario, new capacity can be absorbed, limiting imports to premium catergory only.

List of major new players under green-field licenses

New Players Investment

(PRs Bn) Expected Initial

Capacity Type of vehicle(s) expected Expected COD

Kia-Lucky 15.0 25,000 Passenger Car/SUV 2HFY20 Hyundai-Nishat 16.5 25,000 Passenger Car/SUV 2HFY20 Sazgar 1.8 24,000 Passenger Car/LCV 1HFY20 Renault N/A N/A Passenger Car/SUV 2HFY20 Regal Automobile 0.8 5,000 Passenger Car/LCV 2HFY18

*IMS Research

RD applied earlier

Description Regulatory Duty

Motor Cars 20%

Light Trucks 20%

Bus/Truck 20%

Source: Pakistan Custom Tariff 2017-18, FBR

Of 313k passenger cars/ LCVs sold in CY17, imported CBUs accounted for 73k cars (31% share). Going forward, it is likely the GoP would look to curtail the quantum of the latter.

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While new players will enjoy concessionary duty structure on parts (10%/25% on localized/non-localized parts vs 30%/45% for existing OEMs), we expect local content to increase over time as duty benefits will expire after 5 years of starting operations for greenfield operations. We have not incorporated sales from new players as GTYR management has not initiated any talks with them as yet. Nonetheless – given that new entrants will ultimately have to localize more beyond the concessionary period and GTYR may remain the sole local supplier of passenger car tyres in the medium term – this will be a major sales trigger for the company.

Another expansion on the cards? GTYR’s management is considering options to acquire additional land to carry future expansion plans and a reserve of PRs1bn for capital expenditure has been created on the company’s books. The company is looking to buy 20 acres of land for warehousing and 50 acres for plant expansion (existing land: 25 acres) but the financial plan for capacity expansion has yet to be approved by the BoD. If the expansion takes place, the company will likely introduce radial truck tyres (currently imported) while enhancing capacity in other segments. This project will cost PRs15bn and will take two years to complete.

Keeping debt to equity ratio of 70:30, our preliminary calculation leads to net present value (NPV) of PRs10.3bn (see table below). To keep the leverage ratio in check, the company may have to raise fresh equity, in our view; and we have assumed right share issue at 25% discount.

GTYR’s share in truck/bus tyres is insignificant as the preference is shifting towards radial tyres. By undertaking this project, the company will be able to tap into the growing economic activity and trade within the country, particularly in the wake of China Pakistan Economic Corridor (CPEC).

Expansion (if carried) can add PRs52/sh to our base TP

Project Cost (mn PRs) 15,000 New Shares (mn) @25% disc 28

Debt 70% Total Shares OS (mn) 88

Equity 30% Project NPV (mn PRs) 10,301

Debt (PRs mn) 10,500 Expected COD FY21

Fresh Equity (PRs mn) 4,500 New TP (PRs/sh) 262

Internal Cash (PRs mn) 500 NPV (PRs/sh) 52

Source: IMS Research

We have not incorporated any sales to incoming players in Pakistan’s auto space as GTYR has not initiated talks as yet.

If GTYR expands, it is likely be to introduce radial truck tyres. This could help the company gain a further foothold in CPEC-related demand as well.

Truck/Bus tyre imports of Pakistan

0

50

100

150

200

250

FY10 FY11 FY12 FY13 FY14 FY15 FY16 FY17

400

800

1,200

1,600

Volume '000 - Lhs Value in US$mn

Source: IMS Research, PBS

'000 'US$mn

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Valuation We have valued GTYR by using Discounted Cash Flow (DCF) method, with a WACC of 12%, and assuming a growth rate of 4% in our terminal year (FY27).

GTYR trades at a FY19F P/E of 12.7x vs. 10.1x for main auto OEMs and 9.2x for KSE-100. In our view, higher valuations for GTYR are justified by its promising growth trajectory (3yr projected profit CAGR: 10%) alongside prospects of supplying to the new players in the Pakistan auto manufacturing space.

Restoration of RD will lead to Buy stance! Assuming RD is restored on imported tyres, we expect GTYR to grab an incremental 2-3% share in replacement market post FY18 and our TP jumps to PRs230/sh.

PRs FY19F FY20F FY21F TP (PRs) Base Case (EPS) 16.67 19.48 20.12 210.0 IF RD is restored (EPS) 18.22 23.30 24.34 230.0 Change 9.3% 19.6% 21.0% 9.5%

Source: IMS Research

(PRsmn) FY18F FY19F FY20F FY21F FY22F ... FY27F EBITDA 1,250 1,402 1,532 1,565 1,899 … 2,715

Capex (197) (230) (350) (381) (415) … (671)

Working Capital (160) 76 (127) (179) (286) … (392)

FCFF 892 1,248 1,055 1,005 1,198 … 1,652

PV of CF 892 1,113 839 712 757 … 588

Enterpirse Value 15,159 Net Debt 2,598 Equity Value 12,560 Fair Value (PRs/sh) 210 Source: IMS Research

Assumptions

Rf 9%

Risk Premium 6%

Beta 1.0

Debt 31%

Equity 69%

Cost of equity 15%

Cost of Debt 6%

WACC 12%

Long-term growth 4% Source: IMS Research

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Risks to our thesis

Upside

Contracts with New OEMs: As renowned car makers like Kia, Hyundai and Renault are setting up plants in Pakistan, contract with these OEMs presents a key trigger. New players, however, may not localize products initially as they will have a concessionary duty structure for first five years after operation.

Increase in custom duty: Enhancement of existing custom duties can provide more protection to the local tyre industry, which will allow GTYR to sell more in replacement market.

Restration of regulatory duty: The government can restore regulatory duty (initially placed in Oct’17) removed on court’s order. For that, the federal cabinet needs to apply RD, rather than FBR/Finance minister.

Crackdown on smuggled tyres: With c.30% of the tyre demand (excluding two-wheelers) met by smuggled tyres, we think serious government effort to curb smuggling will be positive for formal players in the tyre industry including GTYR.

Local manufacturing of radial truck tyres: The company will start manufacturing radial truck tyres if the board approves their financial plan. These tyres are currently imported and the company can capture this high-margin market.

Downside

Entry of new manufacturers in tyre market: As imported tyres make up 50% of the demand and industry is protected through custom/regulatory duty, we cannot rule out the entry of new tyre manufacturers in Pakistan. Additionally, with radial truck tyres not being manufactured locally, this segment provides first-mover advantage. Reportedly, a competing local tyre company is planning to manufacture radial tyre for passenger cars

Volatility in raw material prices and exchange rate: Unfavorable movements in raw material and PKR can compress margins especially in the short term, as the company has to renegotiate prices in the OEM market while replacement market demand may suffer in case of price shock.

Switching by OEM customers to imported tyres: Corolla Altis, after its facelift in Aug’17 comes with imported tyres, replacing tyres from GTYR. As GTYR is facing quality/perception issues, the company can lose another variant to imported tyres (like Honda Civic) where the OEM can pass on the cost easily.

Slowdown in auto/tractor sales: GTYR is heavily dependent on OEM sales accounting for more than 50% of the revenues. Decline in auto sales due to factors like policy change, weakness in farm income and poor economic growth will affect GTYR’s performance also.

Delayed revision in custom valuation of imported tyres: While raw material costs for tyre companies are expected to increase, resulting in increased tyre prices, it needs to be reflected in assessed custom values, on which duties/taxes are calculated. Timely revision of these values will reduce the impact of under-invoicing, enabling GTYR to maintain its share in after-market

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Profit & Loss Account

(PRsmn) FY16A FY17A FY18F FY19F FY20F

Net Revenue 9,479 9,645 12,197 13,324 14,494

Cost of sales 7,157 7,589 9,777 10,684 11,601

Gross profit 2,322 2,056 2,420 2,640 2,894

Admin & Selling Exp. 610 700 793 864 943

EBITDA 1,807 1,557 1,823 1,979 2,163

Dep & Amortization 179 254 257 271 289

EBIT 1,628 1,303 1,566 1,708 1,874

Financial Charges 136 124 210 290 215

Other income 65 62 85 92 99

Other charges 150 115 146 160 176

Profit before Tax 1,495 1,184 1,361 1,423 1,664

Taxation 462 303 449 427 499

Net Profit after Tax. 1,032 881 912 996 1,165

Eff Tax. Rate 30.9% 25.6% 33.0% 30.0% 30.0%

Balance Sheet

(PRsmn) FY16A FY17A FY18F FY19F FY20F

Non-Current Assets 3,254 3,778 3,718 3,677 3,738

Total Current Assets 3,558 4,825 6,282 6,963 7,198

Total Assets 6,813 8,603 9,999 10,640 10,936

Share capital 598 598 598 598 598

Reserves 2,352 3,199 3,752 4,270 4,837

Total Equity 2,950 3,796 4,349 4,868 5,434

Long Term Debt 920 1,019 1,190 965 600

Total Non current Liabilities 1,439 1,667 1,839 1,614 1,249

Short term Debt 989 1,679 1,909 2,092 1,994

Total Current Liabilities 2,424 3,139 3,811 4,159 4,253

Total Liabilities 3,863 4,807 5,650 5,773 5,501

Cash Flow Statement

(PRsmn) FY16A FY17A FY18F FY19F FY20F

CF from Operating Activities 1,030 84 1,009 1,343 1,327

CF from investing Activities (1,429) (986) (197) (230) (350)

CF from Financing Activities 273 885 42 (521) (1,060)

Net decrease/increase in cash (125) (17) 854 592 (83)

Cash at beginning 242 117 100 954 1,546

Cash at end of year 117 100 954 1,546 1,463

Key Ratios FY16A FY17A FY18F FY19F FY20F

EPS (PRs) 17.27 14.75 15.25 16.67 19.48

EPS Growth (%) 40.9% -14.6% 3.4% 9.3% 16.9%

PER (x) 11.2 13.2 12.7 11.6 10.0

P/S (x) 1.2 1.2 1.0 0.9 0.8

BVPS (PRs) 49 64 73 81 91

PBV (x) 3.9 3.1 2.7 2.4 2.1

DPS (PRs) - 15.0 6.0 8.0 10.0

DY (%) 0.0% 7.7% 3.1% 4.1% 5.2%

ROE (%) 39% 26% 23% 21% 22%

ROCI (%) 24% 15% 14% 14% 15%

Debt to Equity (%) 1.3 1.3 1.3 1.2 1.0

EBITDA Margin 19% 16% 15% 15% 15%

Gross Margin 24% 21% 20% 20% 20%

Net Margins 11% 9% 7% 7% 8%

GTYR- Financials

GTYR - P/E (x) Band Ju

l-1

0

Jun

-11

May

-12

May

-13

May

-14

Ap

r-1

5

Mar

-16

Mar

-17

Mar

-18

(x)

15

12

9

6

Source: IMS Research

GTYR - PBV (x) Band

Jul-

10

Jun

-11

May

-12

May

-13

May

-14

Ap

r-1

5

Mar

-16

Mar

-17

Mar

-18

(x)

5

4

2

1

Source: IMS Research

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Annexure A: Tyre Manufacturing Process

1. Banbury Blending and Milling Tyre manufacturing starts with mixing of raw materials (rubber, carbon black and other chemicals) to form a homogenous rubber material. At the completion of mixing, rubber is placed onto a drop mill which shapes the rubber into flat, long strips.

2. Extruding and Calendering Calender operation prepares rubber as uniform sheet of definite thickness and width with steel/fabric cords. In extrusion, most of the rubber compounds produced from the mixing operation are prepared into various components (like tyre tread or sidewall) for the ultimate tyre building operation.

3. Assembly At this stage, all tyre components are assembled together to make a ‘Green Tyre’ with the help of assembling machine. The assembled components include beads, plies, side walls and treads.

4. Curing and Inspection This is the final step where Green tyre is cured in a Dom shape machine having mould in its inside part. After the mold is closed, the rubber compound flows in to mold the shape and form the tread details and sidewall. Final inspection is carried out to confirm the tyre is in accordance with the desired output.

Source: IIT Bombay publication

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Annexure B: Custom Duty Regime

Custom Duty

New pneumatic tyres, of rubber. PCT Code FY18 FY17 FY16 FY15 FY14 FY13 FY12 FY11 FY10

motor cars 4,011.100 16% 16% 15% 25% 25% 25% 25% 25% 25%

light trucks 4,011.201 16% 16% 15% 20% 20% 20% 20% 20% 20%

Bus/Truck 4,011.209 3% 3% 5% 5% 5% 5% 5% 5% 5%

Of a kind used on aircraft 4,011.300 3% 20% 5% 5% 5% 5% 5% 5% 5%

Of a kind used on motorcycles 4,011.400 20% 20% 20% 25% 25% 25% 25% 25% 25%

bicycles 4,011.500 20% 20% 20% 25% 25% 25% 25% 25% 25%

agricultural or forestry vehicles and machines* 4,011.700 20% 20% 20% 20% 20% 20% 20% 20% 20%

construction or industrial handling vehicles and machines* 4,011.800 11% 11% 10% 10% 10% 10% 10% 10% 10%

Other* 4,011.900 11% 16% 15% 15% 15% 15% 15% 15% 15%

Source: Pakistan Customs, FBR

Annexure C: Impact on taxes due to underinvoicing

Declared/Assessed Value as % of Cost 100% 75% 50%

Declared/Assessed Value 100 75 50

CD @ 20% 20 15 10

RD @ 20% 20 15 10

Value after CD/RD 140 105 70

ST @ 17% 23.8 17.85 11.9

Value after WHT 163.8 122.85 81.9

WHT @ 6% 9.828 7.371 4.914

Cost of import 173.628 155.221 136.814

Cost Advantage 0 18.407 36.814

Cost Advantage to importer in % terms 0% 11% 21%

Effective Duty/Taxes 74% 55% 37%

Source: IMS Research, FBR

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I, Ahmed Raza, certify that the views expressed in the report reflect my personal views about the subject securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations made in this report. I further certify that I do not have any beneficial holding of the specific securities that I have recommendations on in this report.

Ratings Guide* Total Return

Buy More than 15%

Neutral Between 0% - 15%

Sell Below 0% *Based on 12 month horizon unless stated otherwise in the report. Total Return is sum of any Upside/Downside (percentage difference between the Target Price and Market Price) and Dividend Yield.

Valuation Methodology: We use multiple valuation methodologies in arriving at a Target Price including, but not limited to, Discounted Cash Flow (DCF), Dividend Discount Model (DDM) and relative multiples based valuations.

Risks: Please refer to page 13.

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