Goodyear Stock Tumbles: Is This a Major Buy Opportunity?
Good year (NASDAQ: GT) shareholders did not like the market’s reaction to the company’s fourth-quarter earnings report, which it released on Feb. 11. about $16.00. So what went wrong, and should investors dump the stock or look to buy after this crash?
What went wrong
What spooked the market here wasn’t so much Goodyear’s fourth-quarter earnings as the company’s guidance for 2022. More specifically, it was management’s outlook for free cash flow (FCF). “break even” in 2022.
FCF is the cash flow a company can use to pay down debt, make acquisitions, or return to shareholders through stock buybacks and dividends. It is an extremely important metric that many investors use to value companies. The more FCF, the better.
As such, investors floundered when Goodyear management told them that FCF would break even in 2022. That’s quite disappointing in absolute terms, but it was shocking relative to many investors’ expectations.
To put that into context, when the tire company announced its agreement to acquire Cooper Tires in February 2021, management pointed out that on a pro forma 2019 basis, the combined companies generated $525 million in FCF. Management also discussed a target of $165 million in annual cost synergies, which means that $690 million in FCF would be a reasonable expectation, given the return to 2019 sales volumes.
Fast forward to November, and management told investors its new forecast for the deal’s annual cost synergies was even better: $250 million. As such, it was not unreasonable to consider Goodyear a company capable of generating over $700 million in FCF.
This month, investors have gone from anticipating $700 million in FCF to breaking even in 2022. That’s a big difference, and it needs to be explained.
What happens to the cash
Management discussed the outlook for the earnings call and highlighted two particular elements that will weigh on FCF generation:
- A working capital requirement of $300 million to replenish stocks of finished products, “particularly in North America”.
- Capital expenditures of $1.3 billion to $1.4 billion, compared to $981 million in 2022.
None of these should worry the long-term investor unduly. Starting with working capital and inventory, companies typically value inventory by comparing it to their current rate of sale. Thus, an expected increase in volumes implies an increased need for inventory.
CFO Darren Wells discussed the issue on the call and noted, “Over time, we’ve been able to run the business with working capital as neither a source nor a use of cash. And that’s more the pattern we expect when we get beyond 2022.”
As such, the $300 million expense to replenish inventory should be considered a one-time item. However, it is unfortunate that this has to happen at a time of high commodity prices.
Invest in the future
Regarding the increase in capital spending, management said “this is an increase of $200 million to $300 million over what 2021 would have looked like had Cooper been included for the full year”. So part of that reflects the increase needed to reflect the addition of Cooper, with the rest coming from a marginal increase of $200 million to $300 million.
However, this marginal increase is due to investments to fuel growth, such as increasing its capacity to produce the specialty tires needed for electric vehicles and increasing overall production capacity to meet future demand. Indeed, CEO Rich Kramer explained that some of these investments are advanced in part because the Cooper integration is ahead of schedule.
Typically, investors often compare a company’s depreciation costs to capital expenditures and use the former as an indicator of what the latter would be on an underlying basis. In this case, management expects $1 billion in depreciation in 2022. It’s fair to assume that Goodyear’s underlying capital expenditures are close to that billion dollars, that $200-300 million additional representing the cyclical peak of expenditure.
In total, adding the working capital expense of $300 million and the assumption of $200-300 million results in an underlying FCF figure in the range of $500-600 million. I will come back to this underlying FCF metric in a moment.
Two points less bullish
Before rushing to hit the buy button, it’s worth pondering Wells’ comment regarding capital expenditure: “[T]He expects these programs to run over the next two to three years. In other words, capital spending could remain at relatively high levels over the next two years.
Additionally, management’s plan for 2022 involves double-digit percentage price increases to offset rising costs. (It raised Cooper and Goodyear tire prices by as much as 12% earlier this year.) That’s good, but Goodyear will have to sustain the price increases without losing market share in a competitive market. This is something investors should watch out for.
A stock to buy
Although the earnings release was disappointing, keeping a cool head is essential when it comes to investing. If $500-600 million is a reasonable estimate of where Goodyear’s FCF will be in a few years, then the stock is a compelling value. The company’s current market capitalization is only $4.63 billion, so the FCF range represents 10.7% to 13% of its market capitalization. It’s an excellent value.
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Lee Samaha has no position in the stocks mentioned. The Motley Fool has no position in the stocks mentioned. The Motley Fool has a disclosure policy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.