The Goodyear Tire & Rubber Company (GT) Earnings Call Transcript & Summary

[Audio Gap] side chat, which is with Goodyear. Goodyear, as all of you know, is a global tire manufacturer. They drive around 54% of their revenue from the Americas, 32% from Europe, 14% from Asia. Like many other tire makers, the company's margins had been on a nice upward trajectory up until around 2015, 2016. And at the time, the margins peaked at around 12%. Segment operating income, which excludes corporate overhead, peaked at around $2 billion in that time frame and free cash flow peaked at around $1 billion. Then in 2017, '18 and '19, profitability deteriorated. The company's operating margin fell from 12% to 5.6%, segment operating income declined from $2 billion down to $945 million last year. Free cash flow last year, excluding working capital and restructuring would have been roughly $400 million. Over the past 3 years, the drivers of that $1 billion included $700 million approximately from the convergence of pricing versus raw materials, about $350 million from volume and overhead absorption. Heading into 2020, we actually were thinking that there was the potential for some meaningful improvement, but their guidance suggested that we may be in for kind of a flattish year, and some of the underlying improvements that are actually occurring are masked by inefficiencies that we've listed here on the lower right. At the same time, Goodyear suggested that, as you get into 2021 and 2022, both of those should start to look better. So what do investors hope to see, and this is more of a message to Goodyear than to this audience, so out of this discussion, people want to get a better feel for whether this is really the bottom. Obviously, the past 3 years have been very challenging for shareholders. We listed some of the positives on a number of occasions that Goodyear has outlined. They add up to really big numbers. Question is, will they really materialize or will those be offset by new headwinds? And investors want to get a better understanding of what normal is for a company like Goodyear. As I said, 3 years ago, segment operating income of $2 billion, now it's closer to $1 billion. Even if you got to halfway between where we are now and where we were a few years ago, the free cash flow of this business could be very meaningful. So to talk through some of those things, we're very pleased to welcome Darren Wells, the company's CFO. So thank you very much.

Good, Rod. Thank you. And what I might do is, I mean, if you don't mind, one of the last points you made there, I think, is worth a little bit of a starting point, and then I can come back and talk a little bit about some of the things that are, I guess, causing me to be realistic near term, but continue to be really optimistic as we get out 2 and 3 years. But I think this question about the -- like where the long-term margins for Goodyear or for the tire industry are going to go, it is a fair question. And I think that we went through a period of time that was really favorable for the industry and more favorable than in the sort of 20 years that I've been involved, like you've been involved for most of that 20, maybe more than that, maybe, I don't know. But we went through that period in 2015, 2016, where everything was going very well. I think there were some really good fundamentals that were helping drive that, for sure. Movement towards high value-added tires towards larger rim diameters going very quickly. And some really good dynamics for the premium tire makers going through that point in time. I'll say this, though, that as we look out over the next 2 to 3 years, certainly, we see our ability to get our operating margins back up over 8% in that time frame. And then we're in a territory that is good economic value-adding territory and a place that, in the early part of my Goodyear career, that was sort of aspirational levels. But now it's something we think we can get back to there, and then with the longer-term view of getting back into double digits. And as you say, I mean, at those sort of levels, the opportunity for us to generate cash flow is pretty good. And relative to history, and it's been, I guess, a fairly long history, we no longer have legacy obligations that are going to be a call on that cash flow. And really up until about 2015, those still existed. And so over the period in the last 15 years, we eliminated retiree health care obligations, we funded the unfunded U.S. pension obligation. Sort of a point where, I mean, our leverage is a bit higher than we'd like it to be right now. But overall, as our earnings recover from the part of the cycle that we're in right now, I think we feel good about our ability to generate cash.

So let's dissect that a little bit and think through some of the things that have happened. Look, I mentioned the biggest component of the profit erosion in the past 3 years was that convergence of the spread between raw materials and price/mix. So seems like the industry was starting to recover some of that. And actually, there was -- there have been some price announcements, even subsequent to the last round, which was a couple of months ago. But now this was kind of offset by some concessions on the OE side. Help us parse through this. What -- at a high level, is the supply/demand in the industry good or not good? What's driving that?

Yes. No, I think that it's a fair question. I think it's geographic. I think the industry dynamics in North America are still pretty good. There's still demand. I think there's a lot of segments where there's probably more demand than we can supply. And certainly, if you get into the area of SUVs and light trucks. I mean that's -- those are segments in the market where there is still very strong demand. So I think the replacement business in North America is the -- that's the one part of the industry that has held up very well. I think our performance there we feel very good about. I mean the profitability there and the recovery of market share and the continued strong volumes, even as we have increased prices, I think, make us feel good about the strength of our business, but it also tells you that the industry environment is holding up pretty well. So I would segregate that, even in North America, though, from what's going on in the OE industry. And you know -- you probably spend more time studying this than I do, but certainly, there's some cyclical elements to what the OEs are going through right now. And that hasn't initially been focused in the U.S., but globally, their businesses have been under some pressure from lower volumes. And those cycles tend to have the predictable effect of putting pressure back on the supply chain and I think we're feeling that. Now I think the question for all of us in some ways is a question about some of the transitions the automotive industry is going through. And I think we understand and want to support our OE customers in going through the transitions in terms of the powertrains, the different platforms they're moving to. We're very excited about the opportunities that we're going to have working with them on electric vehicle platforms and beyond in terms of where the automotive industry is going. So I think there's some really good applications for our technology that are going to create another version of high value-added that are going to be favorable trends for tire companies that have the best technology. I think the question is going to be around how long the pricing pressure or just the pressure to give annual price reductions extends. So certainly, it's something that is fairly typical in cyclical downturn in OE production. I think we're asking ourselves the question about what the duration is. Now we're still -- and we're very focused on supporting our OE customers. We're also focused on making sure that we've got adequate returns on the investments that we're making. As we do -- we invest a lot, both in R&D and production. So I mean, there's a balance to be struck there. I still think we love the business. We love the fact that, that loyalty or that replacement pull, if anything, has gotten better over time from the OE business and become even more important for us. So I think the general trends are good, but I think we've had to acknowledge that we are feeling, for the OE part of the business, we're feeling a lot of price pressure right now. And I don't think that's unique to us, but we are, I think, doing our part at least to help with the current environment there.

Was the price pressure that you're alluding to, is that primarily in Europe?

So I would say there's an element of that everywhere in the world. So I would say that's -- there's some truth to that in North America. Our OE profitability is down in North America as well. And that's why we look at the progress that we've made on pricing and recovering raw materials. I think in the replacement business in isolation, the progress would be much more visible than when it's combined with the OE business because OE pricing is moving the other direction.

Well, the OE business used to not make money, right? The idea of the industry years ago was you're sort of breakeven there because, hopefully, in 4 years, that person comes back and buys replacement, that's not the case now.

Yes. No, I mean, our OE business structurally is much better now than it was 10 years ago, I think, for a variety of reasons. Partly, things that we have done to make ourselves more efficient. But partly the fact that the tire technology has become more challenging and more important.

So help me understand what -- how does pricing really work in the OE market, is it annual contracts, it's not on a platform, and it's not multiyear?

So there's a little bit of both. So there certainly are -- when we win OE fitments, I mean, that is on the basis of what the pricing will be at the start of production for the fitment. But then for the existing portfolio, there are always discussions around the pricing annually, and that's generally the case. Now for us, that's partly alleviated by the fact that we do have raw material indices that are in a broad array of our contracts. So as raw materials have declined over the last few months, there is an impact that's just driven by those raw material indices. And those raw material indices helped us initially, but right now, we're moving the other direction.

Right. So there's a threat basically when an OE is coming in and saying, on this existing portfolio of tires that we're buying from you, we can shift to somebody else, and you are responding to that as a realistic threat. And looking at the decremental margins that would occur if that were to happen and negotiate on that basis?

No. And I think it's fair, and I think we're building in the fact that we are -- we do look at our OE customer relationships as important relationships. And to the extent they are facing challenges, we embrace those challenges with them. So we want to make sure that we're doing the right thing for the long term of that relationship because we do see the opportunities moving forward.

Right. Ultimately, though, isn't all this determined by supply/demand in the market? And are you concerned about some of the trends that are occurring on the supply-demand basis because that would obviously worry people as you look out at the offsets to some of the gains that you've got in the future?

So I don't have any long-term concern about that. I think we go through points in the cycle where production is down and we've been among the most capable tire suppliers, there is some extra supply available. And I think that if I go back 12 months ago, I would have said the supply was pretty tight on premium product, both in the U.S. and in Europe. I think sitting here today, the European market has been soft enough in OE and soft enough in replacement that supply -- there's much more supply available. So I think we go through periods of time where there is a little bit. The -- but the demands on tires and the demands on tire manufacturing has generally kept that availability of the most premium tires and a level of being a challenge for us, right? So our -- we're pushing ourselves technically, we're trying to deliver better technology that creates more complexity in manufacturing and requires the best, most modern equipment. And there's not a lot -- while there are -- the lower end of the market, there's lots of capacity. If we look at the premium end of the market, that's not the case. And at least we don't see that, we don't see the evidence of it. And I think the shift toward electric vehicle platforms is the next technical challenge. And those are tires that are going to -- they certainly have greater technical demands than the internal combustion engine counterparts, and that's going to carry greater research and development effort, and it's going to create greater manufacturing challenge. So at least for a period of time, I see that continuing.

But it seems like there's some incongruity here if you're talking about the premium end of the market generally being tight, and that makes -- it seems reasonable. I think every tire company has talked about their capacity actually being under pressure or declining as they've been shifting towards 17-inch and greater. But then the premium end of the market is the OE side, so how do we sort of split the 2 and say, "Look, there may be some pricing on -- price pressure on OE, but that's not going to sort of trickle through to the replacement market?"

Yes. No, I think that, that is -- I mean, they're fair questions, but the fact is the replacement market is still increasing. I mean given the move toward more premium fitments in the last 5 years at OE, that is still -- those trends are still hitting the replacement market, including the growth in SUV and the growth in light truck tires in the U.S., I mean, that's still -- that growth is still out there and building in the replacement market. And so I think as we come out of the cyclical dip, though, in auto production and start to build back up, whichever kinds of platforms we're on, there's going to be a path there that's going to be challenging again as we get -- as we look at what it's going to take to manufacture all those tires.

Okay. Can you talk a little bit about, switching gears, some of the changes in the competitive landscape? And I'm referring to distribution -- the distribution side of things because you and other tire makers have also sort of made some very significant shifts in how you get your tires from the manufacturer to the ultimate dealer in North America that we've seen. And now it sounds like there's something that's about to happen in Europe as well.

Yes. Well, I think it's fair. And the journey for us in North America has taken place over many years. And -- but the fundamentals of what we -- the journey we've gone through in the U.S. and the journey we are going through in Europe are very similar. Yes. So I think the starting point is a market that has developed to the point where there are a lot of competitors, so a lot of different tire brands available, and a lot of distributors working to extend their reach to more and more sales locations. And what that resulted in over time was less and less focus by each distributor -- and what we care about is our brands, but less of their focus being placed on our brands and, therefore, less assistance in focusing on the growth of our brands with those retail sales locations. And obviously, we -- since we have independent distribution that we rely on for a large part of our volume. That's a very big concern for us. And over time in the U.S., what we did is effectively reduced the number of distributors that we were focused on distributing our tires and making sure that retail locations had a couple of options to get individual tires they needed from to make sure that they aren't missing a consumer so they can always get the tire the consumer needs, but also being realistic that we only want people distributing our tires that were focused on growing our brands in the marketplace and helping us get the real value of our products and our brands. And that's been done very successfully in the U.S. It sort of culminated in 2018 in the formation of TireHub in order for us to have an aligned distributor at a national level that was really focused on presenting our brands and servicing retailers across the U.S. In Europe, same dynamic, and this was true. I mean I spent a couple of years running the Europe, Middle East, Africa business for Goodyear. And I would say that some of these distributor challenges existed then, and that was sort of 2014, 2015. And even then, we were contemplating that, we were thinking through what it would take. We are at a point in the industry that was pretty good point. And there were other challenges that we were solving for manufacturing footprint and otherwise. But I think what we found in last year, in particular, is that the lack of focus on our brands by distributors. And I'll say the number of distributors in Europe is much bigger than the number in the U.S. was. But the amount of focus of those distributors on our brands was very small. We're a relatively small part of their shelf space in many cases. And they were carrying a large number of brands. And we, in some cases, would have 4 or 5 distributors all covering the same territory. And it just wasn't -- and we allow -- I mean, in the end, we allowed that situation to occur. But the result of that situation was that we didn't really have partners that were able to help us delivering the value of our brand. And we also found there are a lot of instances where our tires were being moved among distributors multiple times on their way to the retailer. And consumers don't want to pay for that cost and there's no reason for them to. I mean that's inefficiency. So what we went to work at doing was developing a geographic plan for full-service distributors so that we make sure we know who we were going to align with to get tires to market in each geographic area. And we spent the latter half of last year having discussions and getting agreement with the distributors that we wanted to move toward, and obviously, making some selections. In some cases, our call. In some cases, distributors didn't want to make the investment. But now we have started to put in place commercial conditions that will help our full-service distributors make the additional investment in warehouse space, make the additional investment in vehicles and personnel that it will take to grow their business and our brands and to increase their level of focus there.

So you said that, on your Q4 call, that there is the potential to improve margins in Europe by $2 to $4 per unit. And we're thinking that the European replacement market is around 33 million units or something along that -- those lines, which is $65 million to $130 million. Where is that coming from? Is that just kind of -- where is the spread improvement?

No. So I think that -- Rod, I mean, part of it is just improved efficiency. So if there are multiple touch points, if the tire is being moved multiple times on its way to market, that's extra cost in the system. And that cost has to be covered one way or another, it tends to get pushed back to the manufacturer. So I think that is -- getting rid of that inefficiency is part of the story. Now the second part of the story, I think, is the value of our brands and the ability for retailers to present the product. The product's quality and the importance of the brand and the fact that we stand behind the brand only goes up as you see increased focus from the guys that are presenting the product to them.

But the math around this is primarily just the multiple layers of distribution.

So it's both.

And then -- so there is some thinking that there is...

So it is like some value of the brand.

Yes.

So there is a value of the brand. I think the value of the brand improved.

Okay.

As we get more focus on the technical characteristics of the tires that we're offering.

Did you see that happen in the U.S. because we didn't really see that spread improve because of this.

We did. So if we take the period of time over which this occurred in the U.S. I mean we're talking about -- and we're talking about the last 8 to 10 years. So if we look at the improved profitability in our North American business, and this was done over a longer period of time in the U.S. In Europe, for a variety of reasons, we are doing it in a much more compressed time frame. But the structural profit improvement in the U.S. was very much supported by these shifts that we were making to get a more focused distribution effort. So that is part of what's allowed us to get to the stronger point that we're at today.

So as we're building our spreadsheets, should we be thinking that if you're successful, there's $2 to $4 in '21 and '22? Or is this kind of years...

I tend to think of that as a several-year effort.