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Free cash flow issues could puncture Goodyear

by Jamie Mason | Published June 15, 2012 at 3:02 PM

Goodyear Tire & Rubber Co. could be headed for a blowout.

As the Akron, Ohio, tire maker invests heavily in growing markets such as China and Latin America, it could find itself patching out financially before being able to take advantage of that expansion. Goodyear's leaky free cash flow, heavy pension obligations and rising interest expense may challenge its ability to continue making payments on its more than $5.3 billion in long-term debt.

"Goodyear may, in fact, implode under the weight of its leverage," said John Del Vecchio, a forensic accountant and the portfolio manager and principal at AdvisorShares Active Bear ETF. "[The company] could very well go bankrupt in the next two to three years."

Goodyear is currently AdvisorShares' biggest short position, Del Vecchio said, adding that he expects the stock, which trades on Nasdaq under the symbol GT, to drop into the mid-single digits. On Thursday, the stock closed at $10.62.

"It's not a growth stock because there's no growth. It's not a momentum stock because the chart looks awful," Del Vecchio said. "Some people may see it as a value stock, but I see it as a value trap."

And yet Goodyear's 7% senior unsecured notes due in 2022 traded at between 97 and 102 on June 14.

"Others have great confidence in Goodyear," according to Keith Price, a company spokesman who points to a recent refinancing it did that resulted in a better interest rate on its notes, its substantial cash hoard, no shortage of available credit and its lack of near-term debt repayments.

There are other mitigating factors involving Goodyear, too. For example, its debt is covenant-lite. But fundamental business issues -- still-high rubber prices, sluggish demand and an expiring protective tariff -- have others beside Del Vecchio worried about one of the nation's best-known industrial brands.

Pressures on Goodyear's free cash flow have analysts especially concerned. For the first quarter ending March 31, the company reported negative $1.05 billion in free cash flow, compared to negative $783 million for the same period last year, according to filings with the U.S. Securities and Exchange Commission.

For all of 2011, the company had negative $270 million in free cash flow, meaning it gained liquidity after the first quarter.

"We have a seasonal pattern in our cash flow, using cash early in the year and generating cash later in the year," Price said. "We generated approximately $1.5 billion in positive cash flow during the fourth quarter of 2011. Our first quarter 2012 usage was very similar to our usage in the first quarter of 2011."

Problem is, free cash flow is still negative at year's end, and that, too, is a trend. Besides 2011's deficit, Goodyear had negative $20 million in free cash flow in the 2010 fiscal year and $551 million in free cash flow in the 2009 fiscal year, SEC filings said.

"Free cash flow is the heartbeat and life force of a company," said Standard & Poor's analyst Lawrence Orlowski. "If that deteriorates, for any company, it's a bad sign."

That disturbing pattern will continue, Orlowski said, noting that Goodyear is expected to have negative free cash flow in 2012 because of higher spending and increased pension obligations.

Moody's Investors Service Inc. analyst Timothy L. Harrod explained that other factors -- raw material costs, capital reinvestment and competition in Latin America and Asia -- will also lead to negative free cash flow.

Cash contributions to the company's global pension plans will remain a strain on cash flow at an estimated $550 million to $600 million in 2012, according to a May 29 report by analyst Evan Mann of independent research firm Gimme Credit LLC.

In 2011, Goodyear's pension contribution was roughly $294 million, so its 2012 pension contribution is a significant leap, which also puts pressure on its cash flow, S&P's Orlowski said. Goodyear has estimated its U.S. pension obligations at $425 million to $475 million in 2013 but has not made an estimate for its global obligations yet, according to SEC filings.

Price, the Goodyear spokesman, said that the increased pension contributions will actually help improve the company's future cash flow because it will reduce its unfunded amount. He said Goodyear expects to generate sufficient cash in 2013 and retains flexibility to reduce capital expenditures, if needed.

But trimming that spending would represent a strategic reversal, Orlowski said.

The company is having free cash flow troubles because it has been raising the amount of capital expenditures it has been making through investments in China and Latin America. While it's true that during the 2009 downturn, Goodyear spent significantly less -- $746 million -- than in 2010 ($944 million) and in 2011 ($1.04 billion), the plan is clearly to spend even more because Goodyear is anticipating the cash flow such infrastructure will generate.

"[For 2012] we also plan to make capital expenditures of between $1.1 billion and $1.3 billion, about half of which is for projects targeted for profitable growth with a 25% or greater internal rate of return -- again improving cash flows," Price said.

Analysts do see some daylight ahead. For instance, Orlowski said S&P forecasts that Goodyear is expected to be cash-flow positive in 2013. Meanwhile, Gimme Credit's Mann, in a report, asserted that "adequate liquidity and no debt maturities for seven years provides the flexibility to navigate through what will likely be a bumpy few quarters due to sluggish global replacement tire demand, uncertainty in Europe and free cash flow shortfalls."

In an interview, Mann said that things would have to get considerably worse for the free cash flow to become a big problem for Goodyear.

To be sure, Goodyear's financial reengineering has lengthened the maturities of the company's debt. On Feb. 28, the company pushed out the maturity of its senior notes when it issued $700 million in 7% senior unsecured notes due May 15, 2022. But in doing so, it increased the company's debt from the $4.9 billion it reported in its 2011 annual report because, among other things, the new senior notes were used to repay $650 million in 10.5% senior notes due 2016. Then, on April 19, Goodyear refinanced $3.2 billion in credit facilities by amending and restating its principal U.S. credit facilities.

Through the refinancing, the company's asset-based revolver was increased from $1.5 billion to $2 billion, and the maturity was extended to April 30, 2017, from 2013. The loan is priced at LIBOR plus 150 basis points. Goodyear's $1.2 billion second-lien term loan was also extended until April 30, 2019, from 2014. The second-lien loan is priced at LIBOR plus 375 basis points, with a 100 basis points floor on LIBOR.

The maturities may be deeper in the future, but Goodyear still has to pay interest on that paper, and that expense is rising. In 2009, the company paid $311 million in interest expense, Price said, and it has risen since. The company paid $316 million and $330 million, respectively, in 2010 and 2011. And this year Goodyear is estimated to pay between $360 million and $385 million.

What has kept the tire maker from skidding on its obligations is that much of its debt is covenant-lite. For example, Goodyear's domestic first-lien debt doesn't require a financial ratio test as long as available commitments exceed $150 million (or $200 million on and after April 19, 2012), Orlowski said.

The company's second-lien debt is also considered more covenant-friendly because it is triggered upon certain asset sales instead of a ratio that is measuring financial performance from quarter to quarter, he explained.

"Goodyear's covenants are generally more flexible than their peers'," Orlowski said, adding that this is probably due to Goodyear's greater size and therefore bargaining power vis-à-vis the banks.

The company's management has been very prudent in financial management and in refinancing the debt before it becomes a real issue, he added.

Evidence of that is found in Goodyear's cash coffers. The company ended the first quarter with $2.1 billion in cash -- and $2.2 billion of credit availability -- even after a $4 million net loss.

Alas, Goodyear is one of the world's largest tire companies, employs 73,000 people, and makes its products in 53 facilities in 22 countries around the world. But the fundamentals of its business are weakening.

Roughly 80% of Goodyear's business is made up of replacement tires, while the remaining 20% is from new car sales. The replacement market, however, is sagging. Since the economy is weak, people haven't been buying tires as frequently or have been postponing their purchase of tires, Orlowski said. Also affecting people's replacement decisions, he said: rising gas prices, which reduce the miles driven.

Then there's the rising cost of rubber. In 2011, raw material costs increased by 30% in Goodyear's tire business compared to 2010. And for the full 2012 year, the company expects its raw material costs to increase by approximately 5%, SEC filings said.

"However, natural and synthetic rubber prices and other commodity prices have experienced significant volatility, and this estimate could change significantly based on fluctuations in the cost of these and other key raw materials," Goodyear said in SEC filings.

At the end of May, the price of rubber was roughly $1.40 per pound, down from $2.60 per pound in February 2011, but still up substantially from July 2009, when the price of rubber was at 68 cents per pound. In addition, the price of synthetic rubber is tied to the price of oil.

"Our first quarter raw material inflation was $482 million, which we successfully more than offset with $525 million in price/mix improvements," Price said. "This now makes four quarters in a row where we have been able to more than offset raw material cost increases. We don't see raw materials as having a significant effect on this year's cash flow."

But how long will Goodyear be able to pass on the costs to its customers? The company reported record sales of $5.53 billion for the 2012 first quarter, up 2% from the same period last year, when it had $5.4 billion in net sales. The tire maker had $5.7 billion in sales for the fourth quarter of 2011, up 12% from the prior year. For the year, Goodyear ended up with net income of $343 million -- but that was after a $216 million loss in 2010.

A significant nail in the road going forward is the September expiration of a tariff imposed by the Obama administration in September 2009 to help U.S. tire makers compete against their Chinese rivals. The tariff helped stabilize prices for domestic manufacturers against importers. Without it, however, Goodyear may be prone to more competition, Orlowski said.

The company's major competitors are Bridgestone Corp. and Compagnie Générale des Établissements Michelin SCA, while other rivals include Continental Tire, Cooper Tire & Rubber Co., Hankook Tire Group, Kumho Tire Co. Ltd., Pirelli & C. SpA, Toyo Tire & Rubber Co. and Yokohama Tire Corp.

Against such competitors, Goodyear will have to get more efficient. More than half (37,000) of its workers are in unions, and, Orlowski said, it has to improve on its high fixed costs. The incentive is generating more free cash flow so that Goodyear can hum along until its investments in Latin America and Asia start to pay off, he added.

But not everyone is so hopeful. To AdviserShares' Del Vecchio, Goodyear's "combination of increased leverage, worsening cash flow and underfunded pension combined with pressure on the top-line and margins makes me think they're in big trouble in a couple of years."

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