Goodyear (GT -2.56%) shareholders did not enjoy the market's reaction to the company's fourth-quarter earnings report, which it released on Feb. 11. The stock started that day above $21 a share -- now, at the time of this writing, it sports a price in the vicinity of $16.00. So what went wrong, and should investors dump the stock, or look to buy in after this crash?
What went wrong
What spooked the market here wasn't so much Goodyear's fourth-quarter earnings as it was the company's 2022 guidance. Specifically, it was management's outlook for "breakeven" free cash flow (FCF) in 2022.
FCF is the flow of cash that a company can use to pay down debt, make acquisitions, or return to shareholders through stock buybacks and dividends. It's a hugely significant metric that many investors use to value companies. The more FCF, the better.
As such, investors were left floundering when Goodyear's management told them FCF would be breakeven in 2022. That's disappointing enough in absolute terms, but it was shocking relative to many investors' expectations.
To put matters into context, when the tire company announced its deal 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 spoke of a target of $165 million in annual cost synergies, meaning that $690 million in FCF would be a reasonable expectation, given a return to 2019's sales volumes.
Fast-forward to November, and management told investors its new forecast for annual cost synergies from the deal was even better: $250 million. As such, it wasn't unreasonable to think of Goodyear as a business capable of generating above $700 million in FCF.
This month, investors went from anticipating $700 million in FCF to breakeven in 2022. It's a big difference, and it needs explaining.
What's happening to the cash flow
Management discussed the outlook on the earnings call and highlighted two particular items which will drag on FCF generation:
- A working capital requirement of $300 million to rebuild inventories of finished goods, "particularly in North America."
- Capital spending of $1.3 billion to $1.4 billion compared to $981 million in 2022.
Neither of these items should unduly worry the long-term investor. Starting with working capital and inventories, companies usually gauge inventory by comparing it to their run rate of sales. So an expected increase in volumes implies an increased need for inventory.
CFO Darren Wells discussed the matter on the call and noted, "over time, we've been able to manage the business with working capital as neither a source or a use of cash. And that's more the model that we would expect when we get out beyond 2022."
As such, the $300 million outlay to rebuild inventory should be seen as a non-recurring item. However, it's unfortunate that it needs to happen at a time of elevated raw material prices.
Investing in the future
Turning to the capital spending hike, management said "that's an increase of $200 million to $300 million versus what 2021 would have looked like if Cooper had been included for the full year." So part of it 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, that marginal increase is due to investments meant to fuel growth, such as increasing its ability to produce the specialized tires required for electric vehicles, and boosting overall production capacity to meet future demand. Indeed, CEO Rich Kramer explained that some of these investments are being pulled forward in part because the Cooper integration is running ahead of schedule.
As a rough rule of thumb, investors often compare a company's depreciation costs with capital spending, and use the former as a proxy for what the latter would be on an underlying basis. In this case, management expects $1 billion in depreciation and amortization in 2022. It's fair to assume Goodyear's underlying capital spending is something close to that $1 billion, with that additional $200 million to $300 million representing the cyclical peak in spending.
All told, adding together the working capital outlay of $300 million and the assumption of $200 million to $300 million gives an underlying FCF figure in the $500 million to $600 million range. I'll come back to that underlying FCF metric in a moment.
Two less bullish points
Before rushing to hit the buy button, it's worth reflecting on Wells' comment regarding capital spending: "[T]he expectation is that those programs are going to take place over the next two or three years." In other words, capital spending could remain at relatively elevated levels for the next couple of years.
Furthermore, management's plan for 2022 involves double-digit percentage price hikes to offset rising costs. (It increased Cooper and Goodyear tire prices by up to 12% at the start of the year.) This is fine, but Goodyear will need to make the price increases stick without losing market share in a competitive market. That's something investors should keep an eye on.
A stock to buy
While the earnings release was disappointing, it's essential to keep a clear head in investing. If $500 million to $600 million is a reasonable estimate for where Goodyear's FCF will be in a couple of years, then the stock is a compelling value. The company's current market cap is only $4.63 billion, so that FCF range represents 10.7% to 13% of its market cap. That's an excellent value.