Auto Parts: Still Surprisingly Undervalued
History
I still remember, it must be a decade ago by this point, watching the auto parts sector rip to new highs. I was much newer to the market back then & was very a simple value minded person. I remember Magna in particular back then because I couldn't figure it out (why now, why this price). Mostly reasonable priced (on a P/E basis) stocks were those which had fallen or perpetual underperformers. It was rare to find a cheap company aggressively pushing new highs. It was part of my learning experience, why did this one work so well? It turns out that despite the low P/E the company was growing earnings pretty well. (Back then P/E seemed far more arbitrary than today)
I've watched the sector since then & witnessed, in slow motion, why P/E ratio doesn't tell you what you need to know. Since looking inexpensive at the end of their run in 2015, the sector has been a few different degrees of flat. Yes, 8 years, no returns. So aside from being stupid, why have I been talking about a sector that does nothing for three years now?
Back heading into their 2015 peaks, the auto sector was having a strong recovery after the GFC. Parts producers generally have added torque to growth,
more cars = more parts
+ Ability to grow content per vehicle
+ Economies of scale
+ Higher ROC/ROE/ROA
+ Places to deploy profits
Throw in decent business conditions after the 2011 inflation spike and supply chain issues... And these businesses were able to show what they can do. They essentially had things going well for long enough for the market to look a little past the prospects of future troubling times.
One of my favorites nowadays, Linamar, for example traded up to 3x book value. Their narrow margin business has a slight margin expansion which made a big difference. Overall they were showing that they can be a good business in a difficult industry.
A good company at the wrong price will often mean less good returns... And that's what came. They continued making lots of money, investing capital to grow their business, buying business and paying small dividends... Just as they did when they ran up to their peak valuation.
It wasn't enough. Things got marginally less good in a lot of ways; auto volume peaked, margins reverted etc. Every dollar deployed towards growth was catching up.
A String of Bad Luck
Three years on, they had grown the long term value of the business but the stock still hasn't made new highs. Was it ready? It might have been... Except in 2019 there was a big strike in the US auto space & an industrial recession. That delayed things & knocked the stock to a large discount.
2020... Something happened to the economy... Can't quite remember... I feel like it was big. Probably nothing just me coming up with a weak excuse for difficult performance in industrial production.
2021 Shortages of almost everything, most notably, semiconductors, labor and transportation knocked the auto production industry into a recession. I know, you probably missed it amidst everything else going on but used car prices going meme mode was partially because we couldn't buy new ones. If you were waiting for a new car, the line kept getting longer as more and more production issues kept arising.
Big equity like cars have lots of parts, way more than the barbeque that took you 4 hours to assemble. If any are missing, you can't ship. This led to all sorts of stops and starts, volume cuts, inefficiencies. You know all the reasons why you want to own auto parts companies in good auto environments... Except the opposite. This lasted into mid 2022.
To quote the chairman of another holding Martinrea, "people thought it was going to be a blip, we said it was going to be a blimp."
---leave blank for whatever problem appears for 2023---
Through this difficult stretch companies largely still added value but still had little to show for it. The market changed its mind. It no longer thinks these are good companies. In fact, I'd say it now thinks they're bad companies. "Cyclical" "Capital Intensive" "At the mercy of..." Valuations have slumped below the trough of the .com bust.
Was 3x book the right value? Probably not... (I can still point to companies in other industries with comparable ROEs & growth that trade at that price) But we had a reason for thinking it was back in the day. Remember when these were decent companies spitting off big earnings and solidly double digit market beating growth?
Are they useless capital sinks that deserve to trade at discounts to book? Perhaps they have been recently for reasons beyond their control but will that last forever? Probably not.
This isn't a stagnant scale either. The book value has continually increased, (more capacity and assets to provide future income).
Martinrea only recently filled their factories (efficiency), and have made many investments and acquisitions which haven't yet seen a decent market.
Linamar has bought and paid off a $1.5B agricultural business $25/share since 2018. They've also spent hundreds of millions on capital investments and some share buybacks.
Going Forward
As much as I'd love to paint the picture of "We're past all that, now 🚀" I still can't.
.png)
Production schedules are still restrained and disruptive. Volumes are still off highs. This is leading to a sustained period of low inventories both new and used.
Labor costs and other inflationary pressures are still having companies battle over margins & cost recoveries. Capex isn't what the market wants to hear. Higher debt service costs reduce flexibility & require higher IRRs to be worth pursuing. Oh... Also, haven't you heard about the imminent recession? As I mentioned above, my belief (and by definition of you care) is that autos are actually exiting a recession as opposed to entering one. Which, while positive volume, synergies etc, doesn't preclude the possibility of another one... *Sigh*
If 2015 taught us anything it's that you don't want to buy these things on earnings when everything has been going right for a while. It also shows us that the market can change perspectives. Business isn't always good or always bad... But it can be.
Earnings
When I look at earnings I look at normalized or trend of earnings. While it's been a long time since earnings have been stable enough to call normalized, I think we can notice a trend of growth starting from a level that would have today's equity prices look fairly inexpensive. Assuming they can ever recover (I believe they can).
.png)
I continue to be the simpleton when it comes to fair value. I'm not going to assume things will be great and the market will completely forget about the issues experienced by the companies. It may be the time we get there but setting an aggressive target is a great way to be disappointed.
Step one is mean reversion. It looks to me like there's a good chance for these stocks to once again be believed to be worth 1.5x book. I also believe that there are very good odds that book value will continue to trend in the right direction more often than not. At the very least, the companies will be profitable more often than not.
I could do some ROE, EV/EBITDA, or P/E math too which would all use similar historical precedent to point to something in that range as reasonable or slightly conservative.
This means that if those assessments are correct, I'm buying or holdings something at roughly half of their fair value. Further, it's probable that by the time they achieve that mark... If they do, it might be 10-20-30% higher still. When times are good so are the companies. Perhaps even good enough to look cheap at prices higher than my target.
When? No idea. I hoped we'd be there already. I've pushed out the timeline enough to give up at guessing. I do think things are directionally getting better. I think the companies are currently doing well enough to add relevant value proportionally to their current share price. Where I certainly differ from consensus at this pricing at least... Is that I think these companies are sneaky good. No they're not fantastic world class compounders deserving to trade at 50x earnings. But they don't lose money or perpetually struggle to stay flat. They grow by the quarter. This means I have them filed away mentally as something that I'm not eagerly looking to sell. They can also be their own compounder. If you're trading very cheaply buybacks can add a lot of value. Linamar just finished a buyback and decided to spend some catch up capex and slow the capital returns for the time being but can re-institute it if desired. Martinrea discussed a buyback in their last conference call, suggesting that we likely see one when they report in May. Right after the stock dipped on banking crisis news, they instituted one earlier than I thought. Make of that what you will.
My Simple Math
When calculating the value or targets of that I'm buying, using Linamar for example
Price low $60s
Book $78
Mean reverting ROE towards 12-15%
One year out fair value= 78*1.12*1.5 = ~$130 (~12x Earnings)
Two years out fair value = 78*1.15^2*1.75 = ~$180 (~12x Earnings)
So that would be a double to triple in one to two years. Is the ROE aggressive if there's a recession or sustained sector difficulties? Absolutely
Do I think it's aggressive vs what I think they can do upon stability? No. This obviously counts on a positive change in operations and is in no way guaranteed. It can EASILY be delayed by 12-18 months if it happens at all. (An overly competitive person might care).
The most likely ways that I'm wrong are
1: Another Recession would almost certainly mean at least a delay.
2: Sustained inability to recover cost increases & idiosyncratic difficulties persist. Another spike in inflation hurts margins so on.
3: Price-wise the ROE/execution can happen and multiple can contract. If I'm right about the sustainability of that level of earnings it eventually won't matter but it will probably be some kind of delay after all we've seen.
What I appreciate about the price that the market is offering today is that we don't need much positive to materialize in order to make money. The current level of headaches can persist and we can still be buying a stock at roughly a single digit P/E and perhaps expect something like a 10% return.
My Plays
There's nuance between the two... And I structured this in a moronic way to delve too deep into specifics now. Briefly;
Martinrea is smaller and concentrated on autos. It probably has more torque (both directions) for that reason and their higher debt levels. They have, arguably navigated recent quarters slightly better after being more impacted earlier. I enjoy the color in their conference calls. They are also closer to the end of an investment cycle, they've spent their capital and filled their factories. Now they will be pickier with investments and return some capital. They guided for 150-200M in free cash flow this year. I don't know exactly what earnings will look like as it's been a while since they've been uninterrupted but I'd guess towards all time high territory.
Linamar is two stories. Their industrial business (Skyjack and MacDon/Salford) has annual price resets to should fix what was a 2022 of depressed margins. Rough math would suggest that's good for $330M of operating earnings (10% sales growth and mean reverting margins). My personal belief is that this business line is worth well more than autos. They own the brand names, they have higher margins and probably will generate higher returns on incremental capital. I mention this first in an auto parts post because you mostly need to back it out to figure out the Mobility business. The parts business is currently experiencing depressed margins not only due to the industry challenges but also because they have a foundry "Mills River" that's losing money because it's not ramped up to scale yet. This probably keeps margins artificially lower than their artificial low for 12-18 months. Linamar is also in the middle of a capex cycle so there are a few assets globally that are works in progress.
The technicals (chart) of both are in nowheresville mostly nothing special. The main note is that both have what I'd call overhead resistance between here and what I'd refer to as fair value. (Aka people that will want to sell at old highs). This isn't a problem per se but something to recognize. If you think fair value is 100 and there's tons of resistance at 90-95, you probably won't see 100 until fair value is more like 125. The other side of it is if you do break a big resistance level, you're more likely to see prices overshoot a fair value. In the examples above, share price may move up to 150 after breaking the 95 barrier before waiting for fundamentals to catch up. I don't know how relevant this is here, but my value analysis isn't the only one and certainly isn't a snap of the fingers, so I figured I'd mention it.
In 8 years of no total returns we've gone from 3x book to below 1x book. The rubber band has stretched. Maybe we go to 0.3x book... It certainly feels that way some days. Mostly these companies have traded off of earnings. They should come with increasing ease in a future with more business lines, assets & capacities. I believe patience eventually gets rewarded here. Even if we don't get the rerating I expect, I think we've gotten to values where earnings growth will drag value higher, kicking and screaming if need be.
Disclosure:
At the time of this article I own both $LNR.TO and $MRE.TO as well as have sold some puts so many be buying more later this year.
Not investment advice, please see (Can Do Investing: Ground Rules) page for more information.
No comments:
Post a Comment