Auto Parts... Still Picking Up The Pieces

Auto Parts... Still Picking Up The Pieces

When we left our heroes things were finally looking bright. They had finally worked their past the endless disru... Never mind.

This UAW strike now further delays whatever a normalization would look like. The average length of a strike is roughly 41 days. This time feels especially contentious and perhaps especially large in scale. Still it is unlikely to last forever and what I've heard suggested about the impact is that historically, volumes get made up. Still it's a pain for a sector that's faced endless challenges over the last 5 years now.

Maybe the fear of this strike has been why the stocks have remained historically discounted recently. Maybe they'll be irrelevant in 3 months. For now all that can be done is watch the situation hoping for a resolution.

I'm going to discuss  Martinrea, Linamar, Wages, Capital Moat & answer a question.

Martinrea

I'll be honest, I was very much enjoying Martinrea's 40000 share per day buyback. At that rate, I'd own the last share of the company in 400 weeks... and I'd be a billionaire. Hard to be too upset with that. Ok so that wouldn't happen & the buyback would max/black out before we got too far into that. Still it was easy to see how things were not only getting better by the day but benefitting from the continued discount when the buyback was running.

There are a number of ways I could measure the "Yield" on the buyback... and maybe I'll write more about this someday... but for now let's call it the earnings yield on the shares begin bought. That means that a 5x earnings company would yield 100/5 = 20%. That's pretty decent prospects for sitting on a cheap stock.

When the strike was basically imminent they paused the share repurchases. I understand why... uncertainty about scope or length... risk to short term guidance & looking like fools when they buyback before a miss. Perhaps some wish to preserve liquidity for if things last longer or some opportunities open up for acquisitions. I get it.

It was interesting that Rob Wildeboer bought another $100k right after the buybacks stopped. My read is that he still liked the value even if it was prudent on the company level to pause.

I honestly don't know how impacted Martinrea has been or will be by the totality of the situation. I'm not surprised that GM and Stellantis are moving towards short term layoffs. It was obvious that they'd be necessary the second UAW decided to be tactical with their implementation of the strikes. As the last few years has shown, if you're missing one piece, vehicles can't ship so if the XYZ -99 engine assembly plant is stalled, anyone assembling any part of those cars is useless.

I hope there's a resolution that doesn't end up sending the companies to bankruptcy in the future as that's not good for anyone's business or employment. Hopefully it comes in a few days or weeks.

I've suspected recently that the potential strike was probably weighing on the otherwise cheap auto stocks recently... and by extension probably keeping the parts manufacturers from rerating back to their fair value. Once that plays through I think there'll be less of an excuse for the low price... on the other hand I'm sure we'll find something. If we don't rerate, hopefully MRE can get back to the aggressive buyback.

Pre-Strike 

Martinrea was on pace to be doing quite well. The breakdown of how their free cash flow was set to play out this year meant that more than 100% of it was going to be in the second half.

That should have taken net debt down to near 800M, even with a continued 1.5 months of buybacks.

Their quarterly adjusted EBITDA was coming in in the 150-160M range so the debt was moving to a very reasonable level.

It was a great setup for next year when debt moving below target was to meet free cash flow's ability to compound the cheapness of the stock.

My fair value assessment and outlook hasn't changed much from when I last wrote about them. I can calculate normalization I'm a bunch of different ways but they all seem to give similar fair values of roughly $27 today and hopefully above $30 in 12 months.

Linamar

Linamar has been back to their old ways. They've now quietly put USD$400M to work on acquisitions in the second half of this year to compliment a full capex regime. On one hand it's what should be expected from them and what they did well a decade ago. On the other hand, it's frustrating that they're going out and buying things as prices that look like significant premiums to what they're trading for...(or what my other auto parts stock is trading for).

I'll hold off judgement until we see how the plan comes together (we won't). It looks like they got excited about the structures group they're putting together. Maybe it leads to scale, growth opportunities, synergies and other good stuff... for the time being I think it's fair to ask what kind of returns and immediate earnings power the acquisitions bring in especially considering the first was essentially funded by 6% yielding term debt. I'm sure it makes sense but does it make more sense than buying more of existing businesses at a 20% OE yield?

The whole auto division hasn't been doing well recently and the improvement has been slow. Perhaps that's part of why putting capital there at full price+ has been less exciting. It's almost like, the second they buy them at 1x sales they get lumped in to something the market values at basically 0. I'm not one to appeal to what the market cares about at the moment but I'm having some difficulty understanding the appeal vs some other options. It is understandably hard to plan business around numerous changing prices.

One bright spot has been the industrial segment after the annual price resets. The performance in the agricultural segment has been solid and the volume ramp in Skyjack continues as past capital investments start paying off. Using a midpoint of normalized margins on trailing revenues the operating earnings of the segment should be just above $380M. That could easily be +$400M in 2024. I still contend that's easily $4B in value right there... or ~$64/share. As difficult as this may be to believe, in theory the mobility segment should be even more valuable... or at least generate more earnings. Using the same calculation with the Mobility's normalized margins, they should have $560M of OE. That's before the most recent acquisitions. $600M of earnings power on a go forward basis (not expected to be immediately achieved). That's maybe $9.50 per share in pre-tax earnings power... gotta be worth something.

The unnormalized results were as follows. If you can forgive my backwards charts (most recent quarter on the left).

Note: The MacDon acquisition was near the first data point

You can see results with numbers going back to 2017. As you can see, COVID hit both hard but for a while the supply chain impact on industrial was worse for a while. Mobility rebounded quickly with stimulus before the supply chain broke & inflation bit. As I mentioned above, Mobility 'should' be basically at the top of the historical levels.

*TTM = Trailing 12 Months *MRQ = Most Recent Quarter (on left)

The combined picture basically explains why we haven't seen new highs in the stock in +5 years.

This final chart has one added data point which is what things 'would be' with normalized margins in the past year. Adjusting for prior peak stock prices, share counts debt levels, recent acquisitions etc... i could estimate a number... but it doesn't matter until they actually do it.

Basically, the stock tracks earnings. It's also noteworthy that, after the MacDon acquisition there was a significant amount of debt reduction that slowed down the operating earnings growth (IE: operating earnings showed up immediately but the debt burden didn't in those charts, time was needed to reduce that burden)... along with the GM strike, COVID, etc. Again, the clean balance sheet of early 2023 is potential earnings growth.

Linamar was hit hard by the GM strike in 2019. For that reason alone I have on the back of my mind that they may be at increased risk today. That said, given how much value the market is currently putting on the entire mobility business I don't think the share price risk 'should' be significant. Despite whatever I think, history seems to suggest that it's an auto stock when you don't want to be an auto stock and a diversified industrial when you do.

While I could debate the merits of where it goes, Linamar continues to generate relevant amounts of earnings... and even more earnings power relative to their market cap. They're using that to add value by the day. Some days that's buying businesses others it's generating capital. Hopefully the higher interest rate environment is allowing them to get more bang for their buck with purchases.

*Q&A*

In my last post about Linamar, someone commented that LNR's Free cash flow/ EBITDA ratio is erratic and asked what I think about that.

I think that's a good thing that the market will treat as a bad thing. I dislike free cash flow as a metric for the simple reason that absence of free cash flow can be better or worse than the presence of free cash flow. The erratic FCF simply means that sometimes there are good places to spend capital investing in PP&E... and sometimes there are less. This means they invest when there's something to do but don't for no reason. That's the theory at least. Capital investment getting a 1% return get just as removed from Free cash flow as capital investments generating a 20% return. One you do all day, the other is never worth it and drains resources. It's good that they're not forcing poor investments... but the market prefers stability and consistency.

Wages

One thing that suppliers pointed out when asked threats to wages in response to UAW results is that they were actually ahead in that regard. They saw the wage pressure in 21 and 22 and were already eating that expense vs expectations. The prior union contract was actually locking UAW below market. That's why the UAW offer and ask look exceptionally high. (The 20% offer vs 40% ask).

The wages that UAW employees received before the raise they're about to get would be considered quite high in Canada and astronomical in Mexico. This is one of the holdups in the whole "reshoring" initiative. Wages and availability of labor make it cost much more. The half answer is Mexico... probably why they're doing well. I'd love to throw Canada in the 'we could be a good idea' ring but our wages aren't that much more favorable than the US (I mean +30% is big but much less than other places) and cost of living & union culture isn't helpful. A more elaborate solution might be automation. The higher wages go the more that makes sense. Don't get me wrong, it can work in Canada and even the US but it obviously means higher prices.

Capital Moat

It sounds a bit ridiculous to consider... a moat in a low margin, cyclical, metal bending industrial. It is until you realize that all businesses have some kind of moat. Today, although not a traditional moat, I'd suggest looking at how capital can be a moat.

I mean, "I can get 6% guaranteed, why would I want to spend a lot of money and take lots of risk to try to earn 10% on money I'm going to put towards a new auto parts business?" Martinrea vocalized this point well a few conference calls ago when they said, "now with these interest rates our ROIC hurdle his higher." In other words it would stand to reason that the returns on capital in capital heavy industries would increase with increased competition... from treasuries.

I get why value investors seem to love higher rates. It's worse for economic growth and the consumer but when it comes to the random/average business (aka value stocks) it makes their investments and cashflows more valuable (even if their valuation decreases). It's more expensive to compete. Don't get me started on the topic of inflation. It's not a full, lasting or permanent moat but, for the time being it should work to partially offset the decreased demand from higher financing cost for autos.

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.

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)

Zoom out on your stock chart app for full effect, it was dramatic...

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.

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).

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). 

Even with my knowledge of history, sometimes I feel foolish for thinking this. It would be a significant move in a company that has spent a decade in a range. Further still, a liquid multi-billion dollar company that should have some actual eyeballs on it. Eyeballs that probably know this+ why this won't happen or won't matter if it does. Or, perhaps it's destined to trade off earnings and the earnings haven't been there & haven't been consistent in recent years.

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.