Auto Parts Firms can be Undervalued Despite Weak Competitive Positions
Cary is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
At Valuentum, we think an in-depth understanding of the long-term structural characteristics of an industry is key to being able to capitalize on the most interesting companies that score high on our Valuentum Buying Index (our stock-selection methodology).
As many investors can attest to, the automotive industry is highly cyclical. It depends on a number of factors, including general economic conditions and consumer preferences, which can be fickle at times. The price of gasoline is another major factor in the automotive industry and, to little surprise, represents a commodity that can not only impact a firm’s input costs but also the types of vehicles demanded by consumers. Plus, looking within the auto-parts supply chain, the OEMs have considerable power over suppliers to dictate terms on largely-commoditized parts. Suppliers need to quickly adapt to this ever-changing environment to minimize losses and deal with contractual price concessions, which can become magnified during the trough of the economic cycle. The industry is regulated by various environmental and safety laws that must also be taken into consideration by suppliers and manufacturers, providing both challenges and opportunities. As the landscape of the industry continues to change, constituents remain highly competitive, preventing significant outsized economic returns over the long haul. In this article, let's take a look at five of the industry's top auto-parts suppliers:
We Think TRW is Significantly Undervalued
In our view, TRW Automotive (NYSE: TRW) has weak competitive strengths. The company is one of the world’s largest and diversified automotive systems suppliers. However, competition in the automotive supply industry is fierce both in the US and internationally. Although production levels in the automotive industry have recently stabilized to some extent, both sales and production are cyclical, depending heavily on economic conditions as well as consumer spending and preferences. Gas prices also affect its business, and recent demand for smaller, more fuel-efficient vehicles, has limited profit potential. Further, TRW continues to experience increased inflationary pressures for commodities such as leather rawhides, yarn, and resins that cause a strain on the company with respect to both cost and quality. Rising costs coupled with pressure to reduce prices is an ongoing problem that affects profitability.
Though we're not big fans of the company's competitive strengths, we feel TRW is is significantly undervalued on a discounted cash-flow basis, and here is why:
Chicago Rivet's Bargaining Power Is Weak
Chicago Rivet’s (NYSEMKT: CVR) competitive strengths are extremely weak, in our view. As one of the smaller companies in its industry, the firm lacks many of the resources that larger companies possess. And because North America is its primary market, Chicago Rivet doesn't have the benefits of a global presence. Though this can be viewed positively by some given European financial turmoil and widespread austerity measures, over the long haul, we think this is a major negative attribute of the firm. Due to its size, we think Chicago Rivet has little bargaining power over its customers. Though the firm has been able to increase order activity and keep costs consistent in recent years, the company faces substantial competition in both of its segments and is burdened by the domestic automotive industry’s highly cyclical conditions. Price and availability of raw materials, costs related to environmental laws and regulations, and labor issues can be considered beyond its ability to predict.
Not only do we think Chicago Rivet's position in the automotive supply chain is weak, but we also feel that the firm is fairly valued:
Johnson Controls Generates Solid Returns
Johnson Controls’ (NYSE: JCI) competitive strengths are moderate. Although the company is the leading supplier of batteries to vehicles and one of the largest automotive suppliers in general, there is steep competition in all nine of its segments, in our opinion. Its power-solutions segment experiences high volatility in commodity prices, specifically lead, fuel, acid and resin. The firm's automotive-experience segment are highly dependent upon auto production rates, which are cyclical. Further, the company's building-efficiency segment relies on suppliers for major components necessary to produce HVAC equipment. However, the firm has an expansive global network, supplying most major automakers (with no customer exceeding 10% of total net sales the last few years). Johnson Controls' 3-year historical return on invested capital (without goodwill) is 20.1%, which is above the estimate of its cost of capital of 9.8%, an indication of the company's competitive strengths. The company scores excellent ValueCreation rating.
Though Johnson Controls has had a nice track record of economic returns, the company is fairly valued, in our view:
Lear Remains Exposed to Price Concessions
Lear Corporation’s (NYSE: LEA) competitive strengths are weak. Although the firm is one of only four suppliers with complete manufacturing and distribution capabilities for electrical systems, it has major competitors in every market it operates in. Business depends upon the automotive industry’s production rates, which are cyclical and sensitive to general economic conditions (not unlike other auto suppliers). We think the firm better utilizes supply contracts versus peers to minimize the impact of fluctuating prices, especially steel, but also raw materials, energy, and other commodity costs. The firm's gross profit has increased in recent years due to improved production volumes, but it has been difficult offsetting customer-imposed price reductions, which will remain an ongoing issue and is the primary reason why we think Lear's position is weak. If it had a strong position, the firm would be largely able to negotiate its own prices and achieve increases year-after-year. Based on our DCF process, we think Lear is fairly valued:
Tenneco Looks Cheap
Tenneco’s (NYSE: TEN) competitive strengths are weak, which is a common theme in the auto-parts sector. The firm is one of the industry’s top original equipment and after-market suppliers for emission control and ride control systems, but it faces significant competition in each product segment. Key commodity costs, such as rubber, oil and steel, have been volatile, and costs related to more stringent environmental laws and regulations have increased in recent years. Changes in input prices cannot be predicted accurately or passed along effectively to customers due to increasing contractual pricing pressure. Further, the company’s business is highly cyclical and exposed to the same poor conditions as other suppliers. Though the company is working toward more cost-effective manufacturing, the firm will always be exposed to the threat of overcapacity and burdened by its dependency on the automotive industry’s fluctuating production rates.
Despite its weak competitive profile, Tenneco is undervalued, in our view:
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