The Auto Parts industry maintained solid performance in the first half of 2011, as suppliers continued to post solid top-line growth, with strong margins and earnings. Indeed, despite the fact that profit margins have come down a bit from the record levels in 2010, many auto parts companies remain on track for earnings improvement this year. The sector has staged a dramatic recovery since the low point of the industry downturn, which is attributable to a combination of improving industry volumes and substantial margin gains. Heavy restructuring in late 2008 and 2009 enabled many suppliers to achieve impressive earnings as the top-line recovered in 2010. Meanwhile, the recent bottom-line results have been notable, given the rise in expenses to meet improved demand, and a sizable raw materials cost headwind.
Although overall supplier results have remained solid, and guidance remains cautiously optimistic, investors have clearly become concerned about the sector’s prospects for 2012. Recent automotive sales data have shown signs of a broader slowdown, or at least a moderation in the pace of the recovery. The U.S. Seasonally Adjusted Annual Rate (SAAR) recently recovered to slightly above 12 million in the months of July and August. Yet, this follows a substantial drop in May and June, and is still well below the previous 13 million-plus level. The increase in month-to-month sales volatility, along with heightened economic and consumer uncertainty, has cast a shadow over the entire automotive supply chain.
Investor concern regarding the sustainability of margins/earnings in a declining volume environment is definitely warranted. Industry margins have already begun to moderate from the recent high levels, and would definitely face pressure if sales fall below expectations. However, not all suppliers are created equal, and some are better-positioned from a sales and/or earnings perspective. Moreover, the recent selloff in auto parts stocks has lowered valuations to a level that in many cases appears very bearish, reflecting the expectation of a sharp decline in results in 2012.
Due to the uncertain economic outlook, there is limited visibility on industry volume for the year ahead. However, looking from a company-specific level, there are a couple of basic issues to understand. Investors need to recognize whether the supplier’s top line is highly dependent on underlying automotive production/sales, or can it potentially outperform the broader industry. The two primary catalysts for outperformance are a favorable secular growth theme and/or market share gains. The easiest way to ascertain which companies may have these characteristics is to look at recent performance. One particular area where this has been evident is in the vehicle safety business. Safety parts suppliers have benefitted from increasing content value per vehicles, which has been driven by higher safety standards and increased regulations, as well as technological advancement. Meanwhile, greater exposure to emerging markets is providing a dual benefit in the form of rising vehicle ownership and accelerating content gains in these vehicles.
The automotive safety business is dominated by Autoliv (ALV) and TRW Automotive (TRW). Both of these suppliers have posted impressive top- and bottom-line results in the past two years. Autoliv has been a prime example of significant sales outperformance relative to underlying light vehicle production (LVP). The company has consistently posted sales growth that has far outpaced LVP across all its geographic regions. In the most recent second quarter, North American sales (excluding the benefit from acquisitions) improved 12%, which was four times the 3% increase in production. At the same time, sales in the rest of the world segment climbed 17%, compared to a 4% gain in the underlying market. Companies that are capable of above-production sales growth should be well positioned to weather an industry decline.
The other fundamental part of the equation is the sustainability of margins and earnings. This basically comes down to the position of the company’s cost structure, and inherent leverage. Heavy restructuring throughout the industry downturn resulted in dramatic improvement to suppliers cost structures, and the benefits became evident as volume recovered, with margins soaring to record levels in 2010 and early 2011. Restructuring and cost-cutting initiatives included plant closings/capacity rationalization, improved supply chain and manufacturing efficiencies, supplier consolidation, improved sourcing from low-cost countries, and the shift of workforce and operations to lower-cost locations.
TRW Automotive’s restructuring helped it substantially improve its cost structure, with a significant reduction in its breakeven point. This resulted in a record EBITDA margin of 11.5% in 2010, which was well above its historical 8%-9% range, and earnings per share of $6.57, compared to $0.88 and $1.50 in the pre-downturn years of 2007 and 2008, respectively. Looking forward, TRW is well positioned for solid bottom-line performance in 2012, even if the industry weakens. Although expenses have picked up as volume has recovered, much of the cost cutting and efficiencies have remained intact. Indeed, the company has removed over $400 million from its cost structure, as is evident in the improvement in 2010 EBITDA compared to 2007, despite a $319 million drop in sales.
Federal-Mogul Corp. (FDML) is another supplier that is well positioned to deal with a weaker environment. The company got a head start on the industry downturn by starting a comprehensive restructuring plan when it emerged from Chapter 11 bankruptcy protection in 2008. Initial actions included the closure of nearly 30 facilities, and simultaneous opening of 10 higher-capacity plants in lower-cost countries. Additionally, it cut headcount by 22% by mid-2009, and even with the recent workforce additions, it still remains 15% below the level of early 2008. Moreover, FDML‘s solid mix of aftermarket sales should support top-line performance even if the OE side of the business softens.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.