By David Whiston
The auto parts sector has gone through some painful restructuring during the past two years, but the worst seems to be over. As of April 24, North American light-vehicle production is up almost 1.5 million units year over year. Most industry forecasts are calling for continued increases in auto demand over the next few years.
Unfortunately for investors not already positioned in the space, we think the market has already priced this recovery into current stock prices. Now that the recovery is underway, we take a look at the current sentiment among suppliers, examine where this sector is going, and offer some of our favorite names.
Do Larger Players Have the Most to Gain?
One of the best snapshots of current trends in the auto parts world is the supplier barometer survey, which is published every other month by the Original Equipment Suppliers Association (OESA). The March edition had many insights. The supplier sentiment index remained positive at 70, but was down slightly from January's mark of 73. The index has been in positive territory (above 50) since July 2009, once the survival of GM and Chrysler seemed assured. In March, a new data point came out that supports our longstanding view that, over time, the recovery will be better for large suppliers than for small suppliers. OESA says that suppliers with over $500 million in sales keep reporting that they feel "somewhat more optimistic" or "unchanged" from the prior survey. OESA, in our opinion, correctly states, "larger systems integrators will first show improved business performance across an entire sector." A systems integrator would include firms in our coverage universe that can sell somewhat related parts, such as Johnson Controls (JCI), which sells seating and interiors.
Small suppliers however are showing more disparity in sentiment. While some are optimistic, others are pessimistic, due to unemployment and delays in customers receiving funding from the Department of Energy and private equity firms. There is also uncertainty as to whether the current production upturn is sustainable, or if it's just due to restocking inventories.
We Think This Recovery is Sustainable.
We have repeatedly asserted that recent U.S. light-vehicle demand has been well below sustainable levels. For example, last year the U.S. scrapped more vehicles than it sold. According to Automotive News, the last time that happened was during World War II. Assuming OEM production levels continue to rise, the most significant threat to suppliers would be commodity price increases (especially steel and oil) to levels seen in the summer of 2008. Fortunately, the majority of our supplier coverage involves healthy Tier 1 suppliers that have the liquidity to withstand another spike in commodity prices. Preliminary results of automotive research firm IRN, Inc.'s 2009 Pricing Survey shows that, during the 2008-2009 downturn, 59% of firms reduced costs by at least 20%.
Supplier Consolidation: How Much, and How Soon?
The current state of the industry is one of optimism not seen in several years, but it is also important to look at what the industry will look like in a few years. We see strong suppliers becoming stronger, and other firms weakening or even exiting the industry. The Detroit 3 are reducing the number of North American suppliers they will use. Ford (F) states in its 10-K that U.S. suppliers account for 80% of its North American purchases. In 2004, the firm used 3,300 suppliers, and reduced that amount to 1,600 in 2009. Ford says it already has a plan to get to "about 850 suppliers in the near- to midterm, with a further reduction to about 750 suppliers targeted." The reason for the reductions is that automakers want to only rely on strong suppliers for parts, and because Detroit is moving toward common global vehicle platforms. Common platforms means fewer suppliers are needed to service a vehicle line-up. General Motors Company has a similar plan. A company spokesman has said that, by the end of 2011, GM intends to reduce its North American supply base to 1,000 from 1,500.
The automakers want to deal with the strongest suppliers, but this consolidation could give the suppliers at least a small increase in pricing power. Traditionally, automakers have held all pricing power over suppliers, and we expect automakers to remain in control. The question is whether the Detroit 3 will stay true to their goal of consolidation, or put consolidation on the back burner in order to obtain a lower price from another firm.
Suppliers are feeling more optimistic about their ability to negotiate with OEMs. IRN's 2009 Pricing Survey says 57% of suppliers feel they have more power relative to customers compared to three years ago. We think this optimism is justified for our coverage list, as these firms are the best of the best. However, we think even the top suppliers will, at best, have little pricing power over OEMs. Most suppliers do not have an economic moat, and cannot keep competitors at bay. The best a supplier can do is foster a low-cost structure in order to remain profitable, while still submitting the lowest bid for a contract.
As for the weaker suppliers, we think some will go out of business while others will seek revenue sources from outside the auto industry. OESA's March barometer says suppliers expect non-automotive revenue to be 19% of sales by 2014, compared to 17% on average today. We have been skeptical of parts suppliers' success in diversifying revenue, since many firms have operated solely in the auto world for decades. We think the OESA data supports our theory as many firms do not have the relationships, knowledge, capital, or personnel to expand beyond the auto industry.
If suppliers had this expertise, we think there would be more revenue forecasted from non-automotive sources. However, OESA's data says suppliers do expect more diversity in their auto customer base, with the Detroit 3 expected to represent 31% of revenue by 2014, compared to 35% on average now. This trend will likely be a function of the Detroit 3 losing market share (especially Chrysler), as well as more foreign automakers adding U.S. capacity in light of the weak dollar. For example, Volkswagen (VLKAF.PK) will open a Tennessee plant in 2011 for a new midsize sedan.
Are Suppliers Already in the Rearview Mirror for Investors?
As for our own parts coverage, we still think many of our firms represent the best suppliers in the space. Unfortunately we think the time to buy them was during the crisis, when few investors paid attention to the auto industry. The recent rally in the space is a good example of stocks acting as a leading indicator, as auto stocks rose hard in 2009 despite the GM and Chrysler bankruptcies. That rally aside, we briefly touch on some of our favorite parts names that would interest us if their prices fell from current levels.
Autoliv (ALV) is the leader in auto safety equipment. Safety is one of the few growth areas for parts names since emerging markets have a wide range of safety content per vehicle. Over time, we expect consumers in these nations to become wealthier and therefore be able to pay up for expensive vehicles with more safety equipment.
BorgWarner (BWA) operates in the other best growth area, which is engine and transmission components. The company's expertise in turbochargers and dual clutch-transmissions makes it one of the top firms to benefit from ever increasing fuel economy laws.
We think Gentex (GNTX) is a fantastic company that does not get enough attention. The company dominates the auto-dimming mirror market with 83% share and its biggest problem is what to do with all the cash on its debt-free balance sheet. The firm is also moving beyond autos to supplying auto-dimming windows on aircraft such as Boeing's (BA) 787, and just reported its best quarter ever.
Finally, Johnson Controls is a firm that does more than make seats and interiors. The firm also has a lucrative battery group that garners about 75% of its business from the aftermarket. This fact means JCI has more pricing power with customers than if it were selling largely to automakers. The company also gets nearly 45% of its revenue from outside the auto industry via the building efficiencies segment. This unit seeks to make buildings more energy efficient, and we expect it to do well with nations around the world seeking to reduce energy consumption and pollution.
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