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2 auto parts stocks are ‘best buys’

Analysts follow as many as 20 stocks, most of which are rated “buys.” Of those buys, an analyst has one or two special favorites seen as most suitable for new buying. This column is devoted to those one or two favorite “best buys.”

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Autonomous driving, electrification and/or hybrid technology add value to auto parts companies.

Canadian auto parts stocks have gotten a poor rap since the second half of 2015 and accordingly suffered the neglect of investors. But that may mean now is the time to buy in, argues Montreal-based Raymond James Financial analyst Michael Glen.

“While investors have largely chosen to avoid auto parts stocks, we believe this potentially opens the window to an opportunity,” he says.

Mr. Glen has covered Canadian consumer and diversified industrial companies for Raymond James since joining the firm earlier this year. He has nearly 15 years of experience in the capital markets, most recently working for Australian banking giant Macquarie and covering Canadian stocks before taking on his current position.

The analyst explains: “Auto parts stocks have been out of favour among investors for a number of years, as everyone waited for the inevitable pullback in global auto sales.”

Over the past four years, sentiment towards such companies swung weakly “between fairly negative and something approaching neutral”.

Global market has been cool

Although expectations of flattening global auto output, particularly in the United States, prompted the market’s chilly attitude toward their makers, looming uncertainty about the impact of emerging technological trends, namely autonomous driving and the electrification of vehicle powertrains, have kept it cool, the analyst says. Concerns related to global trade in automobiles and auto parts also weighed on prices.

Commenting on negotiations for the “new NAFTA”, he says: “While it did create a tremendous amount of uncertainty at times, the three countries involved were able to establish an agreement in principle (last September) with respect to the new USMCA (United States-Mexico-Canada Agreement), which perhaps quite importantly, has yet to be ratified or approved by the US Congress.” Unfortunately for Canadian auto parts manufacturers, the tentative deal was not enough to ease trade worries; any news suggesting either deteriorating trade between the US and China, or the US and Europe, tended to have an outsized negative effect on automotive stocks, the analyst points out.

Magna: “market perform”; Martinrea: “outperform”

Mr. Glen compared current auto parts company valuations to historical multiples in the sector and overall market multiples as part of his research prior to initiating coverage of two domestic auto parts companies, Martinrea International Inc. (TSX—MRE) and Magna International Inc. (TSX—MG; NYSE—MGA).

Mr. Glen sets a target price of $16 a share for Martinrea and US$60 per share for Magna. For the time being, he considers Magna a “market perform” and Martinrea an “outperform”.

The analyst says that, based on his examination of those valuations: “If investors are willing to give an auto parts company credit for exposure to any of the following key trends: autonomous driving, electrification and/or hybrid technology, this will generally afford a more attractive or expanded valuation, which can be quite meaningful.”

Magna looks to the car of the future

In the case of Magna International, which Mr. Glen describes as a “deep value stock with significant free cash”, this informs the analyst’s own long-term positive view of the company.

Magna’s management has worked to actively evolve its product portfolio, both by taking on new investments and shedding assets, as it positions itself to “reflect the car of the future”, says the analyst.

In addition, it boasts a conservative balance sheet. At present, its net debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) ratio is 1.3 times, Mr. Glen notes. Meanwhile, Magna’s 2019 free cash flow forecast of US$1.9 billion to US$2 billion implies a free cash yield of up to 12 per cent, and it has continued an aggressive share buyback program.

The analyst says Magna is currently trading at around historical trading multiples, making him hesitant to assign a higher multiple when calculating a price target, but he also notes: “With the company anticipated to release 2020 guidance in early or mid-January, we will look to review our thesis at that time.”

Investors ignore Martinrea’s progress

As for Martinrea, the analyst says management laid out an operational improvement plan to investors and largely delivered on it (for example, margins on earnings before interest and taxes expanded from 4.1 per cent in 2014 to 7.8 per cent in 2018), but investors have not paid attention to the shift.

The company’s absolute and relative discount compared to peers continues to widen. “The only factor we can see to explain this valuation anomaly is free cash generation, which we fully anticipate to keep improving during the fourth quarter of 2019 and 2020,” says Mr. Glen.

This is an edited version of an article that was originally published for subscribers in the December 20, 2019, issue of Investor’s Digest of Canada [2]. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada. [2]

Investor’s Digest of Canada [2], MPL Communications Inc.
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