The auto industry has been slowly and surely recovering since the financial crisis, building and selling more new cars each year. That's been good for the General Motors and Fords of the world — and it's also been good for the companies who make the parts that go into the vehicles.
Two Canadian companies that fit that bill — Magna International Inc. and Linamar Corp. — have rewarded their shareholders, rising roughly 90 per cent and 70 per cent over the last year. And yet they're still among the cheapest of stocks on the Toronto Stock Exchange, based on expectations for their earnings next year.
There is a small Canadian auto-parts maker that's even cheaper, however. It's called Martinrea Inc., and its shareholders haven't participated in the boom in the sector, owing to a recent sharp decline in its stock price.
The current environment sets up an interesting choice for investors intrigued by the sector: Pick from the two bigger, more stable players and bet on future gains from a continuing auto rebound. Or wager on the much riskier Martinrea, and hope to generate even more sizable returns — if the company can get its house in order.
For the past 15 years, Martinrea has grown through a series of acquisitions, particularly the 2002 deal for Rea International Inc. that gave it the latter half of its name. With a variety of products, including an aluminum diecasting business set for growth as carmakers explored lighter-weight vehicles, Martinrea was a full participant in the industry's rebound. By the late summer of 2013, its shares were close to double the levels of the prior year.
Then, some bad things happened. In September, Martinrea's former vice-chairman, Nat Rea, filed a lawsuit in Ontario Superior Court that accused company officers and directors and a former chief executive officer with breaching their fiduciary duties and engaging in corrupt practices. Over the course of the next few months, the company filed a counterclaim seeking damages for abuse of process, and Mr. Rea updated his lawsuit with additional allegations. (None of the allegations, by either party, have been proved or examined in court.)
In December, the company acknowledged that it will miss fourth-quarter earnings expectations due to litigation costs and operational issues at a plant in Kentucky. It also said it had discovered one of its Canadian plants misreported financial results from 2005 to 2012, which led Martinrea to overstate its profits by $10-million to $18-million in total.
The shares have regained a portion, but not all, of the 21 per cent tumble they took on that news. But at Friday's close of $8.59, they remain well below their 52-week high and trade at a significant discount to nearly every peer in the industry.
Justin Wu of GMP Securities, who has never backed off a $14.50 target price for the shares, believes Martinrea's actions to form a special board committee to oversee the case and add two new independent directors "will help dispel much of the concerns shareholders have." New contracts from GM, Ford and Chrysler and a new financing package "give confidence that it will be business as usual despite the litigation."
Canaccord Genuity's David Tyerman offers a more conservative $10.25 target price, but notes it represents an enterprise value, or market capitalization plus net debt, of just 4.5 times his next 12 months' forecast of EBITDA (earnings before interest, taxes, depreciation and amortization.) The industry average multiple, he says, is 6.5. He believes Martinrea can dispense with all the recent issues in the first half of 2014.
Peter Sklar of BMO Nesbitt Burns provides a contrary view, however. He cut his earnings forecast for the company, so when he uses the same 4.5 EV/EBITDA multiple that Tyerman does, he derives a $9 target price and "underperform" rating. He believes Martinrea will struggle for quite some time with a discount to the Canadian auto-parts makers, which already trade below U.S. peers' shares.
Mr. Sklar notes Martinrea, which carries a heavier debt load than the other Canadian parts makers, had problems at two U.S. plants in 2012 and worries "there may be a pattern of operational issues and equipment failures out of the norm." The accounting problem at the single plant may cause investors to question the overall accuracy of Martinrea's numbers, he feels. And the litigation? "Our concern is that the costs related to the litigation are likely to continue for some time."
His recommendation for investors is to look at Magna and Linamar; he has "outperform" ratings on both.
Mr. Sklar raised his target price on Magna from $92 (U.S.) to $98 last week on the strength of the company's investor presentation at the Detroit Auto Show. (The U.S.-listed shares closed Friday at $86.56). The company's new 2014 earnings guidance, revealed there, was a step up from expectations. The company also said, importantly, that it would take advantage of its nearly debt-free balance sheet by borrowing more. Mr. Sklar says the company should take on somewhere between $1-billion and $2.5-billion in debt and use it for dividends, deals, higher levels of growth, or share buybacks.
Linamar, he says, should be able to maintain its strong margins through 2014 (its EBITDA margin is nearly twice Magna's and Martinrea's.) It should also post superior growth because it focuses on engine and transmission parts, areas that will benefit as the manufacturers design new transmissions that meet stricter fuel economy standards. His target price is $46, which seemed more aggressive before Linamar went on a run of more than 20 per cent over the last two months. (It closed Friday at $43.02 on the Toronto Stock Exchange).
You might say the buy case for Magna and Linamar isn't missing quite as many parts as Martinrea's.
David Milstead