Pair Trade: Auto Part Manufacturers

For my explanation on pair trading, please see here.

Industry: Auto Part Manufactuers

The weakness of the US (and global) auto industries is no secret, and the parts manufacturers suffer directly as demand has shrunk and margins have contracted. However, the industry is in for a lot of change and consolidation. The companies that supply to the newer age of automobiles and have management with growth strategies that generate ways to survive the current lull will produce substantially better returns than those that are unwilling to change and try to ride out what could be a long recession in the industry. Companies will go bankrupt from the cash burn required to stay alive due to production cutbacks by the auto companies such as Ford (F) and General Motors (GM). 

The auto part suppliers will continue to have balance sheets weakened, job cuts, and other restructuring initiatives to survive this harsh downturn. The companies that have a lot of short-term receivable securitization facilities will struggle to find revolving credit lines and could be the first to “go under”. However, there still is value to be found in the industry although the number of constituents is expected to shrink rapidly.

Long: Wabco (WBC), $18.15: Wabco looks to be best positioned to withstand the troubled times as it has a strong current ratio of 2.14, and the highest ROA (13.61%) and ROE (41.45%) by a large margin in the group. Wabco also has the best operating margin at 11.26%, well above the industry average of around 6%. Also, with $4.40 per share of cash on the books the company will be able to withstand “cash burn” and recent job and production cuts are a start in the right direction. 

At an EV/EBITDA of 2.46 the company is at a historic low valuation and could be a nice takeover target if auto makers wanted to control costs through integration. Wabco shares are down 63.41% on the year, which is slightly more than the industry average of -60.95%. Shares are right near all-time lows and we expect Wabco to outperform in this devastated industry. A recent bullish MACD crossover and RSI and stochastics came out of oversold territory are positives for shares technically.

Short: Borg Warner (BWA), $22.91: Borg Warner shares look relatively expensive compared to the rest of the group, with a PEG of 1.36, and a P/E of 23.16. The premium price is not justifiable as the company has only $1.17 in cash per share, operating margins below the group average, and very weak management efficiency rates.

The lack of cash gives Borg Warner a quick ratio of 0.82 (less than half of WBC’s 1.74 figure), and this is not a good number to withstand near term weakness and “cash burn”. Shares have outperformed the group this year, down only 56.55%, and we expect shares to play “catch-up” and fall more sharply than the rest of the group in the medium-term. 

“Fight Card”

The Trade

WBC: Long 1 March ’09 Vertical Call Spread $17.5/$22.5 for $2.00 debit

BWA: Short 1 April ’09 Vertical Call Spread $20/$25 for $2.25 credit

Disclosure: none

Comments

[sumosama:]

thanks for a thought provoking article, along with your recommendation!

2008 Nov 04 11:50 AM