Standard Motor Products (NYSE:SMP) has been on an extraordinary run by any measure, and the recent earnings miss has punished the company, as it has dropped by just under 9% in the two days since its earnings call. That followed on the heels of a downgrade by Goldman Sachs in the middle of July.
The reason for the miss given by the company was the cooler spring and summer, where its Temperature Control segment underperformed, pulling the overall performance of the company down with it. Past results in response to the weather has proven this isn't just spin, so I consider it just a bump on the road for the company, although one that may affect it for the next quarter as well, although not nearly as much.
Standard Motor Products Inc. won't be growing like it has over the last five years or so, but I think it still has a lot of tailwinds over the long term. The focus of the company on cost-cutting and boosting margin is the right direction to take when revenue growth starts to slow, as it can maintain solid earnings in a slower-growing market. That's how I see Standard Motor performing going forward, and even if the overall sector slows down, it is positioned to continue to grow, albeit at a more steady pace than in the past.
The key to the company going forward is organic growth, margin, and acquisitions. SMP does well with all three, but especially well with margin and acquisitions, which has driven the company so strongly over the last year, as it is up over 200% during that time.
With that in mind, I believe Goldman Sachs is wrong and the market over-responded to the miss, and will show why that's the case.
Near term it'll continue to struggle because the Temperature Control segment of the company, which was the primary reason for the weak quarter, is expected to remain under pressure, even though it is showing some improvement in the current quarter. It looks like the stock is going to bounce around in the $32.00 per share to $34.00 per share range throughout this quarter, with the occasional drop below and above those parameters.
Shareholders and investors are going to go into a wait-and-see mode until the next earnings report to see how the Temperature Control segment performs and the impact it'll have on the numbers. Shares could be punished more if investors believe the weaker performance went beyond the weather factor.
Revenue in the second quarter of 2013 came in at $270.1 million, up 0.4% year-over-year, but missing the consensus estimate of $280.8 million. Earnings per share was $0.70 in the quarter, falling short of the $0.75 analysts were looking for.
Breaking it down, the Engine Management segment generated revenue of $182.1 million, up 5.4% from last year in the same quarter. Operating profit was $24.8 million, surging 38.1% from $17.9 million last year in the same reporting period.
In the Temperature Control segment, revenue dropped to $86.7 million, down 6.9% from last year in the second quarter. Operating income in the quarter was $6.9 million, down from $7.7 million in the second quarter of 2012.
For the All Other segment, which accounts for only about 2% of the company's revenues, it dropped from $3.2 million to $1.4 million in revenue generated in the quarter, a plunge of 55.7 percent.
The major story with the earnings in the second quarter was the impact weather had on the company's bottom line.
Below are key metrics in how the company has performed from 2009 through the end of 2012.
After the record-breaking heat wave in 2012, there was no way the performance of the Temperature Control segment could have matched that performance in 2013. Yet when it was announced the unit underperformed in comparison to last year, the market has punished the company.
Even though the company continues to reiterate that weather conditions year-to-year will dictate the performance of the segment, it can catch investors by surprise who don't take it into account.
The reason this is important for anyone investing in Standard Motor Products to understand is if the weather is cold or hot in any given season, it will generate volatility in the performance of the company - for better or worse.
The problem Standard Motor faces is convincing shareholders this isn't simply an excuse that many companies tend to offer for underperformance.
In the case of weather, this isn't one of those excuses or attempts to make a poor performance look better, it's simply part of doing business in the southern part of the United States. Every year has an element of uncertainty in regard to the Temperature Control segment, and it can be a positive or negative surprise.
What makes it troublesome is in a particularly cool year, not only will the results affect the performance of the company in the quarter, but will possibly do so over two quarters. It depends on how much the weather warms up in the second part of the summer as to how much it will affect the following quarter.
Yet even if the weather warms up in the latter part of summer, it isn't usually enough to offset the effects on the company by cooler weather in the earlier part of the year. So this year the third quarter will be affected by the weather, although not as much as it was in the second quarter. That's the usual experience of the company, and it can reverse in the warmer years and perform similarly on the upside for two quarters; at least in the Temperature Control segment, which accounts for approximately a third of the revenue for the company.
Fluctuations in the past have resulted in a move of 20% in either direction for sales, and the company has and is taking steps in order to improve and do well in the cool summers, and to do extremely well in the years with hot summers. The acquisition of CWI is one of the steps taken to mitigate the volatility, and it has been integrated into Four Season very well.
The reason CWI helps mitigate the Temperature Control segment is it is adding revenue and earnings to the unit, which will boost the overall performance of the division even in cooler summers. In the second quarter it added sales of $4.9 million to the segment, and from January 2013, it has added $16.6 million in sales. Standard Motor Products' strategy is to raise the lower end of sales and earnings in the cooler years by adding CWI to the unit, while doing the same on the higher end in the warmer months.
It understands it can never get rid of the drop in sales in the cool springs and summers, so it is raising the sales bar on the low end so there will be less impact on the performance of the company when the cold weather arrives.
Goldman Sachs Downgrade
While the weather issues in its Temperature Control segment point to pros and cons depending on the year, which deals with potential volatility, there are potential larger headwinds faced by Standard Motor Products, as pointed out by Goldman Sachs in the middle of July 2013 when it downgraded the company to sell while maintaining its price target of $34.00 per share on it.
Here's what Goldman said in a note: "We downgrade Standard Motor Products to Sell with 9% downside to our six month price target of $34 vs. 10% average upside for our coverage. The company has exhibited solid operational execution and successfully integrated a number of acquisitions over the last 12 months and the shares have risen 206% since the June 2012 trough (vs. the S&P up 28%). However, this has driven Standard Motor's NTM P/E to 15.5x from 7.6x, which is approximately 30% above peers even though we see the company sitting at the bottom of our stock ranking framework based on growth, expectations, and end market positioning. Our 2013 and 2014 EPS estimates of $2.22 and $2.45 are 2% and 3% below consensus, respectively, relative to mid-single digit upside across our sector."
While Goldman states the obvious with the NTM P/E of Standard Motor, its leaving off of the ongoing improvement in gross margins, which could upset its EPS estimates for 2013 and 2014, which as it stated, is 2% and 3% below consensus. In the second quarter the Engine Management and Temperature Control combined to deliver overall 300 basis point gross margin improvements.
Standard Motor Products management has guided for what appears to be in line with the rest of the industry. When queried about that in its latest earnings call, Chief Financial Officer James J. Burke was asked about if "there a reason that you wouldn't continue to outperform the industry?" His answer was there are over 40,000 SKUs in just the Engine Management category that move back and forth in sales; meaning projections and estimates are hard. He said the company is just being cautious in its guidance, adding if the product categories improve and hard parts increase only a little, it should be able to outperform the industry.
If the company finds it difficult to project future near-term performance with that many SKUs, it is of course impossible for Goldman Sachs to. In my opinion, Goldman is making assumptions taking into account far too few metrics. It needed to include the margin improvement and the probability of increased sales across its larger Engine Management segment when it came to its conclusions, as the company has hinted that's the most likely scenario.
As a matter of fact, Goldman Sachs lowering of its outlook for new car sales in the auto sector, if it's accurate, would point towards more demand for parts sold by Standard Motor because of people spending more on servicing and fixing their cars rather than buying a new one, reinforcing the idea there's a strong chance the company will perform better than guided.
Even so, the cautious guidance of Standard Motor suggests it is unsure about the next couple of quarters. Add to that the impact of a cooler summer and it could pressure the share price down in the short term. I don't see the company being held back over the long term for any of the reasons mentioned by Goldman, although in the next couple of quarters it may struggle.
One of the strengths of Standard Motor Products, which can easily disrupt any analysis of the company when looking at raw data is its tremendous ability to target terrific companies for acquisition and relatively seamlessly integrate them into the company. The value of that can't be understated, and in and of itself should be considered a moat. I'm not aware of any of its peers that do it better than SMP, when taking into account the entire process of acquisition and integration.
Over the last 12 months this has largely been the reason for the amazing growth of the company, although it has been coupled with effective cost-cutting of low-hanging fruit, which is why the company has soared in share price.
The firm adds that while it continues to look for acquisitions, it is doing so with the idea of looking for companies that have related products, but products different enough so they would open up new manufacturing or market possibilities.
With a strong balance sheet, integration expertise, and a proven ability to boost margin, acquisitions will continue to be a big part of the Standard Motor Story. This is one of the major tailwinds I see interfering with a lot of analysis that is based on data and assumptions from existing units and products under the company umbrella.
Don't underestimate the margin part of this, as the cost-cutting has been deliberately done to not only improve margin for existing products, but to have a strategy in place to quickly apply cuts to companies it acquires. This is another tailwind the company has at its back.
It looks like Standard Motor Products may be a victim of its own success, as it is up over 200% over the last 12 months. That is enough to make any potentially negative event result in a major drop in share price. It's what has happened with the low sales results from its Temperature Control segment.
I don't really find that having much meaning for the company other than it helps to understand it better as to how it may perform during the summer months, which has been in a range of about 20% either way, depending on whether it is hotter or colder.
What's more important is organic growth, margin, and its acquisition expertise. When the company guided to fall more in line with industry growth, it was a reference to organic growth. That's the place where it is more cautious. On the margin side, it continues to do extraordinarily well, which could overcome softness in sales if it has a couple of challenging quarters.
Where the company really stands out is in its combination of cost-cutting, margin, and acquisitions expertise. Even though it benefits its overall performance, it enables the company to quickly add and integrate businesses which can be streamlined and boost performance.
So when I mentioned my thesis is the company will grow steadily and incrementally, that's when it is growing organically rather than via acquisition. When acquisitions are part of the narrative, it changes the overall picture.
This may sound like what would be the performance of any company, but the difference is the level of expertise Standard Motor Products has in quickly and effectively integrating an acquisition into the company fold, providing almost immediate benefit to the firm.
I expect this to continue, and see SMP being a terrific short- and long-term investment because of the recent pounding it has taken, which provides a terrific entry point and an opportunity to move in and out fairly quickly for a fast gain.
For those wanting to take advantage of the weather play, mark on your calendar or list the importance of weather for Standard Motor Products. Whether it's hot or cold, the company will respond up or down to seasonal temperatures, and it's as predictable as it gets to the effect it will have on the company. Just be sure when making the decision the Engine Management segment isn't overperforming to the point it overrides the temperature factor. It's also a play to consider when looking for a better entry point if the weather is cooler than normal like this year.
Overall I believe SMP will outperform, and see it as having great future growth potential, albeit at a slower pace than over the last year.