While industry brethren got skinny at the rib after 2008, Standard Motor Products, Inc. (SMP) prospered from lean-living Americans who repaired older auto models rather than upgrading to new ones. The average age of American cars is a record 11.4 years. For Standard, which makes its money in the automotive aftermarket industry, this buildup in older models has meant more replacement parts sold. That's a fantastic trend for Standard Motor, and it has shown as Standard shares outperformed the S&P 1500 Auto Parts & Equipment and the S&P 500 three-to-one between Dec. 31 2007 and Dec. 31 2012.
Unlike suppliers to original equipment manufacturers ("OEM's"), such as Visteon (VC), which went through a reorganization after the 2008 market crash, Delphi Automotive (DLPH), or Johnson Controls (JCI), Standard Motor sells largely to warehouse distributors and large retailers including O'Reilly Automotive, Inc. (ORLY), NAPA Auto Parts, and Advance Auto Parts (AAP). Comparatively, Standard's business yields higher returns than the OEM supplier business.
While investors are bidding for shares of Standard near all-time highs, it's still attractive if the future is anything like the recent past. EBIT/EV ("earnings yield") is high at 9.02%. Free-cash-flow ("FCF") yield is 7.52%, which provides a 3.52% pre-growth margin-of-safety over a 4% risk-free-rate. Gross margins increased from 23.75% in 2008 to 27.36% in 2012, and 28.68% for the first 6 months of 2013. Return-on-invested capital ("ROIC") for the last twelve months is 29.58%. Since 2008, sales have increased a total of 22.4%. The last five years have been excellent.
As newer models replace older ones, record margins and revenues will begin to face headwinds. The logical extension of a newer auto base is that sales and margins will contract. If the sales trend reverses, and revenues begin to decline, EBIT margins could face significant downward volatility. Consider that the average operating leverage ratio between 2009 to 2012 was 5.28. Between sales of $875 million to $950 million, the operating leverage moved in tandem at about 1.4:1 with sales growth. Below $875 million, EBIT volatility picks up dramatically.
What this means is that the company can endure an 8% decline in sales while still keeping its valuation in tact. After 8%, the valuation falls apart for a time, at least. Mark Seng of Polk, the firm that conducted the study behind record average auto age released last month, said that he does not necessarily see the age declining. If the age hovers around 11.4 years, then Standard will continue to have a broad base of vehicles to serve. Assuming a long-term 5% FCF growth rate and a required rate of return of 8%, Standard looks to merit a bump in its FCF multiple from 13.3x to 16.9x on a discounted cash flow ("DCF") basis. Shares may be worth as much as $40.82, a 33% upside from today's market price. The company is financially sound with a debt-to-equity ratio of 34.6%.
To boot, management's shareholder letter fires on all cylinders. The letter is clear and concise, and it focuses on all the right things: cash generation, margins, shareholder return, and an explanation of five recent acquisitions.
Standard Motor's future marginal returns depend largely on the average age of the American automobile. Robust auto sales will be offset by longer lasting vehicles and financially pressed consumers. As this occurs, Standard will have time to build out its business based on the brains of a straightforward management team. The price of the shares offer an attractive opportunity to play both sides of the coin: a better economy in which people hold onto cars longer or a worse economy in which people hold onto cars longer. The road ahead is clear.