By David Whiston
Auto parts suppliers continue to recover from the great recession but there is more hope of higher production volumes than the last time we looked at the sector. We continue to see an environment where the strong suppliers will get stronger while weak firms will eventually exit the industry or be acquired. For this article, we look at the current state of the industry, briefly discuss our favorite suppliers and then discuss the trend of automakers consolidating their supply bases.
We think the best place to get a snapshot of current supplier conditions is by looking at the Automotive Supplier Barometer of the Original Equipment Suppliers Association (OESA). The last survey, published in November, surveyed both small and large firms for current sentiment and other items such as capital investment and hiring. The sentiment index increased to 61 from 52 in September and posted its highest level since 70 in March. A reading above 50 indicates positive sentiment. The index declined from November 2009's level of 69, which is not surprising.
The second half of 2009 was the first period since 2007 that the industry did not have to think about sales declining further. Cash for clunkers also gave suppliers reason to be optimistic in summer 2009. We found it interesting that the recent increase in optimism is coming from firms with revenue under $1 billion while larger firms remain pessimistic to neutral in their outlooks. This development is good news because the smaller firms are likely Tier-2 and Tier-3 suppliers whose health is critical to the automotive supply chain. If Tier-2 and Tier-3 firms are distressed, then the Tier-1 firms have to spend time and money more closely monitoring the health of their own suppliers and in some cases even acquire them to prevent supply chain disruptions. We expect Tier-1 optimism to improve in 2011 barometer results.
We see the OESA increase from September levels as indicative of improving macroeconomic conditions since the Greek debt crisis started in May, as well as another sign that 2009 was the bottom for North American light-vehicle production.
Management at Ford (F) and Toyota (TM) and have recently made public comments suggesting 2011 U.S. sales of close to 13 million units. Although these levels are still below replacement demand, which we calculate to be nearly 13.7 million vehicles, it is better than the 10.4 million sold in 2009 and this year's expectation of about 11.5 million U.S. light-vehicle sales.
In a November 22 Automotive News article, Toyota Motor Sales, U.S.A. general manager Bob Carter was quoted on current sales saying:
We're starting to see some of the pent-up demand release and confidence coming back to the market. We're starting to see 'want' purchases as well as 'need.'
The chart below shows per-capita U.S. new light-vehicle sales. As we argued in a June Stock Strategist on automakers, we strongly believe current levels are not a new norm. Looking at our auto sales and total population data from Chart 1 below, and multiplying the 2009 U.S. population by the average sales per capita for 1951-2009 gives a mean reversion sales total of 15.90 million vehicles. Another proxy of normative demand would be the same multiplication using a more recent per capita sales average. For example, using the per-capita average from 1976-2009 implies a normative demand of 17.31 million vehicles.
(Click to enlarge)
Another interesting development is that 48% of respondents to the OESA survey are budgeting more than a 10% increase in plant and equipment spending in 2011. The auto industry is very capital intensive, so capital expenditure cannot be deferred forever.
We believe the planned investment is more for maintenance capital expenditure than growth capital expenditure for two reasons. First, respondents are planning no increase in information technology spending, which would be needed for incremental projects. Second, respondents also indicated a median North American light-vehicle production figure of 14 million vehicles before they would purchase "equipment beyond normal replacement."
This data point in particular suggests to us that the planned capital expenditure increase is mostly for replacing machinery in anticipation of higher volumes from 2009 and 2010 as well as due to equipment age. Firms that could see a tailwind from higher supplier capital expenditure include Rockwell Automation (ROK) and Siemens (SI).
Hiring is the last insight worth noting from the OESA Barometer. Sixty-nine percent of respondents are adding hourly personnel and seventy-seven percent are adding technical staff. This data is certainly good news for the U.S. economy but there are frictional and structural unemployment issues that slow the hiring rate. Thirty-six percent of respondents are having difficulty filling technical positions while twenty-two percent are having a hard time meeting hourly labor needs.
This data supports commentary we have heard from industry sources over the years of an engineering shortage in the United States. Respondents also said that the median industry production figure to hire hourly workers "beyond normal attrition levels" was 12 million. The 13 million 2011 sales figure discussed earlier suggests next year could see significant hourly hiring which may help lower the unemployment rate. One of the suppliers we cover, Gentex (GNTX), has already been hiring engineers and hourly production people all year, and just purchased a new plant in Michigan.
No Bargains at This Time
Although we believe U.S. auto sales are well below where they should be (and therefore likely to rise substantially in the future), we do not see any suppliers trading at bargain prices. We cover Tier-1 suppliers that are generally the best in the sector, and we briefly discuss some of the best suppliers we cover.
Gentex is the dominant player in auto-dimming mirror technology, with 83% of the market and no debt on a cash-rich balance sheet. We expect the company to increase its penetration in the U.S. market as more volume platforms from Detroit automakers are equipped with higher-end content to justify the price premium from older models. The firm should also benefit from a December U.S. government proposal to have back-up assist camera technology in all new vehicles by 2014.
Autoliv (ALV) and TRW Automotive (TRW) will continue to benefit from emerging market consumers gradually increasing demand for safety content. Johnson Controls (JCI) is a very shareholder-friendly firm that is really three great businesses in one (building controls, seating/interiors and light-vehicle batteries) and has paid a dividend every year since 1887, including a 23% increase in November.
Magna (MGA) is an interesting name to watch since it finally operates without the dual share class structure that gave founder Frank Stronach control. The stock no longer suffers from this overhang and the company has an excellent balance sheet. Management is looking to make acquisitions which we would expect to be in the electric vehicle space, Asia, and Russia. Recently, Magna has been rumored to be interested in buying Italian design firm Pininfarina. We suspect the motivation for this deal would be to try to vertically integrate the Steyr assembly segment with a marquee design operation.
Finally, although we think BorgWarner (BWA) stock is looking expensive, the firm's leadership in turbochargers and dual-clutch transmissions makes it the best positioned of all suppliers to reap rewards from governments increasing emission and fuel economy requirements.
Supplier Consolidation Still Likely
Our last supplier strategist discussed the fact that automakers are significantly consolidating their supply base. We still see that trend continuing, and strongly believe the Tier-1 suppliers mentioned above will all benefit from more business. These are all suppliers that are big enough and good enough to merit remaining suppliers to the OEMs.
For example, BorgWarner is Ford Motor Company's global turbocharger supplier for all 4-cylinder engines. Ford is a good illustration of where the industry is heading. The company had 3,300 suppliers in 2004 but is seeking to reduce that number to 750 over an unspecified time frame. In 2009 the firm had about 1,650 suppliers but according to global purchasing director Burt Jordan, only 850 suppliers are eligible for new sourcing and that figure will eventually be 750. More volume will go to the larger suppliers in our opinion since these firms are best able to serve Ford's move to more global vehicle platforms. This consolidation will force some smaller suppliers to exit the industry or sell themselves to a surviving Tier-1 firm. The remaining suppliers have to be able to serve Ford all over the world which means they must share technology with another supplier in a region where they will not operate.
We think the trend of the Detroit automakers moving to more global platforms means the suppliers we cover will be in the select group of fewer suppliers winning more business. We think it is apparent the worst is over for the auto industry but the question now is how fast the industry will recover.
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