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TRW Automotive Holdings Corp. (NYSE:TRW) is one of the world's largest suppliers of active and passive safety related products primarily to Tier 1 original equipment manufacturers (OEMs). Active safety products deal with vehicle dynamic controls such as steering and braking while passive safety products deal with occupant restraints such as airbags and seat belts, and safety electronics such as crash and occupant weight sensors.

Sales Composition

The company derived 85% of its revenue from major OEMs with 51% of revenues coming from Europe, 30% in North America, and 14% from Asia. Volkswagen was the largest customer and accounted for 20% of the 2010 sales followed by Ford (NYSE:F) with 15% of sales.

The product mix as a percentage of 2010 sales is as follows:

  • Active safety products - 59%
  • Passive safety products - 25%
  • Automotive components - 11%
  • Electronics - 5%

Industry and Competition:

According to IHS Automotive, light vehicle production for the year 2011 is estimated at 13 million units and is expected to increase to 14.6 million units by the end of 2013. China and Brazil are the biggest growth drivers for the industry with a projected combined production increase from 17.2 million units in 2011 to 20.6 million units in 2013. Europe is expected to be flat because of the on-going debt crisis.

The automotive supply industry is extremely competitive. OEMs can almost always call the shots and pressure the suppliers on pricing, product performance, timeliness etc. TRW's major competitors include Advics, Bosch, Continental-Teves, Takata (OTC:TKTDF), Autoliv (NYSE:ALV), ITW (NYSE:ITW), Nifco (OTCPK:NIFCY), Raymond and Valeo (OTCPK:VLEEF).

Profitability:

In 2010, gross margins increased from 7.8% to 12%. Operating margins also jumped from 2.5% to 8.2%. Correspondingly, the company was able to increase its net margins from a miniscule 0.47% to 5.8%. The company was largely able to maintain the performance in 2011 with TTM gross margins, operating margins and net margins of 11.7%, 8% and 5.8%, respectively.

Return on Invested Capital, a critical metric in my opinion, has significantly improved from 1.45% to 2010 to TTM ROIC of 23%. These numbers make TRW a company worth considering for possible investment.

The cash conversion cycle TRW has been fairly consistent ranging from low of 13.76 in 2008 to a high of 21.84 during the last 12-months.

Growth:

The company has reported accelerating growth in revenue, operating income and net income during the last 5 years. The combination of rising revenues and increasing margins is wonderful news for the company. The table that follows presents the growth rates.

Company

5 Year

1 Year

Revenue

3%

24%

Operating Income

16%

310%

Net Income

33%

1416%

Going forward analysts expect the company to increase its earnings at annual rate of 5.4%.

Implied Growth:

Applying Graham's formula to determine intrinsic value of a company, at its current price of $35.4, the market expects the company to contract at an annual rate of 1%. This is very similar to my 0.5% contraction estimate based on the discounted cash flow model I developed.

My Growth Estimates:

In the medium term, I expect the company to benefit from the secular growth trend in the industry. The company has increased its capital expenditure from $294 million in 2010 to an estimated $570 million in 2011 to fuel future growth. I estimate a growth rate of 30% in capital spending for the next five years with a projected 4.3% annual increase in revenues.

Debt:

The company has been aggressively paying down its above industry average debt. The net debt has reduced from $2.3 billion in 2007 to a very respectable $642 million at the end Q3 2011. The company expects to continue to use its excess cash to pay down debt.

Valuation:

Valuation was performed using a two-stage discounted cash flow analysis with high growth period of 5 years. The major inputs and the valuation results are presented below.

TRW

Cost of Equity

14.69%

After-tax Cost of Debt

4.52%

Cost of Capital

12.07%

Growth Rate Years (1-5)

4.36%

Stable Growth Rate

2%

Valuation

Present Value of FCFF in High Growth Period (Billions)

$1.93

Present Value of Terminal Value of Firm (Billions)

$4.96

Cash, Marketable Assets and Non-Operating Assets (Billions)

$0.89

Outstanding Debt

$1.53

Market Value of Equity

$6.25

Market Value of Equity/Share

$50.3

As shown in the table above, I estimate a fair value of $50 a share for TRW and believe that the company is grossly undervalued. At current levels, a return of 42% is possible. The market does not seem to appreciate the industry growth prospects and is probably overly concerned with the events in Europe. I would look to build a position in TRW at these levels.

(Kindly use this article for information purposes only. Please consult your investment advisor before making any investment decision)

Source: TRW Automotive: Significantly Undervalued, 40% Return Possible