If you've bought shares in Dana Holding Corp. (NYSE:DAN) in the past six months, you are probably quite pleased with yourself. In fact, if you've bought shares anytime since the market bottom in March of 2009, you are probably doing very well. Shares are up over 18% for the year (as of closing on May 29, 2013), and up 6800% from their lows in 2009! But I am afraid that if you are just looking at shares now, like I am, the train has already left, and we're at the station, looking for a suitable ride home.
Free Cash Flow and Valuations
Dana Holding, for those of us new to it, is a worldwide supplier of automobile and construction vehicle parts, such as axles, driveshafts, and off-highway transmissions. The company sells parts to just about every major vehicle manufacturer, including Ford (NYSE:F), Toyota(NYSE:TM), and Caterpillar (NYSE:CAT).
The company still looks healthy. My Finviz.com screener shows a lot of green, and not much negative. With a P/E of 15.42, a forward P/E of 9.54, and a Price/book value of 1.54, one's first impulse might be to conclude that this stock is still a steal. The company looks sustainable with a healthy quick ratio (1.69) and current ratio of (2.25). Debt levels are manageable.
But I'm looking to buy into a company at a bargain, and not a fair value. As a dividend payer, Dana has just a little over a year of history (it recently emerged from bankruptcy in 2007), and hasn't raised its dividend yet. Yields are currently hovering around 1%. If I'm going to buy this company, I'll need to expect some capital appreciation, and that means I need to get my cash flow at a discount. I don't value using earnings, I value with Free Cash Flow (for my reasons see here). My discount free cash flow calculations are listed below. If you need further explanation, please ask in comments or email me directly.
My buy under price is WAY under the current price. I've set my required rate of return as 11%. A 9% required rate of return would give you a fair value, and an 8% required rate of return would make this company a buy.
My other inputs for cash flow calculations should be less contentious. I used analyst estimates for growth rates for 2013 (4.6%), and a growth rate of 8.62% for the following five years. I then apply a 3% growth rate into perpetuity for everything beyond 2018. I end up with a calculated value of operations of $4256 million. After subtracting the value of preferred stock, equity deficits from pension plan shortages, currency exchange losses, and accumulated deficit to shareholders, I calculate the value of equity at 1973.5 million. This gives us a fair value of $13.31, over 30% lower than today's prices in the low $19's. BTW, I pulled my financial statements from Google finance here, and the specific equity deficit numbers came from the 2012 Dana holding Corp 10K here, specifically the consolidated statement of comprehensive income and balance sheet on page 38 and 39.
As a sanity check for my FCF valuation, we can look at earnings. The Price/Earnings ratio is currently listed as 15.42 (from Finviz.com). I like to build a "defensive earnings" income statement and an "enterprising earnings" income statement. The defensive earnings statement expenses fixed and working capital investments that accrual accounting does not, in an attempt to verify that the company can self-fund. The enterprising earnings statement capitalizes intangibles such as R&D and advertising to try to determine whether the company is prospering from its investments in these areas. For much greater details on the why's and how's see two of my previous analysis here and here.
My defensive earnings study shows that the company has struggled to benefit from its investments in fixed and working capital since emerging from bankruptcy. Without looking at bankruptcy specifics, we could assume that many assets were sold off to pay creditors, and Dana management should not be blamed. Dana's inability to fund itself after fixed and working capital expenses may be somewhat unsurprising, but does add an element of risk to our risk/reward calculation. It's important to note that the past three years (even with a dip in 2011) were vast improvements over 2008-2009. The company does seem to be using its invested resources more effectively. A "defensive P/E" of 14.04 shows a somewhat better value than the conventional P/E, but is neither outstandingly cheap, nor is there enough time of positive defensive earnings to confirm a healthy trend.
Per share "earnings" may be improving, but with only two years of positive "enterprising earnings", it may be a little too early to feel comfortable with Dana's ability to capitalize on its R&D and other intangible investments. Furthermore, I normally use enterprising earnings statements to analyze companies who rely heavily on intangible software investments, but in this case, Dana's R&D and Engineering costs are a significant portion of the company's gross profit. Dana makes the argument that this expense is necessary to maintain competitiveness, so a quick look at how they are performing is appropriate. Using per share "enterprising earnings" shows that their enterprising P/E ratio was 21.18 on Jan 2, 2013 (share price $16.08).
Neither defensive earnings nor enterprising earnings raises red flags for me, but they do not show an exceptional value. Assuming my FCF growth rates are accurate, I am comfortable saying that current share prices do not offer a discount.
The biggest problem with my DCF analysis is the growth rates are completely open to interpretation. While it may be a useful starting point, it should not stand alone as an argument of value. Are the growth rates used in my calculations realistic, or pessimistic guesses of a few embittered analysts? In addition, a lot of valuation through Discounted FCF analysis depends on your perception of what constitutes a satisfactory return on your investment (the discount rate). I base rate of return on several things. What is my minimum rate I want to earn from any equity investment? How certain am I that my growth rates in my calculation are accurate? How much risk is hidden away in the financial statements? I can't answer question #1 for anyone but me, but I'll try to shed some light on question 2 and 3.
Dana's 10Ks are some of the most transparent reports I've seen lately. It gives us a breakdown of where its sales come from in terms of segments and regions. In addition, Dana provides growth estimates for each region's sales.
Source: Dana Holding Corp. 2012 10K
Source: Dana Holding Corp. 2012 10K
Now we know how many more units Dana estimates it will sell for each region. A simple (and admittedly simplistic) way of forecasting the increase in sales is to simply find out the average growth rate for each region, as well as the share of sales that each region held in 2012. We can then take 2012 sales and multiply them by weighted average growth rates for each region.
(7224 X 47% X 1.022) North American growth rate and sales share + ((7224 X 28% X .963) European growth rate and sales share + (7224 X 12.6% X 1.051) S. American growth rate and sales share + (7224 X 12.4% X 1.02) Asia/Pacific growth rates and sales share. = 1%
This is a quick, rough look at sales, because it treats each unit equally in terms of sales dollars. Dana tells us that LVD and Power Technology segments, which serve light vehicle markets, make up around 50% of sales. Light truck sales also dominate the expected increases in units sold for 2013, so the calculated 1% growth in overall sales is probably overly conservative. Still, one of a few things must happen for earnings to grow the 4.6% analysts estimate. Either sales must grow more than what Dana Holding projects, or costs (e.g. commodity prices, foreign exchange rates) need to fall significantly. Either way, growth substantially over 4.6% looks unlikely.
It's also useful to note that in the recent past, Dana Holding Corp has been reporting lower earnings than expected by analysts. While analyst reports, such as Ford Equity Research (24 May 2013), call the drop in earnings from 1.93 to 1.53 in the past five quarters "neutral", the drop and sanguine attitude of analysts makes me comfortable that the analyst's consensus growth rate is adequately liberal for my DCF calculations.
Comparison to Peers
It is entirely possible that an improving economy, low interest rates, and recent commodity price drops will bode well for the automotive industry as a whole. This is an argument for the sector, not necessarily for Dana Holding. How does this company stack up when compared to peers?
It's easy to see from this comparison graph that DAN is neither the cheapest (when measured by earnings), nor the best performing amongst its peers. Lear (NYSE:LEA) and American Axle and Manufacturing Holdings Inc (NYSE:AXL) both look like they provide more growth potential at a cheaper price from this cursory look. However, looking at a number graph can make it hard to visualize relationships between different metrics. We can pit Dana vs. its competitors on a scatter graph depicting several metrics relationships to get an idea of the company's competitiveness in the automotive parts industry.
Here I've compared DAN's EBITDA margins and revenue growth rate vs its peers. Those companies with higher EBITDA margins and revenue growth rates tend to outperform those with lower relative measurements. DAN (down near bottom left) outperforms several peers on EBITDA margin, but lags in terms of revenue growth. AXL again seems to outshine DAN, but Gentex Corp (NASDAQ:GNTX), Dorman Products Inc (NASDAQ:DORM) and Drew Industries Inc. (DW) provide superior revenue growth AND EBITDA margins.
Here I've made the same comparison, but this time I substitute Earnings Yield for EBITDA margin. Again DORM and DW outperform (owing almost entirely to revenue growth rates). But this time LEA and AXL stand out, as having superior earnings yield and revenue growth rates.
As investors, we expect a reward for a company taking a risk with our money. Companies who maintain higher debt levels should be compensating us with higher growth rates. We can chart out Debt/Equity vs. Return on Equity (ROE) to get some sense of how industry peers are using leverage to benefit their shareholders. We can see from this chart that the auto parts industry is not particularly debt laden. Most of the companies cluster around each other, but LEA seems to be getting the best overall results with an ROE of 42.35 vs. DAN's 21.79, while using less debt to achieve it.
At this point, Lear is starting to look like a better deal than Dana, but of course we'd need to do a whole new analysis of the company before making that assumption. What we have learned from this analysis is that Dana may not be the cheapest buy in the industry, and that it doesn't appear to be the best performing company in terms of earnings growth or leverage. Even in an improving market for automotive parts, Dana is vulnerable to competitors who use their resources more efficiently.
Momentum vs. Threat of Dilution
In the short run, momentum often keeps winners winning. Dana Holding's stock certainly has momentum. Since the middle of April, it has appreciated nearly 25%. Long-term investors are wise to shrug off such market movements as a signal to buy. Nevertheless, it is often hard to resist buying a fair valued company when it looks like the price trend is still upwards. Often, if I feel a stock has some upward momentum, and I'm not averse to owning it (but not overly eager to own it for the long run), I'll trade a long-term diagonal call spread.
However, in this case, I believe that the company's price increases are limited by a threat of dilution. Most investors in Dana are probably aware that there are still a little over 7.7 million preferred shares outstanding. Dana provides a somewhat cumbersome calculation for converting preferred shares to common shares on its investor webpage:
"The number of shares of common stock to be issued is calculated by dividing for each share ((i)) the then-effective Liquidation Preference ($790,000,000) plus all accrued but unpaid dividends by (ii) the Conversion Price ($11.93). Divide this result by the total number of Series A and Series B outstanding (7,721199) to obtain the conversion."
This works out to be roughly 8.37 shares per preferred share, or potentially 64.7 million new common shares to dilute the current EPS. The potential impact on EPS is significant, and I would argue that any impact on EPS, given its universal usage in pricing models the world over, will have an equally significant impact on prices people are willing to pay for the stock… in the short run. If all preferred shares were converted today, and the company's earnings grew at the estimated growth rate of 4.6%, EPS would likely be reported as $1.46. At today's prices, forward P/Es in the 9s become more like P/Es in the 13s. Of course a more immediate effect would result from the newly converted shares placed on the open market. Anyone converting preferred shares that pay 4% to cash in on the capital gains earned is going to sell his/her new common shares as soon as possible.
Of course, the chance of all the preferred shares being converted is pretty low. Especially when we consider that investors in 2011 had an opportunity to convert shares at near these price levels, and they only converted 90,099 shares. Still, this is no longer 2011. Those prices were in the high 18's, and as the stock price rises, so will the interest in converting shares. Furthermore, given the company pays a 4% preferred dividend, if interest rates start to rise, as some forecast, a juicy return on conversion and a chance to invest in something else paying more may be tempting.
For instance, if I held 1,000 preferred shares that originally cost me $100,000, I'd be making $4000 a year. If common stock prices are now $20.00 a share, I could convert my shares to 8370 common shares, which I would then sell for $167,400. Ignoring the attraction of pocketing $67400 in gains (not counting the interest I'd already made), I would only need to find an investment that would pay me over 2.4% to earn more money on my return. A combination of rising interest rates and a rising common stock price significantly increases the chance that investors will convert their shares en masse.
Even if interest rates do not rise, common stock investors are not safe. Dana wrote in a clause in their preferred share contract allowing them to convert all shares should common stock share price stay above $22.24 for at least 20 consecutive trading days. The opportunity to clean up the balance sheet, and rid the company of a 4% loan may be tempting, and would probably benefit shareholders in the long run. However, it is difficult to measure the likelihood that management would undergo what is likely to be a contentious move, especially as they're own compensation is likely tied to either share price or earnings per share growth.
Still, company managers don't actually have to intend to call the shares for the option to have a dampening effect on share price. Investors merely need to know that as share prices rise, EPS is more and more likely to take a significant hit. The mere perception that all of the outstanding preferred stock may be called could provide a ceiling on the price of the stock in the low $22's.
Dana Holding Corp. is a fairly healthy company selling at an ok price. But the name of the game in investing is putting odds in your favor. An investor must make many assumptions when valuing a company, some of which are bound to be wrong to some degree or another. The world is an uncertain place, and an investor's chosen company is subject to all kinds of unforeseen risk. Dana Holding fails to provide investors with a significant safety moat at these prices.
Despite its current healthy appearance, it's important to remember that Dana has had little time since emerging from bankruptcy to build up a managerial record we can examine. Net income and free cash flow were both negative prior to 2011. Neither its defensive earnings nor its enterprising earnings are impressive, or have impressive histories. It has lower EBITDA margins, revenue growth, and earnings yields than many of its peers. It has very little debt, but the same can be said about most of its peers, most of which are able to produce higher comparable Return on Equity for their shareholders.
Finally, potential dilution in the near term future, ironically tied to share price success, adds a new layer of risk. While conversion of shares should not have an unfavorable effect on the business in the long run, it does increase the likelihood of a selloff in the near to midterm, and could put a ceiling on the share price.
In the United States, people say "Time heals all wounds." Time may be all that is needed to turn this currently lackluster stock into a great company. A large drop in price could make it worth taking a stake despite the uncertainty that hangs around this company. A small drop or price stagnation, accompanied by a couple years of improving performance could mitigate many of the risk factors. Either way, in my opinion, investors who are considering purchasing DAN should wait and keep their eyes open for a better price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.