Can Dana Do What So Few Parts Companies Can?

| About: Dana, Inc. (DAN)
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It hasn't exactly been difficult to find winning auto parts/components stocks over the past year, but Dana (NYSE:DAN) has nevertheless enjoyed a good run - up more than 80% and within a hair's breadth of its 52-week high as of this writing. There are definitely a lot of things to like about Dana - it has a pretty good balance sheet (for a parts/components company), it has a good recent history of margin improvements, and a very diverse and balanced business.

The question is whether the good times can continue. There are certainly some near-term headwinds. Expectations for light vehicle (LV), commercial vehicle (NYSE:CV), and off-highway vehicle volume growth in Europe have come down significantly, and growth in key markets like Brazil is still erratic (recently LVs have been weak, while CVs have been strong). What's more, while Dana appears to be on a good path today, the track record of companies in this industry with respect to sustained long-term free cash flow generation is not at all good. Although I do believe Dana still scores well for quality and relative value, the probable free cash flow path is a little less convincing.

Here, There, And Everywhere

One of the key positives at Dana from my point of view is the company's diverse set of operations. Although the type of parts/components Dana sells are fairly concentrated (largely driveline products like axles and driveshafts), the company offers a good mix of end-market exposures between LVs (typically around 35% to 40% of sales), CVs (25% to 30%), off-highway (20%), and Power Technology components for all three markets.

Likewise, the company's customer base is reasonably diverse. Ford (NYSE:F) is a significant part of the LV business, but the company also sells to the likes of Nissan (OTCPK:NSANY) and Tata (NYSE:TTM). Dongfeng is a major CV customer, but Dana also counts PACCAR (NASDAQ:PCAR) and Volvo (OTCPK:VOLVY) on that list, while the off-highway customer roster includes both agriculture (Deere (NYSE:DE)) and industrial/mining (Manitou and Sandvik).

While about half of Dana's LV business comes from North America, Dana does business with car makers around the world. Likewise with the CV and off-highway businesses; Dongfeng (a Chinese manufacturer of passenger and commercial vehicles) is a major customer, but Brazil accounts for a significant portion of Dana's CV business.

Will Volumes Support Higher Sales?

Dana faces meaningful competition in LVs from companies like Magna (NYSE:MGA), GKN, and American Axle (NYSE:AXL) in its driveline business, and some of these competitive relationships run deep (like the one between American Axle and GM). Likewise in commercial vehicles with companies like Meritor (NYSE:MTOR) and American Axle in the CV market. I also believe that investors shouldn't overlook the risk that Chinese parts/components suppliers could emerge as a bigger threat to the industry in the coming decade, as China's burgeoning vehicle markets certainly would support expansion.

It's not competition per se that really concerns me now, though. Instead, I'm more concerned about basic underlying vehicle demand. The European outlook for vehicles is pretty uninspiring. Tenneco (NYSE:TEN) management recently pointed to a pretty soft outlook for European LV volumes, and the outlook for CVs and off-highway vehicles isn't exactly smoking hot (though a few companies, including Manitou, seem to think demand is getting for some types of vehicles in particular applications).

Companies like Caterpillar (NYSE:CAT) and Deere have seemed more cautious about their outlooks recently, and the expectations for a big rebound in demand seem to be fading. So while I do think commercial vehicle demand in North and South America should be getting better (and likely China and India too), there's still a significant amount of uncertainty out there in the market right now.

Can Dana Find A Sustainable Path To Higher Cash Flows?

I'm not all that concerned about Dana's long-term revenue growth prospects. While I don't think Dana is looking at the same sort of potential sales growth as say Tenneco (which is trying to increase its commercial vehicle business to a significant degree), I think long-term growth of around 3% is manageable and there could be some upside to that number if the company can find success in convincing off-highway vehicle OEMs to outsource more of their parts.

The margins is where I get more nervous. The company's more profitable Power Tech segment has been stronger (in terms of revenue growth) lately, and I think this could be a bigger part of the mix in the future if hybrid/electric vehicle demand accelerates (Dana sells systems to cool batteries), thermal management components see wider use, and if fuel cells start making their way into more vehicles. It's also well worth noting that Dana has been one of the stronger companies in the sector from the perspective of improving margins in recent years.

All of that said, the record of this industry stands against it. Cummins (NYSE:CMI) may be the best-regarded company in the space (if you consider engines and parts to be the same space), and even Cummins has had its challenges getting free cash flow margins into the high single digits. My base-case assumption for Dana right now is that they can attain and hold mid-single digit free cash flow margins, but that's a pretty bold assumption at this point.

The Bottom Line

The bad news regarding Dana's valuation is that on a discounted cash flow basis, the stock seems a little expensive now - my revenue growth assumption may be a little low, but then my free cash flow margin assumptions are pretty aggressive, so I think the basic outlook of double-digit free cash flow growth is pretty positive on balance.

The good news is that companies in this sector are rarely, if ever, bought and sold in large quantity on the basis of DCF. Due in large part to the fact that historical cash flows have been so bad, EV/EBTIDA is a preferred metric and Dana looks a bit undervalued on that basis. I'd prefer to hope for a pullback (or a more reasonable entry price relative to the DCF-based fair value), but Dana would do well on a commercial vehicle rebound, and/or higher global passenger vehicle sales, and the company's good margins make this a pretty good ongoing holding in what is admittedly a volatile and cyclical space.

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.