It's been a rough 12 months for the vehicle components space, as investors have started worrying about whether passenger vehicle growth will prove sustainable in North America and the EU, while commercial vehicle demand rolls over and off-highway vehicle demand remains moribund. Of the companies I pay the most attention to, Dana (NYSE:DAN) has been among the weakest performers as the company has significant exposure to the weakening/weak commercial and off-highway markets and additional market share concerns as well.
When it comes to the valuation, Dana is probably undervalued today but it is difficult to defend a company with a track record of more earnings misses than beats, heavy exposure to weak markets and geographies, and relatively weak prospects for leveraging unique technology into significant margin or return outperformance. If Dana can boost its long-term free cash flow margins above 4%, it takes less than 3% annual revenue growth to support a $14.50 fair value. That said, sentiment is pretty sour here (only Cummins (NYSE:CMI) appears worse in the group I follow closely), so a run of outperformance, however unlikely that may be, would be a powerful driver for the shares provided it is enough to convince the doubters to get more bullish.
A Messy End To The Year
While Dana did beat the top-line expectation for the fourth quarter, I believe that has to be viewed in the context of lower expectations coming out of the company's third quarter report and updated guidance at the Detroit Auto Show in January. In other words, I don't see it as much of a win.
Revenue fell 13% as reported and 4% on an organic basis, as currency and divestitures did have a notable impact on results. While the company's Commercial Vehicle segment was crushed with a 23% organic revenue decline, management reported that the other segments would have grown 3%. Management didn't give much more detail than that, but I would assume that the off-highway business was probably down in the mid-to-high single digits on an organic basis, while the light vehicle business was up in the low-single digits.
Although input prices have declined (steel, etc.), volume and currency have created definite currency headwinds. Gross margin declined about a point and a half and is quite weak on a relative basis at 12.5% versus the 17%-plus to 40%-plus range of the other parts companies I follow. To be more fair to the company, though, the margin isn't so out of line with closer comps like Meritor (NYSE:MTOR) and American Axle (NYSE:AXL).
EBITDA declined 28% on an adjusted basis, which missed expectations, with a big decline in the Commercial Vehicle segment. Strip that out and the remaining businesses were nearly flat on an adjusted EBITDA basis. Even so, margins were down across the board with relatively better performances in Light Vehicles and Power Tech (not too surprising given they were the stronger performers on a revenue/volume basis).
Light Vehicles Will Lead… To A Point
Light vehicle sales have remained pretty healthy in North America and the EU, and sales in China frankly haven't been that bad either (up 9% in January). Light vehicles are about 40% of Dana's business (and closer to 55% when it included Power Tech sales to that segment), and the company is closely tied to Ford (NYSE:F) and Fiat Chrysler (NYSE:FCAU) at over half of its light vehicle mix. Tenneco (NYSE:TEN) and BorgWarner (NYSE:BWA) also have heavy exposure to light vehicles, but they are more broadly diversified across OEMs.
Generally speaking, the components companies have been relatively positive on light vehicle sales growth in 2016, and Dana is included in that group. Unlike BorgWarner and Tenneco, Dana really isn't leveraged to high gas prices or low gas prices. With that, the biggest risk to the company in the short term would most likely be that the industrial recession expands into a general consumer recession that sees auto demand fall.
Longer term, it will be interesting to see if Dana can leverage its technology to the changing requirements of auto OEMs (lighter vehicles and more electric). Dana doesn't have BorgWarner's brake recuperation or start/stop technology (nor its focus on fuel-saving technologies like turbochargers), but Dana has what could still prove to be underrated exposure to electrification and alternative fuel given its battery/electronics cooling, hydrogen reformer, and fuel cell plate products. The company has also recently entered the all-wheel drive space with product offerings that improve the fuel efficiency of these systems. I'd also note that hybrid vehicles will need driveshafts and all-electric vehicles will still need axles, so there should be opportunities for future innovation here.
Commercial And Off-Highway Are Struggling… And Likely To Continue To Do So
There's not a lot of obvious good news outside of the light vehicle and LV-exposed Power Tech for Dana right now. Above-average exposure to Brazil was a positive for Dana (and Eaton (NYSE:ETN)) not so long ago, but that market is on its backside now and without any real hopes of improvement in 2016 (Cummins is looking for a 20% drop). China's CV market is also looking weaker for 2016 and a healthier India isn't going to be nearly enough for Dana.
Making matters worse, Dana is not only exposed to the rapidly (and significantly) weakening North American Class 8 line-haul market (which is no issue for Allison Transmission (NYSE:ALSN) or Tenneco), it has lost share with its largest customer PACCAR (NASDAQ:PCAR). As I understand it, Dana undertook a significant reorganization of its supply chain in the Commercial Vehicle business and while doing so was unable to meet PACCAR's demands for multiple driveline combos. With that, PACCAR moved business over to Meritor and it doesn't sound like that business is coming back right away (if ever).
There's likewise no good news in off-highway right now. Manitou (Dana's third-largest customer) is probably relatively better off given improving fundamentals in construction in the EU, but Deere (NYSE:DE) and AGCO (NYSE:AGCO) are having a rough time of it, and there's just really no good news to be found in the construction, mining, or ag segments of the market.
Recalculating The Value
It's not all bleak and hopeless for Dana. The company's three-year backlog of new business has risen 10%, skewed heavily to the Light Vehicle segment. Dana also probably deserves more credit than it gets for R&D/product development, and I'm curious to see what the market will do with its new all-wheel drive systems, new electronics cooling products, and the Spicer PowerBoost, which allows for waste energy recovery/re-use in off-highway vehicles and could offer up to 40% fuel savings. Unfortunately, I'm not confident that these will be enough to carve out a strong technology-driven margin profile.
The company is also willing and able to use a relatively healthy balance sheet to return capital to shareholders and acquire complementary businesses. With the fourth quarter earnings, the company announced the acquisition of Magnum Gaskets - the third-largest aftermarket sealing brand in North America.
All of that said, Dana is going to have its work cut out pushing significant light vehicle content growth over the next couple of years, and commercial vehicles and off-highway vehicles are likewise likely to remain under pressure for a little while. I've lowered my expectations for long-term revenue growth to a little under 3%, but I'm still expecting the company to improve its free cash flow margin into the 4%'s. The last seven years have largely been in the 2%'s, but I think the company can now leverage a more flexible supply base and increasingly leverage new product introductions to drive better margins.
If Dana can hit those targets, high single-digit FCF growth is in play and a fair value in the mid-teens is reasonable today. If FCF margins remain stuck in the 2%-3% range, though, there's no reason to get involved with these shares other than on a trading basis. Going further, this valuation model really is driven by those FCF margins - doubling my revenue growth rate assumptions over the next 10 years only adds about 25% to my fair value, while a flat 3% over the next 10 years (consistent with the average of the last seven years) pushes the value below $10/share.
The Bottom Line
I do think that Dana is undervalued, but it's hard to get excited about the shares right now. The share loss at PACCAR is worrisome, and the company doesn't have an obvious meaningful growth driver. Allison, BorgWarner, and Tenneco all have their respective challenges and problems now, but they look more promising to me right now than Dana.
Disclosure: I/we 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.