Magna International - Undervalued Dividend Powerhouse

Summary

• Magna is drastically undervalued with 26% upside.
• Superior dividend growth with 27% dividend CAGR over the past six years.
• Presents a unique US tax arbitrage opportunity for Canadian investors.

Thesis

Magna International Inc. ("Magna") (NYSE:MGA), a major manufacturer of vehicle-related products, is currently undervalued relative to its fundamentals when measured against EPS and book value. Since 2010, it has demonstrated itself to be a strong dividend player with a positive outlook and plenty of room to increase dividends into the future. At its current market price (U$44.41 and C$58.13 as of market close on February 10, 2017), it is a bargain.

Background

Magna is a major automotive parts manufacturer that generates revenue from eight key categories:

• Body systems and chassis systems
• Exterior systems
• Powertrain systems
• Seating systems
• Tooling, engineering and other
• Vision and electronic systems
• Complete vehicle assembly
• Closure systems

As a true international conglomerate, it reports revenues in four key geographic segments:

• North America
• Europe
• Asia (as of 2012)
• "Rest of World"

With over 350 facilities spread amongst 29 countries, the company has generated over $30 billion in revenue in each of the past four years (2012-2015) and increased its EPS every year since 2010. Over the course of the past decade, the company has paid a dividend each year, consistently increasing the dividend since 2009. Moreover, during that same period, Magna has had only a single fiscal period of negative EPS (in 2009, following the financial crisis).

Magna's mission is to "[d]evelop and supply mechanically and electronically controlled powertrain and electronic systems and components that improve fuel economy, minimize pollution, and enhance safety and performance," and it is accomplishing this mission through a four-pronged strategy focused on:

• Lightweight material and science to drive performance and quality through innovative mass reduction;
• Becoming smarter through comfort, convenience, and connectivity, designing and delivering an inspired, best-in-class cabin experience;
• Becoming safer through active and passive safety, engineering protection and peace of mind for all who share the road; and
• Becoming cleaner through efficiency and sustainability, optimizing the use of energy to meet the needs of their customers, and the planet.

(Source: Magna International Inc. 2015 annual report)

Strengths

Magna's key strengths lie in its manufacturing prowess, size, number of production facilities, and network effects with its clients.

As mentioned, it operates in seven key categories, which span practically all elements of automotive design and manufacturing. Moreover, where a manufacturer does not have the need to assemble a vehicle itself, Magna offers an eight revenue category of complete vehicle assembly. This positions Magna to be a one-stop shop (no pun intended) for automotive design, fabrication, and assembly.

Of Magna's top six customers (General Motors (GM), Fiat Chrysler (FCAU), Ford (F), Daimler (DDAIF), Volkswagen (OTCPK:VLKAF), and BMW (OTCPK:BMWYY)), four are in the top 10 of the 2015 ranking of automobile manufacturers by the International Organization of Motor Vehicle Manufacturer's (OICA). When you expand this list to the top 15, it includes all of Magna's top six customers:

Magna Customer Rank	OICA Rank	Manufacturer	2016 Revenue ($000s)
1	4	General Motors	$6,424
2	7	Fiat/Chrysler Group	$5,094
3	5	Ford Motor Company	$4,923
4	14	Daimler AG	$3,779
5	2	Volkswagen	$3,301
6	12	BMW	$3,300

Click to enlarge

While it is not explicitly indicated in Magna's financial filings, one may draw the conclusion of network effects: It simply makes more practical sense to leverage existing relationships (e.g. existing vendors) where possible for manufacturing parts for vehicles, which is what I refer to as the network effects with clients.

Moreover, as mentioned, Magna has over 350 facilities in 29 countries. In addition to this, it is creating tight coupling with local providers, such as the 2015 business combination with Chongqing Xingqiaorui, which is discussed in the opportunities section below.

Finally, through its Lighter, Smarter, Safer, and Cleaner strategy, Magna is positioning itself as an innovator. Government regulations on emissions and fuel efficiency, and improvement and demand for autonomous vehicles and smart cars, are well supported by Magna's strategy:

(Source: D26 Consulting Ltd.)

Weaknesses/Risks/Threats

Contrasting its strengths are a number of weaknesses and/or risks for Magna. As mentioned, Magna has six key customers which account for the majority of its revenue:

As observed over the past six years, each of the six key customers accounts for at least 10% of overall revenue, and overall, the combined base of these six customers represents over 80% of revenue. To the extent that one of these customers leaves Magna, this would leave a large hole in its revenue stream for a given period. This has also been recognized by Magna:

While we have diversified our customer base somewhat in recent years and continue to attempt to further diversify, there is no assurance we will be successful. Shifts in market share away from our top customers could have a material adverse effect on our profitability.

(Source: Magna International Inc. 2015 annual report)

A second risk involves particular revenue streams. While Magna does not provide a breakdown of each revenue stream (i.e. of body systems and chassis systems, exterior systems, etc.), a shift in revenue between (or completely out of) streams may affect overall profitability. For example, if there is a large shift away from body systems and chassis systems to seating systems, revenue may be negatively affected.

Magna also has significant employee benefit and/or pension liabilities, which it records as future employee benefits:

While the relative amount of the benefit has gone down in recent years (because total liabilities have risen), it has been consistently above 15% over the past 10 years. Moreover, in the most recent year, these future benefits are a $500,000 liability against Magna. Insofar as there is a change in interest rates and/or the actuarial valuation of future employee benefits, there may be a material increase in the total dollar liability.

Magna is also susceptible to currency risk. Operating in four major markets, it must deal with a number of different currencies for receipt of revenue and payment of employees and vendors. To the extent that foreign currencies strengthen against the US dollar, all things being equal, profits may decrease.

Finally, Magna is susceptible to any legal proceedings, which may come forward either through its own products and/or services or the automotive sector in general. For example:

In September 2014, the Conselho Administrativo de Defesa Economica, Brazil's Federal competition authority, attended at one of the Company's operating divisions in Brazil to obtain information in connection with an ongoing antitrust investigation relating to suppliers of automotive door latches and related products.

(Source: Magna International Inc. 2015 annual report)

To take this a step further, as Magna pushes into new areas such as autonomous vehicles and smart technology, it increases its exposure to any developments in those areas. For example, if there were a major legal event with regards to autonomous vehicles in general, or if Magna produced part(s) for an autonomous vehicle, it may be susceptible to litigation and/or damages arising from those proceedings. It is hard to quantify a risk such as this, as it is a "known unknown": There is no telling what Magna may produce in the future, or what events may transpire in the future to cast a negative light on autonomous and/or smart technologies.

Opportunities

Despite the risks, other than organic growth and/or acquisitions, there are currently three key opportunities for Magna.

The first opportunity is with expansion into Asia. Since 2012, Magna has been moving more into the Asian market (see the Profitability chart in the next section). As Asia is currently the smallest contributor to Magna's overall revenue, there is plenty of room for (organic) growth in Asia relative to other revenue segments. Moreover, Magna recently completed the Xingqiaorui Partnership, which resulted in Magna receiving a 53% controlling interest in three manufacturing facilities owned by Chongqing Xingqiaorui in China in exchange for giving a 47% non-controlling equity interest in its own facilities to Chongqing Xingqiaorui. From a strategic standpoint, this transaction served two purposes: first, it provided Magna with increased exposure to manufacturing in Asia. Second, while Magna retained controlling interest in its own facilities, it also gained controlling interest of the Chongqing Xingqiaorui facilities, which positioned Magna to sustain its manufacturing moat in the Asia. Deals such as this entrench Magna in foreign markets, while still providing it with a competitive advantage vis-à-vis equity control.

Second, Magna can expand its Vision and Electronic Systems. In the preceding section, I spoke to possible legal issues in the future depending on the direction of the smart and/or autonomous vehicle market segment, but despite potential risks, there is virtually limitless upside. Provided Magna can become a key stakeholder in this burgeoning segment, there may be substantial organic growth in this revenue stream.

Finally, with increased legislative requirements (e.g. CO₂ emissions, fuel efficiency, etc.), as discussed earlier, Magna has opportunities to increase its exposure in this area by leveraging its Lighter, Cleaner, Safer, Smarter strategy.

Profitability

Revenue has been solid the past 10 years, marred only by a single dip following the financial crisis. However, growth has lagged in recent years: F2015 revenue is down 12.3% relative to F2014, but this may be attributed to currency fluctuations.

Despite the dip in revenue growth, profit margins and EPS growth have been steady, with consistent increases in the past five and six years, respectively

Dividend

Magna's board policy on dividends sums up Magna's position nicely:

Our Corporate Constitution contains a Dividend Policy that entitles holders of Common (formerly Class A Subordinate Voting) Shares to dividends which, in aggregate in respect of a financial year, shall be: (A) equal to at least 10% of our After Tax Profits (as defined in our Corporate Constitution) for that financial year; and (B) on average, equal to at least 20% of our After Tax Profits for that year and the two immediately preceding financial years. We have complied with this requirement since 1992 and intend to comply fully with this requirement.

(Source: Magna Company Website, retrieved February 13, 2017)

For the past six years, Magna has demonstrated a dividend payout ratio (measured against EPS) of less than 25%, and its dividend currently sits at a compounded annual growth rate of 26.97% for that same period. Moreover, its dividend payout ratio measured against free cash flow per share has been consistently less than 10%.

With Magna's corporate policy to pay out at least 20% of revenues over the preceding three years, and 10% in any given year, insofar as revenue remains steady or rising, the dividend should continue to do the same. Even in years of slowing or negative revenue growth, given the low dividend payout ratio, Magna should be able to consistently raise its dividend, even when faced with revenue headwinds.

An important note on the dividend for Canadian investors is that the dividend is recorded in US currency. Insofar as the USDCAD exchange rate remains high, dividends received by Canadian investors will benefit from the increased exchange rate. However, this also means that the dividend, when observed in Canadian dollars, may not be consistently increasing: insofar as currency exchange rates fluctuate, all things being equal, the dividend may "fluctuate" for Canadian investors.

Valuation

Currently, Magna is undervalued when measured against its Graham number. Since the effects of the F2008 financial crisis, which resulted in a negative EPS in F2009, the price to earnings per share (P/E) ratio has been consistently less than 12.50, with the most recent fiscal year (F2015) having a P/E ratio of 8.21. Moreover, the price to book (P/BV) ratio has also been consistently less than 2.00, except for a minor spike in F2014. When valuing a firm against the Graham number, one typically wishes to see a P/E of less than 15.00 and/or a P/BV less than 1.50, or a combined ratio (i.e. P/E P/BV) of less than 22.50. As of F2015, the Graham number is 14.89. Moreover, based on the following values, the forecast Graham number is 20.71:

• Forecast EPS of U$5.27 based on analysts' estimates
• Most recent quarter book value of U$26.72
• Current price U$44.41 (C$58.13) as of February 10, 2017

Given this forecast, Magna is considerably undervalued. Using the above figures, the maximum price one should pay for Magna is U$56.29. When compared to the February 10, 2017, share price of U$44.41, there is 26.75% upside potential.

Currency Benefits for Canadian Investors

For Canadian investors, there are indirect cost savings to Magna as well. Because Magna reports in US dollars, and pays its dividend in US dollars, there two benefits to Canadian investors.

First, Canadian investors may purchase Magna shares on the Toronto Stock Exchange, and transfer them over to the US side of their brokerage account. Doing so allows them to purchase the shares in Canadian dollars, and once the shares are transferred over, receive dividends in US dollars. The Canadian share price will already have an implicit currency exchange rate when the shares are first purchased, which is often in line with the spot price for USDCAD. This provides a mechanism for Canadian investors to purchase a US listed stock while minimizing currency exchange fees.

Second, Magna provides Canadian investors with access to a US dividend stock while avoiding the US withholding tax for non-registered accounts. If a Canadian investor purchases shares in a US company, when they receive US dividends, typically they are subject to a 30% withholding tax: for every U$1.00 received, only U$0.70 is kept. However, because Magna is a Canadian company, any US dividends received will not be subject to such rules for Canadian shareholders. This provides a vehicle to receive US dollars, while providing a mechanism for cost avoidance, and these US dollars can then be used to purchase other US companies. In short: this provides a way for Canadian investors to more easily invest in the US market.

Closing Remarks

As an investor focused on dividend stocks, the ample headroom with Magna's dividend payout ratio gives me little concern at this time for any clawbacks in the dividend. Moreover, as a Canadian investor, Magna presents an excellent vehicle for capturing income in US currency. Given these strengths, Magna's future prospects, its profitability and sound fundamentals, Magna's current share price provides presents a fantastic opportunity to buy a good company at a great price.

Notes

All dollar figures are in US dollars.

Consult a tax professional to ascertain the exact impacts of US withholding taxes on your investments.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MGA over 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.