I was puzzled by Dana’s (DAN) valuation back in October, thinking that the shares looked undervalued even factoring in a weaker near-term outlook for light vehicles and an eventual end to the heavy truck boom. Lending some support to my notion that stocks don’t move up just because they’re cheap, the shares are more or less in the same place now (down about 5%), albeit with a steep drop into the close of 2018 and a rally in the interim.
Now Dana is in the middle of that light vehicle slowdown, and heavy trucks in North America are enjoying an extended peak, but orders have been plunging. Meanwhile, heavy off-road machinery has been looking a little wobbly lately. So even though Dana has built up a strong electrification portfolio that management believes will help drive revenue to over $10 billion in 2023, nobody seems to believe that today. With the shares undervalued even at lower long-term growth rates, valuation remains a head-scratcher and I’m increasingly tempted to take a flyer on this name.
Okay, And Fairly Familiar, First Quarter Results
The theme for auto, truck, and machinery component suppliers in the first quarter was to more or less meet revenue expectations, beat on EBITDA, and reduce guidance for the second quarter.
To that end, Dana reported 1% revenue growth, with organic growth also at 1%, which was a slight miss relative to expectations. Adjusted EBITDA rose about 4%, though, and beat expectations by around 3%.
Breaking down the numbers further, the 3% organic revenue contraction in the Light Vehicle segment was very consistent with the recent results at BorgWarner (BWA) and Valeo (OTCPK:VLEEY), and better than the Driveline results at American Axle (AXL). Power Tech, which is predominantly a light vehicle business, was also down 3%. It's worth mentioning, though, that Dana's Light Vehicle is more truck-oriented than the name might otherwise suggest.
In the Commercial Vehicle business, strong production growth for North American Class 8 trucks (up 20%) and medium-duty trucks (up mid-single-digits) helped drive nearly 12% organic revenue growth, while Off-Highway revenue improved 3% on an organic basis.
Overall gross margin declined 50bp this quarter, with higher material costs being a significant driver. Within the aforementioned 4% overall EBITDA growth, the LV business was down 1% (margin up 50bp), Power Tech was down 24% (margin down 280bp), Commercial was up 21% (margin up 100bp), and Off-Highway was up 14% (margin up 30bp).
By region, North American sales rose 1% on an organic basis, whiles sales in Europe were up 3%, driven by the Off-Highway business.
Okay Guidance Not Enough To Change Minds
Where Dana broke a bit from the pack was in not meaningfully reducing second quarter expectations and/or backloading the second half of 2019 further. The Street being what it is, there seemed to be a little pouting that the company didn’t raise guidance, but I see nothing wrong with a conservative outlook, particularly when the global light vehicle market seems weaker than expected and there’s ample uncertainty about machinery demand trends in agriculture, construction, and mining.
As far as commercial vehicles go, management acknowledged a strong North American and EU market for medium-duty and heavy-duty trucks (good for other truck suppliers like Allison (ALSN), Cummins (CMI), and so on), but a weaker market in the EU and Asia for light trucks. To that end, it’s worth remembering that Dana’s leverage in light vehicles is to light trucks (pickups, etc.).
Electrification Should Be An Asset For Dana
There’s no end of controversy about what electrification will mean for auto and truck component suppliers. When will it happen? How far will it go? What will the margins be like? Who’s placed to win the most business/content?
The same trend in vocational heavy-duty and medium-duty trucks that is putting a meaningful chunk of Allison’s business at risk is a positive driver for Dana. Through internal efforts and a series of M&A transactions (TM4, Oerlikon, and SME Group), Dana has assembled a good collection of assets in motors, inverters, and thermal management. With that, the company is prepared to offer eDrives, eAxles, hybrid axles, hybrid transmissions and other powertrain systems for P0 to P4 architectures.
Looking at the end-market opportunity, it’s worth remembering that a significant percentage of vocational trucks travel less than 200 miles a day, making them well-suited for electrification. Management believes that electrification could reach 12% in 2023, and with 2x or more content per vehicle in EVs versus internal combustion models, this is a growth opportunity for Dana. While the content uplift is also attractive in light-duty trucks and off-highway vehicles, the market penetration there is likely to be slower (I believe American Axle’s business is shielded, in part, by a slower process of electrification for large pickups).
I also wonder if Dana could attract some attention and interest from the traditional car market. This isn’t a market that Dana serves, but many of the eDrive/eAxle and low/high-voltage electronics technologies are transferable and could make Dana an attractive JV/licensing partner.
As I said before, I’m below management’s guidance for 2023 revenue ($10 billion-plus), but so is seemingly everybody else. I seem to be closer than most of the Street, at least among those who’ve published estimates that far out, and I’m looking for about 4% revenue growth over the next five years and 3% over the next 10 years. That’s below Dana’s trailing growth rate, so I don’t feel like my expectations are all that bullish or ambitious, even though the cyclicality of the commercial vehicle and off-highway markets isn’t going away.
On the margin side, I do believe Dana has improved the inherent earning power of the business, but I’m not looking for a large-scale change. Dana has historically converted about 3% of its revenue into free cash flow, and I believe that can improve to around 4% over the next decade. There are still a lot of questions about what margins will look like with EV components, but I don’t see why the fundamental profitability of the sector will change all that much – though I do see a bigger split between the have’s and have-not’s as electrification accelerates in five to 15 years.
Dana looks undervalued on both discounted cash flow and EBITDA margin-driven EV/revenue. It feels dumb to talk about a fair value in the mid-to-high $20’s when the shares trade below $20, but that’s what my models are producing, so I’m not going to lie about it.
The Bottom Line
Maybe I’m missing something and Dana’s long-term growth potential just isn’t what I think it is … but I don’t feel like I’m making particularly ambitious assumptions. I suppose I could be too bullish about long-term margin improvement, but if Dana can only replicate the past, then the shares are more or less fairly valued on 3% forward revenue growth. Given all of that, including weak near-term sentiment, this may not be a quick alpha-generator, but I do like the valuation now for more patient investors.
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.