Subaru's Decade Of Strong Performance Has Left The Share Price Depressed: A Recipe For Outsized Future Returns
Summary
- Subaru has grown substantially between 2010 and 2020.
- The company is relatively small but has some key technological advantages and a strong branding strategy.
- Subaru has a history of strong financial performance.
- Vehicle quality issues in 2018 and 2019 and the global pandemic have left the share price depressed as profits have declined.
- With a large net cash position, an excellent history of free cash flow generation and sales growth, Subaru is very undervalued with limited downside risk.
With markets at all-time highs, value stocks are becoming harder and harder to find. Especially in the United States. However, abroad there are still some bargains to be found. Investors who are mainly interested in American companies but can't find undervalued businesses to invest in are the key audience for this article.
I will discuss Subaru, the Japanese car manufacturer that has a higher percentage of its sales from the U.S. than any of the 'American big three' car companies. More than 70% of Subaru's cars are sold in the U.S. On top of that, I belief Subaru is very undervalued. I argue that value investors who are looking for "American" companies should consider Subaru.
In this article I will first discuss Subaru's business and its strengths and weaknesses. Secondly, we will look at the financials of the company. Lastly, I will discuss Subaru's valuation and why I think it is undervalued.
Subaru: Being a small player has its advantages
Subaru is first and foremost a car manufacturer. Secondly, it also operates an Aerospace company that mainly builds defense helicopters and makes parts for Boeing's 777x and 787 airliners. With only 4.2% of revenue being derived from the Aerospace segment, which is only marginally profitable, it is of minor importance to this investment thesis.
The automotive business is Subaru's core operation and the area of focus for this article. While it accounts for more than 95% of Subaru's sales, Subaru sells a tiny number of cars each year compared to almost any other car company. With around 1 million units sold in 2019 globally, Subaru is not even in the top 20. However, as more than 700.000 of these units are sold in the U.S., Subaru was the 8th largest brand there in 2019 (although Hyundai and Kia will most overtake Subaru in 2021 most likely).
Subaru has been growing its sales steadily over the last decade. From 563 thousand cars sold in fiscal 2010 to over 1 million in fiscal 2020 (Subaru's fiscal year starts in March, so fiscal 2020 coincides mainly with 2019 sales figures).
This is a CAGR of more than 6%. Subaru has been able to grow steadily because of its unique line-up of vehicles, their vision of which technology should be incorporated in their cars and Subaru's progress in creating a loyal customer group that love Subaru's brand and messaging.
As a small manufacturer Subaru does not have the scale to sustain a vast line-up of vehicles. Instead, over the last 20-30 years Subaru has catered their line-up in such a way that they have a presence in most popular car segments. The fact that Subaru has been able to keep its line-up very similar over the last 20 years has enabled them to fine-tune their models in such a way that many are considered above average or top-rated cars in their respective class.
(source: Subaru Company Brochure)
Subaru has a strong presence in the SUV market with the small Crosstrek, the larger Forester and the SUV/Wagon Outback. On top of his they recently introduced the Ascent which is already close to a, for Subaru meaningful, 100.000 units sold a year. Why does this relatively small range of models work well for Subaru? Because Subaru has created an excellent vehicle line-up linked to a viable brand strategy that is catered around "boring" ideas; Reliability, safety, dependability, longevity and off-road performance.
Subaru's core ideas for its line-up
Subaru would not be able to design new engines, chassis or drive-trains for every different model or generation. It simply does not have the scale to do this. Instead, Subaru has wisely chosen to standardize all its models around some key concepts that reinforce its branding strategy and image. This gives Subaru a bit more scale advantage (or rather a smaller disadvantage) which enables them to reduce production and R&D costs. These key technologies are:
1. All Wheel Drive system (AWD) on all their vehicles
2. A standardized Boxer engine in all their models
3. A wide-array of active and passive safety features fitted on their vehicles
Subaru does not intend on creating the sleekest sedan or most daunting looking SUV. Nor are their cars the quickest, most fuel efficient or the most innovative. Instead Subaru vehicles are built to last a lifetime and guarantee that that life will not be cut short by an accident. The following info graphic explains Subaru's standardized key technologies well.
(Source: Subaru 2020 Annual Report, p. 32)
These core technologies are usually not hot topics when buying a car. However, they achieve two key things for the company. First it allows Subaru to fit the same (or very similar) drive-train, chassis, engine and safety systems in all of their cars. This saves them money and most importantly a lot of R&D costs. Subaru basically spends its money once making one system really good and then incorporating it in all its models. Secondly, these core technologies fit well with the company's branding and its customer group.
Branding: Catering to the nature loving, sensible, reasonable (and a tad bit dull) customer
Subaru was smart to standardize its line-up to increase safety, quality and reduce (development) costs. However, for such an approach to work, customers need to appreciate such a car as well. To do this, Subaru relentlessly advertises its core strengths and ensures that they connect with the people who appreciate their unconventional focus on reliability, safety, longevity and so on. Subaru appeals to people who 'want to be different' in a sensible way. A Subaru customer does not take pride in in having the most stylish looking car with a special paint job. A Subaru owner takes pride that in 10 years from now their 2020 Subaru Outback is able to get up snowy hill while a new high-end German SUV might not. Subaru owners are the people that look up IHS safety ratings and show pride in the fact that their car will most likely be able to run for 500.000 miles. There customers love to go out in nature, feel safe, sensible and not need to worry about buying a new car for at least a decade. Subaru knows this and they know that if they make unassuming reliable, safe and long-lasting cars and market them well, their customers are most likely going to be very pleased. If this all seems a bit fuzzy to you, I encourage everyone to look at these pages on vehicle safety and Subaru 'owner stories' on their website and I think you will understand what I mean.
Financials: A solid foundation
Subaru has taken the same approach to managing its financial situation as it has to making its cars. Subaru is in excellent financial shape especially for a car company during a global pandemic. Before any discussion of the financials can take place, a housekeeping note is in order. As Subaru is a Japanese company it reports its financial results in Yen. I decided to convert all relevant information in this article to US dollars to make it more readable. Let us first look at Subaru's revenue and profits during the last decade to see whether their growth in vehicle sales matches the financial numbers.
(Source: Seeking Alpha. Note: the current exchange rate between the Yen/USD is 106 Yen for $1. Be aware that Seeking Alpha has updated these numbers at a slightly different exchange rate (as they don't update these figures daily).
As we can see, Subaru's sales have grown substantially over the last 10 years. Profits have doubled as well, although they are currently significantly below Subaru's stellar years of 2014-2018. Investors that notice the very high profit number for fiscal 2016 should see this as an exception. Favorable currency gains, one-time divestures of investments and other one-time positive events elevated profitability for fiscal 2016. However, I do belief that Subaru has the ability to generate profits of around $1.5 billion a year, a figure more than 25% lower than their best years during the 2014-2018 period. The last two years of diminished profitability seems to be due to increased spending to increase production capacity as well as to correct mistakes made during the years before on the vehicle quality front.
Quality issues in 2018 and 2019
Because of Subaru's growth, quality control and vehicle quality diminished during Subaru's record financial years. 2019 was the year when most of these issues hit the company at once. Vehicles needed to be recalled, issues with building quality surfaced for recent models and Subaru's carefully crafted image of dependability took a hit.
These recalls and Subaru's investments to prevent these issues going forward have hurt profitability for fiscal 2019 and 2020. Of course, profits are going to be meager during fiscal 2021 due to COVID. But Subaru has acknowledged the issue, is working hard to resolve it and for now fiscal 2020 has seen a lot less issues with quality problems and recalls. Anyone reading Subaru's 2020 annual report will notice the company takes the issue very seriously. They know quality and dependability is one of the brands key pillars, so lagging in that department for long is simply not an option. I encourage everyone interested to read the Q&A with the CEO where they discuss the past problems and how to fix it. For a CEO to acknowledge these major issues openly at the beginning of Subaru's annual report and providing a detailed plan how to tackle it later in the report should be a great sign of confidence for investors. On top of this, the current CEO has been in place for only two years, so he has every incentive to fix the situation as he did not cause the company's problems.
On a whole, I think that after the pandemic is over and after fixing all the quality issues, Subaru can comfortably hit $1.5 billion in net profits as they did with ease in 2014-2018. The company has proven it is able to achieve these numbers. With Subaru aiming for operating margins of 10$, my estimate of $1.5 billion in annual profits is on the low end. With the Japanese tax rate at approximately 30% hitting a 10% operating margin would result in net profits of around $2.1 billion a year. With the quality issues being resolved and COVID behind us I think it is very likely that net profits will come back to at least $1.5 billion a year.
Cash Flows
Secondly, we need to look at cash flows. With car manufactures net profits usually look stellar, but after capital expenditures and other cash expenses their free cash flow numbers are usually a lot worse. This is also the case with Subaru albeit not dramatically.
(Source: Subaru's annual reports, table by author. Yen/USD conversion rate set at the current 106 Yen for 1 Dollar for all years)
As we can see Subaru's FCF numbers are generally a bit below their net profit figures. For these years net profit averaged $2 billion while the average FCF is just shy of $1.8 billion. On top of that, we need to note that fiscal 2020 FCF was unusually low because of more than $1.5 billion in negative working capital flows. Generally, we can state that Subaru is an excellent generator of cash, especially for a car company. With my assumption of $1.5 billion in net profits going forward, we should see FCF coming in at approximately $1.2 billion on average for the coming years. The last part we need to evaluate is Subaru's balance sheet and cash position.
Balance sheet
The last decade of growth and solid FCF numbers has left Subaru in a more than excellent financial position. Especially for a car manufacturer weathering a global pandemic, Subaru is in excellent shape financially. I converted the Q3 fiscal 2021 and fiscal 2020 balance sheet from Yen to dollars to show Subaru's great financial position even after the quality control issues and the COVID pandemic.
(Source: Subaru's 2021 Q3 report and 2020 Annual Report, table by Author. Yen/USD conversion again at 106)
As we can see Subaru has a large net cash position. As some assets and liabilities are classified slightly differently in Japan, I made a separate net cash table.
| All figures in millions | Fiscal 2021 (Q3) Dollar | Fiscal 2020 Dollar |
Cash and cash equivalents | US$ 7781 | US$ 8103 |
Other financial assets | US$ 2648 | US$ 1928 |
Total | US$ 10429 | US$ 10032 |
(Current) financing liabilities | US$ 157 | US$ 115 |
(Non-current) financing liabilities | US$ 2997 | US$ 2142 |
Other financial liabilities (Current and non-current) | US$ 1263 | US$ 1056 |
Total | US$ 4417 | US$ 3313 |
Net cash: | US$ 6012 | US$ 6718 |
(Source: Subaru's 2021 Q3 report and 2020 Annual Report, table by Author. Yen/USD conversion again at 106)
The line 'other financial assets' are basically short-term investments and some equity holdings of other businesses (which is common in Japan). I decided to add this to Subaru's cash position as these are all very liquid holdings. Separately, the 'financing liabilities' is all of Subaru's short and long-term debt. 'Other financial liabilities' are basically lease liabilities and some other minor obligations. However, as Subaru treats these liabilities as debt payments in their cash flow statement (they see it is a financing cash flow instead of an operating one), I elected to follow their lead. This results in Subaru having $6 billion in net cash. Only a $700 million decline during the pandemic, which is impressive considering that Subaru has actually had negative working capital changes during this period.
On top of this great net cash position, Subaru also has other valuable assets on its balance sheet. Let me walk you through these as well.
| All figures in millions | Fiscal 2020 Yen | Fiscal 2020 Dollar |
Land value | JP¥ 172430 | US$ 1627 |
Buildings | JP¥ 224665 | US$ 2119 |
Investment property | JP¥ 24366 | US$ 230 |
Other financial assets | JP¥ 33464 | US$ 316 |
Total | JP¥ 454925 | US$ 4292 |
(Source: 2020 Annual Report, table by Author. Yen/USD conversion again at 106)
First of all, we can see that Subaru has vast real estate holdings of more than $3.7 billion. The list of properties is large in their annual report. Although they do not specify which of their factories, offices and land they actually own and which they lease, they must own the majority as their property holdings are at least $3.7 billion. We could argue the $3.7 billion is on the low end as this already includes almost $2.4 billion in depreciation. Furthermore, they also have non-current other financial assets and investment property worth more than $0.5 billion. Of course, Subaru will not be able to liquidate the majority of its property and real estate as it is needed for its operations. But on a whole, it shows that there are a lot of hard valuable assets on Subaru's balance sheet. For example, the fact that Subaru owns an airport and an airstrip shows that they definitely have a large range of assets of which some could potentially be liquidated in the future.
In conclusion, we have established that Subaru has the ability to generate lots of FCF, grow its earnings and sales and that they have a stellar balance sheet to support the company. What kind of value might we put on a company like that?
Valuation
So far, we have not talked about Subaru's valuation at all. With the positive financials we would expect that investors have to pay a steep price in this market for a company like Subaru. Surprisingly though, you don't.
All figures in millions (except share price) | Market Cap and Enterprise Value |
Shares outstanding | 769,175 |
Current share price (1959 Yen) | 18,48 |
Market cap: | US$ 14215 |
Net cash | US$ 6012 |
Enterprise Value | US$ 8203 |
Book value | US$ 16325 |
Goodwill and Intangibles | US$ 1999 |
Tangible Book Value | US$ 14326 |
(Source: 2020 Annual Report, table by Author. Yen/USD conversion again at 106)
Subaru's share price has been in a long decline ever since its great performance in fiscal 2016 and the subsequent quality issues. As we have seen though, Subaru has continued to generate ample amounts of FCF.
Right now, Subaru's enterprise value is just $8.2 billion. You pay 1x book value for a company with vast real estate holdings, $0.5 billion in long-term financial assets and the ability to consistently generate more than $1.5 billion in FCF. On top of this, the company has grown its revenues by more than 60% between fiscal 2011 and fiscal 2020. Subaru is a growing company, with a strong brand, a loyal following and vehicle line-up that has proven to be successful. Frankly, besides the quality issues of 2018 and 2019 there are very little negative points to be found. And even that issue seems to be taken care of well already. I will now provide two scenarios.
The first base scenario basically assumes Subaru will never reach its average financial performance of 2013-2020 again. Assuming no growth and simply a slight rebound in profit margins after the quality issues and the COVID pandemic could easily leave Subaru averaging $1.2 billion in FCF a year. This is more than 32% lower than the 2013-2020 average FCF. In such a scenario you would pay an EV/FCF multiple of 6.8x. Furthermore, you are buying a company for just its tangible book value with a lot of solid real estate and financial assets on the balance sheet. Lastly, Subaru has a good history of paying dividends. They aim for a pay-out of 144 yen per share ($1.35 a share) yearly. Right now, it is lower due to COVID. For fiscal 2020 they paid 56 yen ($0.53 a share). In this scenario Subaru should start paying its 144-yen dividend at least in 2022 again. With the current share price that would result in an annual yield of 7.3%.
I belief that the scenario above is a conservative estimate of Subaru's earnings capacity. Especially as it assumes no growth in the future and a significant decline in FCF going forward.
If we look at Subaru's future with a bit more positivity, we can assume that Subaru will at least be able to grow its revenue's somewhat over the next decade. A CAGR growth of around 3% for the next decade would result in Subaru selling more than 1.3 million vehicles in 2030. Just assuming that this growth would get them back to the average FCF generation of 2013-2020 of almost $1.8 billion would result in an EV/FCF multiple of just 4.5x. If Subaru is able to get their FCF up to levels seen in 2014-2018 that multiple would drop to around 4x.
An afterthought
Having read all this I presume there is one pressing issue on your mind still. What about electric vehicles and hybrids? How will a small car company like Subaru make that huge transition? The answer will most likely be, slowly but surely. Toyota is a long-term 20% owner of Subaru and the two companies have worked together on many projects since 2005. It is common knowledge that Toyota is one of the front runners in hybrid and hydrogen technology. Luckily, for Subaru it has been able to partner with Toyota on rolling out new hybrid and full electric vehicles. Subaru and Toyota will together develop a new platform for both fully electric vehicles and hybrids. Subaru will use the Toyota hybrid system to make this happen. Currently, Subaru offers a PHEV Crosstrek and a hybrid Forester. Expect their EV offering to increase significantly from 2022 onwards. Of course, it is uncertain how well these new EV models will do and how the future of electric vehicles will develop. But I belief that, by partnering with Toyota, Subaru has made a very smart choice in how to confront the electric vehicle transformation. There current electric line-up is modest, but Subaru's plans seem well thought out. While Subaru is unlikely to emerge as a frontrunner in the electric segment, they are on track to catch-up surely but slowly. I don't think it will have much negative or positive influence on Subaru's business.
(Source: Subaru's 2020 CSR report, p. 45)
Conclusion
Summing up, I belief that Subaru's share price has been unjustly punished by the slump in production quality of 2018 and 2019. The company is working hard on this problem and has openly and extensively acknowledged the problems. Furthermore, this problem was a first for Subaru as they have historically have produced solid vehicles. Their small size and focus on a few key strengths have enabled the company to build a strong and vibrant brand focused on quality, reliability, longevity, safety and off-road capability.
Financially, the company is in great shape. Subaru's balance sheet is excellent and they have a track record of solid FCF generation. At the current share price, you can scoop up a good company with a promising future for a bargain price. Your downside is limited due to the high tangible book value with quality assets and the conservative valuation. Anyone interested in investing in Subaru might need to wait a couple of years to truly capture the upside, but they will most likely get a good dividend in the meantime and the upside could easily be more than a 100%. If Subaru where to hit its 2016 high again, investors would have a 150% return excluding any dividends.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in FUJHY 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.
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Comments (14)
2) it has almost no EV offerings and will have to face stiff competition when it does have some
3) Yes, it is cash rich but no catalyst for growth. Where will the future sales growth come from? In that sense, it provides false sense of value. People invest in a company not because it has lot of cash lying around but how well the management is able to deploy that capital to generate ROI. In that sense, I do not see any visibility in its current line up of product offerings. Having said that, I am impressed by the discipline the management has showed in deploying the capital. I hope I am right but so far nothing from management about its plans for the future. Until there is visibility in this front stock price will languish.
4) potential investor should also factor in the trading cost as it is traded on OTC and foreign taxes on dividends. I’m not sure if it’s ADR pays dividends. Even if it does, consider high Japanese taxes taken at source, ADR fees etc.
5) Subaru vehicles GENERALLY cost more to insure and maintain/service, lower efficiency in fuel consumption in comparison to Toyota, Honda etc. so it hurts their appeal to car buyers.
5) Toyota could absorb both Subaru and Mazda as both probably have valuable patents but as a stand alone company would be hard to invest in. Investing in Toyota as a proxy for both companies would be safer.
6) Major brokerage houses rate Subaru as underweight for investment
I observe generally it seems possible (not easy) to find japanese companies with cash and low EV... Nikon last year.... Keep up the good work! Ty @Daniel @John - is as is
6.6% production cut is what I last read. This includes shipping container shortage. Do you have something more recent?www.reuters.com/...
The production cut is indeed 6.6% for 2021 as @John - is as is pointed out. As my thesis is mainly a long-term bull thesis on Subaru, the performance of 2021 is of relatively limited significance for my article. Of course it is better if Subaru did not have the shortage, but I don't think it impairs the long-term bull cash which I belief will most likely play out 2022 onwards. I think it is very hard to make any good guess on Subaru's results for 2021 (which falls mostly in fiscal 2022) due to the pandemic, this issue and the remaining quality problems that is getting fixed.Therefore, I don't expect much from the coming year. Subaru has proven to be able to withstand 2020 well, so there is no reason to belief 2021 will be worse. My main bullish arguments are all based on normalizing sales and earnings from 2022 onwards. I hope I have clarified my position!
also for sake of history, could u explain the crazy share price upwards move 2012-2013 + 300% or am I reading chart wrong? couldn't understand why it catapulted upwards.
I don't mean to speak for Daniel. Hopefully, he'll chime in. Here's my take:
When Subaru stock dropped recently, I revisited Subaru, Mazda, and Nissan, though I didn't dig very deep. With the exception of Toyota, they are all still in stock price recovery mode right now. Arguments can easily be made for/against any of these companies. For me, Subaru has seen the least love from investors in 2020 despite all the positives noted in this article and others on SA. I'm hoping investors will come around and push the stock value up in line with the auto industry competitors. Basically, I'm hoping that I jumped in pre-momentum. Mazda is improving and certainly has upside as well. I think I would have been happy splitting my investment between the two had I chosen to do so.EV concerned me too. It's kind of a mixed bag in my mind. I would expect the core Subaru following to be increasingly against ICE vehicles. On the other hand, if you are driving off into the mountains somewhere, hybrids (which they do offer) are a better bet for now. I am comforted that they are teaming up with Toyota going forward on that front instead of developing completely new concepts on their own. It is also a positive in my mind that Toyota has 20% ownership in Subaru vs 5% in Mazda. I'm not sure what happened in 2012-2013 (aside from US election, fed reserve support, stock market and housing in general shooting up). I wasn't following the auto industry at the time. Mazda, Toyota, and Subaru all saw big gains from 2012 lows though. Mazda jumped up just as much as Subaru.
Mazda does not have a net cash position right now (debt/cash is roughly even) compared to Subaru.
Mazda has doubled its share count over the last decade. I don't know the reason for this, but it is generally not a great sign.
Mazda's cash flow performance is decidedly worse than Subaru. Especially if you know that sales of both companies are roughly even.On the quality front I think Mazda also makes great cars. They have similar line-up to Subaru in that it is relatively small but well executed. Their interiors and driving experience are top-class for their segments. I might delve a bit deeper into Mazda, but these would be my quick take-aways.With regard to the EV development for Subaru, read the last part of the article and check the CSR report, Subaru detailed explanations there. For now the Boxer engine is staying in all PHEV's and Hybrid's Subaru is going to make. For full EV they will have to replace it most likely, but they have plenty of time to find a proper solution for this.Lastly, I don't know specifically why the share price increased so dramatically during 2012-2013. My best guess would be that it is basically investors being overly bullish as those were the years Subaru's financial performance really improved a lot coming out of the Great Recession. Just as investors are too negative rn in my opinion, they were overly optimistic about improving results back then. I think it is a nice reminder that the current pessimism is not a given. Sentiment can change quickly.Note: I have no idea why my reaction is printed in bold ;)