STRT - Strattec Security: Balance Sheet Strength An Advantage Amid Current And Potential Headwinds

2023-04-07 09:14:29 ET

Summary

• Net sales are expected to recover by 2024.
• Profit margins are depressed as a result of inflationary pressures.
• Debt does not pose a significant risk thanks to high cash and equivalents and inventories.
• Investors should not expect dividends in the short to medium term.
• This represents a good opportunity to acquire shares at a low price in order to obtain capital gains once current and potential headwinds subside.

Investment thesis

Strattec Security (STRT) is going through a delicate moment, and that is reflected in the price of its shares, which has suffered a strong negative impact in recent quarters. Net sales have stabilized at a slightly lower level than in fiscal 2019, which means that the company has not yet fully recovered from the coronavirus pandemic crisis despite enjoying a strong fiscal 2021. In fiscal 2022, net sales fell as a result of the global semiconductor shortage, and now inflationary pressures are heavily impacting profit margins.

Despite this, its low debt pile compared to cash and equivalents and inventories greatly reduces short- and medium-term risks and places the company in an advantageous position in the face of the current inflationary crisis, in addition to providing it with plenty of resources in the face of a potential recession due to recent interest rate hikes. That is why I consider that the current share price decline of 68% since February 2021 represents a good opportunity to acquire shares at a reduced price due to the current pessimism of investors, to later sell them at a higher price once current and potential headwinds have been overcome.

A brief overview of the company

Strattec Security is a designer, developer, and manufacturer of automotive access control products. The company's products include mechanical locks and keys, electronically enhanced locks and keys, passive entry passive start systems, steering column and instrument panel ignition lock housings, latches, power sliding side door systems, power tailgate systems, power lift gate systems, power deck lid systems, door handles, and related products. The company has been the world's largest producer of automotive locks and keys since the late 1920s, and its market cap currently stands at ~$89 million, employing over 3,000 workers. The company supplies major players in the automotive industry, including General Motors ( GM ), Ford ( F ), Stellantis ( STLA ), Hyundai ( HYMLF ), and tier 1 customers, among others.

Strattec Security is a result of the spin-off from Briggs & Stratton Corporation in 1995, but it has been in business since 1908. The company temporarily canceled the quarterly dividend of $0.14 in May 2020 in order to retain cash amidst the coronavirus pandemic crisis, and hasn't reinstated it yet. Certainly, the dividend was a reason for shareholders to hold the company's shares, but currently, the only way to get returns on the investment is through capital gains, which makes it necessary to sell the shares at a price higher than that paid. Considering the current share price, the dividend yield on cost would be ~2.62% (in the case the company fully reinstated it), but considering the current margin contraction due to inflationary pressures and a potential recession due to recent interest rate hikes, investors should not invest for a higher-than-usual dividend yield on cost in the foreseeable future as economic conditions are uncertain.

Currently, shares are trading at $21.40, which represents an 80.71% decline from all-time highs of $110.96 on November 24, 2014, and a 68.19% decline from the recent high of $67.28 on February 2, 2021. Indeed, this is a sizeable drop in the share price that could represent a good opportunity for investors interested in capital gains once the company's prospects become more promising and investors' optimism drives the share price significantly higher, and I will explain why in consider it so in this article.

Net sales are expected to reach record highs by 2024

Before the coronavirus pandemic, the company was experiencing a very acceptable pace of sales growth. Then, in fiscal 2020, it reported a net sales decline of 20.88% as demand declined due to coronavirus-related restrictions. Nevertheless, net sales recovered almost completely in fiscal 2021 thanks to an increase of 25.95% as these restrictions were mostly lifted, but demand decreased again in fiscal 2022 as net sales declined by 6.81% due to the global semiconductor chip shortage, as well as supply chain issues with other raw materials.

As for the current fiscal year, net sales increased by 19.95% year over year during the first quarter but remained virtually flat during the second quarter as they only increased by 0.24% year over year (and declined by 5.98% quarter over quarter). In this regard, it seems that net sales are stabilizing at a slightly lower level than in 2019, but are expected to reach $478 million in 2023 and $507 million in 2024 (compared to $487 million in fiscal 2019), thus reaching new record highs. Despite these expectations, it is important to note that they may not materialize if the recent interest rate hikes to combat high inflation rates trigger a global recession, and therefore the recovery could take longer to arrive.

The recent share price decline coupled with fairly stable sales has caused a significant drop in the P/S ratio to 0.178, which means the company currently generates $5.62 in net sales for each dollar held in shares by investors, annually.

This ratio is 53.28% lower than the average of 0.381 during the past decade and represents an 81.78% decline from the peak of 0.977 reached in late 2014, which means that investors are placing less value in the company's sales not only due to their stagnation and a potential recession but also due to the impact of current inflationary pressures in the company's operations.

Margins are depressed due to inflationary pressures

Before the coronavirus pandemic, the company enjoyed a gross profit margin of above 10% and an EBITDA margin of around 8%, but lower demand in fiscal 2020 caused a significant decline that was followed by a strong rebound in 2021. During fiscal 2022, the company's margins were again significantly impacted by higher raw material and purchased components prices. Also, VAST China operations were temporarily shut down due to coronavirus-related restrictions in China. As for fiscal 2023, the company reported a net loss of $1.8 million during the second quarter of fiscal 2023, compared to a net income of $3.4 million during the same quarter of fiscal 2022.

This loss was the result of a further margin decline to 6.53% during the past quarter, and an EBITDA margin decline to 0.22%, which reflects the intensification of the impact of inflationary pressures on the company's operations. In this regard, trailing twelve cash from operations of $19.2 million was possible thanks to a $5.3 million decline in inventories, a $0.7 million decline in accounts receivable, and only a $2.8 million decline in accounts payable. Considering trailing twelve months' capital expenditures of $18.30 million and interest expenses of $0.44 million, it can be concluded that the company would not have been able to cover these expenses through its operations without making use of its inventories.

But the worst part of the calculation took place during the second quarter of fiscal 2023 as cash from operations was $4.0 million and inventories declined by $7.1 million and accounts receivable by $3.4 million while accounts payable declined by $3.5 million, which means that the company is currently unprofitable due to margin contraction as a result of inflationary pressures. That is why it will most likely have to continue making use of its inventories, which are luckily high, in order to withstand current headwinds and a potential recession.

The balance sheet is strong thanks to high inventories and cash and equivalents

During the past few years, long-term debt has steadily decreased from over $51 million in fiscal 2018 to $11 million in fiscal 2022 and has increased during the past two quarters to $17 million due to margin contraction. Despite this, cash and equivalents have increased at the same level thanks to the emptying of part of the inventories.

In this regard, the balance sheet remains strong as the company has cash and equivalents of $13.58 million and inventories of $67.85 million, which gives it enough resources to cover interest expenses and CAPEX while operations cannot do so on their own.

Obviously, depleting inventories will weaken the balance sheet until global economic conditions allow the company to enjoy profit margins as healthy as those of 2021 and before the coronavirus pandemic, and this weakening could be significant considering the potential recession that the economy could face as a consequence of interest rate hikes to combat high inflation rates. That's why time is against Strattec Security in the current economic environment, and if the current headwinds intensify or last longer than expected, as well as if the recession finally materializes, the share price could continue declining as the perceived potential damage to the balance sheet increases before the stabilization of high inflation rates and the return to a more optimistic economic landscape.

Risks worth mentioning

Although it is true that the company's balance sheet is very robust, there are a number of risks related to Strattec Security that I would like to mention.

• First of all, inflationary pressures will likely continue to impact the company's operations for more quarters, which would likely keep profit margins at levels as (or more) depressed as they are currently. This would force the company to keep making intensive use of its inventories for longer, which would continue weakening the balance sheet. Although some of this potential damage is reflected in the current share price decline, a longer duration or intensity than expected could increase shareholder pessimism further, which would have a further negative impact on current share prices in the short term to medium term.
• Second, the recent interest rate hikes carried out by central banks in order to stabilize high inflation rates at acceptable levels could lead the world economy into a recession, which could have a significant impact on the demand for automobiles. This would not only decrease net sales but also profit margins as the company would be unable to fully leverage its workforce.
• Third, the company could be forced to add significantly to its debt if it is unable to deplete its inventories fast enough to cover gaps in its operations due to low profit margins. Furthermore, the speed of debt growth could intensify as inventories dwindle since inventories are essentially limited (to $67.85 million).
• Another risk that I would like to mention is that of share dilution. During the past decade, the number of shares outstanding has increased by 19.07% and continues to do so. This means that each share represents a smaller and smaller portion of the company, which has a direct negative impact on per-share metrics, which limits share appreciation.

Conclusion

The situation of Strattec Security is worrying, and that is why the share price has already accumulated a 68.19% drop since February 2021. Although net sales are expected to reach record highs by 2024, current inflationary pressures are having a profound impact on the company's operations, which are currently not self-sustaining. That is why the company needs to make use of inventories to maintain positive cash from operations and thus be able to cover capital expenditures and interest expenses.

Despite this, inventories and cash and equivalents are high enough to allow the company to navigate current and potential headwinds for many more quarters without making intensive debt usage, and debt levels are very low considering that interest expenses are much lower than the cash from operations usually generated by the company when not exposed to current headwinds. For this reason, I consider that it is a good time to acquire shares and thus take advantage of shareholders' pessimism, and then sell them at higher prices once current inflationary pressures are no longer part of the macroeconomic landscape. Despite this, I highly encourage investors to keep a bullet in the chamber in case inflationary pressures intensify or last longer than expected or if a recession finally materializes, that is, to average down from current share prices.

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