STRT - Strattec: Transformational Deal Activist Involvement Unlocking Hidden Value

2023-07-31 00:25:17 ET

Summary

• Strattec Security Corporation is seen as a compelling investment opportunity due to the recent sale of its 1/3rd interest in VAST LLC, activist investor involvement, and securing new contracts with original equipment manufacturers.
• Strattec's strong balance sheet, low debt, and significant owned asset base, along with a compelling valuation, make it well-positioned to navigate a challenging environment.
• Despite recent challenges due to inflationary supply chain constraints and fixed-price contracts, Strattec is expected to rebound with improved margins, higher volumes, and lower costs.

Company Overview: Strattec Security Corporation (STRT) is a leading manufacturer of auto components, specializing in power liftgates, keys and locksets, latches, aftermarket components, and user interface controls. Additionally, Strattec owns 51% of a consolidated joint venture, ADAC-Strattec LLC, focused on producing door handles and exterior trim components. The Company contracts with Original Equipment Manufacturers (OEMs) to supply components for vehicle models over the life of the vehicle platform, which is typically around five years. Strattec's major customers include General Motors, Ford, and Stellantis (formerly Fiat-Chrysler.) Strattec was founded in 1908 and became publicly traded after it was spun off from Briggs & Stratton in 1995. Strattec has 3,373 employees and is headquartered in Milwaukee, WI.

Investment Thesis: Strattec Security Corporation's near-term performance has been adversely affected by inflationary supply chain constraints coupled with fixed-price contracts. However, we believe the company is poised for a rebound and presents a compelling investment opportunity for the following reasons:

• Monetization of Illiquid Asset: The recent sale of the Company's 1/3rd interest in VAST LLC for $18.5 million in cash unlocks substantial value and enables the management team to focus on core business operations. Additionally, Strattec gains full control of its most profitable business segment Strattec Power Access.
• Activist Investor Involvement: Prominent value investor Mario Gabelli owns approximately 18.5% of STRT shares and is an active 13D filer. Gabelli has notified the Company of his intent to nominate two director candidates to STRT's board of directors.
• New Contracts and Improving Volume: Strattec is securing new contracts with original equipment manufacturers (OEMs) while North American auto production volumes continue to rebound as the auto industry recovers from supply chain constraints. These contracts will have updated pricing terms, driving improved margins for the business. Higher auto production volumes should also result in higher volumes for Strattec.
• Lower Costs: STRT's primary input costs are steel, resin, and zinc, all of which have declined substantially from recent highs. Raw materials have historically accounted for 55-60% of STRT's cost of sales, and improved material costs should provide an additional tailwind to gross profitability.
• Strong Balance Sheet: Unlike many of its peers in the auto industry, Strattec boasts a robust balance sheet with low debt and a significant owned asset base. With $99 million of net working capital, $12.1 million in cash, and our estimate of $14.5 million in net after-tax proceeds from the VAST LLC sale, Strattec is well-positioned to navigate a challenging environment.
• Compelling Valuation: Strattec's current market capitalization of $89.4 million is well below the value of its net working capital and owned real estate alone. We expect Strattec to generate $518 million in sales and $26 million in EBITDA in fiscal 2024, representing a forward EV/Sales of 0.2x and EV/EBITDA of 3.2x, adjusted for ADAC's 49% stake in ADAC-Strattec LLC. These ratios appear attractive on both an absolute and a relative basis. There is significant potential for free cash flow generation that could drive considerable returns for investors.

VAST LLC Sale: VAST LLC was a joint venture between Strattec, WITTE Automotive (a German auto supplier) and ADAC originally formed in 2001 to expand the partners' product offerings and distribution channels to the global market, primarily in China. VAST LLC generated $192 million in sales in fiscal 2022 and has historically generated low to mid-single-digit operating margins. Strattec announced the sale of their 1/3rd interest in VAST LLC to WITTE on June 30, 2023, for $18.5 million in cash and WITTE's 20% stake in Strattec Power Access LLC.

This transaction provides significant financial and strategic benefits for Strattec. It realizes substantial value from an illiquid and hard-to-value asset, streamlines management focus, and grants Strattec full control over its most profitable business segment. After accounting for our estimate of $4 million taxes and professional fees, we expect Strattec to receive around $14.5 million in cash from the transaction.

The sale of STRT's interest in VAST and gaining full control of Strattec Power Access LLC cleans up the Company's structure dramatically, making it much easier to consummate a potential strategic transaction or sale of the entire Company.

Activist Investor: GAMCO, an investment firm founded by Mario Gabelli, currently holds 742,192 shares of STRT representing an 18.5% stake in the company. GAMCO has notified the Company in an updated 13D filing of their intention to nominate two candidates to join Strattec's board of directors. We believe Gabelli's involvement in Strattec may lead to improvements in governance and capital allocation, and meaningfully increases the likelihood of further accretive strategic transactions or a sale of the entire company.

Business Segments:

• Strattec Power Access LLC: This division manufactures power liftgates, power tailgates, and power sliding doors, generating approximately $100 million in sales and maintaining profitability through the recent downturn. Strattec holds several patents on power access systems and is the sole supplier of power tailgates for the Ford F-150 and Chevrolet Silverado, the #1 and #2 best-selling vehicles in the U.S., demonstrating a competitive advantage. Strattec competes primarily against Magna International (MGA), a Michigan-based auto supplier, in power access systems. In 2018, Strattec received a prestigious PACE Award for their Honda Odyssey power liftgate. Power access systems have several potential applications across a wide range of vehicles, including SUVs, trucks, minivans, and sedans, as consumers increasingly value the convenience of automatic doors and trunks. Strattec introduced the power tailgate in 2018 on the Chevrolet Silverado and has supply contracts for the life of each vehicle platform a Strattec Power Access component is used on (typically five years). While power tailgates and liftgates are currently higher-end vehicle features, we expect they will become standard on most vehicle models as they grow in popularity with customers and OEMs seek to reduce manufacturing complexity. A power tailgate typically costs an additional $500-3,000 for a customer to add to a base model vehicle. Following the VAST LLC transaction, Strattec now has complete control over this subsidiary, further strengthening its position.

• Keys & Locksets: Strattec's keys and locksets segment generates around $110 million in revenue. Prior to the supply chain-driven downturn in auto production, the segment has grown at low single digits. Strattec supplies keys, fobs, and locksets to several vehicle platforms, including the Ford F-150, Chevrolet Silverado, RAM 1500, and GMC Yukon. STRT competes against Huf North America and other auto suppliers in keys and locksets. While there is a shift in the industry away from traditional keys, Strattec has led innovation in the vehicle access space and manufactures digital fobs in addition to traditional keys.

• Latches: This segment focuses on manufacturing latches for car doors and trunks, contributing around $50 million in revenue. Strattec's latches business has historically grown at a mid-teens rate. STRT competes against several auto suppliers in vehicle latches, including The Eastern Company (EML), Magna International, and Kiekert AG.

• Aftermarket & OE (Original Equipment) Service: Strattec's aftermarket components division provides components for the secondary market, which typically commands higher margins than OEM components. Due to supply chain constraints since the pandemic, Strattec has been unable to fully service aftermarket components, resulting in depressed profitability. This segment generates $40-50 million in sales.
• User Interface Controls: Strattec manufactures driver control panels, generating $30-40 million in sales. User Interface Controls includes controls for various electronic vehicle components like air conditioning, media, and ignition lock housings. Strattec's competitors in User Interface Controls are Huf North America, GM's in-house ignition lock housings, and other auto suppliers.

• ADAC-Strattec LLC: As a consolidated 51% owned joint venture, ADAC-Strattec LLC manufactures door handles and exterior trim components, generating approximately $120 million in sales. Strattec's 49% minority partner in the business is ADAC, a Grand Rapids, Michigan-based auto supplier. Strattec and ADAC formed this joint venture in 2006 to manufacture door handle components in Mexico. While the segment has recently operated near breakeven levels, it has historically generated mid-single-digit net income margins and grown sales at a low-double-digit annual rate. Our projections deduct ADAC's minority interest from free cash flow estimates. Following the VAST LLC transaction, it is possible that Strattec will look to divest or fully consolidate ADAC-Strattec LLC.

Management Team: Strattec's CEO, Frank Krejci (pronounced CRAY' chee) is a long-term industry veteran and has been CEO of Strattec since 2012. Dennis Bowe, a former Harley-Davidson, Mazda, and Ford executive, was brought on as CFO in September 2022. We travelled to Milwaukee earlier this year and met with Frank and Dennis in-person. We found them to be grounded, conservative, and highly focused on returning the business to profitability. We toured the Milwaukee plant during our visit and thought it was well-maintained, clean, and had adequate capacity to support the business's continued growth.

Balance Sheet Strength: In contrast to its industry peers, Strattec has a strong balance sheet. With $99 million of net working capital and $12.1 million in cash, combined with the estimated $14.5 million from the VAST LLC sale, Strattec is well-capitalized to weather uncertainties or a potential economic downturn.

Strattec currently has a $40mn corporate credit facility with $8mn drawn, and ADAC-Strattec (STRT's 51/49 joint venture with ADAC) has a $25mn credit facility with $13mn drawn on it, which is fully consolidated on Strattec's balance sheet. We calculate STRT's true debt to be $14.6mn ($8mn on corporate credit line plus 51% of $13mn on ADAC-Strattec's credit line) but note that STRT fully guarantees the ADAC-Strattec credit facility.

Owned Real Estate: The company owns unencumbered real estate totaling 762,124 square feet. This includes its factory and headquarters in Milwaukee (345,123 SF), a Sales and Engineering office in Auburn Hills, Michigan (62,736 SF), and three manufacturing facilities in Juarez, Mexico (354,265 total SF). ADAC-Strattec LLC, the consolidated joint venture, also owns property in Leon, Mexico (129,887 SF). We believe that Strattec's manufacturing capacity is currently under-utilized, and the Company may have excess real estate to monetize should auto production volumes fail to rebound. Strattec has invested over $43 million at historical cost into land and buildings.

Our estimated market value of this real estate significantly exceeds $50 million, providing a substantial margin of safety and limiting the potential for permanent capital loss. Strattec's book value per share stands at $47.80, with a Net Current Asset Value (NCAV) per share of $18.30.

Income Statement and Financial Projections: North American auto production volumes have fallen dramatically from pre-pandemic levels approaching 17 million units annually to just 13 million units in 2021. Stellantis (formerly Fiat-Chrysler) has been particularly challenged by supply chain and labor constraints, leading to a 30% decline in Strattec's revenue from Stellantis since 2019. Auto production has already begun rebounding, with Ford, GM, and Stellantis all increasing vehicle production year-over-year. Industry forecasts call for North American vehicle production to approach 16 million units in 2024, representing 8.1% unit growth over 2022.

Supply chain constraints, declining auto production volumes, and fixed-price contracts have impacted Strattec's recent operating results. Strattec's primary raw materials are zinc, steel, and resins (for which oil is the primary input), which all rose substantially in price during 2022 but have since fallen from peak pricing. Labor costs have risen as well, driven by a tight labor market in the U.S. and increasing minimum wages in Mexico.

As the automotive industry recovers and contracts roll off for renegotiation, we anticipate a gradual normalization of unit-level profitability. Strattec and other auto suppliers are pursuing contracts that are variable-priced or have cost pass-through provisions to protect margins from future inflationary pressures. Higher volumes, lower raw material costs, and new contract pricing all provide tailwinds to gross profitability, which may prove to be substantially higher than our forecasts forecast due to timing of inventory purchases and higher volumes driving additional operating leverage.

We forecast consolidated revenues of $487 million for 2023 and $518 million for 2024, incorporating vehicle production rising by 7% in fiscal 2024 and 2-3% in fiscal 2025, coupled with low-single-digit price increases. We expect Strattec to generate operating margins over 4% and annual free cash flow of $14 million by fiscal 2025, implying an FCF yield over 18%. Strattec is a full cash taxpayer and has maintenance capex requirements of $8-9mn per year. We expect the Company will utilize free cash flow to repay debt and return capital to shareholders in the form of dividends or repurchases. Strattec has historically paid a dividend but eliminated it in response to the COVID-19 pandemic in 2020.

Valuation: Using a discounted cash flow analysis with a 12.5% discount rate, we arrived at a target enterprise value of $139 million. We subtract $2.5 million of net debt and add our estimated $14.5 million in proceeds from the VAST LLC sale to arrive at an equity value of $151 million or $38.46 per share.

STRT currently trades around 0.4x net book value, well below both peer values and its historical range (0.86x average P/B over the past ten years). We note that STRT has often traded at a premium to its book value in the past and appears exceptionally cheap on a price-to-book basis.

Unlike almost every peer in the auto supply industry Strattec will have a net cash balance sheet pro forma for the VAST LLC proceeds. Despite this fact, STRT trades at a considerably lower valuation than many peers in the auto supply industry, with an LTM EV/Sales ratio of 0.2x and LTM EV/EBITDA of 5.4x. This compares favorably with peer averages of 0.6x and 12.7x, respectively.

Comparable Companies:

Key Risks:

• Microcap Company: Strattec is a microcap company, with limited analyst coverage, no conference calls, and a market cap of only $89mn. Trading liquidity is extremely limited with an average daily volume of 10,622 shares, making it difficult to establish or exit a position in STRT.
• Industry Competition: Strattec operates in a highly competitive industry where business is primarily awarded based on price, creating a challenging environment.
• Economic Downturn: The auto supply industry is cyclical and vulnerable to economic downturns, which could negatively impact Strattec's business.
• Fixed-Price Contracts: Strattec's business model relies on long-term, fixed-price contracts that do not account for higher input costs. This lack of flexibility may impact profitability during periods of cost inflation.
• Supply Chain Disruptions: Ongoing supply chain disruptions and component shortages may continue to hamper Strattec's near-term revenues and profitability.
• Unionized Workforce: While most of Strattec's employees are non-union, the Company is subject to collective bargaining agreements at their Milwaukee, WI, and Leon, MX facilities.
• Changing Industry Trends: As the industry trends away from traditional keys towards fobs and cell phones for vehicle access, Strattec's significant business in keys and locksets may face challenges in the future.
• VAST LLC Sale Estimates: Our estimate of cash proceeds from the sale of VAST LLC may prove inaccurate due to taxes and fees, impacting the overall financial benefits of the transaction.

Conclusion:

Based on our analysis and discounted cash flow valuation, we believe Strattec Security Corporation is undervalued and assign a price target of $38.46 per share. This represents a potential upside of approximately +69% from the current share price. With its strong balance sheet, unencumbered properties, and substantial working capital, Strattec has a large margin of safety should our forecasts prove overly optimistic.

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