2023-06-27 02:21:44 ET
Summary
- Magna International's shares are down 24.5% from 52-week highs, making them an attractive contrarian investment.
- The company is expanding into active safety and electrification products, with the acquisition of Veoneer Active Safety.
- Magna's valuation is in line with its peers, and its strong financial health and strategic moves position it well for the future.
Shares of Magna International ( MGA ) have me excited once again with the share price down 24.5% from 52-week highs. While the company is highly cyclical along with the economy and auto industry, Magna is an industry leading company with a great balance sheet that has survived (and thrived!) through many cycles of its 65-year history. The company continues to expand into active safety and electrification products as seen by the acquisition of Veoneer Active Safety to help drive the company's future.
Magna is currently trading at 10.5x forward P/E and long-term value investors should get the opportunity on their radar for a contrarian investment. This article will take a look at the latest results as well as the historic growth and profitability of Magna as we also estimate a free cash flow yield that may be achievable over the next business cycle for long-term investors. Compared to their peer group, Magna has seen the largest pullback in its valuation over the past 3 years as can be seen in the chart below and its relative valuation at the moment reflects favorably as will be touched on later as well.
Latest Q1 2023 Results
In the latest Q1 2023 results released back in May, Magna reported strong organic sales that outperformed industry production by 8%. Management commented that in these times of higher inflation and interest rates Magna is working with customers to recover inflationary costs and drive operational improvements.
Total consolidated sales of $10.7 billion in Q1 2023 were up 11% from the prior year. Adjusted EPS of $1.11 was down 13% with adjusted EBITDA of $437 million down 14%. The decrease was due to EBITDA margins falling 1.2% from 5.3% in Q1 2022 to 4.1% of sales in Q1 2023 (a 22.6% decrease). The net 1.2% decrease can be broken down into operational inefficiencies (-0.7%) mainly due to the BES facility in Europe, input costs rising (-0.6%) due to higher labor and energy costs, and non-recurring items (-0.8%) including warranty accruals; these reductions were partially offset by volume increases which drove efficiencies in operations (+0.8%).
Since I last wrote about Magna , the company has seen sales remain pretty stagnant only increasing back near their 2018 pre-COVID level of $40.8 billion in the TTM period to be around $38.9 billion. Profits have also been squeezed over this time with operating margins falling from 6.9% in 2018 to 3.83% since 2018. Looking at a common sized income statement in terms of % of revenue, the squeeze can mainly be attributable to cost of goods sold rising by around 2.1% over the period in addition to 0.5% higher SG&A costs in terms of sales as well as depreciated expense creeping up 0.5%.
Since Q1 2022, Magna has reduced their number of outstanding shares 3.29% from 298.1 to 288.3 million. Along with the dividend yield of 3.31% ($132 million paid in Q1), together these figures imply total shareholder yields of 6.60%. These share repurchases have helped drive great per share revenue and adjusted EPS growth at Magna as they continue to invest in their own shares at opportune valuations as well as tackle bolt-on acquisitions to drive further growth.
The company continues to execute well on strategic plans with announcements such as a new eDrive systems for Europe-based global premium OEM (SOP 2026), battery enclosures for GM EV Trucks (SOP 2023), and my flashy favorite from the Q1 2023 presentation, SmartAccess power door system for market debut on Ferrari Purosangue (SOP 2023). These internal product development and contract wins are in addition to the notable acquisition of Veoneer Active Safety which continues to expand Magna's active safety product and software line-up in a meaningful way. The company is doing a great job of adapting to the new high tech and electrified world of cars offering a great suite of product solutions to OEM clients.
During the quarter, Magna also issued $1.6 billion in debt related to the acquisition of Veoneer Active Safety. This acquisition will diversify and compliment Magna existing active safety product portfolio and help establish Magna as a top active safety supplier in what is expected to be a $50 billion market by 2030. Management expects the company's financial leverage to come back down to target by the end of 2024 as the company digests the acquisition and gets the balance sheet ready for the next bite-sized meal.
A Quick Intro To The Company
With over a 65 year history Magna has grown to be the world's 4th largest auto supplier with operations throughout four continents and 29 countries that continues to grow and expand its reach. Through its 343 manufacturing operations, the company is involved in the production of automotive body & chassis, power-train, seating, roof systems, electronics, exteriors, closures, vision systems, and full-out vehicle engineering & contract manufacturing.
Magna’s level of involvement in automotive manufacturing leads some to make comparisons to the position of Hon Hai/Foxconn Technology (FXCOF) in the consumer electronics manufacturing business and their role in the outsourced production of smartphones. Magna works hard to innovate and stay competitive with efficient manufacturing processes and new product offerings through 100 product development, engineering, and sales centers worldwide.
A Profitable & Growing Company, But Cyclical
Being a large global player in the automobile industry has allowed Magna to be nicely profitable with return on equity (ROE) and return on invested capital ((ROIC)) averaging 12.4% and 11.3% respectively since 2007. This average level of ROE is slightly below my rule of thumb of 15% ROE, but as we will discuss later, the return investors are getting is all about what price-to-book value they are buying the equity of the business at on the stock market.
Potential investors should also note that the auto industry is highly cyclical as highlighted by ROE from Magna being 8.4%, 0.9% and -6.7% for FY 2007, 2008 and 2009, respectively. The average ROIC since 2007 is above my rule of thumb of 9%, which does allow me to be confident that, in my opinion, the company is able to maintain and even possibly increase its intrinsic value over the course of a business cycle.
Returning Cash To Shareholders
Magna does a tremendous job of returning cash flow to shareholders through the form of dividends and share repurchases. With capital expenditures and acquisitions only taking up on average 60% and 7%, respectively, of cash flow from operations since 2007, this leaves approximately 33% to be returned to investors through the form of dividends and share repurchases. With average cash flow from operations of $3.0 billion over the past five years, this 33% would imply free cash flow available to shareholders of $1,041 million for a respectable 7.0% free cash flow yield at the current $14.9 billion market capitalization.
Financial Leverage & Share Repurchases
Since 2007, financial leverage has grown slightly from 1.78x to now 2.62x in the latest quarter. However, the interest coverage ratio (taking into account $395 million of lease expenses) is currently healthy at 5.42x in the latest quarter. This has declined from recent pre-COVID highs of 8.97x in 2018. That being said, I would still expect Magna to lose a good amount of money in the depths of the next sales cycle due to their businesses' profitability being highly cyclical alongside the auto sales cycles and their operations high fixed costs.
Also notable in the above graph is that since 2007, the company has bought back a whopping 36.8% of their total share count since 2007 for an average repurchase rate of 2.8% of their outstanding shares a year. The total shares over this period decreased from 456 million in 2007 to currently around 288 million today. I always like to see share repurchases by management as it shows capital budget discipline and management's faith in the long-term prospects of the business.
Getting a Sense of Potential Returns
To get an idea of potential returns, I also always like to examine the relationship of ROE and price to book value. While Magna's 10.5x forward P/E seems highly attractive, we have to remember that this is a cyclical company and earnings might be at the peak of the cycle. Similar to the CAPE ratio, which calculates the P/E from the average 10-year earnings adjusted for inflation, we can take the average ROE over history and adjust it for the current book value.
With the company earning an average ROE of 12.4% since 2007 and the shares currently trading at a price to book value of 1.31 when the price is $52.03, this would yield an adjusted ROE of 9.5% for an investor's equity at that $52.03 purchase price, if history repeats itself. As can be seen in the graph below, this earnings yield is coincidentally the same as the forward earnings yield based on the 10.5x P/E. Both these earnings yields are right around the 9% that I like to see and adding a 3% growth rate to represent the company growing alongside GDP could increase this potential total return up to 12.5%.
How does the Valuation Compare to Peers?
Looking across a peer group of Lear Corporation ( LEA ) and BorgWarner ( BWA ) to get a sense of relative valuation, Magna's seems to be priced in line with the group. The forward P/E of 10.5x is in the middle of the pack and well below Lear's 12.3x P/E. Magna's price-to-book value of 1.3x is the lowest of the peer group with Lear once again having the highest valuation in this metric at 1.7x P/B. In terms of enterprise value to EBITDA, Magna's valuation is once again near the lowest of the pack with a similar 6.4x EV/EBITDA valuation to BorgWarner.
Risks in a Competitive Industry
The auto industry is highly competitive with dozens of well capitalized market participants. The current technological advances we are seeing in safety and automation are driving an increase in capital expenditures and R&D spending across the industry. This increase in competition is partly what is hampering operating margins at Magna in recent year and what has led to recent acquisitions in an attempt to grow in these new areas.
Magna currently expects to spend around $900 million in engineering for 2023 - 2025 related to these "megatrend" product areas. As highlighted in the below slide from the Q1 presentation, this currently represents around 100% of sales in these areas. The plan from management is that sales will reach $6.5 - $7.0 billion in 2027 for these segments with the engineering spend then dropping to 20% of sales.
While Magna has a diversified product portfolio and customer base across more and less technologically designed areas (i.e. seats), their ability to execute on these plans and navigate the technological changes in the industry is very meaningful. They are spending significant engineering dollars on these new product developments and if they are unsuccessful, there could be asset impairments in the years to come.
Takeaway
Magna's valuation is starting to look attractive having pulled back 24.5% from 52-week highs. The company currently trades at 10.5x forward P/E and the longer term cyclically adjusted investors' ROE also indicates potential 9.5% returns before considering growth. While the company is cyclical along the auto industry and global economy, Magna's financial health looks strong and the company is making the right moves into electrification and active safety features to help cement its place as the 4th largest auto supplier.
For further details see:
Buy Industry Leader Magna On The Pullback At 10.5x P/E