2023-11-29 10:12:48 ET
Summary
- Increases in interest rates have caused a worrying increase in interest expenses.
- Profit margins are beginning to recover after many years of contracting, and further expansions are expected in the short and medium term.
- Revenues have not stopped growing in recent years, and the company broke a new record in Q2 2024.
- Both margins and revenues are expected to keep improving in the foreseeable future, and the balance sheet is very strong.
- This represents a good opportunity for long-term investors with enough patience to wait for the company's prospects to improve.
Investment thesis
The share price of Motorcar Parts of America ( MPAA ) has suffered a significant decline in recent years caused by a steady contraction of margins and, more recently, due to a significant increase in interest expenses. Although the steady decline in profit margins was partially offset by continuous increases in revenues in recent years, now a macroeconomic environment marked by high interest rates that have driven interest expenses through the roof has caused even more concerns among investors.
This explains why the share price has already accumulated a 76% drop from all-time highs. It is true that these two factors, contracted margins and much higher interest expenses, are a true cause for concern, and that is why I consider that the share price decline of recent years is actually justified. Still, I consider that the company currently has enough means to significantly improve its situation in the medium and long term.
The management has carried out product price increases in recent quarters to offset inflationary pressures and higher interest expenses, and further increases are expected in the coming quarters. Due to a current macroeconomic landscape full of uncertainties for consumers, this should not lead to problems with volumes as the average age of circulating cars has been increasing in recent years and is expected to continue doing so in the future while products manufactured by the company are replacement parts, which are needed for these vehicles to continue circulating without needing to be replaced with new ones. Therefore, profit margins, which have improved significantly in recent quarters, are expected to continue improving in the foreseeable future as product prices are expected to keep increasing. In addition, we must add unusually high inventories and a recent increase in receivables which, together, should translate into higher cash from operations in the short and medium term, which should help navigate current headwinds and, ideally, reduce debt exposure to more sustainable levels.
Furthermore, we must not forget that both inflationary pressures and higher interest rates represent temporary headwinds as they are directly linked to the current economy, so I consider that the recent drop in the share price represents a good opportunity for those investors with enough patience and risk tolerance to wait for the company's prospects to improve.
A brief overview of the company
Motorcar Parts of America is a leading supplier of automotive aftermarket parts, including light-duty rotating electrical products, wheel hub products, brake-related products, and turbochargers. Thanks to recent acquisitions, in 2017, the company added test solutions and diagnostic equipment to its product portfolio, and in 2019, it added heavy-duty rotating electrical products. The company was founded in 1968 and its market cap currently stands at ~$194 million as it employs over 5,000 workers.
The company's operations are divided into 3 business segments: Hard Parts, Test Solutions and Diagnostic Equipment, and Heavy Duty. Under the Hard Parts segment, the company manufactures light-duty rotating electric products, as well as turbochargers and wheel hub and brake-related products. The Test Solutions and Diagnostic Equipment segment includes solutions for combustion vehicles, test and diagnostic equipment, and software for EVs. And under the Heavy Duty segment, the company manufactures replacement parts for heavy-duty truck, industrial, marine, and agricultural markets.
The company has broken revenue records year after year thanks to recent acquisitions, but a lower profitability profile and current headwinds have caused the share price to plummet.
Currently, shares are trading at $9.66, which represents a 76.47% decline from all-time highs of $41.03 in November 2015. This drop undoubtedly reflects a prevailing pessimism among investors because, although revenues have increased steadily in recent years thanks to acquisitions, an increased debt exposure and higher interest rates have caused a worrying increase in interest expenses that is putting a lot of pressure on the balance sheet, a situation that comes at a time when profit margins are contracted due to current inflationary pressures.
Past acquisitions
The company has followed a growth strategy through acquisitions in recent years that has allowed it to expand its product catalog, which has been accompanied by very acceptable revenue growth rates.
In 2015, the company acquired OE Plus , a remanufacturer of alternators and starters, and after a significant deleveraging, in September 2017, it also acquired D&V Electronics , a Canada-based designer and manufacturer of test equipment for performance, endurance, and production testing of electric motors, inverters, and belt starter generators for the EV/HEV industry.
Later, in December 2018, the company acquired E&M Power , a designer and manufacturer of advanced power emulators (AC and DC) and custom power electronic products, and a month later, it also acquired Dixie Electric , a Canada-based manufacturer and remanufacturer of alternators and starters for automotive aftermarket non-discretionary replacement parts for heavy-duty truck, industrial, marine and agricultural applications.
Revenues keep increasing
The company manufactures and sells products under its own brands and by supplying private label brands and has managed to continually increase its revenues over the years boosted by acquisitions as they more than doubled in the past 10 years.
As for fiscal 2024, revenues decreased by 2.61% year over year during the first quarter but increased by 13.97% year over year during the second quarter, which marked a new quarterly revenue record of $196.6 million boosted by strong demand and product price raises. Revenues are expected to increase by 8.20% in fiscal 2024 and by a further 10.00% in fiscal 2025 as the company keeps raising product prices and the current complex macroeconomic landscape is expected to translate into a higher average vehicle age, which should lead to an increase in demand for aftermarket parts.
But despite strong revenue growth and expectation of further increases, the long-lasting contraction of profit margins and the recent increase in interest expenses have caused a steep decline in the P/S ratio to 0.268, which means the company generates $3.73 in annual revenues for each dollar held in shares by investors.
This ratio is 73.09% lower than the average of the past 10 years and represents an 87.69% decline from 10-year highs of 2.177 reached in 2015, which essentially reflects the intensity of the pessimism that currently reigns among investors as the company's situation is not easy at all because the combination of contracted margins and higher interest expenses are putting enormous pressure on operations.
Margins remain depressed but are showing strong signs of improvement
Coinciding with the latest acquisitions, profit margins have suffered continuous contractions in recent years that have taken them to very low levels. Still, these have improved significantly in recent quarters as the trailing twelve months' gross profit margin currently stands at 17.76%, and the EBITDA margin at 8.98%.
Furthermore, the gross profit margin improved to 20.9% and the EBITDA margin to 8.30% in the second quarter of fiscal 2024, compared to 15.37% and 2.86%, respectively, reported in the same quarter of fiscal 2023. This has been possible thanks to strong volumes and higher product prices, and the management expects further margin expansion in the foreseeable future as volumes are expected to keep increasing, and the last price raises took place in middle of the Q2 2024. During the quarter, EBITDA was $16.3 million, and $31.4 million if we exclude non-cash and cash impacts, which represents a significant improvement compared to an EBITDA of $4.9 million in the same quarter of fiscal 2023 (and $16.7 million when excluding non-cash and cash impacts). This has allowed for a significant improvement in the trailing twelve months' cash from operations to -$9.97 million which, despite still being in negative territory, is expected to enter positive territory in the immediate future. Also, more product price raises are expected in the coming quarters.
In this regard, the company reported positive cash from operations of $15.3 million during the second quarter of fiscal 2024, and inventories increased by $2.2 million and accounts receivable by $16.7 million while accounts payable increased by $19.9 million, which reflects the current margin expansion as the company reported a net loss of $2.0 million for the quarter (vs. a net loss of $6.5 million in the same quarter of fiscal 2022). Additionally, capital expenditures have decreased significantly from $14.2 million in fiscal 2020 and $13.9 million in fiscal 2021 to $1.73 million in the past twelve months.
This decrease in capital expenditures together with the recent margin expansion, in addition to the upcoming product price increases expected in the near future and the eventual conversion of unusually high inventories and accounts receivable into actual cash, should allow the company to navigate current headwinds and even start a deleveraging phase in order to achieve more sustainable debt levels.
Debt is becoming a serious problem
And here lies the most worrying headwind that the company is currently going through. As we should have deduced by now, a share price drop of 76% cannot be explained by revenues and profit margins alone if we take into account steadily growing revenues, the recent margin expansion, and expectations of improvement in both metrics in the short and medium term.
As a consequence of recent acquisitions and capital expenditures, the company's total debt increased from just $30 million in fiscal 2016 to $281.8 million in fiscal 2023, and during fiscal 2024, total debt increased by $19.1 million in Q1 but declined by $14.7 million in Q2 boosted by an increase in accounts payable.
Currently, inventories are unusually high at $366.40 million, which is $81.54 million higher than total debt as the management expects strong demand in the foreseeable future. This significantly reduces the risk that debt represents for the company as part of these inventories should be converted into actual cash eventually.
But despite having such high inventories, increased interest rates, as well as an increased debt exposure, are putting the balance sheet's integrity at risk as trailing twelve months' total interest expense increased to $50.45 million in the second quarter of fiscal 2024, compared to $15.21 million in the second quarter of fiscal 2023, which is why reducing high inventories is becoming a priority for the management, which should start converting them into actual cash in the medium term.
Furthermore, quarterly total interest expenses increased by $6.1 million year over year to $15.38 million during the second quarter of fiscal 2024, which means the company is expected to pay over $60 million in annual interest expenses at current debt levels and interest rates.
With demand likely remaining robust in the coming quarters and years, the management is currently trying to maintain high inventory levels and, before starting to partially empty them, it first plans to convert a large part of accounts receivable, which are also elevated at $163 million, into cash, while at the same time trying to maintain accounts payables high as reducing debt exposure (and thus interest expenses) is currently a top priority.
In this regard, the company currently holds $529.28 million in accounts receivable and inventories vs. a total debt of $284.9 million, and accounts payable are significantly lower at $161.12 million. This, together with recent revenue increases, margin expansion, and expectations of higher margins and revenues in the coming quarters, should allow the company to cover interest expenses until interest rates are reduced or, ideally, generate some excess cash with which reduce debt exposure as already happened in Q2 2024.
Share dilution should be monitored
At the close of fiscal 2014, there were 15.1 million shares outstanding, which represented a 4.30% increase compared to fiscal 2013, and the increase intensified in fiscal 2015 as they increased by a further 19.17% to 18.0 million. Since then, shares outstanding increased by ~9% to 19.6 million today.
This means that each share represents an increasingly smaller portion of the company, which poses a risk for shareholders as share dilution could partially destroy potential returns in the future. Although I believe that the current pace of growth in the total number of shares outstanding does not pose a significant risk given that the increase has slowed significantly in recent years, this is a metric that investors should keep in mind and monitor regularly.
Risks worth mentioning
Before investing in Motorcar Parts of America, it is important for potential investors to understand that the company's risk profile is currently high, as suggested by the share price decline that has taken place in recent years. Next, I would like to highlight those risks that I consider most significant for the short and medium term.
- Only part of the increase in the product prices that the company has carried out in recent quarters (as well as the increases that are expected in the near future) is to compensate for current inflationary pressures, whereas a significant part is intended to compensate for higher interest expenses, the increase of which has been significant in the case of the company due to its particular debt profile. This means that the company could lose competitiveness if consumers stop seeing its products as the best option for repairing their vehicles or if customers look for other suppliers to supply their private labels.
- If the company fails to reduce accounts receivable and inventories at a fast enough pace, it may not be able to cover interest expenses in the coming quarters. The same applies if the expected margin and revenue expansion for H2 2024 and full fiscal 2025 don't finally materialize.
- A further intensification of inflationary pressures could put pressure on profit margins again.
- High interest rates could remain a headwind for longer than expected, so the balance sheet could end up being unable to continue supporting the company's operations in time for interest expenses to be reduced.
- A further increase in interest rates would likely have adverse effects on interest expenses.
- Share dilution could accelerate if the management decides to issue shares to cover interest expenses or reduce debt. Due to the current low share price, this is highly unlikely unless there is no other option.
Conclusion
Without a doubt, the current situation of Motorcar Parts of America is very delicate and I consider that the share price decline in recent years is actually justified. Although revenues have continued to increase year after year and profit margins have expanded in recent quarters, the recent increase in interest expenses is very concerning as covering them will certainly be a headache for the management in the coming quarters. The company slightly reduced total debt in Q2 2024 thanks to an increase in accounts payable, and now the plan is to significantly reduce accounts receivable and, later, inventories, in order to boost cash from operations. This should allow the company to cover interest expenses as the balance sheet is strong and, ideally, continue to reduce debt exposure, which would eventually translate into lower interest expenses.
Although the current situation is not buoyant at all, I consider that the 76% decline in the share price from all-time highs represents a good opportunity for those long-term investors with enough patience to wait for the company's prospects to improve as I strongly believe it has the means to navigate current headwinds. Considering that the company currently holds $529.28 million in accounts receivable and inventories whereas total debt currently stands at $284.9 million, and that both revenues and profit margins are expected to continue expanding in the foreseeable future, I believe that the company should be able to continue reducing its debt exposure or, failing that, cover interest expenses until eventually finding itself in an environment of lower interest rates, which would significantly improve its prospects and, in this way, significantly calm the current pessimism of investors, which would ultimately translate into higher share prices.
For further details see:
Motorcar Parts of America: Good Opportunity For Long-Term Investors Due To Headwinds