Auto sales are falling, production schedules are being slashed and the Big Three automakers are headed for losses. So why would I want to get near the auto parts suppliers, whose fates are closely tied with their customers?
John Casesa and Stephen Haggerty, the senior auto and parts analysts at Merrill Lynch, recently published a report that makes a compelling case for looking at the supplier stocks. Their analysis of previous auto cycles suggests that three events must occur before the auto stocks --
-- are likely to bottom -- a rise in the unemployment rate, a steep drop in consumer confidence and negative real disposable personal income, or DPI, growth. So far, we've see two of those three events. But while it was months or even quarters later that auto sales and the automakers' stocks hit their lows, the auto parts suppliers were quicker to discount the negative events and started outperforming much sooner.
Indeed, in the chart below you'll see that the suppliers bottomed right at the point that real DPI turned negative, and well before auto sales reached a trough. So with the first two events already behind us and the possibility that real DPI will turn negative in just a quarter or two, doesn't it make sense to go shopping for parts?
Supplier Stocks Bottom Before Automakers' Shares
Source: Merrill Lynch
The parts suppliers used in the analysis included
Not only that, the valuations on the suppliers, relative to where they have traded historically, are even more appealing than those of the Big Three. One could argue that the suppliers have more risk in this cycle because they've become more asset-intensive by assuming so much of the Big Three's component manufacturing and their balance sheets are carrying more debt. But that's why investors should be selective, sticking with the companies that have market-leading products, strong cash flow and solid balance sheets.
The company that best fits this description is
. According to Haggerty's analysis, Lear is selling at an enterprise value (market value of equity plus net debt) to sales ratio of just 34%, assuming a 15% sales decline. That's one of the lowest valuations in the entire supplier group, most of which are selling at ratios of between 45% and 80%. In the 1990 recession (before Lear was public), none of those that were public at the time traded below 43% of sales.
Lear is one of the leading suppliers of interior systems for light vehicles, arguably one of the best places to be in the auto supplier industry. In the past five years, the global interior market has grown 33% from $45 billion to $60 billion as predominantly North American manufacturers outsourced their component assembly to outside suppliers. This trend will likely take hold in Europe, which Haggerty says is "five to eight years behind the U.S."
In addition, the automakers are increasingly willing to hand over the more value-added jobs like engineering, designing and manufacturing complete interior systems to more efficient outside suppliers. This provides the suppliers with another avenue of growth, as they can share in the cost savings they achieve for the Big Three.
Lear will continue to be a major beneficiary of that trend. The company's current backlog of new business is $3.5 billion on a sales base of about $14 billion -- that's roughly 25% of current revenue. This new business is helping to offset the declines occurring in Big Three production schedules.
Lear reported earnings basically in line with analysts' estimates on Tuesday, and announced a fourth-quarter $150 million restructuring charge for staff reductions and plant closures. This can only help the earning power of this company when the cycle turns. For 2002, analysts are expecting earnings of $2.58 compared with $2.46 this year, according to First Call/Thompson Financial, but I wouldn't be surprised to see next year's estimates come down closer to $2. Lear earned $4.20 in 2000.
One nice thing about Lear is that management seems intensely focused on generating free cash flow and cleaning up its balance sheet. The company generated $64 million in free cash flow in the third quarter, reducing debt by $95 million, which is now about 64% of capital. The company anticipates generating about $200 million in free cash in 2002, which will also be dedicated to debt reduction, with the goal of achieving a 45% to 50% debt-to-capital ratio and investment-grade debt rating within 9 to 15 months.
Lear's debt-to-EBITDA ratio is 2.7, below average for the auto supplier group. If you're tempted by the downturn in the auto cycle and the investment opportunities it affords, this is a high-quality name, which at $33 is selling at a very cheap four times cash flow.
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Odette Galli writes daily for TheStreet.com. In keeping with TSC's editorial policy, she doesn't own or short individual stocks, although she owns stock in TheStreet.com. She also doesn't invest in hedge funds or other private investment partnerships. She invites you to send your feedback to