Few companies have less profitability and yet more promise for investors than the world's auto-parts makers.
Just think about it for a moment. U.S. automakers will produce 16 million new cars this year; the rest of the world will make three times that number. And every one of those cars has more than 10,000 parts. Vehicle manufacturing is America's largest manufacturing industry in terms of both dollar value and employees. But more importantly, one of every six American businesses feeds off the building or servicing of cars and trucks -- a figure that amounts to about a fourth of all retail sales.
Most of the components that go into all these vehicles are low-value nuts, bolts, sheet metal and glass, but as we move deeper into the middle of this decade, a lot of the components will be quite exciting. We're talking new safety, fuel-efficiency and entertainment enhancements as technologically advanced as anything at a computer trade show.
It's well known, of course, that cars contain an increasing number of digital circuits that control everything from climate control to combustion. What is less understood is the magnitude and speed of change occurring today as two vectors combine: Regulators have heaped new requirements on automakers to add boring stuff to meet public policy aims, and competitive pressures have pushed them to add cool stuff to meet marketing aims.
To satisfy both, the automakers are developing a thoroughly fresh approach to leveraging the precision of electricity in places where mechanical parts -- such as brakes, fans, hydraulics and pumps -- once sufficed.
The old-line U.S. parts manufacturers that were spun out of the big automakers in the last five years, such as
, are having a tough time in this environment. They find it nearly impossible to tear down, rebuild and retrain plants that are staffed with middle-aged union employees.
These companies are badly hampered by morbidly obese labor agreements that restrain efficient work-rule changes as well as management inertia, and seem bound and determined to keep stamping out commodity parts at ever-shrinking profit margins to their former parents while being beat on price and quality.
But some of the less old-school companies, such as
, and Europeans, such as the Swedish-based
, have a fighting chance to survive the next chapter in automaking and to reward investors in the process.
Move Toward Electricity
The most interesting opportunity, however, might be in companies that supply parts to the parts makers. Outfits focused on the development and production of analog semiconductors for the new electrical regime in cars -- particularly for the gas-electric hybrid vehicles -- may have the most to gain.
The move toward electricity is more pervasive than you might imagine. Even though hybrid electric cars cost at least $4,000 more than their peers, dealers have waiting lists of six to 12 months. Registrations of hybrid vehicles in 2004 were up more than 80% over 2003. They're still less than 2% of all cars registered, but you can see where the demand is shifting. According to some industry forecasters, most new cars and trucks 10 years from now will have a hybrid gas-electric drive, as they achieve the goals of coolness, fuel efficiency and an emissions cut with one fell swoop.
Jim Williams, head of the trend forecasting firm Williams Inference Center, points out that the one electrical component important to all of these efforts is called the thyristor. Although the term might be unfamiliar to you, it's really just a semiconductor that is focused on the control of electricity and is sometimes called a "power chip." A broadening of their use is energizing the effort to take all the movement, and friction, out of such common auto behaviors as braking and steering.
Williams says that the next to go is the entire mechanical drive shaft. He notes that while electrical systems governed by thyristors account for 15% of the base cost of conventional cars, they make up nearly 50% of the cost of hybrids.
The leading American maker of thyristors is
, a small mid-cap that is among the few chip manufacturers whose shares are within shouting distance of highs made in 2000.
While International Rectifier is still 25% below its 2000 high, that is still much better than a company such as
, which is 65% off its all-time high. It has a strong balance sheet, has posted 10 consecutive quarters of profits and has a bountiful and rising free cash flow. Return on capital and equity are both above industry averages.
When you think about auto-parts makers now, it might be best to put a company like this -- as well as peers
Fairchild Semiconductor International
( SYXI) -- at the top of your list rather than the Michigan-based old-line companies. Jim Williams notes that they have achieved their success by wrapping the internal combustion engine with a layer of semiconductors.
Williams also observes that the same is happening with much larger vehicles as well: New locomotives are still powered by diesel engines, but almost everything else is electric. He says the same approaches are coming off the drawing boards of U.S. Navy designers, as everything from guns to propellers are shifting from mechanical to electrical control, and all are regulated and given life by those same kinds of chips.
TRW in the Lead
As for the actual parts makers benefiting from the swerve toward safety, the leader appears to be TRW. The company -- which specializes in safety features such as air bags, antilock breaks, tire-pressure sensors, stability apparatus and steering systems -- has been through more changes than a drag queen at a costume party.
Two years ago,
bought the conglomerate named TRW strictly for its military aerospace and information technology business. Northrop paid for the deal by spinning off the company's legacy automotive business to private-equity firm Blackstone Group. And Blackstone, in turn, sold a bunch of it back to the public at $27 per share in a February 2004 initial public offering that collapsed almost immediately. The shares sank to the mid-$16s by last fall.
In recent months, however, investors fleeing other auto-parts makers have found a safe haven in TRW as business has improved, consistent earnings are within sight, debt is being paid down and shares are almost back to their IPO value, with a recent quote of $23.50.
One of the more interesting innovations TRW announced for the 2007 model year is an "occupant-sensing vision system" for its airbags. According to the company, the TRW system, using a dime-sized camera mounted in the overhead console, tracks the position of the seat occupant's head in the vehicle and suppresses airbag deployment if the person is in a "keep out" zone. Currently, the task is accomplished with a weight-based system that is less accurate.
These things are all in high demand. In the 2006 model year, Honda will equip all cars with front side airbags, side curtain airbags, antilock brakes, electronic stability controls and rollover sensors. Analysts report that automakers are committed to having 50% of new cars sold in the U.S. equipped with side curtain air bags by 2008, and 100% by 2010 -- up from 10% currently.
Car parts are just not what they used to be, in other words, so it makes sense for investors to look at Visteon and
( DPH) as potential value plays, but to look to companies such as International Rectifier and TRW for growth. Early next month, I'll look at the impressive new investment opportunities presented by the addition of the new entertainment and communications systems being added to cars.
At the time of publication, Markman did not own positions in any stocks mentioned in this column, although positions may change at any time.
Jon Markman, writer of TheStreet.com Value Investor, is the senior investment strategist and portfolio manager at Greenbook Investment Management, a division of Greenbook Financial Services. Separately, he is publisher of StockTactics Advisor, an independent weekly investment research service. While Markman cannot provide personalized investment advice or recommendations, he appreciates your feedback;
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