Delphi Can't Go Far Without GM

Auto-parts suppliers may still look like better investments than their Big Three customers these days, but that doesn't necessarily mean it's time to buy all of them.

Delphi ( DPH) is one example. Although the company has demonstrated tremendous progress on restructuring relatively high-cost operations and diversifying its sales base, its fate is still heavily tied to General Motors ( GM), which accounts for roughly 60% of Delphi's total sales. And as GM wrestles with market-share losses and historically high levels of inventory, the outlook for GM's production, and consequently Delphi's GM sales, is not encouraging.

With the stock down close to 6% so far this year, slightly worse than the 5% decline in the Dow Jones Auto Parts supplier index, many of the company's potential near-term challenges are already reflected in the stock price. On a valuation basis, however, the stock is not very tempting.

Although shares trade at an enterprise value-to-EBITDA ratio of 4.5, less than its peer group average of just over 5, the stock should trade at a discount due to its reliance on GM, its leveraged balance sheet (long-term debt to capital ratio of about 50%) and pension obligations (a roughly $4 billion unfunded liability at the end of last year). With its P/E ratio of 11.7 times this year's consensus earnings estimate of 82 cents per share, Delphi is right in line with the auto-parts supplier average of 11.5.

Down the Road

That's not to say Delphi isn't worth watching. Indeed, the second quarter pointed to encouraging progress the company has achieved on a number of fronts that could make the stock interesting a year or two from now. For instance, growth in Delphi's non-GM business continues to be quite strong, surpassing most analysts' expectations. Revenue from non-GM customers jumped 20%, excluding the impact of foreign exchange, and it accounted for a record high level of 45% of total sales.

Delphi is also an interesting way to play growth in China, where the company has 10 manufacturing facilities. Delphi generates roughly $1 billion in sales in China, which are growing in the 25% to 30% range. However, profit margins are in the double digits (compared with 3% for the company as a whole), suggesting that even though China sales are just 3% of the company's total, China profits could be as much as 25%.

And while stubbornly high post-retirement health care and pension costs continue to cloud Delphi's underlying profit performance, the company is clearly making headway on lowering its cost structure. Delphi had been aiming to reduce its hourly U.S. head count significantly this year, and Delphi CFO Alan Dawes said on the company's conference call that progress in this area was ahead of schedule.

Indeed, 4,925 employees out of a goal of 5,000 by the end of this year have already been cut from the payroll. Dawes also said the company may lose an additional 500 to 1,000 this year through attrition -- a number that some analysts like Deutsche Bank's Rod Lache estimates could add 15 cents to Delphi's earnings per share in 2005.

For the rest of this year, however, Delphi has its work cut out for it. General Motors will not be helping matters: It has one of the worst production outlooks among all of the automakers. In North America, for example, while total production is expected to be down less than 1% in the third quarter and up 0.7% in the fourth, GM's production is slated to be down 3.5% and 4.5%, respectively, in those two periods.

Not only that, in its efforts to wean itself off of lower-margin business with its former parent -- the right move in the long run -- Delphi's sales to GM could be off even more. For example, in the second quarter, while GM's production was down 1%, Delphi's GM revenue was off more like 4%. This trend could accelerate in the second half of this year.

And while Delphi has been generating strong free cash flow, much of that is still earmarked for its pension obligations. The company produced $469 million in free cash flow in the second quarter, putting it on track to meet its goal of $1.4 billion for this year. Between this year's free cash flow target and a similar goal for next, Delphi plans to contribute $2.2 billion to its pension over the next two years. With the additional funding and a higher discount rate (which reduces the present value of the pension obligation), it's conceivable that Delphi could fund its pension by the end of 2006.

While there may be good reason why Delphi, with its attractive non-GM growth, restructuring benefits and strong cash flow, is an interesting long-term story, near-term challenges could put a lid on the stock price for now.

Odette Galli is a freelance columnist for RealMoney.com. She has been a writer at SmartMoney Magazine and a senior manager at Ark Asset Management, where she co-managed $3 billion in institutional assets. In addition, Galli was a senior vice president at J & W Seligman. At the time of publication, she had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. She welcomes your feedback and invites you to send your comments to odette.galli@thestreet.com.

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