The company has substantial exposure to the North American automotive industry; thus, its share price was severely impacted by the financial crisis, which was exacerbated by troubles experienced within the North American industry around that same time and the loss of a major contract with General Motors in association with GM’s bankruptcy proceedings. The company has been able overcome the challenges faced during this period and has had a strong recovery in its financial results over the past few years. However, we believe the market has not responded to the company’s corresponding recovery in terms of financial strong performance since this time and, even in light of a number of considerable risk factors (discussed further below), the market valuation is well below AM’s intrinsic value.
This trend can be seen in the following table, which highlights the stock’s mediocre recovery that has deviated from its financial performance (and future growth prospects) over the same time period.
AM’s success is dependent on its ability to deliver modules that meet quality requirements of customers quickly, and it must do so at a price that reduces the cost structure of its clients’ relative to if they were to maintain this function internally. Over its history, AM has developed a highly efficient operating model as it currently receives orders at an average rate of one order every 40 seconds (sometimes as frequently as every 5 seconds). The company is able to deliver the completed module within two hours of receiving the order.
The company has established a number of competitive advantages that positions it to continue to expand into providing its services to a growing number of industries, highlighted by its recent entrance into the clean energy sector, assembling modules used for wind turbines through a contract recently signed with Vestas (discussed further below).
Our thesis is based on the fact that on a probability-weighted basis, the company will be able to maintain its position within the automotive industry while leveraging its core competencies into a growing number of supplemental market segments, initially expanding within the rapidly growing clean-energy space, but also into a wide variety of other potential industries that rely on highly-efficient manufacturing processes. The company has established a strong competitive advantage through its proprietary process and technology that increases efficiency for its clients in a way that will be sustainable for the foreseeable future. Moreover, located in southern Ontario, AM has appropriately focused its geographic presence – a factor that critical to protecting its competitive positioning.
Finally, management has demonstrated a proven commitment to minimizing its cost structure, utilizing capital in a highly effective manner and appropriately distributing cash to its shareholders, primarily through recurring special dividends (on top of its stated recurring quarterly dividend); moreover, given the company’s current market valuation, management has recently received approval from its board to buy back up to 10% of the company's outstanding shares.
Automodular is responsible for sub-assembly of modules built into various mechanical devices. Historically, the company has focused exclusively on assembling modules (e.g. rear suspension, dashboards, etc.) for automobiles. However, it has recently diversified its revenue stream through contracting with Vestas (a subsidiary of the publicly traded Danish company Vestas Wind Systems A/S) to provided outsourced assembly of modules used in the manufacturing process of wind turbines.
For most of its history, AM’s primary client was General Motors Corp. (GM). Around the time of the financial crisis and GM’s bankruptcy filing, GM pressured the company to reduce its pricing by 50% — an offer that was rejected by AM and had a material unfavorable impact on its revenues, earnings and share price, an effect that was exacerbated by the economic downturn, particularly seen in the North American automotive industry. However, AM had already established an agreement with Ford Motor (F) around the same time, which allowed the company to remain solvent. In 2010, AM was able to extend its agreement with Ford through June 2014 and is currently in discussions to renegotiate the agreement for a further extension.
Key Risk Factors
Automodular’s biggest risk by far is its customer concentration. Currently, the company only has two customers (Ford and Vestas) and lost its longstanding primary customer since inception (GM) abandoned its arrangement with AM prematurely, illustrating the level of pricing pressure that exists within this market niche and how vulnerable the company is to losing individual clients. Management has indicated that it is optimistic that it will be able to negotiate a new agreement with Ford in the near future. However, in the case that it fails to maintain its relationship with Ford, based on our projections (which are partly driven by consensus estimates for Ford’s North American operations), we would expect AM to lose approximately $100 million of pro forma annualized revenue beginning in the second half of 2014.
It seems evident that this is a meaningful catalyst that the market is factoring into AM’s current valuation. However, we would argue that this needs to be considered from the basis of a probability-weighted view of potential outcomes, and have incorporated this potential loss (with a 33% probability of coming to fruition) into our model. We do however believe that AM has positioned itself well to win the new agreement given its proximity to Ford’s Ontario-based manufacturing plants. Moreover, in the case that the company is able to renegotiate with Ford, given Ford’s negotiating leverage over AM, would expect that the terms of the agreement would entail a material unfavorable change in terms of the economics of the agreement. We have incorporated this element into our model in a conservative manner, by decreasing the economics of the agreement beginning in the second half of 2014 in both our base and upside scenarios (by 25% and 10%, respectively).
Furthermore, AM is susceptible to the same risk factors that its customers face, which for its automotive operations include macro factors such as eventually increasing interest rates, commodity prices and competitive pressures from international players.
In terms of its new clean energy-focused operations, due to the fact that this is a rapidly growing space, there are increasing competitive pressure emerging as new competitors enter the industry. This may have adverse effects to AM from the standpoint of its ability to maintain its existing contract with Vestas, to succeed in its plan of expanding its client base within this space, and facing contracting margins due to pricing pressure for any customers it is able to attain due to natural economic forces. In addition, clean energy entails exposure to additional government scrutiny and trends in other more traditional sources of energy, particularly with the developments in recent years pertaining to shale gas, which has emerged as a potentially abundant, cleaner energy source located within North America.
Projections and Valuation
Our revenue projections are based on consensus estimates for revenue growth rates for Ford’s North American operations, with a probability-weighted adjustment in the second half of 2014 for the risk of losing Ford as a customer, and two scenarios entailing retention of Ford with reduced pricing structures. Similarly, we use a probability-weighted blended methodology for projecting the growth trajectory of the Vestar (and other) revenue estimates. We have included an upside scenario where the company is able expand its client base within the non-automotive space by adding additional clean-energy customers and/or alternative contracted sub-assembly initiatives.
Our valuation assumes that the company reaches a “steady state” in 2016, at which point we used the Earnings Power Valuation methodology, whereby we took normalized EBITDA (-) maintenance capex* (1 – proxy for the statutory tax rate). The associated calculations are included in the appendix and the following outlines a sensitivity table of the valuation range:
Appendix: Supporting Valuation Calculations
Appendix: Trading Comps