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Why You Should Invest in This Auto Parts Supplier

October 04, 2013 | About:
Patricio Kehoe

Patricio Kehoe

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As the U.S. automobile industry recovers, auto parts suppliers are expecting to see increasing sales volumes. Particularly firms such as Delphi Automotive (DLPH) and Stoneridge Inc. (SRI), which specialize in electronic components, expect to make large profits. Increasingly electrified vehicles, higher demand for hybrid and electric powertrain vehicles and stricter governmental emissions regulations should drive revenue growth for these firms in coming years.

A Narrow-Moat Auto Parts Supplier

Delphi is a large auto parts supplier, which handles electrical architecture, powertrain, safety and electronics. The firm makes around 45% of its revenue in Europe, yet its largest customer is General Motors, with roughly 20% of revenue stemming from the Detroit giant. The company’s business strategy consists in following trends in the automotive parts industry, such as the rising demand for greener technology.

As the auto market shifts towards fuel efficient and electric vehicles, Delphi’s sales are expected to grow faster than the average growth rate in global vehicle demand. The firm’s power modules, converters and battery packs, for example, provide the electric and hybrid car industry with technology that is in high demand. Also, as electronic architecture in vehicles becomes increasingly complex, the company can benefit from products like wire harnesses, connectors and smart distribution boxes.

By meeting clean air standards set by governments and improving automakers’ fuel economy, Delphi can stay ahead of competitors. In addition, the firm’s operations in low-cost countries, along with its manufacturing discipline, must also be noted. As production volume increases, this should enable a great deal of operating leverage.

Delphi’s narrow economic moat, which stems from its intellectual property and cost advantage over competitors, has been noted by James Barrow of Barrow, Hanley, Mewhinney & Strauss. The guru recently increased his stake in the firm by roughly 166%, bringing his total holdings to over 9.5 million shares. Delphi is now trading at 17.1 times its trailing earnings, which translates to a slight price premium relative to the industry average of 15.4. Despite the premium, I agree with Barrow on his purchase, as I too feel highly optimistic about this stock.

Risky Business

Stoneridge provides electronic components, control devices and systems for cars, trucks and agricultural vehicles. Roughly 50% of the company’s sales are generated by its electronic segment, which is responsible for instrument clusters and display systems production for commercial vehicle original-equipment manufacturers, or OEMs. Innovative products in this sector, along with increasing demand for electronics, have driven the company’s growth.

The increase in electronic content in vehicles, due to the introduction of electric vehicles and the penetration of hybrid cars, is bound to continue. This could be highly beneficial for Stoneridge as demand for its products is expected to rise in the long term, bringing about interesting growth rates. By dealing mainly with commercial vehicle OEMs, which are also exposed to the cross-over vehicle fuel economy, the company can achieve more attractive contract terms than with light vehicles OEMs. Since medium and heavy-duty trucks require more electronics than small vehicles, and electronic components are in high demand, Stoneridge can take full advantage of its long-term contracts with OEMs.

Despite the positive outlook in a market that is seeing increasing per-vehicle electronic content, the company has financial issues, which could be a problem looking forward. A large debt burden and the corresponding interest payments, constrain the firm’s ability to reinvest. Also, the company’s reliance on Navistar and John Deere for approximately 35% to 40% of annual revenue could be troublesome. Navistar has not yet recovered from a failed engine product line, which did not meet U.S. Environmental Protection Agency requirements for diesel emissions. Considering the troubles the company is facing, I feel pessimistic about this stock, and it comes as no surprise that Guru George Soros of Soros Fund Management LLC sold all his holdings in the company.

Follow the Guru

Although a recovering U.S. automobile market and the increasing demand for electronic components provide a stimulus for both companies, I think Delphi is the wiser investment option. The firm boasts low costs with a strong financial position, lots of free cash flow, a large operating margin and a narrow economic moat that works to its advantage. The fact that James Barrow holds a large position in the company should provide shareholders with an extra portion of optimism regarding this stock.

Disclosure: Patricio Kehoe holds no position in any of the mentioned stocks.

About the author:

Patricio Kehoe
A fundamental analyst at Lone Tree Analytics

Rating: 3.4/5 (5 votes)

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