As the auto industry continues to impress investors due to its rapid recovery, auto parts manufacturers are also becoming increasingly popular. Companies which focus on emissions control are especially sought after, since new government requirements have generated elevated demand for these products. Thus, taking a closer look at this industry segment might bring about some interesting investment opportunities.
A Large, Trustworthy Supplier
Tenneco Inc. (TEN) is a major provider of auto parts, specifically emission and ride control systems for vehicles. The firm produces converters, diesel particulate filters, mufflers, shock absorbers, and advanced suspension systems, amongst others. The company’s innovative nature and global footprint make it very attractive for original equipment manufacturers (OEMs) looking for a large, trustworthy supplier.
The main advantage Tenneco has over industry rivals is its size. The firm’s advanced technical research capabilities were made possible thanks to hefty investments, which peers are unable to finance. A large scale and ample portfolio, have thus enabled the company to continuously develop exciting new products. In addition, as new regulations regarding emissions are put in place with increasing frequency, Tenneco not only offers top-of-the-line auto parts, but lower prices relative to industry rivals. Thus, the firm should see revenue remain on its current growth trajectory.
Customer Care at Its Best
One of the attractive features of Tenneco is its ability to build and maintain solid customer relationships. The firm’s long-term contracts make it especially hard for those seeking entry into this industry sector. Since most OEM’s prefer to establish five-to-10-year contractual obligations, in order to secure the necessary parts for production, a sudden change of supplier does not come into question. This means Tenneco has a wide array of secure sources of income, while it is largely protected from industry newcomers seeking to take a chunk out of its market share.
In addition, revenue increases are practically guaranteed: The recovering auto industry could see Tenneco’s average revenue growth reach 10% by the end of the year. And, there is no reason to believe this number should not increase, especially considering regulations are becoming increasingly tighter and more widespread, while the automobile market is booming.
With the backing of two important investment gurus, Tenneco enjoys solid support. Yet despite their bullishness regarding the auto parts supplier, some risks must be mentioned. Since around 40% of the firm’s revenue is derived from European customers, such as Volkswagen AG ADR (VLKAY), Daimler AG (DDAIF), and General Motor Co. (GM)’s Opel division, 2013 has not been the best year. With sales in Europe stagnant, auto parts are not exactly in high demand. Nevertheless, the current market situation is bound to turn around over the coming years, with some firms already projecting break-even numbers for next quarter. Also, the increasing U.S. sales should help counteract any problems Tenneco is facing on the European front.
Financial Situation and Valuation
Tenneco presents further risks when one looks at its balance sheet. High debt levels have left the firm with a cash to debt ratio of 0.2, which is quite surprising for an auto-parts manufacturer. Large expenditures in research are mostly responsible for this trend that must be reverse, unless the company wants to continue spend large amounts of cash on interest payments. Despite entailing certain risk, Tenneco offers shareholders an impressive 28.8% return on invested capital, and has the highest return on equity in the industry. With such rewarding returns, the moderate risk involved in investing in this auto parts manufacturer might be worth taking.
In terms of valuation, however, Tenneco seems overpriced. Trading at 21.1 times its trailing earnings, the stock is available to those willing to pay a 37% price premium relative to the industry average. And, with share prices hovering around their 52-week high, time for entry seems to have passed. Nonetheless, further growth opportunities and bright future prospects could counteract the elevated asking price for common stock. Once again, the high-risk, high-reward slogan seems fitting. Overall, I feel bullish regarding Tenneco’s future performance, and believe Jim Simons and Joel Greenblatt were correct in increasing their stake in the firm.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned.