As one of the largest and most diversified auto parts supplier worldwide, Magna International Inc. (NYSE:MGA) provides auto repair shops with an extremely vast array of products, including seating, roof systems, powertrain, electric vehicle systems, vehicle assembly and engineering, amongst others.
Although this sort of diversification has earned the company some profitable years, many analysts consider it to be unsustainable in the long term, as management is forced to spread its resources throughout multiple product development groups. Also, the prior bankruptcy cases of fellow competitors Delphi Automotive PLC (NYSE:DLPH) and Visteon Corp (NYSE:VC), which had a similarly diverse business model, should be a warning regarding this firm’s balance sheet.
However, the company’s high returns of 26.8% on invested capital, as well as an outstanding EBITDA growth of 120.60% year-over-year, have caught my attention and left me wondering if these metrics will continue looking forward. The company will also be reporting its latest quarter earnings on Monday. Therefore, in the article below, I will analyze Magna's past profitability, capital, and operating efficiency, in addition to looking at which institutional investors have recently bought the firm’s stock in the last quarter. Based on this information, we will get an understanding of the company´s revenues, operating metrics and quality of earnings.
Profitability is a class of financial metric used to analyze a business’ ability to generate earnings compared with expenses and other relevant costs incurred during a specific period of time. In this section I will study several profitability metrics, such as return on assets, quality of earnings, cash flows and revenues, by which we will be able to elucidate if the company is really making money.
In addition, I always compare a company's revenue growth and operating cash flow growth. Over the past three years, the Magna's operating cash flow has increased by 81%, augmenting from $1.210 million to $2.206 million. I always advise to look for companies with strong cash generation profiles, as these will have less risk when debt levels grow.
ROA - Return On Assets = Net Income/Total Assets
ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. In simple terms, this metric tells you what earnings were generated from invested capital (assets).
I am encouraged by the fact that Magna’s ROA has increased from 7.43% to 9.02% in the past 3 years because it indicates that the company is generating more from its assets than it did in 2010.
Quality of Earnings
Quality of earnings is the amount of earnings attributable to higher sales or lower costs, rather than artificial profits created by accounting anomalies -such as inflation of inventory. In order to assess Magna's quality of earnings we will compare the level of income with operating cash flows.
The company augmented its profits at a rate of -66%, but the growth of cash flows was higher, which is strong evidence of profits being created through a boost in sales or cost reductions.
Working Capital is a measure of both a company's efficiency and its short-term financial health, by indicating whether the company has enough short term assets to cover its short term debt. Most believe that a ratio between 1.2 and 2.0 is sufficient.
In order to appreciate a company's working capital structure, we need to analyze its current ratio growth. Magna's current ratio has decreased from 1.50 in 2010 to 1.37 in 2012. This shows that the company´s balance sheet was stronger in the past.
Gross Margin: Gross Income/Sales
The gross profit tells an investor what percentage of revenue/sales is left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors -and overall industry- is more efficient. Investors tend to pay more for businesses that offer higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.).
Over the past three years, Magna’s gross margin has decreased. The ratio shrank slightly from 13.2% in 2010 to 12.4% in 2012, indicating that the company has been becoming somewhat less efficient year-after-year.
Asset turnover measures a firm's efficiency in using its assets to generate sales or revenue - the higher the number the better. It also indicates pricing strategy: companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover.
The fact that this company’s revenue growth has outpaced the assets growth (05% growth) on a percentage basis, indicates that the company is making money on its assets.
In the recent quarter, both Joel Greenblatt (Trades, Portfolio) and Scott Black (Trades, Portfolio), among other investment gurus, bought Magna’s company shares at an average price of $81.95. This encourages me to think that the company will do well looking forward.
Currently, many analysts have a good outlook for Magna International. Analysts at MSN money are predicting that the company will retrieve a growing EPS of $7.66 for FY 2014, while Bloomberg is estimating revenue to grow from 2013’s $34.40B to $35.73B for FY 2014.
Although I believe Magna’s balance sheet is relatively stable and showed some signs of profit, some concerns regarding the irregularity of this company’s results over the past decade remain. Furthermore, with raw material costs increasing (steel, copper, aluminium, and magnesium are only some of the manufacturing essentials), and low exposure to emerging markets, the firm should maybe redirect its efforts in developing a stronger customer base in Asia.
I also think profits could be obtained by limiting the product portfolio, thereby redirecting resources to technological innovation, which would put the company ahead of its competitors. Nonetheless, there is no denying that Magna is an interesting investment option, especially for the long term, given the volatility of its balance sheet. The fact that the stock is currently trading at a price discount of 10% relative to the industry median of 15.60x, should be attractive for investors seeking to buy company shares.
Disclosure: Patricio Kehoe holds no position in any stocks mentioned