We believe American Axle Manufacturing Holdings Inc. (AXL) is an attractive long investment idea due to its leverage to 1) an ongoing US auto sales recovery that will continue into 2012, 2) attractive incremental margins and 3) a well-diversified net new business backlog. Once the company is perceived as a diversified play on autos across both geography and product rather than as a heavily concentrated North American supplier to GM (as has been the case) the market will ascribe a higher multiple to the business. AXL is currently trading at $11.15 or 4.6x our 2011E EBITDA estimate. Based on a median industry peer group EBITDA multiple of 5x, We calculate a target price of approximately $15.80 using our 2012E EBITDA estimate - this represents upside of approximately 42%.

Business Description

Based in Detroit, Michigan, American Axle Manufacturing Holdings Inc. (AXL) is a tier 1 supplier to the automotive industry. It designs, engineers and manufactures driveline/drivetrain systems and chassis modules for light trucks, sport utility vehicles (SUVs), passenger cars, crossover vehicles and commercial vehicles. Examples of AXL's products include rear/front axles, driveshafts, power transfer units, chassis, steering components and transmissions parts.

AXL is the exclusive supplier of driveline components to General Motors (GM) for its rear-wheel drive light trucks and SUVs manufactured in North America, supplying substantially all of GM's rear axle and front four-wheel drive and all-wheel drive (4WD/AWD) axle requirements for these vehicle platforms. Major GM vehicles supported by AXL include the Chevy Silverado, GMC Sierra and Cadillac Escalade. These models are all considered to be on GM's GMT900 truck platform. Sales to GM were approximately 75% of total net sales in 2010, 78% in 2009 and 74% in 2008. AXL's other notable large customer is Chrysler. AXL is one of the principal suppliers for Chrysler's heavy-duty Dodge Ram full-size pickup program. Sales to Chrysler were 9% of total net sales in 2010, 8% in 2009 and 10% in 2008.  AXL also supplies driveline systems to large OEMs including Volkswagen, Scania, Harley Davidson and Ford. On a geographic basis, approximately 90% of AXL's revenue is derived from North America. In addition, the majority of its revenue comes from the passenger car/light truck as its revenue from the commercial vehicle market represents less than 5% of total net sales.

Recent History

AXL, a former GM subsidiary (spun-off in 1994), felt the harsh impact of the downturn in the domestic automotive industry during 2008 and 2009. The collapse of housing, lack of consumer credit, unemployment and volatile commodity prices resulted in sudden drop in industry production and sales volumes. The U.S. seasonally adjusted annual rate (SAAR) of sales declined from 16.1 mm units in 2007 to 13.2 mm in 2008 and 10.4 mm in 2009, representing the lowest SAAR figure in 25 years. During the first quarter of 2009, AXL received an auditor's opinion filed with its 2008 10-K that stated it may not be able to continue as a going concern due to the potential Chapter 11 filings of its two largest customers, GM and Chrysler (approximately 90% of 2008 revenue). AXL's net leverage had increased from 1.3x (Net Debt/EBITDA) at year-end 2007 to 12.3x at year-end 2008. Due to the equity market's concern that AXL would violate its secured leverage covenant and not be able to receive an amendment from lenders, AXL's stock traded down to a low of $0.40 per share on March 2^nd, 2009 (or an implied market capitalization of $22 mm).  As a result of subsequent bankruptcy filings from GM and Chrysler and extended production shutdowns, AXL's revenues were adversely impacted as its second quarter 2009 net sales fell to $246 mm from $528 mm during the same period in 2008, representing a decline of 50%.

Although AXL received a temporary covenant waiver from its lenders during the second quarter of 2009, it was not enough as it also required AXL to maintain minimum liquidity (cash and available borrowings) of $100 mm. In an 8-K filing, AXL said its total liquidity as of June 30, 2009 was $283 mm, implying a $50mm burn from total liquidity of $330 mm as of March 31^st, 2009.  In addition to this cash burn and its revolver being fully drawn, AXL guided to $95 mm of cash restructuring costs. These restructuring costs alone and any further cash burn would have taken AXL dangerously close to its minimum liquidity required by its bank group.

During the third quarter of 2009, AXL and GM entered into an agreement in which GM paid AXL $110 mm for cure costs associated with contracts assumed and/or terminated during GM's Chapter 11 bankruptcy proceedings and resolved certain other commercial/financial obligations outstanding between the two parties at the time. In addition, GM extended a $100 mm second lien term loan facility to AXL (that has not been drawn to date) and received 4.1 mm warrants to purchase AXL common shares. GM also granted AXL expedited payment terms on receivables from GM from approximately 45 days to 10 days in exchange for a 1% early payment discount through December 31^st, 2010.  After receiving this liquidity life line from GM, AXL continued to address is capital structure by refinancing its existing term loan and completing a stock offering to further improve liquidity during the fourth quarter of 2009.

From an operational standpoint, AXL management proactively reduced its fixed cost base by 50% during 2008 and 2009 by rationalizing its plant facilities and converting from a fixed United Auto Workers (UAW) legacy cost structure to a variable cost structure.  The net result was that AXL reduced its operating breakeven level to a US SAAR equivalent of 10 mm vehicle units from a pre-downturn breakeven of 12 mm. On the labor front, AXL reduced its fully-loaded labor cost from $73 per hour to $34 per hour on a blended average basis. AXL also implemented permanent changes to its previously un-competitive OEM-style healthcare, pension and OPEB plan - they are now "defined contribution" plans.  

During the 2008-2010 time period, AXL management also started to execute a plan to diversify its revenue base. Going forward, AXL will not be as dependent on its North America-centric, full size/heavy duty pickup customers.  Its new product backlog for the years 2011-2013 is currently $850 mm with over 50% of the backlog consisting of customers other than GM, 60% outside of North America and over 66% for passenger car, crossover vehicle and commercial vehicle programs.

So why didn't AXL management take these seemingly "no-brainer" actions earlier in the decade? In our conversations with AXL management, they stressed that they spent most of their time focusing on first improving product quality. For example, the AXL management team, which includes many individuals who have been with the company since the 1994 spin-off, reduced AXL's discrepant parts per million (PPM) from 13,411 in 1994 to just 50 PPM in 2006. Our opinion of the management is very favorable as they have been with the company for a long time, executed on the business plan and are very responsive to investor questions/inquiries.

Investment Positives

Participation in US SAAR Rebound: US SAAR fell from a peak level of 16 mm in 06-07 to a depressed level of 10 mm in 2009. As small business owners continue to replace their pickup trucks (per public commentary from GM and Ford), used car prices continue to increase and credit is becoming increasingly easier to access, a rebound to 14 mm SAAR in 2012 is very realistic given that OEMs have not lowered their 2011 forecasts of approximately 13 mm despite the Japan earthquake. Assuming GM and Chrysler (approximately 85% of AXL revenue) continue to hold onto their strong market positions in full-size/heavy duty pickup trucks, AXL will benefit tremendously even if the industry does not see prior peak volumes.  

Strong Position in Supply Chain: AXL is firmly entrenched in the axle/driveline supply chain. OEMs prefer to source locally and become very entrenched with suppliers of key products to ensure safety and quality. There are rarely movements in market share related to contracts for legacy programs. In addition, the AXL/GM financing agreement reached in late 2009 essentially serves as a backstop for AXL, which should provide comfort to equity investors that GM has invested and would like AXL to do well since it serves all of its major pickup/SUV platforms.

Attractive Incremental Margins: Although AXL's preferential payment terms with GM ended on December 31, 2010 (as mentioned above), which resulted in increased COGS for AXL, the company will still be able to generate attractive mid-teens/ low-twenties incremental margins as seen in 1Q11. On the 1Q11 earnings call, management quantified the adverse impact of the expiring GM terms on gross profit as $5.5 mm per quarter going forward. AXL reported a year-over-year incremental EBITDA margin of 16% in 1Q11. In addition, there has been no commentary out of the company that it will need to add additional fixed costs as US SAAR rebounds and in our previous conversations with management, they have reiterated that AXL can handle production volumes in a 16 mm SAAR environment without adding brick and mortar capacity.

Increasingly Diverse Backlog: AXL management continues to execute its plan to diversify the company's revenue base. Over time this will result in equity investors applying a higher multiple to AXL's EBITDA. Historically, AXL has traded one turn lower than its public auto supplier peer group due to its dependence on GM. (the peer group trades 5 to 6x mid-cycle EBITDA). This perceived risk will abate as revenue from AXL's $850 mm backlog is 37% from North America, 20% from South America, 33% from Asia and 10% from Europe. This is significantly different than its 2010 revenue mix of 90% from North America. In terms of type of vehicle AXL's supports, its backlog is 54% passenger car/crossover, 8% North American light truck, 23% international light truck and 15% commercial truck. This is in sharp contrast to its current mix of 78% of revenues coming from light trucks (GMT900 platform, other GM light trucks and Dodge Ram).

We consider a downside scenario in 2012 to be one where SAAR does not improve from the 13 mm expected by OEMs in 2011 as well as the share GMT900 as a percentage of SAAR decreasing to 5.5% in instead of getting back to 6.5% as we have seen in the past. This set of assumptions would yield a 2012E EBITDA of $362 mm. Applying a trough EBITDA multiple of 4x to this downside EBITDA yields a stock price of approximately $9, implying a downside of 17% from current levels.

Investment Concerns

Dependence on GM: On a historical basis, General Motors has represented approximately 75% of AXL's revenue. Although AXL has very little risk of losing business during the life of a vehicle platform program (typically 3 to 5 years), AXL must win new GM programs when old programs are retired and new ones come up for bid. If GM falls into financial difficulty again or chooses to source its axles from another supplier, it could adversely impact the financial performance of AXL. However, due to GM's firm entrenchment with AXL, including the 2009 GM/AXL agreement, GM's preference to source locally and AXL's deep knowledge of GM's GMT900 platform, we see little probability that GM will take its business elsewhere.

Another aspect of AXL's dependency on GM is the level of inventory GM keeps on hand for its GMT900 platform. Per GM's most recent sales call, the days inventory for its GMT900 related trucks was 110 days inventory, well above the historical average of 85 days (higher during summer quarters due to production build for next year's models). If this days figure remains high, it could mean downward pressure on AXL's sales in coming quarters. However, OEMs have not reduced their full-year SAAR projections of approximately 13 mm which reflects their belief that demand will persist during the second half of 2011 despite a slowdown in April/May of this year 2011.

This is an important data point that investors must try to monitor on a regular basis as it provides a sanity check on how much sales growth to project for AXL. Days inventory data is available anecdotally on OEM monthly sales calls, from sell-side research reports or from third party research firm Ward's.

Exposure to Light Trucks/Gas Prices: During April 2011, as gas prices approached the $4 per gallon mark, the light truck mix within the US SAAR dipped to 9.7% in April 2011 compared to a 10-12% range in a normal environment. However as gas prices have fallen over the last month, the mix recovered to 10.1% in May 2011. In addition, OEMs GM and F continue to make public comments that small businesses are still replacing their older light trucks.

Incremental Margin Sustainability: Due to the nature of AXL's industrial business model, investors must constantly monitor the degree to which types of costs (i.e. fixed vs. variable) are added to the cost structure as sales increase. In recent quarters, many public auto and truck supply companies have made comments that the supply chain is tight in certain areas including electrical components, tires and, in particular, axles. If AXL experiences any supply tightness for smaller components, it could experience additional premium freight costs (variable costs) and additional labor (fixed cost) that is not efficient as its current employees because they are not trained as well.

To date, AXL has not experienced supply chain pressure with respect to axles. Dana Holdings, a competitor that provides axles to Ford's F-Series platform, has commented that it has not also experienced any significant supply chain issues (per its last IR presentation hosted by Deutsche Bank in June 2011). 

Transparency on Timing of Backlog: Although AXL gives excellent detail on the mix of its $850 mm backlog (geography, vehicle type), it is hard to discern the exact time that this revenue will be booked. Given widely available industry production data and historically consistent revenue per unit for the GMT900, other GM platforms supported by AXL and Chrysler's Dodge Ram, it is easy to predict approximately 80% of AXL's revenue on a quarterly basis. However, the composition of what we call "Other Revenue" is made up of revenue from 1) metal forming, 2) other small passenger platforms, 3) the commercial vehicle market and 4) portions of the $850 mm backlog we described above. Because AXL does not give the dollar amount of backlog that hits the revenue line when it reports earnings, this could be a source upside or downside surprise when modeling the business.

Leverage Due to Pension Obligation: As of December 31, 2010, AXL had an unfunded pension liability of $253 mm. If investors capitalize this liability and treat it as part of total debt, AXL's total leverage is 3.8x TTM EBITDA (3/31/11) compared to 3.0x when this liability is not capitalized. AXL earned upgrades from all three major credit rating agencies during the third quarter of 2010 and has stated that one of its goals is to earn additional upgrades in 2011.   

Increasing Steel Prices: As global economic conditions improved in 2010, demand and prices for key commodities that AXL uses, such as steel and other metallic have increased. The company has historically taken actions to mitigate this cost pressure such as having metal market price contractual provisions to pass on price increases to its largest customers or using strategic sourcing arrangements to reduce the amount/cost metallic content of AXL's products. Despite these actions, AXL's results could be adversely impacted by higher steel or other metallic costs as it does not have metal market price provisions with all of its customers for all of the parts it sells.

Risk of Labor Strike: All of AXL's hourly associates are members of industrial trade unions employed under the terms of collective bargaining agreements. In the US, all of AXL's hourly associates are represented by the United Auto Workers (UAW). With this labor cost structure, there is always a risk of a work stoppage or labor cost increases. At this time, AXL has very good relations with its unionized employees.