Description

If you are looking for a value stock with substantial upside and reasonable certainty of success and a really simple-to-understand investment thesis, I believe American Axle (“AXL”) fits the bill.  AXL is highly leveraged to North American auto production volumes, which I believe is in the early innings of a substantial recovery.  The U.S. auto fleet never fully recovered from the deep under-supply in 2008-2014 and was poised to continue to deliver robust volumes until the pandemic hit.  Then the pandemic and supply-chain issues caused the under-supply situation to become acute.  AXL is cheap on below-normal volumes at 4.5x EBITDA with a 25% FCF yield.  On mid-cycle, I estimate that AXL is 3.5x EBITDA with a 40% FCF yield.  If the 4.5x EBITDA multiple holds on mid-cycle, the stock should trade at $18/share vs. $9/share today.  There is an extremely high probability that volumes exceed mid-cycle – potentially offering substantially more upside.  Lastly, AXL was reportedly the target of PE interest last year.  This could present itself again as AXL is certainly cheap enough for PE – even with rates here.

U.S. Total Annualized Sales SAAR

The alleviation of the chip shortage and other supply chain issues is allowing auto OEM’s to ramp production aggressively after four years of undersupplying the market.  The auto industry is a highly fragmented industry with a long list of incentives to drive up volumes; including

• Fragmented industry
• Enormous fixed-cost leverage
• Union contracts that incentivize volume growth
• Political subsidies on a national, state, local basis to drive up production

The OEM’s have been the unwitting beneficiaries of the chip shortage as it curtailed supply.  Demand substantially exceeded supply and continues to do so.  As such, the OEM’s had pricing power for the first time ever because it’s a dreadful commodity industry with a flattish cost curve.  Auto OEM investors might pray that the industry can “be rational.”  Unfortunately, the only rational decision in the above framework is to get lower on the cost curve by flexing your fixed cost leverage and taking share.  As the impediments to supply quickly evaporate, supply should come roaring back… Frankly, it has already started. This argument is further buttressed by the fact that, short-term, the under-supply in the market is so acute that it should mean that OEMs can drive up volumes for a long-time before it starts to present as oversupply driving price concessions.  As the OEMs ramp, their profits will soar and it will be impossible to stop chasing the enormously profitable volume.  Only after they are running at 17-19mm units per year for 3-4 years (and maybe more) will we run into over-supply.  At this point, they have an enormous lever to pull to hold onto share and keep their fixed cost leverage up…. Price.  Margins are at record levels, and total earnings could be on the verge of moving substantially higher as pricing holds with higher volumes.  Ramping volumes is a colossal trap for the OEMs but an inevitable and unavoidable one.

The last four years have been a disaster for AXL as the key driver of profits is higher North American volumes.  The substantial decline in volumes has meant that AXL mgmt. has had to work overtime to offset the substantial decline in fixed cost leverage.  Despite this major headwind, AXL management has retooled and held on to a solid margin profile and generated meaningful FCF.  In fact, AXL has generated $294mm of CFFO-CAPEX on average from 2020-2023 which compares extremely favorably with the $1.1bn market cap today (27%).  Today the stock trades at 4.6x 23 EBITDA with a 25% FCF yield despite overspending on CAPEX this year by $75mm.  Should we see volumes lift by 20%, this should mean about $1.2bn more revenue for AXL and with 20% incremental margin $240mm of EBITDA for a total of $1.0bn.  Management presents $1.0bn as normalized EBITDA.  At which point, the stock would be 3.5x EBITDA and 40% FCF (again with $300mm of capex vs normal of $225mm).  If the 4.5x EBITDA holds on a MID-CYCLE production of 17mm SAAR, then you double your money.   So here is the bull case:

• Supply chain / chip shortage is basically over
• The OEMs are going to blast out volumes and have blowout earnings
• AXL will see a 20% lift to volumes and do $1.0bn of EBITDA and quite possibly more as the OEMs supply a short market
• There is a real shot that the OEMs move above normal supply of 17mm for a sustained period and AXL has higher earnings but on levels that might be above mid-cycle.
• This should last for 3-5 years.  We sold 14.5mm cars a year since 2020.  We probably should have produced 17-18mm each year to meet demand – especially given the wealth creation.  If we go to max capacity for 4-5 yeers, then we will likely be rebalanced.

Why does the opportunity exist?

• Auto-part suppliers are typically viewed as cyclical despite the apparent reality that auto volumes are likely to go up even in a recession scenario (see risks)
• AXL and other part suppliers haven’t presented 2Q results, which would be the first evidence of the recovery
• Most auto-part suppliers have a more global footprint where demand recovery isn’t as robust, complicating “the bet” you are making.  AXL derived 73% of its sales from North America in 2023 and is one of the cleanest ways to play a US automotive volume recovery.
• Some investors have concerns about AXL’s transition to EV’s (see risks below)

What are the risks?

Realistically:  today’s volumes are the uber bear case for AXL.  The stock is cheap on trough.  The only incremental risk would be the loss of a an enormous customer like GM – who just gave AXL a prestigious supply award.  Downside seems extremely well protected as we are 4.5x EBITDA with a 25% FCF yield on trough.

Recession: normally auto saar drops to 14mm in a recession.  However, the industry has undersupplied by 8-12mm units.  This presents in higher used car prices and a fleet of cars that is the oldest its ever been.  The lack of mechanics is driving up repair costs meaningfully and repair needs on older cars increase dramatically.  Further, the dealer lots have 2mm fewer units on their lots than normalized.  If demand does in fact drop substantially, OEMs can start to push price to offset that given record margins.  As such, unless there is a catastrophic economic event, I suspect that OEM volume runs as hard as the supply chain lets it.  further, a recession should see substantially lower rates, allowing consumers to replace their incredibly old cars.

POLK Average Age of Passenger Cars

EV:  AXL is the legacy axle supplier to GM.  GM represents 40% of AXL sales too.  Over the last two decades, AXL has diversified away from GM.   Given the strong legacy relationship, it was expected that GM would select AXL to build its EV axles.  However, the first generation GM EVs will have their axles in-sourced by GM.  EV axles typically house the engine(s) and are, therefore, more critical and complex components.  Further, the decreased complexity of assembly of an EV makes some wonder if the OEM’s need to in-source more parts to keep their unions fully employed.  That said, AXL has won substantial new assignments.  Investors fretted over this for years.  When GM announced that they would in-source their 1st generation EV, AXL’s stock was hit hard.  Remarkably, the stock yawned when Stellantis selected it for its EV program this spring.  Stellantis is just as large of an auto manufacturer as GM.  The Mercedes S63 AMG uses its technology.  The main reason AXL is cheap is that many question its ability to transition to the EV world.  However, it clearly has a highly attractive solution and is winning customers.  Further, the increased complexity of the EVs axle drives up price per unit and margins, expanding AXL’s end market.  AXL is targeting a 10% market share in EVs by 2030 in a $20-30bn market.  I suspect that the EV market is a net opportunity for AXL.  The market is assuming it’s a net detraction, and it reflects in the absurdly low valuation.  I believe this because AXL will likely be a cost-competitive source of an increasingly complex and critical part for EVs.  Given its singular focus on axles, it’s more likely to have the best technology too – especially given its history of innovation.  Some OEM’s may pursue an internal strategy, but over time I suspect that AXL’s early technology development and reliable quality and supply will be sought out by at least 10% of the market.  The Stellantis win may be an enormous contract with the potential to replace GM’s 40% of sales over the rest of the decade.  Further, I suspect that over time that GM and other OEMs are overwhelmed in making the transition to EVs efficiently, given the race to the bottom on cost.  I suspect that GM and others are more likely than not to turn to outsourced solutions, as AXL provides a cost-competitive solution with superior technology and superior reliability.  Lastly, it is worth mentioning that today 40% of AXL’s backlog is in Electrification, which seemingly thwarts the bear case.  AXL may not be a winner during the investment hold period because the bear case is obliterated, but it certainly seems wrong, providing some chance that it is disavowed and AXL starts to trade at more like 6-8x EBITDA.

Pick-up/SUV:  OEM’s have marshaled resources to produce the most desirable and profitable models in the downturn.  This has meant that AXL wasn’t hurt as badly as most of its axles are pick-ups/SUVs.  It might mean it doesn’t have quite as much torque to the volume recovery.   

Entrenched management:  CEO, David Dauch, is the son of the founder.  Dauch family does not own a substantial amount of AXL shares, but the allegiance to the family is remarkable.  Reportedly, multiple Dauch family members hold positions at the company.  Dauch may have scuttled the PE interest (if it was real) in part to protect these family members and his ambitions to empire build.  The board is staggered limiting activism to force their hand.

Supply Chain problems:  we could see a return of supply-chain issues, or production could run into a new bottleneck as it moves higher.

AXL Background:

AXL was formed in 1994 when the current CEO’s father bought AXL out of GM.  At the point of purchase, GM was a 98.5% customer and Ford was 1.5%.  Today, they have over 400 customers.  GM represents roughly 40% of sales, Stellantis 18%, Ford 12% - a substantial diversification.  AXL is regarded as a reliable and high-quality supplier and won GM’s Overdrive Award last year

AXL has two business units.

Driveline and Metal Forming.  The Metal Forming unit is the largest automotive forging unit in the world, and many of its operations are used to supply the Axle segment.

Driveline produces rear/front axles, driveshafts, differential assemblies, clutch modules, balance shaft systems, disconnecting driveline technology, and electric and hybrid driveline products.  Driveline represents 70% of sales and 73% of EBITDA.

In auto-parts, it is important to determine how margins are derived.  In general, commodity parts with numerous suppliers will create miserable margins.  AXL’s parts are relatively complex and can be a source of substantial innovation.  For instance, AXL created an axle for all-wheel drive systems where the drive to one axle detached when it wasn’t necessary but instantaneously re-engaged when needed.  This improved MPG by 1-2 miles.  Further, the domestic suppliers of AXL are limited and they are actually truck heavy competitors too (Dana and Meritor).  Historically, these features have helped AXL derive above average part-supplier margins.

Metal Forming produces parts for engines, transmission, driveline, and safety-critical components and represents 30% of sales.  This segment is also less susceptible to the EV transition.  Again, AXL competes with a limited subset of competitors – Magna, Tower and Dana.

Catalyst

- higher auto production volumes

- solid 2Q this week and possibly raised guidance as production seems likely to be ahead of estimates in guidance