Description

Disclaimer: This writeup represents my personal opinions only and is solely for VIC members. Do not distribute. Do you own due diligence to verify or discredit my work. None of the material below should be taken as a statement of facts. Subject to error. (I also suck at timing, stock ran a little since I started writing but investment case still valid in my opinion)

I am recommending Automodular (AM-T) as a long for VIC members. I will be upfront that I don’t have in depth knowledge of the auto and auto parts/sub-assembly industries and this is a very small cap idea (~$60 mln) but to me it is very compelling. Frankly, I have ideas where I know the industry a lot better and seemingly have a perceived “edge” but the upside/downside just doesn’t compare with AM. As usual, I suggest the reader gain a basic understanding of the company through its website, filings (go to www.sedar.com) and sell-side research on the auto parts makers (nobody covers AM).

Investment Thesis Summary:

I believe AM represents an extraordinary opportunity to invest in an average business at a very cheap price. Trading at 3.1x 2012 P/FCF, and 1.8x 2012 P/FCF ex-cash, I argue the business is already priced for liquidation associated with a possible termination of a sub-assembly contract with Ford. Therefore, I see virtually no downside to the current share price and various scenarios where there is significant upside:

1)      Obviously announcement of a Ford contract extension renewal

2)      Some wind turbine assembly work, given Ontario Canada’s FIT program

3)      Winning and receiving some proceeds from litigation against GM et al.

Most importantly, a fairly shareholder friendly management and board gives me confidence the downside support isn’t just theoretical (i.e. they might squander the cash). Specifically, AM has been paying out a generous dividend and year end special dividends and buying back stock, having no problem returning most of the FCF they currently generate.

Company History and Background:

Again, I would direct readers to www.automodular.com for details but here is my narrative:

AM has been around for ~ 20 years that started off helping GM assemble some components when GM’s own facilities were at capacity. I think automakers understood there is also labour arbitrage opportunity given the big three automakers’ generally bloated labour (and benefits) costs. Further, by outsourcing, the automakers would not need to make the upfront capital spend to build and maintain facilities for some of this assembly work. Generally, this worked just fine for AM although frankly, I doubt they realized in the early 2000’s that vehicle sales were probably well above normal and fueled by a credit boom and a consumer more and more willing to take on debt (and spend). Hence, AM did make an acquisition in the US in an attempt to expand and duplicate their success (in 2003) – it has since been closed.

Heading into the financial crisis, it is scary to look at AM’s share price as it cratered to < $0.40/share. Interestingly though, to my untrained eye, fundamentally during 2008/2009, AM seems to have been able to adjust its cost structure enough to be broadly operating cashflow positive during this time period. This is a relevant point when considering whether AM will burn a lot of cash if it anticipates an upcoming liquidation scenario.

Post financial crisis, the most obvious change is the recalibration of the big automakers’ labour costs and general cost structure. While AM refuses to divulge the order of magnitude of this change and how it affects their competitiveness, I would presume much of the “labour arbitrage” argument has at least somewhat narrowed. Second, GM terminated their contract with AM and went with another subassembler in 2010. AM was, however, able to secure work for Ford – which it is currently subassembling: 1) cockpits (instrument panels), 2) suspension and 3) powerpack (parts around an engine). In fact, it secured a contract extension in 2011 with Ford (post labour arbitrage compression in theory) to subassemble the Edge, MKX, Flex and MKT until June 2014.

The GM termination served as a wake-up call for AM to diverse its business and try to do assembly work for other customers/applications. With the benefit of Ontario Canada’s FIT program (http://fit.powerauthority.on.ca/fit-program), AM did win a mandate to subassemble certain wind turbine parts for Vestas Nacelles (represented 25% of gross margins in 2012). Looking forward, AM hopes to win more contracts from other wind turbine OEMs, and obviously win an extension with Ford.

Downside Case:

I think the downside scenario is actually the most compelling aspect of AM and why I don’t think there is much risk of permanent capital loss here.

The downside valuation is somewhat straight-forward using basic math and assumptions:

1)      $1.23/share - Currently $1.23 per share cash on the balance sheet

2)      $0.33/share - Excluding cash, $0.33 per share in net working capital. Discount this number as you wish.

3)      Off the balance sheet operating lease liability of $10 mln. However, the amount drops to $4.4 mln after Ford contract expiry. Management indicated there are clauses in the lease agreement that would mitigate that liability if it had to be terminated. I’m not sure what that means. With $10.3 mln in depreciated plant and equipment, I’m assuming that would cover this liability. Also the last time they shut a facility, it cost them $2.3 mln to get out (~$0.11 per share) in 2010. Finally, labour contracts expire coinciding with the Ford contract expiry - my guess is labour contracts are struck with the possibility of a Ford termination in mind already.

4)      $1.4/share - With $0.94 per share in 2012 FCF, 1.5 years of Ford work plus some wind oem work would probably mean $1.4 per share in FCF between now and contract expiry. In theory, FCF could be a little higher if things are actually winding down (cut costs a little?)

So net net, I would say downside is somewhere between $2.63 and $2.96 per share. I put good confidence in the downside values especially given the management/board’s record of setting a $0.05/qtr dividend in 2011 and taking it higher to $0.06 in 2012. Given the FCF generation, they also paid a year-end special of $0.20/share in 2012 and bought back 180K shares. They seem to have no problem returning capital to shareholders especially if they don’t see AM continuing as a going concern.

Non-Downside Case:

Frankly, I don’t know how to come up with an exact base case and upside case for AM given my lack of expertise in this industry. But I would say there is a reasonable chance AM can be a going concern. My general comments and some comfort in the business reside in these generalizations:

1)      They’ve been around for ~ 20 years

2)      They have a near to medium term competitive advantage given their proximity to Ford’s facilities in Oakville

3)      To replicate AM’s facilities, Ford would have to spend an incremental $30 mln capex and hire 400-500 employees. These upfront costs should favour AM getting an extension or some sort of contract going forward

4)      AM’s business is currently very profitable, gross margins 22%, net income margin 14%, FCF conversion 16.5%. Maybe this is not sustainable, but it shows there is a lot of room for AM to negotiate with Ford to get an extension/renewal etc. Any corporate life beyond 2014 is upside to AM given the current valuation.

5)      Of the four Ford/Lincoln models AM is subassembling, I understand Flex and MKT will continue to be built while Ford has confirmed 2 replacement vehicles for Edge and MKX that apparently use the same/very similar modules. So despite recent poor sales figures, these 4 models in one form or another don’t appear to be going away.

6)      In the 2012 Annual Report, AM hinted at getting new contract from “other wind OEMs”. I don’t know what that means but the Vestas deal probably generated $5-$6 mln in gross margins.

So you can do the math better than me, but either AM gets another $0.90 in FCF each year it can continue its current run-rate or margins compress but they get something on a more sustainable basis (wild stab of $0.30-$0.40 FCF?). If AM’s business proves to be somewhat sustainable, then maybe I put a conservative 8x 2012 FCF, which would be $7.20 per share (but seriously, I don’t know, anything but liquidation should be upside from here).

GM Litigation Kicker - $1/share Potential

When GM terminated its contract with AM in 2010, apparently GM also went with another subassembler. AM management won’t give me details on the current litigation. All we know is AM alleges there is a breach of contract and seeking $20 mln in damages and $5 in punitive damages. If they get what they ask for that’s another $1/share in value (well, before taxes).

Rumour is the actual costs and impairments AM took as a result is ~$9 mln. So that may be something they could get, i.e. $0.36 before tax.

Other than the above discussion, I have no idea how to probability weight the value of this litigation, although I would speculate GM wouldn’t mind just settling this out of court and moving on.

From a longer-term perspective, the negative aspect obviously is my sense is AM will never want to work with GM again, so that kind of limits any major blue-sky scenario an investor is considering.

Why Does This Opportunity Exist?

1)      No sell-side coverage, very small cap name

2)      Fear AM business is done by 2014

3)      Share overhang from 20% stake of previous CEO. Michael Blair appears to have been indiscriminately selling 1H12. Maybe he started again. I have no idea, but one would have to assume he is just trying to get his money out, vs. having unique insight into why the stock is overvalued at this point.

4)      Recently poor published Ford sales numbers on the models AM is subassembling: http://media.ford.com/images/10031/March13sales.pdf

Risks:

General macro risks and auto sector in particular

Ford terminates contract or terminates contract early

Management/Board pursues aggressive acquisitions in desperation should Ford terminate, destroying shareholder value

Working capital, plant and equipment turns out to be worthless and obsolete because it is too specific to Ford

Catalyst

• Ford contract renewal
• GM litigation win or getting settlement
• Wind OEM wins
• Continue aggressive return of capital to shareholders