Description

AXL is a liquid name that is trading at 9.6 times forward earnings despite several interesting trends in its business and a near-term catalyst (or two) in place.

ABOUT THE BUSINESS
American Axle is one of the largest suppliers of driveline components and systems (primarily axles) for trucks, SUVs and real-wheel-drive passenger cars. The company was originally acquired from GM in 1994, and GM currently represents about 81% of the company’s sales. The company signs lifetime program contracts covering product sales with typical lead times of 3-5 years and typical life spans of 6-12 years per vehicle. In 2001, the company was awarded the GMT-900 program, which is expected to run through model year 2014. The axle manufacturer base is concentrated in the U.S., with three companies (AXL, Visteon and Dana) controlling more than 80% of the market (which is quite good for pricing).

Though it is far from an exciting line of business, what first caught my attention about this story was that the company was trading at an apparently cheap valuation on an earnings basis (under 10x forward EPS of $4.00) and that the company was making a concerted effort to use its free cash flow to aggressively reduce debt. Long-term debt has been reduced from $888 million at end of March 2002 to $573 million at the end of September 2003 and will likely be reduced to around $390 million at the end of 2004. For the trailing twelve months, the company has generated free cash flow (defined as CFO minus capex) of about $240 million (roughly a 9% yield on an enterprise basis). In turn, tangible book value has steadily risen from $8.3 at the end of March 2002 to $13.5 at the end of September. ROIC is above 19% versus 17% a year ago.

Despite the six-month run-up, its shares still look interesting as a fairly low 6 multiple of forward EBITDA (or a 13 multiple of earnings) would imply a $52 stock, up nearly 40% from current levels. The valuation at under ten times earnings looks particularly interesting when one considers that the industry concerns, although valid broadly, appear overblown in the case of this company and when one examines the favorable growth trends in the company’s new business.

Broadly speaking, market share losses of the Big 3 (GM, Ford, Chrysler) pose a considerable concern for suppliers who are overweight these customers. The Big 3 have lost about 2.3 percentage points of truck share on a trailing twelve month basis, which has clearly helped keep a lid on the valuations of many of the respective suppliers. Investors have also fretted about how the Big 3 are imposing increased pricing pressures on their suppliers and how industry auto sales are stagnant. In particular, AXL is overweight GM, with GM contributing about 81% of sales this year.

There are a few reasons why these concerns could be overblown in relation to AXL:

First, the argument that GM is losing market share applies much less to AXL because AXL operates more in the light truck area, where GM has largely held its ground and which is steadily growing as a category. GM’s market share of overall U.S. car sales has decreased from 30% to 26% over the last three years, while its market share of U.S. light truck sales (by far AXL’s main area) has remained relatively flat at about 30% over the last three years and has declined only about 70 basis points over the last year. In terms of the industry, light truck sales have grown from 51.5% of industry sales in 2002, to 53.8% of industry sales for 2003 to date. That means that GM, while losing 70 basis points of truck market share y/y in 2003, should still sell 40,000 more trucks in 2003 than in 2002. Since more industry innovation is occurring in the truck segment and this mix shift is continuing towards bigger cars (a steady trend since the early 1990s), suppliers like AXL which cater more to light trucks should benefit.

Second, it looks like AXL continues to penetrate GM’s account. For example, in the recent (Sept.) quarter, AXL’s GM sales were up 3% (versus a 2% increase in GM North American truck production), which indicates that GM internal growth for AXL was up 1% (e.g. helped by the new Hummer H2 business). The company has increased “content per vehicle” to $1,170 from $980 at the end of 2000 due to the industry trend towards higher 4WD/AWD, another indication that the company is deepening its relationship with GM.

Third, it looks like AXL is less susceptible to pricing pressures than other suppliers. For 2003 to date, AXL has given GM price downs of roughly 1% versus 2-3% for most suppliers. AXL is often involved earlier in the design process than other suppliers, has been making more quality improvements and has generated higher warranty savings, which could account for the reduced pricing risk. Since 1994, AXL has achieved productivity improvements of over 7% annually. Over the last six years, these improvements have saved GM roughly $250 million ($40 annually) in warranty costs.

Fourth, estimates for GM and industry auto sales are rising due to the perceived economic recovery, which would bode well for AXL if the recovery is actually sustained. It is important to note that any auto industry growth next year could cause both multiples as well as earnings to expand for leading suppliers to the industry, which could be a powerful combination.

While the industry concerns and their particular relevance to AXL are of much debate on numerous levels, there is one area that is becoming increasingly clear: the favorable growth trends in the company’s new business. Helped by new business, the company’s revenue growth has been consistently higher than industry levels over the last few years. While North American light truck production in 2003 is up about 4% from 1999, AXL’s sales have risen by about 25% (from $2.9 B to $3.7 B) over the same period and EPS has nearly doubled. Year to date, over 80% of the company’s sales were generated from products introduced after mid-1998 (versus 78% in 2002 and 69% in 2001). In the most recent quarter, non-GM internal sales were up 13% y/y, driven primarily by the new Dodge Ram. With this program, DaimlerChrylser should represent nearly 10% of sales in 2003 versus 4% in 2002 and less than 1% in previous years.

Backlog is an important indicator of future sales growth. Backlog of new business in 3Q03 came in at roughly a 25% gross margin (markedly above the company’s gross margin of 13.8% in the quarter). The company has a net new business backlog of about $500 million through 2006 and is bidding on an additional $800 million in new opportunities.

With the company arguably less vulnerable to industry concerns and with the growth prospects from its new business (and diversification away from GM), it appears that the company should arguably trade at least in line with its peers at 5.5 times EBITDA (implying a price of $46, +20% from current levels). As mentioned, a rather low 6 multiple of forward EBITDA (or a 13 multiple of earnings) would imply a $52 stock, up nearly 40% from current levels.

An important catalyst is how the company continues to spend its free cash flow. Continued debt reduction could be an important catalyst. It appears that the company could also use some cash to make a small, bolt-on acquisition. Historically, the company has made fewer acquisitions than many of its peers, which I would view as a good thing as the best acquisitions in the auto supplier industry typically need 2-3 years of 20-30% revenue growth to get low double digit ROIC. Sales from new acquisitions represented 5.1%, 1.6%, 0%, 0% and 0% of sales from 1999-2003.

This week Moody’s upgraded the company’s debt to investment grade status. The improvement in ratings could lead the company to actively consider buying back stock, issuing a dividend, and/or refinancing its senior secured debt, which could also help drive the shares higher.

Also of note is that Blackstone Capital sold its remaining 12% stake in AXL this month. As of 18 months ago, Blackstone owned 27% of the stock. Without this overhang, the shares could arguably more easily trade higher. The company can also now increase the number of independent directors to its board. The CEO still owns about 14% of the equity and many of the other executives are large holders.

Catalyst

Company trading at a low multiple of earnings with earnings estimates rising for company, industry
Any auto industry growth could cause multiples to expand for leading suppliers
Continued growth of new business
Continued debt reduction
Share buyback or dividend announcement
Refinancing of senior secured debt
Removal of overhang from Blackstone Capital