Description

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

Linamar manufactures auto parts and other industrial products.  For the 1 in 5 readers who I didn’t lose by leading with the words “auto parts”, here are a few facts about the company:

1)      It is an owner / operator type business.

2)      The company did not lose money in any year for at least 3 decades (including 2008 and 2020)[i].

3)      In the last 10 years, the company generated high teens ROE with low levels of leverage.

4)      For decades, Linamar’s EPS grew in the high teens.  In this writeup I will present the case of why the trend is likely to continue.

5)      The company is essentially debt free and is trading at under 8 times TTM earnings ($8.6 EPS) and likely under 6 times 2023 earnings.

I think that at current price level, Linamar’s stock provides an opportunity for a 2x return in the next couple of years with a limited downside risk.

Before we dive in, credit when credit is due.  Abra399 did a wonderful 2017 write up on the company.  Abra’s writeup is comprehensive and provides a great background of the company, so I encourage anyone with an interest in the business to read their writeup first.  I will try not to repeat too much.

Note: Linamar is a Canadian company, and all the figures are in CAD.

History

Frank Hasenfratz immigrated to Canada from Europe in the aftermath of WWII (his story and a lot more information about the company can be found in the book “Driven to Succeed: How Frank Hasenfratz Grew Linamar from Guelph to Global”).  Arriving penniless to Canada, Frank put his mechanical skills into use and got a job at an auto parts factory.  Frustrated about the slow pace of work, the inefficiencies and the unions meddling with everything, he reached an agreement with the factory to fabricate the parts at a fixed price through outsourced contract work.  In his basement, Linamar was born (Linamar = Linda, Nancy, Margaret; his two daughters and wife).

With relentless work Linamar earned the reputation for quality, timely deliverables through which it was able to attract more and more work orders.  Frank continued running and expanding the business until 2002, when he handed over the reins to his daughter, Linda.  Frank stayed on as chairman, a position that at 86 years young, he still holds today.

Frank and Linda, together, own ~30% of the company.

Under Linda, the business grew organically as well as through M&A.  Acquisitions served not just to fuel growth and expand capabilities, but also as a mean to diversify the business away from pure auto parts.  First, Linamar acquired SkyJack, an industrial lifts manufacturer in the early 2000s (see Abra399’s writeup, everything still stands) and then expanded into combine headers with the acquisition of MacDon in 2018.  In between these two acquisitions, the company acquired auto parts fabrication businesses to expand geographically and increase its capabilities.

The strategy behind the non-auto acquisitions is the following:

1.       Acquire stable, established businesses at single digit multiples using debt, which is quickly repaid post acquisition.  This protects the downside.

2.       Expand the product range and the geographic reach to increase the chances of an outsized upside.  It was a complete home run with SkyJack (see Abra’s write up) and is going to be at least decent with MacDon (more on this below).

Business Breakdown

The company reports under two segments – Mobility (auto parts) and Industrial (SkyJack and Macdon).  Let’s take a look at each.

Mobility –

Linamar signs long term contracts with OEMs (typically 5-10 years long), with an expected volume for each year.  This is a major difference from the pre-2008 days, which I’m not sure is fully appreciated by the market.  It’s easiest to explain with an example.  Say Ford picks Linamar to manufacture an E-Axle for the new Mustang Mach-E and say Ford expects to need 200K parts per year at program peak.  In the past, Linamar would need to build a factory line that can manufacture 200K parts per year on day one.  Post 2008, after many auto parts companies went bankrupt, the OEMs switched models and have been allowing their suppliers to match production to the expected volumes.  Per the company this is the number one reason ROE stepped up from pre-2008 days to 2011 and onwards. 

While the above is consistent across the industry, Linamar got some truly unique attributes that I believe differentiate it from peers. 

The biggest differentiator might be the “take-over” work.  During downturns some auto parts companies go under (it’s a tough industry!).  It’s hard to find others that are willing to step in and invest in people, machinery, and inventory at the same time that revenue is declining.  Additionally, growth in this business means not only investing in working capital and capex but also accepting lower margins temporarily (while programs ramp up) – not great attributes during a recession.  Fortunately for Linamar, the company has a strong balance sheet, reusable capital equipment and an agile workforce that are all very helpful during exactly such periods.  This creates a flywheel effect where the OEMs choose Linamar for take-over work, because it won’t go under and has the technical ability to ramp up production faster than others.  This makes Linamar stronger, which is even more appealing to the OEMs.

This is not just a narrative.  The company’s Mobility segment never lost money (including in 2008) and experienced only one year of revenue decline in the GFC.  The recovery was quick too.  Mobility’s 2011 revenue was over 40% higher than 2007’s revenue[ii].  I don’t believe that any auto parts company hit this milestone before 2017 (many have yet to reach it).

Another unique attribute is that the company runs smaller footprint plants, with the goal of having the manager personally know everyone (~500 employees and under).  This way workers’ relationship is supposed to be good and consequently, no unions.  Plant managers are compensated based on return on capital and products quality for alignment of interests.

One aspect of the business I just touched above may be worth expanding a bit.  The company is knowingly working harder and spending more, so that its capital equipment is reusable.  This means that when a product line is discontinued, the machinery can be easily repurposed.  This approach recently proved itself when the company reported that EV related parts will be fabricated by the same ICE parts manufacturing equipment (easily repurposed).

Through these attributes, the company is able to get industry leading ROE, while keeping the customers happy enough to let Linamar grow share.

Mobility Segment Growth

The company reports a metric called Content Per Vehicle.  This data point is calculated by dividing the total segment sales in a region (North America, EU and Asia), to the total number of vehicles sold in that region during the same period.  This figure increases if the company sells parts to a larger share of the vehicles under production in a region and / or if it provides more parts per every vehicle it supports.

On the latest report, the company disclosed that its Contents Per Vehicle was $186 in North America, $81 in the EU and $13 in Asia.  In 2010 the same data points were $126 in North America, $8 in the EU and $2 in Asia.

This reflects a growth of 48% in North America (4% annualized), 10x in the EU (26% annualized) and 6.5x in Asia (21% annualized).  Note that the growth in Europe included M&A, while in the US / Asia growth has been predominantly organic.

My point here is that the company doesn’t need auto sales to explode globally for it to grow, because the share gain is a substantial driver (as well as the push to outsource more by OEMs, a point that Abra expanded on in their writeup).  Looking ahead, the Content Per Vehicle should continue growing:

The graph above depicts the Content Per Vehicle per engine type.  Note that past data just documents history, while the future ones are based on the expected revenue from the already existing order book divided by the forecasted global auto sales.  This graph demonstrates two important trends:

1)      The segment will clearly grow even with no growth in auto production.

2)      Many consider the transition away from ICE vehicles and into EVs as a major risk for auto parts companies in general and specifically Linamar.  The logic behind this take (which I don’t disagree with) is that EVs have fewer moving parts than ICE vehicles. The above graph demonstrates that as early as 2023, Linamar will have a similar Content Per Vehicle for EVs as it had for ICE a mere 3 years ago.  This also demonstrates how well Linamar should do in an all-EV future (if and when).  The company’s R&D efforts of developing early on E-Axle, battery housing, Electric motor housing, hydrogen storage tanks and so on, clearly cemented its future growth.

Of course, if auto sales will grow, that will be a positive for the segment’s revenue.  Current new auto inventories in the US (the company’s largest market) are at an all-time low[iii]:

Getting back to the pre-COVID level of inventories would mean tripling the current inventory levels.  According to the last quarterly call, the company believes that getting back to that pre-COVID inventory levels would mean 2 years of elevated auto production.  Since management said that, inventories further collapsed.  Note that this expected elevated auto sales environment is before any pent-up demand from consumers who just do not have the supply available[iv]:

For these reasons I believe that the industry should have at least 3-5 years of strong growth and that Linamar will continue taking share. 

Industrial –

The segment includes SkyJack and MacDon. 

MacDon manufactures and sells combine headers and windrowers.  The reason a farmer would purchase MacDon’s equipment is that it provides a superior yield compared to a generic header.  The headers are normally sold through the combine dealerships and are heavily tied to the combine retail sales level.

Combine sales tend to trend in 7 years cycles that are correlated with the age of the fleet, Ag commodity price environment and so on.  As can be seen in the graph below, the 2018 acquisition seems to have been made in a trough: 

Looking at past cycles and current levels, there could be tailwinds as combine demand increases.

Even though the acquisition was made during a low part of the cycle, the company paid under 10x earnings (not EBITDA, earnings) and used cheap debt to finance the acquisition.

The business plan for this acquisition is not merely to wait for the cycle to turn, but rather, to expand globally and add new products.  The expansion was well under way, but obviously COVID delayed things.  It’s too early to tell whether the acquisition will be a complete home run (successfully adding new products and selling in more countries) or just a great investment (steady state, growing with the general growth in combine sales).  In any case, the debt used to finance the acquisition was already repaid.

As for SkyJack, Abra covered it very well and I do not have a special insight into future trends.  I will just note that United Rentals (a major customer) expects the 2021 gross rental capital spend to be 20% higher than 2019[v].  Linamar itself guided to double digit revenue growth for both 2021 and 2022.  A US infrastructure bill will obviously be positive for this business.

So far in 2021, the annualized growth of this business was 26% yoy.

The next acquisition will likely be yet another industrial company that will be again accretive to earnings and further diversify the company’s businesses.  Earlier this year Linamar issued 10 years Euro denominated debt at 1.3%, so any deal with an even remotely comparable multiple to the one paid for MacDon will be highly accretive.  

Management

Let’s not pretend that Linda’s pick as CEO had nothing to do with her being Frank’s daughter.  However, it’s hard to ignore her 2 decades of track record in which the ROE just kept rising, EPS increased mid-teens annually, and the company expanded globally and diversified into new industrial niches.

Dale Schneider, the CFO, has been in his role just over a decade and seems to have a great grasp of every part of the company.  In addition, he led the charge on improving working capital days.

Linamar’s industry is not the easiest to operate in, so I would struggle not to give credit for this management team when examining the company’s ability to generate high teens ROE over the cycle.

Valuation

If we assume that Linamar’s Mobility segment will grow 2.5% annually from the 2018 level, then the segment will generate $6.5B in 2023.  I suspect that this might prove conservative, because of the industry tailwinds mentioned above, but let’s just use it anyway.  At this revenue level and with 8.5% operating margins (midpoint guidance and below the 8.7% 10 years average, even though scale improved so would expect upwards and not downwards trend), EBIT will be $550M.

On the Industrial side I think a $2B revenue in 2023 would be conservative (1% annual growth from the 2018 level, which implies that combine sales would have been depressed for 9 years).  Again, using mid-range of their EBIT margins guidance for the segment of 13.5% (again, lower than the 14% of the past decade), we get $270M of EBIT from the segment.

This adds up to $820M of EBIT[vi].  Assuming the company doesn’t acquire any business between now and 2023, I expect $1.2B in cash to accrue on the balance sheet by then. Without debt, EBIT approximates EBT.

Applying 23.5% tax rate and adding back $50M of intangible amortization we get $10.5 EPS and $20 / share in cash.  In the last 10 years, the company had an average year high PE of 11 times, so applying this figure would put the stock at $136.

But I doubt that the company will have $1.2B in cash in 2023.  More likely, Linamar will acquire a company.  Assuming 1.5 times leverage ratio post deal, an acquisition at 8x EBITDA and 4% cost of debt, EPS will be $13.  So, we got a company earning $13 / share that can fully repay the debt within 2-3 years.  11 times earnings would get us to $143 / share.

We can also take a stab at the book value for the valuation.  Historically, the company traded above book value every year except for 2019.  In the last 10 years, the average P/B year high was 1.7 and almost every year exceeded 1.5.  Current P/B is under 1.  2023’s yearend BVPS will likely be over $90.  At 1.5 times book, stock can be $135 ps. At 1.7 times book, shares might be trading for $152.

Yet another way of looking at it, is that book value grew ~20% a year in the past decade.  Paying below book value doesn’t feel like a terrible deal.

Additional upside could come from multiple expansion.  11x earnings is not exactly screaming expensive for a company that grows high teens and expands in recessions (through take-over work). 

No matter how we look at the valuation, a double from here would not be too much to expect.

Risks

1)      EVs

a.       As explained above, it is likely more of an opportunity than a risk.  It seems to be the fastest growth area for the company.  In fact, just recently the company announced the formation of a new group focused solely on electrification opportunities[vii].

2)      Dependence on key customers

a.       This applies mostly for the Mobility segment, where the large auto OEMs are the customers (hard to get granularity).  SkyJack sells substantial amounts to the United Rentals of the world.

This is definitely a risk.  I would note that their customers have extremely long-term relationship with Linamar.  In addition, every acquisition helps diversifying into new end-markets and customers.

3)      End markets cyclicality  

a.       All 3 end markets are cyclical, this is an issue that weighs on the multiple.

b.       MacDon actually helps here because its cycles differ from the normal economic cycles (2008, 2011 were great for combine sales example).

c.       Could it be that the market will notice that every recession makes Linamar stronger, larger, and more robust?  Sure, but wouldn’t use it for the base case.  That’s why I use the 11 times earnings as an exit multiple. 

d.       One more point on this.  Yes, Linamar is a cyclical company, but it is also a growth company.  It grew EPS over 16% annually between the cycle-high 2007 and the cycle-high of 2018.  Share price increased 13% annually if you bought at the worst time (highest valuation) of the last 20 years and simply did nothing.  Would be hard to claim any of their businesses are in peak cycle nowadays.

4)      Could there be a better time to buy?

a.       I believe that the auto industry is in a longer than expected chip shortage.  If, for example, it will take 6 quarters for the supply chain issues to get resolved, Mobility’s segment revenue could be temporarily lower over this timespan.  I am not sure if the analysts covering the company fully model this and so I could see a short-term downside to the share price.  I don’t pretend to know whether this is already priced in or not. One can argue that this is the reason for the trough valuation, but in any case, at some point chips’ supply chain issues will get resolved.

If share price drops, I expect the company to resume share repurchases (made a significant amount of repurchases around the GFC).  In any case, this would just make the pent-up demand more extreme, which would be helpful in the longer term.

b.       Note that the stock had materially underperformed the markets YTD and especially since the chip shortage became apparent.  I think that’s part of the reason the opportunity exists.  Before the supply chain issues, on March of this year, the stock touched $92, 40% higher than today.  In the last decade, the company’s PE ranged 5-17x.  At under 8x and an imminent (immediately accretive) acquisition, some negatives are clearly baked in.

Disclaimer:  This is intended for information purposes only (not investment advice) and should not be relied upon as a basis for investment.  The author holds a position in the issuer and undertakes no obligation to update any future changes in the position or in the investment opinions expressed herein.

[i] 2008 showed a negative GAAP result, but adjusted for non-cash impairments, the company was in the black.

Data from the 90s is based on the book “Driven to Succeed: How Frank Hasenfratz Grew Linamar from Guelph to Global”

[ii] Acquisitions contributed somewhat to the 2011 result, but likely to the scope of ~2% of Mobility’s revenue at the time.

[iii] https://fred.stlouisfed.org/series/AUINSA

[iv] https://fred.stlouisfed.org/series/TOTALSA

[v] https://www.sec.gov/Archives/edgar/data/1047166/000106770121000030/uri-6302021xex991.htm

[vi] Note that corporate overhead is already incorporated to the segment’s costs.

[vii] https://www.linamar.com/wp-content/uploads/2021/09/eLIN-Group-Press-Release-FINAL.pdf

Catalyst

Catalyst?  Possibly the opposite of a catalyst…  The next 12 months will not look good (slowdown in auto manufacturing due to chip shortage).  Arguably at under 8 times TTM earnings and EPS that should grow 50% from current levels once chip shortage abates, this is already priced in, but there could certainly be better entry points in the next 12 months.

The closest to a catalyst would be:

1)      Chip shortage gets resolved.

2)      An Acquisition.

3)      Revenue growth:

a.       Auto inventory replenishment + pent up demand materializing pushing Mobility revenues far higher + continue gaining share.

b.       Combine sales rebound drive MacDon revenue growth.

4)      Potential for buybacks on stock weakness.