Description

Martinrea International Inc. (“Martinrea” or the “Company”) is a Canadian-domiciled tier one automotive supplier. Shares currently trade for less than 5x 2017E earnings, a significant discount to both competitors and intrinsic value. With an improving leverage profile, accelerating free cash flow generation, and expanding margins, I expect this discount to narrow materially going forward.

Martinrea operates in two primary segments: metal forming services and fluid handling systems. The metal forming business produces a broad range of steel and aluminum parts and assemblies including engine blocks, transmission housings, suspension arms, cradles, frame rails, and crossmembers. The fluid handling systems business also produces a wide range of products (hoses, tubes, and assemblies) for fuel, oil, engine cooling, HVAC, and hydraulic subsystems. The Company has a global presence, with 44 facilities spread across four continents and eight countries; however, North America is by far its largest region, accounting for 36 of the 44 facilities and over 80% of consolidated revenues. Martinrea is a top three supplier in North America in both of its primary segments.

Martinrea’s genesis as an automotive supplier was in 2001, when it was co-founded by Rob Wildeboer, the current Executive Chairman, and two former colleagues from Magna International Inc., another Canadian tier one automotive supplier. Through a combination of organic growth and a series of acquisitions over the subsequent decade, the Company grew from roughly C$200 million in revenue in 2002 to nearly C$4 billion today. Martinrea’s most recent acquisition of size was the 2011 purchase of Honsel AG (“Honsel”). The purchase of Honsel, which was accomplished through a bankruptcy proceeding, was transformative for Martinrea as it brought aluminum casting and machining competencies to the Company’s metal forming segment. Aluminum content per vehicle has been growing quickly, and will likely continue to do so, given its favorable strength-to-weight ratio versus steel and the associated beneficial impact on vehicle fuel economy.

An aggressive acquisition program can admittedly be a yellow flag for investors, given that it increases the risk that shareholder value will be destroyed through poor capital allocation decisions. However, the Martinrea management team has minimized this risk through a disciplined M&A approach focused largely on the purchase of distressed assets. By capitalizing on turmoil among automotive suppliers over time, Martinrea has built the metal forming side of its business through purchases where acquisition consideration is primarily for hard assets and not intangibles. This approach increases the likelihood that management has paid a fair value for the underlying assets, and minimizes the possibility that future write-downs may be necessitated as a result of overly optimistic financial expectations and associated aggressive purchase prices.

Notwithstanding Martinrea’s relatively lower risk approach to M&A activity, the Company suffers from a valuation discount in the public market. This is due to several factors, the most significant of which I believe are questions over the inherent quality of the underlying business, as well as concerns that the Company’s acquisition activity has made it difficult to accurately discern the relevant underlying core trends. Although Martinrea’s last material acquisition (Honsel) was completed in 2011, it has continued since then to build additional manufacturing facilities to provide the capacity necessary to address major new business awards. A combination of the ongoing integration of prior acquisitions and the ramp up of the newer manufacturing facilities has led to suboptimal utilization levels, which in turn have negatively impacted the Company’s return on its invested capital. Management has undertaken a disciplined approach to address this issue by deemphasizing, in the near-to-medium term, additional acquisition activity and, instead, focusing on optimization of the existing asset base. With the major new business launches now in the rearview mirror, management has more recently been able to focus the Company on increasing its utilization levels and optimizing manufacturing processes – initiatives which have helped drive major improvements in product quality and a nearly 50% improvement in the Company’s operating margin since 2012 (EBIT margins have moved from 3.4% in 2012 to 4.9% on an LTM basis). Near-term goals are targeting a 20% minimum additional improvement in margins. Improving margins on a relatively static asset base should enhance both return on invested capital and free cash flow generation, each of which will likely drive increased investor confidence and an improvement in the Company’s trading multiple going forward.

The market is also currently anxious about how the Trump administration’s trade policies may impact the automotive ecosystem (and, by extension, Martinrea). While it would clearly be foolish to dismiss this risk outright, I am cautiously optimistic that the eventual impact will be muted. From a qualitative level, those responsible for actual policy (Trump’s economic advisors/appointees and Congress) are materially more free trade-oriented than Trump himself appears to be. Trump is going to find it impossible to micromanage companies on a case-by-case basis, and my belief is that as long as he can garner a few high profile “jobs” headlines here and there, actual policy changes will be modest and incremental. In addition, Trump’s rhetoric to-date seems to be more focused on punishing companies that offshore existing jobs from the U.S., as opposed to those that already have non-U.S. locations. There are also legal impediments. Outright tariffs will not likely pass WTO scrutiny, and border tax adjustment is legally suspect from a WTO perspective as well. By some estimates, there are parts in a given vehicle that have crossed international borders as many as seven times before reaching the end consumer. Unwinding these supply chains would wreak absolute havoc on the automotive industry, not to mention they would drastically increase end cost to the consumer. Any material increase in prices will sap demand, thereby poleaxing the industry Trump has been most vocal about “saving”. Lastly, with respect to Martinrea in particular, the Company’s North American footprint positions it reasonably for a range of potential outcomes. Martinrea has 13 facilities in Canada, 14 in the U.S., and 8 in Mexico. With early indications out of the Trump administration that there may be one-on-one renegotiations of NAFTA provisions between both Canada and Mexico, respectively, Canada is likely to fare better than Mexico. As such, Martinrea’s heavy US/Canada weighting (vs. Mexico) is reassuring. And lastly, the Company can always move equipment across borders to the extent necessary to respond to changes in the tax and/or regulatory environment.

Today, Martinrea trades at under 5x 2017E (consensus) earnings and a discount to its tangible book value. This earnings multiple represents a discount of roughly 45% to a comparable group of metal forming and fluid systems competitors, and a discount of nearly 60% to a broader group of auto parts suppliers. The Company also trades at a material, though smaller, discount to comparables on an EV:EBITDA basis (25% and 40%, respectively). Leverage ratios, currently at about 2x debt:EBITDA, have come down consistently over the past two years after peaking with the buy-in of the outstanding minority interest in Honsel in late 2014.

There are legitimate reasons to question the growth prospects of the North American automotive industry given that current unit volumes may be near peak levels. However, with Martinrea’s favorable relative positioning vis-à-vis its aluminum fabrication capabilities, I believe that the sizable discount to competitors is unwarranted. With continued improvement in operating margins, return on capital, leverage, and free cash flow generation, I expect this valuation discount to either narrow or disappear over time. In the interim, Martinrea’s hard asset value should help provide downside protection in the event of greater-than-expected headwinds for the broader North American automotive industry.

Catalyst

Continued margin expansion. Delevering. Favorable resolution of current uncertainty surrounding Trump/trade/tariffs, etc. Eventual more aggressive deployment of capital to equity holders.