Description

Investment Opinion: MPAA is a beaten down small-cap stock with a:1) mis-priced traditional business that provides upside potential and an underlying margin of safety and 2) a free call option on turning around a recent acquisition. Over the last 18 months the shares dropped by ~60% tied to a series of disappointments associated with a major acquisition (Fenco) that the company is digesting. No doubt the headlines have been messy as the company has been forced to take on a significant amount of debt, raised equity capital, delayed its SEC filings, reported large losses over the last few quarters and trimmed its forecasts for the merger. However, despite all the problems associated with the acquisition, when you peal back the onion, you see the company’s traditional rotating electric business has performed well and its intrinsic value has strengthened. I believe that the underlying value of this business is above the current share price and that the Fenco acquisition is being accorded negative value. With the Company beginning to make progress on its integration plan for Fenco and bringing its filings up to date, I believe investors will begin to look through the noise and value the Company’s rotating electric business more appropriately. Based on its profitability and private market values, I believe the rotating electric business is worth about $8-$10 per share. Success in streamlining its Fenco acquisition is somewhat of a free call option and could lead to further appreciation in the share price. With an EV of only $194 million and potential EBITDA for the combined company of +$50 million (representing an EV/EBITDA multiple of ~4x), upside in the share price of 50%-100% is reasonable if evidence suggests these financial estimates are achievable.

Key Statistics:

Profile: MPAA is a leading re-manufacturer of replacement automotive parts and sells to a base of large retailers (serving the “do-it-yourself” market), warehouse distributors and professional installers (serving the “do-it-for-me” market). With the acquisition of Fenco in May 2011, the Company diversified from its traditional market focus on selling rotating electric products (primarily starters and alternators) to include a range of “under-the-car” products (steering, braking, wheel hubs, clutches and drive shafts) as well as distributing some “new” products. The re-manufacturing process takes defective cores from cars or light trucks and rebuilds them to meet or exceed OEM specifications. Re-manufacturing creates a supply of replacement parts, especially for older model cars, that are no longer available from the automotive companies. Acquiring used cores and maintaining a broad assortment of product for most vehicles are important competitive factors. The Company carries over 13,000 SKU’s for a broad range of cars and light trucks. In the rotating electric segment of the market, MPAA is the third leading vendor of product behind Remy International and privately held BBB Industries and significantly trails Cardone Industries (private) in the under-the-car segment of the market. Some of the industry factors that have helped grow the market for re-manufactured products include: the aging of the vehicle population, the increased complexity of vehicles, the number of miles driven, economic conditions and weather. The following sections highlight some of the key points behind my positive view on MPAA.

Acquiring Fenco Provides A Strategic Fit, But Integration Challenges Lead Investors To Bail Out: After a period of relatively good growth and improved profitability following a transition of its manufacturing to Mexico & Malaysia and a streamlining of its supply chain in the late 2000 period, MPAA announced in May 2011 its acquisition of Canadian based Fenwick Automotive Products Limited (Fenco). The merger offers a number of appealing attributes. Fenco enables MPAA to expand into a higher growth tangential segment of the automobile re-manufacturing industry selling a new set of “under-the-car” products (steering, braking, wheel hubs, clutches and drive shafts) that complement its rotating electric products (primarily starters and alternators). Additionally, the merger opens up new cross-selling opportunities within each customer base and better positions the Company to increase its penetration of customers in the “do-it-for-me” auto repair market. By transiting Fenco to lower cost manufacturing operations, reducing redundant overhead and improving its supply chain and systems, MPAA expects to turn Fenco’s money losing operations around. Management issued guidance that following a two year transition period, Fenco should contribute incremental EBITDA of $20 million annually. The purchase price of 360,000 shares, equating to about $5.3 million, suggests a very attractive purchase price upon realization of Fenco’s profit goals.

However, like most big acquisitions, the Fenco merger, which doubles the size of the Company, came with big problems that may not have been visible at first. Turning around Fenco has proven to be more challenging and more costly than management expected. As a result of sloppy accounting (especially for core inventories) and systems, MPAA was forced to delay its SEC filings. The initial losses from Fenco’s operations proved much deeper than most investors were expecting. The terms on the debt that the Company had to accept were quite high. On top of this, management came to the conclusion that certain Fenco product lines had to be divested and modestly reduced its forecast for the EBITDA contribution from the acquisition. With all the negative news and Fenco appearing to be an anchor ready to take the whole ship down, investors bailed out of the stock and sell-side analysts dropped coverage. After a brief rally in the stock to ~$16 per share following the merger announcement, the shares declined on the continued spade of bad news to ~$4-5 per share in Fall 2012. With the tide beginning to turn more favorable and the stock recording only a slight rebound from recent lows, the shares should appeal to contrarian investors. Consistent with this thought, I am reminded by a quote from Howard Mark’s of Oaktree Capital who said: “We like to buy things when everybody says ‘no way’, and sell them when everybody says ‘no sweat’.” 

Despite All The Noise At Fenco, MPAA’s Core Business Remains Healthy: While most investors have been focused on all the problems at Fenco, business fundamentals at the Company’s traditional rotating electric business have remained very healthy. Noteworthy, management’s guidance from its last conference call on November 28^th suggests that this business is poised to report record results in its soon to be reported September 20012 quarter. The following table highlights the results from the Company’s rotating electric business pre and post (beginning in FY 12) the Fenco acquisition for the fiscal years ended March along with my estimate for the current year (already six months completed).

The figures highlight a number of important points relative to MPAA’s rotating electric business, including:

• Revenues show a business with moderate growth and some recession resistant characteristics.
• The profitability shows both the healthy returns in the business and that despite all the issues at Fenco, not only has this business remained unaffected, its EBITDA margins have risen during the Fenco integration.
• Relative to the major competitors in this business, EBITDA margins exceed those at its close competitor Remy International (which have ranged from 9.4% to 13.8% over a similar period) as well as most automotive parts retailers and manufacturers/OEM’s (see table below).

An Undervalued Asset And A Margin Of Safety: So what is MPAA’s rotating electric business worth? I believe the best way to properly value this business is to look at its profit in the eyes of both a private market buyer and public equity investors. Research shows that the automotive aftermarket industry has historically attracted a fair amount of M&A activity, especially from the private equity community. My discussions with knowledgeable industry sources and due-diligence relative to prior transactions in the sector suggests a multiple of ~6.0x-6.5x EBITDA is reasonable. Applying this multiple to my EBITDA estimate of $37.8 million for the Company’s rotating electric division for the current year suggests a price of $8.40-$9.70 per share for the equity. However, this value may still be conservative. It is important to note that MPAA structured its Fenco division as a separate subsidiary, where its debt is non-recourse to the parent company. Thus, a buyer could acquire MPAA just for the rotating electric business and shut down or sell off Fenco to reduce its debt load of ~$57 million (based on the latest public information). Even considering an increase in debt at the parent level since the latest filing, my analysis suggests that by doing this, a buyer could pay in excess of $10 per share at the same EBITDA multiple. Additionally, Fenco has NOL carryforwards on its books in excess of $40 million to shield future profits, which could be valuable under certain sale conditions.

Another way to look at valuing this business is by estimating what public equity investors would pay for it based on GAAP earnings. Earnings from MPAA’s core rotating electric business (including the incremental debt load during the Fenco integration held at the parent company) were $0.96 on a ttm basis (thru June) and are projected to about $0.87 for the full year. As illustrated in the following table, the leading automotive parts retailers (with EBITDA margins about similar to MPAA’s rotating electric division) trade at approximately a mid-teens P/E multiple. Relative to the public automotive parts/OEM vendors (who on average have EBITDA margins only approximately half as much as this division) trade at an average P/E above 10x GAAP earnings. Thus, valuing this division’s GAAP earnings (including the recent increased debt/interest) would translate into a price of $8-$10 per share. Moreover, if you reduce the debt (and associated interest costs) back to pre-acquisition levels, earnings power for MPAA’s rotating electric division would jump to approximately $1.25-$1.30 per share. On that basis, the shares are currently trading at only ~5x the earnings power of this division.

This analysis illustrates the key tenant of my investment thesis on the shares of MPAA. I believe the shares are mis-priced because investors have not recognized the earnings power of the Company’s rotating electric division and properly valued it, while according negative value to the MPAA’s Fenco operations. With MPAA’s share price significantly below the intrinsic value of this division, I believe the shares are mis-priced. Additionally, as no value is currently being accorded Fenco’s operations, investors have a free call option on a potential turnaround of this business. 

Fenco Represents A Free Call Option That Could Lead To Significant Share Price Appreciation: My investment thesis on the shares of MPAA is not centered on turning around Fenco’s operations. However, success on this issue would be an additional catalyst and provide further potential upside to the share price. To say the least, Fenco’s results have been quite messy during the last 18 months since the acquisition was completed. The good news is that from the breakouts in the Company’s filings and based on management’s commentary, it appears that progress is being made. Noteworthy, the operating loss from this division and extraordinary charges (thru the June report card) have begun to decline as cost initiatives and restructuring efforts begun to take hold. To date MPAA has transitioned Fenco’s operations to new ERP, accounting and warehouse management systems, closed or discontinued unprofitable product lines (i.e. axles and clutches), and reduced the use of outside sales and support personal. Initiatives are currently in progress to consolidate its logistics and supply chain and make significant cuts to duplicate staff. The final phase of the transition, which will begin in the new calendar year, will entail eliminating unprofitable accounts and phasing in price adjustments to be followed by consolidating manufacturing and warehouses. Management has a goal of completing these initiatives by the two year anniversary of the acquisition in May 2013, with expectation that Fenco will be at an annualized EBITDA run rate of $15 million beginning at this time. While the September results are expected to show some further progress in reducing Fenco’s operating loss, management believes more significant progress will be evident in the December quarter with EBITDA getting close to breakeven. While there is clearly execution risk associated with hitting its financial target by this time, this level of profitability (an EBITDA/revenue margin of ~11%) appears consistent with its product mix and the financial profile within the industry. Knowledgeable industry participants I have spoken with have not downplayed the significant challenges that the Company is currently experiencing and has to work through before turning Fenco around, but also suggest that there is room in this market for another healthy competitor. 

We should be receiving a fair amount of evidence as to the progress management is making in turning Fenco’s business model around over the next few months. Management hopes to get Fenco to a breakeven EBITDA level in the March 2013 quarter and hit its run rate goals by the end of May. Should management be successful in getting Fenco’s operations to breakeven, it would clearly be a major catalyst for the stock. Importantly, once Fenco is profitable, it will give the Company some new options relative to its debt. Management has stated its intent is to use its cash flows to pay down its credit line and to restructure the Company’s high priced debt at the corporate level. If management is successful in delivering its stated run rate EBITDA of $50 million for the combined operations, it would be an additional catalyst for the stock. The current enterprise value of approximately $194 million, which represents a ~4x multiple, suggests that this level of profitability for the combined company is not being discounted in the stock price. 

Management’s Past Success In Restructuring Its Business Gives Some Credibility In Turning Around Fenco: One thing that should give investors some comfort that the turnaround plan for Fenco is achievable is the past success management has had in a multi-year transition of their manufacturing operations from California to Mexico and Malaysia during the mid-2000 time period. This transition was driven by the inroads that Asian manufactured “new” products were having in the automotive replacement market. These “new” replacement products, not manufactured by the original OEM’s or up to the same standards as original equipment, found appeal with customers as they closed the price gap relative to the price of re-manufactured products. A number of the leading re-manufacturers in the industry, including MPAA, reacted to this competitive threat by moving to lower cost manufacturing facilities. Given its close proximity to theUS and its highly skilled workforce,Mexico was the country chosen by MPAA and other re-manufacturers. The Company helped fund the transition through a line of credit. The Company began its transition in June 2005 and achieved its goal of manufacturing 95% of its products offshore by the end of fiscal 2008 (March). This manufacturing and supply chain transition improved MPAA’s business model by lowering its cost structure and better positioning the Company from a competitive pricing perspective. However, from a financial perspective, the costs associated with this transition had a negative impact on profitability, especially in and around the fiscal 2007 period. During this period, which was followed by the meltdown in the financial markets, these issues lead to a nosedive in MPAA’s share price. Subsequently, with improved profitability and a reduction in debt, the share price began a significant rebound to near record levels. 

Customer Concentration, Not As Big An Issue As It First Appears: Like most automotive replacement parts manufacturers, MPAA derives a significant portion of its revenues from a handful of the leading automotive parts retailers. In the latest fiscal year, 69% of revenues came from the top four retailers, with the largest customer, AutoZone (not named by the Company), accounting for 41% of sales. This level of customer concentration, especially with AutoZone, represents somewhat of a risk. However, things may not be as concerning as they look on first blush. There are a couple of points investors should know. Aided by the Fenco merger, which helped MPAA expand its customer to a more diversified base of retailers and distributors, the Company’s customer concentration has been steadily declining over the last few years. This is illustrated in the data that shows that in fiscal 2005, MPAA’s top three customers accounted for 93% of revenues, while AutoZone alone comprised 72% of sales. Importantly, in January 2010 MPAA resigned a new ten year supply agreement with AutoZone. 

However, there is a more important point that helps mitigate MPAA’s customer concentration risk. During the last decade, MPAA and the industry transitioned to differently structured supply agreements with the major retailers. Longer multi-year agreements were welcome by the suppliers. On the other hand, the major retailers required their suppliers to provide more competitive prices and more attractive terms. Among other things, suppliers, like MPAA, had to agree to accept 52-week A/R terms and basically own the core inventory held at the retailers. These agreements have assisted the retailers in moving to a just-in-time inventory model; allowing them to reduce their working capital needs and increase cash flow. Thus, this inventory on MPAA’s books really represents future sales and provides somewhat of an insurance policy to dampen the effect of any discontinuance of their supply agreements. Regarding MPAA’s core exchange agreement with its major retail customers, the Company’s SEC filings state:

• “The Company does not expect to realize cash for the remaining portion of these Remanufactured Cores until its relationship with a customer ends.”   
• “The customer is obligated to repurchase the cores in the customer’s inventory upon termination of the agreement for any reason.”

Given the large amount of re-manufactured core inventory held at customer locations, any curtailment in its retail supply agreements would add up to a significant cash infusion to MPAA’s balance sheet. The latest SEC filings show the inventory that the Company is holding for its retailers is $121 million. On a per share basis this represents ~$5.77 of cash. Using the customer concentration data from the latest 10-K as rough proxy to gauge the impact for individual customers (which may not line up perfectly), shows that if its purchase agreement were to end, AutoZone would have to repatriate the Company ~$3.42 per share in cash. Noteworthy, MPAA’s 10-K refers to this as: “a possibility that the Company considers remote.” Thus, while the loss of AutoZone, or any of its major retailers, would not be a welcome possibility and would clearly negatively impact MPAA’s business model, the terms of the agreement mitigate the impact somewhat. I do not believe the structure of these agreements are properly understood by investors and in a worst-case basis, the cash value of these agreements provides investors some downside protection.

Debt Is The Biggest Risk/Issue To Monitor: There are a number of inherent risks to an investment in MPAA. Some of these include: execution issues in streamlining Fenco’s operations, slowing industry growth, competitive challenges, customer order disruptions and global economic conditions. However, the most visible risk is clearly the increased debt at the Company post the Fenco acquisition. The two big issues are the level of the debt and its high cost. In order to help fund the turnaround efforts at Fenco and insure no customer service issues arise during the transition, MPAA needed to significantly increase its debt in the last few quarters. MPAA’s total debt has increased from about $7 million prior to the merger to approximately $141 million (as per the latest June filing), while the recent losses have dropped the Company’s shareholder’s equity position from approximately $117 million to about $77 million over the same period. Net debt has increased from $5 million to $105 million over this period. This increase in debt, combined with it’s A/R factoring costs, have had a significant impact on profitability.

MPAA’s traditional rotating segment and Fenco’s undercar segment have separate bank facilities. Based on the last filing, about $85 million of the debt is held at the parent company level and roughly $57 million is held at its Fenco subsidiary. Importantly, the non-recourse structure of these loan agreements shield the parent company from credit repayment issues at Fenco. This should give investors some comfort as it would allow MPAA to continue to operate as an on-going entity should management not be successful in restructuring the Fenco business and allowing it to meet its debt obligations. However, the issue that has been concerning to investors has been the cost of the debt that MPPA was forced to accept. The debt at the parent level carries an average rate of about 10.5% (LIBOR plus 8.5%). In addition to greater interest costs, the rate on the debt highlights the perceived risk in the eyes of outside lenders of the challenges the Company faces during this merger transition. The debt at Fenco carries an interest rate in the mid-5% range while the Company factors it’s A/R’s at a rate of approximately 3.5%-$4.0%.

Management has guided that debt is projected to increase further thru year-end to fund an increase in rotating electric inventories and peak at a net debt level of $120 million in the December quarter. Management’s goal is to rapidly pay down its bank lines and restructure its debt as soon as possible. Once EBITDA profitability at Fenco is reached and inventory levels at its rotating electric business return to more appropriate levels (beginning in early calendar 2013), the Company will start to have the cash flow to begin paying down its credit lines. Thus, until significant progress in made by management in turning Fenco around and reducing/restructuring its debt burden, this issue is likely to be a concern and weight heavily against the share price. 

Catalyst

A Number Of Potential Catalysts On The Horizon: I believe there are a number of potential catalysts on the horizon that could help turn investment sentiment more favorable on the shares and help drive the share price higher. These include:

• The Company becoming current on its SEC filings should be viewed that there are no more skeletons hidden in the closet at Fenco and increase the reliability of information. Management expects to file its 10-Q for the September period sometime before calendar year end 2012.
• Further evidence to suggest that business fundamentals at the Company’s core rotating electric business remain healthy. Given managements guidance on its last conference call suggesting that this business will have a record quarter in the September period, this information should provide investors better information to value this business more appropriately.
• Any signs that overall debt levels have peaked (with a target for the December quarter) or are declining will be well received by investors.
• Regarding Fenco, the first milestone for management will be turning its under-the-car operations to breakeven on an EBITDA basis (targeted in the March 2013 quarter) and providing evidence to support achieving its targeted EBITDA contribution of $20 million from this business.
• Successfully restructuring the Company’s high cost debt and/or re-capitalizing its balance sheet (possibly in mid-2013) will be a clear sign that the merger has been a success, drive a fair amount to financial leverage and move investors to view management’s EBITDA targets for the combined company as a basis for re-valuing the stock price.