Description

A poorly-positioned vendor to the big auto DIY retailers with LTM earnings that could be as much as ~85% overstated

MPAA sells remanufactured auto parts (primarily starters and alternators), mostly to AZO, AAP, and ORLY (~85% of sales to these 3). Remanufacturing involves salvaging reusable components of auto parts and combining these with new components to make an aftermarket auto part.  

We believe MPAA’s LTM EBITDA could be overstated by as much as 85%+ due to its:

1. Capitalization of costs via “core” inventory, and;
2. “One-time” adjustments that resemble ongoing costs of doing business.

Further, MPAA has generated a cumulative negative $35mm of FCF since Jan. 2014, providing a measure of validation directionally to our forensic accounting analysis.

Below we haircut our adjustments by one-third for conservatism, and deduct this amount from the Street’s NTM Adjusted EBITDA estimates. We then value MPAA at 7x this adjusted NTM EBITDA, yielding a target price of $13, or ~50% lower than MPAA’s current price.

D = A – [66.6% * (B+C)]

Capitalization of Core Inventory

MPAA’s accounting is not straight-forward, and the source of much investor confusion.

Some explain MPAA’s core inventory accounting by simple analogy: the “core” of its remanufactured starters or alternators are akin to a keg shell (i.e. recyclable part of its manufacturing process).

But there’s a glaring limitation to this analogy.  An MPAA “core” (the salvageable part of a given starter or alternator) eventually becomes obsolete as new car models (or model platforms) are released, and the number of cars on the road under the old model diminishes.

At a high level, the value of “cores” (or keg shells) on MPAA’s balance sheet should therefore grow in concert with sales. It would be problematic if the “Days sales inventory” of core inventory grew rapidly. This could suggest MPAA’s balance sheet is becoming a graveyard for obsolete cores and/or the capitalization of the costs of the remanufacturing process and logistics.

Given the finite life of cores (versus the theoretically infinite life of keg shells), it’s important to see cores exiting the closed-loop system at various points (i.e. with the consumer, off MPAA’s balance sheet via write-downs, via a competitors unseating MPAA, etc.); and all the while, MPAA’s sales should march along with the amount of cores on its balance sheet.

Looking through MPAA’s complex accounting, however, we see cores piling up on their balance sheet (by more than can be explained by growth):

“Core DSI - as reported” (I) =   A /C

“Core inventory – as adjusted” (B) = (G*C)/360

“Total Adj. to Core Inventory” (E) = A – B

Incremental Adj. to EBITDA (F) = Et – Et-1

Adj. EBITDA less inflated Core Inventory (H) = D – F

% difference = H/D

Z: In the most recent quarter, “Long-term core inventory” has been reclassified within “Inventory – net” and “Contract Assets”. We have to make an assumption for how much of the increase in “Inventory-net” is related to the reclassification of “Long-term core inventory”. $80mm is the non-core inventory in the MRQ that would keep y/y non-core inventory DSI flat.

In the above table, we estimate how much MPAA’s LTM EBITDA may be overstated from “cores” piling up its balance sheet. We take Core DSI in Fiscal year ending in March ‘14, and keep it constant through time, using it to calculate what Core Inventory would have been at a constant DSI. We then calculate the possible contribution to gross profit from MPAA’s failure to write-off old cores. We then compare this amount to LTM EBITDA.

In the below section, we also show how MPAA is writing-down inventory at an increasing pace (via the lower of cost and market revaluations). And even so, it appears it isn’t writing down the value of their inventory fast enough (to the benefit of its adjusted results, but at the expense of future earnings).

“One-time” items that are an ongoing cost of doing business in the hyper-competitive landscape for shelf space among DIY auto retailers

MPAA’s adjusted results have also included serial add-backs. The adjustments we take issue with fall into three general categories.[1]

1. Customer allowances – when MPAA wins shelf space with ORLY, AAP, AZO, they unseat an incumbent (like Remy). For awarded business, MPAA must a) make payments to its customer for the business awarded, and; b) take the incumbent’s inventory onto its balance sheet (which it then tries to liquidate, but often at a discount to cost). The scope and frequency of these expenses within MPAA’s results would alone suggest they are something more than the non-recurring, upfront expense that MPAA bills them to be.
2. Stock adjustment accruals/initial returns – these are the remittances or costs associated with extracting the inventory from the incumbent’s ERP system and supply chain into MPAA’s. These expenses are part and parcel with Customer Allowances.
3. Inventory revaluation to lower of market and cost – just what it sounds. And core inventory valuations are highly-subjective estimates, given cores exist within a closed loop system, free of price discovery in an open market. Valuations of cores, therefore, are messy extrapolations of the limited cores that do trade hands in an open market, or are simply “SWAG” estimates. This fact considered along with MPAA’s booming core inventory should be enough to raise eyebrows.  

Here’s the amount by which we believe LTM EBITDA has been overstated over time due to these three items:

Channel work on Competitive Dynamics

The remanufacturing space has consolidated to four major players:

• MPAA;
• BBB (Private; Pamplona Capital Management-backed);
• Remy (was purchased by BWA; in 10/16 BWA sold the aftermarket biz of Remy to Torque Capital Partners);
• Cardone (Privately-held and family owned).

Cardone doesn’t compete within remanufactured starters and alternators. In this space, MPAA and BBB Industries are clear market leaders, with Remy third, and having lost share since becoming part of BWA and now under PE-ownership. We estimate a market share split in starters and alternators of roughly 45%/35/20 for MPAA/BBB/Remy. We believe MPAA has been up until now the biggest benefactor of Remy’s conceded share, at least from a top-line standpoint.

In October 2016, BWA divested of the Remy aftermarket business to Torque Capital Partners. In Aug. 2017, BWA noted on an investor call, “We did dispose of the [Remy] aftermarket business, which is about $300 million in sales…That wasn't really a good fit for us, and the added benefit was we disposed of $300 million sales with basically no margin.”

BWA sold the Remy aftermarket business for $80mm cash. At the time, the sold business did ~$308mm in LTM sales (and BWA transferred $95mm of inventory off its balance sheet).

The massive discount which Remy sold for versus MPAA’s current multiples, as measured by P/S and P/B, is unjustified in our view by any differences in the relative quality of the businesses.

Also, Remy at the time of its sale had a DSI about ~1/3rd the size of MPAA’s current DSI, further reinforcing our concern that some of the core inventory on MPAA’s balance sheet could be obsolete or more aggressively accounted for than normal.  

A Includes all inventory categories divided by LTM sales

B Source: Factset

C BWA sold its aftermarket business for $80mm cash, and took a $127mm impairment at time of sale.

BWA is talking above about a business very similar to MPAA’s. And MPAA recorded ~16% adjusted EBIT margins in the most recent fiscal year (despite generating no FCF) vs. BWA saying its comparable Remy business basically broke even. Granted MPAA operates with slightly more scale, and they have been growing where Remy has been shrinking. But we believe operating leverage and negative absorption alone could not possibly explain such drastic margin differences among two businesses that are so similar.

In addition to having no experience in aftermarket, the challenges BWA likely saw with the Remy business include:

• ROIC in this business has diminished over time, given the increasing working capital demands placed on vendors by their customers (see next section);  
• Our channel work suggests MPAA and BBB are having to make greater concessions over time to win new business (i.e. via Remy’s share donations):
  • MPAA bills many of these concessions as “upfront” and one-time, in return for a long tail of sticky, profitable business.
  • But our fieldwork suggests that the guaranteed length and profit of guaranteed business has shrunk over time, as MPAA’s retailer customers have grown in power.
• Our checks suggest there’s a higher probability today more than ever before of a change in vendors upon contract rebids:
• AAP, ORLY, and AZO are lessening their loyalty to vendors, and flexing their hard-earned power from further industry consolidation;
• This puts inventory-obsolescence risk disproportionately on vendors, as this risk in the past was partly shared via renewal terms within an ongoing partnership, and;
• Less customer loyalty towards vendors ultimately means more costs for them.
• Finally, while this is less true for “starters and alternators” product, auto retailers are increasingly finding cost-competitive “new” alternatives from China for certain products that were previously the domain of the remanufactured industry.

For these reasons, MPAA has found itself in a “prisoner’s dilemma” in recent years, when it comes to new business up for rebid (whether that be its own business at risk of loss, or BBB/Remy business it’s trying to capture):

• The costs of losing business are becoming so acute that the best option is to rebid business at lower and lower margins (and yet MPAA has kept these higher costs/lower margins hidden in its adjusted income, but they are readily evident in its anemic FCF);
• The costs of a lost contract, for vendors like MPAA, include:
  • the lost sales with customer (the most obvious);
  • the inventory, paid for and taken from you by the winner, typically gets sold at a discount back into channels you have to compete with resulting in more lost volumes, and;
    • Inventory destocking at customers like AAP have only worsened these dynamics

Shifting balance of power

Perhaps better appreciated among investors is how the Accounts Payable-to-Inventory ratio for AAP, ORLY, and AZO over time has been rising, as these mighty retailers have consolidated and extended payables and destocked inventory. This trend has adversely impacted smaller vendors like MPAA.

Some believe this trend is stabilizing, but our channel checks suggest AAP is likely to remain in inventory reduction mode for years to come, particularly for products like the ones MPAA sells.

Perhaps less appreciated, though, are further ways that MPAA’s competitors have flexed their muscles in recent years:

• The first way relates to “core” deposits. Recalling the keg-shell analogy, customers like AZO historically would pay cash deposits to MPAA for the cores they received.
• They would then pass-through these costs to consumers, something plainly evident on retailers’ websites.

Source: https://shop.advanceautoparts.com/

• However, these are slow-turning items. A few years ago, MPAA’s customers realized they were financing the core deposit over the ~18 months it took the MPAA product to turn, something they didn’t like.
• Changes were made; and our research suggests reman companies like MPAA are now in many cases being asked to finance this deposit.
• One way we believe MPAA is doing this is by offering “rebates” to its customers. How it works:
  • Instead of getting cash for core deposits, MPAA gets an A/R;
  • Over time, though, instead of making good on these inventory core deposits with a cash payment, customers would cash-in awarded rebates (which net against MPAA’s A/R);
  • Simply put, MPAA went from getting ~$20-40 in cash for a core deposit upfront for every core it sent to a customer to not getting, it seems based on our research, any cash at all;
  • This is one reason we believe MPAA’s FCF has perpetually trailed its adjusted income (which we believe adds-back the “rebates” as part of the aforementioned “Customer Allowances” it makes to win new business);
  • This is another way of showing how MPAA might possibly be characterizing a price concession incurred over time as an upfront, one-time cost.

The reason this dynamic is not readily apparent in MPAA’s accounting, however, is because they use a large factoring program (and because the rebates are contra-asset accounts buried in what little net A/R remains for them post-factoring).

The factoring program arose because MPAA’s customers used their power to stretch payment terms to ~360 days.

MPAA’s factoring allows it to get paid right away by a bank partner net of a discount. That bank partner then collects receivables from MPAA’s customers 1-year later. This allows MPAA to finance its A/R using the strong credit rating of its powerful customers. There is nothing unusual about this program. And further, when interest rates were so low, MPAA didn’t mind the small ~2% concession it was making.

But this program obscures the increasingly-onerous working capital requirements MPAA’s customers are placing on it. MPAA is not only housing on its own balance sheet its customers’ inventory for the ~12 months it takes to turn, but they’re also being asked to wait 1-year to get paid or to pay a discount to get paid sooner. Finally, since their customers are also their largest raw material suppliers, MPAA has only about ~2 months of days sales payables (so no opportunity to finance inventory and A/R investments that way).  

Also, with rising rates, the cost of that factoring program is only getting more expensive, or the discount MPAA is having to offer its customers is rising. This dynamic is yet one more underappreciated headwind to MPAA’s future returns on invested capital.

Valuation

Our assumptions:

• We give MPAA credit for hitting the high-end of its sales range (i.e. 8% growth) in the fiscal year ending in March 2019.
• The following year we grow sales at GDP (this is a mature category, where the only growth in excess of GDP would come from share gains from Remy. But as stated above, we think share gains – if any – come at a cost, i.e. low-margin business).
• We run through COGS ~$20mm of the capitalized costs we estimate are sitting on MPAA’s balance sheet from excess cores. This results in 200 bps gross margin compression p.a. in the fiscal years ending in Mar. ’19-’20 (bringing gross margins to 24.6% by Mar. ‘20).
• We run serial “one-time” add-backs back through the income statement, resulting in a further $26mm expenses or 540bps of total margin compression.
• This takes MPAA’s EBIT margins down to MSD by March 2020, and its FCF in the same year to ~$13mm, reflecting what we believe to be the true margins or economics of this business, and something closer to the effectively “zero margin” BWA management referred to Remy earning on a very similar business.

Applying a generous 7x EV/NTM EBITDA and 13x P/NTM FCF and P/NTM EPS to these March 2020 estimates yields an average Mar ’19 target price of $10, or ~60% below MPAA’s current price.

Insider Sales[2]

In many of our channel checks, people we spoke with were complimentary of CEO Selwyn Joffe. Many complimented his ability to navigate difficult industry challenges, and nearly all commented on his dynamism. But looking at his insider sales/buys dating back to 2004 shows a trend counter to the promotional and buoyant language he consistently uses to describe his business and opportunity set:

• Joffe has sold a total of $16mm worth of options across 5 transactions at average stock price of $27.63. These options had an average of 166 days left to expiration at the time of Joffe’s exercises.
• Joffe has sold another $1mm worth of options via 10b5 sales (at an average price of $38).
• Open-market and 10b5 sales of shares amounting to ~$1mm at average prices in $30s.
• He has purchased a mere 16k shares at an average price of $9.64 (with 6k of these shares in Feb-Jun 2018 at average prices ~$20).

In total:

• Joffe has sold ~$18mm worth of shares and options at prices ranging from MPAA’s current price of ~$26 into the high $30s.
• He has made minimal purchases at average prices ~60% lower than MPAA’s current price.
• Net-net, the CEO’s total share ownership has increased only ~11% since December 2013 (141k vs. 127k shares), with him exiting 600k in granted shares over this same time, despite consistently and emphatically touting the company’s growth prospects all the while.  

Why it’s mispriced

• MPAA has limited sell-side coverage with 2/4 of the covering firms (Roth and Craig Hallum) being lead runners on MPAA’s last big equity offering in 2014.
• No true public comp. With the sale of Remy first to BWA, and BWA subsequently selling the aftermarket biz that competes with MPAA to a PE firm, there is no true comp to MPAA in the public eye.
• Extremely opaque accounting that obscures the headwinds facing its business:
  • MPAA has taken great strides to explain its accounting process for “cores” inventory, even releasing videos online that attempt to better explain it. Despite these efforts, however, we believe MPAA’s accounting is still confusing and muddy (perhaps intentionally so) to most market participants. [3] 

Risks

• On the most recent earnings call, MPAA increased its fiscal 2019 sales outlook to the “upper end” of its previously guided range of 6.5-8.5% growth. This due to the award of $40mm in new annual sales (we believe most likely AAP business that Remy lost).
• The bull case is that this business comes with upfront investment, but will result in higher sales and improving margins (27-30% gross) through the back half of fiscal 2019. We outline in detail above why we feel those sales will not translate to the margins and ultimately cash earnings investors are expecting.
• But a risk to our short case is MPAA announces further new customer wins, and investors are willing to look past earnings-quality concerns, or the lack of FCF generated from these wins.
• Further, MPAA has talked about the car fleet in the key window of 7-9 years for its products is improving as we move beyond the period 7-9 years after the Great Recession.
  • To look merely at the number of vehicles in this key age window as THE driver of demand is an oversimplification.
  • Demand for aftermarket starters and alternators is also a function of: miles driven, the quality/expected life of the original OE part, the weather/trauma that part suffers, whether there are “new” alternatives that can compete with reman aftermarket product, and mix of vehicles with newer technologies (i.e. start-stop) where MPAA is not well positioned.
  • Also, looking at all these variables impacting starter and alternator demand would only forecast the # of MPAA units demanded. This does not forecast sales, as it says nothing about price.
  • Frost & Sullivan’s view of the total $ demand for aftermarket starters and alternators in North America (factoring in ALL the above demand drivers and price) is for a mere 2% CAGR from 2016-23.[4]
  • Regarding the rise of start-stop technology, hybrid and EV, and what it means over time to MPAA’s core business, we believe the company’s more recent D&V Electronics acquisition is telling. It is perhaps an admission that MPAA’s current portfolio is not well-positioned vis a vis these emerging technologies.
• MPAA has also touted the potential of moving into new product areas like wheel hubs, brake master cylinders, turbochargers, and testers. Our research suggests, though, that product areas beyond starter and alternators are more susceptible to cost-competitive, brand new product from overseas markets, and the challenges described above pertain to these areas as well.

[1] The concentration of add-backs in these three buckets is not readily apparent by looking at data services like Factset, because MPAA, whether intentionally or not, has made subtle changes to the name of their add-backs items over time (causing Factset, for example, to classify items into different buckets, when in reality, they are the same).

[2] Source: Insiderscore.com

[3] http://motorcarparts.com/news/new-video-by-mpa-explains-the-core-exchange-process/

[4] https://ww2.frost.com/news/press-releases/north-american-class-1-8-starters-and-alternators-aftermarket-players-focus-improving-services-expand-market-share/

This report (this “Report”) on Motor Parts of America (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold short positions tied to the securities of the Company described herein and stand to benefit from a decline in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their short exposure to the Company’s securities or establish long positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

• MPAA is forced to lower its margin outlook for balance of fiscal 2019 (ending in March 2019), as the inflection in customer order patterns expected in 2H of fiscal year doesn’t materialize
• Adoption of ASC 606 accounting makes investors increasingly aware of the dynamics described above by shifting “Long-term core inventory” to more traditional accounts, like “inventory-net” and removing some A/R contra assets accounts.  
• Retailer customers shift more towards “running changes” of vendors versus the traditional, longer, and stickier contracts of the past. This will reduce the thin but remaining barriers to entry incumbent vendors enjoy, and make the industry a further race to the bottom.
• Investors punish MPAA for its declining ROIC, poor earnings quality, and lack of cash flow.