Stoneridge Inc. (NYSE - SRI)

Based on rapidly improving trucking industry fundamentals, an underappreciated Brazilian growth opportunity and attractive secular trends in the automotive industry, I believe the equity of auto and truck part supplier Stoneridge Inc. (SRI) is significantly undervalued by the public equity market. Currently trading at $13.36 per share or 6.7x my 2011 recurring EBITDA estimate, I believe SRI's base business is worth $17 per share (applying a 6x multiple to my 2012 EBITDA estimate) and its 50% stake in its Brazilian JV is worth another $7 per SRI share, resulting in a target price of approximately $24 or 83% upside from current trading levels. Significantly, a downside case in which the underlying industry does not grow and the Brazil business actually shrinks to its 2009 trough level suggests a valuation slightly above the current stock price. 

Business Description

SRI designs and manufactures electronic components and sensors for the medium and heavy-duty truck, automotive and off-highway end markets in North America and Europe. In 2010, revenue from medium + heavy-duty trucks, automotive and off-highway markets represented 50%, 32% and 18% of total revenue, respectively. The company's primary customers are North America-based OEMs such as Navistar (24%), John Deere (14%), Ford (8%) and GM (5%). SRI holds joint venture interests in Brazil and India. In addition, the company recently started a subsidiary in China (no meaningful revenue contribution from either the India JV or China subsidiary at this time).

The company operates in two segments, Electronics and Control Devices. The Electronics segment, primarily serving the commercial (aka medium/heavy-duty or Class 5-8) truck market, manufactures parts including wiring, driver information systems, dashboard assemblies and switches. The primary driver of this segment is monthly Class 5-8 truck industry order data collected from OEMs. This order data is typically published by third-party trucking industry research firms ACT Research and FTR Associates within the first two days of each calendar month. From 2002 to 2008, this segment experienced a revenue compounded annual growth rate (CAGR) of approximately 11%. Historically, operating margins for this segment have varied between high single digits in strong commercial truck build environments to slightly negative during downturns.  

The Control Devices segment, which serves the automotive end-market, manufactures components that monitor, measure or activate specific functions within a vehicle to improve performance, reduce emissions and enhance safety. Examples of these products include seat belt buckle sensors, brake switches, seat track position sensors and fuel shut-off switches. Compared to the Electronics segment, the Control Devices segment requires more engineering due to the high-value added nature (e.g. safety, emissions) of its products. The most effective way to gauge the trajectory of this segment is to track the Seasonally Adjusted Annual Rate (SAAR) of production for the US auto industry on a monthly basis and follow sales data released by US Auto OEMs on the first business day of every month. From 2002 to 2008, this segment experienced a CAGR of -7%, which reflects deteriorating pricing for the company's light vehicle products during this time period. Since then, the company has shifted its focus to higher content products for light vehicles and has rebounded nicely with US Auto industry production as sales were up 36% for full year 2010 and 21% 1Q11 on a year-over-year basis. Compared to those of the Electronics segment, the operating margins in the Control Devices segment have shown more variability, ranging from negative mid-teens to positive mid to high single digits.

Founded in 1965, the Warren, OH-based company historically has grown through acquisitions and joint ventures. In 2007, SRI management laid out a multi-year restructuring plan to realign operations which reduced the number of business units, diversified the customer base, increased investment in technological and design capabilities and achieved permanent cost savings. Because its management implemented its plan in 2007 and 2008, SRI was able to navigate the downturn more effectively than other smaller transportation parts suppliers. As of 4Q10, management estimated it achieved $50 mm or 25% from the Cost of Goods (i.e. overhead) line item on the income statement, which represent permanent annual fixed cost savings. On the top line, beginning in late 2007, management started to diversify its revenue by winning more business in the off-highway (e.g. agriculture) and passenger vehicle sensor markets. Currently, SRI's $250 mm backlog of net new business consists of significant business from Asia and Europe as well as a larger mix of higher value-added sensor products. From a capital structure perspective, the company successfully refinanced its high yield notes in October 2010 (reduced SRI's all-in interest rate from 11.5% to 9.5%) and completed a secondary offering in November 2010 which improved the stock's trading volume (selling shareholder was the family trust of SRI's deceased founder). Prior to the secondary, the stock traded at $11.33 (closing price on November 2, 2011) versus $13.36 today.

Investment Positives

Improving Commercial Truck Industry Fundamentals: Production for Class 8 trucks in the United States dropped to a trough level of 118K units in 2009 after peaking at 376K in 2006. Commentary from truck OEMs, suppliers and industry research groups estimate 2011 and 2012 production to be approximately 250K and 300K, respectively. Based on recent monthly Class 8 order numbers, these estimates appear conservative - April 2011 Class 8 orders were 38K, arguing for a production rate significantly above expectations (even after taking into account seasonal factors). In addition, used Class 8 truck prices continue to increase and the average age of trucks continues to be around 6.8 years, reflecting pent up replacement demand (up from a historical norm of 5 years). Class 5-7 truck orders have also rebounded and benefitted SRI but not as rapidly as Class 8 due to the Class 5-7 market's close relation to short-haul, intra-city activity that is often linked to residential housing.

In the United States, truck classification is determined based on the vehicle's gross vehicle weight rating (GVWR) with classes ranging from 1 to 8. Trucks in Classes 4 to 7 have a GVWR of 14,000 lbs. to 33,000 lbs. Any truck above 33,000 lbs. in the United States is considered to be a Class 8 truck. Examples of trucks in Classes 4-7 include those used for local U-Haul moving trucks, school buses, dump trucks and UPS ground delivery trucks. The prime examples for Class 8 trucks are large 18-wheel tractor-trailers.

Highlighting Value of Brazilian JV: SRI owns a 50% interest in a Brazilian JV called PST Eletronica (PST). PST, with a market share over 50% in the Brazilian automotive market, sells sensors that control vehicle functions such as car alarms, door locking and tracking systems. It is a higher growth, higher margin business relative to SRI's base business and I believe it can generate EBITDA of $55 mm in 2012. At a 7x EBITDA multiple, I estimate SRI's 50% stake in PST is currently worth approximately $6 per SRI share. In a recent conversation with management, the CFO stated that he believes an 8x multiple is appropriate for the Brazil business. This valuation range was validated by Sensata's October 2010 acquisition of Honeywell's automotive sensor business and June 2011 acquisition of Sensor-NITE. Both acquisition targets produce sensors for the automotive end market and the acquisition multiple (post-synergies) were approximately 7x EBITDA.

In addition, SRI management has made it clear to the market that it is in active discussions to increase its stake in this business and expects a transaction to be completed by the end of calendar 2011. After this transaction is complete SRI will be able to consolidate PST in its financial statements. This will provide more transparency into its significant Brazil growth story, which will most likely receive a higher overall multiple by equity investors (not reflected in my stock price target).

Increasing Content on Passenger Vehicles: SRI will benefit from increased content on vehicles driven by both consumer preference and increased regulation for automobiles. As US SAAR continues to recover, both passenger cars and light trucks will require components that will improve performance, reduce emissions and enhance safety. Historically many of these components have been optional/ discretionary, however during the last ten years they have become required.

Experienced Management Team: The top management of SRI has significant industry experience with the CEO John Corey previously having served as CEO of automotive parts supplier Safety Components (majority sold to Zapata in 2005) and CFO George Strickler having previously served as CFO of auto supplier BorgWarner (BWA). Prior to BWA, Mr. Strickler was employed by Goodyear Tire & Rubber (GT) for 30 years where he held finance and treasury positions (last title there was VP of Finance). Mr. Corey joined SRI in 2006 while Mr. Strickler joined in 2004. Based on my conversations with this management team, it is very clear that it has a very deep understanding industry dynamics, the ability to get very granular when discussing SRI operations and the ability to communicate clearly with investors. 

Increased Management Communication with Market: Over the last three to four quarters management has been increasingly more granular with respect to its operations by making frequent presentations at sell-side conferences and increasing its level of disclosure in its investor presentations. This has increased the ability of equity investors to model SRI's business. For example, management started including slides that identified which specific cost line items were being impacted by its cost savings program. This allowed investors to identify where permanent fixed cost savings were achieved so they could increase precision when forecasting margins.

Current Valuation (6/22/11)

Financial Model Summary

Detailed Revenue Build

Base Business - Does not include Brazil JV

Key Model Assumptions - Base Business

• Assumes revenue growth across both Electronics and Control Devices Segments is driven by industry volume growth; prices have remained stable over time so I do not assume any change due to price (see Detailed Revenue Build)
• In terms of Gross Profit margin, SRI management has been very clear about its long-term target of 23-25% in its presentations; on recent conference calls, it has stated it continues to achieve an incremental margin (i.e. flow through) of 25-30%
• The $24 mm of one-time items included in COGS in 2011 (May 2011 IR Presentation) consists of  $4.4 mm due to labor inefficiencies, $3.9 mm due to premium freight costs, $4.6 mm related to rising copper prices, $6.4 mm related to Mexican Peso exposure and $4.7 mm related to new facility construction in Mexico.
• For Design and Development expense, SRI has publicly said it expects the annual cost to be $45-$50 mm
• SRI's management's long-term goal for Other SG&A (training, back office, etc) is 10% of Total Revenue by 2012

1Q11 SRI Results

SRI reported first quarter 2011 earnings on May 6^th, 2011. The company exhibited continued strong year-over-year revenue growth across both of its segments with Electronics and Control Devices growing 38.5% and 20.8%, respectively. However, the company reported a decline in Gross Profit Margin from 23% a year ago to 20%. Management attributed this shortfall to four factors, having to unexpectedly add additional shifts, paying premium freight for electrical components, copper prices and Mexican Peso currency fluctuations. In aggregate, the total negative impact from these items to Gross Profit for the quarter was $8 mm, which reduced Gross Margin to $39 mm. Adding back these items flagged by management would result in an incremental margin of 29% - this is in line with the company's previous comments.

On the earnings call, management asserted that these items will impact SRI numbers for the remainder of 2011 and quantified this impact (including costs related to a new plant in Mexico starting in 2Q11). The numbers are clearly laid out in SRI's May 2011 presentation from a conference hosted by UBS in New York. In addition, SRI management was clear with the market that each item is being proactively addressed which includes an aggressive headcount reduction plan coupled with improved employee training, and the May 2011 hiring of a VP of Operations to put more focus on the supply chain and acceleration of cost recovery mechanisms for commodity pass-throughs with customers.

The full impact of these items on 2011 is reflected in my financial model of SRI's base business above. SRI management does not expect these items to persist in 2012. Finally, SRI's situation is not unique among smaller auto/truck suppliers, particularly with respect to adding additional workers, commodity input costs and premium freight. This is evident from listening to the conference calls/commentary of peer suppliers such as CVGI and MTOR.

Brazil JV (PST Eletronica) - 100% of Operations

 Valuation

2012E SRI EBITDA Sensitivity - Base Business Only (excluding JVs)

 Based on recent truck order figures, it is highly likely that Class 8 production in 2012 will exceed 300K (my base case) - the impact to EBITDA is shown above.  

SRI Public Peer Equity Comps

2012E SRI Base Business Equity Valuation Per Share Based on Comps

Valuation of SRI's 50% stake in Brazilian JV (PST Eletronica)

SRI Price Target

SRI Price Target = $24.49/share (A + B)

Quantifying the Downside of SRI

I believe downside, worst-case scenario for my SRI forecast in 2012 would be one where US SAAR remains at the current depressed level of 12 mm and US Class 8 truck industry deliveries do not increase on a year-over-year basis from the 250,000 expected by the truck OEMs (e.g. PCAR, NAV) in 2011.

Investment Concerns

Operational/Execution: For the last several quarters, SRI has felt the impact of a tight truck parts supply chain in its Electronics segment, which has been consistent with commentary from other commercial truck suppliers and OEMs. Any unexpected increases in labor inefficiencies or premium freight costs needed to procure supplies will prevent SRI from achieving its stated goal of 25-30% incremental margins. In its most recent investor presentation (May 2011), management for the first time quantified the expected impact from one-time items for the remaining 2011 quarters and laid out a plan to combat each item. In the past management did not seem to have a clear plan on how to handle controllable one-time cost items which hurt the stock price - I believe the most recent SRI presentation at a UBS conference in New York addressed these issues as they were specific as to how it was attacking issues on the cost side of the business.

Dependence on Navistar (NAV): Navistar has historically been one of SRI's largest customers for both medium and heavy truck end-markets and represented 24% of SRI revenue for the fiscal year ended 2010. SRI's revenue from Navistar could be adversely impacted if Navistar loses heavy duty truck market share if it cannot persuade its OEM and fleet customers to adopt its new Selective Catalytic Reduction (SCR) engine technology. Supporters of SCR technology argue that it will reduce emissions and increase fuel efficiency better than the legacy industry engine standard, exhaust gas recirculation (EGR).  Based on public comments from industry participants during the last few quarters, there is evidence that SCR technology is being adopted by OEMs and fleet customers.

No Brazil JV Transaction: As stated above, SRI management plans to increase its stake and consolidate for accounting purposes its Brazilian JV, PST Eletronica, by the end of 2011. If this does not take place this year, many public investors will continue to overlook the higher-growth, higher-margin Brazilian JV and not give it much weighting when developing a 2012 price target for SRI.

US SAAR Weakness:  Due to rising fuel prices and the tragic Japan earthquake, the US SAAR number could come in lower than previously stated industry expectations of 13.0mm for 2011, which would negatively impact SRI's Control Devices segment (which mainly serves the automotive market). However, commentary from public companies in the auto supply chain and auto OEMs indicate that US SAAR will experience weakness in 2Q and 3Q of 2011 and make up lost ground during 4Q, ultimately reaching a 13 mm SAAR for the year. Current estimates indicate that 2Q US SAAR has been trending as low as 12 mm down from around 13 mm in 1Q11. For every 1 mm decrease in US SAAR, the adverse impact to SRI's 2012E EBITDA is a $3 mm decrease.

Copper Prices:  SRI has historically purchased five to six million pounds of copper annually. It is able to pass on copper prices to customers via contracts. If copper prices were to experience a rapid increase, it may be difficult for SRI to recover all of these price increases from customers. SRI management has stated with increased volumes and a tight supply chain, it expects to purchase nine million pounds of copper during 2011. Because of sharp commodity price movements in recent quarters, SRI management has quantified the impact of copper movements in an effort to reduce surprises on the expense side.

Disclosure