Description

 Long SUP (Superior Industries International) – $17.21

Overview

Superior Industries (SUP) makes aluminum wheels for passenger cars and light trucks.  You can probably guess why it’s unloved:  it’s a Tier 1 auto supplier.  Its customers are primarily the Detroit 3 (76% of FY 2011 revenue, with similar concentration in years past).  It’s “inefficiently” capitalized, with half its market cap in cash.

I find it attractive for a few reasons:

(1)    The continued rebound in auto sales will ultimately provide a tailwind

(2)    SUP’s full margin potential has been obscured

(3)    I believe there is potential for the company to be sold in the near term

Rebound in auto sales

I think a rebound in auto sales is a good theme to play over the next few years.  I won’t go into too much detail here as I think mjw248’s recent write-up on MNRO lays this out well.  The age of cars on the road is at all-time highs and the spread between new and used cars is extremely tight.  As the cycle continues to turn, I think we will see a rotation in valuation in the coming years between the more expensive aftermarket names and the cheaper OEMs and suppliers.

Obscured margin potential

SUP is your typical auto supplier where volume rises and falls with the fortune of the industry.  You will notice margins have been under pressure / erratic since 2004.  This can be attributed to a mixture of structural and cyclical factors.

The key structural change has been the entrance of Chinese suppliers, which began to put pricing pressure on SUP around ’04.  In response, SUP has done a lot of restructuring to become cost competitive, shifting the majority of their production to low cost markets (Mexico):

The plants in Mexico are performing well, but margin expansion hasn’t been noticed due to several cyclical issues.  The run-up in gas prices and resultant drop in SUV sales (see: GM bankruptcy) hurt SUP as they experienced an adverse mix shift since they make their margins on bigger SUV wheels.  The ensuing recession and plummet in auto production crimped margins in ’08 and ’09 as capacity had to be slashed to match the decrease in demand.

SUP performed well in 2010, achieving 90m in EBITDA (12.5% EBITDA margins), but began to experience more trouble in ’11 through today, as the rebound in auto production strained their reduced capacity after shuttering plants during the downturn.  Looking at US vs. Mexico margins in 2010 and 2011 provides an interesting comparison.  In 2010, US operations printed 10% gross margins while Mexico was at 17%.  As demand began to exceed capacity in 2011, US gross margins dropped to 3% while Mexico dropped to 14%.  You can see that Mexico margins are not only higher on an absolute level due to a lower cost base, but they are also less impacted by changes in production due to more flexible wage laws that allow for easier scaling of operations to meet demand.

It’s the fate of auto suppliers with substantial fixed costs to get whipsawed by the cycle and it seems like SUP is always facing some new challenge that’s hurting margins.  Why should the future be any different?  This type of thinking is what creates the opportunity.  I think it’s a mistake to extrapolate the violence of the last cycle forward, and SUP has received little credit for the operational improvements they have made with their Mexico operations.

Potential Sale

Management has been somewhat vague in addressing their plans to address capacity, but they have roughly guided to 25-30mm in CapEx to add incremental capacity at existing plants.  The alternative is a greenfield project, which would cost 100m+ and take several years before wheels would move out the door.  I don’t think there is the appetite for a project of this magnitude.  To explain why, let me provide a bit more background on SUP:

SUP was founded by Louis Borick in the 1950s.  His son, Steven, took over as CEO in 2005 while Louis remained a member of the board until he passed away in November of 2011.  Steven is now 59 years old, with no kids.  The average age of the board of directors is 66.  Steven owns 2.2m shares individually and is trustee of the Louis L. Borick Administrative Trust, which owns another 3.3m shares (both stakes together equal about 20% of the company).  I am assuming the principal trust beneficiaries are Louis’ three children (Steven and two siblings that are not involved in the business).

I don’t think there is the appetite to put $100m+ at risk for a greenfield considering the difficulty in timing where we will be in the cycle three years out.  Given the recent change in ownership and the new constituents involved, I imagine there must be pressure among the family to get liquid.  SUP should be an attractive target for a sponsor that can pick low hanging fruit by getting more aggressive with the balance sheet while also operating within a timeframe to address capacity and turn the cycle upswing into a tailwind instead of a headwind.

Valuation

In the absence of a sale, SUP will continue their CapEx plan to add incremental capacity.  A year from now (3Q13), I see this as a company running 12% margins on 900m in sales.  At a 4x multiple and adding back cash (170-210m, considering CapEx and cash build) gives a share price between $22-24 (30-40% upside).

Although upside may be lower than your typical VIC submission, I think the margin of safety makes this a particularly compelling risk-reward.  Even if my analysis is entirely wrong and there is no sale and no margin improvement, you won’t be in a terrible place.  In a worst case scenario, we end up in the worst recession since that last worst recession, and auto production yo-yos violently.  During the downturn, SUP was cash flow positive during each fiscal.  Their worst four consecutive quarters (3Q09-2Q10) printed cumulative CFO of -5.5m and 5.5m CapEx.  SUP reached a low of $9 a share at the start of ’09, which was a 240m market cap vs. net cash at the time of 140m.  Today net cash is 210m.  You can take additional solace that this company already trades at a cheap 3.5x multiple vs. consensus and is run by owner-operators who have continually paid a dividend since 1984.

Catalyst