Description

Strattec is the #1 auto/light truck lock manufacturer in the world. In Strattec’s FY01 ending last June, its Return on Assets (ROA) was 12.4% and Return on Equity (ROE) was 21.6%, despite FY01 being a pretty lousy year (detailed later). The ROE was achieved without significant leverage. Free Cash Flow (FCF) has been higher than earnings in each of the past three years and also in the most recent quarter. They have bought back 28% of their shares over the past 2 ¼ years. The P/E on depressed trailing earnings is 12. Using reasonably conservative assumptions I project a stock price of 48 to 64 within the next two years, compared to the current price of 36. The Margin of Safety is quite reasonable, I believe.

Strattec provides mechanical and electro-mechanical security systems (a fancy name for locks and keys) for 84%, 63%, 97%, and 100% of GM’s, Ford’s, Chrysler’s and Mitsubishi’s North American automotive and light truck production. Along with Delphi, those are its biggest customers. It has a 62% market share of the North American market. In addition, Strattec has 22% of the North American market for Ignition Housings. Current customers are Delphi, Mitsubishi and Visteon. Almost all of its $200 Million in sales are within North America, although that is gradually changing. Manufacturing is done in its Milwaukee and Mexico factories.

Participation in particular car models is typically fixed several years ahead of time. Thus, the chance of error when forecasting revenues for much of Strattec largely comes down to projecting auto sales by model for the industry. There’s a gradual “decontenting” of Strattec’s traditional products, as the manufacturers try to cut costs by reducing the number and cost of locks per vehicle. Strattec is looking for new sources of revenue to combat this trend and is starting to have some success. The Integrated Key program starts in FY04 and is expected to generate revenues of $10 Million in FY05. In FY04, an additional $7-$10 Million of revenues will be generated from the Ford F-Series Ignition Housing program. In CY02, the first fruits of Strattec’s globablization program will generate $3 Million of revenue from China and Brazil for the joint venture with Witte. Specifics on these have not been mentioned in the most recent 10Q and 10k, but were noted in a November presentation (see Strattec’s website).

Strattec was spun off from Briggs and Stratton in the mid-1990’s. As I investigated Strattec, the company sounded more and more familiar. I finally remembered that it was a case study in Joel Greenblatt’s book. The fact that Joel is one of the founders of VIC is strictly coincidental (I’m really not trying to curry favor for the weekly prize!)

Net Income in FY2001 declined to $13.0 Million compared to $18.5 Million in FY 00 and $17.0 Million in 99. In Q1 02, Q! FY02 Net Income was $3.7 Million compared to $3.9 Million in Q1 FY01. FY2001 and Q1 FY 2002 was an unusually tough period;
- auto plant shutdowns Nov 00 – Feb 01 (North American auto/light truck production declined by 11% last year)
- 16 day strike at Strattec in June 2001
- high costs in Q1 2002 (ending Sept 2001) to expedite shipments after the strike
- Post September 11 disruptions in auto sales and production

Free Cash Flow (Cash Flow from Ops minus Capital Expenditures) has been higher than earnings in each of the last 3 years and also last quarter (Q1). Inventory Turnover has increased each and every year from at least FY 97 (Turns of 8.5) through FY01 (Turns of 13.5). Besides the direct impact on FCF, improved inventory turns has all sorts of positive influences on manufacturing productivity.

Strattec has a very strong Balance Sheet, For Q1 of FY02, it breaks down as follows:
ASSETS Cash: 24.3M, A/R: $25.2M, Inv: $12.4M, Other: $7.6M, PPE: $40.6M
CURRENT LIAB A/P: $18.3M, Other: $11.9M
Accrued Pension (I consider this comparable to LTD): $15.7M
Common Eq: $64.5M
Accrued Pension Liability is based on 8.5% investment returns and 7.5% discount rate. The 8.5% is probably too high, but I think the 7.5% discount rate is high also by about the same amount, so $15.7 Million is probably a pretty reasonable accrual.

Strattec has been actively buying back stock for several years. Diluted shares outstanding have declined from 5,791k diluted shares in FY99 to 4,401k in FY01. Q1 FY02 diluted shares were 4,153k diluted shares. There are 400k shares left in the buyback program authorization. The buyback limit has been increased at least once by the Board. As the stock price increases of course, the diluted share count will also increase until the average share price gets above $45.79, when diluted shares will have increased by a total of approx 320k. Given this, the Board’s proven policy of reducing share count, and Strattec’s FCF, my calculations use a diluted share count in 2 years of 3.75 Million.

Last year was an unusually poor year for Strattec, as explained above. 2000 however was a boom year for the auto industry. To get a reasonable sustainable earnings estimate, I averaged the last 3 years Net Earnings, resulting in $16.2 Million. To increase the Margin of Safety, I used $15 Million for my estimate. We know that October – December were very good months for US auto sales, but we don’t know how much of those sales cannibalize future demand. I do know that a lot of people bought Corvettes in November, which they would not have done in the normal course of events. Also, auto inventories are currently fairly low. The weight of the evidence leads me to believe that FY2002 Revenues and Earnings will be better than FY 2001.

To get comparables, I went through the current issue of Value Line and picked out Auto Parts Manufacturers with strong balance sheets (Total Interest Coverage > 5x). Next to each company in parentheses, I list VL’s Trailing PE on generally depressed earnings: Gentex (31), Genuine Parts (17),Johnson Controls (16), Magna (11), Modine (28), Superior (17). Magna’s PE is the lowest but its FCF is less than earnings, not more, as with STRT. Some of these companies have better long-term growth prospects than Strattec, but not all of them. On the other hand, Strattec has a better Balance Sheet than most of them. The PE for these companies can be expected to contract as the cycle moves off the bottom, Looking at the above and being reasonably conservative, I used a fair PE of 12-16.

$15 million average earnings / 3,750k shares generates a $4 EPS within 2 years. (Strattec’s FY 04). For what it’s worth, the 2 analysts following Strattec have a FY03 EPS estimate of $3.64. There is no FY04 estimate. Applying a PE of 12-16 to EPS of $4.00 per share generates a conservative fair price of 48-64. A PE of 12 is in Strattec’s traditional range; I believe a higher PE is appropriate considering the comparables, ROA, and ROE.

Senior management is reasonably young (in their 40s and 50s). Most have been with Strattec since the spinoff or longer. Compensation is reasonable, but not piggy. Part of the senior officer cash compensation is based on the company’s multi-year profitability after a charge for the cost of capital (12%). Also, most of the options granted over the past three years have been at a strike price greater than the current stock price. Options are exercisable 3-5 years from the grant date. Director and executive officers control 9% of the shares, with institutions (holding at least 5%) owning another 55% or so of the shares. In sum, management’s incentives are reasonably consistent with that of long-term shareholders.

Strattec is using a long-term rate of 7% for the health insurance increases. Right now, the rate of increase is much higher than this. An increase of 1% in the long term rate of increase would raise Strattec’s annual costs by $94k and it’s Pension/Postretirement accrual by $665k.

Strattec is thinly traded ($100k daily). It is not that volatile however. For most of the past 2 ½ years it has traded in the 30-36 range, so it should be possible to accumulate a reasonable position with some patience.

Risks:
Decontenting
Health Insurance rate increases
Continuing loss of market share by their prime customers (GM, Ford, Chrysler) to non-customer (Toyota, Honda, etc...)

Catalyst

High Free Cash Flow allows Share Buybacks to continue at heavy rate.
Investment community sees new programs that will generate incremental revenue and earnings.
Reasonable FY02 Auto Market
Higher PE ratio consistent with ROA, ROE, and comparables