Auto Parts Driven by Cyclical Turnaround

 | May 07, 2013 | 1:00 PM EDT
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It may be silly to think anyone can predict the future direction of markets, but history has shown us that markets and businesses tend to operate in cycles. And cycles can't be timed. If you bought stocks in October 2008, you suffered painful losses until March 2009. But history has repeatedly proven that investing at or near the worst of a cycle is likely to lead to favorable results for those patient enough to wait through it.

To increase the probability of success significantly, however, investors shouldn't blindly invest in an industry experiencing a cyclical downturn (shipping stocks come to mind), but examine the individual business in an attempt to identify the most attractive candidates within that industry.

Today, the U.S. auto industry continues to show signs of strength, as evidenced by operating results from General Motors (GM), Ford (F), and Toyota (TM), new car sales continue to show strength domestically. With new cars sales booming, the average age of a vehicle on the road goes down, which means businesses that benefit from older cars suffer. As a result, a bullish case can be made for auto-parts-related companies over the next several years.

My favorite pick is Advance Auto Parts (AAP), one of the top three auto parts retailers in the U.S. Trading above $80 a share, AAP is at a deep discount to peer O'Reilly Automotive (ORLY) at about $110. AAP trades for 1x sales vs. 2x for ORLY. AAP also trades for 7.3x EV/EBITDA while ORLY has a similar multiple of nearly 12x. AAP experienced operational difficulties in 2012 that it is fixing. But assuming AAP can't execute and the stock price drops below $65, it's highly likely an opportunistic buyer would seek to acquire the company (that was the case last year when it looked like a private-equity firm was rumored to take out AAP at $80 to $90 a share).

Small-cap Modine Manufacturing (MOD) is a $440 million producer of radiators and other heat-exchange systems to the auto industry, as well as industrial and residential applications. Shares trade for less than $10, or 5.8x EV/EBITDA. Before the recession and housing crash, shares traded at nearly $20. Shares may not get to $20 this time around, but the industries Modine serves are clearly improving, which should lead to an improvement in earnings and cash flow. Analysts see earnings per share climbing to $0.62 in fiscal 2014 from $0.39 in fiscal 2013 (ending March 30).

Motorcar Parts of America (MPAA) was firing on all cylinders until a major acquisition dealt the company major setbacks. Nonetheless, this $91 million provider of alternators, starters, and other related components to the automotive aftermarket should continue to improve as the acquisition adds to earnings. A couple of years ago, shares were trading for more than $15 when the company was half its current size. Today, shares trade for about $6.20, approximately 20% of sales.

Small-cap Standard Motor Products (SMP) trades for 73% of sales and generates 4.5% net profit margins and a forward price-to-earnings ratio of 13. If MPAA traded for 60% of sales, the stock would fetch more than $18, a near-200% return. If MPAA can earn 3% net margins, net income would exceed $12 million. At 13x earnings, the company would be valued $156 million, or 60% above today's price.

These conclusions have yet to be realized, but what matters is that when you invest at attractive prices in a sector where the future could present favorable tailwinds, the odds of success far outweigh the odds of capital loss. In most cases, the upside is vast outperformance over the stock indices.

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