Tuesday, October 23, 2012

Automodular's pretty cheap eh?

Except for the bottom of a bear market, it always seems like there aren't many cheap stocks to be found.  Some cheap stocks (like most of the current net-nets) are full of warts, with one food in the grave, and the other on a banana peel.  In every market there's always someone who things stocks are overvalued and is willing to sit on their hands clutching cash waiting or the next crash, waiting, and waiting.  A preferable strategy is to find safe and cheap stocks in any market, buy, and be patient.  The stock I want to discuss today is a good classic cheap stock.  There is unfortunately no sexy story, full of mystery and intrigue surrounding it.

Automodular (AM.Canada) is a Canadian manufacturing company based in Ontario.  The company did have a small amount of operations in Ohio, but those have mostly been wound down.  Sales are now predominantly in Canada.  The company is an integral part of the car supply chain, they, supply assembled sub-modules for cars.  The modules are things such as an instrument panel, or powerpack.  The company receives orders every forty seconds, and ships the completed components within two hours.  The car assembly process at the destination plant cannot continue without Audomodular's components, so timing is critical.  Because of this the company is locates their facilities within 12 miles (20km) of the final assembly facilities.

The company relies on contracts with auto manufacturers, mainly Ford and GM.  Ford and GM use third party modular assemblers because historically it's been cheaper to outsource component production.  Automodular states that the price advantage gap has been closing over the past few years, and if the difference becomes inconsequential it's possible that Ford or GM might insource their work.  In an effort to diversify the company has sought new lines of business that might use some of the expertise they already employ.  Out of this initiative they have started to manufacture windmill components.

There are a few things that make Audomodular really interesting as a potential investment.  The company is trading slightly below book value, and has a P/E of 2.7x.  With a P/E this low ROE last year came in at 36%.  What makes the numbers even more impressive is that the company has continued to grow into 2012.  The 2011 annual report looked great, but the 2012 half year results are even better.  Sales are running 36% higher than last year, with earnings coming in 31% higher.  The company's sales weren't artificially high in 2011 due to a one time gain, they've been consistently strong coming out of the recession.

The large gain in year over year results come from the company's windmill fabrication efforts.  Unfortunately is the windmill production program is only a year long.  There's the possibility of extending it, if successful, but windmill demand relies on government subsidies, and renewable energy demand, two unknowns.

The company has the ability to generate strong cash flows, in 2011 they had free cash flow of $15,768k, and in 2011 free cash flow was $22,578k.  Free cash flow for the first half of 2012 was significantly lower at $2,920k.  The company attributes their strong free cash flow over the past few years to a significant rebound in orders from Ford and GM.

The company has been a responsible steward of cash, they have accumulated a sizable cash hoard, recently amounting to $15m.  Management has been shareholder friendly, paying a sizable dividend last year, and buying back shares, when appropriate.

Naturally for a company this cheap, with a history of sizable earnings the first question asked is: "what's wrong?"  There are two major forces working against Automodular, and they're the primary cause for cheapness.  The first was touched on briefly above, the current extraordinary results are from the temporary production of windmills.  It's possible this production could be extended, but as of now there isn't any visibility into that decision.  When windmill production ends, results will drop back down to where they had been in the past.

The second cause for the cheapness is that Automodular works on a contract basis for Ford.  They're currently contracted to produce subassemblies for a few different car models, but the contracts are set to expire in the next couple years.  The company is working hard to secure a future contract, but if they're unable to, Automodular will be a company with a lot of expenses and no revenue.

I believe it's the fear over the visibility into the company's future that's holding the price down.  While it would be nice to lock up 10 years of revenue in a long term contract it's aldo very rare for a company to do that.  Most companies are in the opposite position of Automodular, they don't know who will be making purchases tomorrow, and how many purchases will be made, there is no visibility.

A third and more minor concern is that management is looking for ways to diversify their lines of business.  This diversification effort led to the windmill project, but in the future it could lead to projects of dubious value.  Management has been a good steward of shareholder capital in the past, but that doesn't mean they can't make an ill-timed acquisition, or make a mistake in the future.

With all the potential negatives it's worth discussing a potential positive as well.  The company has a lawsuit pending against GM for breach of contract for the amount of $25m.  The lawsuit is pending in the Ontario courts, with an uncertain resolution date.  If Automodular wins the case the settlement amount would be material, and could be used to pay a dividend, or buyback more shares.

If an investor believes Automodular will be able to extend their contracts with Ford, or diversify into profitable side businesses this could be a very nice investment.  This could also be a great first international investment for an American.  The company has shares that trade on the pink sheets, as well as their Toronto listed shares.  All of the reports are in English, and Canada isn't that far away for most Americans for a quick visit to company facilities, if desired.  For American investors afraid of the shark infested international markets, Canada is a great baby step.  Not only do both countries share hockey, and baseball leagues, we also call our money the same thing.

Talk to Nate about Automodular

Disclosure: No position

23 comments:

  1. I looked at AM a few months ago and took a pass. The future depends on management finding profitable new businesses to enter, and mgmt does not have a track record of entering new businesses that we can judge them by.

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    1. I'd agree with you with a caveat. The business has always been like this where they need to renew contracts with auto suppliers every few years. Historically they've always been successful at doing so, from that there is a track record to look at. But in terms of diversifying into other lines of business you're correct, all we have is the windmills, which have been successful, but it's a one off.

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    2. As I recall, Automodular's auto business is basically a labor arbitrage; Canadian law or business practices in this particular area allow for cheaper production, so it makes sense for U.S. firms to outsource their work. When I spoke with the CEO in June or July, I remember him saying the arbitrage was disappearing due to changing U.S. regulations. I can't find my notes on this right now, but I'll try to be more specific if I can find them.

      Basically, I couldn't find a margin of safety since there is at least some chance the Ford contract won't be renewed. That was enough for a pass for me.

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    3. Ted,

      You're right about the arbitrage, they discuss it in the business description in the annual report. They said the gap has been closing, so it still exists, but who knows for how long.

      I agree with you, risky outlook, and no margin of safety, even at the low price, I passed as well. But not much has to go right for this to work out, if the contract is extended this is really cheap.

      Nate

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  2. Great post on a very interesting company!

    You outlined the risks going forward, but what I really do not understand is how they are able to generate profit margin of 15% and ROA of 25%. They are involved in a highly competitive industry with large capex needs, so how can they be so profitable? You are referring to the temporary production of windmills which seems to be a reason for the high profitability, but why do the customers allow for the high margins?

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    1. Thanks!

      I wondered the same thing as I looked at the company, and didn't touch on it in the post, because I really don't know. What I do know is their business is guaranteed by contract, so they negotiate up front, and until the contract expires there is no competition. If a competitor goes to Ford and says they can do it for a lower amount the competitor has to wait until the contract expires and bid on it.

      I would guess part of the profitability is due to location. To be successful in this business you need to be located very close to the final assembly plant. That limits competition to companies that are already close, if the plant is too far away there wouldn't be enough time to assemble the module and transport it.

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  3. Perhaps one of the reasons they are so profitable is that they DO NOT have competition during the length of the contract. They are located within a few miles of the plant, and deliver within the hour for their products.

    Any competition would HAVE to be in very close physical proximity. In the short term, this may preclude competition.

    The auto manufacturers may prefer to use them so that they aren't dealing with UAW/CAW and worker headaches.

    As to the wind turbines...most of these have turned out to be incredible boondoggles and further investment in this field is going to be cut back, and cut back drastically.

    Even so, the financial metrics just seem to be out of whack and too cheap... considering the financial position and dividend.

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  4. Alright, I am going to post because there is some brutal misinformation on here. First, the extraordinary results are NOT from the production of windmills. They didn't even officially start that work until June 2012 and I do not think it is nearly as profitable as the Ford work. I'm pretty sure that they have had the Ford work since 1995, so while there is certainly a risk of losing the contract after June 2014, history is on their side. Best guess is that it is extended, but at terms that are not quite as profitable. They've been integrated into the Ford Oakville plant for a long time and the person above IS correct in the importance of being very close to the plant.

    Automodular also has CAW workers, so I'm not sure what arbitrage you guys are talking about.

    At current levels, you are probably buying it close to liquidation since they would have almost 2 more years of work with Ford and then there are probably a few assets you could sell. If the contract is extended at all, this thing is certainly cheap. And the future of the business is not dependent on new business lines.

    Good luck. I own some of this (so I am biased I guess). But the story is pretty compelling in my opinion.

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  5. I personally think that one reason for this stock's cheapness is because ex-CEO and other insiders are selling their position

    Started to sell in Spring 2012 and only stopped recently

    The price was about 2,8$ per share when they started to sell. It peaked at 3,05 in Jan 2012

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  6. One important question about a stock like this is how much shutting down the Ford operation will cost them.

    They do have a provision for this on their balanace sheet - but at $106,000 it seems absurdly low. This figure includes "includes severance/termination costs and facility‐related costs incurred following the expiration or
    termination of customer contracts".

    Does anyone understand why this figure is so low? Have they arranged their leases and employment contracts so that they can just walk away if the contract with Ford ends, because all their supplier contracts are set to end on the same date? Good job by the management if they have, but I'm not sure I believe that it can be so easy and cheap.

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  7. They are having 15 Million in cash and no debt, maybe because situation like that?

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  8. The employment agreement coincides with the Ford contract. I'm not sure about the lease on their facility.

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  9. Not sure what you have in mind

    Thats what I would too aswell, make employment contracts as long as the main contract.

    I dont have information about the facility leases either, would be nice to know how long they have it

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  10. Stayed away from this previously because former CEO Michael Blair was a snake. He'd buy stock in the market cheap and then get the company to do a self tender at a big time premium and then tender his freshly purchase stock for big $$$

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  11. Quite a dividend! 0,26$ per share.

    Q3 results improved.

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  12. It seems that the windmill job started at Jan 2012 for one year:

    "Work is already underway on the contract which is for a fixed number of units to be assembled over an estimated period of one year."

    http://www.reuters.com/finance/stocks/AM.TO/key-developments/article/2460310

    and Ford contract ends in 2014:

    http://www.reuters.com/finance/stocks/AM.TO/key-developments/article/2352289

    but read as well:

    "The MYA provides for certain price reductions over the course of the agreement some of which are retroactive to January 1, 2011. The impact on previously reported first quarter 2011 financial results is a reduction in revenues and pre-tax earnings of $0.6 million and a reduction in net earnings of $0.4 million. "

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  13. Having owned this now for a couple of years I would like to point out the one great aspect of a small publicly held company doing exclusive business with another larger publicly held company that in this case posts monthly sales figures which give an early warning of the small companies quarterly results.

    Ford releases data the first week of the month that gives sales numbers for the four models produced exclusivly at Oakville and with parts supplied exclusively by Automodular. By tabulating the sales one gets a pretty good idea of units supplied quarterly to Ford and therefor revenue and this all within days of the quarter end as opposed to the six weeks or so for quarterly reports.

    Now that the foray into wind turbines with the the Vestas contract is over the data once again is fairly pure.

    Furthermore the contract renewal should not be expected until June 2013 as the past two contracts were announced only a year before expiration. I believe there will be another dip creating a buying opportunity prior to this.

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  14. This clearly seems to be a play on the renewal of A contract. No contract - no company. Are my odds better at the baccarat table ?

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  15. They lost the Ford contract. Any thoughts going forward? They're estimating a loss of $6mm post-tax. Given that they had $25mm of cash and $13mm of A/R with $8.5mm in current (total) liabilities, the stock is trading at NCAV and 30% below book. Also they are going to continue working for Ford through 2014. Did the market overreact?

    Will

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  16. Here are my valuation thoughts: 20% downside, 100% upside. Let me know if I'm missing anything.

    https://www.dropbox.com/s/jgzyl7a6vmmwapn/AM.xlsx

    Downside
    + Cash given 100%, A/R 75%, no credit for any other assets
    + All liabilities accounted for at 100%
    + Incremental $6mm from closing costs at 100%
    + No FCF through 12/31/2014

    Upside
    + Cash given 100%, A/R 75%, no credit for any other assets
    + All liabilities accounted for at 100%
    + Incremental $6mm from closing costs at 100%
    + $25mm in FCF through 12/31/2014

    This FCF assumption strikes me as conservative as:
    - They generated $18mm in levered free cash flow last year
    - I think we can assume very little capex going forward
    - Taking $21mm in fcf before capex and multiplying by 1.5 yields $31mm

    I didn't account for their not liquidating and pursuing wind turbines---hard to handicap that risk.

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    1. I have a similar opinion their value to your upside case, which I posted at http://safetyinvalue.blogspot.ca/2013/05/automodular-update-tsxam-1.html. I think they are likely to liquidate if they don't find something lucrative between now and 2014. Management has proven to be sharehold friendly in the past (special dividend).

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    2. Now the March 31 cash balance declined by 1.2m due to the recent dividend.
      Are the operating leases (9.7m at Mar.31) accounted for in the management's 6m estimate?
      Would it be a tax-free liquidation?
      Does the company have any realistic liquidation value in the PP&E?

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