Magna Still Not in the Driver's Seat

Magna International (MGA) does many of the things that we like to see from suppliers in order to generate economic profit. And last month when we attended the Magna's analyst day in Brampton, Ontario, the company highlighted two themes that we view as being requisite for an investment in an auto supplier stock--global presence and innovation.

Even so, there is a disconnect between what Magna says and what shows up in its results. Other than 2010, Magna has not shown significant excess returns on invested capital over its weighted average cost of capital since 2005. In recent years, the company has generated subpar returns in all regions. But more recently, North America and other world regions including Asia have improved, while Europe has been a substantial drag on profits. We were hoping to hear more definitive plans to turn around Europe’s performance, but the company offered no specifics other than it is continuing efforts to restructure there.

Our views on Magna remain unchanged and the stock is rated without an economic moat, a negative moat trend, and high uncertainty. Despite these ratings, this 4-star stock currently trades at an attractive 33% discount to our fair value estimate of $50 per share.

Magna's Footprint Leaves Competitors With Big Shoes to Fill
Global vehicle platforms, or architectures, enable substantial cost savings for original-equipment manufacturers (OEMs), as greater volumes of common parts are spread out over an automaker's fixed cost base. Auto suppliers with a global research and manufacturing footprint are well-positioned to benefit from the increasing use of global platforms by OEMs. A supplier’s ability to globally produce a common component should improve its manufacturing efficiency by reducing variation, increasing repeatability, and enabling a homogenous manufacturing process in multiple facilities. Having a global footprint also provides a moderate barrier to entry due to the substantial capital investment.

Magna quoted IHS Global Insight numbers that stated the top 20 global platforms accounted for 25 million units of production in 2010, up from 19 million units of vehicle production in 2005. By 2017, global platforms will account for 38% of worldwide production and 41 million vehicles will be produced on the top 20 platforms. To benefit from this trend, Magna's global manufacturing footprint consists of 275 production facilities and 85 research-and-development locations. The company has plans for 20 more greenfield production plants in the next two years.

Innovation Remains Magna's Motivation
Innovation in both product and process also has been one of our major investment themes. Since OEMs demand and get annual contractual decreases in price, suppliers need to be world-class manufacturers just to enter the market. At the least, lean manufacturing practices should partially offset price declines with constant year-over-year improvement in efficiency. Suppliers able to consistently generate returns for investors that significantly exceed their cost of capital are those companies that regularly bring new and improved products to market for which OEM customers are willing to pay a premium. This enhances the average pricing on a supplier's entire portfolio of products, improving consolidated margin, and further offsetting contractual price declines beyond what lean manufacturing can provide alone.

While the company was understandably reticent to share its latest innovations due to the automotive industry’s highly competitive nature, Magna demonstrated numerous technologies, including advanced processes (laser welding), improved fuel efficiency (alternative fuel and active transfer case), reduced vehicle weight (composite and alternative materials), increased safety (driver assistance and pedestrian protection systems), and improved passenger comfort and convenience (seamless touch control with wireless smartphone integration).

In November, we also toured Magna's Mississauga seating facility, which provides just-in-time (JIT) complete seats for Ford's assembly plant in Oakville, Ontario, where the Ford Edge, Ford Flex, Lincoln MKX, and Lincoln MKT vehicles are produced.  As expected, our tour of this facility did not reveal any manufacturing issues. Seating operations are relatively labor intensive due to the assembly of many different types of parts using various types of fasteners. While this kind of process does not easily lend itself to automation, there were some robots along the assembly line.

This JIT facility operates in near unison with Ford's Oakville plant, with a four- to eight-hour window between when the seats roll off the Magna line and when they need to be available to install in the vehicle. As a result, inventory turns are high and work-in-process plus raw material is kept at a minimum. When Magna's seats are delivered, they arrive in sequence with their corresponding vehicles on the assembly line.

Still, No Moat for Magna
Despite Magna's display of innovation and its global footprint, the company does not possess an economic moat. The company was able to generate excess returns over its cost of capital earlier in the last decade, but returns faded to a 9.5% cost of capital in 2006 from a peak of 19.1% in 2002. In 2007, the company's returns held up at the same level as 2006, then plummeted in 2008-09 because of the Great Recession. With a return of 15.6% on its invested capital in 2010, it appeared as though Magna was making a comeback, but as we expected, this was only short-lived. During our explicit five-year forecast period, we estimate that Magna will continue to generate returns around its cost of capital as the company strives to bring innovation to market and maintain world-class manufacturing processes.