Look for manufacturers exploiting hot segments with new models and defending current market share with fresh styling, innovation, and value pricing. For suppliers, invest in a book of business that is migrating towards high vehicle content growth (electronics), and value-added (complete systems or modules).
6. Invest in cash flow.
While the production cycles may have become less cyclical, the financial fortunes of vehicle manufacturers and suppliers swing dramatically once capacity utilizations fall below 85%. That’s 85% utilization of an assembly plant or component facility. This is particularly true for capital-intensive suppliers such as forgers and casters whose cash flows move radically around production schedules.
7. Invest in experience.
Corporate performance from core competencies comes only through deep experience. It takes a special understanding of the complexities of engineering and assembly plant launches to successfully run a vehicle manufacturer. Suppliers typically are best in serving the original equipment market or the aftermarket - not both at the same time. And always be sceptical of any manufacturer strategy that involves moving into retail. Manufacturing and retailing (at least in the auto sector) require two different mindsets.
8. Invest in the best cost structure
Due to the cyclicality of auto production, invest in the vehicle manufacturers with the best cost structure. Higher margins going into downturns provide flexibility in pricing and capital spending that will maintain a manufacturer’s long-term competitiveness. Vehicle manufacturers will always keep three or four suppliers competing for the business to maintain price discipline. Therefore, the supplier with a track record of improving its cost structure will typically offer a longer-term advantage.
9. Invest in established trends.
Year-over-year and quarter-over-quarter comparisons are difficult due to the cyclicality of sales, the seasonality of sales within a year, and the common occurrence of extraordinary events (delayed product launches, labor disputes, and weather disruptions). Therefore, always question the base date when you see significant increases or decreases in operating performance ratios.
10. Invest in liquidity and visibility.
Because of the industry’s volume, ‘small’ suppliers can still have revenue levels of $300 to $500 million. However, many of these companies have limited float and few research analysts following the story. Always take into consideration family and management-owned shares that are unlikely to trade. It is unlikely that institutional investors are drawn to these limited float companies and typically it is the institutional money that pushes demand and share price increases.
‘Market sectors vary in how quickly they respond to information. Large cap U.S. stocks, for example, are followed by so many analysts and reflect company fundamentals so quickly, that it is nearly impossible to add value through active strategies. I recommend indexing such sectors.’
Ben Warwick
Nick Antill
Nick Antill is a Director of EconoMatters, an energy consultancy offering an extensive range of skills to clients involved with gas markets worldwide. He is also an associate of BG Training, a City financial training company, specialising in equity valuation. Prior to this, Nick spent 16 years as a financial analyst covering the oil and gas sector and was responsible for Morgan Stanley’s European team.
Books
Company Valuation Under IFRS: Interpreting and Forecasting Accounts Using International Financial Reporting Standards, Harriman House Publishing, 2005
Oil Company Crisis: Managing Structure,Profitability,and Growth, Oxford Institute for Energy Studies, 2002
Valuing Oil and Gas Companies: A Guide to the Assessment and Evaluation of Assets, Performance and Prospects (Robert Arnott), 2000
Company valuation
1. The most often-repeated mistake in finance is “It doesn't matter - it's only a non-cash item”.
While it is true that the value of a company is the discounted value of its future free cash flows, it does not follow that non-cash items do not matter. There is a clear difference between provisions for deferred taxation that are unlikely ever to be paid, and provisions for decommissioning a nuclear power station - a large future cost that will certainly be incurred.
2. It is easy to get to a high value for a company - just underestimate the capital investments that it will need to make.
There are three components to a cash flow forecast: profit, which is often analysed quite carefully; depreciation and other non-cash items, which are usually analysed adequately; and capital expenditure, which is often a banged-in number that is quite inconsistent with the other two, and generally much too low.
3. Valuations must be based on realistic long term assumptions - at best GDP growth rates and barely adequate returns.
It is tempting, when valuing fast growing companies with strong technical advantages over their rivals, to assume that these conditions will continue forever. They will not. As the saying goes, 'In the end, everything is a toaster'. If this means that the forecast needs to be a very long one, so be it - it will be less inaccurate than running a valuation off an accurate five year forecast, and then extrapolating this to infinity.
4. Don't spend too much time worrying about financial efficiency.
Playing mathematical games with the weighted average cost of capital is tempting and fun, but generally has a disappointingly small effect on valuation. Substituting debt for equity shifts value from the government to the providers of capital because the company pays less tax. That is it. And even then there is an offsetting factor - it is more likely to incur everyone the inconvenience of going bankrupt.
5. Remember the ‘Polly Peck phenomenon’, especially in countries with high inflation.
If a company operates in a weak currency with high inflation, its revenues, costs and profits will probably grow quickly. If it funds itself by borrowing in a strong currency, with low interest rates, it will pay little interest, but will tend to make large unrealised currency losses on its debt. It may still be looking very profitable on the day that it is declared insolvent.
6. Unfunded pension schemes should be treated as debt.
Many companies fund their employees’ pensions by paying into schemes operated by independent fund managers. These schemes are off their balance sheets. Some companies operate a ‘pay-as-you-go’ system. They will show a provision for pension liabilities on their balance sheets, generally offset by a pile of cash among their assets. These companies are effectively borrowing from their employees - the provision should be treated as debt.
7. Remember to ask: ‘Who's cash flow is it anyway?’
Companies consolidate 100% of the accounts of their subsidiaries, even if they only own 51% of the shares in the subsidiary. In the profit and loss account the profit that is not attributable to their shareholders is deducted and shown as being attributable to third parties. Unless it is paid out in dividend, however, the cash remains inside the company. This means that the popular ‘cash flow per share’ measure implies that the shares should be valued by including something that does not belong to them - they should not.
8. Accounting depreciation is a poor measure of impairment of value.