This Just In: Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." Today, we'll show you whether those bigwigs actually know what they're talking about. To help, we've enlisted Motley Fool CAPS to track the long-term performance of Wall Street's best and worst.

Picking a-part the auto industry boom
America's auto industry is undergoing a renaissance. After GM's and Chrysler's bankruptcies, Detroit is riding high on a wave of renewed auto sales. But if you ask the analysts at Credit Suisse, the best way to play this boom isn't by buying shares of General Motors (NYSE: GM  ) or Ford (NYSE: F  ) . According to Credit Suisse, the real money to be made these days is in auto parts.

Yesterday, the analyst named the top five companies in auto parts that it expects to outperform the market: Tenneco, Dana Holding (NYSE: DAN  ) , BorgWarner, Lear, and Johnson Controls (NYSE: JCI  ) . Five potential bargains that should do at least as well as, if not better than, the big-name automakers they sell to. But what are the chances of that happening, really?

Junkyard bargains
After all, at P/E ratios of 5.8 and 7.4, respectively, shares of GM and Ford look screamingly cheap -- and far cheaper than the P/E ratio of the rest of the S&P 500. These ratios also suggest bargain-level valuations if either firm manages to achieve the average 10.6% long-term earnings growth rate that Wall Street expects to see over the next five years. So if anyone's likely to outperform the market, surely it's the giant car companies...

...or not. One problem with the P/E ratios at GM and Ford, you see, is that they don't necessarily give a good picture of the real cash profits being produced at these companies. According to GM's most recent financial statements, only $1.2 billion of last year's $7.6 billion reported "profit" was backed up by actual free cash flow from the company's automotive division. (Total company free cash flow for the year has not yet been released.) Similarly, at Ford, firm-wide free cash flow of $5.5 billion was a small fraction of the company's claimed $20.2 billion in "net income" for the year.

But are the auto parts companies any better in this regard? Let's take a look:

Company P/E Ratio Growth Rate Free Cash Flow (as a percentage of net income)
Lear 9.3 8.3% 86%

Dana

 

25.7 38.8% 79%
BorgWarner 18.7 24.9% 57%
Tenneco 15.6 31.9% 20%
Johnson Controls 13.9 18.5% Negative

Source: S&P Capital IQ.

At first glance, you can see why these companies might appeal to Credit Suisse. Each and every one costs more than Ford or GM on a P/E basis, sure. But get a load of the growth rates! Even if Lear looks a mite pricey at nine times earnings and 8% growth, everyone else in this industry appears to be priced to move. Eighteen percent for Johnson Controls? Thirty-two percent for Tenneco? Nearly 40% per annum for Dana Holding? Buy, buy, buy!

Danger, Will Robinson!
But again I say, "Or not." Like their fellows further down the supply chain, the auto parts makers share one thing in common: weak free cash flow. Across the board, not one of these companies is generating actual cash profit at the levels claimed on its income statement. (In fact, Johnson Controls isn't generating free cash at all.)

Fact is, the only company here that really appeals to me at all (Ford and GM included) is recent bankruptcy survivor Dana Holding. Released from much of its old obligations in BK court, Dana now sports a management debt load -- basically zero debt, net of cash on hand. It's not generating quite as much cash as its income statement would suggest, true, but it is generating enough to give the firm a price-to-free-cash-flow ratio of 14.

Foolish takeaway
Valued on GAAP profits, or valued on actual free cash flow, Dana looks like a winner -- if the firm can achieve the 39% long-term growth rate that Wall Street has it pegged for. If Dana can only manage the 21% growth rate more widely expected in the auto parts industry, though, it still looks ripe for the picking. Out of the five recommendations Credit Suisse gave us this week, it's the only one I think holds merit.

In demonstration of which, I'm heading over to Motley Fool CAPS right now to rate Dana Holding an outperform. Want to see how it works out? Follow along (and feel free to jeer if I'm wrong).

Cheap Dana might be, but it does lack one thing that might make it a better investment: A dividend. If that concerns you, you might be better advised to consider one of the Fool's recommended stocks offering Rock-Solid Dividends. Find 11 of them right here.    

The Motley Fool owns shares of Ford. Motley Fool newsletter services have recommended buying shares of General Motors, Ford, and BorgWarner, as well as creating a synthetic long position in Ford.

Fool contributor Rich Smith does not own shares of any company named above. You can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 406 out of more than 180,000 members. The Motley Fool has a disclosure policy.


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