Despite continued trouble in Europe, the auto supply sector has been outpacing the broader market averages over the past year, as it rides higher auto production in North American and Asian markets. According to the North American Auto Dealers Association (NADA), domestic auto sales were running at an annualized rate of 15.5 million for the first eight months of 2013, an 8.9% gain over the prior year period. Legendary investor Carl Icahn's investment vehicle of choice in the sector is Federal-Mogul (NASDAQ:FDML), whose shares perked up nearly 30% in July on the back of a pickup in sales growth and higher profitability in its second quarter of FY2013. Should investors follow his lead?
What's the value?
Federal-Mogul produces a diverse variety of parts for vehicles, including leading positions with its Wagner braking and Moog suspension product brands. The company has a wide operating footprint of 94 manufacturing facilities across 34 countries, which allows it to provide parts for all of the major auto manufacturers, regardless of where the companies choose to domicile their plants. However, Federal-Mogul has been shrinking its plant capacity lately as it exits non-core product areas, with current plans to close or sell fourteen plants.
Despite the positive surprise in its second quarter results, Federal-Mogul's increase in sales for the FY2013 year-to-date period has been less impressive, with a 1.6% gain over the prior-year period. Its top-line growth has been capped by weak auto sales in its large European segment, an area that accounts for roughly 43% of its overall sales. In addition, Federal-Mogul's gross margin was hurt by a lower market share for diesel-based vehicles in the European market, an area that generates a higher margin for the company's related products.
Moving toward systems
While Federal-Mogul's recent rights offering of $500 million will improve its leveraged financial position, its current operations aren't providing the cash flow necessary to fund its annual capital expenditure programs. The company likely needs to move into providing more system products rather than individual components, a strategy that has worked well for larger competitors, like TRW Automotive (UNKNOWN:TRW.DL) and Johnson Controls (NYSE:JCI).
TRW has placed its bets on safety systems for vehicles, an area that generates roughly 89% of its overall sales. The company has benefited from a greater focus on vehicle safety by the National Highway Transportation Safety Administration (NHTSA), including its 2011 mandate for vehicles to have electronic stability controls, which are capable of taking over braking in critical situations.
In FY 2013, TRW has found growth hard to come by, with a 3.3% increase in revenues versus the prior-year period. Like Federal-Mogul, TRW's large exposure to the relatively weak European market, accounting for roughly 49% of sales, has limited its top-line growth.
However, the company's safety technology product offerings position it for solid future growth, as industry regulators continue to push manufacturers to make more safety systems standard options across their vehicle portfolios.
Meanwhile, Johnson Controls has tied its fortunes to interior systems, including seating, instrument panels, and electronic information displays. Like its competitors, Johnson Controls has found limited sales growth in FY2013, while its profitability has been negatively affected by higher product launch costs and a sales mix that has tended toward lower priced products.
However, the company's restructuring initiatives have led to stronger operating cash flow, roughly $1.6 billion in its latest fiscal year, allowing it to reinvest in higher growth areas, like its leading automotive battery franchise.
The bottom line
Federal-Mogul has some definite pluses, including leading product positions in important areas, like suspensions and brakes, and an active, majority shareholder who increased his stake above 80% through the recent rights offering.
However, the auto supply business is no place to run with a leveraged business model, due to the auto manufacturers' negotiating power and long-standing practice of extracting price concessions from their suppliers each year. Federal-Mogul likely needs to continue shrinking its operating footprint and product portfolio, which currently tops 500,000 SKUs in its component segment, in order to reach a level of operating cash flow that will fund its product development.
Until then, investors might want to stick with the competitors that have stronger balance sheets and are winning a big share of vehicles' overall component make-up, which will lead to better future growth trajectories.
Robert Hanley has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.