Auto Parts Could Rev Up Returns

By Stephen D. Simpson, CFA | May 20, 2010 AAA

Reports of the death of the auto industry have been greatly exaggerated.

American automakers are certainly still in trouble, but there is a wide world out there and people, especially Chinese people, continue to buy cars. If people are still buying cars, that means companies are still building cars. If companies are still building cars, that means there is still business out there for auto parts companies.

Back From the Dead
Investors are right to be skeptical of the thesis that there is actually money to be made from investing in auto parts stocks. After all, many of these companies had the same problems as the U.S. automakers - stagnant sales, competition from foreign companies, outdated (and excessive) cost structures and too much debt. More than a few companies went bankrupt or flirted with bankruptcy. (For more, see Analyzing Auto Stocks.)

That was then. This is now.

New Technologies, New Markets
If investors do want to give auto parts companies a chance, they would do well to focus on those companies that have the opportunity to leverage new technologies and/or new markets into greater growth.

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Autoliv (NYSE:ALV) has long been a pioneer in auto safety products, and the company holds roughly 40% of the still-new side impact airbag market. Consumers are not going to look for less safety in the future and it is a fair bet that Autoliv will see more and more demand from developing markets in Eastern Europe, China and India.

Gentex (Nasdaq:GNTX) is another parts supplier bringing new ideas to an old industry. Do you have an auto-dimming mirror? There is a better than 80% chance that it came from Gentex. On top of auto-dimming rear-view and side-view mirrors for cars, the company is also working with Boeing (NYSE:BA) to develop auto-dimming passenger windows for airplanes.

Of course, we cannot have a discussion about cars without mentioning China and its huge (and still growing) market. While building a share in China has to be a goal for nearly any auto parts company that wants to have a future, why not start by looking at some home-grown talent? SORL Auto Parts (Nasdaq:SORL) and Tongxin International (Nasdaq:TXIC) are both fast-growing companies that feed directly into the Chinese auto market, and SORL is already the largest brake supplier to the Chinese commercial vehicle industry.

The Tale of the Tape

Company EV / EBITDA ROIC Debt / Equity
Autoliv(NYSE:ALV) 5.4 5.3 0.37
ArvinMeritor(NYSE:ARM) 13.0 Neg Neg equity
American Axle(NYSE:AXL) 9.3 Neg Neg equity
Gentex(Nasdaq:GNTX) 12.8 13.2 0
SORL Auto Parts(Nasdaq:SORL) 8.2 16.0 0
Tenneco(NYSE:TEN) 5.7 0.3 Neg equity
Tongxin Intl(Nasdaq:TXIC) 4.6 5.2 .32

Keep On Trucking?
It is important to point out that many of these stocks have already had impressive runs, though in some cases these were rebounds off of lows that presupposed bankruptcy. That could mean that future gains are pressured by early investors looking to take profits. It is also worth noting that these are largely bets on growth and improvement in the sector - if the world economy slows again and/or these companies cannot grow and improve margins, a lot of the potential gains go away. Given that many of these companies still have high debt loads (if not negative equity), that is a risk that investors cannot ignore.

All of this said, I think investors can still make some money in this sector. Innovators like Gentex tend to do well no matter what industry they are in, and I believe an upcoming upgrade cycle in commercial trucks could be a boon to companies positioned in that space (like ArvinMeritor and Tenneco). As always, do your own due diligence and make sure you can afford to take the risks that go with this cyclical sector.

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