Although the passenger vehicle market has stayed relatively healthy in the United States, slowdowns in Europe and emerging markets have left many auto parts companies drifting this year. In the case of Federal-Mogul (Nasdaq:FDML), it could be argued that macro pressures have hidden some of the cost improvements the company is trying to make, while the weak performance of the aftermarket business has likewise weighed on the numbers. Although Federal-Mogul likely can do better from here, investors should not lose sight of the risks that accompany the stock.

Discount Brokers Comparison: Your one-stop shop for finding the perfect broker for your investments.

The Split Is in, but Will It Help?
Earlier this year the board of Federal-Mogul decided to restructure and effectively split the business of the company. That split was executed earlier this month, dividing the company into "Federal-Mogul Powetrain" and "Federal-Mogul Vehicle Component Solutions," the latter largely being the company's aftermarket and friction businesses.

The company has gone all out with this split, including the hiring of co-CEOs. Rainer Jueckstock runs the Powertrain business, while Michael Broderick is charged with turning around and improving the new Vehicle Component unit. While the company has said that they are not anticipating selling the Vehicle Component business, the emphasis on the independence of the two segments calls that into question for me. A healthy (or at least healthier) aftermarkets business could definitely add value for the company, but selling it could bring in over $1 billion and that certainly wouldn't hurt the balance sheet any.

SEE: How To Evaluate A Company's Balance Sheet

Good Underlying Trends, but Is It a Good Business?
On the surface, Federal-Mogul looks like a business well worth researching further. The company is a diversified player in product categories like pistons, piston rings, seals, bearings and so on. While the company's 10% exposure to BRIC countries is a little light, the overall diversification between vehicle types and manufacturers is attractive, with the Big Three ((Ford (NYSE:F), General Motors (NYSE:GM) and Fiat-owned Chrysler)) less than 20%, but most major manufacturers ((including Toyota (NYSE:TM) and Volkswagen)) represented.

What's more, Federal-Mogul should be in position to take advantage of ongoing demand for better fuel efficiency and lower emissions. Areas like improved exhaust energy and reduced engine friction play into the company's Powertrain offerings, and the company has some exposure to improved gas exchange as well (the "big three" of improved engine performance). Now, for the other side of the ledger. While Federal-Mogul doesn't have high customer exposure, auto makers in general are not too willing to let their suppliers thrive at their expense. So, while a lot of Federal-Mogul's competitors are not exactly household names to non-gearheads ((names like Kolbenschmidt and Mahle, along with better-known companies including Dana (NYSE:DAN), Honeywell (NYSE:HON) and TRW Automotive (NYSE:TRW)), there's more than enough competition to weigh on margins and returns.

In fact, at no point in the last decade has Federal-Mogul come close to earning its cost of capital, and it's hard to imagine that the company can lift its free cash flow margin above the mid-single digits. Couple that with a debt-heavy balance sheet and the financial outlook isn't as appealing as the company's market share or business exposures may suggest.

The Bottom Line
I do like the company's leverage to fuel efficiency and emissions, but I believe BorgWarner (NYSE:BWA), Honeywell and Cummins (NYSE:CMI) are better plays on that theme (with Cummins much more focused on commercial vehicles). Likewise, I like the company's strong market share, particularly in aftermarket parts, but it's pretty clear that strong share has not yet translated into good financial returns, and it may never do so.

On a discounted cash flow basis, forget about Federal-Mogul - the huge debt load just saps any DCF-derived fair value to almost nothing. On an EV/EBITDA basis, though, maybe this could work as a turnaround play. Federal-Mogul's EV/EBITDA is around 5.5 today, and I think there's a pretty fair chance that the company can deliver EBTIDA growth in excess of 6%, though probably not this year or next. Accordingly, this is a risky stock with questionable fundamentals, but some upside for more aggressive investors who believe that the global passenger vehicle market can improve and that Federal-Mogul's restructuring efforts will pay off with better margins.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

Related Articles
  1. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  2. Stock Analysis

    Analyzing Altria's Return on Equity (ROE) (MO)

    Learn about Altria Group's return on equity (ROE) and analyze net profit margin, asset turnover and financial leverage to determine what is causing its high ROE.
  3. Investing News

    Icahn's Bet on Cheniere Energy: Should You Follow?

    Investing legend Carl Icahn continues to lose money on Cheniere Energy, but he's increasing his stake. Should you follow his lead?
  4. Stock Analysis

    Analyzing Google's Return on Equity (ROE) (GOOGL)

    Learn about Alphabet's return on equity. How has its ROE changed over time, how does it compare to its peers and what factors are driving ROE for the company?
  5. Investing News

    Is Buffett's Bet on Oil Right for You? (XOM, PSX)

    Oil stocks are getting trounced, but Warren Buffett still likes one of them. Should you follow the leader?
  6. Stock Analysis

    The Top 5 Micro Cap Alternative Energy Stocks for 2016 (AMSC, SLTD)

    Follow a cautious approach when purchasing micro-cap stocks in the alternative energy sector. Learn about five alternative energy micro-caps worth considering.
  7. Stock Analysis

    Analyzing Porter's Five Forces on Under Armour (UA)

    Learn about Under Armour and how it differentiates itself in the competitive athletic apparel industry in light of the Porter's Five Forces Model.
  8. Stock Analysis

    The Biggest Risks of Investing in Qualcomm Stock (QCOM, BRCM)

    Understand the long-term fundamental risks related to investing in Qualcomm stock, and how financial ratios also play into the investment consideration.
  9. Stock Analysis

    The Biggest Risks of Investing in Johnson & Johnson Stock (JNJ)

    Learn the largest risks to investing in Johnson & Johnson through fundamental analysis and other potential risks. Also discover how JNJ compares to its peers.
  10. Investing News

    Chipotle Served with Criminal Probe

    Chipotle's beat muted expectations and got a clear bill from the CDC, but it now appears that an investigation into its E.coli breakout has expanded.
RELATED FAQS
  1. What is the formula for calculating EBITDA?

    When analyzing financial fitness, corporate accountants and investors alike closely examine a company's financial statements ... Read Full Answer >>
  2. How do I calculate the P/E ratio of a company?

    The price-earnings ratio (P/E ratio) is a valuation measure that compares the level of stock prices to the level of corporate ... Read Full Answer >>
  3. How do you calculate return on equity (ROE)?

    Return on equity (ROE) is a ratio that provides investors insight into how efficiently a company (or more specifically, its ... Read Full Answer >>
  4. How do you calculate working capital?

    Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining ... Read Full Answer >>
  5. What is the formula for calculating the current ratio?

    The current ratio is a financial ratio that investors and analysts use to examine the liquidity of a company and its ability ... Read Full Answer >>
  6. What is the formula for calculating earnings per share (EPS)?

    Earnings per share (EPS) is the portion of a company’s profit that is allocated to each outstanding share of common stock, ... Read Full Answer >>
COMPANIES IN THIS ARTICLE
Trading Center