jebmo’s posthaven

I. Introduction

Linamar (OTCPK:LIMAF) is a Canada based auto parts supplier (trading as LNR on the TSX) that operates primarily in the Powertrain/Driveline segment. It's the second largest automotive supplier in Canada after Magna International (NYSE:MGA) and competes with OEM suppliers around the world. Linmar derives 60% of its automotive revenues from North America, 30% from Europe, and 10% from Asia (mainly China and India).

In addition to its Powertrain/Driveline business (85% of revenues), the company manufactures industrial work platforms under the Skyjack brand, a niche market that Linamar dominates with a >40% market share. Barriers to entry are high as the top three manufacturers account for 98.9% of the market. Linamar estimates that the global market for Skyjack products will be worth $8B by 2020. The company hopes to eventually capture a 15% share (or $1.2B in revenues). Given the competitive dynamics within this space, its estimate seems conservative.

The story of Linamar's origins makes it almost impossible to root against the company. Founded out of the basement of Frank Hasenfratz, an Hungarian immigrant who escaped Soviet occupation in the 1960s, it has since grown into a multibillion dollar company that's still being run like a family business. Frank's daughter Linda Hasenfratz is currently CEO with a senior management team that's been with the company since the early 90s.

II. Financials

• Price: $59.75
• Shares outstanding: 65.2M
• Market Cap: $3.75B
• Revenues (TTM): $5.87B
• Gross Margin: ~16%
• Operating Margin: ~11%
• Debt to EBITDA: 1.2
• EBIT/Interest Coverage: 20x

Note: all dollar figures are in CAD

For starters, Linamar has an exceptionally strong balance sheet. The majority of its debt was only recently issued to fund its acquisition of Montupet, a French aluminum castings company, which was completed back in Q4 2015.

Over the past five years, Linamar has been on a growth tear, with 13% annual revenue growth, 34% earnings growth, and >20% return on equity. This performance is reflected in its stock chart:

The company is targeting $10B in revenues by 2020, an achievable figure considering it already has $7.7B of annual sales lined up in booked business. This also assumes an extremely conservative scenario of flat automotive growth over the next four years (source: Linamar 2015 annual report).

III. Mispriced Opportunity

Despite consistent double-digit top and bottom line growth, Linamar's stock price has been volatile of late and is now trading at a 30% discount from its highs in mid-2015. After the Trump victory, it traded below $48, before rebounding to $58 per share.

Any way you look at it, the stock is trading at depressed valuations: 7x forward earnings, 4.8x EBITDA and 0.7x sales.

There are several reasons for this but the top three in ascending order in magnitude are as follow:

• Peak auto fears
• Turmoil in European markets (e.g. Brexit, French elections)
• Thematic risks in Trump policies (e.g. border tax, regulatory uncertainty)

There are many reasons why these fears are misplaced. To address each point:

1. Peak Auto: Linamar's growth is largely driven by market share expansion rather than auto sector growth

There's been a prevailing misconception that Linamar is subject to the same peak auto risks as its large competitor Magna International. In reality, the company is agnostic to all but the worst case scenario for the auto sector (i.e. a recession driven decline).

For example, in FY15, Linamar's revenue grew by 24% year over year vs. auto sector growth of 2%. Even when you exclude the impact of acquisitions, Linamar's organic growth rate is still around 12-14%, or seven times the industry average.

2. Turmoil in Europe is overblown

According to its Q3 2016 filings (post Brexit), content per vehicle (CPV) continues to grow by double digits irrespective of geography. In fact, Europe was a positive outlier, up 54% quarter over quarter.

3. Trump Risk: In the worst case scenario, U.S. consumers and large competitors (including U.S. Big Auto) would be hurt a lot more

Linamar's strong relative operating margins (11% vs Magna's 8%), the nature of its product line (powertrains are the most complex and costly systems to insource) and its cost leadership position enables it to adopt a nimbler response to policy changes. Given that an auto part moves across borders at least six to seven times before it's installed in a vehicle, a border tax would in reality be a tax on the U.S. consumer, whose displeasure would surely be heard by the Trump administration.

IV. Other Catalysts

In addition to continued market share expansion, Linamar's stock could potentially outperform its peer group due to the imminent availability of free cash flow to fund dividend and share repurchases.

A conservative 10% operating earnings growth yields $1B in operating cash flow for FY17. Subtract $400M in CapEx (vs. $376M TTM), and another $300-400M to reduce debt-to-EBITDA under 1, this leaves $200M-300M for dividends and share repurchases. In the most recent Q3 2016 call, Linamar CEO provided the following guidance:

Linda Hasenfratz

Yes. Of course, we do consider our share repurchase or dividend of other ways that we can try to return money to shareholders. Our primary priority right now is debt reduction I mean we've increased the debt quite a bit with the acquisition of Montupet at the beginning of the year and we've been saying along that our number one role is to get our leverage down under one, we're sitting at 1.16 now. So, we're not far from that goal. Once we reached that goal then we can assess other uses of capital including share buyback or dividends.

V. Management

It's hard not to look at Linamar's management through rose colored lenses. Here's this gem from Linamar's 2015 Annual Report on management's strategic principles (highlights are mine):

Strategy

The overarching principle in strategy development at Linamar is to develop a strategy that will drive success in a variety of outcomes; a strategy based on optionality. That means identifying long term markets of opportunity, reviewing technology challenges and opportunities in each and assessing the likelihood of a variety of scenarios. We then endeavour to develop a strategy that is not betting on success in a particular market, technology or outcome but can in fact have great success regardless of outcomes.

In addition, management has a long track record of acting as owner/operators with a 100-year vision for the company (with specific milestones to be reached).

One way I assess management quality is to examine their operating decisions during a crisis. 2009 provides the perfect case study: the automotive industry was in shambles as both General Motors (NYSE:GM) and Chrysler filed for bankruptcy, and Linamar's stock plummeted 90% to under $4 a share. Management's actions during this period speak to their long-term orientation and growth mentality:

• Cut its workforce in half
• Prepaid their long-term debt
• Repurchased $67M worth of its own shares
• Made $130M in purchases for manufacturing facilities abroad
• Maintained $100M in cash reserves

VI. Valuation

Barring a major catastrophe within the industry and using a conservative 5-7% earnings growth rate over the next four years, I can't see how Linamar fails to achieve at least $9 EPS by 2020. This implies a minimum upside of 30% (or around $78-80 per share), although I think the base case favors continued market share expansion with a $90 price target within a 2-3 year time frame.

VII. Recommendation & Trading Strategy

While I consider myself a long-term value investor, I don't rely completely upon bottom-up analysis when making investment decisions. The contrarian in me incorporates macro considerations. I've built a starter position in Linamar and will be adding if/when volatility returns to the global markets.

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Disclosure: I am/we are long LIMAF.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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