Pent-Up Demand Driving Auto Rebound

The renaissance currently transpiring in the North American automotive sector will reward the investors that have the patience to see it through.

From 2000 to 2007, over 16 million vehicles were produced each year. In 2009, that number fell to a mere 10 million. Though it will take several more years to return to the production levels seen in the 2000s, analysts estimate that over 15 million vehicles will be produced next year.

What’s driving the auto recovery is pent-up demand. Consumers delayed large capital expenditures during the credit crisis. Now that economic conditions have improved, so too has consumer confidence and the decision to replace old vehicles. In 1995, the average vehicle on the road was 8.4 years old. Today it is almost 11 years old. Furthermore, favourable credit conditions have played a role in driving demand. In 2007, commercial banks in the US charged its customers 8% for auto loans but today that rate has dropped to almost 5%.

One way to participate in the auto rebound is through Magna International (MGA). With 47% of its 2011 revenues stemming from Detroit’s General Motors (GM), Chrysler, and Ford (F), Magna is a direct play on the North American auto recovery. Though unattractive for years due to unfavourable corporate governance policies, the company today is unlike the one that existed before.

There are four company-specific reasons for investors to be bullish.

First, the company has raised its dividend four times after reinitiating the payout back in 2010. Its current yield is 2.6%, a full percentage point higher than a 10 year Canada bond. Because the company is paying out only 20% of its earnings to shareholders, there is room to grow the dividend down the road.

Second, management has its skin in the game. CEO Don Walker is the beneficiary to 617,142 common shares (including rights restricted shares), representing over $25 million.

Third, the company has a pristine balance sheet with $1.1B in net cash. This is equivalent to $4.29 per share. Without material long-term debt and the interest payments that go along with it, Magna has greater flexibility that many other companies do not.

Fourth, after excluding the $4.29 in net cast from the $42.50 share price, the company is trading at only 6.8x its 2013 earnings. This is about half the S&P 500’s 12.5x P/E for next year.

Last, while Europe does indeed account for 30% of the company’s revenues, 90% of Magna’s profits (before interest and taxes) emanate from North America.

Given these attributes, Magna is an undervalued stock that is attractive to value investors as the North American auto industry continues to rebound.