Few people can say they’ve ever bought a brake company.
João Pinheiro can assert, with only a slight exaggeration, that he’s bought a stake in three of them.
He works for the boutique asset management firm Intermoney Gestión as an investment analyst, alongside fund manager Álvaro Cubero.
The firm invests broadly across public Eurozone companies. Currently it is invested in Brembo and Continental, and in the past it had a position in Spanish firm Lingotes Especiales.
The BRAKE Report had a conversation with Pinheiro over email. We discussed why brake companies are attractive to Intermoney Gestión and what they look for before investing in one.
In general, what does Intermoney Gestión look for in a company?
We conduct our analysis with a generalist approach and a simple six-point checklist:
- Identifiable and sustainable competitive advantage (patents, long term contracts, low cost advantage, pricing power, etc.);
- Some sort of sectorial tail wind (consolidation);
- Companies with low disruption risk or that are protected from it (high R&D expenditure);
- Management or owner-operators with a track record of good capital allocation;
- Adequate financial leverage (especially in cyclical industries);
- An attractive valuation considering all the above characteristics.
When we identify the few companies that meet the criteria we turn to our business mindset. This means thinking like owners of the business, in order to assess both historical and potential value creation and market expectations of that value creation. This involves conducting extensive analysis of the companies’ value chain and competitive environment. We spend our time reading public fillings, trade magazines and conducting conference calls or meetings with the companies.
Subsequently, we look at real market transactions to understand what private market participants are paying for similar companies and we try to assess if the company’s top shareholders would sell their stake to us at current market prices. We then add to our portfolio the companies we believe are undervalued considering the analysis conducted. The process is dynamic and does not stop there, since we continue to monitor the businesses to increase our understanding of the sector and potentially our shareholding of a particular company.
What qualities do brake companies have that make them attractive for you?
Our approach regarding automotive components is to focus on critical component manufacturers. For example, vehicle safety is one the most important concerns for OEMs. For components such as tires, brakes, seat belts or steering wheels, manufacturers spare no expense. Recalls related with safety issues are a nightmare for OEMs, therefore it is no surprise that those component manufacturers enjoy higher operating margins and returns on capital employed.
A Lazard/Roland Berger study demonstrated that companies who supply exterior components have enjoyed higher operating margins across the last seven-year economic cycle. Also, if the company is a product innovator it has also enjoyed higher growth rates and higher operating margins as OEMs are willing to pay higher prices for differentiated products. And if the company combines product specialization with innovation, then you have a winner. This is the case for my favorite company in the sector, Brembo, which was also the first stock I pitched when I joined IM Gestión.
The common narrative across the auto companies we spoke to or analyzed in the last three months is that revenue visibility is becoming foggier. There are multiple reasons: Global trade war, lower car sales, diesel demonization and implementation of WLTP, which is forcing companies to repurpose production lines, vehicle electrification, and shared mobility, among others. This has led to significantly higher volatility in market expectation and large declines in stock prices and valuations for the automotive component sector. This is the case because companies keep shifting their own operational and financial targets. Therefore, we favor companies that are honest about expectations and give broader guidance or no guidance at all.
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Interestingly, we found that certain brake companies are great at positioning themselves for the trends that I mentioned, including contributing for CO2 emission and weight reduction potential, which are particularly useful for consumer demand of SUVs and implementation of the WLTP standards. Also, brake systems make up a small portion of the overall vehicle cost, which gives these companies an uncommon negotiation power over OEMs. In terms of disruption risk, we believe it is low since brake discs will still be used when the brake-by-wire technology proliferates. We particularly like Brembo’s positioning since they have historically had an incredible R&D testing platform through their dominance of the racing market and subsequent adaptations to the high-end passenger car market.
What does Intermoney Gestión look for in a specific brake company?
We believe that there are five critical components for a successful brake company:
- Integrated manufacturing process (foundry + full braking systems + aftermarket);
- Substantial R&D investments, preferably in partnership with customers;
- Global customer base and production and operating at high utilization levels;
- Raw material price inflation pass-through clauses with customers;
- Solid balance sheet (low debt levels or flexible financing terms).
Many of the Tier 1 or 2 brake application suppliers that we have looked at are not fully integrated and are thus more vulnerable to the cyclicality of the industry. This is the case since a local manufacturer of disc or drum brakes or a foundry will have difficulty competing in terms of pricing and volume adjustments with a global one when a recession hits and OEMs pressure their suppliers.
There is a publicly listed company in Spain called Lingotes Especiales (LE) that went through a tough restructuring process in 2009 when sales fell from €76m to €45m. The surprising detail about it is that instead of focusing solely on cost cutting across the board, LE started hiring sales people in order to bolster their commercial muscle and recover the lost business across the EU. LE also recognized that to stay competitive they had to keep investing beyond the foundry business. LE invested R&D euros into production process upgrades and to develop added-value solutions such as brake discs. Today, LE is earning more than €110m in revenue.
During our research, we found out that replicating the manufacturing plants of LE would cost north of €250m. If we include the important contracts and customer relationships the company has secured over time, then the full replication value is certainly higher. Yet, LE recently had a market value of €100m. Even if you paid off all the liabilities, wrote off the entire inventory and accounts receivable, the liquidation value of LE would be approximately €200m. LE is a good example of a company that has been successful at vertical integration, and developed a sustainable competitive advantage, but its intrinsic value is not being recognized by capital markets.
Brake companies should be able to supply OEMs at competitive prices, guarantee safety/quality and deliver fast and consistently on a global basis. A globally diversified customer base enables a company to develop a more agile commercial effort which will protect it during a turn of the economic cycle. Companies with this profile also tend to build a manufacturing footprint close to their customers and end up developing strong switching costs. We think that market participants underestimate how difficult it is from these companies to acquire and maintain those customer relationships.
During our research we have come across plenty of smaller foundry or disc manufacturers who have gone into bankruptcy because of their smaller size and were unable to compete with other integrated players. In addition, some of these overinvested and operated at low capacity utilization levels which led to small operating margins. Therefore, we favor companies that expand slowly and only do so when they have secured contracts to justify increasing capacity. This is the case with Brembo and LE.
Raw materials range from one third to half of the cost structure of brake companies (depending on integration level). Therefore, the ability to pass on raw material inflation to customers is critical for brake companies. We have come across some publicly listed companies that operate with an extended lag in pricing updates. In our experience, this leads to much higher profit volatility and results in a lower valuation multiple. Brembo is a great example of a company that updates pricing very fast to smooth out the effect of aluminum, iron or steel price inflation.
The Credit Suisse Research Institute has found that family-owned companies survive longer, recover from crisis faster and boast greater profitability. Therefore, we favor companies with an owner-operator or management team because they tend to operate with very healthy balance sheets across the economic cycle.