Automodular's pretty cheap eh?

Except for the bottom of a bear market, it always seems like there aren't many cheap stocks to be found.  Some cheap stocks (like most of the current net-nets) are full of warts, with one food in the grave, and the other on a banana peel.  In every market there's always someone who things stocks are overvalued and is willing to sit on their hands clutching cash waiting or the next crash, waiting, and waiting.  A preferable strategy is to find safe and cheap stocks in any market, buy, and be patient.  The stock I want to discuss today is a good classic cheap stock.  There is unfortunately no sexy story, full of mystery and intrigue surrounding it.

Automodular (AM.Canada) is a Canadian manufacturing company based in Ontario.  The company did have a small amount of operations in Ohio, but those have mostly been wound down.  Sales are now predominantly in Canada.  The company is an integral part of the car supply chain, they, supply assembled sub-modules for cars.  The modules are things such as an instrument panel, or powerpack.  The company receives orders every forty seconds, and ships the completed components within two hours.  The car assembly process at the destination plant cannot continue without Audomodular's components, so timing is critical.  Because of this the company is locates their facilities within 12 miles (20km) of the final assembly facilities.

The company relies on contracts with auto manufacturers, mainly Ford and GM.  Ford and GM use third party modular assemblers because historically it's been cheaper to outsource component production.  Automodular states that the price advantage gap has been closing over the past few years, and if the difference becomes inconsequential it's possible that Ford or GM might insource their work.  In an effort to diversify the company has sought new lines of business that might use some of the expertise they already employ.  Out of this initiative they have started to manufacture windmill components.

There are a few things that make Audomodular really interesting as a potential investment.  The company is trading slightly below book value, and has a P/E of 2.7x.  With a P/E this low ROE last year came in at 36%.  What makes the numbers even more impressive is that the company has continued to grow into 2012.  The 2011 annual report looked great, but the 2012 half year results are even better.  Sales are running 36% higher than last year, with earnings coming in 31% higher.  The company's sales weren't artificially high in 2011 due to a one time gain, they've been consistently strong coming out of the recession.

The large gain in year over year results come from the company's windmill fabrication efforts.  Unfortunately is the windmill production program is only a year long.  There's the possibility of extending it, if successful, but windmill demand relies on government subsidies, and renewable energy demand, two unknowns.

The company has the ability to generate strong cash flows, in 2011 they had free cash flow of $15,768k, and in 2011 free cash flow was $22,578k.  Free cash flow for the first half of 2012 was significantly lower at $2,920k.  The company attributes their strong free cash flow over the past few years to a significant rebound in orders from Ford and GM.

The company has been a responsible steward of cash, they have accumulated a sizable cash hoard, recently amounting to $15m.  Management has been shareholder friendly, paying a sizable dividend last year, and buying back shares, when appropriate.

Naturally for a company this cheap, with a history of sizable earnings the first question asked is: "what's wrong?"  There are two major forces working against Automodular, and they're the primary cause for cheapness.  The first was touched on briefly above, the current extraordinary results are from the temporary production of windmills.  It's possible this production could be extended, but as of now there isn't any visibility into that decision.  When windmill production ends, results will drop back down to where they had been in the past.

The second cause for the cheapness is that Automodular works on a contract basis for Ford.  They're currently contracted to produce subassemblies for a few different car models, but the contracts are set to expire in the next couple years.  The company is working hard to secure a future contract, but if they're unable to, Automodular will be a company with a lot of expenses and no revenue.

I believe it's the fear over the visibility into the company's future that's holding the price down.  While it would be nice to lock up 10 years of revenue in a long term contract it's aldo very rare for a company to do that.  Most companies are in the opposite position of Automodular, they don't know who will be making purchases tomorrow, and how many purchases will be made, there is no visibility.

A third and more minor concern is that management is looking for ways to diversify their lines of business.  This diversification effort led to the windmill project, but in the future it could lead to projects of dubious value.  Management has been a good steward of shareholder capital in the past, but that doesn't mean they can't make an ill-timed acquisition, or make a mistake in the future.

With all the potential negatives it's worth discussing a potential positive as well.  The company has a lawsuit pending against GM for breach of contract for the amount of $25m.  The lawsuit is pending in the Ontario courts, with an uncertain resolution date.  If Automodular wins the case the settlement amount would be material, and could be used to pay a dividend, or buyback more shares.

If an investor believes Automodular will be able to extend their contracts with Ford, or diversify into profitable side businesses this could be a very nice investment.  This could also be a great first international investment for an American.  The company has shares that trade on the pink sheets, as well as their Toronto listed shares.  All of the reports are in English, and Canada isn't that far away for most Americans for a quick visit to company facilities, if desired.  For American investors afraid of the shark infested international markets, Canada is a great baby step.  Not only do both countries share hockey, and baseball leagues, we also call our money the same thing.

Talk to Nate about Automodular

Disclosure: No position