Motorcar Parts Of America: Higher Rates Detracting From Improving Fundamentals (MPAA)

Motorcar Parts of America, Inc. (NASDAQ:MPAA) primarily manufactures and remanufactures aftermarket automotive parts, and sells diagnostic equipment for alternators and starters with applications in ICE and electric vehicles. In the aftermarket car parts segment, Motorcar Parts of America’s (“MPA”) largest product types are rotating electrical parts, which include alternators and starters, brake related products, and wheel hubs. MPA has upwards of 40% market share in the alternators and starters aftermarket and upwards of 20% in the wheel hub aftermarket. The company sells these parts to auto retailers such as O’Reilly Automotive, Inc. (ORLY), AutoZone, Inc. (AZO) and Advance Auto Parts, Inc. (AAP) and has quite extreme customer concentration due to the structure in that market. MPA’s top three customers account for over 80% of sales.

MPA has benefitted from long-term demand tailwinds due to an increase in the average number of miles driven per vehicle and an increase in the average age of vehicles. These trends are being driven by high costs for new and used vehicles and high costs of financing these purchases. As long as these trends continue, MPA will continue to benefit from demand tailwinds, which will help fuel more growth in the future.

However, despite the growth and tailwinds, earnings have not grown due to declining margins. This has been caused by concessions offered to its customers, as market structure in the auto retailer industry gives the retailers negotiating power when dealing with parts manufacturers.

This is also caused by the company’s inverse relationship between earnings and interest rates. MPA utilizes an accounts receivable discount program whereby it sells receivables to banks in order to get payments faster. While this reduces working capital needs, it raises interest expenses due to the cost of borrowing from these banks. These rates are variable, which means that expenses increase greatly during times of rising rates. The company notes in its 10-K that “for each $500,000,000 of accounts receivable we discount over a period of 180 days, a 1% increase in interest rates would have increased our interest expense by $2,500,000.” For a business that has seen declining margins and cost inflation, this relationship with interest rates has been especially detrimental.

While this receivable program is built into the business model, it is not directly related to the business of manufacturing/remanufacturing and selling aftermarket car parts. I believe this has created the opportunity with the stock today, as rising rates, thus declining EPS expectations, has pushed investors to sell MPAA despite favorable long-term tailwinds and business fundamentals. MPA’s EV is currently 4.5x my estimate of FY2025 EBITDA, which is quite low given its importance in its industry and given comparable multiples, specifically from a private equity deal in 2022 involving an industry peer, BBB Industries.

Assuming EBITDA of about $72mm in FY2025, $200mm in net debt, and a 5x multiple, I see a credible path for MPAA to trade at around $8.25 as quarterly results continue to show solid business and industry fundamentals due to the previously mentioned demand tailwinds.

Recent Quarterly Results and Industry Backdrop

MPA’s financial results over the past nine months have been solid as the company has continued to grow organically and gain market share. Margins have improved when compared to FY2023 due to higher selling prices, lower freight costs, and improvements in the supply chain. For FY2024 ending March 31, revenue is expected to be around $726mm, representing growth of about 6% when compared to the prior year, and adjusted EBITDA is projected to be about $90mm, representing growth of about 25% when compared to the prior year.

Importantly industry fundamentals remain positive despite MPA noting unexpected demand weakness in November and December 2023. While other auto part retailers are expected to report soon, Genuine Parts Company (GPC) recently reported positive earnings results. GPC operates two segments, one of which is its Automotive Parts Group. This segment is an auto parts distributor that buys products from companies like MPA and sells them to do-it-for-me (“DIFM”) auto shops and do-it-yourself (“DIY”) auto part retailers. Sales to DIFM customers makes up about 80% of GPC automotive revenue, while DIY customers make up the other 20%.

In its earnings call, GPC called out continued demand tailwinds such as an aging automotive fleet, an increase in miles driven, and elevated new and used car prices. Additionally, GPC called out an improvement in US automotive sales versus the prior quarter, the same quarter in which MPA mentioned softer demand in November and December. The full quote from GPC’s conference call is as follows:

In the U.S., Automotive sales were essentially flat during the first quarter with comparable sales increasing approximately 1%. This represents a notable improvement from the fourth quarter in both reported and comparable sales. The first quarter performance was in line with our expectations. As we moved through the quarter, we saw a sequential improvement in average daily sales growth each month.

During the quarter, we also saw positive buying behaviors from our independent owners, a trend that we expect to continue over the course of the year. From a customer segment perspective, sales to commercial customers in the quarter were slightly down, while sales to Do It Yourself customers were approximately flat. For commercial, Auto Care continued to outperform while major accounts underperformed, driven by a cautious end consumer.

While MPA sells primarily to auto retailers and not DIFM auto shops, this commentary bodes well for the industry. MPA’s stock did jump about 8% on the news of these results, but I believe the stock remains cheap despite this move.

Valuation and Price Target

MPAA’s low EV/EBITDA ratio is due to the company’s sensitivity to interest rates. Interest rates are elevated and look like they may stay elevated, meaning MPA’s earnings will remain depressed. However, I think this factor, which is unrelated to business fundamentals, is creating an opportunity for investors that are willing to take a look beyond the next 12 months. MPA has high market share and is a high value vendor to its customers. This fact, along with longer-term demand tailwinds, lead me to believe that the business will be able to get through this difficult period. If the company manages this, the stock’s upside is very attractive.

For context, BBB Industries, another aftermarket automotive part manufacturer/remanufacturer, was recently exchanged in a private equity deal in 2022. I was unable to find much data on BBB Industries financials or the info regarding the 2022 private equity transaction, but details from a Bloomberg article and details from S&P Global regarding a debt issuance following the private equity transaction, lead me to believe BBB was sold for a 10x EBITDA multiple.

The Bloomberg article cites an anonymous source that claims BBB Industries was valued at $2.7bb in the deal. Along with this, the S&P Global debt rating overview wrote that BBB Industries took on $1.545bb of gross debt to fund the deal which took its leverage ratio up from 6.6x to 8.6x. S&P further states in the report that, “combined with sourcing opportunities, labor productivity, and material savings, the company should generate fiscal 2022 adjusted EBITDA margins of 19%-20%, leading to our fiscal 2022 forecast for adjusted leverage of 8x-8.5x.” Note that S&P Global seems to be including an issuance of $1.19bb in common equity in the $1.545bb gross debt figure.

This info provides us with two equations (total debt/EBITDA before and after the deal) and two unknowns (debt and EBITDA). Solving for the two unknowns leads to EBITDA of $772.5mm and total debt of $5.098bb prior to the transaction. This amount of debt plus the $2.7bb equity value cited in the Bloomberg article leads to an EV of $7.798bb which is just about 10x the $772.5mm EBITDA figure I calculated above. Again, I was unable to find much data on BBB Industries financials to check this with, so I am taking these estimates with a grain of salt.

I don’t expect MPAA should be valued with an EV/EBITDA ratio of 10 given BBB Industries’ larger scale and higher margins (20% adjusted EBITDA margins according to S&P Global compared to about 13% for MPAA), however this comparable provides some indicator that MPAA trades at a low valuation and has high upside if the interest expense issue goes away with lower interest rates, or if management is able to reduce debt through its initiatives to neutralize working capital.

Below is an illustrative model which shows a bullish outcome if growth continues and MPA is able to generate cash to reduce debt over the next few years. With a 5x EBITDA multiple on FY2025 EBITDA, and $200mm of net debt, I see a credible case for the stock to trade at around $8.25, providing solid upside from current levels.

This valuation is further supported by open market purchases of the stock by insiders over the past 12 months and as recently as one month ago at prices higher than current prices.

Risks

If interest rates remain elevated for a long period of time, or if they continue to rise from current levels, MPA’s earnings will continue to suffer. This will continue to justify a low multiple and may create the need for MPA to issue debt. This unfortunately makes an investment in MPA a bit of a bet on interest rates, which may be a frustrating outcome if business fundamentals continue to improve. MPA also has known accounting complexities due to core accounting in its remanufacturing business. I am choosing not to touch on this in detail as it has been well covered in the past, and I think the outcome for the stock won’t be decided by this accounting. However, there are risks that financial results may need to be restated due to accounting issues.

MPAA is also a relatively illiquid stock. The stock trades on average, less than $500,000 of volume per day which may make it difficult to sell a position without bringing the price of the stock down. If an investor may have a need to sell the stock quickly for any reason, it would be best not to invest in MPAA at all.