08/16/2022

A Case to Buy Delphi – AFG Instrinsic Value Analysis

A Case to Buy Delphi - AFG Instrinsic Value Analysis

Delphi Automotive PLC (DLPH) is a vehicle components manufacturer that serves automotive and commercial vehicle markets through three segments: Electrical/Electronic Architecture; Powertrain Systems, and Electronics and Safety.  Delphi’s history reflects a number of corporate actions that will likely require the application of advanced valuation techniques to improve upon AFG’s default model accuracy.  This company analysis article will review historical financial statements provided by DLPH and attempt to estimate intrinsic value using assumptions that not only better align with the economics of the firm, but lead to improved accuracy historically to provide a higher degree of confidence in our analysis of the firm’s investment thesis.

Originally formed as a spinoff of GM in 1999, Delphi fired its CFO for improper accounting in 2005 and restated earnings since the company was formed.  Delphi was then forced to file for Chapter 11 bankruptcy protection, which led to the delisting of all of their publicly-traded equity and the closure of 21 out of 29 US plants.  In October 2009, the remaining assets of Delphi were purchased by a group of investors while previous stock was cancelled and replaced with new shares of DLPH, which began to trade in November 2011.dlph1

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*EquityInsights.com, Snapshot, 8/16/2016

DLPH currently has an attractive overall grade of a B, and this is predominantly driven by strong Valuation and Management Quality characteristics.  The upside of the default model is in excess of 300%, which should automatically trigger concerns of a model bias that is likely related to the Steady State Growth Rate applied in the default model, but we will explore this in more detail shortly to confirm if this is accurate.  We can also see poor Earnings Quality, EM Momentum, and Price Momentum grades, which might reflect concerns related to recent accrual growth, recent downward analyst revisions, and the recent sell-off of the stock from a high of $90/share last summer to more recent market prices around $65/share.  Based on these grades, our due diligence will attempt to confirm that the stock continues to look attractive after revising model assumptions, while ensuring that the recent decline in market value and analyst revisions are not reflective of material long-term concerns.

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*EquityInsights.com, Snapshot, 8/16/2016

DLPH’s recent decline in market value began in June 2015, which coincided with the announcement of a divesture of their Thermal Business unit to Mahle-Behr GmbH for $670M.  This is reflected in negative sales growth and a decline in operating cash flow in 2015, although we can also see ongoing expansion in EBITDA Margins with slightly higher financial leverage in 2015 based on new debt assumed in Q4 to pay for the acquisition of HellermannTyton Group PLC in December 2015.

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*EquityInsights.com, Wealth Creation, 8/16/2016

Based on historical financials provided by DLPH since their emergence from bankruptcy in 2011, we can observe stable EM levels with mild improvement over the last four years, with even higher forecasted EM levels in 2016 and 2017.  The extremely high upside observed in the default model warranted speculation on a likely model bias related to growth, and we can affirm this from the Wealth Creation chart.  While DLPH would be able to grow by nearly 20% each year by simply reinvesting operating cash flows (after funding interest expense, maintenance capex, and dividends) back into their business, they have only grown by roughly 7.5% on average over the last four years.  Once we begin to develop a custom model for DLPH in the Proforma builder, we will explore alternative growth rates that may be more appropriate for our custom model.  In addition to this, we can see that DLPH has outperformed the S&P500 every year between 2011 and 2015.  2016 is shaping up to be the first year of underperformance, but if we believe the forward-looking prospects of the firm are attractive, this recent sell-off might reflect a great entry point into owning the stock.

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*EquityInsights.com, Intrinsic Value, 8/16/2016

From the Intrinsic Value chart, we can see that AFG’s default intrinsic value estimate for DLPH has persistently overtracked the trading range each year.  This further affirms that we will need to examine growth assumptions, as well as other AFG model assumptions, to improve the degree of confidence we will have in our intrinsic value estimate.

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*EquityInsights.com, Estimates, 8/16/2016

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*Finance.yahoo.com, Analysts, 8/16/2016

AFG’s EPS forecasts provided by Zack’s will be useful in model building.  Our Zack’s database does not include sales forecasts, but we can find this data from alternative sources, and we will apply the data currently available through Yahoo for 2016 and 2017 estimates.

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*AFG Proforma Builder, Value Expectations, 8/16/2016

Value Expectation updates include 2016 and 2017 sales forecasts, with growth then slowing to 4% by 2020, alongside roughly 100 basis points in EBITDA Margin improvement from last year’s level.  Net Intangibles have grown to nearly a quarter of the balance sheet following the recent acquisition in 2015 Q4.  We have opted to use productive asset turns to link balance sheet growth to our sales forecasts, as this turnover ratio has been stable over the last five years while overall asset turns have been declining due to a number of acquisitions over the last several years.

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*AFG Proforma Builder, Balance Sheet Editor, 8/16/2016

The default model will grow each financial statement line item either in-line with historical common size ratios or by targeting a consistent capital structure.  Since our custom forecast focuses solely on organic growth of the firm, we will keep last year’s net intangible level flat over the next five years.

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*AFG Proforma Builder, Balance Sheet Editor, 8/16/2016

Prior to taking on additional debt in Q4, debt levels had been relatively stable for DLPH, so we will assume that this will continue in the future by pushing LFY debt forward.

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*AFG Proforma Builder, Income Statement Editor, 8/16/2016

Note that Plant Life (Gross Plant / Depreciation Expense) has been increasing almost every year historically, from 6.6 years in 2011 to 10.3 years in 2015.  Given the corporate action and reorganization history of DLPH, we should assume that economic assumptions based on this approach will likely be distorted due to the large amount of management discretion and loss of information from previous asset write-downs.

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*SEC Edgar, DLPH 2015 10-K, Notes to Financial Statements, Property Net, 8/16/2016

Based on information available from the DLPH’s 2015 10-K, we can briefly observe that the largest component of plant is Machinery, which has an estimated life of 3-20 years.  If we assume that the mid-point of this range is 11.5, we can use this to guide a more appropriate forecasted life estimate that is not influenced by potential historical distortions.  We will use this assumption to forecast DD&A expense on the income statement, and we will revisit this shortly when we analyze Plant Life under the Advanced Valuation report.

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*AFG Proforma Builder, Income Statement Editor, 8/16/2016

Interest expense as a percentage of total debt fell from 5.5% in 2014 to 3.2% in 2015.  This was primarily due to taking on an additional $1.3B in debt in 2015 Q4, which would distort the debt rate to a lower value than would have been realized had that new debt level been held the entire year.

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*SEC Edgar, DLPH 2015 10-K, Notes to Financial Statements, Debt, 8/16/2016

By further exploring the footnote on debt, we can see that DLPH recently replaced a 6.125% note with 3.15%, 1.5%, and 4.25% notes, so simply reverting back to 2014 debt rate levels would be inappropriate.  Based on this table, alongside an assumption of a 4.5% rate on the Trance A Term Loan, we can calculate a weighted average debt rate of 3.7%, which we have applied to the model forecast.

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*AFG Proforma Builder, Income Statement Editor, 8/16/2016

DLPH is incorporated in Jersey, while retaining British tax residence, which has led to a relatively low tax rate over the last five years despite the majority of executives and corporate headquarters located in Troy, Michigan.  The IRS formally challenged this foreign domicile distinction in 2014, but an appeals panel has sided with Delphi to allow them to continue operating as a UK tax-resident.  (SEC Filing)  Based on this recent ruling, we will use last year’s tax rate of 17.3% in our forecast, with the caveat that we should continue to monitor any potential challenges to UK residency if we end up investing in DLPH.

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*AFG Proforma Builder, Value Expectations, 8/16/2016

Based solely on adjustments to the income statement and balance sheet, our EPS forecasts (using the w/Buybacks version) are fairly close to the EPS estimates provided by Zack’s.  It’s possible that the EBITDA margins assumed here are lagging consensus estimates, since “EPS no Buybacks” is trailing consensus EPS, but we will err on the side of being conservative at this point.  We still see significant upside, but our advanced valuation work should better reconcile any disconnect from a model bias.

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*AFG Proforma Builder, Free Cash & Financing Report, 8/16/2016

The final plug applied by AFG to ensure reconciliation of all financial statements is that any excess cash not reinvested back into the business will be used to repurchase shares (or a cash shortage will lead to share issuance).  Historically, DLPH’s share repurchases have averaged roughly 4% of outstanding shares each year, and our model forecasts reflect a similar rate of repurchases in 2016 then growing by a couple hundred basis points through 2020.  Through the first two quarters of 2016, DLPH has already repurchased nearly 5M shares, which is in-line with our model assumption for 2016.  While it’s likely that the share price will appreciate as time passes and the firm purchases more shares, or management may opt to increase the level of cash held on the balance sheet, we will simply include a 4% share repurchase assumption into our growth rate instead of tackling the issue here.  (An article published on AZO highlights growth rate vs. shares for valuation approaches to handle share repurchases in additional detail)

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*AFG Proforma Builder, Advanced Valuation Report, 8/16/2016

Earlier in this article, we reviewed PP&E footnotes to provide a more reliable estimate of plant life for use in our depreciation expense, and the same research can be applied here.  We noted a life estimate of 11.5 years based on simple assumptions around the footnote, and we can see that the industry median for vehicle parts firms affirms this with a median level of 11.  We can use 11 years for our plant life assumption in our forecast, but we can also apply this to historical model assumptions to see if they would have led to more reliable intrinsic value estimates historically.

Note that when plant life is artificially low, it implies that the depreciation expense is either too high (or accelerated), or that the gross plant level is too low.  Given the number of corporate actions/reorganizations that have occurred since the spinoff from GM, we believe it is likely that accumulated depreciation at various points have been written down, creating a distortion that makes DLPH’s capital investments appear newer than a more realistic estimate of their age.  For reference, GM has typically had a Net Plant / Gross Plant ratio below 0.5. We can note that the industry median for vehicle parts is 0.57, but the broader median of all US companies is closer to 0.5, and we will err on being more conservative due to the limited guidance available for this and modify the N/G ratio to 0.5.

Applying these model adjustments lowers our target price from $252.63 to $197.68, and improves model accuracy from 0 to 4, indicating that we will still need to explore additional levers related to growth and decay.

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*AFG Proforma Builder, Advanced Valuation Report, 8/16/2016

Actual growth historically has averaged roughly 7.5%/year for the last four years, but given the volatility in the growth, I’ve applied a slightly lower growth assumption of 7% historically, falling to 5% in 2017 through the remainder of the forecast.  We have also lowered the Competitive Advantage Period (CAP) to 17 years to attempt to reconcile historical market prices with intrinsic value estimates, which could be justified given the uncertainty due to their tax status and recent emergence from bankruptcy.  These growth and CAP estimates are highly conservative, but are useful in our discovery process of attempting to reconcile intrinsic value estimates with realized market prices.

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*AFG Proforma Builder, Intrinsic Value Chart, 8/16/2016

Applying these conservative assumptions leads to highly accurate model forecasts since 2013, with an updated accuracy score of 71.  Given the recent history of chapter 11 bankruptcy, however, it may not be reasonable to attempt to use data from 2011 and 2012 in our accuracy formula, as newly issued shares for DLPH would likely be treated skeptically by the market place.  Based on a 17 year CAP and 5% steady growth growth, our target price estimate is $88.20, with nearly 36% upside.  At this point, these advanced valuation adjustments simply reflect the lower end of “reasonable” assumptions since their share repurchase activity should justify higher growth rates and steady EM levels should justify a longer CAP.

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*AFG Proforma Builder, Advanced Valuation Report, 8/16/2016

Revisiting advanced valuation, we believe it is more appropriate to use a 20-year CAP for DLPH given their stable EM track record, as well as a 7% growth rate, which allows for roughly 300 basis points of organic growth on top of a 4% share repurchase each year.  This leads to a slightly lower accuracy score of 63, but we believe that these estimates are better aligned with realistic expectations for the firm.

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*AFG Proforma Builder, Value Expectations, 8/16/2016

Based on these assumptions, our estimate of intrinsic value for DLPH of $104.92, with nearly 62% upside based on their 8/15/2016 closing price.  EBITDA margin forecasts are still admittedly conservative, and could lead to additional upside if they find further success in automated driving technology.  The recent victory over the IRS on their tax domicile should provide more confidence in assuming a lower tax rate in the future.  While reporting quality is likely poor for DLPH given the loss of information due to corporate actions and reorganization, the company appears to be managed in a shareholder friendly manner.  Shares of DLPH have fallen nearly 27% since the announcement of the Thermal divestiture in July 2015, and have depreciated nearly 10% since the IRS ruling in their favor in April 2016.  Significant upside despite conservative forecasts, alongside the recent market sell-off, highlight a potentially attractive entry point into DLPH if you believe the forecasts applied in this custom model are reasonable expectations for the firm.

 

 

About Derek Bergen, CFA 3 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005

About Derek Bergen, CFA 3 Articles

Partner at The Applied Finance Group
Focus areas: Equity Analysis, Portfolio Consulting, Quantitative Research.
Joined AFG in 2005