Magna International Is a Well-Diversified Auto Parts Supplier With an Entrepreneurial Culture

Senior Equity Analyst

Richard Hilgert

Magna International is one of the largest, most diversified auto parts suppliers in the world. However, large and diversified is no guarantee of economic profits for investors. While breadth in product and services can be advantageous with regard to cross-selling--commercial activities that bolster content per vehicle and market penetration--we see only limited evidence that Magna's diversified strategy has benefited investors in the form of higher margins and ROIC.

Many suppliers focus on a particular area of the vehicle. In sharp contrast, Magna's capabilities are so broad that the firm could nearly design, develop, supply, and assemble vehicles all on its own. In 2022, the firm contract manufactured roughly 107,500 vehicles, generating $5.2 billion in revenue and $235 million in adjusted EBIT for a margin of 4.5%. While Magna's Complete Vehicle segment has a growth opportunity with startup electric vehicle companies, the operation is highly capital intensive with limited margin, constraining return on invested capital. Diversifying into so many areas increases the risk that management resources become spread too thin, allocation of capital resources may be less than optimal, and the firm becomes less effective at developing expertise in any one area.

We would be more confident in Magna's ability to generate long-term excess returns on invested capital if its product offering was more focused but its customer base and geographical manufacturing footprint were better diversified. We would also like to see more disclosure regarding research and development, especially with certain parts of the business focused on powertrain electrification and autonomous technologies. Even though we believe Magna will benefit from these industry disruptive technologies, the degree of Magna's product diversity dampens consolidated top-line growth and ROIC expansion potential from electric powertrain and vehicle autonomy. Even so, the firm's healthy liquidity and balance sheet are able to support operations through severe industry downturns, such is the case with the coronavirus pandemic, microchip shortage, and acquisitions like Veoneer that should close roughly midyear 2023.

Business Strategy & Outlook

While the company generates innovations, benefits from high customer switching costs, possesses long-term highly integrated customer relationships, and has wide product breadth, it does not benefit enough from intellectual property or cost advantage to drive economic profits. Owing to restructuring actions taken in 2009, Magna economic profits were relatively fair until the 2020 coronavirus pandemic. However, since 2002, economic profits have averaged 2.4 percentage points, with seven years being negative. As a result, we think Magna has no moat.

In our view, one of the hallmarks of moatworthy auto suppliers is consistent product and process innovation. A single innovation in a highly competitive industry represents a temporary advantage at best and by no means creates a durable economic moat. Competitors are able to quickly adapt to or even outright copy the technology in some markets. To the contrary, the frequent development of innovative products and processes enables a pipeline filled with individual competitive advantages, generating a steady stream of economic profits, potentially flowing into a narrow economic moat. 

We believe Magna indeed has been hard at work developing product and process technology. The company regularly touts and demonstrates innovation to the investment community. Even so, annual research and development expense as well as number of patents are not disclosed by Magna, leaving no way for the market to judge the extent of technological innovation.

According to Magna's corporate constitution, management is required to annually allocate no less than 7% of pretax profits to research and development. While we applaud management's decision to codify a minimum level of R&D, 7% of Magna's pretax profit generally represents around 1% of total revenue. Even though this is only a minimum required level--Magna can invest in research and development at higher levels--most innovative, successful automotive suppliers invest at rates around 2%-4% of revenue, while some reach as high as 6%.

The only measures we are left with to discern technological innovation is ROIC in excess of cost of capital and profitability. Magna's average economic profit since 2002 is 2.4% and its 15-year historical median adjusted EBIT margin is 5.7%. The company's performance is unimpressive by moaty innovative auto supplier standards, where we would expect to see 15-year average economic profits in excess of 5 percentage points and margins at least in the upper-single-digit range.

Given the company's breadth of product, it is our opinion that the pace and scope of technological innovation should be faster and broader than it appears to be on the surface from Magna's economic profit and adjusted EBIT margins. Lean manufacturing and cost-cutting measures, in and of themselves, cannot keep pace with the annual contractual price decreases that are standard operating procedure for the industry. Magna has been executing such measures along with restructuring actions, especially in Europe, where the firm does contract vehicle assembly, since the Great Recession to improve returns to shareholders. But auto-parts suppliers cannot cost-cut their way to prosperity and must invest in and commercialize technological innovation to increase the top line.

None

Economic Moat

Magna International

Magna International, Inc. is a mobility technology company, which engages in the design, engineering, and manufacturing of automotive supplies. It operates through the following segments: Body Exteriors and Structures, Power and Vision, Seating Systems, and Complete Vehicles. The Body Exteriors and Structures segment includes body and chassis systems, exterior systems, and roof systems operations. The Power and Vision segment comprises of global powertrain systems, electronics systems, mirrors, lighting, and mechatronics operations. The Seating Systems segment deals with global seating systems operations. The Complete Vehicles segment focuses on vehicle engineering and manufacturing operations. The company was founded by Frank Stronach in 1957 and is headquartered in Aurora, Canada.

Earnings data Q2 2023

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