TRW Automotive Holdings Corp. (NYSE:TRW)

Note: TRW was MagicDiligence's Top Buy pick for 10/18/2011!
It comes as no great surprise that investors would be wary about investing into the automotive sector. 2008-09 are fresh in people's minds, during which American automakers General Motors (GM) and Chrysler filed for bankruptcy, and Ford (F) barely survived. Auto suppliers such as Delphi and Lear (LEA) trudged into bankruptcy court. The industry, put simply, was decimated by the "Great Recession".

Even in the best of times, this is a difficult business. Auto sales are highly coorelated to the general economic cycle. Capital costs for production equipment are high. Labor disputes and rising commodity costs are ever-present dangers. Consumer tastes can change quickly, wreaking havoc on model design plans that take years to come to fruition. Tight credit markets make it difficult for many buyers (consumers and businesses) to finance new vehicle purchases. And, historically, both automakers and suppliers have carried poor balance sheets with large debt burdens, "living on the edge" in a very unpredictable industry.

Given this, we need a very attractive candidate in order to gain exposure to this sector. Fortunately, Magic Formula Investing (MFI) has dug up one such stock in TRW Automotive (TRW).

TRW is one of the world's largest auto suppliers. The firm's primary focus is on safety-related systems present in modern vehicles. These run the gamut from electronic steering to anti-lock brake systems to air bags to lane assist systems and everything in between. TRW supplies most of the major auto makers. Its top 4 customers are Volkswagen Group (20% of sales), Ford (16%), Fiat/Chrysler (14%), and General Motors (12%).

I like TRW for several reasons. First and foremost, the firm has an attractive set of growth opportunities. Over 80% of sales come from developed economies in North America and Europe. These two geographies have suffered from 30-year low vehicle volumes in the 2008-09 period. While 2010 and now 2011 have been an improvement, volumes are still some of the lowest in the past 40 years. To illustrate this, consider just U.S. sales. From 1968-2008, average new vehicle sales in the U.S. were 14.3 million units. More recently, from 1998-2008, the average was 16.8 million. In contrast, 2009 sales were 10.6 million and 2010 11.8 million. Even 2011, a rebound year, is only showing volumes around 13 million - about 23% below the '98-08 average. This also remains well below the scrappage rate of about 15 million units. A similar story exists for Europe. Put simply, there is still plenty of room for rebound growth in TRW's main markets.

Another growth driver is secularly increasing auto sales in developing economies, particularly China. China is now the world's largest auto market at about 19 million units, and has been growing at over 30% rates up until this year. However, China has less stringent safety requirements at current, with content per vehicle at only about $200, compared to about $350 for U.S. and Japanese vehicles (India is even more pronounced). As safety requirements are developed, TRW stands to earn more per vehicle sold in these geographies. Even vehicles for developed countries continue to add more advanced safety equipment, such as side curtain air bags and electronic stability control systems.

TRW has also made great strides in improving its operations and financial footing. Restructuring efforts underway since before the "Great Recession" have really shown themselves as sales rebounded in 2010-11. Gross margins have risen from 9% in 2006 to over 12% today. Operating margins have soared from under 5% to over 8%. Returns on capital have climbed from 8% to 21%. As a result, operating profits have more than doubled since 2006 - on a much lower base of vehicles being sold.

Going along with this are substantial improvements in the balance sheet. As recently as 2007, TRW was buried under a $3.2 billion mountain of debt. Today, that figure is down to $1.7 billion, and the firm has $1.2 billion in cash offsetting it. Interest coverage (how many times profits cover interest requirements) is over 9 today, from under 3 a few years ago - I consider 5 times relatively safe. TRW is well positioned to handle the $770 million in debt coming due in 2014, and much better positioned to handle any "double dip" recession.

We've already covered the risks here, most of which are inherent to the industry. I don't expect a double-dip recession, and aside from that it is much more likely that vehicle sales continue to rise towards historical levels. However, if they do not, TRW will likely not be able to get to our sell early target.

Given what looks like solid near-term industry and company specific dynamics, I think TRW is in a short-term price trough that we can benefit from. My price target is $64, right around the 52-week high and a substantial 55% upside from current levels.

Read the TRW Automotive Research Report

Disclosure: Steve owns TRW

Cyclical. Super cheap at this price. Pessimism is a good time to evaluate the situation. Should be low downside in the 30-35 range.