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Morningstar | Magna Reports Record 2Q Results but Lowers 2018 Guidance; Maintaining $57 Fair Value Estimate

No-moat Magna reported record second-quarter earnings per share before special items (EPS) of $1.67, $0.22 higher than the same period last year. Magna included in the EPS result the impact of a fire at a supplier that temporarily shut down some customers' production and a negative currency impact to a deferred tax asset adjustment. Excluding these special items, we estimate EPS would have been $1.75, a penny higher than the sell-side consensus EPS of $1.74. Magna's 3-star rated shares currently trade at a slight 5% discount to our $57 fair value estimate. Accordingly, we view the stock as reasonably valued relative to our forecasts for revenue, cash flow, and return on invested capital.

Revenue increased 12% to $10.3 billion from $9.1 billion reported for the second quarter of 2017. Even excluding 3 percentage points of currency translation, organic revenue would have increased by a very healthy 9%. However, adjusted EBIT margin (before special items) contracted by 50 basis points to 7.8% on a higher mix of lower margin vehicle assembly business and the dilutive effect of currency translation that increases the proportion of lower margin European based business but partially offset by a significant increase in equity income from China JV transmission business.

Management lowered 2018 guidance on slightly less favorable currency effect, modestly lower North American production, tariffs, and reduced Power & Vision JV equity income. The new revenue range of $40.3 billion-$42.5 billion represents a $600 million decrease from the prior range. However, management lowered adjusted EBIT margin guidance to a range of 7.7%-7.9% from a range of 7.9%-8.2% primarily due to reduced equity income guidance (now $270 million-$305 million, down from a range of $335 million-$375 million) but also a $60 million tariff impact. While vision business growth remains strong, reduced guidance was due to a Chinese automaker customer's lower powertrain volume and higher warranty costs.

Magna returned $844 million in cash to shareholders during the quarter, including the repurchase of 11.7 million shares worth $729 million, plus $115 million in common stock dividends. We forecast approximately $1.3 billion in 2018 free cash flow (cash from operations less capital expenditures). Consequently, we expect some additional share repurchases and maintenance of the dividend through the remainder of the year.

Our forecast for the year was already in line with management’s guidance, with the exception of JV equity income. We had already forecast 2018 revenue of $41.5 billion versus management's new guidance of $40.3 billion-$42.5 billion. We lowered our JV equity income estimate to the low end of management guidance at $270 million. We also reduced the growth rate in our JV equity income forecast such that our Stage I terminal year results in JV equity income of $364 million, down from our prior forecast of $397 million. We maintained our margin assumption, resulting in a 7.7% adjusted EBIT margin that is at the low end of management’s new guidance, on the reduction in JV equity income, partially offset by solid operational performance. The change in our estimates had less than a $1 impact on our fair value estimate, which we have maintained at $57.

Our investment thesis remains intact. We believe Magna will continue to benefit from the increase in customers' use of global vehicle architectures. In our opinion, the company’s electrified powertrain and autonomous driving technologies represent significant growth opportunities for Magna, but the relative size of these businesses compared with the overall total restrains consolidated revenue growth. The company is one of the most diverse suppliers in the auto industry following years of auto supplier consolidation, yet it has maintained an ultraclean balance sheet compared with other vendors.

Due to the potential for both higher content penetration and acquisitions, we think Magna revenue growth will surpass the annual growth in global vehicle demand that we forecast at an average annual rate of 1%-3%. However, owing to its relatively higher-cost capital structure, despite a slight shift to lower-cost debt capital, we remain concerned about Magna’s ability to generate excess returns on invested capital through the economic cycle, resulting in our no-moat rating.