American Axle (AXL): Underappreciated Today, But Uncertain Future Is A Major Overhang

A year ago I thought the market was being too harsh on American Axle (NYSE:AXL), underrating the company’s ability to survive the transition to electric vehicles and giving the company little credit for the cash flows to be earned over the sunset of internal combustion (or ICE) powertrains. Since then, the shares have risen about 25%, not too shabby over a period where most other parts suppliers are down by double-digits, and I believe only Visteon (VC) has managed double-digit appreciation without a buyout.

While American Axle has been looking stronger of late, and I applaud the company’s ability to adjust its expense structure to lower volumes, the investment case is quite a bit more difficult now. High leverage makes valuation sensitive to even relatively small changes in long-term growth rate or margin assumptions, and the company is still facing a difficult ICE-to-EV transition. I don’t think it’s a stretch to argue for a mid-teens fair value today, but I’d be careful about an extended commitment to this name.

Another Beat In Challenging Times

Although the auto volume recovery in 2022 is coming in short of initial expectations at the start of the year, American Axle is navigating this challenging period relatively well. The company has now logged two straight better-than-expected quarters, and six of the last seven quarters have likewise come in stronger than expected (though in many cases stronger against lowered expectations).

Revenue rose 12% in the second quarter as reported, beating expectations by 5% to 8% (different sources had different average estimates). This comes at a time when vehicle production rates are still soft (July SAAR was down more than 8%, with trucks down 5%) and inventories are still lean (more than 40% below the long-term average).

Gross margin declined almost two points (to 12.4%), while EBITDA declined 13% and operating income declined 5%. That was still good for better than a 6% beat on the EBITDA line, with EBITDA margin down almost four points (to 13.6%) and operating margin down about a point to 5%.

Not only was American Axle one of the relatively few suppliers to beat in the second quarter, they were also among the few to raise guidance for the rest of the year. It’s worth noting, though, that while revenue guidance headed higher ($5.75B-$5.95B versus $5.6B-$5.8B), EBITDA guidance didn’t go up proportionally ($790M-$830M versus $785M-$830M), so cost inflation is still a significant challenge for the company.

Navigating Well Through Challenging Times, But With An Uncertain Future

At a recent sell-side conference, management gave their outlook that will take “a couple of years” for vehicle production volumes to return to a more normalized 16M-17M annual rate in the United States. While semiconductor shortages are easing, other issues like cost inflation, supply chain difficulties, shipping/logistics, and weakening consumer confidence are all contributing to a challenging near-term outlook.

To American Axle’s credit, management has adjusted the business to be more profitable at lower volumes – more so than I thought they would be able to. While I suppose it’s worth asking how the company will handle the re-acceleration of production to more normalized levels, I think that process should be gradual enough that it won’t cause massive disruptions.

Management has handled the pandemic-driven disruptions well, but there are still serious questions about the company’s future in an electrified world. While only about 5% to 8% of current passenger vehicle production is electric (the range depends on specific definitions), that ratio is set to accelerate significantly as more auto OEMs curtail their ICE-powered lineups in favor of EVs.

As I’ve written in prior pieces, the main issue for American Axle is that their relative strengths in an EV world aren’t in high-value components (inverters, connectors, battery management), but in lower-value areas like eDrives. That is likely to pressure margins, and sales are also going to be pressured by a significant move toward OEM in-sourcing for electrified driveline components – in fact, major current customers like General Motors (GM) could conceivably become rivals (GM and Honda (HMC) have announced a partnership whereby Honda will use GM’s Ultium EV platform for at least some models).

I’ve previously said that insourcing may not ultimately be quite the threat that people think now – many OEMs will try to insource, but I expect failures along the way, and that means future business for American Axle. I also see American Axle benefitting from opportunities to serve/supply up-and-comers like REE Automotive (REE).

Last and not least, EV insourcing isn’t necessarily a zero-sum game. While GM has a strong insourcing effort, they nevertheless went to American Axle for front differentials for their electric Hummer model. This isn’t a wash for American Axle (I’d estimate a little less than half of the content value versus a regular Hummer), but it’s also not a wipeout.

American Axle is also expanding the business, having recently acquired Tekfor. Tekfor makes auto fasteners and metal components, and the acquisition will not only broaden American Axle’s product lines (and fasteners will still be used in EVs), but also boost its EV portfolio with products like rotors and stators for electric motors.

The Outlook

Modelling American Axle is tricky, especially as there is still so much uncertainty over EV production rates, content per EV vehicle, and the margins on that content. I think a target of EVs representing 50% of passenger vehicle production in 2030 is credible, but even in such a scenario, that means that 50% of vehicles produced will still be ICE-powered, including the lucrative trucks that make up so much of American Axle’s business (and yes, it is possible that light truck electrification will deviate from the broader trend, either to the benefit or bane of AXL).

Even in a scenario where American Axle’s content per ICE vehicle is flat through 2030 and the company has only one-third the content on EV vehicles, that could still support around $4.5B in revenue (or more). The margins on this revenue are certainly up for debate (many analysts believe EV components will carry lower margins), but at a minimum I would expect that American Axle would be reinvesting less in capex to support the ICE business, offering some support to FCF margins.

If there is good news, it’s that auto suppliers aren’t typically valued on the basis of long-term cash flow projections, but rather near-term margin prospects (there’s a reasonably solid correlation between EBITDA margins and EV/revenue multiples). To that end, 14% EBITDA margins for 2022, let alone potentially 14%-plus margins for FY’23, should be able to support a forward multiple of at least 0.75x and a fair value around $15.

The Bottom Line

Ignoring the risk of significant long-term erosion in American Axle’s business due to electrification is risky, and likewise the company’s positioning in an electrifying world is uncertain at best. Still, I do expect improving vehicle production rates in the near future (the next few years) and improved margins on that volume, and I believe that can support a higher share price, but this is a name to approach with caution given those significant long-term risks.