Dana: Past The Worst On Costs, But Volumes In 2023 Are The Next Worry (NYSE:DAN)

This has been an interesting year for Dana (NYSE:DAN). This large supplier of driveline, thermal, and sealing products to the passenger vehicle, commercial vehicle, and off-highway markets has done well on revenue, boosted by strong commercial truck and off-highway equipment demand, but has been hit hard by input cost inflation and unrecoverable costs tied to erratic production schedules at their OEM partners.

With all that, the shares are down about 10% since my last update; not terrible relative to the market, but also not all that exceptional relative to the sector. Looking ahead, Dana should see some cost-related tailwinds in 2023, but will also likely see growing headwinds from weaker commercial and off-highway markets. Even with those concerns, I believe Dana is an undervalued play on long-term commercial vehicle electrification and margin recovery across its segments.

A Very Welcome Beat On Margins

After a series of quarters featuring meaningful guidance cuts due largely to cost inputs, Dana reported a very welcome quarter where margin performance and guidance were concerned. While management did emphasize that cost pressures are still significant, I think the takeaway from guidance, as well as commodity market movements and commentary from other companies, is that the worst of the input cost inflation is now behind the company.

Revenue rose 15% this quarter, modestly beating expectations. Light Vehicle Drive Systems saw 14% revenue growth, which was good for a 1% beat relative to expectations but does pale next to the 24% growth in North American vehicle production in the quarter. Power Technologies sales rose 10%, missing by about 3%. Off-Highway Drive and Motion Systems sales rose 11%, missing very slightly, and Commercial Vehicle Drive and Motion Systems rose 28%, beating by 5%.

Gross margin fell 130 bp yoy to 8%, but did beat by 60 bp and improved 90 bp from the prior quarter (on a 2% qoq revenue decline). Adjusted EBITDA rose 9%, beating by 6% or 8% (depending upon the source for the sell-side average estimate), with the margin down 190 bp to 7.6% (up 130 bp qoq). Operating income fell 9% (margin down 100 bp yoy to 3.9%, up 130 bp qoq), and Dana’s operating income beat sell-side expectations by 27%, driving a $0.07/share beat at this line (higher taxes clawed back some of this further down the income statement).

By segment, EBITDA rose 11% in Light Vehicle, beating by 50%, with the margin down 20 bp yoy and up 250 bp qoq to 5.7%. Power Technologies fell 45%, with the margin down 710 bp yoy and 10 bp qoq to 7.3%, missing by 28%. Off-Highway segment EBITDA fell 9%, missing by 4%, with the margin down 280 bp yoy and up 10 bp qoq to 13.1%. Commercial Vehicle profits fell 10%, beating by 20%, with the margin down 150 bp yoy and up 160 bp qoq to 3.6%.

Importantly, management maintained its guidance for the remainder of the year and did sound some optimistic notes about cost recovery opportunities in 2023 and customer production plans.

A New Mix Of Headwinds And Tailwinds In 2023

Strong commercial and off-highway markets have been a definite tailwind for Dana in 2022, as demand has been strong in these markets, and producers like Deere (DE) and PACCAR (PCAR) have been scrambling to catch up and fulfill their order books. Dana has also made some progress with its order book, announcing its largest-ever passenger vehicle BEV order earlier this year ($1 billion in lifetime value), and announcing a significant award for the next generation of Stellantis‘ (STLA) Jeep.

Costs have clearly been a headwind for Dana this year, driving the underperformance relative to initial 2022 earnings expectations. As I said above, while I don’t think Dana is going to see an immediate improvement in input costs, I don’t think those costs are going to get worse from here, and the company should benefit from cost recovery efforts and an eventual reduction in input costs in 2023 and 2024.

Dana should also benefit from a normalization of supply chains and product availability. One of the big hits to Dana’s margins this year has come from operational inefficiencies tied to erratic production schedules as OEMs altered their orders on short notice in response to their ability to source key components (like semiconductors). As production schedules become more predictable and consistent, Dana should see better manufacturing efficiencies and higher gross margins.

While costs could become a tailwind next year, the outlook for commercial and off-highway vehicles could become more of a headwind. While there will still be meaningful backlogs going into 2023, truck builders like PACCAR are likely to see weakening orders in 2023 as freight markets correct. The outlook for off-highway is trickier; backlogs are still meaningful, and markets like mining and agriculture look healthy, but construction could start easing off.

The Outlook

Dana’s 2022 revenues are running about 3% ahead of my prior expectations, but I’ve trimmed back my 2023 and 2024 estimates on greater caution/uncertainty around the trucking market and some off-highway markets, particularly in light of weakening macro sentiment. Longer term, though, my assumptions don’t change much – I still expect around 3% to 4% long-term top-line growth here, and I believe Dana will not be left behind as its markets electrify.

With margins, I seem to be more bullish than the Street, as I think a return to double-digit EBITDA margins is possible in 2024. Long term, I expect FCF margins to average out in the low-to-mid single-digits, driving long-term core FCF growth of around 8%.

In a cyclical business like vehicle parts/components, discounted cash flow is a tricky approach to valuation, as it’s difficult to predict the timing and magnitudes of cycles. That said, even if the year-by-year estimates prove less than precise, I’ve found that DCF can still provide insight as to when valuations are getting rich or cheap; right now I think it’s the latter, and I believe Dana is priced for double-digit annualized long-term return.

I also approach valuation with multiples-based approaches (EV/revenue and EV/EBITDA), with the multiples based upon what the market has historically paid for given levels of profitability (EBITDA margin, et al.) and returns (ROIC, et al.). Using my 2023 modeling assumptions, I believe 0.475x revenue and 6x EBITDA are fair forward multiples, supporting a fair value in the $19-$21 range.

The Bottom Line

I do have some concerns that Dana will see weaker demand from commercial and off-highway customers in 2023, but I think the risk there could be more on the sentiment side, with investors avoiding the stock if and when they see Class 8 truck orders declining. Likewise, the cost leverage improvements I expect are not certain and may be compromised by a more challenging macro environment.

I acknowledge these risks, but I believe Dana is a well-run vehicle OEM supplier, and I believe the current valuation is attractive for investors willing to take on a little extra risk today.