The Auto Parts sector has maintained strong performance over the past year. Aggressive restructuring and cost-cutting initiatives, early on in the industry downturn, resulted in significant operating leverage as volumes recovered. Indeed, many suppliers have achieved record levels of profitability in recent quarters, with strong margins providing a boost to earnings. However, following the initial recovery, the outlook for industry volumes is somewhat uncertain. Meanwhile, auto parts companies face substantial pressure from higher raw materials costs, and it remains to be seen how much of the recent margin gains can be sustained, both in the near term, and further out.

The outlook for industry volumes remains clouded, with recent softening in domestic auto sales, and ongoing weakness in Europe. Therefore, investors should look for suppliers that are positioned to benefit from secular growth trends, with the ability to outperform underlying automotive production rates, without being dependent on rising industry volumes.

A major trend on the supplier side revolves around the environmental/fuel economy theme. In this category it’s worth focusing on products and parts that improve fuel economy and reduce emissions. There are multiple avenues for improving fuel economy, including technological advances that boost engine efficiency, products that reduce overall vehicle weight, and the introduction and increased acceptance of hybrid, electric, and alternative fuel vehicles. 

Auto Parts companies that have a strong position in these areas include BorgWarner (BWA), Federal-Mogul (FDML), Tenneco (TEN), and Johnson Controls (JCI). BorgWarner has a diverse engine and transmissions product portfolio, including turbochargers, torque transfer, and specialty transmission components that help reduce engine size and provide fuel efficiency. Favorable trends have resulted in increased penetration and share gains for BWA’s products. Notably, sales from the core Engine and Drivetrain divisions climbed 38% and 26%, respectively, in the first quarter of 2011. This growth easily outpaced the underlying global production gain of 5%.

Federal-Mogul has a broad set of products that provide a different set of solutions, with advanced materials for weight reduction, and innovative powertrain technologies that help increase efficiency and reduce emissions by enabling higher combustion pressures and temperatures, which promotes engine downsizing. Federal-Mogul’s Original Equipment segment has also consistently outperformed the broader market growth. Notably, FDML has a nice OE/Aftermarket mix, with Aftermarket sales accounting for 37% in 2010. Although the Aftermarket business has lagged the recovery in OE volume, it has begun to show signs of improvement, and makes the company less dependent on improvement in production/sales levels.

Emissions control is another attractive area, with the ongoing global efforts to reduce emissions and the prospect of increasingly stringent standards. Tenneco Inc. is uniquely positioned to capitalize on this opportunity, with a strong platform of emissions control and exhaust products. Notably, the company has particular strength in the commercial vehicle segment, where stricter diesel regulations should fuel solid growth. Content growth and share gains have enabled Tenneco to easily outperform the underlying market, with OE sales surging 54% in the first quarter of 2011.

The potential growth in hybrid and electric vehicles also presents a compelling investment theme. Although there are numerous ways to play this trend, many of the more-direct investment opportunities are somewhat speculative and based upon the success of one particular technology. However, Johnson Controls is a strong, diversified supplier with exposure to this market through its Power Solutions segment. The company is the largest producer of traditional lead-acid automotive batteries, but has expanded its focus and offerings to AGM and lithium-ion battery technologies, which are used in hybrid vehicles. The AGM business in the U.S. and Europe has recently gained further traction, with the increased use of Stop/Start technology in standard, non-electric vehicles. The technology and battery capability in these “micro-hybrid” autos allow the engine to shut down when the vehicle is stationary and automatically turn back on when the driver presses the gas. This technology should continue to gain traction as automakers look for ways to achieve improved fuel economy. The estimated fuel savings for stop/start vehicles is around 10%.

Although there are many other suppliers that have exposure to these favorable growth trends, we have highlighted a few that stand out based on their dominant position in particular markets, and overall solid investment appeal. Considering the uncertain outlook for industry volumes, this attractive, secular growth story should warrant closer attention from investors who are looking for exposure to the auto parts sector.

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.