Canadian auto-parts czar Frank Stronach will need more than one bottle of his favourite toast when his gold watch strikes midnight on New Year's Eve. After all, this past year provided the philosophical founder of Magna International Inc. with plenty of things to celebrate.
Top of the list could very well be the recent decision to move reality TV show The Next Great Prime Minister from CTV to CBC — where funnyman Rick Mercer will take over from not-so-funny Seamus O'Regan to host the second Magna-sponsored search for a twentysomething philosopher king (read: policy wonk wannabe who can appreciate Stronach's parliamentary reform proposals). Then again, with Stronach's high-profile MP daughter already serving as gadfly to both sides of the Hill, the 74-year-old corporate socialist might tip his first glass to the budding organic farm providing jobs for residents of Canadaville — the commune-like town that Stronach's companies planted in a Louisiana sugar-cane field last year to house Hurricane Katrina victims.
The entrepreneur in Stronach, of course, might toast the long-awaited startup of poker and slot machines at Magna Entertainment Corp.'s Gulfstream Park in Florida, or the recent zoning approval that will allow North America's top operator of horse racing facilities to break ground next year on a 15-year development designed to transform MEC's flagship property into the “Vatican of racetracks.” The Village at Gulfstream Park — which will include everything from luxury condos and specialty shops to high-end restaurants and entertainment venues — is part of Stronach's plan to restore horse racing's popularity by drawing “virtually every type of consumer” to tourism destinations built around MEC's racing and casino operations. The ultimate prize, of course, is a global gaming operation that offers races worldwide, 24/7, via mobile technology and the Internet.
Many people think the master plan is nuts, but even common shareholders have little say in the matter, which brings us to another thing Stronach has to celebrate this year.
If you recall, it was the negative reaction of Magna shareholders to being forced to play the ponies that led to the spin-out of MEC and MI Developments Inc., a real-estate outfit, from Stronach's multibillion-dollar automotive operations in 1999 and 2003, respectively. Simply put, MID was set up as MEC's parent company and corporate sugar daddy. Shares in both companies were distributed to Magna's shareholders so they could decide whether or not they wanted to roll the dice with Stronach as he set out to build the world's largest gaming and entertainment company.
After investing in both MEC and MID, however, New York's Greenlight Capital started attacking Stronach's vision. David Einhorn, the hedge fund's cocky president, compared Stronach to Fidel Castro at MID's 2005 annual meeting, where investors voted on Greenlight's shadow management plans to cut MEC loose and convert MID into a trust.
The motion — which was supported by investors owning a majority of common shares — had no chance, but Stronach was forced to use his controversial super-voting shares to keep MEC in the Magna family. Einhorn, a professional poker player, then claimed Stronach's control of the company oppressed shareholders. He threatened court action. Stronach called Einhorn's bluff and was rewarded in late October, when Ontario Superior Court Justice John Ground noted MID management was in fact doing exactly what the company told investors it might do with its strategic investment in MEC.
The Ground decision further legitimized Stronach's my-way-or-the-highway school of management. And it was followed by another early Christmas gift, one that should help silence two of Stronach's most vocal Canadian critics. After all, Stephen Jarislowsky and Claude Lamoureux are directors of the Institute for Governance of Private and Public Organizations, which released a surprising study in mid-November that touts the benefits of family-controlled companies.
As a result, Canada's most flamboyant entrepreneur (who is No. 58 on this year's Canadian Business Rich 100) heads into 2007 more powerful than ever. And that's probably a good thing, because he needs to focus on the foundation of his empire, which is built on an aging customer base that is cracked and possibly crumbling under the pressure of globalization.
In the third quarter of 2006, the auto-parts powerhouse that Stronach built from his humble start in a Toronto garage did something it hasn't done for some time — it missed Street expectations. Magna reported Q3 earnings per share from operations of 90¢US, down from US$1.40 in the same three-month period a year earlier. The consensus analyst estimate was US$1.29 per share. Industry watchers were taken by surprise, but not by the problem. After all, everybody knows Magna's profits are heavily tied to North America's traditional Big Three, which are fighting the declining popularity of pickups and SUVs while also facing increased competition in all product segments from lower-cost manufacturers such as Toyota, Nissan and Honda.
In the all-important U.S. market alone, where the Big Three are putting pressure on suppliers' margins while also hitting them with production cuts, the combined market share of GM, Ford and DaimlerChrysler's Chrysler Group has dropped about 10% in the past five years. It now sits just above 50%, which GM alone used to boast. Even worse, U.S. consumers may be running out of confidence, not to mention free cash flow, thanks to a significant decline in home values south of the border — where a possible currency crisis is brewing. As a result, at least one automotive industry forecast calls for U.S. sales of light vehicles (cars and trucks) to hit 16.3 million units in 2007, the lowest level in almost a decade.
Simply put, Magna's main customers are losing share in a shrinking market. But while other big players (Dana, Tower, Delphi) have sought court protection from creditors to deal with the fallout, Magna became legendary for offsetting Detroit's sputters with regular increases in North American parts per vehicle.
No more. Magna's North American revenue was down 7% in the third quarter, mostly due to the effect of recent customer production cuts on Magna's interiors business, which has also been hampered by rising material costs. Total Q3 operating income plummeted 35.4%, to US$155 million from US$240 million, in the same period last year.
When it comes to globalization, Stronach is enough of a capitalist to see the writing on the wall. “The primary mandate of business is to make a profit,” he told an Empire Club audience years ago. “Profit means money, and money has no heart, no soul, no conscience, no homeland. It flows to the path of least resistance. So in the global economy, business will go where it can make the most money, where the costs of doing business are low.” And yet, if you want to find fault with Stronach, UBS Investment Research analyst Fadi Chamoun says forget Magna's dual-share structure and points out that the company was slow to react to emerging-market opportunities.
According to Chamoun, Magna has been run very well, generating among the best returns in the automotive industry. Most people, he notes, fail to take into account the value of dividends and spinoff shares when they look at a Magna stock chart. That said, “You can come up with a criticism of the company for being, maybe, late in pursuing diversification outside of the Big Three and outside North America,” adds Chamoun.
How big is the problem? In 2005, when Magna generated US$12.7 billion of its total US$22.8-billion revenue in North America, DaimlerChrysler accounted for 25% of the company's sales. GM accounted for 24% of revenue and Ford 15%. In Europe, where Magna made US$9.9 billion in revenue last year, the two largest customers are BMW (18% of sales) and Volkswagen (6%).
The rest of the world, home to emerging markets like Russia and China, not to mention booming Asian automakers, accounted for just US$200 million of total revenue. Still, Chamoun says investors should give Magna credit for moving swiftly when it sets its mind to something. And Magna has set its mind to emerging markets. In Russia, for example, Magna co-CEO Siegfried Wolf recently signed a major deal with local automaker operations owned by billionaire Oleg Deripaska's GAZ Group. According to Russia's Federal Industry Agency, the partnership is “a considerable landmark on the way to creating modern production of car components and parts in Russia,” where a booming resource-rich economy has boosted consumer spending.
The GAZ agreement is expected to be followed by another significant deal this month with AvtoVAZ. Magna, which designs and builds complete vehicles for other automakers in Austria, is seen as a perfect fit for Russia's major domestic vehicle companies as they modernize to compete for share with foreign giants in the Russian market for light vehicles.
How fast can Magna move to diversify its customer base and grow outside North America? “In 2001,” Chamoun points out, “Magna had five locations in Asia. Now they have 24. They have really stepped up.” And there is a possibility that Magna could actually benefit from the Big Three's trials and tribulations. After all, there are already industry whispers of outsourcing North American production to non-union Magna operations.
In the meantime, investors should note that nobody expects Magna — which has already posted profits of $499 million in the first three quarters — to suddenly start losing money. Some analysts have downgraded target prices, but positive ratings still dominate the stock.
According to UBS, Magna's shares (NYSE: MGA), currently trading at about US$78, probably offer significant upside, even after applying valuation multiples consistent with the low-end of Magna's historical trading range (a.k.a., the Frank Factor). Unless, of course, the wheels really start falling off the Big Three. Chamoun gives Magna his second-highest Buy rating with a target price of US$88.
What about a possible return to the old days, when Stronach used the auto-parts firm to directly fund ventures like the MEC gambit? Dennis Mills, vice-chairman of MEC, doesn't think shareholders should worry about it now that the courts have freed MID to keep subsidizing its subsidiary. Analysts are not so sure. Chamoun doesn't think it will happen, unless it does. (While on the topic of MEC, it should be noted the gaming venture recently paid down its debt by US$175 million, including US$112 million that cleared up the MID-supplied bridge loan that Greenlight Capital claimed was too risky for shareholders.)
For Magna, however, the lack of a clearly defined succession plan remains a real issue. After all, Stronach plays a unique role as head of what he calls the Magna church. And at this point, shareholders don't know if anyone is slated to inherit that role or what happens to the voting shares Stronach controls.
Magna's main man, of course, is a health nut, one reportedly fit as a horse. In other words, Stronach isn't done by a long shot. He also isn't big on booze. That's why on New Year's Eve, he might just fill his glass with Frank's Energy Drink, an Austrian-made beverage out to castrate Red Bull. It's exported to Canada by Stronach-controlled MCP Holding GmbH, which stands for Magna Consumer Products. But that's another story.