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The NAFTA effect: Investors in Canadian auto-parts makers may soon face a rude awakening

An upending of the continuing renegotiation of the North American free-trade agreement, could throw a significant wrench into Linamar, as well as Magna International Inc. and Martinrea International Inc.’s business models.

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The stocks of Canadian auto-parts makers have been on a tear, buoyed by the belief that replacing all the cars lost in last summer's hurricanes will boost sales. Third-quarter earnings numbers, which start Tuesday from Linamar Corp., should do little to dissuade investors.

Still, the stocks have run so far, so fast, it suggests the market is ignoring another storm: The continuing renegotiation of the North American free-trade agreement, an upending of which could throw a significant wrench into the three companies' business models.

Linamar, as well as Magna International Inc. and Martinrea International Inc., have all participated in an updraft in auto-parts makers since Hurricane Harvey; Goldman Sachs notes the entire group of North American auto suppliers jumped 15.8 per cent from Aug. 17 to mid-October, with the S&P 500 up just 5.1 per cent. The three Canadian parts companies have added to those gains in the past three weeks.

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The shares of all three were down in the dumps at the beginning of the Donald Trump administration, what with the newly elected President's tough talk on trade. But solid numbers of auto purchases in the U.S. auto sector, believed to be late in a sales cycle, plus the hurricane factor have boosted the shares in 2017. Now, the average auto-supplier stock's earnings multiple is closer to peak than to its average, Goldman says. According to Standard & Poor's Global Market Intelligence, Linamar, Magna and Martinrea are all sporting multiples not seen since early 2016.

That's led Goldman to suggest investors trim positions with significant regional exposure to North American production.

And while Goldman's Canadian coverage is limited to Magna – which it cut to a "sell" rating last month, with a target price of $41 (U.S.) that implies 25-per-cent downside – the description applies to all three of the Canadian suppliers.

Peter Sklar of BMO Nesbitt Burns Inc. says Canadian and Mexican production is most at risk in a NAFTA renegotiation.

And while Martinrea and Magna derive roughly half of their North American production revenues from plants in Canada and Mexico, the number tops 80 per cent for Linamar, making it the most vulnerable to major changes in the agreement.

What are the possibilities? Well, for the past 23 years, NAFTA specified at least 62.5 per cent of a vehicle must originate from North America to qualify for duty-free trade within the region, Mr. Sklar says. The Trump administration has proposed the North American number to be raised to 85 per cent, with a 50-per-cent minimum requirement for U.S. content. A minimum U.S.-content requirement "would likely isolate the Canadian and Mexican plants of the Canadian suppliers," Mr. Sklar says, and be "very negative" for the three.

There's also the possibility negotiations fail, and NAFTA is terminated. A high tariff – say 35 per cent – may prompt auto makers to import from lower-cost countries that can offset the high tariff, again a "very negative" outcome for the Canadian companies, Mr. Sklar says. Reverting back to "most favoured nation" tariffs – 2.5 per cent on light vehicles but 25 per cent on popular pickup trucks – would be merely "somewhat" negative, he says.

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And of course, NAFTA could also be renegotiated with something other than what the United States has proposed, which is the big unknown. But Mr. Sklar believes at least one thing: "There could be potential downside for the Canadian auto stocks as they are not pricing in any likelihood of a materially negative outcome from the NAFTA renegotiation."

Mr. Sklar has "market perform" ratings on Linamar and Magna and an "outperform" on Martinrea, "due to our belief that the company is executing a successful turnaround story following three consecutive quarters of stronger-than-expected results."

That sunny view on Martinrea is widely shared: According to Bloomberg, eight of the 10 analysts covering it have a "buy" rating, with a return potential of 13 per cent on the average target price. The run-up in the sector is cooling sentiment on the larger two: Magna has 11 buys, nine holds and two sells in the analyst coverage, and Linamar has four buys, four holds and a sell. Their average target prices imply returns of 1 per cent to 2 per cent – likely not enough upside to justify the continuing risk of the Trump trade.

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