Description

Recommendation

This was originally intended to be a simple credit idea but ended up morphing into a bond and equity idea as ACW stock melted down with the market in August.  I view both instruments as special situations – the bond as a potential yield-to-call play and the stock as part of a levered equity basket trade.     

Buy ACW equity.  ACW is a rather boring small-cap levered industrial equity that could very well continue to be a value trap but is worthy of consideration for a small part of a portfolio given its undemanding valuation and potential for near to mid-term shareholder value enhancing catalysts.  With a market cap of $157mm and total net debt of $383mm (includes pre-tax unfunded pension in the amount of $93.4mm), the equity is trading at 6.2x FY15 EBITDA.  Free cash flow in FY15 should approximate $18.5mm representing a yield to equity of nearly 12%.  If you strip out the cash of $31mm, then the FCF yield would be closer to 15%.  On this basis, I don’t believe the stock is expensive but perhaps also not screaming cheap given the Company’s checkered past (2009 bankruptcy), the uncertainty of where we are in the heavy-duty trucking cycle, its above average leverage, and the historical volatility of its P&L. 

However, what the market may be not be pricing in is the high likelihood of material deleveraging of the Company’s balance sheet, along with much improved margins in its core businesses, and a more attractive growth profile over the next several of years.  It’s a matter of time that the Company refinances its expensive bond at a significantly lower interest rate which would save the Company $5 – 7mm per annum  (an additional 4% to equity).  Additionally, it’s also a matter of time that the Company divests its low margin Brillion Iron Works business (~19% of total revenues) to focus on its higher margin core wheels and wheel end assemblies businesses; proceeds from this sale would be used to pay down debt and to fund international growth.  Assuming these two events materialize within the 12 – 18 months, the stock could appreciate to $4.50 – 5.50/sh by the end of 2016, representing potential medium-term upside of 40 – 65%.  Further upside could come from a significant accretive acquisition and/or additional large contract wins.  Regardless of where we are in the trucking cycle, I expect ACW to be a larger wheels oriented business within 2 – 3 years and after factoring in the operating leverage and prudent use of financial leverage on acquisitions, there is potential for significant shareholder value creation here. 

Buy ACW 9.5% secured bonds.  If you can find them at or below par, this short duration first lien secured paper, which essentially sits close to the top of the capital structure, makes for a solid coupon clipper and a decent place to hide in today’s turbulent markets.  At 3.3x EBITDA, the bond has above average asset coverage and while the there is some risk that management may be unable to call it at 102.375 given the volatility in the high yield markets, I believe that the odds of a refinance are high once we get through this current market turbulence.  Best case is a solid risk adjusted 12 – 13% IRR and worst case is that you’re the fulcrum instrument in a business that is delevering via strong cash flow generation and has decent near-term growth prospects.

Company Overview

ACW is a manufacturer and supplier of commercial vehicle components in North America, primarily for heavy and medium-duty truck OEMs.  ACW products can be found in heavy and medium-duty trucks, commercial trailers, light trucks, buses, as well as specialty and military vehicles.  Its products include commercial vehicle wheels, wheel-end components and assemblies, and ductile and gray iron castings. These products are marketed under the Accuride (wheels), Gunite (wheel-end components), and Brillion (iron castings) brands and are manufactured at eight plants across the U.S., Mexico and Canada.  The Company was forced to file bankruptcy in 2009 after the trucking market collapsed during the financial crisis.  It exited Chapter 11 in 2010 but with a debt load that was still too high. 

Sales to OEMs represent 70% of the Company’s total revenues with the balance coming from aftermarket channels.  As of today, all of the Company’s revenues are generated in North America – approximately 80% of sales are generated in the U.S. with the balance in Canada and Mexico.  The Company’s heavy-duty truck customers include Navistar (International brand), Daimler Truck North America (Freightliner and Western Star brands), PACCAR (Peterbilt and Kenworth brand), and Volvo Group North America (Volvo and Mack brands).  Commercial trailer customers include Great Dane, Utility Trailer Manufacturing, and Wabash National.  The Company’s light truck customer is General Motors.

Competitors in the wheel markets include Alcoa (aluminum wheels) and Maxion Wheels (steel wheels). Primary competitors in the wheel-ends and assemblies markets for heavy- and medium-duty trucks and commercial trailers are KIC Holdings, Meritor, Consolidated Metco, and Webb Wheel Products. For the balance of its industrial component products, the Company competes with various foundries in the U.S.

Thoughts on Truck Builds

We are at a point in the cycle where views on the economy and cyclical industries can vary substantially.  My personal view on truck builds is neutral – I don’t see a lot of growth over the next few years but also don’t see a major contraction.  It’s fair to see assume that NA Class 8 builds will peak this year and will approach cycle adjusted average levels in the coming years.  However, the NA medium duty builds are still growing and might surprise to the upside behind the continued strength in the U.S. housing and automotive markets, both of which generate substantial amounts of freight.  A few other high level observations that suggest that fundamentals may remain stable in the near-term:

     * trucker cash flow is at record levels

     * trucker capex is still subdued relative to prior peaks

     * fleet age remains elevated which could bode well for expanding orders

     * key industry metrics including tonnage/volumes, contract rates/pricing, and utilization are all trending up

I will note that the recent economic data points are concerning and do point to slower economic growth than what most were anticipating only a few months ago.  Time will tell what these indicators will show in the coming months but I think its still too early to throw in the towel on the U.S. economic recovery thesis.

A few charts below from the Company with industry forecasts for builds:

Capitalization

The Company’s balance sheet is levered but not very complex.  There is a $100mm ABL facility which has only $10mm drawn against it.  As of June, the Company had $31mm of cash and $59mm in availability under the ABL facility for a total liquidity of $90mm.  The rest of the funded debt is attributable to the 9.5% secured notes in the amount of $310mm.  The bond matures on August 1, 2018 and has a first lien on assets not pledged to the ABL and a second lien on collateral pledged to the ABL.  Total funded leverage is a manageable 3.3x EBITDA, however, total leverage climbs to 4.4x EBITDA after factoring in the $93.4 mm of unfunded pension and OPEB liabilities.  The 9.5s are currently callable at 102.375 and the Company will look to opportunistically refinance this bond at an interest rate of 7.5 – 8.0% resulting in annual interest expense savings of up to $6.2mm, or 4% of the current market cap.  Based on my conversations with the Company, excess pension/OPEB contributions will run in the $8 – 9mm per year range for the next couple of years and then decline to $2 – 4mm per year range thereafter. 

Summary Financials

The first thing you notice about the P&L is how volatile it has been in recent years.  Some of this volatility can be explained by the nature of the trucking business – production levels can be lumpy on a year over year basis as evidenced by the 12% decline in Class 8 production in 2013 versus 2012.  Additionally, the mining industry downturn contributed to a 31% decline in the revenues during 2013 in the Brillion segment.  However, there were also company-specific issues that contributed to the significant decline in profitability in FY12 and FY13.  The Gunite segment lost OEM and aftermarket business to competitors because of quality issues and not being able to ship product on schedule.  These issues left Gunite devastated as the revenue loss translated into significant red ink within that segment during that time. 

The Company has responded well to these challenges and conditions and by FY14 EBITDA was back to FY11 levels and margins as well as revenues continue to improve into FY15.  Management invested a significant amount of capex (~$150mm) on projects post FY11 to selectively increase aluminum wheel manufacturing capacity, fix and improve Gunite, reduce labor and manufacturing costs and improve product quality.  The Company’s plants are now strong, competitive, and operate at industry high-level efficiency.  The business is right-sized now so that the Company can compete at current demand levels and still maintain capacity to meet increased demand should there be a recovery in the end markets.

The Wheels segment is where most of the value in ACW resides.  It will never be a high growth, high margin business and will always catch a cold when the trucking industry sneezes, but it is now strategically well positioned after all the capital investments made by management in recent years. The Company controls around a third of the wheels market and has been able to increase its share in recent quarters thanks to its reduced cost structure and exceptional operating performance at the plant level.  This year, the Company has recorded several key fleet wins in this segment, driven by its Steel Armor product offerings as well as portfolio of aluminum wheels.  Additionally, they’ve also recently renewed a three-year contract with one of the top four trailer manufacturers. Aftermarket demand for aluminum wheels has been very strong and this is an area where the Company is rapidly gaining share. The strategic decision to invest in and double aluminum wheel capacity is now starting to pay off and will continue to benefit the Company going forward as more OEMs shift away from steel to aluminum.  With contribution margins of ~25%, this new business should lead even higher segment profitability in the coming quarters and years. 

Gunite was a turnaround project that appears to be on strong footing and ready for top line growth.  In 2011, this business that was on life support with uncompetitive plants, unhappy customers, a tired product line, inadequate equipment, and poor relations with the unions. Rather than close down this business, the board instead decided to invest in it and the results today are obvious.  With new equipment and better process control, on-time delivery is now 99% versus 40% a few years ago, pricing is extremely competitive and product portfolio has been broadened. As a result, customers who had written off the Company are back and looking to do more business with Gunite.  Recently, Gunite was selected as the primary break drum supplier for Daimler's truck aftermarket parts division and other new wins have also been booked this year.  Management is confident that this segment can keep taking back share and grow at 6 – 7% per year with contribution margins of 15 – 20%. 

Brillion segment is the problem child at the moment.  While the problems are not self-inflicted, its customers are in some very difficult end markets including oil and gas, agriculture and mining equipment. The second half of this year will be very challenging for this segment and full year revenues will be down 15 – 20% and profitability will be breakeven at best.  One of its largest energy customers cut back order levels significantly in Q2 and this continued into Q3.  Unfortunately, there’s no visibility beyond this year and given what we know about these end markets, its very possible that the top line continues to shrink in FY16.  This business clearly does not have much in common with the other two segments and divesting it makes the most strategic sense. 

M&A Scenarios

With the capital investment projects and the plant turnaround efforts now basically complete, the Company is on the hunt for growth opportunities.  Management has repeatedly told investors that they’re actively pursuing transactions that will grow the wheels segments both in the U.S. and overseas.  My sense is that management prefers international growth to North American and this could be achieved by either acquisitions or moving excess U.S. capacity to an overseas location.   In terms of timing, they’re hoping to announce something within 12 to 18 months and perhaps even sooner if they can get the proper level of customer support.

At the same time, the Company has also made no secret of its interest in divesting the Brillion segment as they look to focus exclusively on the wheels and wheels-end businesses.  Apparently, there are several strategic players that are actively looking to buy assets but the issue has been price.  The buyers are looking to take advantage of the depressed market conditions and ACW has been unwilling to dump Brillion at a fire-sale price given how much they’ve invested to turn around the business.  Brillion’s asset quality is good and has strategic value but there’s really no hope for it (or many of it competitors) to make any money until commodity end markets start recovering from their current depression like conditions. 

What would ACW look like if it were able to exit Brillion at an acceptable price and also acquire a wheels asset?  Well there’s really no way to know with any level of precision but we can make some high level assumptions given what we know about the capital structure.  We know that with leverage already at 4.4x, it is very unlikely that the Company can partake in any transactions that will actually worsen its leverage metrics.  And with the stock price where it is, it’s also unlikely that equity can be used as an acquisition currency.  What this means is that the Company will have to live within its means and use proceeds from the sale of Brillion and tap the unused capacity on the revolver to fund an acquisition – without worsening the leverage metrics. 

Trying to figure out what someone would pay for Brillion is not easy.  While it generated segment level operating income of $3.5mm during the LTM, I expect it to lose money for the full year FY15 and likely FY16.  This asset has made money for the Company in the past: $12mm in operating income in FY12 and $4.5mm last year.  With the plants in better shape today then in the past, its earnings power in a stabilized environment is likely to be much higher.  For the purposes of this analysis, I’m assuming that Brillion is worth $30 – 60mm based on a very low EBITDA range of $6 – 10mm and a 5.0 – 6.0x multiple.  I highly doubt management would part with the asset at these levels but it’s as good a starting point as any given the current market conditions.  If the Company simply sold Brillion, used the proceeds to pay down debt and refinanced at a lower interest rate, the equity could rerate to $4.00 – 5.00/sh if the market values the FCF at a conservative 8.0x. 

The more interesting scenario, however, is where the Company sells Brillion and makes an acquisition that would significantly grow revenues and EBITDA.  To keep the analysis simple, I again assume that Brillion is sold for $30 – 60mm and that the proceeds were used to acquire assets, financed at 50% LTV; in essence, I’m assuming that ACW goes out and acquires assets for a total cost of ~$60 – 120mm.  Such an acquisition would add $9 – 18mm in incremental EBITDA to the Company.  Pro forma for this incremental profitability, the Company’s FCF would increase substantially, to perhaps as high as $30 – 35mm.  Once again, if the market values this FCF at a conservative 8.0x, the equity could be worth in excess of $6.00/sh.  

Obviously, lots of assumptions here, many of which could very well be way off base (garbage in/garbage out) but I think the optionality is attractive.

Risks to Consider

* This is not a steady business because trucking cycles are volatile.  While the large aftermarket business provides some cushion, an unexpected collapse in builds would erase much of the current FCF and could put the Company in a cash burn mode.

* There is some customer concentration and Navistar is the largest with ~14% of revenues.  Navistar is a highly levered and challenged business that has lost market share in recent years.  While it’s a turnaround project, any further distress there would have a negative impact at ACW.  On the flip side, a successful turnaround at NAV would be a huge benefit to ACW.

* Given the commodity nature of the Company’s products, there is significant competition from low cost countries. The aftermarket business for steel wheels and brake drums in particular has been impacted by overseas competitors.  A strengthening dollar would likely increase this risk.

* Company can’t/won’t sell Brillion because of market conditions, which then makes it difficult to refinance the bond, which then blows up the entire M&A value creation thesis.

Catalyst

* Sale of Brillion

* Refinance 9.5s

* International acquisition