Description

We believe the Dowlais Group (DWL LN) is an interesting special situation with substantial upside over the next two years. The high level thesis is as follows:

• DWL is the former GKN auto and powder metallurgy business. Melrose bought the business in 2018, has restructured and fixed and, now spun it back out to shareholders as Dowlais Group.
• The DWL spinco is the orphan asset in the DWL/MRO spin, which has been well documented on VIC. Its more cyclical, lower margin, and generally indexed to global automotive end markets
• As you might expect, it spun into the void, with few buyers coming in to support the price, and now trades meaningfully below its intrinsic value
• Moreover, the company has a conservative balance sheet, great management team, is poised for significant margin expansion and has great global positioning whether or not you are a believer in ICE or EV powertrains

Situation Summary:

The aerospace side of the recent Melrose spin has been well discussed here, and will surely make an excellent investment. I recommend reading recent posts by HTC2012 who has covered this very well.

At a high level, the publicly traded private equity firm, Melrose, bought GKN in a hostile bid in 2018. It dramatically restructured the entire business, nursed both segments through Covid, and then split the businesses to create the AeroCo (MRO LN) and the AutoCo (DWL LN).

Normally, situations like this would be pretty scary. For example, I’m sure many remember Honeywell spinning out the GTX business, burdened with massive legacy liabilities and secularly declining end markets. And so AutoCo spins are to be highly scrutinized, as they can often be a large company spinning off their most cyclical, low quality assets.

The difference here is that Melrose is not some sleepy conglomerate – the opposite in fact. Melrose is an operations-obsessed PE firm with a very simple motto: Buy. Improve. Sell. And Melrose has an incredible track record! Melrose has:

• Fully funded every pension of any company it has ever acquired
• Improved operating margins by 30-70% in every business it has acquired
• Earned an equity rate of return on its large 4 deals of 30%/29%/33%/19%

And, as a result, Melrose stock and associated spins have returned 1700% since their first acquisition, 10x the FTSE, or an annualized return of about 17.5%. Not bad.

So, I pose the question. Let’s say you could buy a Melrose acquisition – after they have had 5 years really dig in and fix everything – but pay LESS than Melrose paid in the first place? And not on a multiple basis – on an absolute basis. Would that interest you?

Well, Melrose paid £9bn+ for the enterprise value of GKN. And now you can buy the piece of the business that generated 75% of the operating income when they acquired it...for an enterprise value of £2.5bn. This is AFTER it is been dramatically improved. I present: The Dowlais Group

Dowlais Group

DWL LN is the world leader in driveline components for automobiles and powder metallurgy and sinter in the auto market.

Driveline:

Surprisingly OK auto parts supplier?!?

Driveline components are the architecture that rotate the wheels within a car. This primarily consists of sideshafts that connect the wheels to the motors (for EVs) or engine/transmission (for ICE). But this also includes the differential locks, parking brakes, AWD power systems, etc. They also make components for electric driving systems and electric drive motors themselves.

DWL is the world leader in Driveline segments, with 45% of sideshaft production globally (the largest driveline market), and a balanced customer and geographic mix. They work with 90% of global OEMs across the world.

As far as auto businesses go, driveline ranks near the top for me. A few reasons:

• Limited number of players with global reach and scope, where top 3 players have 75% share in sideshafts, for example. So the large players will continue to push out the smaller players, particularly as more local OEMs (like Chinese OEMs) globalize supply chains
• Driveline for GKN is either EV agnostic or beneficial from EVs. EVs require, on average, more sideshafts than an ICE car, but will also need multiple eDrive systems, so the potential value per vehicle on EVs is at least as good, and often better, than with ICE. Essentially, the AWD from an ICE vehicle becomes a more sophisticated motor on an EV, which allows DWL to capture more revenue and profit over time in their eDrive business.
• These are mission and driver critical components at the core of the vehicle. Critical to driver comfort and balance, off-road capabilities, and applied torque/acceleration. Also require extremely tight tolerances given amount of torque that passes through these components
• Finally, the input costs are very controllable – no lithium or rare earths required here

The above is backed up by GKN’s future order book, which mirrors global auto production forecasts in terms of their ICE/EV mix:

And unlike other EV auto darlings that are hosting undifferentiated wiring businesses as 50% of their revenue (sorry to subtweet APTV here), the IP that goes into every sideshaft and drivetrain component is real and durable. Given the global leadership position, product stability, and EV optionality, I think Driveline should trade near the top of the auto parts value hierarchy.

Powder Metallurgy:

An even better business has entered the arena!

And if that weren’t enough, you also get the world leader in sinter and #2 in powder metallurgy thrown in as well.

If you are unfamiliar, sinter is the process by which extremely precise metal components are manufactured from powder. DWL harvests scrap metal, turns it into a powder, does some magic to said powder, then pressurizes and heats it to create custom finished products. This process is precise, yields very little waste, and is often the most cost competitive manufacturing technique for many metal parts – gears, bearings etc. They are the global #1 in this business.

They also have a more classic powder metallurgy business that uses non-sinter techniques like powder compaction to create precision parts. Global #2 here.

Finally, they have a nascent additive manufacturing business. Essentially, as 3D printing of scale parts grows, DWL is in prime position to supply specialty powders and may even have a hand in production themselves. Small part of the business today.

Finally, they are leading player in the nascent e-motor magnet production business. Essentially, 90%+ of all magnets in eMotors are produced in China, a big issue for global OEMs. DWL is positioning themselves to be the non-China solution here, and has booked significant business, although most hits in the 2025+ timeframe.

Powder metallurgy has double the margins of auto, a global footprint, and significant market share. Historically powder met businesses have traded at substantially higher multiples than classic auto parts – more below.

Operational Improvements:

Both DWL businesses have been through significant operational restructurings over the last several years, which are just beginning to bear fruit.

In Driveline they’ve implemented the following:

• Reduced fixed headcount by 12%, 2800 heads
• Closed 7 manufacturing plants, all in high cost geographies
• Increased purchasing productivity through contract restructuring and consolidation, reducing COGs by 3% per year
• Grown production in low cost facilities in Mexico and Hungary
• Changed new business booking requirements such that no bookings are undertaken below a 10% EBIT margin on 2019 average production volume
• Reduced trade working capital from 7% of revenue to 4% of revenue

This has resulted in significant restructuring charges in 2019-2022, although that restructuring does seem to be ebbing now (more below). Notably, the business paid for capex, restructuring, pension funding, and returned cash to Melrose parent during this horrible time period for the industry.

What is the result of these initiatives? Management is committed to 10% operating margins at 2019 auto production levels. Current margins sit around 5.5% - sensitivities to follow in the valuation section.

The potential margin uplift here is enormous, tangible, and near-term – and in no way currently baked into the share price.

Similar operational excellence has been adopted at Powder Metallurgy:

• Closed 5 high cost plants and opened a new plant in Mexico
• Reduced fixed headcount by 30%
• Implemented more robust controls for limiting input cost inflation via a continuous improvement plan unique to the industry
• Reduced trade working capital by 35%

As a result, management promises similar operating improvements in a normalized production scenario, where EBIT margins could expand from 10% to 14%.

The result here is you have two solid businesses that are linked to auto production, with the potential for significant margin expansion if auto production just returns to 2019 levels, trading at a price that implies zero improvement anywhere.

Auto Production

I don’t want to spend too much time here – as with any macroeconomic factor, its worth thinking about in terms of scenarios and the level where we currently sit.

I think its commonly – ultra commonly – believed that in a global recession that most in the cyclical world consider inevitable, that auto production will plunge – just as it did in 08-09. But there are a few important facts to consider:

• The US has produced autos well below replacement levels for three straight years, with SAAR of 13/13/14 in 2020-2022. There are 283 million cars on the roads in the US with an average age of 12.2 years. Depending on the availability of new cars, we scrap between 11-15m cars a year – and the population of drivers grows by about 4m a year in a non-covid year. This means we need between 15-19m cars to be produced just to keep up.
• You couple this with the under-production post GFC, and while car quality is allowing cars to get older than they used to, its very hard to sell just 12-14m cars in the US for some extended period of time. This is why used car prices have been so stubbornly high
• Finally, the US 2019 level was not absurd at all – around 16m cars – the same amount sold in the US in the mid 1980s and throughout the 1990s.
• The reason for the reduction in production wasn’t demand – it was supply. And as those supply chain issues get resolved with inventories low, a 2019 production scenario should be the base case even in a weakened economy.
• Europe is even crazier, with production falling from 18m in 2019 to 13m in 2022. All the above stats about the US make the case for Europe even better – and there are greenshoots, with IHS meaningfully revising up its 2023 Q1 auto production estimates for the geography.
• Finally, there’s the insatiable demand for vehicles given the long-term secular urbanization trends in China and India.

I can just end with this chart. Global light vehicle production:

COVID and supply chain issues took us very, very far off the slope of this chart and it is not a difficult bet to make that we catch up at some point – likely some point soon. Otherwise stated, global auto production volumes are already in a significant recession.

So maybe at least considering 2019 volumes as a possibility – not crazy.

Valuation and Scenarios

When DWL spun out of MRO, I had done some work and decided I thought a good place to add substantial shares would be at 155-165 per share. So imagine my amazement when the stock fell to £112 on day 1. It sits now at £125, startlingly cheaper than I expected. Now, there are reasons for this – who wants to own the dirty autoCo when you can own the dazzling AeroCo with all those great RRSPs? Long cycle! Etc. And, I mean, sure, I think that is going to be great. But the AutoCo has been – in my opinion – uneconomically sold just to get it off the sheets, and now is a great time to capitalize at a very inexpensive valuation.

As is true for many spincos, we do not have amazing disclosure here yet, as the spin occurred just a few weeks ago. But, I have combed through the financials and put together some base case forecasts for the business. Caveat is that there may be some serious errors/omissions here that become clear as we get more disclosure – this is the nature of investing in spins like this (and the opportunity).

The business also spun publicly with limited leverage – 1.3x EBITDA at a 5.5% rate (ahh, Europe).

My base case valuation, including all corporate costs, restructuring, pension funding etc:

The base case assumptions are pretty simple:

• Modest volume growth in 2023 driven by supply chain easing at OEMs
• Modest progress toward margin targets with increased volume in 23 and 24
• Cash restructuring of £45m in ‘23, falling to £20 in ‘24
• Pension funding of £30m in ’23 and ’24, despite a fully funded pension
• Limited working capital draws from here, in accordance with recent history

Nothing about this is heroic, in fact I’m sure management would be very disappointed with these margin results. And you still are looking at a 16% FCF yield to equity on 2024 with limited leverage.

Now, lets look at downside and upside cases:

I believe both of these are reasonable cases. If we have another GFC then downside will be worse, and if SAAR goes to 20 in the US, they are going to print much more money than this. But I do think 90% of macro outcomes probably fall within these boundaries. As such, you are today buying this at a 5x EBITDA multiple on trough earnings (and lets not forget, they managed to generate cash during COVID), and a 26% FCF yield on management targets. Good situation.

Finally – we almost forgot about Powder Metallurgy. This higher margin business is worth more than a classic auto supplier, and its hidden in here. I’ve heard industry commentators consider this more like a 7-8x EBITDA business, but there aren’t a lot of great public comparables to confirm this and, at the end of the day, most of the end market is still auto.

That said, its gotta be worth more on a multiple basis than Driveline, and given the entire business here is already getting a bargain basement auto multiple at less than 4x a depressed margin structure – well, there’s upside if anyone ever cares about Powder Met.

And, at some point, they just might – as the management team has committed to pursue a strategic process for this asset within 2 years. So, feel free to dream the dream.

A few final points:

So, where could I be wrong here?

• Restructuring: Auto companies always seem to restructure forever, and new restructuring programs look like the apple in every CFO’s eye. While the commentary from the company and the accounting treatments in their documents do not indicate a ton of go forward restructuring cash costs (for example, there is only $20m cash costs on the restructuring reserve remaining), there is the definite possibility that new programs gobble up cash flow in 23 or maybe 24. But the restructuring will end, and I trust these programs have a pretty solid IRR.
• Disclosures: They are weak so far, so maybe there are substantial cash-guzzling items I am missing
• Macro: Macro
• Management: I am a big fan of Liam Butterworth and his team, former head of powertrain at Delphi who was poached by Melrose to come fix this business – and I think he has executed well. But without the watchful eye of Melrose overseeing the business, could we fall back into some bad old times? Perhaps.

I think an investment in DWL allows one to capitalize on negative spinco trading dynamics, a business with great margin improvement prospects, great cash flows, and the potential for a macro upswing over the next several years.

Disclaimer

This document is for informational purposes only. All content in this report represents the author's opinion. The author obtained all information herein from sources believed to be accurate and reliable. However, such information is presented “as is,” without warranty of any kind — whether express or implied. All expressions of opinion are subject to change without notice, and the author does not undertake to update or supplement this report or any information contained herein. This report is not a recommendation to purchase the shares of any company. The information included in this document reflects prevailing conditions and the author’s views as of the date submitted, all of which are accordingly subject to change. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity. Any or all forward-looking statements, assumptions, expectations, projections, intentions or beliefs about future events included in this document may turn out to be incorrect. Any investment involves substantial risks, including, but not limited to, pricing volatility, inadequate liquidity, and the potential complete loss of principal. Investors should conduct independent due diligence, with assistance from professional financial, legal and tax experts, on all securities, companies, and commodities discussed in this document and develop a stand-alone judgment prior to making any investment decision.

Catalyst

Removal of spinco trading dynamics

Margin expansion

Additional coverage/attention