Description

Once marred by >$1.5 Bn of Asbestos claims, Enpro Industries (NPO) is seeing light at the end of the tunnel: not only does it have a strong case to contain the final exposure below $300 mm vs. $1 Bn+ cited by claimants, but the step it took to bankrupt one of its subsidiaries (GST) optically depressed EBITDA/FCF by 25-40%, makes the stock appear expensive, but is in reality under-levered at roughly net-cash and sporting a 6.5x EV/EBITDA vs. 8-10x peers. With ~$210-220 mm of consolidated EBITDA, NPO sits in a stable niche that allows for strong cash-flow generation, has an event path over the next 2 years to put all asbestos-related issues behind it, and is a good set-up for an activist-induced break-up & sale that should prompt multiples rerating while earning 7-8% FCF yield and having the ability to lever up 1-turn+ retire 20-25% of market cap. $80-90 bull case (35-50% up), $52 bear case (12% down), 3-to-1 risk-reward.

Business Overview

• EnPro Industries, Inc. (NPO) is a diversified industrial company incorporated and headquartered in North Carolina that was spun out of Goodrich Corporation in 2002.

• 20% exposure to trucking, 13% to O&G (mid/downstream focused).

• 55% US exposure, 28% Europe (mostly in auto, trucking, and aerospace).

• 50/50 OEM/aftermarket split. Think of the portfolio levered to broad industrials.

• 3 business segments that collectively generates $1.1 Bn in sales and $160 mm EBITDA

• Sealing products = 55% of revenues, 64% of segment profits.

  • Garlock – sells sealing products (gaskets, seals, compression packing) into the chemicals, O&G, power, metals & mining, water, and infrastructure markets.

• Technetics – sells highly engineered seals and components into semiconductor, nuclear power, aerospace, oil & gas, and general industrial markets

• Stemco – sells wheel end, suspension, and brake products into the heavy-duty truck market.

• Engineered products = 30% of revenues, 18% of segment profits

  • GGB – sells plain bearings into the automotive, construction equipment, and general industrial markets

  • CPI – sells components for reciprocating compressors into the refining, natural gas, chemical, PET bottle blowing, and LNG markets

• EEngine products = 15% of revenues, 18% of profits

  • Fairbanks Morse – manufactures and services large, medium-speed diesel engines for the U.S. Navy and nuclear power plants

• Garlock Sealing Technologies (GST), a subsidiary within the Garlock family of companies, filed for Chapter 11 protection in the Western District of North Carolina (WDNC) on June 5, 2010 as a result of pending and expected future asbestos personal injury claims and has since been deconsolidated from NPO’s financial results. GST generates ~$220 mm in Sales and $55-60 mm EBITDA. It also owns a ~$275 mm 11% intercompany PIK note issued by Enpro to mostly cover the bankruptcy costs.

Why does this opportunity exist?

• Since GST is de-consolidated and materially “over-capitalized” with inter-company notes, a cursory screen will display NPO as an overvalued (11-12x EBITDA, 25x+ PE) and over-levered (2.2x) company with weakening margin and top-line; whereby in reality these figures understated real EBITDA/FCF by 25-40%, and NPO actually has a net-cash position assuming $275 mm of asbestos liability. I believe it the core reason why NPO is mis-valued.

• Despite material progress on the Asbestos front and a confirmation hearing planned for 3Q15, the final resolution will likely take more than 1-2 years barring a settlement. This quagmire (like any other Asbestos case) likely prevents many event funds’ involvement.

• On the same token, little-to-no strategic/take-out premium is placed on NPO since (1) no company is willing to be involved in this litigation, (2) a pro-forma Co with stronger financials may weaken Enpro’s negotiating position against the claimants prior to plan approval.

• Management had been criticized in the past for its lax capital allocation behavior. Its acquisition history had not been stellar, thus a discount on existing cash.

• The hodgepodge of assets and reluctance to consider alternatives create a SOTP discount.

• KeyBanc, Sidoti, Oppenheimer, & Sterne Agee are the only firms that offer meaningful coverage. Sidoti just downgraded NPO to “underperform” and calls for the top of truck cycle.

• Liquidity is somewhat constrained with volume at 150k shares / day or ~$7-10 mm

Developments and Considerations

1. The core business remains sound with potential optionality on all fronts.

• Like any other comfortably-situated niche industrial parts companies, Enpro’s products are mostly mission-critical with a high cost of failure, custom-tailored for customer specifications and designs, and relatively low-cost within a customer’s overall bill of materials. The long history and large installed base allows NPO to reap recurring revenue at 2x the margins on replacement parts (20% vs. 10% rule-of-thumb), and once the clients’ trust is established on 1-2 products over a long period of time, cross-selling other parts (from acquired businesses) or bundles become much easier.

• From a client’s perspective, while Enpro’s parts are typically 15-20%+ more expensive, the value proposition largely lies with the lifespan and quality of the product that materially reduces down-time and potential hazards. This demand will in-turn force distributors/OEM to carry the product, and since Enpro can actually fulfill the inventory quickly, it actually also helps the working capital management of its distributor clients. None of these practices are new, but given that Enpro’s core products are either #1 in consolidate areas or growing in fragmented areas, both with limited TAM that grows at GDP+, It had the chance to earn itself decent margins.

• Compared to pre-2007 periods, NPO’s margins across segments are 4-10 points lower and top-line rebound remain somewhat muted. Perhaps one can point to their diminished competitive positioning (hard to prove), but I believe the core reasons are due to (a) higher OEM mix as the rebound occurs, (b) acquisitions changing the margin structure, (c) One of the acquisitions (CPI) is poorly situated and only earns 4-5% margin and the turnaround is not yet in-sight, and (d) sequestration postponing government replacement orders. Note that NPO’s Operating Income remain 35-40% below its 07/08 peak of $200 mm; and while it’s hard to bank on the #’s getting back there, as the installed base and aftermarket mix rise and government orders come back eventually, the margin could creep back to the 13-14% level.

• Other long-shots include a European recovery (Europe = 28% sales, mostly in auto, trucking, and aerospace), a turnaround in CPI (Canadian nat-gas compression, hard to envision).

• After all, the company had been around for a long time. Note that its ~$550 mm acquisition spending over the past 10 years hasn’t really improved the bottom-line to this point (1/3 went to O&G that didn’t quite work, 1/3 went to trucks that did okay but mostly OEM & lower margin), but the long-lasting relationship and good product specification allows it to pull-through good margins going forward. In a decent year, it can pull around $210-220 mm EBITDA without material underlying improvement; and typically these businesses trade at 8-10x in mid-to-late cycle.

2. NPO has a strong case w.r.t. Asbestos and the liability is likely well-handicapped.

• The detailed history and summary of the case can be found on NPO’s website – the 65 page court opinion is very well-written.

• http://phx.corporate-ir.net/External.File?item=UGFyZW50SUQ9MjE2NzYzfENoaWxkSUQ9LTF8VHlwZT0z&t=1

• Essentially, NPO’s Garlock division made gaskets that contained asbestos and had been settling along the way in the tort system since 1980s. By 2000s, the claims got so big as the remaining thermal insulation defendants filed bankruptcy case that it also filed for Chapter 11 in June 2010. Since the first asbestos-related lawsuits were filed against Enpro in 1975, it has processed more than 900,000 claims to conclusion, and, together with insurers, have paid over $1.4 billion in settlements and judgments and over $400 million in fees and expenses.

• Section 524(g) of the Bankruptcy Code is a unique and powerful tool can allow a debtor plagued with massive asbestos liabilities to reorganize by channeling such claims into a trust—and thus ring-fence the debtor once-and-for-all upon final approval, but it is clearly an arduous process that requires discovery and approval.

• At the onset of the estimation trial, NPO filed a proposed resolution for $270M, while the claimants are asking for $1-1.3 Billion. Key difference here is that NPO’s approach is analysis given likelihood of recovery based on estimated exposure, while claimants’ method is based upon an extrapolation from Garlock’s history of resolving mesothelioma claims in the tort system.

• On January 13^th, 2014; Judge Hodges sided with NPO concluded that $125 million is the “reasonable and reliable” estimate of present and future liability for mesothelioma claims.

• The depth of the NPO argument is extensive and, in my opinion, extraordinarily compelling:

  • The product was encapsulated, so was not friable – couldn’t be airborne or inhaled. And product was between 2 metal flanges – not exposed to air. While at the same time, the pipe is wrapped in thick covering of asbestos insulation that was highly friable.

  • It was only when the gaskets were cut, hammered, scraped, brushed or abraded that they could generate breathable asbestos fibers. And it was necessary to remove the insulation before replacing the gasket.

  • Garlock’s products used chrysotile almost exclusively. While the asbestos-containing thermal insulation uses amosite. amosite have relatively longer, wider and straighter fibers. Various studies showed that amosite is at least 5x more toxic than chrysotile. A person would also have to have a much greater exposure to chrysotile to increase their risk of mesothelioma.

  • In the full discovery of 15 closed tort cases that the court allowed, In each and every one of those cases it disclosed that exposure evidence was withheld (10-20 exposures withheld vs. 0-7 disclosed). Out of the 161 cases in which Judge Hodge allowed further discovery, “almost half” involved misrepresentation. These claimants and their lawyers later actually identified the non-disclosed exposures to win trust claims. In other words, these plaintiffs are “double-dipping” – sue Garlock, hide evidence, get settlement, then go other after trusts for the same asbestos claim. Had they been honest in disclosure, the total amount spread across defendants should be much smaller.

  • No court has held that analysis of the debtor’s claims resolution history is the exclusive means to estimate liability.

• Ultimately, Enpro’s historical settlement costs really have no representation of true liability; and one can argue that the plaintiffs are committing borderline fraud to extract settlements.

• Since the January ruling, NPO filed its amended plan for reorganization to provide $275 mm in total funding for all present and future asbestos claims in the trust. A petition to reopen the case was rejected by court, and NPO asked for the plan confirmation hearing to begin on July 15, 2015.

• Delay to the process and appeal post hearing confirmation are broadly expected. However, I believe any final outcome will skew heavily towards the $275 mm end. This is really the first time “double-dipping” is used as a valid argument in court and this point is not only valid given the evidence we know, it is catching steam in Washington (http://www.wsj.com/articles/the-double-dipping-legal-scam-1419535915). One can reasonably speculate not only some legislations may be put into law to curtail such behaviors (The FACT Act had no chance in Harry Reid ’s Senate, but a Republican Congress might be different), it also opens up doors for previous defendants to sue their prior claimants/law firms. The point is, clock is ticking on the claimants’ end – if they were smart, keeping it low-key and settling might be the smartest decision; the attention the federal appellate brings to the case may very much be beneficial to NPO’s case. Justice shall prevail, no?

3. The path-dependent upside is a matter of when, not if; rekindled activist interest won’t surprise us.

• Hence, assuming ~$275 mm of Asbestos liability, ~210-220 mm of EBITDA, and a reconsolidated entity that spends an additional 80 mm on legal fees but enjoys ~90-100 mm of DTA from Asbestos, a 8-10x multiple will get us to $80-90 / share, or 30-50% upside. To put it another way, the current $59 / share implies ~$1 Bn mm of Asbestos liability – actually similar to the stock prior to Judge Hodges’ ruling; or if we assume $275 mm is the right number, the implied multiple stands at 6 x, much below the 8-10x peers. See SOTP below:

• The downside case points to ~$52 / share if we haircut EBITDA by 20% across the board (similar to 2009-2010 levels), use a 7x multiple on this trough number, and assume Asbestos liability come out to be $400 mm. Note that if we look at NPO on a consolidated basis, it actually generates ~$110-120 mm of FCF per annum, so this $55 / share would imply a 8-9% FCF yield on a company with no leverage.

• Ultimately, the upside to Enpro is rather path-dependent: when the Asbestos case is resolved and the trust is established, Enpro will be reconsolidate GST back into itself, the quant screen should pick the numbers up, and the rerating should occur rather quickly. It is also abundantly clear that NPO is not running its balance sheet efficiently – large pile of inaccessible cash in GST that earns nothing coupled with high-interest debt on NPO level @ 6%. Once the structure collapses, Enpro can comfortably take on 1x of leverage (~$300 mm, or 20% of market cap) to pursue value enhancing activities.

• A potential break-up / sale alongside activist involvement is another reason to believe that NPO should trade at least in-line with peers or at a premium. Warren Lichtenstein’s Steel Partners made a run at the company back in 2008 – it first offered to buy NPO shares at $47 / share (which was ignored), then threatened proxy battle and urged a sale-process / break-up alongside accelerated share buyback. This activist effort was settled with a director add and de-staggered board and Steel Partners eventually sold out of its stake in 2009.

• The consolidated sealing business is high-quality and accounts for >70% of NPO’s EBITDA. The business has proven to be resilient, highly cash-flow generative, and could certainly find a suitor – be it a PE firm or a strategic like Flowserve. The Power Systems segment is a bit more difficult as it relies on MAN’s license and thus mercy. The CPI compressor business had been a drag on margin and, once jettisoned to a strategic, should lift the overall multiples, and the GGB business should be a nice tuck-in for bearings strategic in Europe. Bottom-line is, these segments enjoy little to no synergies under the same roof. If the management is willing to sell, buyers should surface.

• Another oft-cited criticism to management is that they might squander cash on less-than-stellar acquisitions. An activist involvement should partially offset such concern.

• According to the latest proxy, CEO stands to make ~$19.6 mm should he be terminated upon a change in control, and the definition of CoC actually includes owning >20% of the stock (vs. the usual 50%)

Risk / Mitigations

• Inefficient balance sheet may cause stock to underperform: this is a valid concern, but the under-levered balance sheet should also cushion downside should there be a draw-down – making NPO essentially a lower beta stock barring a resolution.

• Risk to capital allocation: another valid concern. If anything, recent comments indicate that management had stepped back on the acquisitive pedal given liquidity constraints.

• 13% Sales in Oil exposure: The oil exposure is concentrated in Sealing and CPI in engineered products. There is no drilling exposure. For sealing, end-market is mostly to downstream refineries, processing, petrochemicals plants, and pipelines. For CPI, it is valves and replacements in reciprocity pump & compressors, mostly for permanent, large horsepower installments that transfers gas. While O&G CapEx cut might be contagious and impact downstream also, one can argue that refinery shut-downs & mandatory maintenance could actually lift margins and shield Enpro from a big drop.

• Trucking (20% sales) maybe entering peak of the cycle: Could be anyone’s guess, but Class 8 truck net order @ 40k+ for Oct/Nov 2014 did spark discussions on whether we will see a cliff in 2015. Sidoti makes the analogy that 2015 for trucks is like 2006 – where net orders quickly tapered off and the economy followed. Well, the orders probably won’t go higher, but while I am no expert, the picture this time looks a little bit different: GDP and PMI are not trending lower like 2006, interest rate is still very accommodating, fleet age remains elevated at 56 month+, fleet size estimate is still 5-10% below the 2006 peak, tonnage is so far showing no signs of flattening out, and small truckers anecdotally couldn’t even get their orders into the OEMs since the backlog is filled into 2H15 for the big guys. In other words, the setup does not seem like impending doom and order more likely flattens out at elevated levels into FY16 or so. But I would love to be educated otherwise. Regardless, the increased fleet and ton-mile should boost NPO’s aftermarket business post OEM sell-through and improve margins too.

• Litigation extension & settlement beyond $275 mm expected: affirmation likely helpful. Appeal comes after. Timeline is at risk of dragging out but meanwhile cash is piling up. Ultimately, to own NPO, one has to be comfortable that their side of the argument is just (which all evidence points to) and the right side should ultimately prevail. Being willing to take directional and timing risk here is largely how this return could be made.

What will make me change my mind?

• If the trucking and/or economic cycle definitively turn for much worse in 2015 despite my belief.

• If other asbestos claims surface besides mesothelioma that drastically worsen the $275 mm estimate.

• If NPO management does a transformative acquisition outside of core competency.

Event Path / Catalysts

• Dec 31, 2014 – Jan 30, 2015: Board nomination window

• Feb 6, 2015: 4Q14 Earnings

• April 30, 2015: Projected 2015 Annual Meeting

• Early May 2015: 1Q14 Earnings

• June – July 2015: Amended Reorg Plan confirmation hearing

• Settlement with Asbestos claimants could happen at any time

• Activist involvement / chatter could happen at any time, although after confirmation more likely

• Trucking-related data points + European Auto SAARs

Appendix

Peer T12M EV / EBITDA ( ATU, B, CIR, CLC, CR, FDML, FLS, GDI, RBC, RBN, SKFB, TKR,TRS,WWD,WTS)

Peer T12M PE ( ATU, B, CIR, CLC, CR, FDML, FLS, GDI, RBC, RBN, SKFB, TKR,TRS,WWD,WTS)

Peer Net Debt / EBITDA ( ATU, B, CIR, CLC, CR, FDML, FLS, GDI, RBC, RBN, SKFB, TKR,TRS,WWD,WTS)

Peer EBITDA margin ( ATU, B, CIR, CLC, CR, FDML, FLS, GDI, RBC, RBN, SKFB, TKR,TRS,WWD,WTS)

NA Class 8 Trucks Net Orders, Retail Sales & Backlog, by BMO

Catalyst

• Dec 31, 2014 – Jan 30, 2015: Board nomination window

• Jan 21: FCR - ACC Bar Date request hearing

• Feb 6, 2015: 4Q14 Earnings

• April 30, 2015: Projected 2015 Annual Meeting

• Early May 2015: 1Q14 Earnings

• June – July 2015: Amended Reorg Plan confirmation hearing

• Settlement with Asbestos claimants could happen at any time

• Activist involvement / chatter could happen at any time, although after confirmation more likely

• Trucking-related data points + European Auto SAARs