Description

ZZZ007 wrote this up as a long in Feb 2018 which includes a timeline from the spin to that date which adds some good context to the situation this company is in today. 

HZN is a good short because:

·         Cyclical end markets and losing share

·         Mis execution will result in cost cut misses

·         8x levered on pro forma consensus EBITDA estimates and pro forma capital structure post the sale of the Asia pacific business (leverage is likely understated as estimates look too high)

·         Selling crown jewel to meet debt maturity.  Left with sick European business and a North American business that isn’t growing

·         High probability BK in a recession given debt maturity schedule and lack of further asset sale/cost cutting options

·         Expensive at >10x pro forma EV/EBITDA

·         Bad business – not likely to not earn its cost of capital even with a clean capital structure at the peak of the cycle.  Low gross margin, high fixed costs, commodity exposure, no pricing power

Overview

HZN was spun out of TRS in 2015.  The business reports in three segments.  Americas, Europe-Africa and Asian-Pacific (just sold).  The management team that came with the spin initially levered up to buy some businesses in Europe which had some integration issues and the US business has been going through some execution issues associated with improvement plans which was combined with higher input costs and tariff costs and overall slowing end markets.  This resulted in GAAP profit going from $35m in 2017 (51m adjusted EBIT) to a loss of $170m in 2018.  While ~175m in costs were deemed 1x (5m in adjusted operating profit), execution is still mixed and even giving credit for some growth and improvement this leverage is >8x EBITDA (at mid point of pro forma estimates) with no path to de-lever and its end markets appear to be rolling over.  Below is a more detailed timeline of events. 

The business is 50/50 work vs play and the end markets are agriculture, oil/gas/mining, construction (mostly nonres), marine, RV, bicycle and light trucks; however no breakout is provided.  Notably all are cyclical and discretionary.  The industry is very fragmented in all of its markets.  Including the above, the business exhibits most things investors avoid such as a lack of pricing power (more on that later), lack of differentiated offerings or strong value proposition, lack of recurring revenue, and exposure to commodities.  The only attractive part of the business was the low capital intensity (2-4% of rev), but the bad qualities far outweigh that benefit, resulting in 3-7% returns.   Even at peak EBIT, ROIC was 7% and ROE was 9%.  This is much higher than the firms cost of capital.  Especially when considering the recent 2^nd lien floated in March came with a 2% OID, 11.5% PIK (or LIBOR +10.5%) and 3.6m warrants (additional 2.65m warrants subject to shareholder approval) with a strike of $1.50; and a requirement by the first lien holders to amend the first lien which included a 50bp amendment fee, plus 3% PIK on top of the LIBOR + 6%.  It’s amazing that the market bid up the value of the equity after those terms were announced, especially when considering the amendment to the first lien term loan requires $100m to be paid down in the next year which has resulted with them 1)selling the crown jewel to meet the liquidity requirement. 

The Americas

The America business peaked in Q3 2017 and has been hurt by weak weather during peak seasonal periods and some lost sales due to disruption from the facility consolidation.  The business shrank in Q1 and mgmt. blamed weather for the 2^nd year in a row and was flat in Q2 heading into the price season.  Gross margins are down from a peak in 2016 of 29.6% to 20.5%.  3.5% of the decline has been volume related and the rest is from commodities, freight, penalties for late shipments and costs associated with closing facilities.  Gross margin declines continued in the 1H, even on cleaner 1x costs, driving y/y declines in EBIT even after some SG&A savings from last year, lower ad spend and no consulting fees. 

The bull case for the Americas business is that they are under earning (consensus is for 2019 EBIT of 35m vs peak  of 48m) with a low risk plan to grow earnings through price increases which are starting to flow through, savings from facility consolidation and steel is 29% off its peak.  This all may be true, but management is notoriously bad at executing, and end markets are either rolling over or look to be peaking (declining volumes hit GM% by 50% on an incremental basis).  In fact, throughout 2018 management talked about entering 2019 with 10-12m in runrate cost savings, however, after primary research, I don’t think even 50% will be realized.  Freight costs and labor is more expensive than planned at the new facility in Kansas City (labor $4/hr more than Houston or South Bend where previous facilities were located) and bad cash flow generation due to mis execution during the facility transition + high leverage resulted in the need to enter into an operating lease for some equipment that is a $2+ million drag.  All said and done, realized cost savings are likely only going to add $4-$5m.  Furthermore, my sense based on my conversation with the management was that price increase negotiations were disappointing given customer pushback due to the fast drop in the price of steel during price negotiations.

So what does this roll up to?  See below base, bull and bear case with assumptions.  Notably, the street is assuming 33m which I view as too high and even the best case is below 2017 levels (which I view as unrealistic assumptions on steel price recapture and aggressive assumptions on other line items). 

End markets rolling over

Agg spending is the worst in three years.  According to UST, during peak season “American farmers already plagued by a near biblical parade of misfortune that includes years of low prices and a trade war with China are now grappling with record Midwest rain that will likely prevent a large portion of this year’s crop from even getting planted.”  That would require little investment in equipment; which is showing up in the data – spending being the lowest since 2016.

The growth rate in light truck sales appears to also be approaching negative territory

With their largest customer, Ford already in negative territory

RV shipments are getting worse as dealers are working down inventories due to weak demand

Boat registrations peaked in August with dealer sentiment now in negative territory

US construction spending growth peaked in 2015 and nearly in negative territory

This impacts the Europe-Africa business (more below), but Germany is 26% of consolidated revenue and nearly 60% of Europe-Africa and it’s PMI is negative. 

Europe-Africa

The Europe-Africa business peaked in Q2 2018 and has been hurt by overall weak demand, mostly in the aftermarket and auto businesses. 1H margins were hit due to a recall but overall volume, commodity costs and freight pressure continued to be headwinds.  Managements plan to re-expand margins is localizing supply (which they are behind on), productivity improvements, and higher margin product introduction.  These are not quick fixes – they’re multiyear initiatives and the benefits have not been quantified. 

The bull case for the Europe comes with much higher hurdles, as the compares aren’t as easy as in America.  Gross margin expansion will need to come from mix which appears to be unlikely as weaker demand and market share losses has hurt the higher margin aftermarket business which was down 20% in the 1H. FX is going the wrong way and freight inefficiencies continue.  The only offset is $8-$10m in cost savings from layoffs last year. 

So what does this roll up to?  See below base, bull and bear case with assumptions.  Notably, the street is assuming 180k in EBIT which I also view as too high after 1H results and the lack of recovery in economic activity and mix headwinds.  

Asia-Pacific

The company announced the sale of this business closed on 9/19/19 for $233m in gross USD proceeds.  It has been the only growing asset with no restructuring needed and has by far the highest EBTIDA/capex flow through of the three businesses.  This is a value destroying transaction which management was forced into to meet a $100m maturity in January of 2020 as part of the amended First Lien Term Loan.  I was surprised they got such a good multiple on this business given it was likely valued on peak EBITDA as trends were starting to roll.

Capital structure

In March, HZN amended its First Lien Term Loan while securing a $51M Second Lien Term loan. Additionally, Horizon amended its ABL facility, reducing its borrowing capacity to $90M to allow for the Second Lien Term Loan. The Second Lien Term Loan comes with a LIBOR plus 11.50% PIK or LIBOR plus 10.50% cash interest, maturing in September 2021. Financial covenant for the Second Lien Term Loan includes a net leverage ratio of 6.75x by 4Q19, through till 2Q20, and decreasing to 5.25x starting in 3Q20. The Second Lien also includes 3.6M warrants, with a strike price of $1.50 per share and duration of 5 years. As part of this transaction the first lien holders also required a $100m paydown in 2020. These are, in a nutshell, bad terms and its clear the banks want out (management is pretty upfront about this)

Below is pro forma debt and leverage ratios

Below is my estimate on deal fees and taxes to get to net proceeds

Valuation

From a comparable basis, OEM suppliers trade at 4-6x EV/EBITDA and aftermarket suppliers are closer to 10x.  Aftermarket is only 5% of HZN revenue and HZN has historically traded at 5-8x and is currently trading at 14x pro forma (554m EV less $200m in debt paydown over $25m in pro forma EBITDA).  I see no reason, given deteriorating end markets and high leverage that this asset should trade over 6x and is likely worth closer to 4-5x in this environment or ~1 per share. 

Risks

·         A refinance of the second lien would be a negative for the short, but even if the lower debt profile allows them to refinance and they can get the interest rate on the second term loan down to 8%, interest expense would come down to $12-$15m vs the $30m they paid last year implying EBT of <-22m.  Bottom line is they likely will still be burning cash (EBITDA less interest would be -2 to -5m) and this likely gets worse as their end markets roll over.

·         Global industrial activity reaccelerates    

Catalyst

Global macro slow down 

Recession

SAAR declines

Bankruptcy