Description

Horizon Global (HZN) - a market-leading manufacturer of automotive accessories including towing, trailer, and cargo management products – is an orphaned, small cap spin-off trading well below intrinsic value. Thanks in part to indiscriminate forced-selling from legacy holders of its parent company Trimas (TRS), HZN trades at a double-digit FCFE yield (at the midpoint of management’s FY15 guidance), with the potential to more than triple FCF by 2018 in our base case.

This upside will be achieved mostly through straight-forward supply chain optimization and through very strong cash flows allowing HZN to rapidly pay down the debt that they were spun-out with. This debt pay down will bring net debt/TTM EBITDA from 3.6x to 0.6x by 2017 in our base case, or alternatively to management’s 2x target, resulting in available cash to return to shareholders or do accretive M&A, creating a potential 4-bagger for equity holders.

We believe the earnings power potential of this business (once its cost-cutting initiatives are complete) is for EBIT margins in excess of 10%, which is more in-line with peers (and more than double HZN’s 4.6% 2014 EBIT margins excl. special items). We model EBIT margins of 9.3% by 2018 in our base case. Further, HZN’s sizeable aftermarket/replacement and retail businesses help to insulate them from the full vicissitudes of Recreational Vehicle (“RV”) and Truck/SUV production cycles. Numerous low-hanging fruit cost cutting opportunities before HZN will make their go-forward trough margins higher, and further insulate them against any potential cyclical headwinds in their end-markets. Finally, we believe HZN is incorrectly perceived by the investment community as a business akin to that of an auto OEM parts supplier. HZN, however, has large retail and aftermarket businesses that comprise ~2/3 of its sales and operating profit. This combined with its overall lower capital intensity allows it to convert EBITDA to FCF at ~4x the rate of their OEM supplier peers.

Our base case has HZN generating $2.84 in FCF per share in 2018. Applying a conservative multiple of 12x to that, HZN would trade for $34, nearly 4x its current share price. This equates to an 80%+ IRR (See “Valuation Section” below).

Summary Business Overview: Strong Brands, Loyal Customers, Leading Market Share

HZN is a market-leading manufacturer of automotive accessories including towing, trailer, and cargo management products, which they sell through multiple channels (1/3 OEM or OES ie. through the new vehicle dealer, 1/3 Aftermarket, and 1/3 Retail & ecommerce - with their strongest position vis a vis competition enjoyed within retail/ecommerce channel and with certain Aftermarket customers). They are a clear top-2 player in the ~$2 billion market for towing and trailer accessories, with ~25% market share. Their chief competitor, Curt Manufacturing, also has ~25% market share. HZN’s market share has expanded over time due to international acquisitions. HZN’s key brands (Reese®, Draw-tite®) have been around for over 60+ years, and are well-recognized by customers. Industry professionals we spoke with said Draw-tite® is such a ubiquitous and strong brand in the towing space that customers routinely call trailer hitches a Draw-tite® much like many people are apt to call tissue a Kleenex®.

They are a #3 player behind Thule and Yakima in their much smaller cargo management business (including vehicle mounted bike carriers as an example). HZN’s end-markets are GDP growers, with the potential for slightly higher growth via higher international expansion, as wealth and therefore RV and truck ownership rates grow in these markets, and due to favorable demographic trends in North America. Management thinks the business can grow 3-5%. (See “Detailed Business overview: HZN has strong brands and global multi-channel distribution” section below for a more complete business and industry overview).

Why this opportunity exists: The spin-off and other value dynamics

Spin Background

HZN’s parent company, the industrial mini-conglomerate Trimas (TRS) became subject to an activist campaign led by Engaged Capital, whose stake in TRS was announced in Nov. 2014. The HZN spin was announced in December 2014. In Feb. 2015, Engaged Capital was awarded one board appointee to TRS, with the potential for one more in 2016.  

Regarding the spin rationale, HZN’s organizational structure within Trimas was sub-optimal; there were no benefits from having these two businesses together. HZN, while the lower margin and lower growth business when compared to parent co, was also the “cash cow” within their parent.  In the old structure, HZN’s FCF would get diverted to TRS growth projects, preventing them from making more tuck-in deals or necessary investments in their business. Finally, TRS wanted to shed more light on, and lend greater flexibility to, HZN’s growth and margin improvement strategies largely underway but not yet evident in their operating results.

On July 1st, the spin-off was consummated and HZN closed its first day of regular-way trading at $13.75. In the subsequent trading sessions, HZN’s stock price came under extreme selling pressure due to its relative size and perceived business quality. As we studied the HZN spin, we saw an intriguing and classic combination of spin-off attributes and idiosyncratic value dynamics that together have created a unique and compelling investment opportunity.

The classic spin-off dynamics that we see in HZN include:

• Indiscriminate selling from TRS shareholders: On July 1st, TRS market cap was ~4.5x that of HZN, making many TRS investors deem HZN too small to bother with. In most cases, it was likely outside of their investment mandate, particularly as HZN’s market cap fell below $200mm, a key threshold for many small-cap funds. With 100% of HZN’s share count having traded hands as of 11/17, the forced selling is now complete. As small and micro-cap value investors begin to gain awareness of the HZN story, this orphaned stock will get to trade unencumbered from any overhang of legacy Trimas holders yet to sell.  

• Spin-co management team had a financial incentive for a lower stock price in the short-term: We believe management had an incentive to undersell the HZN story prior to August 14th, as the number of LTIP shares they were to be awarded was determined using the dollar amount of TRS stock they held divided by the average price of HZN between July 1st – August 14th (i.e. the lower the share price, the more HZN shares they would own). While this time period is now past us, it is relevant in understanding how HZN may have missed its first chance to gain a strong institutional following.

• Equitized, incentivized, and energized management team: In the medium and long-term, gaining independence through a spin-off and issuing direct equity incentives are powerful motivational tools for multiple layers of management. We see CEO Mark Zeffiro and CFO David Rice as a strong leadership team with the right vision for the future.

• Organizational structure revamped: As part of TRS, the HZN business lines were organized sub-optimally by channel (“Retail” and “Performance Products”, i.e. essentially every other channel). Now untethered from their parent company, HZN can optimize their organizational structure to better drive performance.  

• Logical acquisition candidate: We see multiple strategic buyers, both public and private, that would likely have significant interest in a deal for all or part of HZN.

• Niche business with limited sell-side coverage: Sell-side coverage is currently limited to three small shops (Barrington, Roth, and Seaport). HZN’s only true direct peer is private. The overall RV and Truck/SUV accessory niche is very under-followed. For example, Drew Industries (DW), which is peripherally related to HZN, in that it supplies components for RVs, has a market cap nearly 10x that of HZN and still only has research coverage from four small brokers.

In addition to the classic spin-off dynamics outlined above, there are idiosyncratic elements that have exacerbated HZN’s orphan status (we’ll elaborate on each in sections further below):

• Recent financial performance is misleading: Both full-year 2014 and Q215 (HZN’s first reported quarter out of the gate) were depressed by non-recurring factors including the temporary share losses noted below. Analysts are extrapolating forecasts off of these artificially low earnings. Further, as part of the spin HZN was saddled with debt that temporarily weighs on return on capital metrics.

• Headline EPS is misleading: HZN’s cash flow per share greatly exceeds its GAAP Earnings per Share, due mostly to non-cash amortization and to GAAP depreciation that far exceeds the ongoing maintenance capital needs of the business. HZN’s maintenance capex is $5mm (capex in recent years has been higher, $17-23mm in both 2012 and 2013, due to a plant realignment, chiefly moving some capacity to Mexico). D&A runs closer to $19mm, $8mm of which is amortization of intangible assets. Consequently, the $0.975 midpoint of management’s 2015 EPS guidance equates to $1.65 in Cash EPS (Net Income plus D&A less maintenance capex), a 69% increase. When we adjust the midpoint of 2015 guidance to include a full-year of GAAP interest expense, adjust for special items, and apply the 25% cash tax rate to the resulting Pre-tax Income, that would be 2015 EPS of $0.54, and $1.42 in cash EPS, a 161% increase.

• Recent share losses that were an outgrowth of HZN’s supply chain disruption may reverse: HZN’s plant/supply chain relocations resulted in the loss of high margin, fully priced peak season Installer sales. Our research in the channel suggests that HZN has strong brands and loyal customers and it should win back share. We estimate that direct aftermarket sales to installers are ~10% of HZN’s overall sales.

• Substantial cost-cutting opportunity: With proper incentives in place and HZN’s results no longer a rounding error within a much larger company, management is attacking costs and catching up to the competition in terms of cost-effective sourcing and logistics. We believe that, with conservative calculations, the potential size of the costs to be taken out over the next three years equates to a 13%[1] free-cash-flow yield without even considering the free-cash-flow of the business as it currently exists. This assumes that $6mm of management’s ~$33mm targeted savings should already be reflected in 2015 results.

Detailed Business overview: HZN has strong brands and global multi-channel distribution

Competition

Horizon’s chief competitor in towing and trailering is a privately-held company, Curt Manufacturing. In March 2014, Curt was purchased by the private equity firm Audax Group.

Our research suggests that together Curt and Horizon comprise about 50% of their total addressable markets, and are roughly equal size. The other 50% of the towing and trailer market is highly-fragmented. Other noteworthy brands include Blue Ox, B&W Hitches, Demco, and Hopkins. None of the companies that own these brands are publically-traded, making a pure comp to HZN impossible.

Chart 1: Horizon’s Key Competitors

Brands and Key Products

HZN, more so than Curt, has a portfolio of nationally and well-recognized brands, some of which are more than 60-years old. HZN’s most notable brands include: Tekonsha® (founded in 1964), Reese® (1952), Hayman Reese, and Draw-Tite® (1946). Their Bulldog® brand dates back to 1920.

Chart 2: Horizon’s Key Brands and Products

Horizon also owns some IP associated with some of these brands, which they have successfully defended via litigation in recent years.

Sales Channels and Key Customers

Horizon sells their products through multiple channels, where sales are evenly-split between: OEM/OES, Retail/e-commerce, and Aftermarket:

Chart 3: Horizon’s Sales Channels

The difference between OEM and OES is that OEM sales are products actually designed into an OEM platform – i.e. a brake controller or towing accessory is part of the design of the Ford F-150. OEM sales depend on platform design wins, the number of automobiles on said platforms that HZN products are on, and take rates for the given product/accessory. The majority of HZN’s OEM sales are in international markets.

Source: Trimas December 2014 Investor Presentation.

OES refers to installations that occur after the point of sale, and are essentially customized add-ons requested by the customer as part of their purchase. For example, a customer buys a new RV from a dealer, and as part of that purchase pays $1,000 to have a series of towing accessories added to their vehicle.

Based on Cequent (i.e. HZN as part of TRS) disclosures within Trimas filings, we estimate OEM and OES are about equal-size sales-wise (so each about ~17% of company-wide sales).

Aftermarket can be split into three sub-categories: RV Distributors (LKQ: Keystone & Stagg), Automotive Distributors (LKQ: Keystone), and Installers. HZN also enjoys a strategic partnership with U-Haul in the Aftermarket.

Finally, is Retail/Ecommerce (Autozone, West Marine, eTrailer.com, Amazon, Walmart).

Relative to Curt, Cequent/HZN has long had a better foothold with the retailers (like AutoZone for example). Curt – given their more efficient, just-in-time operational success in recent years has captured more of e-commerce business on sites like etrailer.com. But according to Horizon management, e-commerce is HZN’s fastest-growing and most profitable segment (as it essentially allows them to cut out the middle man, and they are able to maintain price in this channel too).

HZN’s omni-channel distribution (selling to distributors and direct to installer, dealer, OE, mass market retail, and ecommerce-only customers) can result in channel conflicts, which is a risk we are not quick to dismiss. This issue is one we have done considerable diligence on, and are comfortable that HZN is managing effectively. Long-term we think HZN’s traditional aftermarket customers will have to evolve and continually enhance and justify their value proposition to maintain their place in the supply chain. And long-term for HZN, we think the transition to more direct-to-consumer sales will be a slowly-evolving one, and ultimately a net positive, as it will mean cutting out a middleman and preserving more margin.

To gauge the strength of HZN’s online presence  we analyzed SKUs on web properties like eTrailer.com and streetsideauto.com (owned by LKQ Keystone Automotive),  which showed that HZN claims 40-75% of the SKU count within all their major product categories, well in excess of their market share in towing and trailering products (~25%).

Chart 4: HZN Brand and SKU representation on eTrailer.com

So as the ecommerce channel grows to be a larger part of HZN’s business, it should create favorable mix benefits.

Among HZN’s three primary selling channels, there is no significant difference in EBIT margins (except the aforementioned slightly higher margins enjoyed on ecommerce), according to management. OEM/OES carries lower Gross Margins, but requires less SG&A to support the same level of sales in the other channels. Aftermarket has higher gross margins, but also higher SG&A. And Retail sits somewhere in between.

Chart 5: HZN’s Key Customers

No customer for HZN represents more than 10% of overall sales.

Favorable Business Tailwinds

Demand for HZN’s products are ultimately a function of RV and truck/SUV demand.

Regarding RV demand, demographic trends are supportive, with the key RV demographic of consumers aged 55-70 is growing ~3% per year.

Second, the trend towards a more active outdoor lifestyle is a tailwind for the towing, trailer, and cargo markets. Recreational Off-Road Vehicles that are towed to the destination, mountain bikes that use HZN gear to attach to the back of a vehicle, and “tail-gating” for live events using an RV are all manifestations of the trend.

Third, North American SUV/truck sales have gained share of overall production volumes in recent years, owing to low gas prices. This will mean a greater “installed base” of truck/cars on the road potentially in need of aftermarket towing and trailering parts and accessories.

Finally, as wealth in emerging markets grow, recreational vehicle and SUV consumption rates rise. HZN is positioned well to capture this international growth.

Management believes their end markets can grow slightly greater than GDP, or 3-5%, on account of the above favorable trends.

Falling LME Prices to Provide Gross Margin Boost

Recent large declines in the commodity prices of key raw material inputs for HZN suggest a likely margin benefit in the coming quarters. LME steel, copper, and aluminum prices (key raw material inputs for HZN) are dramatically lower in recent months. The degree to which HZN has to pass-through these lower raw material costs to their customers varies by channel (for example, OE has a quicker pass-through mechanism then Aftermarket), but some benefit should be retained. HZN is naturally reticent to talk about this trend and thereby invite customer pushback.

Idiosyncratic Factors Create Opportunity  

Previously, we outlined a set of idiosyncratic dynamics that obscure HZN’s true earnings potential. Below we discuss each of these dynamics in more detail.

Recent financial performance is misleading

• As we will elaborate on below (see “Market share may mean-revert in HZN’s favor once their supply chain normalizes” section), 2014 was an anomalous year operationally for HZN as they reformatted and improved their supply chain. HZN posted 4.6% Adj. EBIT margins including a corporate overhead allocation - versus the 7.5%+ Adj. EBIT margin including corp. overhead allocation it was achieving during 2010-12, prior to their 2013-14 transition from their Goshen, Indiana facility (ultimately shuttered Q4 2013) to  their plant in Reynosa, Mexico. This transition continued to adversely impact results in 2014, as the new facility struggled with inefficiencies associated with ramping-up production. HZN invested $50mm into this plant transformation.

• Gross Margin gains experienced thus far in 2015 have been masked by $3.5mm of non-recurring charges associated with ‘Consolidation of Americas’ (see below), $3.9mm in FX headwinds, and some negative operating leverage. HZN’s first reported quarter as a standalone public company (Q215) was not pretty. Revenues dropped 11% compared to the prior year. However, 3.9% was due to currency translation, with the remainder of the weakness largely explained by two factors:

• First (and we believe most impactful), management eliminated a discounted pre-buy program in the aftermarket channel, which made for a difficult volume comparison. We see this as a sign of good medium-term profit maximization, and it may have also conveniently helped to provide a lower share price to the personal benefit of HZN management.

• Second, a major aftermarket customer (LKQ) reduced inventory in conjunction with a warehouse consolidation. We do recognize the risk that this decline in aftermarket sales could be a sign of burgeoning channel conflict issues, as HZN’s ecommerce channel grows in size and importance. We take comfort that no customer is more than 10% of HZN’s sales, and that the long-term shift to more direct-to-consumer sales is a margin positive development for HZN. Near-term, it is a contained risk, but one that we are closely monitoring in the channel. In the most recent quarter, reported on November 10th, sales were up 2.6% on a constant currency basis year-over-year, which is just below management’s targeted range of 3-5%, and supportive of the assertion that the factors impacting sales in the previous quarter were more transitory in nature.

• Reported results in the most recent quarter (Q315), -2.9% y/y sales decline and 2.6% y/y sales growth on constant currency basis, reflect currency translation headwinds of about 550 basis points, which will improve meaningfully by March 2016.

Market share may mean-revert in HZN’s favor once their supply chain normalizes

• It may be helpful to review the recent changes to HZN’s production and distribution footprint. Across 2013-14, HZN invested over $50 million in cash for restructuring or other initiatives and capital expenditures, primarily as follows:

• Closed and moved production from their former Goshen, Indiana manufacturing facility to a new lower-cost facility in Reynosa in 2013, relocating approximately 420 positions;

• Relocated the supply chain from the Midwestern United States to localized supply near Reynosa;

• As a result of the Goshen manufacturing move, relocated the main U.S. distribution facility from Huntington, Indiana to Dallas, Texas;

• Consolidated two former Australian facilities in into one newer one, and;

• Consolidated two former facilities in Brazil into one facility.

• More recently announced plans to close its manufacturing facility in Juarez, Mexico and its distribution warehouse in El Paso, Texas. Manufacturing from these locations will be moved to existing facilities in Reynosa.

• Such moves naturally cause temporary ripples, both big and small, through a supply chain like HZN’s – impacting things like order-fill rates, product availability, freight costs, etc.

Chart 6: HZN’s supply chain improvements over last 5 years

• In times when HZN is not reformatting their supply chain, HZN achieves higher order-fill rates, customer satisfaction, and EBIT margins in the high single digits vs. 4.6% in 2014. High fill-rates are particularly important in the aftermarket towing and trailer business during the high selling season (summer). It is during this time, when dealers and installers can get unexpected surges in demand, and are often a lot less price sensitive when ordering parts for their customers/sales floor as they are when they are buying well ahead of the busy season. This is especially true when it comes to high ASP, custom, under-the-car products (i.e. under bed gooseneck hitches).

• In the Aftermarket, these products are sold through the Installers predominantly. So when supply chain disruptions occur, HZN is more inclined to dedicate their more limited capacity to their large retail customers at the temporary expense of the Installers and Dealers. Not only does HZN temporarily lose these sales, but in-season Installer sales are high margin sales to boot – because they are less price sensitive purchases.

• Further, in the past periods when HZN has been reformatting their supply chain, Curt has gotten very aggressive going after HZN’s Installer customers. A Hitch Pro, old-school direct installer would have been almost 100% Cequent/HZN a few years ago, according to our industry research. Over the last year that same installer may have split their business between Curt and Horizon, while HZN was undergoing its transformation. Luckily for HZN, their Installer customers are very loyal and captive, particularly the top-selling Installer customers historically organized into a buying group called “Hitch Pro”. There are probably 300 of these customers.

• Over the next 6-12 months, however, as HZN’s Reynosa plant continues to improve productivity, and increasingly lower cost inventory continues to work through the income statement, margins will improve.

Substantial cost-cutting opportunity

1. $20mm+ in savings from productivity improvements at Mexican operations (or 2-3% productivity improvement per year in 2015-18 vs. 2014 levels, coming primarily from four buckets - purchasing, manufacturing, freight, and distribution);

2. $5mm in reduced management compensation associated with Juarez plant closure;

3. $5 million in savings from the reversal of an illogical distribution framework that is a fallout of HZN’s organizational structure within Trimas, and;

4. Further unspecified amount from brand consolidation and other initiatives.

• Management has articulated a plan for the Company to reach 10% segment level margins by 2017, and 10% margins after corporate expenses by 2018. We believe management’s cost-cutting targets are based on a conservative set of assumptions.

• Our research suggests that HZN’s private-equity owned competitor, Curt Manufacturing, operates above these margin levels, which we find encouraging given the similarity in size, products, and distribution channels between the two companies.

• HZN’s 10% EBIT margin goal by 2018 will require taking approximately ~$33 million in costs out of the business (based on 2014 Adj. EBIT margins of 4.6%), assuming no sales growth and related operating leverage (which would be further upside).We believe that HZN can get roughly $20 million of these targeted savings alone through consolidating production into Reynosa, including in 2016 from the Juarez, Mexico plant, and from other purchasing, manufacturing, freight, and distribution improvements.

Analyst Investor Presentation, May 2015.

• In 2015, HZN has been starting to enjoy the benefits of productivity improvements at Reynosa, specifically through lower labor costs, but the full extent of even this benefit has not yet been realized, given HZN was not at full production at Reynosa in 2014, meaning new lower labor costs were allocated over a smaller number of units.

• HZN has much more runway for further improvements vs. 2014 results related primarily to ramping up production to full capacity utilization at Reynosa, continuing to move more vendors closer to new Reynosa plant, procurement savings, consolidation of Chinese vendors, among others.

• We estimate that HZN’s production volume coming out of Mexico comprises ~40-45% of their total 2014 production volume.

• Therefore, 2-3% improvements per year, or 10% improvements at midpoint, would produce ~$21mm in savings alone, or 10% improvements on ~$210mm of COGS (45% of 2014 COGS). This does not account for any offsetting benefit or drag from operating leverage. The benefits from the Juarez closure (both productivity improvements from transferring Juarez production into freed-up Reynosa capacity made available there partly by the improving productivity at that plant, plus $5mm in reduced management compensation associated with Juarez’s closure) should be completely reflected in HZN’s operating results by the end of 2016. Other productivity improvement opportunities abound, including the announced closing of their Tekonsha, Michigan facility on their most recent earnings call. Brand consolidation (see below) may bring further production efficiencies.

• There is another $5 million of costs coming out from the reversal of an illogical distribution framework that is a fallout of HZN’s organizational structure within Trimas, where HZN was broken into “Retail” and “Performance Products” (i.e. all other channels). This initiative is what HZN is calling the “Consolidation of the Americas”. HZN, within TRS, had an inefficient system of delivery and logistics, whereby a Retail distribution center would not be used to serve a nearby Performance Products customer, and vice versa. As their system is currently configured, products for the Retail side that need to end up in a Texas Autozone, for example, are manufactured in Mexico, transported to an Indiana retail distribution center, and then transported back down to Texas and other southern retail stores, resulting in many unnecessary costs.

• The remainder of the cost opportunity, along with some possible scope for upside, should come from initiatives like brand consolidation (they support more than 30 brands currently, and recent commentary suggested they might remove 3-10 brands from this portfolio). Discontinuing underperforming brands alone will reduce costs for the design, marketing, and administrative support for all those extraneous brands. There is also an opportunity to better integrate and improve sourcing for acquisitions made in international markets in recent years.  These savings are not even contemplated in the “$33mm” targeted savings.

• In summary, the $5mm in lower SG&A costs from reduced management costs at Juarez, the $5mm in reduced SG&A costs from the Americas consolidation, and the ~10% in productivity improvements across Mexico production have and will continue to lower HZN’s cost structure. This lower cost structure means that HZN will better be able to weather any future cyclical slowdowns in sales.

• To give a sense of the magnitude of recent cost reductions, in 2008 (when prior trough EBIT% occurred), SG&A as a % of sales at Cequent was 18.4%, ex any corporate allocations. If in a downside scenario, where we assume sales declined peak to trough ~21% (similar to the ~24% peak to trough declines from 2007-09), this would equate to trough sales of $483mm. $10mm in SG&A savings amounts to 2.1% of this trough level of sales. Another $21mm in Gross Profit improvements would be 430 bps of this estimated trough sales.

• Therefore, highly likely productivity improvements and cost take-outs should mitigate the negative margin impact from a down cycle, if HZN were to see sales declines similar to those of the 2007-09 period (which we do not view as likely).

In summary, to see the potential full benefit of recent investments made in plant reformation, as well as the current and future cost initiatives outlined above, one must first appreciate how these actions have temporarily depressed recent operating performance for HZN. Beyond this, it is also important to look further out beyond the next twelve months to see the full benefit of HZN’s efforts on the cost side as well as the favorable impact of prodigious cash flows on the balance sheet. We cover this in the section below, and outline the risk/reward for HZN at current prices.

Valuation: HZN inappropriately compared to automotive OEM suppliers

In what little research exists on HZN, we believe the company has unfairly been comped to automotive OEM suppliers. The analyst at Roth Capital Partners even openly acknowledges this brush of conservatism, “To arrive at our $12 price target, we use the OEM supplier multiple…We do this for conservatism, although in our view, HZN should justify a higher multiple given exposure to non-OEM markets such as the automotive aftermarket and retail channels.”

We agree that a more appropriate peer universe is a set of automotive aftermarket providers and other industrial manufacturers with similar non-OEM exposure and a Return on Invested Capital (“ROIC”) profile comparable to that of HZN’s.

Patrick Industries (PATK), Cooper Tire (CTB), and Standard Motor Parts (SMP) fit the bill; and with post-tax ROIC of around 15%, they are a more appropriate peer universe than one comprised solely of low-ROIC OEM suppliers such as Dana Holding (DAN), Federal-Mogul (FDML), and Tower International (TOWR) to name a few. Also, OEM suppliers like DAN, FDML, and TOWR – to whom HZN has wrongly been compared – are far more capital intensive businesses than HZN’s, and historically have converted far less EBITDA to FCF on average than HZN. We believe HZN, on an unlevered basis, converted ~55% of EBITDA into FCF from 2011-14 vs. an OEM supplier average of 25%. Adjusting for their new capital structure, we believe HZN would have converted ~40% of EBITDA to FCF on a levered basis over this same time vs. an OEM supplier average of 11%. Special items and growth capital expenditures for HZN over the time period in question have obscured the above point, causing some investors to miss the superior FCF conversion attributes of HZN’s business model versus that of auto OEM suppliers. Also, different than an OEM parts supplier, HZN will capture the majority of the productivity improvements it realizes, both because of its aftermarket and retail presence, and because as a supplier of accessory products vs. more standard parts, they are able to better preserve margin in the OE channel. So we believe HZN’s FCF conversion gap over the likes of a DAN, FDML, and TOWR will only grow over time, particularly as its cost initiatives continue to take hold, as each additional dollar of EBITDA from cost savings will convert at 75% (taxes are the only deduction, given maintenance capex will not increase).

Our more appropriate peer universe currently has a median NTM P/FCF multiple of ~13x and a 5y-average median of 12x; it has a current median NTM EV/EBITDA less capex of 9x and a 5y-average median of 9x. We use 12x and 8x NTM P/FCF and EV/EBITDA less maintenance capex respectively in our base case.

Base/Downside: Attractive risk/reward with an IRR of 80%+ in base case

In our valuation scenarios, we used both a NTM FCF and EV/EBITDA less Capex multiple to our 2018 estimates to arrive at an average Jan. 2018 target price.

In our downside case, cost cutting initiatives help to buffer profitability in the face of declining sales. Additionally, we see multiple levers for HZN to preserve and free up cash in the face of cyclical downdrafts. These dynamics create downside protection at current prices.

Here are key assumptions under each scenario below:

Table 1: Model Summary (please note that 2014 and 2015 results include a full year of interest for comparison purposes – and so differs from mgmt. guidance).

-2014 is Proforma adj. for special items - but annualizes interest and "other" expense

-2015 includes a full year of interest and applies 25% cash tax rate to Net Income to make it an apples-to-apples with other years. It also takes out non-recurring, spin-related corp. overhead

Base: $31.79 target price; IRR 84%.

In our base case, we give management credit for nearly all of their 10% / 10% cost savings and operational goals, with estimated 2018 EBIT margins of 9.3%.

We grow sales by 3% (low end of management’s targeted 3-5% organic), after declining by ~5% in FY 2015, largely due to FX headwinds, consistent with management guidance.

We assume management will use all FCF to de-lever. The cost savings will be show up in both Gross Margins (the up to $20mm of productivity improvements at Reynosa) and in SG&A ($5mm from both Juarez management costs and from the Consolidation of Americas benefit).  

We apply a 12x and 8x FCF and EV/EBITDA less Capex multiple to our 2018 estimates respectively, and average the target prices from these two valuation methods.

In our base case, HZN will delever to ~.6x Net Debt/EBITDA, so one could argue that it is appropriate to focus less on Enterprise Value metrics and more on FCF yield. Using our $2.84 estimate of FCF/share and a 12x multiple, HZN would be worth ~$34 per share. Additional upside is possible if HZN finds accretive uses of its unlevered balance sheet, or if it is ultimately acquired by a strategic player.  

Downside: $8.51; Target Price; IRR -2%

In our bear case, we assume a comparable peak-to-trough decline (-21%) in sales as that experienced from 2007-09 (-24% peak-to-trough). Specifically, we assume sales decline from $611mm in 2014 to $483mm by end of 2018. Note that HZN’s sales have a work and play component, and have exhibited far less cyclicality than the RV and truck production cycle in past recessions. In 2008-09, sales were down -12% in each year, despite dramatically higher declines in RV and auto production.

In our downside case, we apply 2008 Gross Margins (20.8%, trough margin year) to our 2018 sales estimates. But we give HZN credit for half ($10mm) of the cost reductions they are targeting from improved productivity within their Mexican plant operations. This increase of $10mm in Gross Profit applied to our 2018e in the downside case makes trough GM% 22.9%.

For SG&A, we apply 2008 operating expense ratio (18.4%) to our 2018 downside trough sales estimate, add corporate expenses (2% of sales), and deduct the $10mm in SG&A savings (Juarez management cost take out and Consolidation of Americas cost reductions) that will be fully out of the business by the end of 2016. This amounts to SG&A of 18.3% of sales; and therefore trough EBIT margins of 4.6% (which compares to Adj. EBIT% of 4.6% from 2014).  

Some debt pay down occurs in our base case from FCF generation, and from working capital tailwinds that would likely occur. Cequent/HZN managed cash flows well in 2008-09, slashing capex (to ~$3mm in 2010) and other costs, and managing working capital well too. We expect they would do so again.

In our downside case, we apply a 10x our $1.13 in 2018 FCF to yield $11.33 and 6x EV/’18 EBITDA less Capex to yield $5.69. We average the target prices from these two valuation methods ($8.51), but note that there would still be very favorable asymmetry of the Reward to Risk ratio even if we conservatively used only the lower $5.69/share.

Risks

Automotive distributor consolidation: HZN’s biggest aftermarket customer/distributor is now LKQ. They have been actively acquiring specialty aftermarket distributors in recent years (Keystone, Stagg Parkway, and Coast). If the aftermarket distributors consolidate further, and gain scale, this could possibly provide them with enhanced negotiating leverage versus H ZN. HZN has no current commercial relationship with Coast, which is likely set to consolidate warehouses in Q415.  

Cyclical risk: RV, truck, and SUV sales are highly-cyclical. For example, Travel Trailers & Fifth Wheel RV industry unit sales, according to Drew Industries, declined from a peak of 293k units in 2006 to a trough of 138k units in 2009, for a 53% peak-to-trough decline. With that said, HZN saw a smaller 25% peak to trough sales decline over a similar time, given steadier aftermarket sales and the work-related applications for many of their products.

FX: HZN faced a 550bps translational FX headwind in y/y sales in MRQ, which we believe will mark a peak, and will decline to a 230 bps headwind by summer 2016. This improvement, however, assumes no further US dollar strengthening from late November spot rates. HZN’s biggest FX exposures are to the AUD and EUR.

Channel conflict: HZN’s multi-step, multi-channel distribution is prone to potential channel conflicts. Through our research, we have found no evidence that HZN has mismanaged its “map pricing” by allowing product pricing in one channel (i.e. ecommerce) to be below that of another channel (i.e. aftermarket wholesale distribution). Having said that, there remains some risk within the Aftermarket and Retail segments that HZN’s ecommerce success could alienate certain customers to some degree. We feel that our base case can absorb a great deal of this and still be compelling, and in the long run any share loss is likely to even out or be in HZN’s favor.

Customer lost in transition to Reynosa don’t come back: If the Installer customers that had to find alternative product suppliers during HZN’s transition to Reynosa from Goshen decided not to resume buying HZN products, this would adversely impact HZN’s future profitability.

Light-weighting: As CAFE (fuel-efficiency) standards force auto OEMs to increasingly make lighter vehicles, one way they are achieving lower targeted weights in their designs is simply removing many of the heavy, steel towing and trailer accessories from the OEM design. This may benefit HZN, though, because the products most likely to come off auto designs to save weight are products in which HZN has small OE market share, but high OES market share.

This report (this “Report”) on Horizon Global (the “Company”) has been prepared for informational purposes only. As of the date of this Report, we (collectively, the “Authors”) hold long positions tied to the securities of the Company described herein and stand to benefit from an increase in the price of the common stock of the Company. Following publication of this Report, and without further notice, the Authors may increase or reduce their long exposure to the Company’s securities or establish short positions based on changes in market price, market conditions, or the Authors’ opinions with respect to Company prospects. This Report is not designed to be applicable to the specific circumstances of any particular reader. All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the Company’s securities. Information contained herein was obtained from public sources believed to be accurate and reliable but is presented “as is,” without any warranty as to accuracy or completeness. The opinions expressed herein may change and the Authors undertake no obligation to update this Report. This Report contains certain forward-looking statements and projections which are inherently speculative and uncertain.

Catalyst

• Company reports Q415 earnings, and releases FY2016 guidance.

• More sell-side coverage and management outreach.

• Market cap goes back above $200mm, bringing it back into the purview of more small-cap fund managers.