Description

We are posting Montupet as a timely event-driven opportunity that offers potential upside of 30%+ with very limited downside

Background

Montupet is a French auto supplier of cylinder heads (“CH”) and structural aluminum products. CH contribute 80% of revenues and profits, while structural products add 20% (which include Turbo Charger castings, support Knuckles and EGR exhaust castings).  Regionally, around 85% of Montupet’s operating profits originate from Europe with N.A and Asia splitting the difference. The company is based near Paris. 

Recent Development – Tender Offer by Linamar

Last week, on October 15, 2015, Montupet received a cash offer to be acquired for 71.53 euros per share from Linamar, a Canadian industrial company which offers several products, including engine blocks.  Linamar’s offer is fully funded and includes ‘standard’ break-up fees per the M&A announcement conference call. The deal is expected to close by February 2016.

Montupet’s board supported the deal and recommended investors accept the offer. This price represents a forward earnings multiple of only 11 times 2016 earnings. The board is effectively controlled by Montupet’s top executives, including the longstanding CEO, CFO and two other senior managers which together own 37% of the company. 

Management is willing to sell the business at what we judge too low a valuation, which gives little credit to future earnings expansion. It appears to us that management, which are in their mid to late 60's are fatigued of managing a publicly traded company with a volatile stock that is judged by sell-side analysts focused on near-term performance, and that managment desires to retire in the near-term (as they have publicly stated in the past).  As such, we believe that there is a better than normal chance that a White-Knight could offer a higher price for Montupet given the upside embedded in the business but also in light of the strategic importance Montupet plays as one of the only two independent global suppliers of cylinder heads.

Our analysis of Montupet suggests that the company is worth 95 euro per share for a financial buyer and above this for a strategic acquirer.

Background on the market and business:

The Market

               The overall market for cylinder heads is mature and grows at 2-3% per year over the business cycle, in line with the volume of production of PVs and LCVs. In Europe the auto cycle is recovering, with volumes at 80% of Normal and we expect ~4% growth into normal in 2018; North America is close to normal and should grow 1.5% into 2018.  

On the supply side the mix is shifting away from in-house OEM production. Since the 90s, western OEMs have gradually moved production away from captive foundries (while Japanese OEMs kept 100% captive and Asian foundries serve low grade engines for the local market).  Today, about 50% of the market is served by independents and 50% by captives. The trend of outsourcing continues, albeit at a slower pace than the past as some OEMs have already achieved 80%+ outsourcing (mostly in N.A), while others are taking a more measured pace (in Europe). Still, outsourcing continues as several OEMs have announced that they will not expand their foundry capacity further, while their utilization is approaching 100%. As such the market for independent foundries is growing around 2X the rate of overall demand.

               During the financial crisis, many foundries shut down or consolidated. Currently, the market is dominated by Nemak, a division of Alfa, a Mexican industrial holding company. Nemak has 58% market share in terms of volume, while Montupet has 22%. The next largest player has less than 4% share.  Of the different players, Montupet appears to be the one taking share and growing materially above market.  From 2010 to 2014, Montupet took an estimated 600bps of share of the total market (captives + independents).

Drivers of Montupet’s Share Gain

               As a provider of CH for European OEMs Montupet has historically been the leader in engineering capabilities and quality of product. Auto producers in Europe tended to use small, more efficient engines relative to N.American car manufacturers, which pushed Montupet to innovate faster than competitors.  Nemak on the other hand has historically served N.A where engines tended to be bigger but less sophisticated.  However, as regulation on emission and energy consumption has accelerated over the last 4 years, OEMs have had to move more into small engines. To meet customers’ desire for horsepower, the OEMs had to increase the pressure in the engines and employ Turbo chargers. This led to material elevation in heat and pressure that cylinder heads had to cope with.  In turn, it has played into Montupet’s engineering strength, developed in the European market.

               In addition to Montupet’s technological leadership, OEMs have been diversifying away from Nemak, which built up a very dominant market share from inorganic acquisitions within a relatively short period of time in the middle of the last decade and during the downturn.  As Montupet started to build new capacity, especially in North America where the company was a non-player in the past, OEMs responded favorably. In this respect, we note that the smaller players in the market are likely to lose further share as their production capacity cannot follow the OEMs globally and given that they appear to struggle in terms of technology and production capabilities for newer engines relative to Nemak and Montupet.

               The combination of product leadership and improving position as an alternative to Nemak and captives, allowed Montupet to secure contracts which management expects will drive 11.8% CAGR in volume from 2015 to 2018.  Beyond contracted business Management is already on the path to win new business, which will drive growth in volume of 15% per annum in 2019 and 2020.      

Compounding and IRR

               We are modeling CH volume growth of 8.5% from 2015 and reach a target just shy of 6mm heads in 2018, relative to management’s goal of 6.4mm (on an overall basis Montupet’s message to the public market is “more than 6mm” but analyzing the company’s plans per plant yields 6.4mm). For ARPU we project flat ASP (management expects expansion; confirmed also by Nemak as a result of expanding sophistication of the engines). This in turn leads to revenue cagr of 8.2% for the CH piece of the business, which makes up 80% of sales.

               For the structural components products we model growth for Turbo Chargers at half of management’s expectation (in a market that overall is growing >50% per year due to regulation). For EGRs and Knuckles we assume growth with overall volume of autos at 3%. Combined we expect the structural components segment to compound sales at 9%.

               In terms of margin, we underwrite a target of 16.5% operating margin, relative to management’s goal of 19-20%.  This yields EBIT cagr of 16% from 2015 to 2018. Combined with a yield of 5.5% on 2015 and little leverage our model calls for 21% EPS cagr during this period; management goals imply EBIT cagr of ~27% and EPS cagr of 32%. In terms of return on capital, Montupet generated 16.5% return in 2014 and we expect this return to exceed 20% in 2018.

               Applying 12X on 2018E EPS we see Montupet AS worth e115/shr towards the end of 2017.  Discounted back at 10% per year, this implies value of e95/shr today as a standalone business before any synergies for a strategic buyer.

Catalyst

- Higher bid by White-Knight