Description

We believe NN Corp. (Ticker:  NNBR - $8.75) represents a compelling long opportunity with 60%+ upside in the coming 12 months?  We see limited downside to intrinsic value.

We concede – this company might be considered a bit boring:

• They make primarily bearings and some precision metal components
• Yes – the name is NN Corp. – that’s certainly not very exciting
• The primary end market is automotive – so, it’s got that going for it

However, even though NN Corp. is not terribly exciting, there are a number of things to like about the company and the investment opportunity:

• This is actually a pretty decent industry
  • It has evolved into somewhat of an oligopolistic structure
  • Changes in raw materials prices are effectively passed through to customers leading to predictable gross  margins
• The company is cheap
  • 8.0x Est. 2013 EPS
  • 4.2x Est. 2013 EBITDA
  • Averaging roughly 15% FCF Yield to Equity
• The company is out of favor and trading below historical multiples
• A few key catalysts could “make this stock work” in the coming quarters

What does NN Corp Manufacture?

• Metal Bearing Components (68% off Revs) – Bearings, rollers, stampings – primarily for automotive.  Note there are two types of competitors:
  • Bearing manufacturers have in-house (captive) production of their own balls and rollers
  • There are independent manufactures of balls and rollers.  Many of these independents are Japanese companies that tend to behave themselves in terms of pricing and share gain attempts.  That’s not to say the industry is not competitive but it has somewhat settled into and oligopolistic framework
• Note:  There is customer concentration with SKF AB in Europe – 34% of total sales.  However, as outlined later in this write-up, catalysts with SKF are core to this investment thesis
• Precision Metal Components (21% of Revs) NNBR machines metal components for industrial uses.  They bought this business in 2006 (Whirlaway) and there were problems from the outset:
  • They mistimed the deal and the end markets crashed (commercial vehicles, air conditioning, other) 
  • As well, they mis-bid some contracts and it took years to get through this low margin work
  • But, they finally have this business running well – it went from losing $8mm in 2010, to losing $3mm in 2011, to making $6.0mm in 2012.  We think it settles in at 10% margins against $80mm in Revs and will continue to grow
• Plastic and Rubber Components (11% of Revs) – We won’t spend much time on this division – it is a mediocre business with $40mm in revenues and $3mm in income

Capitalization and Valuation

We think fair value in one year is $14 per share – a 60% premium to today’s share price.  We base this on the following assumptions:

• Net debt comes down another $20mm to arrive at 2013 YE net debt of $30mm (consistent with cash flow guidance given by management)
• EBITDA goes to $52mm in 2014
  • We’ll substantiate later why we think this is the case (for what it’s worth – The Street is at $55mm for 2014)
  • Also note, this level of EBITDA does not imply mean reversion to historical margin levels – rather, mean reversion to historical levels would suggest even more upside to EBITDA
• $52mm of EBITDA would equate to roughly $25mm in FCF and $1.25 in EPS
• Our valuation is based on:
  • 5.5x Forward EBITDA = ~$14/share (note LT median multiple is closer to 6.5x)
  • 10% FCF Yield = ~15/share
  • 11.5x Forward EPS = ~14/share (note LT median multiples are closer to 15x)
• We think we’ve been reasonably conservative in these multiple – and if the company executes as we expect – these multiples should be readily attainable

Ok – It’s Cheap – But What Makes the Stock Work?

We think the most important catalyst for NNBR stock is the end of destocking by the company’s largest customer.   SKF AB in Sweden accounts for 34% of sales – this is a long term and stable relationship.  NN’s products are a critical component to what SKF manufactures – there is not enough bearing capacity in the world for SKF to replace NN with another supplier.   The problem is that SKF has been aggressively destocking their inventories since the beginning of 2012.  That means that with auto sales down 8% to 10% in Europe in 2012 NN saw more than a 20% decline in their sales to SKF.  So, while the rest of NN is performing pretty well this destocking has resulted in meaningfully lower overall revenues.

Now, the interesting thing about destocking is it can’t mathematically go on forever.  Destocking means that a company’s inventory purchases are lower than its production – thus, if they continue this too long they’ll run out of inventories with which to build their products.  The question is – how much longer will SKF destock?  Our contention is they are done or close to done – and, we’ll see a tailwind to European sales because of this.  Why do we think this is the case:

• As we said – destocking can’t last forever – it’s just math
• NNBR Management has noted that in the past when they’ve experienced customer destocking – it usually lasts at the most four quarters.  If that were to hold, then 4Q of 2012 would have been the last quarter of destocking for SKF
• Year end 2012 commentary out of SKF suggests that destocking may be coming to a close:
• “…During the quarter we continued our journey to reduce inventories…”.   They mentioned that they were very aggressive in the 4^th quarter (NNBR clearly saw this in their numbers). 
• Importantly, they went on to say, “I can say we will run manufacturing broadly in line with sales in the first quarter, so we’re not looking to take further inventory out in the first quarter.”  While they said they will continue to evaluate this – to us it sounds like a clear message that destocking is over for the time being
• Then on the 1Q call (just happened on 4/17) SKF was pretty positive about the rest of the year – and basically guided to flattish inventories:
• “For the coming quarter, though, I would say the risk I think is more on the upside than on the downside…For manufacturing, we will keep the manufacturing level broadly at the same level as the first quarter, which means it will still be lower year-over-year.  Inventories, no big change.  It may be slightly up, but not dramatically at all.”
• When discussing destocking of their customers, “…destocking, a really good question.  Its hard to see how it can continue, to be quite honest, because in discussions we’ve had with big distributors, et cetera, we think now they’re towards the end…we are more in balance of sales at SKF as well.”

To summarize the SKF situation – we see an end to the destocking which has been so painful for NN.  And, in general SKF management is pretty positive about the remainder of 2013. 

However, NNBR management decided to be conservative and guide based on 2013 being flat to 2012 at $370mm in revenues.  And they went on to say, “…our guidance assumes the European recessionary levels will continue and no improvement in the destocking for all of the upcoming year. “

In other words management decided to guide 2013 assuming continued destocking even when it is apparently coming to an end (per SKF commentary).  We think NNBR management has been exceedingly cautious and they are setting up to beat guidance in 2013.  They even conceded this to some extent, “We are hopeful that these assumptions prove to be conservative.  And, in fact our first quarter 2013 results are exceeding our forecast for revenues thus far” (4Q Call).

So, that begs the question of how much 2013 could be boosted if Europe does not destock?  Looking at the geographical segments we can see that Europe was down about $54mm 2012 vs. 2011.  We think at least $50mm of this was in bearings.  Management has said the destocking has a 2x factor on lowered auto sales – suggesting about 50% of the $50mm was due to lower auto sales in Europe and the other 50% was due to destocking.  This means that if Europe does not destock NNBR could see upwards of $25mm in additional revenues in 2013 over 2012.  This would come in at about 30% contribution margins so would represent roughly $7.5mm in additional EBITDA. 

Will we see all of this in 2013?  It is hard to know but we think the end of destocking provides meaningful upside to NNBR’s 2013 numbers.  If sales to Europe improve then guidance has to come up.  As estimates come up, sentiment will improve and multiples will as well – all of this will happen in the face of nice FCF and declining debt.  This will, “make the stock work”.

Other Catalysts

Beyond the ‘end-of-destocking’ catalyst – there are a couple of things we think may also help the stock:

• Last year the company expanded capacity in China – 2013 is the year to fill up that capacity.  We think this can help the stock as it could contribute $20mm to sales
• The long time CEO announced his retirement and they are in a CEO search.  A new CEO, with a clear path forward and improved communication with investors could do a lot for sentiment around the stock
• The company has mentioned that the declining debt levels allow them to consider acquisitions and/or dividends – either of which could help the stock

Conclusion

NNBR is a pretty good company in a decent industry – but at present is an unloved story.  The company has actually performed well even in the face of a very difficult European situation.  This quarter or next – we will see the end to destocking in Europe – setting up for a better 2013 than currently perceived (and guided to).  While we wait – we have a cheap stock, with lots of FCF, which is deleveraging nicely.

Catalyst