Description

Recommendation: I recommend buying Park-Ohio's (PKOH) 6 5/8% unsecured bonds due 2027 at the current offer of $83 (11.1% YTW, +853 OAS) and believe the bonds can tighten by 100-200 bps over the next 12 months to trade at $89-$92, generating total returns of 14-18%. I think the bonds will re-rate as the market gains clarity on the following three key points (more on each of which below):

1. Assembly Components and Engineered Products segments enter 2022 with record revenue backlogs and end markets starting to recover from covid-induced supply chain shocks
2. The company will start to benefit from decelerating metals input cost growth--particularly aluminum--as three- to six-month pass-throughs lap dramatic commodity price increases
3. Gradual easing of supply chain disruptions, which beyond contributing to (i) and (ii), will help PKOH unwind excess working capital built up over the last two years, driving a recovery in FCF as well as greater market confidence in the company's liquidity position

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Company history: Park-Ohio is a mini-industrial conglomerate headquartered in Cleveland, OH. PKOH's history dates back to 1907 with the formation of Park Drop Forge, which made closed die forgings for crankshafts, camshafts, and other parts for trucks, buses, and diesel locomotives. Separately, Ohio Crankshaft was incorproated in 1920 to finish machine crankshafts and camshafts for diesel engines. It later developed a surface heating technology that used high frequency electromagnetic fields to heat, harden, and melt metals, which the company used in the production of its crankshafts and camshafts. In 1967, the two companies merged and adopted the name Park-Ohio. 

In the early 1990s, Ed Crawford acquired a stake in Park-Ohio and assumed the role of Chairman and CEO. The company grew revenue and EBITDA by 9-10% per year from 1992-2018 through a mix of organic growth and adjacent M&A. Ed Crawford retired in 2018 and was replaced by his son, Matthew, who had served as President and COO from 2003. The Crawford family owns ~29% of the stock.

Business description: PKOH today operates through three segments that serve a variety of automotive, heavy-duty truck, and general industrial end markets. 

In its Supply Technologies segment (38% of 2019 revenue, 31% of 2019 pre-corporate EBITDA), PKOH provides supply chain management and procurement services to customers in industries including heavy-duty truck, power sports and recreational equipment, aerospace and defense, semiconductor equipment, electrical distribution, automotive, agricultural and construction equipment, among others. Through its Total Supply Management solutions approach, PKOH essentially replaces its customers' numerous supply chain relationships with a sole-source relationship with PKOH's Supply Technologies segment. PKOH's applications engineering specialists and direct sales force work closely with the engineering staff of OEM customers to provide engineering and design support, part usage and cost analysis, supplier selection, quality assurance, and other ongoing technical support. The relationship helps PKOH's customers reduce the costs of production component processes by outsourcing internal purchasing, quality assurance, and inventory fulfillment responsibilities, reduces the required working capital invested in inventory and floor space, and reduces component costs through purchasing efficiencies including bulk buying and supplier consolidation. Supply Technologies sells its approach to >7500 customers domestically and internationally. Five large auto OEMs were 33% of 2021 segment sales, and 60% of 2021 segment sales were to domestic customers. Supply Technologies is the crown jewel of the business, having generated low-double-digit returns on identifiable assets over the last 10 years. 

Park-Ohio's Assembly Components segment (33% of 2019 revenue, 39% of 2019 pre-corporate EBITDA) designs, develops, and manufactures aluminum products, direct fuel injection rails and pipes, fuel filler pipes, and plastic and rubber assemblies used to transport fuel from the vehicle's gas tank to the engine's fuel injector nozzles. The segment also prodcues a range of extruded and molded rubber and thermoplastic products, and engine cradles and buckets, which are powertrain-agnostic and which are found all over the batteries present in electric vehicles. Per the CFO, just $80-100mm of segment sales (18% of segment sales at the high end) generated from fuel rail and fillers, and I estimate less than a third of segment sales support internal combustion engines. Five large auto OEMs were 46% of 2021 segment sales, and 66% of 2021 segment sales were to domestic customers.

The Engineered Products segment (29% of 2019 revenue, 30% of 2019 pre-corporate EBITDA) designs and manufactures a broad range of capital equipment  including induction heating and melting systems (serving the metals, silicon, coatings, automotive, and construction equipment industries), pipe threading systems (primarily serving the oil and gas industry), and forged and machined products (serving locomotives and the aerospace and defense industry). Roughly half of segment revenue is derived from the sale of replacement parts and provision of field service for the company's installed base of products.

Recent developments 

After recovering 2020 covid losses and again trading above par for much of 2021, PKOH's bonds fell to the mid-$90s in August after the company reported weak Q2'21 earnings. While the company saw a continued recovery in revenue across its business segments and end markets, the Q2 report kicked off three straight quarters of disappointing results driven by a litany of supply chain-related challenges. The global semiconductor chip shortage impacted product sales in several key OEM platforms including the Ford Explorer and F-150, the Jeep Cherokee, and the Chevy Equinox, which impacted Assembly Components segment sales by $20mm (~15-20% of typical quarterly segment sales). More importantly, the chip shortage created significantly increased volatility in demand from OEMs, which impacted PKOH's plant production schedules and increased labor costs. In addition, Park-Ohio started to see an acceleration in raw material costs: front month futures for aluminum, rubber, and steel were up 59%, 75%, and 204%, y/y, on average, in Q2. PKOH has contractual pass-throughs on its aluminum exposure, but on a three- to six-month lag, giving the company limited ability to absorb sharply spiking costs intraquarter. PKOH does not have contractual pass-throughs on its other raw material inputs. 

In Q3 the company reported an operating loss in Assembly Components, again driven by supply chain disruptions impacting auto production on key platforms. Front month futures for aluminum and steel were up 10% and 23%, respectively, sequentially, and up 54% and 276%, respectively, from Q3'21 levels. PKOH again reported increased labor costs caused by local labor shortages, and in response, the company announced it will relocate production to lower-cost facilities with open capacity. 

In Q4, PKOH reported slightly improved adjusted EBITDA of $16mm (up from $13mm in Q3 and $12mm in Q2), but deepening losses at Assembly Components, again driven by an inability to recapture accelerating aluminum prices, which were up 44% y/y and 4% sequentially. Steel prices on average were +135% y/y in Q4, but 7% off Q3'21 highs. Management again cited reduced or erratic production schedules at OEM assembly plants continuing to cause inefficiencies, including albor challenges and increased premium freight costs. 

Aluminum prices were up another 18% sequentially on average in Q1, but PKOH should start to see better pass-throughs as it starts to lap the acceleration in prices which began in earnest in Q2 last year. Steel prices were down 30% q/q in Q1. Most importantly, management is growing more confident they will see more normalized production schedules into the back half of 2022, allowing the company to reap more of the benefit of its reduced manufacturing footprint

Average front month futures for key raw material inputs

What can go right? 

PKOH's end markets are recovering nicely, the company reported record revenue backlogs in all three segments as of end of 2021, and input costs are either decelerating or declining quickly from peaks. The thesis really boils down to this: PKOH is a decent (not great) business with TEV under almost any reasonable scenario covering the bonds, and with ample liquidity to get through another two years of rising input costs and other supply chain-related headwinds. 

Working assumptions behind each of the thesis linchpins above:

(i) Revenue recovery in Assembly Components and Engineered Products segments: 

• IHS and ACT forecasts for Class 8 and Class 5-7 truck, auto, and manufacturing point to mid-single digit unit growth in 2022 and 2023. PKOH’s weak revenue recovery in 2021 in the two problem segments weren’t out of line with industry volumes: IHS auto volumes weighted to PKOH's revenue mix were just +1.5% y/y in 2021 and manufacturing volumes were just +5.8% y/y, after -18% and -17%, respectively, in 2020
• Supply chain woes have had as much to do with the anemic revenue as slow-to-recover end markets. ~45% of Assembly Components sales are to the big US automakers, which continue to be impacted by the semiconductor chip shortage.
• Also in Assembly Components, in 2021 PKOH won a $40mm block of business on fuel assembly for the Gen 5 engine for GM. That is one of a few 2021 wins the company referenced on the Q4 call where quoted volumes will hit the P&L in 2022, in addition to the general recovery in automotive volumes
• The Engineered Products segment serves oil and gas, rail, and aerospace end markets, which are generally recovering in 2022-’23. Backlog in this segment for capital equipment was $164mm as of 12/31, +20% y/y. Revenue was +11% y/y in 2021 here, thanks to replacement parts and field service, which account for ~50% of segment revenue

(ii) Slowing input cost growth 

• Front month aluminum was +81% y/y in 2021 and should be +12% in 2022 (weighted average of 3 months to date and 9 months ’22 futures), before -13% in 2023 and -9% in 2024 (futures curve). PKOH has 3- to 6-month pass-throughs on aluminum in its contracts with customers, but a 6-month lag does little to help current period results when the commodity is up >25% in one quarter, as it was in Q3’21 before falling in Q4. Front month aluminum closed Q1’22 up 58% from 3/31/21 and up 25% from 12/31/21, so aluminum will be a problem again in 2022, at least in 1H (see chart below). But pass-throughs should start to contribute to margin more and more into the back half of the year, and increasingly so once aluminum tops.
• Rubber prices were +27% in 2021 and I have them +10% in 2022 (again, 3 months YTD’22 and 9 months ’22 futures, weighted average), before +3% in 2023 and -5% in 2024.
• Steel prices were +173% in 2021, should be -12% in 2022 (same methodology as above), and could be as much as -43% in 2023 even remaining well above 2012-’19 averages 
• PKOH does not have contractual pass-throughs on rubber and steel but said they have had some success negotiating pass-throughs with customers there
• Taking a simple average of those three commodities, costs were +81% y/y in 2021, should be +12% in 2022, and -13% in 2023

(iii) Working capital unwind, other sources of liquidity

• Pre-covid, PKOH pretty consistently managed working capital to a cash conversion cycle of 70-80 days. That has increased to 105-110 days in 2020-’21 largely due to three factors: (1) supply chain issues (PKOH having to dual-source raw materials and other inputs due to increased supplier lead times), (2) increasingly volatile customer ordering patterns, and (3) elevated raw material prices. PKOH should see relief on all three accounts, but the likely pace of relief is difficult to quantify.
• The CFO said he thinks there is $50-70mm of working capital unwind coming in the next two years, but to be conservative I have modeled flat working capital through year-end 2023, before $28mm of unwind in 2024 (see model summary below)

Other points of interest along the way:

·         M&A history: PKOH has spent ~$300mm on acquisitions, net of asset sales, since 2012. Incremental adj. EBITDA through year-end 2019, using 2012 as the starting point, was ~$36mm, implying a rough average purchase multiple of 8.2x. If you use different bookends (i.e. $111mm in 2013), you can get closer to a ~15x multiple. I challenged the CFO on whether that had been a good use of capital over the period and was a little unsatisfied with his answer. He essentially said they have a 25% hurdle rate for deals and that their acquisitions have been successful, and pointed to severe downturns in oil and gas, power generation, aerospace, and heavy truck even pre-pandemic as cause for the unflattering realized multiples. More importantly, and positively, looking forward: the current CEO’s father was CEO during the entire acquisition spree, and reading past transcripts, he seems to have relished the role of deal guy. Since his son took over, the company has dialed back M&A spend dramatically (just $8mm in 2019 and $5mm in 2021), has sold $20mm of non-core assets, and is moving two plants to Mexico, which the CFO says will generate “millions” in savings.

·         Assembly Components as a melting ice cube: Brian Dirubbio at Baird said in his initiation that the Assembly Components business is a melting ice cube and is worth 4x EBITDA at most. His opinion appears driven by the premise that the segment’s fuel rail business will go extinct as EVs supplant internal combustion engines. Fuel rails take a mixture of air and gas and deliver that mix to the cylinders. That framework is not present in EVs. The industry is shooting for 30% EV penetration of new car sales by the late 2020s, with current expectations roughly for 30% EV penetration between 2026 and 2030, and hitting around 50% by 2035. The fuel rail business is $80-100mm of revenue, which is 18% of 2019 Assembly Components revenue and 6% of 2019 overall revenue of $1.6bn, and with comparable EBITDA margins to the company overall, so it likely accounts for <$10mm of EBITDA.

·         Questionable EBITDA adjustments: Dirubbio also objected to PKOH’s 2021 EBITDA adjustments. PKOH has an overfunded pension and has recognized $7-10mm of non-cash pension income in its company-reported adjusted EBITDA figures. I take that out of my numbers (labeled “adj. operating EBITDA” throughout the analysis), along with other credit agreement adjustments for one-time expenses related to covid ($20mm in 2021) and EBITDA losses to certain subsidiaries ($4mm in 2021). On the whole, their adjustments going back to 2012 are on the less offensive side of the spectrum.

Exhibits:

Cap table

Summary historical and projected financials

DCF-based TEVs and implied unsecured bond recoveries assuming $100mm incremental FCF burn

Catalyst

• Raw material price relief
• PKOH demonstrating an ability to pass through some non-contractual raw material price increases
• Relief across automotive supply chain / tangible signs of stresses peaking