Description

Long – PHINIA (PHIN)

Phinia (PHIN) represents a compelling sum-of-the-parts opportunity in the vehicle parts sector that has been overlooked and misunderstood by investors since its spin-off last summer.  The Company sells parts, components and related services into the following end markets: automotive light vehicles (“LV”) (44% of revenue), aftermarket replacement (32% of revenue) and commercial vehicle (“CV”) and off-highway (24% of revenue).  The Company also boasts geographic diversity with revenue distributed 41% in the Americas, 39% in Europe, and 20% in Asia Pacific.  Investors generally view the aftermarket as PHIN’s most attractive end market followed by commercial vehicles and off highway, and then light vehicles are a distant third.  Consequently, aftermarket parts peers trade at an average EV/EBITDA multiple of 9.1x, commercial vehicle suppliers trade at 6.5x, and low-quality light vehicle parts companies trade at 4.8x.  However, rather than trading at a blended sum-of-the-parts multiple, PHIN trades at a 3.3x EV/EBITDA multiple, a significant discount to the lowest multiple company in the lowest multiple peer group.  A multiple re-rate to the valuation level of its low-quality light vehicle peers would drive 56% upside in PHIN shares, while a more appropriate 6.6x blended sum-of-the-parts multiple would result in a 128% return.  In fact, the Company’s aftermarket segment is worth 88% of the entire enterprise value at peer multiples despite representing only 32% of revenue, meaning the remaining 68% of the business is currently valued at a ridiculous 0.6x EV/EBITDA.

We believe that the main reason for PHIN’s severely discounted valuation multiple is not due to the quality of its businesses or a lack of growth opportunities relative to peers, but instead from poor sentiment resulting from its spin-off from BorgWarner (BWA).  First, PHIN traded poorly from the beginning because of normal spin-off dynamics where investors in the larger market capitalization parent, BWA, were compelled to dump the smaller market capitalization SpinCo, PHIN.  Second, and more importantly, BWA was incentivized to downplay the quality of PHIN’s businesses because it was making a pivot from supplying the legacy internal combustion engine (“ICE”) and focusing on electric vehicles (“EVs”).  Therefore, PHIN’s business, which focuses on ICE components, did not fit BWA’s narrative around the future of the automotive space.  BWA had just made a very expensive acquisition in the electric vehicle space as part of their “Charging Forward” strategy and had to justify this move with a downbeat assessment of PHIN’s non-EV products.  In turn, PHIN was forced to market a business plan at its pre-spin-off Investor Day which emphasized projections that were very optimistic about the pace of EV adoption and called for steep declines in its ICE markets.  However, the story is not so simple, as Brady Ericson, the head of strategy at BWA and architect of its electrification strategy, saw enough promise to become PHIN’s inaugural CEO.

While investors mistakenly see PHIN as a declining business, we believe that the Company will surprise the market with better-than-expected growth over the intermediate term, driving a substantial multiple re-rating.  First, the transition from ICE to EV is clearly happening but it is not moving nearly as rapidly as EV bulls initially expected.  Second, not all light vehicle ICE components are created equally and PHIN’s product portfolio, which is skewed to hybrid vehicle components is well-positioned to thrive despite declines in traditional ICE vehicles.  Third, these light vehicle declines do not extend to the 56% majority of PHIN’s business in the commercial vehicle, off-highway and aftermarket space, which each have attractive growth prospects.  Fourth, in all segments, PHIN can now pursue significant new products and market share growth opportunities that BWA had ignored in its single-minded push towards EVs.  Finally, PHIN is a strong cash flow generator trading at a 14.4% free cash flow yield, and we expect management to capitalize on PHIN’s discounted valuation with significant share repurchases.

 We believe that investors will be further prompted to take notice of PHIN as it should join the Russell 2000 Index in June.  In a recent Financial Times interview, quant focused investor Rob Arnott referenced research his firm has conducted suggesting that companies in a major index like the S&P 500 or Russell 2000 trade at a 30-50% premium to similar peers who are not in the index.  New index additions have served as an important catalyst for spin-off companies as they generally increase investor visibility and new analyst coverage (currently PHIN has only one sell-side analyst covering it).  Last year, two spin-off related companies we followed closely Leonardo DRS (DRS) and FTAI Aviation (FTAI) were new additions to the Russell 2000 Index and achieved returns of 57% and 182% respectively.  As PHIN demonstrates its resiliency and growth, we see a return of between 56% and 128% based on better-than-expected growth and a re-rating somewhere between low-quality LV peers and an appropriate sum-of-the-parts multiple. 

Rumors of the Death of the Internal Combustion Engine are Greatly Exaggerated

We believe that PHIN’s strategy to support customers, launch new products and gain market share in a much less competitive internal combustion engine parts market, will reward shareholders with strong returns over the coming years.  Many light vehicle parts suppliers, like PHIN’s former parent BWA, have scrambled to make the difficult and expensive pivot from ICE auto parts to EV components based on optimistic predictions of rapid EV adoption.  Even PHIN shared a business plan using BWA’s projections of EV penetration growing from 11% in 2022 to 48% in 2030, at its pre-spin June Investor Day.  This would suggest a 7% per year decline in conventional ICE vehicles from 2022 to 2030.  However, several recent datapoints suggest that EV penetration is running well below industry forecasts, suggesting a lower-than-expected decline for ICE vehicles.  Because of compounding, even small changes in the decline rate for ICE vehicles has a large impact on intermediate term projections for PHIN’s revenue and earnings.  Therefore, investors should be positively surprised by PHIN’s medium-term growth trajectory.

 Recent Datapoints Suggest that Hybrid Vehicles Will Play an Important Role in the EV Transition

With long-anticipated EV launches coming to market, 2023 and 2024 were supposed to represent an important inflection point for EVs, but it appears that the consumer is not ready to make the switch as aggressively as pundits expected.  In the US, Q4 2023 data suggests that sales growth for EVs has slowed versus the same quarter of 2022 despite a high level of growth in available EV products.  This has caused inventories of unsold EVs to pile up on dealer lots.  In January of 2024, Ford Motor Company (F) announced production cuts for its electric F-150 Lightning pick-up truck and production increases for several better-selling ICE SUVs and pick-up trucks.  While some have been quick to blame poor execution by traditional auto manufacturers, even Tesla (TSLA) has struggled.  In Q4, TSLA’s unit volumes grew at 20% or 11% higher than the 9% growth estimated for global autos by S&P mobility.  However, TSLA had to discount so aggressively to achieve this growth that its Q4 revenue growth was a mere 1%, badly lagging auto peer growth estimated at 9%.  Moreover, auto producers do not view these issues as mere short-term growing pains.  Over the last several months, there have been announcements of delayed factory investments and generally slower US EV growth plans from F, General Motors Company (GM), Audi, Nissan Motor (7201 JT) and others, impacting intermediate-term growth forecasts.  Finally, Hertz Global Holdings (HTZ), which had based its rental car growth strategy on being a leader in EVs, recently announced that it would pivot its fleet back toward ICE by liquidating many of its TSLA vehicles because of disappointing customer demand and high maintenance costs.

 In Europe and China, EV adoption is improving faster than in the US, but interestingly many consumers are choosing hybrids over pure EVs because they are substantially cheaper and do not come with the same anxiety around battery range and charging infrastructure.  This shift is important for PHIN as it is a strong beneficiary of growth in hybrids.  In Europe, EVs have grown a robust 40% year-to-date, but this growth is still below automakers internal plans as EVs are coming from a low base.  Meanwhile, European hybrid and plug-in hybrid sales grew by 713,000 units, 38% higher than the 515,000-unit growth of pure EVs.  However, perhaps the most interesting datapoint around the popularity of hybrid vehicles comes from China where a strong government push to New Energy Vehicles (“NEVs”) has caused pure ICE vehicle penetration to dip to 62%.  However, while Chinese consumers are moving away from ICE vehicles, they have been flocking to hybrid NEVs instead of pure EVs.  In the Q3 update, China Association of Automobile Manufacturers (CAAM) data showed that plug-in hybrids and extended range hybrids have been the fastest growing vehicles this year.  Year-to-date, ICE vehicle sales have shrunk by 11%, EV sales have grown by 14%, but plug-in hybrids and extended range hybrids have grown by a whopping 85%.

 PHIN’s Attractive Product Portfolio to Benefit from Hybrid Vehicle Adoption

While investors have been quick to dismiss PHIN as an ICE loser, we believe that they have missed the fact that PHIN is a strong winner in hybrid vehicles.  Within the 44% of PHIN’s business that serves the light vehicle end market, we estimate that products comprising 80% of PHIN’s revenue should be much more resilient to electrification because they improve fuel economy and emissions, and participate in the growth in hybrids.

We estimate that over 50% of PHIN’s LV revenue is tied to its flagship Gasoline Direct Injection (“GDi”) product, which should grow over the next few years despite growth in EV penetration.  If EV penetration disappoints, automakers will have to focus on fuel efficiency and emissions reductions to meet climate goals.  GDi engines offer substantial fuel efficiency gains, reduced CO2 emissions and improved performance versus traditional Port Fuel Injected engines.  Additionally, GDi systems have 75% penetration on hybrids versus only 50% penetration on ICE vehicles, further benefitting PHIN as hybrids take share.

In summary, pure EV penetration is likely to disappoint expectations as consumers prefer hybrid vehicles, which should be a boon to PHIN as its GDi product benefits from this environment.  At its Investor Day, under BWA’s optimistic EV scenario, PHIN saw EV penetration rising from 11% in 2022 to 27% in 2026.  However, even under those conditions, GDi engines were expected to grow at a 2% CAGR over this period while non-GDi should shrink at a 6% CAGR.  On a longer-term basis, GDi was expected to decline at a 7% CAGR from 2026 to 2030 as EV penetration went from 27% to 48%.  However, PHIN planned to offset this decline and maintain flat GDi revenue from 2023 to 2030 by growing market share in GDi systems by 3%, which we will demonstrate is achievable.

However, if we assume EV penetration grows even modestly slower than expected, PHIN’s revenue should surprise to the upside.  Based on recent datapoints, we believe that EV penetration will lag the optimistic 48% rate that PHIN has used to inform their medium-term growth projections.  For illustrative purposes, if the EV growth rate is a mere 15% slower than expectations, we would still end the decade at an impressive 43% penetration instead of 48%.  In this scenario, the GDi engine growth CAGR through 2026 would be 3% rather than 2% and vehicles with GDi engines would not fall below 2022 levels until 2029.  Moreover, if PHIN were able to gain the 3% of market share that we discussed, PHIN’s GDi revenue would grow 13% or a 2% CAGR from 2023 to 2030 rather than merely remaining flat.

Market Share and New Product Opportunities Should More than Offset ICE Declines

As auto manufacturers realize that EVs are ramping slower than expected, they will increasingly choose vendors like PHIN who have devoted resources into products that are important to meet fuel economy and emissions targets in the ICE and hybrid ecosystem versus competitors distracted by EVs.  Currently, PHIN is the #3 player in GDi with 12% market share with the top two players Bosch and DENSO (6902 JT) controlling over 50% of the market.  In canisters and fuel delivery models PHIN is also the #3 player with 13% and 8% share respectively but these markets are less consolidated.  PHIN has begun to take share in all its markets, and we see an opportunity for share gains to accelerate.

First, PHIN has a significant opportunity in China.  China is the world’s largest LV market selling 30 million vehicles in 2023, nearly double US sales of 16 million.  Additionally, in the US and Europe it can take two to three years between a design win on a new product and revenue, while the lead time in China is generally closer to one year.  Historically, PHIN’s China business had been more focused on commercial vehicles than light vehicles, but the Company has recently made an effective push to win LV business.  PHIN is well-positioned to win in China as 80% of its sales are tied to domestic OEMs who are taking share from transplants where Bosch and Denso have leveraged their legacy relationships outside of China.  Additionally, PHIN’s focus on GDi technology for hybrid engines positions them well to serve the hybrid new energy vehicle market that has taken off over the last couple of years.

On its Q3 2023 earnings release, PHIN announced a major GDi win in China that went largely unnoticed by investors.  Our checks indicate that the program is with BYD Company (002594 CH), who is not only a leader in EVs, surpassing Tesla as the biggest EV manufacturer globally, but also has dominated new energy vehicle hybrids.  Currently, BYD makes 8 of the top 10 new energy vehicle hybrids in China.  Additionally, BYD has introduced plug-in hybrids for export markets like Australia and Latin America.  We expect that PHIN will start generating revenue from its BYD relationship in late 2024 and that this could be a significant opportunity over time.  With new energy vehicle hybrids currently comprising 12% of the China vehicle market and growing, this market could represent a 3.6 million unit opportunity.  To quantify the magnitude of this opportunity, 3.6 million units represents slightly under 25% of all US vehicle sales in 2023.  Indeed, BYD alone sold 1.4 million PHEVs in 2023.  If we assume that a GDi system has a sales price of around $175, BYD would represent a $245 million opportunity or 16% of PHIN’s entire light vehicle revenue.  To be clear, PHIN is unlikely to earn 100% of BYD’s business.  However, if PHIN could get half of BYD’s GDi business over time, this alone would increase its overall global GDi market share by 2%, demonstrating that its 3% market share gain goal is achievable.

Outside of China, PHIN has significant opportunities to take share from competitors who have not focused on the neglected ICE and hybrid markets during the rush to win EV business.  The most relevant example is Denso who is the #2 player in most of PHIN’s major products with a market share of 30% in GDi, 15% in canisters and 13% in fuel delivery modules.  Denso has been very clear to highlight that it will focus on electrification products and advanced-driver assistance systems as opposed to its ICE-related product lines.  This shift in focus has led to costly missteps at Denso, most notably a major recall of defective fuel pumps (a business where Denso competes with PHIN).  Since March 2020, when Denso discovered a long-term issue with its fuel pumps, 16.1 million vehicles globally have been subject to recall.  This number has continued to grow with Honda Motor Company (7267 JT) recalling 3.6 million vehicles in December of 2023 on reports that a fuel pump issue had caused a fatality.  We believe that the lack of focus at Denso and others presents a significant market share opportunity for PHIN.  As auto OEMs have moved away from smaller competitors and are cautious of allocating more business to Bosch who already has dominant market share, PHIN has become the best option.  While market share shifts take time to happen in developed markets, each point of market share should benefit PHIN’s revenue growth by 9%.

New Product Introductions Should Contribute Meaningful Revenue Growth

PHIN’s most significant medium-term growth opportunity in the light vehicle business comes from products that BWA ignored in its rush to chase EV opportunities.  The best examples of this are the electronic control unit and power domain control unit businesses.  These products are the brains of a car’s engine and play a crucial role in improving fuel economy.  In hybrid vehicles, these products are even more important as they use sophisticated software to determine when to run on battery or gasoline.  While control units represent a massive $5.4 billion total addressable market opportunity for PHIN, BWA chose to focus on similar products with faster growth in EVs.  PHIN, on the other hand, is introducing a next generation product in 2024 and has a major opportunity to take market share from distracted competitors like Denso.  These units require extensive engineering and software calibration support that PHIN can provide while competitors have increasingly moved their engineering talent to focus on EVs.  Moreover, above and beyond the top line benefit these products can contribute, PHIN can now offer a full system solution that is competitive with those of Denso and Bosch.

We believe that it is possible for PHIN to achieve a 15% market share in controllers over time, which is consistent with our estimate of PHIN’s overall GDi share as these two products are often bundled as a system. This represents a game changing $810 million revenue opportunity over time or 53% of the overall light vehicle business revenue and 23% of PHIN’s overall revenue.  Based on our estimates, ICE vehicles will only decline by 24% from 2023 to 2030, so success in this product alone could allow PHIN to grow nicely in a declining market before even considering PHIN’s market share opportunities and benefits that it will gain from hybrid proliferation.

 In summary, we believe that declines in ICE vehicles will be slower than initially expected and that PHIN can still grow over the intermediate term through market share gains and new product opportunities even in the secularly challenged ICE light vehicle segment.  Thus, we believe that the Company has significantly better growth prospects in its LV business than its low-quality LV peers.  However, the stock offers 56% upside if PHIN can just trade at a 4.8x EV/EBITDA multiple like low quality LV peers as opposed to its current rock bottom 3.3x EV/EBITDA multiple.  While 56% upside represents a nice return for shareholders, realistically PHIN should trade at a blended sum-of-the-parts multiple of 6.6x and offer investors 128% upside as they better understand the quality of PHIN’s aftermarket, commercial vehicle and off-highway businesses.

Aftermarket Business Represents a Hidden Gem in PHIN’s Portfolio

While investors have been fixated on declines in the LV ICE market segment, they have ignored PHIN’s hidden gem of an aftermarket business, which comprises just under one-third of the Company’s revenue.  This business operates under the Delphi and Delco Remy brands, which are some of the most recognized names in the aftermarket space.  Additionally, PHIN is more geographically diversified (64% Americas, 31% Europe and 6% Asia) and derives a much greater share of its revenue from the attractive commercial vehicle aftermarket business than its publicly traded peers Dorman Products (DORM) and Standard Motor Products (SMP).  Indeed, DORM recently purchased Dayton Parts, a commercial vehicle aftermarket parts producer, to accelerate its expansion into that attractive market.

In general, high performance aftermarket businesses can achieve very high multiples in the public markets due to their secular growth and recession resistance.  For example, aftermarket parts retailer O’Reilly Automotive (ORLY) trades at a 17.0x EV/EBITDA multiple.  The biggest long-term driver of aftermarket revenue is the number and age of vehicles in the car parc, both of which have continued to grow.  Since 2019, the average age of a vehicle has grown from 10.2 years to 11.0 years in 2023 and the overall number of vehicles in the car parc have grown at a 2% CAGR despite Covid-related disruptions to the global auto industry.  Additionally, in the US, an increasing number of vehicles are approaching the critical 8- to 12-year-old range where repair intensity is the highest.  According to data compiled by Stephens, the number of 8- to 12-year-old vehicles in the US declined from 2013 to mid-2021 providing a modest headwind to the aftermarket business.  However, starting in 2022, growth in this crucial age cohort began to increase rapidly and we expect 7% growth in 2024 and 4% in 2025. This should drive strong overall demand for the aftermarket industry.

The aftermarket parts industry has also proven to be resilient to recessions with industry sales declining by a mere 1% from 2007 to 2009 at a time when new car sales declined by 35%.  Meanwhile, at that time, the car parc was significantly younger and 8- to 12-year-old vehicles were growing at a slower rate than they are today.  Due to these strong industry dynamics, SMP and DORM trade for attractive EV/EBITDA multiples of 7.8x and 10.5x respectively.  If we put these multiples on the 32% of PHIN’s business in the aftermarket space instead of the 3.3x multiple at which PHIN trades, it would drive upside of between $16.93 and $35.61 per share, or 57% to 119%.

While even an SMP multiple would drive significant sum-of-the-parts upside for PHIN shareholders, we believe that PHIN’s growth rate should be closer to those of DORM than SMP due to company specific above-market growth opportunities.  First, PHIN has invested in an expansion of its capacity constrained remanufacturing business.  Remanufacturing involves taking damaged parts from retailers or distributors and restoring them to working order.  This is a big focus for aftermarket retailers as it allows them to reduce waste and fulfill green objectives, driving strong demand. PHIN’s remanufacturing capacity expansion should improve throughput by 30% and could create a 1% per year tailwind to growth for the next three years.  Second, PHIN has a latent pricing opportunity in the aftermarket business. Historically, PHIN has raised its prices once annually, but as inflation accelerated in 2021 and 2022, the Company was forced to take mid-year pricing actions.  In 2023, PHIN refrained from a mid-year price increase despite higher-than-normal inflation and thus should have a meaningful catch-up opportunity to improve revenue growth and recapture margins in 2024.  Third, with its local manufacturing footprint, PHIN was able to maintain a 95% fill rate throughout the pandemic while many importers of Asian-made products had weak in-stock performance, spurring discussions for PHIN to enter more product lines and grow its market share.

Finally, we believe PHIN did not leverage its distribution and brand strength to rapidly scale new product launches as effectively as it could have while under BWA ownership.  In 2019, prior to BWA acquiring the aftermarket business, the company brought a program focused on steering and suspension parts from its European segment and launched it in North America.  While this program initially focused on European vehicles, customers pushed for broader vehicle coverage.  Ultimately domestic and Asian vehicle parts were added under the well-respected Delphi brand.  This program had no revenue in 2018 but should approach 20% of North American aftermarket revenue in 2027, adding 2% per year to overall organic growth.  We believe that PHIN will have the ability to redeploy this playbook across other markets now that aftermarket is a key focus area and not an afterthought, as it was under BWA ownership.  For example, PHIN attended the large Automechanika Shanghai aftermarket trade show for the first time in four years and should have ample opportunity to expand in Asia which only comprises 6% of aftermarket revenue today.  Additionally, the Company has been working on some major launches in the US and Europe for the coming years.  Finally, PHIN should have opportunities to buy businesses with good products but poor distribution or OE businesses with outsized aftermarket segments.  These acquisitions could be consummated at attractive multiples and prove nicely synergistic.  With enhanced growth and a higher mix of aftermarket revenue over time, PHIN’s overall trading multiple should improve materially.  Overall, a revaluation of just the 32% of PHIN’s business from its current overall trading multiple to peer levels would result in 88% upside for the shares.

Commercial Vehicle and Off-Highway Business Should Exploit Untapped Market Opportunities

PHIN’s commercial vehicle and off-highway business can leverage the Company’s gasoline direct injection (GDi) technology into new and growing end-markets.  PHIN currently derives 24% of its revenue from this segment, which should not see meaningful disruption from electrification like the light vehicle business.  This is reflected in the trading multiples of companies in this segment.  For example, Allison Transmission Holdings (ALSN) which is a commercial vehicle and off-highway business that is very tied to the ICE engine trades at a multiple of 6.5x EV/EBITDA versus PHIN’s current 3.3x multiple.  The value of multiple expansion from PHIN’s multiple to ALSN’s on the 24% of business in commercial vehicle and off-highway would be worth $8.95 per share, representing 30% upside.

While 2024 may be a difficult year for the on-highway commercial vehicle business due to weak freight rates in the US and Europe, there are several strong medium term demand drivers that should catalyze improvement in 2025 and beyond.  In 2027, the US will enact a major emissions regulatory change that should significantly increase the cost of a truck without providing major fuel savings benefits.  The last time we saw a regulatory change of this magnitude was in 2007, when it drove a two-year pre-buy cycle.  Therefore, we expect commercial vehicle demand to rebound nicely from a weak 2024 with significant pre-buy demand in 2025 and 2026.  Moreover, we estimate that around 25% of this segment is tied to China.  This part of the business has been depressed since China’s Zero-Covid policy dampened economic activity and could provide upside should recently announced stimulus drive growth in China’s economy.

Outside of cyclical opportunities, PHIN has been leveraging its GDi technology to pursue significant growth opportunities in the off-highway segment of its business.  The off-highway opportunity has a large $7.5 billion total addressable market but was not a focus for BWA.  Any growth in off-highway would rely on internal combustion engine technology, and improving EV penetration was a much higher priority for BWA.  As off-highway vehicle manufacturers face pressure to improve environmental metrics, GDi is a good solution because it improves fuel economy and reduces emissions without the need for expensive after treatment equipment.  However, high pressure diesel GDi systems had historically been too expensive for many off-highway applications.  However, PHIN has recently introduced a 350 to 500 bar (lower pressure) diesel GDi system that is compatible with many types of off-highway engines.  We believe that this product could gain strong traction as it allows vehicle manufacturers to meet improved fuel efficiency and emission reduction goals at an affordable cost.  Currently, PHIN is actively targeting customers in construction equipment, marine, agriculture, and other industrial machinery.  This business should have strong incremental margins because PHIN can leverage existing engineering resources that are used to support LV applications.  If PHIN can achieve 5-10% penetration of this total addressable market over time, it would add 22% to revenue growth.  As PHIN gains traction in this initiative, we should see accelerating revenue growth and the potential for multiple expansion as it further shifts the business mix away from LV.

Finally, while electrification is viewed as the best option for reducing emissions in light vehicles, hydrogen fuel systems may be the best technology for larger vehicles.  PHIN’s GDi and electronic controller unit technologies can be leveraged into use with hydrogen fuel and other alternative fuel engines.  While hydrogen and fuel cells will not be major revenue contributors in the near-term, PHIN should be a leader in this business over time.  During Q3 2023, PHIN secured its first major award of a large OEM hydrogen fuel cell application for medium-duty trucks.  Moreover, the Company has signed major development agreements with Cummins (CMI) and some of the more respected engine manufacturers in the world.  PHIN has been a thought leader in this emerging space and has a fully functional hydrogen ICE van traveling around as a demonstration vehicle.  Therefore, since 2021, PHIN has seen 50 partnership opportunities, 32 initiations, and 23 advanced product development partnership executions related to hydrogen.  Currently, PHIN estimates the total addressable market of this opportunity to be around $1.3 billion, but it could be much larger.  Investors are deploying significant capital into this space.  According to the Hydrogen Fuel Council, there are currently 1,400 projects requiring $570 billion of investment through 2030.  While we cannot precisely predict the size or timing of the hydrogen opportunity, it is safe to say that it is not reflected in PHIN’s share price at the current depressed valuation.  We believe that this opportunity represents significant positive optionality should investors gain renewed enthusiasm for hydrogen plays as they did in 2021.

PHIN’s Low Leverage and Strong Cash Generation Set the Stage for Cash Returns to Shareholders

We believe that PHIN is on its way to developing a track record of shareholder-friendly capital allocation that will result in multiple expansion over time.  The Company has much lower capital intensity than its peers, which should allow for strong free cash flow generation.  PHIN has made it clear that capital returns to shareholders will be a key piece of its story going forward.  In PHIN’s first board meeting post-spin, the Company established a dividend that will result in a generous 3.5% yield and authorized a $150 million share repurchase program.  With a 14.4% free cash flow yield and a 0.9x net debt-to-trailing-twelve-month EBITDA leverage ratio, we believe that PHIN will be aggressive on share repurchases while the Company’s valuation remains low.  Indeed, in the month of September, the Company bought back $9 million of stock despite having a very short trading window to execute purchases between the approval of its buyback and its quarterly trading blackout.  We believe that this is meant to signal that buybacks will play an important role in PHIN’s value creation.

This shareholder friendly approach to capital allocation should further differentiate PHIN from its low multiple LV peers.  The Company has clearly signaled that it will only target smaller acquisitions at value multiples and is content to repurchase shares should none materialize.  Meanwhile light vehicle peers do not have the same opportunity set in the off-highway, aftermarket, and hybrid space that PHIN does.  Therefore, these competitors may be tempted to make risky, high-multiple acquisitions in the EV space as they chase growth.  Additionally, PHIN’s peers generally have higher levels of financial leverage precluding them from meaningful capital returns.  Consequently, we believe that PHIN will ultimately trade at a valuation level materially above low-quality light vehicle peers as investors better understand the quality of its business and management’s shareholder friendly capital allocation.

Valuation and Conclusion

In summary, PHIN represents a typical spin-off opportunity in a deeply undervalued and misunderstood stock.  As in many spin-offs, PHIN can benefit from needle-moving market share and new product opportunities that its former parent largely ignored.  As the Company executes on its growth plans, we believe that the narrative around the death of the internal combustion engine will fade as the truly secularly declining businesses in its portfolio become an increasingly small piece of overall revenue.  Indeed, as the light vehicle business shrinks as a percentage of revenue, the blended sum-of-the-parts multiple should rise as higher multiple businesses represent a greater part of earnings.  In the meantime, PHIN should be able to capitalize on its disconnected valuation through share repurchases, enhancing the upside opportunity by shrinking the share count.

Over time, we see an upside of between 56% and 128% as PHIN trades somewhere between the low-quality LV peer multiples and its true sum-of-the-parts value.  We expect PHIN to receive an appropriate valuation multiple as investors become more familiar with the Company’s opportunities and it enters the Russell 2000 Index. However, should PHIN’s valuation remain depressed, there has been significant interest in highly cash generative auto businesses in the private markets. We believe PHIN would be a particularly attractive takeout opportunity because of its hidden sum-of-the-parts value and poorly understood growth opportunities.  A private investor could separate out the high-quality aftermarket, commercial vehicle and off-highway businesses, combine them with another private company in the space to gain scale and realize synergies, and then re-IPO them at a much higher multiple.  One possible private market combination opportunity would be with Tenneco (TEN).  In early 2022, Apollo purchased TEN, which was a similar hybrid auto and aftermarket business with much less attractive growth opportunities than PHIN.  This deal took place at a 100% premium to TEN’s previous close and a 5.6x EV/EBITDA multiple.  At a similar multiple, PHIN’s shares would be worth $56.58 or 90% above today’s levels, providing an attractive return to shareholders while still leaving substantial sum-of-the-parts upside for a potential buyer.

Any forward-looking opinions, assumptions, assessments, or similar statements constitute only subjective views. This information should not be relied on for investment decisions and is subject to change due many factors, including fluctuating market conditions and economic factors.  Such Statements involve inherent risks, many of which cannot be predicted or quantified and are beyond our control. Future evidence and actual results could differ materially from those set forth in, contemplated by, or underlying these Statements, which are subject to change without notice.  In light of the foregoing, there can be no assurance and no representation is given that these Statements are now, or will prove to be, accurate or complete. We undertake no responsibility or obligation to revise or update such

Catalyst

- New product win announcements

- Russell 2000 inclusion

- Positive analyst initiations

NB PHIN reports next Wednesday. This is not an explicit call into the print as CV trends should be light in 2024 and management may want to set the bar low. Alternatively, the co could benefit sooner than expected from new wins and could provide some better disclosures to improve investor undersding of the magnitude of the opportunity. Either way, we believe that this is an exceptional medium term opportunity in a market with limited value opportunities left.