Description

Shares: 15.3m
Market Cap: $68.7m
Cash: $4.6m
Debt: $41.9m
TEV: $106.1m
Price/Tangible Book Value = 0.79x (this includes a write-down of assets: see below)

PLI is the successor company of Transpro, Inc. formed when Transpro purchased the aftermarket business of Modine Manufacturing Company for less than tangible book value. They bought $92.8 million of tangible net assets from Modine for $59.3 million and changed the name of the company to Proliance. PLI trades at a price to book value of 0.79x and a conservatively estimated price to net asset market value of 0.64x (net asset market value explained later). The company isn’t going out of business though. PLI is a niche, low cost producer of aftermarket automotive heat transfer and climate control products. It’s not sexy and indeed the automotive aftermarket industry is ultra-competitive. But PLI’s balance sheet is healthy with a debt/cap ratio of 32%. They are also on track to be profitable and cash flow positive in 06 and beyond after a close-to-break-even 05 (no deal synergies were realized in 2005). How profitable for 06 is the big question because the company is facing huge raw material cost pressures as a result of the parabolic rise in copper and aluminum. They have had trouble passing these costs on to their customers because the industry is so competitive. But the Modine transaction is expected to generate huge annual synergies to counteract this and recently they’ve begun to raise prices of their products. We did what we thought was an ultra-conservative model that shows 2006 EBIT of $10.2m (more detail later) and a normalized model that results in $15.2m. These numbers imply operating income yields of 9.6% and 14.3% at today’s prices and capital structure.

Overview
Proliance International, Inc. designs, manufactures and heat transfer products (85% of sales), which consist of radiators, radiator cores, heater cores and condensers and temperature control products (15% of sales), which consists of compressors, accumulators and evaporators used in air conditioning for the automotive and light and heavy duty truck aftermarket.

The market size of the automotive and heavy duty aftermarket for temperature control products is estimated to be $2 billion, with $1.5 billion spent on heat transfer products and $0.5 billion spent on air conditioning products. The vehicular aftermarket is intensely competitive. There has been pricing pressure caused by a general improvement in vehicles, channels of distribution changing from small specialty shops to larger national retailers who hold pricing power, and an increase in the presence of foreign competitors supplying the aftermarket with low quality but cheap products.

How the Business was Formed
In July 2005, Modine spun off its aftermarket business to its shareholders and immediately the spinoff was merged with/bought by a public company called Transpro. The result of the merger was a new company called Proliance International, Inc. (PLI). Transpro management took the helm of PLI with Charles Johnson and Rich Wisott assuming the CEO and CFO positions, respectively (they had been at Transpro since 2001). Since the merger in July 2005, PLI is down 30%.

Transaction Benefits
• Transpro gained assets at a significant discount to their net asset value. Transpro paid $59.3m for the aftermarket business of Modine which had a net asset value of $92.8m. The excess of $33.5m of the net assets acquired was first utilized to write down the acquired property, plant and equipment and intangible assets of the Modine aftermarket business ($20.3m) to zero resulting in lower ongoing depreciation charges for PLI and an understated book asset value on its balance sheet. The remaining amount of $13.2m was included as an extraordinary income write off of negative goodwill (non-cash income recognized on the income statement).
• PLI has a healthier balance sheet over its predecessor, with a debt/cap ratio of 32% at the end of Q4 2005. The company has indicated it will use cash flow to further pay down debt through 2006.
• A restructuring plan immediately commenced upon completion of the merger. This restructuring was originally going to result in $20m of annual cost savings but PLI upped the projected amount to $37m in 2006 and $45m going forward annually starting in 2007. Most of the restructuring charges took place in 05.
• The combined company now has a larger revenue base, more product lines and greater customer access and distribution. The above cost savings resulting from the restructuring plan do not include any upside for sales synergies. It is solely a result of cost savings from personnel reduction and procurement changes such as packaging and product design improvements (changing parts from higher priced copper to lower priced aluminum), supply chain improvements, etc.. But the now larger PLI will have additional channels to sell through for different brands (i.e. Modine sells mainly to independents while Transpro sells primarily to the mass marketing channel) and will have 120 company owned branches to sell additional, new product through.

Financial Projections

Revenue: Price
o Prices for heat exchange products have declined over the past several years due to increased imports from Asia and “irrational” pricing by domestic competitors. Management has seen prices bottom and believes the worst is behind them but this is a huge X factor. In early 2006 PLI raised prices and the company plans to initiate another price increase in Q3’06. Additionally, SPI, PLI’s main competitor in the heat transfer market, is rumored to have raised prices by 15% thus far this year on the copper heat transfer line. It is widely considered that SPI was the culprit behind the “irrational” pricing scenario.
o Pricing for temperature control (air conditioning) and heat exchange in heavy duty trucks have been rising. Standard Motor Products, the market leader in air conditioning has continued to raise prices into 2006.

Revenue: Volume
o Volume is driven by vehicles in operation, miles driven, age of fleet and weather extremes. US motor vehicle registration grew from 80.5m to 92.5m between 2001-2004 (a CAGR of 4.7%). US average annual miles of travel by cars grew at a CAGR of 1.5% between 1993-2005. But for 2005, miles driven were flat primarily due to higher gas prices.
o Volume is also affected by general economic conditions. Times of economic weakness tend to benefit automotive aftermarket volume as consumers choose to repair their current automobile using replacement parts rather than purchase a new car.
o In 2H’05 the company stated that volumes in the heat transfer business “returned to more normal levels” and experienced organic growth. We anticipate this as low single digit growth. The company also stated that temperature control volumes improved significantly and domestic heavy duty heat transfer products “increased in unit volume”.

Revenue Projection for 2006
o Conservative case assumes revenue of $421m. In their 2005 10k and proxy, PLI indicated that if the merger occurred on Jan 1, 2005 and 2004, revenue would have been $421m and $430m respectively (2005 includes pro forma sales of $333m for the nine months ending September, 2005 as indicated in the 3Q 10q + actual Q4’05 sales of $87m). All PLI management has stated is that sales for 2006 would be “in excess” of $400m but we think a worst case is no growth or $421 million especially since they have started to raise prices.
o Our more reasonable case assumes sales growth of 4.7% due to new product introductions and other increases in sales due to sales synergies achieved as a result of greater scale (described under the Transaction Benefits section above). This results in sales of $441m.

Expense: Cost of Goods Sold
o Raw Material Costs are the second big X factor (aside from pricing of heat transfer products). Both the company and its competitors are guarded as to disclosing just how much raw material costs account for percentage of total cost of good sold. Aluminum and copper are the two major raw material components of COGS. Already, since Q4’05, copper and aluminum prices have increased by 70% and 40%, respectively. Are we in the early stages of a commodity bull market or the latter stages of a momentum buying spree? This is a judgment call but we believe prices will abate eventually.
o The company primarily manufactures its products in Mexico at industry low costs. In addition, 50% of its products are sourced from China. The company has stated it believes it is the lowest cost producer of heat transfer and temperature control products in the industry.

Gross Margin Projection for 2006
o For Q3’05, PLI had gross margins of 19.8% and 18.4% for Q4’05 excluding one time charges. PLI has stated that they expect gross margins in 2006 to be in the 25% range as result of a) the $37m of cost savings (most of which will be allocated to COGS), b) a ramp up in production in Q2’06 as the sale of excess, high cost merger inventory is sold in the early part of the year and is replaced by lower cost, internally produced inventory. This latter effect improves margins both because manufacturing utilization will increase and because lower cost inventory will flow through the income statement throughout the year.
o Case 1 and Case 2 assume a gross margin of 25%. Management feels comfortable with this margin number but it does not take into effect any further increases in raw material costs sp again this is the big X factor.
o Spectra Premium has 33% gross margins. They sell primarily to the specialty retail and independent garage channel which allows them to charge higher prices. Standard Motor Products Temperature Control Division has 24% gross margin.

Expense: SG&A
o The primary component of SG&A is branch costs such as logistics and transportation although the company also allocates corporate overhead, insurance, Sarbanes Oxley and other costs into SG&A.

SG&A Margin Projection for 2006
o Management expects SGA to be in the range of $95m for 2006 or a 23% SGA margin on our $421m in sales. SG&A margin is expected to be in the 22-25% range going forward. This is higher than PLI’s historical average due to the addition of the Modine branches (which are offset by higher gross margins realized on Modine customers). We believe there is some operating leverage here, as the company has stated that there is an even split between SGA costs that are fixed as opposed to variable.
o Spectra Premium has 25% SG&A margin and Standard Motor Products (entire company) has 20% SGA margin.

Operating Profit Projection for 2006
o Our gross margin and SG&A margin projections include the $37m in cost savings. Case 1 results in 2006 operating profits of $10.2m. Case 2 results in 2006 operating profits of $15.2m

Operating Profit Sanity Check
o In various filings, PLI has disclosed net and operating income results as if the merger occurred on January 1 2005 and 2004. We tried to work backwards to a clean operating income number for ‘05 and ‘04 by adding back one time charges and making some conservative assumptions for interest and taxes. Here is our table (which we checked with management):

2005 2004
Net Income ($30.358)
+ Tax 0.477
+ Interest 8.097
= EBIT ($21.784) $5.365
+ Restructuring Charges 3.584 (0.490)
+ Charges buried in COGS/SG&A 8.000 --
= Pro-forma EBIT ($9.930) $4.875
+ Synergies 37.000 37.000
= Pro-forma EBIT + Synergies $27.070 $41.875
+ D&A 4.547 4.707
= Pro-Forma EBITDA + Synergies $31.617 $46.582

o The difference in operating results between 2005 and 2004 is attributable to the aforementioned industry issues: competitive pricing pressures, productivity reductions, higher raw material costs that were unable to be passed on to the customer. In 2004, the price of copper was $1.27 per pound vs. $3.50 today and the price of aluminum was $0.78 per pound vs. $1.35 today. If the industry and/or PLI raise prices successfully and if raw material costs decrease, operating results could look like 2004 levels.

Free Cash Flow
o PLI expects to “take out” an additional $10m from working capital in 2006, as a result of further inventory reductions.
o Capex: PLI anticipates capex to approximate $10-12m for 2006.
o D&A: PLI anticipates D&A to approximate $6-7m for 2006. This is less then capex because of the Modine PP&E writedown taken at the time of the merger.

Case 1 Case 2
Sales $420.6 $441.1
Cost of Goods Sold 315.5 326.4
Gross Profit 105.2 114.7
Gross Margin 25.0% 25.0%
SG&A 95.0 95.0
SG&A Margin 23.0% 21.5%
Operating Profit 10.2 15.2
Operating Margin 2.4% 3.5%
TEV/Operating Income 10.4x 7.0x
Operating Income/TEV yield 9.6% 14.3%
Price/Net Asset Market Value (1) 0.64x 0.64x

(1) Reflects $20.3m writeup of assets to reflect market value of Modine PP&E

Comparables
LTM SMP–Temp Control Division(2) SPI(2)
Sales $229.2 $270.6
Gross Margin 23.9% 31.5%
SG&A Margin 20.1% 24.4%
Operating Profit 15.2 6.1
Operating Margin 6.6% 2.2%Price/Tangible Book Value 1.4x(3) 0.4x

(2) Excludes all one time charges.
(3) For entire company.

Other
• Management: Both CEO, Charles E. Johnson, and CFO, Richard A. Wisot, have significant industry experience. They’ve been at the company since 2001. They are no no-nonsense, industry people who are un-promotional. They seem like the “under promise and over delivery” types.
• Stock ownership: Management owns in 9.8%, Gabelli Funds owns 14%, Towle & Co. owns 8.6% and Dinger Group recently reported a 5.45% stake. Beginning in late April, PLI’s stock has come under pressure and has traded with above average volume. It is presumed, and for unclear reasons as to why, that Gabelli is the seller. Gabelli was an original shareholder of Transpro, the pre-PLI entity.
• Because PLI buys raw materials well ahead of production, its actual price to net asset market value is even lower then the .64x level discussed as the value of their copper and aluminum inventory has appreciated with the increase in raw material costs.

Major Risks
• Restructuring Missteps: PLI might fail to achieve their annual cost savings projections. SMP is attempting a restructuring strategy having bought the engine management division of Dana Corporation in June 2003. While their cost savings plan remains consistent with original expectations, their timing for completion has been continually pushed bask. However, as noted, PLI is in fact ahead of schedule and hopes to be operating at high production levels in Q2’06.
• Sales Shortfall: pricing of heat transfer products has been intensely competitive. Since this is the largest component of sales for PLI, any continued downward pressure on prices will hurt the profitability of the business. The company has initiated price increases though and time will tell if they are accepted.
• Rising Raw Material Costs: raw materials costs are a large component of costs. Aluminum and copper prices have risen dramatically in the past few years and have cut into operating profits. Any continued raw material price pressure is a big risk for PLI.
• Acquisition: PLI has stated that the industry needs further consolidation and that there may be acquisition opportunities. As noted, the company has indicated that they would keep their options open to accretive deals but a larger move that requires significant financing may not be viewed favorably by investors at this point in the restructuring process. However, the recent acquisition of the SMP heater core assets has been viewed favorably by larger shareholders.

Catalyst

• Product pricing increase acceptance
• Stabilization of raw material costs
• Realization of and addition to synergies