Description

Rheinmetall is a German mid-cap defense and auto supply company that has been overly washed out with all the negative auto supply news in the past couple of months.  Despite over 63% of its earnings coming from the highly visible and fast growing defense business, RHM trades in line with its auto supply peers (even though its well positioned geographically with little U.S. exposure and is benefitting from the latest trends such as emission control and fuel efficiency).  Further, there are near term (within a year) catalysts that could significantly unlock the value for its shareholders and a management team willing to make the tough choices (RHM was comprised of six divisions in 2000 but has since been pared down to two by the existing management team).  Since the current stock price values the auto business at zero and undervalues the Defense business, there could be 50-100% upside from current levels with little downside.

Overview

Defense Equipment

Defense should roughly comprise 46% of overall 2008 revenue and 63% of 2008 EBIT.  In 2007, sales were 35% to Germany, 41% to the rest of Europe, 9% to North America, 14% to Asia and 1% to other regions.  The business has performed extremely well over the past several years and is well positioned given the significant backlog of big projects starting to roll in during 2009 and beyond and the continued success of selling its products to nations outside of Germany.  The current backlog is ~2 years of 2007 revenue and excludes several large contracts that will be recognized in the next 6 months.  The PUMA (infantry fighting vehicle) and BOXER (armored troop carrier) projects are significant growth opportunities for the company.  The PUMA project has been approved by Parliament but has yet to show up in the backlog.  The size of the PUMA contract is €2.7B and RHM will get 50% of that with a delivery schedule starting in 2010.  The BOXER project is scheduled to roll in during 2009 (some of which is already in the backlog).  There are additional revenue opportunities related to these projects and other large opportunities in the works.  There is a great degree of visibility in the business and the growth trajectory via organic growth and acquisitions should continue to propel Defense into an ever increasing percentage of the overall RHM earnings.  Management is targeting 10.0% EBIT margins by 2010 – they were at 9.1% in 2007, up from 5.5% in 2003.  These are conservative goals as I believe they will surpass that margin goal in 2008 as 1H2008 Defense EBIT margins are up 200 bps over last year.

Defense is comprised of the following

a)      Land Systems (25% of defense sales) – armored wheeled and tracked vehicles, support and mine-clearing systems, protection systems and turret systems

b)      Air Defense Weapons (20% of defense sales) – air defense systems and high performance radar systems

c)      Weapon Munitions (30% of defense sales) – weapons and ammunition for tank and artillery systems, self defense systems, propellants and powder, medium caliber weapons and ammunition

d)      Defense Electronics (25% of defense sales) – command and control recon systems, fire control units and simulation systems

Auto Supply

Auto Supply should roughly comprise 54% of overall 2008 revenue and 37% of 2008 EBIT.  In 2007, sales were 32% to Germany, 44% to the rest of Europe, 12% to North/Central America, 6% to South America, 5% to Asia and 1% to other regions.  South America and Asia are bigger this year and North/Central America is lower.  Customers are pretty diversified across Volkswagen / Audi, Ford, GM, Nissan, Daimler, Porsche, BMW, Fiat and others. Roughly 25% of Auto Supply sales are non-OEM related.  Total U.S. sales are roughly estimated at €216MM on a full year basis (9.8% of auto sales, 5.3% of total RHM sales) but this includes non-GM/Ford OEMs as well (Nissan) and non-automotive related revenue.  EBIT margins have been in the 3.1% to 7.1% range and now stand in the 5.3% zone (for the past 3 years including 2008).  Mgmt is targeting 8.0% EBIT margins by 2010. They have lots of detail on how they get there and our conversations with management have made it clear that if margin improvement doesn’t materialize in the next 6 to 12 months, auto will be sold, spun off or pared down materially.  I assume flat margins in my model as I believe the macro industry headwinds will temper management’s ability to realize margin improvement.  My assumption could prove conservative as raw materials are helping them out as of late.  The business is well positioned for several significant trends (emission control, reduced fuel consumption) happening throughout the world.

Auto Supply is comprised of the following

a)      Pierburg (42% of auto sales) – air management, emission control

b)      Pistons (32% of auto sales) – passenger car pistons, commercial vehicle pistons and large bore pistons (shipping)

c)      Plain Bearings (9% of auto sales) – plain bearings, permaglide bearings, continuous casting

d)      Aluminum Technology (10% of auto sales) – aluminum engine blocks, cylinder heads, bed plates

e)      Aftermarket (7% of auto sales)

Thesis

Compelling absolute and relative valuation/clean balance sheet

a)      On my estimates, RHM is trading at an overall PE multiple (8.5x ’08, 7.3x ’09, 6.9x ‘10) that is lower/in line with its auto supplier peers (8.8x ’08, 7.6x ‘09) while ~63% of 2008 EBIT is from Defense where peers trade at much higher multiples (14.0x ’08, 12.4x ‘09)

b)      Sliced another way, 12.4x on just Defense earnings in 2009 gives you a €45 stock, using 14.0x gets you above €50.  This implies less than zero value for the Auto business.

c)      Morphing multiple dynamic as Defense growth outpaces Auto (CFO believes in 2+ years more than 70% of EBIT will come from Defense – likely happens much faster)

d)      EPS at company margin goals (9.0%) in 2010 and consensus revenue would be €7.60 and deserves a blended 12x forward multiple ~ €91 stock at the end of 2009.  Using my overall margin estimates (7.7%), EPS of €6.00 and 11.0x gets you a ~ €66 stock plus €3 in dividends.

e)      Based on my assumptions, TEV/EBITDA (with full pension) would be 4.6x 2008, 3.9x 2009 and 3.6x 2010

f)       Low double digit FCF yield as working capital uses of the past several years go away

g)      Clean balance sheet (0.4x net debt/EBITDA excluding pension, 1.5x with)

Margin goals are attainable (but you don’t need them to win from here)

a)      Margin improvement on the auto side is doable as the company has a pretty detailed roadmap that includes a lower cost region focus, raw material catch up (now much less of a headwind due to some recent price movements and contract restructurings), other cost save initiatives and a more rationally pricing competitor upon Fed Mogul’s emergence from bankruptcy

Possible Strategic Initiatives

a)      Break up or sale of auto or certain auto divisions - Mgmt has already streamlined the business from six down to two segments since 2000 and have made it clear that if auto margins do not show improvement they will address the situation via structural change

b)      Recent acquisitions have all been Defense oriented – one rumored transaction in the past has been a merger with a decent sized private German defense company – this specific transaction would be a substantial positive catalyst for the stock

Catalyst