Description

Tenneco is a classic value-without-a-catalyst long, which we own with conviction despite zero price appreciation over the last few years since we first purchased it. The reason we patiently hold is that while its price hasn't changed, it has compounded its forward earnings at a 15%+ annual rate -- and we believe it will continue to grow earnings at a healthy rate much longer into the future than the market apparently does.

We think Tenneco has roughly 100% upside to fair value.

If "value-without-a-catalyst" turns your stomach, skip reading the rest of this writeup. For us, value-without-a-catalyst is not an epithet but often rather a source of long-term alpha, given our long holding timeframes and our conviction that in the end, the earnings trajectory always wins.

If you have a similar view, I encourage you to read bdon99 and vincent975's writeups of TEN from 2014 and 2015 to get a great overview of what TEN does and the general investment case. It has only gotten cheaper since those writeups. I will be brief in my background on the company and focus on the primary reason I think TEN is so cheap -- the threat of massively increasing electric vehicle penetration. There are additional drivers of upside, as well as risks, but I will focus this writeup on the one thing I think the market has gotten most wrong on the company.

Tenneco is the leading maker of emissions control devices and shock absorbers for the light vehicle market, with #1 or #2 market share positions in the markets where it competes. Clean Air comprises 70% of operating income and Ride Control 30%. The company has a diverse customer base among the major auto OEMs, and is geographically diverse as well, with 47% or revs from North America, 35% from Europe/South America/India, and 18% from Asia-Pacific.

For the next several years, organic growth for the clean air business should outpace global light vehicle sales growth as increasingly stringent environmental regulations drive higher content per vehicle. In addition, increasing demand for active electronic shocks and better noise and vibration insulation will drive higher-than-industry growth for the ride control business as well.

Altogether, the company expects to outgrow global light vehicle production by 3-5 percentage points over the next three years, driving 5% organic revenue growth in 2018, 6-8% in 2019, and 5-7% in 2020.

With solid topline growth, consistent historical ebitda margins, and significant share buybacks this company has driven consistent mid-teens earnings growth for years. See the following 5-year chart which shows price in the top bar, ntm earnings growth in the next, and forward p/e in the bottom bar.

So why does TEN trade at merely 7x forward earnings? We think it is because the market thinks the clean air business is going to zero, as electric vehicles take market share from internal combustion engines.

Indeed there have been numerous headlines of major auto OEMs planning to end production of gasoline-only cars in the next few years. For example, Volvo said it would end gas-only car production in 2019 https://www.theverge.com/2017/7/5/15921208/volvo-all-electric-by-2019 and many other automakers have made similar announcements, summarized here: https://www.vox.com/energy-and-environment/2017/9/13/16293258/ev-revolution

What we think is extremely misleading in these announcements is that the full electrification and elimination of gas-only engines these OEMs are proclaiming does not equal the end of internal combustion engines -- it primarily means hybridification. Hybrid vehicles, despite their smaller combustion engines, do not mean lower clean air content purchased from Tenneco. The company explained in their Sept 2017, Royal Bank of Canada Industrials Conference that “hybrids for us at worst [are] neutral,” because the emissions regulations remain the same, and the heat cycling of a hybrid puts higher stress on catalytic converters than a consistently burning gas-only engine, so auto makers can’t downsize their emissions control systems, among other technical reasons. The company elaborated on this in their Barclays Global Automotive conference in Nov 2017 and their Deutsche Bank Global Auto conference in Jan 2018. I highly recommend reading these transcripts.

In addition, these announcements are merely stating marketing goals rather than hard commitments, so one should view them with some natural skepticism.

The real risk is not hybridification, but increasing penetration of pure battery-electric vehicles like Teslas. Currently, just 0.6% of total vehicle production is battery-electric only. While electric vehicle sales are growing rapidly, it is off a miniscule base. Hence, that penetration rate has to increase dramatically before it impacts Tenneco’s sales, as ICE vehicles will also grow in absolute numbers as well, and as more stringent emissions regulations boost demand for Tenneco’s content per vehicle at an even greater rate.

Indeed, from the implementation of US Tier 3 (2017-2025), Euro 6c/6d (2017-2022), China CN 6a (est. 2019), and India BS 6 (2020), as well as multiple additional off-highway regulations, Tenneco estimates an increase of 25-30% emissions content per vehicle will be required by 2030.

Because of overall growth in light vehicle sales, Tenneco estimated at the Royal Bank conference last year that it would require a 26% battery-electric penetration rate in light vehicles by 2030 for them to sell into the same number of vehicles as they did in 2015. However, with tighter environmental restrictions requiring more content on each vehicle that still means 25-30% higher sales. Hence, the penetration rate needed for BEVs to result in a decline in Tenneco’s clean air division sales by 2030 is ~41%.

To increase BEV’s current global share of 0.6% to 41% in any foreseeable timeframe will clearly require a stupendous level of technological improvement and infrastructure investment... As much as I like Tesla vehicles, we're taking the under on 41% by 2030 :).

Let’s look at the current estimates for penetration growth. Tenneco cites IHS data pointing to 6% by 2030, BCG 14%, Morgan Stanley 16%, and Roland Berger 20%. In addition, Bloomberg New Energy Finance projects around 23%, and Statoil 30%. By 2040, estimates range from ~10% for ExxonMobil to 51% for Morgan Stanley and 54% for Bloomberg.

http://investors.tenneco.com/~/media/Files/T/Tenneco-IR/documents/events/deutsche-bank-1-15-18.pdf

https://electrek.co/2017/05/05/electric-vehicle-sales-vs-gas-2040/

https://about.bnef.com/blog/forecasts-signal-accelerating-demand-electric-cars/ 

While this massive range suggests an un-analyzable situation, we still find it investable, because under almost all scenarios, Tenneco still grows its sales at robust, above-GDP rates. Indeed, Tenneco picks 16% and 25% BEV penetration rates by 2030 as its two comparison cases, and shows that even at 25%, which is nearly the highest estimate of any independent body, Tenneco still grows its clean air content at a 4% CAGR through 2030, about twice the rate of growth expected from light vehicle sales alone (see the above-linked Tenneco Deutsche Bank conference presentation).

While the accuracy and value of forecasting beyond 2030 is questionable, it is still notable that the average penetration rate of all available estimates for 2040 is still at or below the 41% penetration level required for Tenneco’s clean air division to see a reduction in sales from today's levels.

This situation hardly seems like the melting ice cube one would assume from the news headlines about auto makers ending gasoline car production, and hardly the one implied by a stock trading at 7x forward earnings.

Valuation:

A company with at least 4% organic growth potential through 2030 (the other business lines should grow faster than clean air), consistent margins, and >10% FCF yield should have no trouble delivering double-digit earnings growth through that period. Hence we feel comfortable applying a discounted market multiple on 5-year forward earnings to arrive at an estimate of fair value. We expect roughly $11 in earnings/share in 5 years. A 10x multiple on 5-year forward earnings results in a fair value of ~$110, or ~100% upside.

Perhaps the market never pays "fair value" or a market multiple on this business even if it keeps growing at double-digit rates, so add whatever discount you think is fair, but it still results in major upside.

If the earnings keep growing as they have, the compressing spring of valuation seen in the chart above can't continue compressing forever...

Risks:

Global auto slowdown.
Poor execution; bad capital allocation.
Massive technological change in electrical energy storage and charging.

Catalyst

Earnings keep growing. P/E can't go to zero.

Governments continue to crack down on emissions evasion by big auto OEMs, forcing them to buy even more of Tenneco's products.

The market realizes that hybrids don't result in lower sales of Tenneco's clean air products.

The market realizes it's really hard to grow from 0.6% battery-electric penetration to the level required to impact Tenneco.