Key Stats

4/28/14 Stock Price: $59.37
Diluted Shares: 61.5 mm
Market Cap: $3.65 bn
EV: $4.8 bn
EV / 2015 EBITDA: 5.3x | 4.8x (consensus | my estimate)
P / 2015 EPS: 11.2x | 10.0x (consensus | my estimate)

Investment Thesis

• Tenneco represents absolute and relative value as it trades at 5.3x consensus and 4.8x my estimate of 2015 EBITDA, below many peers in the auto sector, which itself carries an attractive valuation
• The market likely underestimates the secular nature and stability of Tenneco’s revenue growth, which will outpace most auto peers, and increase to nearly $11 bn in 2016 versus the $8 bn recorded in 2013
• Within the next 12 months, TEN will likely introduce a meaningful share repurchase plan, catching up with peers who are already pleasing investors with stronger capital return programs
• With modest operating margin improvement (+130 bps over 3 years) and share repurchases, TEN may earn ~$7 per share in 2016 on EBITDA of nearly $1.1 billion, at which point, I expect the company to still have a high growth runway ahead. Attaching a 6x EBITDA multiple and a 12.5x EPS multiple (based on average of comps) results in my 18 month price target of $90, more than 50% upside from today’s levels.

Company Overview

Tenneco is a leading Tier 1 auto parts supplier operating in two segments:

• The Clean Air segment, which is ~2/3rds of revenue, designs and manufactures emission control systems to clean a vehicle’s exhaust. I believe this segment represents a secular growth story driven by ever-expanding clean air regulations globally.
• The Ride Performance segment, ~1/3^rd of revenue, produces vehicle suspension and vibration control components (shocks, struts). I expect this segment to trend with overall global auto volumes.

TEN’s 2013 revenue was comprised 72% of light vehicle sales, 12% commercial and off-highway, and 16% aftermarket sales. This revenue mix is favorable as commercial and off-highway revenue will grow at a 30+% CAGR over the next 4 years and the 16% exposure to the more stable aftermarket is greater than auto supplier comps.

Competitive Overview

TEN is either the #1 or #2 player across most all of its geographic markets. As one of just three global emissions control suppliers, TEN is well positioned to fulfill OEM’s requirement for global partners as they increasingly seek to standardize their platforms around the world. TEN also possesses a closeness to their customers as a result of their long operating history and close collaboration on R&D (often 2+ years of joint development time before the OEM’s platform launch). In the Clean Air segment, TEN has consistently been one of the top two players for ~15 years and the resulting customer trust earned is important. Emission controls are complicated and highly regulated. The risk posed by failing to meet a regulation is substantial and so TEN, as a leading expert, provides real value to OEMs. While a degree of bidding competition will exist between TEN and main competitor Faurecia, it’s unlikely that new entrants will pose a competitive threat in the future.

How do regulations drive growth?

As countries move to progressively more stringent regulatory standards, more is demanded of a vehicle’s exhaust system. For example, the switch from the Euro 5 to Euro 6 standard in Europe necessitates the use of a “Lean NOx trap” to control harmful nitrogen oxide emissions in diesel engines. For certain vehicles, this addition may double the cost of emissions control. TEN is the beneficiary of this. Notably, whereas Europe is scheduled to move from Euro 5 to Euro 6 later this year, that is just one of the many regulations that will drive content per vehicle increases for TEN. China, for instance, is still largely on a Euro 4-equivalent standard and will need to aggressively improve standards as will other emerging markets. Similarly, regulations are already moving from on-highway vehicles to include off-highway vehicles as well. TEN is a leading partner of CAT and Deere. Regulations will continue to become stricter and more and more engines (locomotive, marine, stationary) will come under the purview of regulators in the years to come. The clearly delineated timetable for major regulations along with the various new geographies and engine types will provide considerable runway for secular growth within TEN’s Clean Air segment.

Margin Improvement Opportunity

Tenneco has a clear opportunity for margin improvement from a couple of areas. First, the continued expansion in Asia Pac and into the commercial and off-road segment will add to TEN’s margins as both these areas have historically earned higher than company average margins. Next, in Sept 2013, TEN announced a large European restructuring that is expected to save $60mm per year, fully achieved by 2016. Putting these factors together, 130 bps operating margin improvement appears well within reason. Also arguing for margin improvement, TEN’s factories have been running under capacity in the growth area of commercial & off-road, and Europe vehicle sales are still ~25% below long term averages. Management continues to focus on operational efficiency and, as an encouraging sign, the recently announced 1Q14 results featured ~90 bps of margin improvement.

Deleveraging and Share Buybacks

Tenneco stands out from its peers (in a negative way) due to its high leverage (1.2x Net Debt / EBITDA as of YE 2013) and lack of a significant share buyback program. A review of some peers' Debt / EBITDA levels reveals TEN as the outlier: Autoliv: net cash, Borg Warner: 0.2x, Dana: 0.4x, Delphi: 0.4x, TRW: 0.2x, Lear: net cash. Each of these stocks has a dividend and active (in some cases very large) share repurchase plans in place. I believe that, upon driving leverage to below 1.0x over the next year, TEN will announce a meaningful share repurchase plan to position its stock more in line with peers. I expect the market will view TEN more favorably once this occurs.

Financial Projections and Valuation

TEN will likely be able to reduce its debt below 1.0x Debt / EBITDA (management’s targeted level) by the end of 2014 with future decreases throughout 2015. Once done, and with operating cash flow of ~$700mm in 2016, TEN will be positioned to put in place a significant share repurchase program (I assume $500 mm in 2016, funded with additional debt, yet staying below 1.0x Debt / EBITDA). Together with 2016 revenue of ~$11 bn (largely in line with TEN’s own 5 year revenue projections), the 130 bps of margin improvement will result in ~1.1 bn of EBITDA and ~$7 / share of EPS. Attaching a peer average 6x EBITDA multiple and 12.5x earnings multiple results in my 18 month share price target of $90, more than 50% upside to today’s levels. As discussed, I believe TEN will still have a very appealing Clean Air growth story to tell in 2016 and so this valuation may well be conservative.

Those are the nuts and bolts of the Tenneco story. For those interested further, I have included additional relevant parts of the story below and I’m happy to provide additional detail / share thoughts in the comments.

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A Word on the Auto Supplier Sector

Auto suppliers have tended to trade 5-6x EBITDA over the last decade as compared to ~7x today. Together with the SAAR recovery that has occurred in the U.S., investors are reluctant to see value in the sector. However, this view doesn’t take into account the vast improvement in the sector since the crisis – leverage ratios have been brought down from ~2.4x in 2006 to ~0.5x today while the labor situation and cost structure at key OEMs has dramatically improved. Further, Europe auto sales are still ~25% below long term averages and have yet to rebound. While difficult to predict a re-rating in the sector, putting these pieces together provides comfort as to the reasonableness of overall sector valuations.

Market Misperceptions of Value

I believe there are several potential misperceptions, or lack of understandings with respect to TEN stock, which I will try to dispel:

Misperception #1: Tenneco is lumped into the slow growth auto parts segment that trades solely based on vehicle demand.

My view: Tenneco is growing its revenue at near industry leading rates and is benefitted by ongoing secular regulatory trends.

Misperception #2: Tenneco is an “old-era” auto parts supplier that continues to be overlevered and sunk with legacy costs.

My view: Tenneco has sharply brought down leverage from 3.5x in 2008 and will be below 1.0x net debt / EBITDA by the end of the year.

Misperception #3: Tenneco has significantly lower margins than peers.

My view: Tenneco’s margins are understated largely due to commodity costs (“substrate revenue”) that are passed through directly to customers. Adjusting for this effect raises TEN’s margins by ~30% and catapults TEN to having near sector-high margins.

Misperception #4: Exhaust control products are hunks of metal and filters that can be made by anyone.

My view: Emission solutions are highly engineered products tailored to each engine platform’s bespoke specifications and to meet various regulatory standards.

Misperception #5: Investors view electric vehicle and turbo charger companies as the way to profit from the clean air and fuel efficiency trend.

My view: Widespread electric vehicle adoption is a distant risk and Tenneco focuses on harmful particulates which will persist even amidst other engine solutions.

Investment Risks and Mitigants

Risk #1: Delays or Reversal of Emissions Regulations.

Mitigant: Regulations in the U.S. and Europe tend to occur on time. China regulations have historically been delayed though I expect that will change and deliver upside surprise (See China section below).

Risk #2: Recent Price-Fixing Investigation (in March, Tenneco along with main Clean Air competitors, Faurecia and Eberspacher, each had an office raided by EU antitrust regulators investigating possible price collusion)

Mitigant: It is still unclear whether Tenneco is yet accused of any wrongdoing as this is a continuation of a broad, ongoing investigation into various auto suppliers. The potential penalty based on precedent would only represent $0.60 - $2.00 per share of value in the worst case and is likely years away.

Why should we believe in this secular growth story that’s based on regulations?

Tenneco’s clean air segment’s exhaust control products address serious pollutants which cause real health risks. Carbon monoxide causes climate change. Nitrogen oxide causes smog and respiratory health risks. Particulate matter causes respiratory health risks (believed to cause >1,000 deaths in London alone). Hydrocarbons contribute to Ozone and smog. Emissions control solutions are needed to continue to reduce these very real health and environmental risks. The consistent pattern over time is a continued strengthening of the strictness of such regulations. In addition to the well-known smog over Beijing, both London and Paris have had major smog issues in 2014, with Paris even enforcing driving restrictions earlier this month.

Market Potential

In its investor presentations, TEN points out the market potential of the emissions market. Today’s OE market is ~35 bn whereas in 2025 TEN projects a potential market size of ~100 bn. This is very speculative and is based on large expansion into the off-road category, but this just goes to show the ample “white space,” or “gray air” for growth.

Being Constructive on China

The pace of China’s emission regulation progression has been a disappointment to both regulators and to investors. I believe this is about to change. At China’s recent National People’s Congress, China’s Premier Li Kequiang stated “We will resolutely declare war against pollution as we declared war against poverty.” Previously, the pace of reform had been inhibited by the lack of availability of low-sulfur diesel fuel. However, this is beginning to change and Premier Li’s remarks specifically mention that high quality diesel fuel will be provided nationwide. China’s implementation and enforcement abilities are second to none and with the publicly announced focus on emissions standards, I expect the pacing of China emissions reform to surprise to the upside. Asia Pac accounted 13% of TEN’s 2013 revenue and is the firm’s strongest geographic growth area.

Announcement of a meaningful share repurchase plan within 12 months, China upside surprise, continued execution on plan inspiring more confidence in 5 year growth figures. An uptick in commercial vehicle sales or a Europe rebound would also likely catalyze the stock.