Description

Long TRW

Equities are very long duration instruments that are often treated as very short duration ones and at times this creates unusual opportunities.

At the current moment, oil is more than $50 a barrel, HRC is above $700, interest rates are rising and the American consumer’s appetite for consumer goods may be sated. It is time to buy good autoparts companies.

These companies are among the least liked and least understood publicly traded entities. They are viewed as tied to dying and unprofitable entities (in particular General Motors and Ford) and subject to wild swings in profitability. They are also viewed to be dead ducks because their operating margins tend to be relatively slim and because they are being forced to absorb increases in raw materials costs. This particular earnings season a handful of companies have already preannounced and some of the weakest companies have already (Intermet) or are on their way (Tower) to declaring bankruptcy.

Against this backdrop of woeful and deteriorating present conditions, a set of slow but important changes have been occurring. First, the volatility of US production has declined dramatically, which is a great development for all of these companies. Many of the parts companies have more exposure to Japanese and European producers than the market is aware of. Third, it looks increasingly likely that auto production is about to be a growth industry again, especially in Asia. Fourth many of the companies in the industry have deleveraged their balance sheets and/or repurchased their stock across the past few years, so stock prices have tended to rise far more than enterprise values. Finally, the increased delegation of mission critical parts to the suppliers and out of the OEMs combined with the increased customer diversification of many suppliers is moderately changing the relative bargaining positions of the OEMs vis-à-vis the tier one suppliers.

In addition the market is currently, for lack of a better descriptive term, freaked out by the rise in raw materials costs and its effect on the near term earnings of various suppliers. It appears that the market is ascribing a permanent reduction in earnings power tied to the increases in raw materials costs. This conclusion is distinctly incorrect. Even if autoparts companies are unable in the near term to pass on any of costs, they will factor the cost increases into bids for later contracts. Consequently it may be correct that 05 and 06 earnings will be somewhat depressed but it is unlikely that the resulting damage will be permanent and it still is not clear how much of these costs can be reduced both through negotiation with the OEMs and through materials substitution.

What I have written above is a preface to my recommendation. I am recommending going long TRW and will discuss the specifics of the company at length at the end. I could make similar cases for several of the companies in the group and they all have their pluses and minuses. I think you get an extra kick from TRW because it is a classic broken IPO orphan and consequently is probably the least well understood member of the group. In addition, the safety segment of its business will benefit from a set of significant secular headwinds as a result of NHTSA regulations and voluntary industry initiatives. Finally, the business is being run by a competent and properly incentivized management team who are being overseen by a private equity player with significant skin still in the game.

That said I almost as easily could have written up autoliv, borg warner (although I have some concerns about BWA’s liabilities) or lear. All of those companies are significantly less financially leveraged than TRW, which may be an advantage to holding them if the environment we are about to enter is a bear market with anemic auto sales. Autoliv in particular is a terrifically well-run company with a true market leadership position in the safety markets and is not expensive (except for as an auto parts company). I own it as well.

A Brief Recent Corporate History of TRW

Northrop Grumman merged with TRW, the defense/ automotive conglomerate, in late 2002 and sold the auto parts division of TRW to Blackstone for 4.65 billion dollars in February of 2003. The deal was mostly debt financed, with a sliver of equity. The deal was done at the bottom of valuations for the auto parts market. Northrop retained a piece of the equity in TRW and a $600 million dollar PIK note that accrued at 8 percent per annum. Management was able to buy in at the then equity price of $10 per share.
The debt placed on TRW was all placed in North America. Consequently the North American business is running operating losses while Europe is making gains. The upshot of this is that TRW is currently paying very high taxes and accumulating North American NOLs.

In early 2004, at the peak of autoparts valuations, Blackstone brought TRW back public at $28 per share. A portion of the shares sold were Blackstone’s and a portion were new shares issued by the company. Immediately following the offering, the shares started to trade down and now hover around $17. The company has reduced debt substantially since the Blackstone takeout. At the end of last quarter net debt stood at about 2.7 billion dollars. So enterprise value is now about 4.4 billion dollars, more than a shade below the enterprise value that Blackstone paid Northrop. Management now holds about 1.7 percent of the common stock. Blackstone holds 56.7 percent and Northrop holds 17.2 percent. The investing public owns 24 percent. As part of the equity offering TRW took in a net of about $330 million dollars.

Very recently, TRW announced that it was redeeming Northrop’s PIK note. Doing so raises the nominal debt of the company by $110 million but lowers interest costs by $34 million annually.

The mild bull case: Valuing TRW as if nothing good and nothing bad ever happens

The easiest and cleanest bull story to be made on TRW is simply as a deleveraging play. Today the market cap of the company is about 1.7 billion dollars and net debt is about 2.7 billion dollars. The pension deficit was about 800 million at the start of 2004 and OPEB deficit was about 1 billion. Adjusting these for eventual tax assets, pension and OPEB was net about 1.2 billion. The total true enterprise value is consequently about 5.6 billion dollars. From this, one should probably subtract out the value of the NOLs which were worth 335 million at the beginning of the year, leaving an enterprise value of about 5.3 billion.

TRW’s current guidance calls for pre-tax operating profit of 570 to 590 million, which includes 35 million of cash restructuring and 33 million of amortization of intangibles. Using the bottom of that range and adding those back gives 638 million. In addition, last year operating income included a pension and opeb cost beyond service cost equal to 44 million. It is probably a bigger number this year, but using that number suggest cash pre-tax pre-pension earnings of 682 million dollars.

In other words, against the projected 2004 numbers, true enterprise value to true cash ebit is less than 8 times.


As the total debt burden is reduced, the amount available to debt reduction grows. By my calculation, assuming that TRW is able to maintain its current pre-tax “cash” ebit, it would generate approximately 1.3 billion dollars of debt and NOL increase across five years. It could do better than that with pension contributions as they are before tax. If the enterprise value remained unchanged across that time. TRW’s equity would be worth $30 a share (or about $19 today using a 10 percent discount rate)

The more serious bull case

There are a variety of reasons to believe that TRW’s profitability will increase rather than stagnate across this period, both internal and external.

The foremost internal reason is that TRW’s management team has been freed from its conglomerate shackles. Having met this management repeatedly, I would describe them as very competent, very focused and spectacularly boring and conservative. I consider that to be a good mix. Although this event happened more than a year and ago, the full fruits of it probably won’t be fully recognized until 2006 and 2007 when the first contracts that the independent TRW bid on start to come on line.

In the meantime, one can observe the increases in revenue and the decreases in SG&A and draw some conclusions as to the direction the company is going in. On an apples-to-apples basis EBITDA was up 8 percent year over year in the first half.

The foremost external reason for optimism is that nearly half of the company’s profitability lies in occupant safety systems, which is a significantly higher margin business than chassis – safety is only about 30 percent of the revenue. The airbag market, especially in North America is about to grow significantly. The industry has already agreed to install side curtain airbags in half of all 2007 model year cars and make them standard by model year 2009. In addition, J.D. Power reports that NHTSA (the national highway traffic safety administration) is likely to require all vehicles pass a side crash test by 2009, which could increase demand for side-impact thorax bags. Given the size mismatch today between SUVs and sedans, the issue is not trivial. In all, JD Power expects global airbag revenue to increase by 2.9 billion dollars. Assuming TRW gets its share of that (and I believe that the Power study is baking in a fair amount of price degradation), it should be worth about 70 million dollars pre-tax (on what is now only 13 percent of their business)

Chances are that in the next few years, the impact should be greater than that. Given the voluntary industry compliance coming in late 06, there is not currently enough capacity in the airbag market to provide 50 percent of models with the bags. As the #2 player in this market, this fact will likely be to TRW’s benefit as all available capacity will likely be used.

In addition, TRW has a variety of other safety based initiatives including tire pressure monitoring and vehicle stability control, which will be higher margin than the companies business as a whole.

The company has guided revenue growth to 4% with something of a lift beyond this for the pending US safety regulations. If this is the right number, operating profit should grow roughly 6 to 7 percent and maybe a little bit better because of improved product mix.

At a 6.5 percent ebit cagr, going through the same exercise in debt reduction raised in the less optimistic case and then applying an 8 times EBIT multiple to the company five years out, I get a $54 dollar stock in 5 years or about a 25 percent compound return. (Using a discount rate of 10 percent would suggest that the stock should trade at $33 today). At the end of this period pension adjusted cash ebit would be about $934 million or about 37 percent above 2004 guidance. I think that this scenario is pretty plausible.

The bear case
Making a bear case on TRW requires that TRW’s 2004 operating EBIT be in some sense above trend or alternatively that TRW as a leveraged company will run into some sort of funding iceberg that will sink the equity.

The first argument – that TRW’s 2003 earnings are above trend—would require either that TRW’s volumes are likely to go down or that TRW’s margins are likely to be cut going forward. For volumes to go down, either TRW’s content per vehicle has to fall going forward (which isn’t likely given the safety initiatives) or overall vehicle production in Europe and North American in 2004 would have had to be above trend.

Year NA production Europe production
1998 15.5 18.8
1999 17 19.1
2000 17.1 19.5
2001 15.5 19.5
2002 16.4 19.2
2003 15.9 19.3

This year is currently looking like it will come in much like 2003. Over time and with TRW’s further entry into Asia, one would expect TRW’s revenue to grow. Similarly over time one would expect TRW’s margins to grow as higher margin higher value add product replaces older product.

The more important question to me is not whether there is whether in fact as a relatively leverage company, TRW faces any real liquidity risk. This argument is a very hard one to make. Post the Northrup PIK buyback, TRW will have almost $1 billion dollars of liquidiy, more than $300 million dollars of that in cash. The company is currently at the low point of its cash cycle for the year. (Q4 tends to be a large cash inflow quarter), so by year end, this liquidity will likely increase substantially. Total debt (not including cash) is less than 3 times trailing EBITDA and TRW’s publicly traded 9 and 3/8 paper now trades at 114. On the Northrop note repurchase call, TRW management said that it felt confident in its ability to access the capital markets at a couple hundred basis points above libor.

The company has no significant debt maturities until 2007 when 97 million dollars is due. 113 million is due in 2008 and then all other maturies are well beyond 2010. In short, business would have to deteriorate remarkably for this company to have a liquidity problem.

That leaves what I consider to be a relatively inane reason for not owning the stock, which is that short term numbers are too high.

In the short term, one could imagine that both volumes and margins will shrink. Volumes because of the big three inventory situation and margins because of raw materials prices, especially steel. I think it is important to contextualize the shortfall if there is one. Volumes in the first half of 2005 may be weak but if so it will be because they are below trend and TRW’s earnings could be weak because of raw materials prices but again a shortfall due to steel prices would not be a permanent reduction in TRW’s earnings power. TRW like most suppliers will not bid their future contracts as if steel were still at 2003 prices.

Because the market can be short-term focused and because the reaction of the market thus far to raw materials related earnings guide downs by the auto parts companies (AXL, DCN come to mind) has been pretty severe, the issue of where exactly TRW’s 05 earnings are likely to come in is important if only to get the entry point right. The current mean earnings estimate for TRW in 2004 is $1.75. The current mean estimate for 05 is $1.86. I would claim that if TRW does not have to guide down, for whatever reason, that the stock is very near its ultimate bottom.

So let’s take the issues in order of likely size and effect. About half of TRW’s business comes from Europe and 42 percent comes from North America. A little less than half of the overall business is Big 3, with the company’s largest customer being Daimler-Chrysler, which has the smallest inventory problem. TRW has 15 percent exposure to Volkswagen, which isn’t great news but at the end of the day in comparison to American Axle, Delphi, or Visteon. It is probably reasonable to conservative to assume that TRW’s end markets shrink 3 percent year over year for the next few quarters.

If that is true then TRW’s sales all else equal would be down about 220 to 330 million and gross profit down 30 to 50 million dollars annualized. However in 2005, according to the Deutsche Bank model, TRW should have gross new business of more than 500 million dollars from new programs. Consequently, deterioration year over year from volume would require more than a 3 percent fall in end markets (which is roughly half a million cars in the US and three quarters of a million in Europe). In fact, at a 3 percent drop, TRW would have about 200 million in additional revenues, which should be sufficient to cover the 11 cents in year over year profit analysts expect.

That leaves raw materials. Any company that does more than $110 of sales per share and $1.75 in earnings is subject to substantial operating leverage. In the second quarter (in which the company beat analyst estimates by a dime), TRW claimed about a 10 to 20 million dollar reduction in operating income from raw materials. This amount would be roughly 6 to 11 cents a quarter. It is entirely possible that the situation has worsened since the second quarter. Analysts on average lowered their estimates for the rest of the year by a dime after the quarter for this reason. Assuming the situation is twice as bad in quarter’s three and four then analysts would be a total of 30 cents too high for this year. (That would be the equivalent of TRW having costs up 160 -180 million dollars annualized pre-tax). Taking those costs out through next year would suggest an incremental 30 cents (twenty cents in the first quarter and ten cents in the second quarter), which would put TRW at $1.26 next year. Ten times this is $12.60. And adjusting for the intangibles amortization, this number on a comparable basis to other autoparts companies would be about $1.50. That’s the best bear case I can make.

And it actually isn’t quite that bad. The end result of the Northrop PIK note buy in is a reduction in interest costs of 34 cents annually. That gets me back to $1.60 (not adding back amortization of intangibles), which is the low end of current analyst range. Moreover after considering that TRW beat 2nd quarter by more than 10 cents with a 10 cent raw materials drag, it is entirely possible that the analyst community is underestimating the current earnings power of the company by as much as twenty cents a quarter (again not a hard thing to believe in a company with more than $110 per share in sales). If I am right on that front then next year could as easily exceed as miss analyst current estimates.

Finally on the short term earnings front, when the company held its conference call regarding the PIK preferred purchase, it had a chance to lower its 3rd quarter or yearly guidance. It will not close on the Northrop deal until after the quarter so it had no obligation to disclose information but from the IPO forward this management team has done nothing but give dour presentations about its business and then proceed to stomp on its estimates. I think it is unlikely that a guidedown of the size of Delphi’s or Dana’s or Axle’s or Visteon’s is in the works, but since the PIK conference call (which should have boosted the stock price significantly) the stock is down 60 cents, suggesting that the market strongly believes a significant guide down is coming.


Conclusion

I have no doubt that the reason TRW is currently available at $17 a share is the belief that the 05 numbers are too high. At the end of the day, they may or may not be, but the company’s future appears bright and the stock is trading at a level that implies negative growth on a go forward basis. I think that this result is unlikely although it may require holding through a period in which the market acts as if the growth will be very negative. I do not believe there is any real risk to the liquidity of the company, and for the moment at least the bond market agrees with me. I also believe that at about this time next year the same buy side and sell side analysts who currently shun this space and ignore this stock will likely be focused on the upcoming safety regulation wave and that the stock will be materially higher than it is today.

Catalyst

deleveraging; increased safety content; unwinding of raw material price pressure