Description

Tenneco Automotive is a Tier 1 supplier to the global automotive industry producing shocks and mufflers for all of the major brands GM, Ford, Chrysler, Toyota, Nissan, Honda, etc. Additionally the company is the largest North American producer of replacement shocks and mufflers and an important one in Europe.

What attracted me to Tenneco is that the company trades at 2.2 x (ltm) free cash-flow of 151 mln and 3 to 4 x projected 2004 FCF. Ten trades at 4.7 x EBITDA and auto suppliers trade between 4.5 x and 6.5x EBITDA. These valuations occur because everyone bunches these companies (auto-suppliers) into the same bucket and does not take the time to realize some of them make money and other’s do not!!. Additionally, several upcoming catalysts which I will discuss later will be very beneficial to the Company.

The company has been improving both operationally and financially over the last couple of years: Debt has been reduced from 6.3 x to 3.7 x EBITDA and margins have improved from the mid 7% to 9% in the most recent quarter. This improvement is the result of concerted management efforts including an important restructuring campaign which will reduce expenses by 30 mln annually from 2002 levels. Furthermore, the Company believes it can reduce capex by 20 mln (longer term not 2004 which is expected to be between 130 and 140 mln) and generate an additional 30 more mln from working capital improvements in 2004. Working capital improvements provided 70+ mln in cash in 2003.

Despite the company being in an ultra-competitive field both revenues and profitability have been stable and free-cash flow generation has allowed the company to reduce debt.

Revenues EBITDA Gross Debt FCF
1999 3,279 292 1,634 (155)
2000 3,528 271 1,527 88
2001 3,364 245 1,515 14
2002 3,459 313 1,445 50
2003 3,800 347 1,430 1,285 (net) 151

I expect that the company will continue to generate at least these numbers going forward except for FCF which should come down somewhat (30-50 mln) because of extensive working capital improvements that were achieved this year that will not be repeatable in 2004. Some catalysts will allow the company to generate more EBITDA and free cash-flow going forward than present levels include:

1)Tenneco is one of two companies with Euro 5 environmental compliant diesel particulate filters. 50% of cars and light trucks sold in Europe (approx 10 mln vehicles annually) run on diesel. The new requirements go into effect in 2005 and will require that vehicles are standard compliant. As one of two manufacturers Tenneco will see substantial benefits from this which could amount to at least several hundred million in incremental revenues annually. These revenues at least for a couple of years should generate EBITDA at higher than average margins. So assuming that these revenues come at 10% margins EBITDA could increase by 20 mln (conservative estimate) which at 5 x would increase the implied equity value by 30%. Audi most recently ( January 8th) said that it would put Tenneco’s filter on its 4 cylinder cars and Merceds Benz has said it will put the Company’s filters on its 6 cylinder cars. Several tough diesel standards are being implemented in the US starting later in the decade.

2)Tenneco, has 500 mln in 11 5/8 % Sr. Sub Notes due in 2009 which are callable in August 2004. The debt currently has a Yield to Call of 4.3% and I estimate that the company could refinance this debt at approximately 7-8%. The annual interest savings from calling this debt are 14 mln annually post tax which is a significant increase to free cash-flow.

3)I believe that the company’s underfunded pension plan ((185) mln at Dec 2002) has been a drag on the Company and with equity returns as they have been, this problem is bound to have improved dramatically.

4)Tenneco has sales to the heavy truck market which is expected to increase by 30% in 2004.

5)The company is deleveraging as evidenced by the table above and will continue to do so through free-cash flow generation and non dilutive equity/linked issues.

6)Ten posted excellent results today which highlighted the improvement in all areas of the Company showing revenue growth and margin improvement and in particular improvement in the Europe aftermarket which has been a sore spot in the Company’s operations for some time. The company guided to improving numbers going forward.

7)They are increasing exposure to Japanese transplant manufacturers which is where you want to be positioned because the Japanese are eating Detroit’s lunch. Exposure has gone from 16% of North American OEM revenues to 18% in 2003 and Ten is well positioned to continue winning this type of business.

For all of the problems in the auto industry, this company has shown improvement both in finances and operations and should continue to do so for the next couple of years.

Catalyst

Diesel particulate filter / environmental regulation
Reduced Debt costs / deleveraging
Improved pension position
Sales to high growth truck market
Continued good results
Exposure to Japanese Transplants