Tognum is a market-leading, premium, off-highway diesel engine manufacturer that is significantly undervalued on both an absolute and relative basis.  On forward earnings, Tognum should trade at €30 and, over the next three years, investors have a chance to double their money in the next three years.  I expect the company to deliver 20% annual returns over the next two to three years, driven through a combination of high-teens earnings growth and a dividend yield of about 3%.  Capacity additions into strong end markets, a favorable pricing environment, and margin expansion will drive earnings growth.  Lastly, Tognum has less than 1x Net Debt / EBITDA and has stated its desires to make accretive acquisitions. 

 

Tognum is a leading manufacturer in the off-highway diesel engine space.  It specializes in the high-speed and high-power segments, and its products range in power from 150kW to 9,100kW.  Today, 86% of its revenues come from sales of diesel engines and related after-sales, including parts and services.  The rest of its revenues come from its Onsite Energy Systems (gas, diesel, and fuel cell power systems) and Components (injection systems and propeller shafts) businesses.  Tognum is very well diversified, as no end market makes up more than 25% of its revenues.  Tognum’s largest segment is Power Generation, which made up 25% of revenues in 2006.  The second largest segment at 21% of sales is After-Sales, which is both the fastest growing and the highest margin business.  Other major end markets include Marine (20% of revenues), Industrial (13%), and Defense (7%).  The company estimates that approximately 50% of its revenues today are non-cyclical due to long-term contracts with defense departments, stable After-Sales revenues, and a multi-year backlog in mega-yachts.

 

Tognum is a combination of two business units formerly under DaimlerChrylser, the off-highway segments of MTU and Detroit Diesel.  MTU was founded in 1909 as Maybach Motorenbau GmbH in Friedrichschafen, Germany. In 1960, Daimler-Benz AG purchased Maybach, and later combined it with its own diesel engine production in 1966.  In 1969, Daimler purchased MAN’s minority stake and changed Maybach’s name to MTU.  It had two main business units: off-highway and aerospace engines (later MTU Aero Engines).  Detroit Diesel was founded by GM in 1938.  After a series of corporate actions, it was floated on the NYSE in 1993.  In 1994, Daimler-Benz entered into an industrial cooperation agreement with Detroit Diesel to bolster its US operations; it purchased 100% of Detroit Diesel in 2002.  At the time, Detroit Diesel had both an off-highway and on-highway diesel engine segment. 

 

In 2005, private equity firm EQT created Tognum as we know it by purchasing and combining the two off-highway segments from DaimlerChrysler.  Up until that point, even though MTU and Detroit Diesel shared platforms and engines, they operated as two distinct profit centers.  This was entirely due to historical reasons.  MTU’s off-highway business operated along with its aerospace unit, and Detroit Diesel’s off-highway unit was combined with its truck engine business.  As a result, there are no historical financial statements and only 2006 pro forma numbers are available.  On July 2, 2007, EQT IPO’ed Tognum at €24.  The free float is around 63% today, and EQT still owns 22%.

 

 

Tognum’s operations are solid and its future prospects are attractive.  Tognum estimates that its relevant industries will grow at a 4.4% CAGR between 2006 and 2011.  The best markets are power generation, industrial, and marine.  Within this context Tognum believes it can grow at twice the industry average.  This will be driven by capacity growth in its core engines division and an increase in after-sales as a percent of the total.  At the same time, we expect Tognum to increase its margins due to the shift in mix towards after-sales revenues, continued benefits from its internal efficiency program, and from the in-sourcing of third-party engine production.  Tognum has additional upside from an under-levered balance sheet, which it will use to make acquisitions. 

 

Tognum’s engine division is currently operating at over 100% capacity.  At the main production facility in Freidrichscahfen, Germany, Tognum is running 3 shifts per day and working on Sundays.  To meet demand, Tognum is growing capacity by 25% each year until 2009 through debottlenecking and capital additions.  Its main engines are the Series 2000 (power range 150kW-1,500kW) and Series 4000 (1,100kW-3,000kW).  They made up 6,185 of the 7,231 engines assembled last year, and the majority of the capacity growth will be in these two high performance engines.  Production of the Series 2000 and 4000 will increase from 7,200 in 2007 to 11,000 by 2009.  Demand for the S2000 and S4000 has not slowed.  Management says they are sold out of 2007 slots and are quickly filling up 2008 slots.  Pricing trends are positive, and Tognum has pushed through a price increase of 3% this year and is targeting an additional price increase of 3% in 2008.

 

Furthermore, Tognum will drive additional top line growth through greater After-Sales revenues.  Management has stated that they are only 30% penetrated in their installed base of 400,000 engines.  Currently, 21% of Tognum’s revenues come from spare parts and services whereas some competitors have more than 40% of their revenues from after-sales.  Tognum believes it can deliver 10%+ growth in After-Sales per year until 2010.

 

Longer-term trends also support Tognum’s top-line growth. We expect Tognum to be the beneficiary of stricter emissions regulations and a greater emphasis on fuel efficiency.  These trends have heavy R&D requirements, which we expect will lead to outsourcing by OEMs and a gradual reduction in the competitive positioning of smaller diesel engine manufacturers.  Tognum is a leader in diesel engine technology.  It spends 3.3% of its revenues in R&D, and its engines are known for their industry leading emissions and high power to weight ratios.  In 2006, Tognum designed the first drive system with diesel particle filters that already meet EU emission targets for 2012, which we believe is the first step to market share gains.

 

I believe Tognum will deliver 10% revenue CAGR over the next 4 years.  This is only slightly ahead of management’s 8%+ revenue growth target, which I view as conservative given the strong industry dynamics, favorable pricing environment, and capacity growth plans.

 

Tognum should deliver margin growth from three sources: increasing the mix of after-sales revenues, bringing in-house the production of bought-in engines, and continuing their cost cutting program.  As stated above, Tognum expects to deliver greater than corporate average growth in its After-Sales division.  Tognum is under penetrated in its installed base and has recently begun emphasizing parts and services contracts along with sales of its engines.  The After-Sales division has 10% higher margins (Gross Margins are ~38%, as per CFO’s comments), and will improve the company’s sales mix going forward.

 

In 2009, Tognum will launch its Series 1600 engine to replace engines that are now supplied by third-parties.  In 2006, Tognum sold 22,011 non-MTU branded engines.  These third-party engines are either in the lower power range (from 210kW-660kW) or extremely high power range (gas turbines in the 20,000kW-31,000kW power range).  Most importantly, they carry below corporate average margins.  Around 16,000 of the engines were sourced from DaimlerChrysler last year, and Tognum expects to replace these sales with their Series 1600 beginning in 2009.  The Series 1600 will have significantly better performance and phase out the DCX engines, which will no longer be emissions compliant in 2011.  Not only do these engines provide higher margins, but they will also enable Tognum to capture after-sales revenues.  Currently, Tognum receives minimal after-sales revenues from the DaimlerChrysler engines.

 

Lastly, Tognum is still benefiting from its Total Operational Performance (TOP) program.  This program was started in 2004 and is aimed at cutting costs across the entire value chain and all business functions.  The benefits will come from global procurement, production, and distribution.  The benefits of the TOP program are just being realized and management has consistently beaten internal benchmarks.  Last year they saved €33mm in total costs and expect similar savings each year until 2008.  For example, despite rising raw material prices for the entire industry, Tognum had constant raw material costs on a constant currency basis due to better procurement.  Once the TOP program is finished, management believes sustainable margins are above 12.5%.

 

We believe EBIT margins can reach 15.5% in 2010, up from 12.2% in 2006.  Tognum has already achieved 15.5% EBIT margins in the first half of 2007.

 

Tognum will finish the year with under 1x Net Debt to EBITDA.  Management agrees that they are under-levered and believes an optimal capital structure is 1x-2x Net Debt to EBITDA.  In the absence of acquisitions, Tognum will have net cash in 2010.  To address their balance sheet, Tognum will make targeted acquisitions.  They will most likely be in After-Sales to extend their service network and in Onsite Energy Systems, similar to the Katolight acquisition they made in April 2007.  These acquisitions will be small and bolt-in in nature. 

 

The OES&C segment made up 16% of Tognum’s revenues in 2006.  It essentially allows Tognum to travel down the value chain and gives Tognum more competence in fully functional power systems.  OES provides generator sets (gensets) using gas, diesel, and fuel cell power.  Its major units are MDE (gas), Katolight (diesel), and CFC (fuel cells).  OES is a relatively new business area for Tognum and basically operates as the systems integrator arm.  It should deliver solid growth in the near-term and is a medium-term strategic holding of the company.  The Components business makes high-pressure injection systems for off-highway engines and propeller shafts for passenger and light commercial vehicles.  The injection systems business (L’Orange) is considered core for Tognum.  Its propeller shaft business, Rotorion, is the only part of its business that isn’t involved with high power diesel engines.  Rotorion is not considered core, and management will likely dispose of the business in the future.

 

 

Tognum has a capable and highly incentivized management in place.  CEO Volker Heuer has been with the company for 30 years.  From 1996, he was President of industrial activities in Spain for DaimlerChrysler.  Mr. Heuer became President and CEO of MTU in August 2004.  From the EQT purchase, the top 30 managers own 10.7% of the business.  Some managers bought additional shares during the IPO.  Management’s lock up expires July 2, 2008. 

 

 

 

Tognum 2008 EPS		2.05
Peer P/E multiples on 2008 earnings		15.5x
Tognum Price Target on peer multiples		€ 31.69
Tognum 2008 EBITDA		510.1
Peer EV / EBITDA on 2008 EBITDA		9.2x
Tognum EV on peer multiples		4,689.1
Less FY07 Year End Net Debt		-372.6
Equity Value		4,316.5
Equity Value per Share		€ 32.86

(Note: Bloomberg’s EV calculation does not take into account pensions.  In order to compare Tognum on a like basis, I have excluded pensions from Tognum’s EV/EBITDA calculations.)

 

On 2007 and 2008 P/E multiples, Tognum trades at a significant discount to its European capital goods peers.  I believe Tognum should trade at a premium given its strong growth prospects, market leadership, and industry leading margins.  On peer multiples alone, Tognum should trade above €30 today, versus a current price of €24.

 

On a ROIC basis, Tognum should also trade at €30 assuming 2% long-term growth.  To see downside from today’s prices, one must assume a WACC of 10% and 1% long-term growth. 

 

2008 EBIT	447		Beta (from Bloomberg)				1.1
Tax Rate	35%		Risk Free Rate (10-Year)				4.5%
2008 NOPAT	291		Risk Premium				5.0%
			Cost of Equity				10.0%
Net Debt YE 2007	373
Book Equity YE 2007	470		Cost of Debt				6.0%
Invested Capital	843		Tax Rate				35%
			Assumed Debt / Capital				25%
ROIC	35%		WACC				8.5%
Long term growth rate (g)	2%
(ROIC - g ) / (WACC - g )	5.02
EV / IC = (ROIC - g) / (WACC - g)					g
EV = (ROIC - g) / (WACC - g) * IC					1%	2%	3%
EV = 5.02 * 843mm			WACC	7%	32.99	38.88	47.70
EV	4,232			8%	27.88	31.92	37.59
Equity Value	3,859			9%	24.04	26.96	30.86
Equity Value per Share	€ 29.37			10%	21.05	23.23	26.04

 

Tognum’s peer group includes Caterpillar, Cummins, Deutz, Volvo, and Wartsila.  None of them are great peers.  For instance, Wartsila operates solely in the low- and medium-speed segments, which have very different industry dynamics.  Deutz is the only other non-captive diesel manufacturer in Europe, but it manufacturers low- to mid-power range engines for on-highway applications.  Cummins and Caterpillar, although they operate in the high-speed, off-highway diesel engine segment, both have significant on-highway exposure.  Nevertheless, Cummins and Caterpillar have the most overlap and provide good read-throughs on industry trends.

 

CAT competes directly with Tognum with its Series 3500 engine out of Lafayette, Indiana.  It is a direct competitor to Tognum’s S2000 and S4000 engines.  Its main applications are in the Industrial and PowerGen markets.  Management states that the S3500 is their best engine segment.  They are operating around the clock and at full capacity.  Like Tognum, Caterpillar is sold out of 2007 production slots for the S3500 and is quickly filling up 2008 slots.  Pricing trends for its S3500 engine are the best in their portfolio.  They have plans to grow capacity 10%-15% per year for the next 2 years, which they believe will be easily absorbed by the industry since they expect demand growth to outstrip supply growth.

 

Cummins is less open about its off-highway engine division, but the underlying trends are robust.  They operate in the Industrial, Marine, and Defense segments, and operating results are very strong.  Cummins reported 29% growth in 2Q07 and 30% sales growth in 3Q07 in its off-highway division. 

 

 

Tognum presents a compelling opportunity to own a growing market leader at a significant discount.  Based on high-teens earnings growth and a 3% dividend yield, shareholder returns should be at least 20% annually over the medium-term before factoring in any multiple expansion.