Description

INTRO

Visteon provides investors with an asymmetric risk/reward profile over the long-term. I recommend a long position in Visteon (Ticker: VC) with a target price of between $10 and $15/share in 12-24 months vs. the current stock price of $6.26/share. Visteon is a deep-value restructuring story that just consummated a transformational deal with its ex-parent, Ford Motor Company. Valuation is anchored at current levels through a profitable and well-run subsidiary, thereby limiting downside from current levels.

(Note: S&P earlier this week dropped VC from the S&P500 index. The stock will experience higher than usual trading volume over the next week as a result of index funds exiting positions.)

'04 Revs: $18.7bn
Pro-Forma '05 Revs: $11.4bn

Price: $6.26
Shares Outstanding: 153.7mm (includes F's warrant to purchase 25mm shares)
Market Cap: $962mm
Debt: $1,9550mm
Pension/OPEB: $1,190mm (tax effected)
Cash: $898mm
Future Warrant Proceeds: $172.5mm (I'm considering this as cash since we included the warrants in the above S/O)
Enterprise Value: $3,036.5mm

VC operates in three segments in the auto supplier industry: Interiors (instrument panels, cockpits), Electronics (wiring harnesses, electrical boards), and Climate Control (HVAC systems). The company also has powertrain and chases plaints in Europe, which management characterizes as non-core. Last month the company finalized an agreement with their largest customer and ex-owner, Ford Motor Company, to take back 24 plants representing $7.3bn in revenues. For purposes of our discussion the remaining assets will be called pro-forma Visteon or New Visteon.

ROADMAP TO TODAY

In order to understand the restructuring, it is critical to quickly review the events that have led up to the current opportunity.

VC was spun-out of F in 2000, and ever since struggled to make a profit after its first year as a publicly traded company. Initially, things looked bright for the company: VC was the largest supplier to F, which enjoyed robust SUV sales and profitability at the time; after the spin VC was poised to profitably begin supplying other OEM's; and pension/opeb liabilities were largely funded by an over valued stock market. Ford justified the spin by claiming to shed non-core assets and union workers. Very quickly the spin-off proved to be unrewarding for new VC shareholders since Ford saddled the supplier from the start with high debt, unprofitable Ford contracts, an overly paid unionized workforce, and inadequate administrative and financial systems. VC management was also layered with ex-Ford managers who had some degree of loyalty to their former employers. The confluence of these factors, coupled with significant market share erosion by F since 2000, forced the ex-parent in May '05 to agree to take back 24 unionized legacy plants and offer VC restructuring funds in order to avoid claims of fraudulent conveyance. In retrospect one can argue VC was not spun out as a viable business.

Fast forward to November 2005: after years of VC profit losses, Ford finally agreed to take back 24 legacy F plants – the worst of Visteon's assets. The key component of VC's agreement with F is the transfer of these 24 plants and all UAW workers to Ford, along with $2bn of pension and opeb liabilities. The majority of these transferred plants were located in Michigan. To put this in perspective, VC's North American footprint now consists of one Michigan plant, ten Mexican plants, and 16 other plants in NA, most of which are located in the South at competitive wage rates. The transferred plants are supplying parts to Ford and are hemorrhaging ~$500mm in annual total losses, mainly due to the uncompetitive wage rates forced by the unions. Management estimates that its average North American (US/Mexico/Canada) hourly cost for wages and benefits will drop to $17/hour from $39 with the Ford deal. Ford also agreed to provide $400mm in funds for future cash restructuring costs.

Visteon released pro-forma financials on 11/20/05 that depicts the company without the 24 transferred plants. Adding back $396 in special charges, pro-forma '04 operating income was +$118mm and '04 EBITDA was +$563mm. Based on the nine-month ending 9/30/05 pro-formas and assumptions for calendar Q4, the company will lose $50mm in operating income but generate $244 in EBITDA for FY05. Although op income and EBITDA significantly declined in '05 from '04 levels, I believe '05 represents the trough in financial performance. More on this in a bit. Suffice it to say that we are no longer gushing losses given F has agreed to take back VC's worst performing assets.

THE FORD DEAL

On May 25, 2005 VC and F announced an understanding that provides significant structural changes to Visteon's NA operations. Prior to the October 1st closing Visteon leased 17,400 UAW employees with an average cost of $47/hour. Technically these were Ford employees working in VC's plants who were leased from Ford at cost. The company also had significant powertrain and chassis operations which were underearning relative to the rest of the organization. It is estimated that these plants will lose $525mm in 2005. Ford agreed to take back these plants, as well as terminate the employee leasing arrangement. Overnight Visteon unloads 24 money-losing plants and eliminates 90% of its unionized workforce. New VC will be left with 36 much smaller plants and a workforce that is less than 10% unionized in its North American operations.

Ford created Automotive Components Holdings, LLC ("ACH") to house VC's divested plants and union employees. As part of the agreement VC is leasing 5k salary employees (engineers, plant managers, IT staff, etc) to ACH, and will be reimbursed at cost for these employees. VC is not retaining an ownership stake in the LLC. It is Ford's intention to ultimately sell these assets.

The agreement also includes $400 in funds from Ford to restructure remaining VC plants. The terms of the reimbursement schedule call for Ford to fund the first $250mm and a dollar-for-dollar match for remaining costs up to $300mm. Therefore, Visteon will spend $550mm in restructuring funds on its remaining NA and European plants with Ford paying for the bulk of it ($400mm = 250 + 300/2). I expect these funds to be expended in the next 24 months. It should be noted that a similar funding agreement is in place for ACH. Ford will first spend $50mm to eliminate excess overhead and redundancies, and if required, VC will match dollar-for-dollar F's remaining restructuring funds up to $200mm ($100mm from F, $100mm from VC). Therefore, VC's total potential cash costs for restructuring efforts are $250mm ($150mm for VC plants and $100mm for ACH).

Why was Ford forced to concede so much? The stock suffered a precipitous decline as liquidity issues mounted earlier this year. As I suggested earlier, I believe Ford was concerned with allegations of fraudulent conveyance. This could have been a large hidden liability given VC's $2bn debt load. Also, in the event of a bankruptcy filing Ford would be liable for the wages and pension/OPEB liabilities for the 18,400 union employees who were leased to VC. UAW leaders could contractually prevent VC from spinning its US plants back to Ford, thus F had no choice but to absorb the pension liabilities. This was a minimal requirement to get a deal approved by the UAW.

PRO-FORMA VISTEON
Management has said very little regarding the pro-forma company. Originally, this was due to the company's delinquency in filing '05 10Qs. The company discovered purchasing managers misallocating non-cash charges between periods. The restatements were immaterial to results, but prevented the company from issuing financials until November 22, 2005. Without financials the company was unable to issue pro-formas, and without pro-formas management was unwilling to comment in detail on New Visteon. The company is currently in compliant with SEC requirements, but management has decided to devote all management time on a restructuring roadmap. Therefore, they have made the decision to keep quiet on plans and future guidance until the Detroit Auto Show in mid-January.

What we do know:
• VC becomes less reliant on F and North America OEM's. Sales to Ford will declines from 64% to 50%. NA F sales are 25% of total company (see Key Risks section below). New VC's geographic breakout is 39% NA, 43% Europe, and 18% Asia.
• Plant footprint is dramatically reduced in NA: 58 plants to 36. Most of the transferred plants are located in the US, so the Mexican square footage exposure as a % of total NA naturally increases.
• Avg North American wages decline from $38 to $17. NA employee count declines from 39,440 to 18,000.
• Segment breakdown: Interiors = 24% of revs; Electronics = 26%; Climate (inc Halla) = 34%, and Other = 16%.


THE ANCHOR IN VALUATION AND VISTEON'S HIDDEN GEM

Visteon's predecessor within Ford originally purchased a 35% stake in a South Korean auto part manufacturer in 1986. Halla Climate Control, as it is now known, primarily supplies HVAC and climate control systems to Asian auto manufacturers. Halla operates a lean organization, has its own managers, and generates impressive margins: op income margins were 10.5%, 9.1%, and 8.7% in '02, '03, and '04, making Halla one of the most profitable auto parts suppliers. The company serves customers in S. Korea (= 26% of total revs), Western Europe, and North America.

VC increased its share to 70% by purchasing an additional 35% interest for $84mm in 1999. The 70% stake is now worth $930mm. The remaining 30% interest is publicly traded on the Korean Stock Exchanges (Bloomberg ticker = 018880.KS). Based on the 12/30 closing market price of SKW 12,300 Halla shares and an exchange rate of 1,010, Visteon's 70% ownership in Halla is worth $5.92 per Visteon share (= $910/154mm shares). Halla is fully consolidated within Visteon's results, and has a net cash position. Therefore, at today's prices, you are effectively paying ~ $.30/share for VC's core operating assets.

Is $.30/share a proper margin of safety given the state of the overall auto industry and continued Ford market share erosion? Based on the current capital structure, I believe it is. There are several ways to look at this, but I put forward the following "going private" scenario that will serve as an anchor to our valuation.

Visteon has $1,9550 in total debt, $550 of which is due in mid-2007 and the remaining portion due in 2010 and thereafter, and $828mm in cash on the balance sheet as of 9/30/05. A private equity or strategic buyer could bid a 25% premium off of today's equity prices, spin-off the Halla subsidiary, pay off the '07 debt, and dividend the cash for a net cash outflow of close to zero dollars. Additionally, Ford is still obligated to fund the $400 million aforementioned restructuring costs in a change of control. Ford's funds are not accounted for below since they will be used for restructuring costs. Here's the math for our going private scenario:

Outflows =
Equity purchase price: $1,202.5 mm (= $6.26 * 25% premium * 154mm shares)
Debt due June '07: $550mm
VC's Cash Restructuring Costs: $250mm
Total Outflows: 2,002.5mm

Less Inflows =
Monetization of VC's Halla stake: $910mm (based on Halla publicly traded valuation)
Dividend Cash: $1,071mm ($898mm Cash Balance + $173mm Ford Warrant Proceeds upon Chg of Control)
Total Inflows: 1,981mm

Net Outflows = $22mm

In other words, at these valuations a financial or strategic buyer could pay a healthy cash premium to today's price and immediately take out 98% of their entire purchase price through cash and the monetization of the Halla asset. Additionally, the pay-off of the 2007 debt with existing cash balances provides our buyer with four years to orchestrate a successful turnaround before the next principal payments are due in 2010. In the end, our hypothetical buyer (Wilbur Ross?) would end up owning a top ten global auto supplier for virtually zero cash outflow…in other words, a virtually free call option on a rebound in the auto sector that expires concurrently with VC's remaining debt (2010). On top of this, our buyer would have access to $400mm from Ford for restructuring efforts: closing down plants, moving ops offshore, etc. For these reasons and others below, I believe the downside risk to Visteon is limited to current levels.

UPSIDE -- THE 12-24 MONTH OPPORTUNITY

Visteon is a restructuring story with a tainted past. Owners have seen dividends eliminated and equity depreciate. Sell-side analysts have witnessed continued earnings misses. The story is hated and operates in an unloved industry. However, unlike most restructuring stories, whereby a painful asset rationalization and significant employee cuts create tremendous financial and human disorder, this one is relatively clean. It's not to say that VC doesn't have its work cut out for it, but the Ford deal does provide VC a viable financial baseline in which to improve upon beginning with a clean plant disposition. Overnight, VC exited its least competitive sectors (powertrain, chasis, and glass) and dramatically improved its North American wage structure. All 14.7k UAW workers moved back to Ford, along with their pension/OPEB liabilities.

VC now has around 90 plants across NA, Europe, and Asia. Of these the company has identified 20 plants they deem to be underperforming in the US and Western Europe, and have earmarked $400 to restructure or close these locations. From numerous industry sources and executives, I do not believe there is anything structurally wrong with the geographic footprint or quality of assets to prevent it from earning peer group margins upon a successful restructuring. The base case is that VC earns industry average margins over the long term:

Segment Pro-Forma Revs EBIT % EBIT ($mm)
Interiors 2,736 2.0% 54.7
Electronics 2,964 5.0% 148.2
Climate Control 3,876 6.8% 262.1
Other 1,824 .5% 9.1
+ D&A 460.0
= Total EBITDA 934.1
+ OPEB/Pension non-cash Expense 210.0
= Adjusted EBITDA 1,144

$1,144 x 4.5x multiple – (Debt + Pension/OPEB – Cash) = 2,924 assumed equity value. /153.7 share count = $19 stock price. Note: since I'm including the unfunded Pension/OPEB liability in my Eval calculation, I believe it's fair to add the associated expense to the EBITDA calculation.

Monies expended on restructuring efforts within the auto and supplier universe typically have an 18-24 month payback. Using the pro-forma financials provided in the 11/17/05 8-K, it appears '04 adjusted EBITDA is $773mm. Assuming the $400 in restructuring funds achieve a two-year payback, the company may achieve a $1,173mm EBITDA run-rate by the end of '07. This is of course using 2004 as a baseline. I believe it is unfair to use 2005 as a baseline for several reasons: first, all auto suppliers have experienced historically high commodity costs in 2005, thus depressing normalized earnings; also, Visteon had a perverse incentive to make things look as bad as possible in order to extract the greatest economic concessions from Ford during negotiations.

GUIDANCE AND SELL-SIDE NUMBERS

During their analyst conference call after initially announcing the Ford deal, Visteon communicated that the deal would bring the pro-forma company back to breakeven profit before taxes. Management rescinded this statement in early November during their third quarter conference call, and attributed the change to a deteriorating commodity environment and declining production volumes. The company has reported pro-forma financial statements that depict the company without the transferred UAW workers and 24 plants. On this basis, the company was roughly breakeven (-$50mm) on the operating profit line for the first nine months of 2005, a period in which most suppliers struggled through OEM production volatility and heightened commodity cost pressures. Regardless, investors were disappointed with the change in the baseline outlook, and the stock dropped from $9 to $5.5 before bouncing back to today's levels.

The company has not provided guidance on 2006, and we expect the company to guide investors to an operating loss. Fortunately to new investors I believe the stock currently discounts these expectations. '06 EPS is all over the board, and ranges from -$1.74 (Prudential) to +$.53 (Argus) according to data provided by Bloomberg. The consensus estimate is -$.43.

So why purchase the stock now? Given the lack of management guidance, historical performance, and "noise" that surrounds the restructuring, I believe investors are missing the long-run normalized earnings power of the company. For example, the '07 consensus estimate for operating profit is $285 for 2007, or 2.3% of revs. Halla alone generated $94mm in operating income last year, and the Lehman analyst covering Halla projects Halla to earn op income of $132mm in 2007. Backing out the Halla subsidiary to focus on the pro-forma ex-Halla piece implies a base business operating margin of 1.4% in 2007, or 100bp higher than the '04 operating income margin ex Halla.

I believe a 100 bp increase is too conservative. VC has significant cost-cutting opportunities to rightsize the company's overhead as it moves from an $18bn rev company (pre-deal) to one generating $11.4bn in revs (pro-forma). Reducing SG&A from the current level of 7% to 6% -- which is still well above industry peers of 5% -- would add one point to op income margins and knock out $114mm in expenses alone. This easily gets op income margins to consensus levels. Additionally, the company believes gross margins have more room to improve than SG&A. This makes sense given that other US suppliers – such as Delphi, American Axle, Lear, Johnson Controls, and TRW -- all generated gross profit margins in excess of 10% last year while pro-forma VC was in the low 8% range. Achieving these goals is consistent with the analysis presented above regarding peer margins.

I believe Visteon's status as a "black box" offers investors to capitalize on overly-conservative assumptions by the street. These assumptions are poised to rise as the company moves forward with its restructuring plans and offers investors a clear plan of action…something they plan to do in January at the Detroit Auto Show. To date, management has been closely guarded on specific actions it intends to take with Ford's $400mm and timing of associated benefits.

MANAGEMENT

Investors have been quick to criticize management for an alleged "botched" call last quarter in which CEO Johnston and CFO Palmer danced around questions of guidance and the inherent restructuring opportunity, as well as for lowering the '05 pro-forma financial guidance from breakeven PBT. We have spent some time with management since the call, and come away confident that management intends to sufficiently address these issues to the investment community at the Detroit Auto Show. We are most impressed with the background of newly hired COO Don Stebbins. Stebbins joined VC two weeks before the announced F deal in May '05 from Lear Corporation. At Lear, Stebbins implemented many of the systems VC is in need of, as well as overseeing the restructuring at Lear. We believe Stebbins was aware of the Ford deal upon his hiring, and recognized the significant opportunity that it afforded the company.

CEO Johnston and CFO Palmer are also duly capable, and come from companies with multi-plant manufacturing processes. Both also replaced former Ford executives. The former CEO who Johsnton replaced was allegedly picked by F due to his amicable relationships with the union. Per Crain's Detroit News (7/2/01), "Pestillo was tapped to lead the company through the spin-off largely, observers say, because of his amicable relationship with the UAW. That led to an agreement that brought Visteon labor peace, but at a price 20 percent to 40 percent higher than most competitors." Pestillo is gone, and so are the unions.

RISKS

The largest risk to the restructuring story are Ford production volumes. The market share erosion by the big three, including Ford, is consistent and well publicized. Shorting Ford stock inevitably removes some of this risk and helps to "hedge out" this risk. We believe management is being very conservative and pragmatic regarding Ford production volumes as they complete the restructuring plan and budgeting process.

Catalyst

Management plans to lay the groundwork for their restructuring actions during the Detroit Auto Show. I expect the company to comment on 2006, and the long-term operating income margin goals for the pro-forma company. Longer-term catalysts are continued cost-cutting efforts by the company to divest money-losing plants, and restructure other assets to achieve peer margins over time. In other words, execution in restructuring efforts.