EUR 850.00 For Business Accounts Only

Morningstar | Tenneco Completes Federal-Mogul Acquisition; $73 FVE Unchanged

Narrow-moat-rated Tenneco announced the completion of the acquisition of Federal-Mogul from Icahn Enterprises for an enterprise value of $5.4 billion. Next year, the newly formed entity will separate into two publicly traded companies, one that focuses on powertrain and a second that contains ride performance and aftermarket products. Management expects to complete the separation in the second half of 2019. We are maintaining our $73 fair value estimate on the resulting synergies from cross-selling opportunities, product combinations, and cost reduction. We think this 4-star stock is attractively valued relative to our forecast for revenue growth, profitability, and return on invested capital.

The combination of Tenneco and Federal-Mogul is a unique opportunity offering synergies that would only be available to the distinct combination of their powertrain, ride performance, and aftermarket groups. Tenneco expects to combine its emission-control business with Federal-Mogul’s engine-parts business, creating a powertrain auto-parts supplier with more than $10 billion in annual revenue. Tenneco’s ride-control group and the remainder of Federal-Mogul’s business contain well-recognized aftermarket brands like Monroe, Moog, and Champion. While the new entity will be mostly aftermarket at roughly 57% or about $6 billion in total revenue, approximately 43% of annual revenue will be derived from ride performance parts supply to global automakers.

Total annual pro forma 2017 revenue of the combined Tenneco and Federal-Mogul is roughly $17 billion, with EBITDA of $1.6 billion but about $1.8 billion post-synergies. Higher steel costs pressured Tenneco's profitability last year, resulting in a 2017 EBITDA margin of 9.4%, down from a 10-year historical high of 9.6% in the prior year. Federal-Mogul's 2017 EBITDA margin was 9.7%. Pre-synergies, the combined entity's EBITDA margin would have been 9.5%. However, assuming management’s guidance for cross-selling opportunities, product combinations, and purchasing savings, the 2017 EBITDA margin would expand 110 basis points to 10.6%.

Our model assumes a 60-basis-point EBITDA margin contraction from 2017 to 2018 to 8.8% on added transaction and integration costs. From 2018 to 2020, we assume margin expands from 8.8% to 10.1%. Owing to the accretive margin opportunity from the combination and subsequent split, we assume a normalized, sustainable, midcycle EBITDA margin of 9.2%, 30 basis points above Tenneco’s 10-year historical 8.9% median EBITDA margin.

Tenneco’s clean air group supplies emission-control equipment to automakers, commercial truck, and off-highway equipment manufacturers plus the aftermarket. Federal-Mogul’s engine-parts group supplies cylinder products, bearings, gaskets and seals as well as heat shield products for passenger vehicle, commercial vehicle, and industrial applications. The combination of the two entities enables a suite of engineering development that improves engine efficiency and reduces emissions, providing customers with product solutions to meet clean air legislation requirements in a one-stop-shop package. Federal-Mogul also brings rotating electrical device expertise to the new entity, enabling potential growth opportunities in vehicle powertrain electrification. The combined group will have growth opportunities in cross-selling products to each other’s commercial vehicle and off-highway equipment customers. Tenneco’s clean air group aftermarket products have already been separated from the original equipment operations and will be placed in the aftermarket group.

Tenneco’s ride performance group includes original equipment and aftermarket suspension systems for light- and heavy-duty vehicle applications. Federal-Mogul’s aftermarket products group also supplies original equipment and aftermarket customers. This group’s products include wheel-end, engine, and driveline components plus spark plugs, wipers, and lighting. For the OE market, the combination of Tenneco's ride control (suspension) and Federal-Mogul's wheel-end products enable packaged development of complete corner modules. A corner module would include everything immediately behind a vehicle’s wheel, like suspension, upper and lower control arms, brakes, wheel hub, and steering knuckle. In our view, expertise in complete corner modules will be integral to capitalizing on OE market trends in mobility and autonomous technologies. Digitization of the vehicle will place the steering, braking, and suspension under computer control, integrating corner modules with the rest of a vehicle’s autonomous functions. The newly combined entity has the in-house engineering expertise to develop complete, digitized corner module technology, creating a compelling value proposition for OE customers.

In the aftermarket, the combined group will have a broad stable of strong brand-name products, fortifying the intangible asset moat source already possessed by Tenneco. Such brands as Walker mufflers, Monroe and Rancho suspensions, and Clevite elastomers from Tenneco would be joined by Federal-Mogul brands like Moog (steering, driveline, brakes), Wagner brakes, Champion spark plugs, Anco wipers, and Fel-Pro gaskets and seals. The opportunity for the combined group will be in the healthy amount of store shelf space commanded by these products as well as the integration of distribution and warehousing.

Management says the $5.4 billion purchase price equates to a 7.2 times enterprise value/2017 EBITDA multiple, pre-synergies. Assuming inclusion of annual run-rate cost synergies of $200 million and one-time working capital synergies of at least $250 million, management set the multiple paid for Federal-Mogul at 5.4 times. The alignment of each company's product groups is complementary in a fashion that creates opportunities for a suite of engineering expertise across major powertrain and chassis systems. We think the post-synergies 5.4 times EBITDA multiple may be conservative as operating leverage from volume opportunities, derived from cross-selling opportunities in commercial vehicle, off-highway equipment, and stationary powertrain applications, will exceed management’s expectations.

The transaction was funded with a combination of cash and Tenneco equity. Creditor commitments were in place to fund the cash portion of the transaction. The Federal-Mogul seller, Icahn Enterprises, received nearly 6 million shares of Class A voting stock and nearly 24 million of Class B nonvoting shares. Management guides to a net debt/adjusted EBITDA ratio of 3.0 times post-closing, a little high for our taste in a cyclical, capital-intense business. However, the company believes this ratio will decline to roughly 2.5 times with EBITDA growth and debt reduction from free cash flow by the end of 2019. While 2.5 times is better, we would prefer to see 2.0 times or less, especially for the subsequently separated powertrain group, which we expect to be slightly more exposed to cyclicality than the aftermarket group.