Description

Horizon Global (HZN) - a market-leading manufacturer of automotive accessories including towing, trailer, and cargo management products – is an orphaned, small cap spin-off trading well below intrinsic value. Thanks in part to indiscriminate forced-selling from legacy holders of its parent company Trimas (TRS), HZN trades at a double-digit FCFE yield (at the midpoint of management’s FY15 guidance), with the potential to more than triple FCF by 2018 in our base case.

This upside will be achieved mostly through straight-forward supply chain optimization and through very strong cash flows allowing HZN to rapidly pay down the debt that they were spun-out with. This debt pay down will bring net debt/TTM EBITDA from 3.6x to 0.6x by 2017 in our base case, or alternatively to management’s 2x target, resulting in available cash to return to shareholders or do accretive M&A, creating a potential 4-bagger for equity holders.

We believe the earnings power potential of this business (once its cost-cutting initiatives are complete) is for EBIT margins in excess of 10%, which is more in-line with peers (and more than double HZN’s 4.6% 2014 EBIT margins excl. special items). We model EBIT margins of 9.3% by 2018 in our base case. Further, HZN’s sizeable aftermarket/replacement and retail businesses help to insulate them from the full vicissitudes of Recreational Vehicle (“RV”) and Truck/SUV production cycles. Numerous low-hanging fruit cost cutting opportunities before HZN will make their go-forward trough margins higher, and further insulate them against any potential cyclical headwinds in their end-markets. Finally, we believe HZN is incorrectly perceived by the investment community as a business akin to that of an auto OEM parts supplier. HZN, however, has large retail and aftermarket businesses that comprise ~2/3 of its sales and operating profit. This combined with its overall lower capital intensity allows it to convert EBITDA to FCF at ~4x the rate of their OEM supplier peers.

Our base case has HZN generating $2.84 in FCF per share in 2018. Applying a conservative multiple of 12x to that, HZN would trade for $34, nearly 4x its current share price. This equates to an 80%+ IRR (See “Valuation Section” below).

Summary Business Overview: Strong Brands, Loyal Customers, Leading Market Share

HZN is a market-leading manufacturer of automotive accessories including towing, trailer, and cargo management products, which they sell through multiple channels (1/3 OEM or OES ie. through the new vehicle dealer, 1/3 Aftermarket, and 1/3 Retail & ecommerce - with their strongest position vis a vis competition enjoyed within retail/ecommerce channel and with certain Aftermarket customers). They are a clear top-2 player in the ~$2 billion market for towing and trailer accessories, with ~25% market share. Their chief competitor, Curt Manufacturing, also has ~25% market share. HZN’s market share has expanded over time due to international acquisitions. HZN’s key brands (Reese®, Draw-tite®) have been around for over 60+ years, and are well-recognized by customers. Industry professionals we spoke with said Draw-tite® is such a ubiquitous and strong brand in the towing space that customers routinely call trailer hitches a Draw-tite® much like many people are apt to call tissue a Kleenex®.

They are a #3 player behind Thule and Yakima in their much smaller cargo management business (including vehicle mounted bike carriers as an example). HZN’s end-markets are GDP growers, with the potential for slightly higher growth via higher international expansion, as wealth and therefore RV and truck ownership rates grow in these markets, and due to favorable demographic trends in North America. Management thinks the business can grow 3-5%. (See “Detailed Business overview: HZN has strong brands and global multi-channel distribution” section below for a more complete business and industry overview).

Why this opportunity exists: The spin-off and other value dynamics

Spin Background

HZN’s parent company, the industrial mini-conglomerate Trimas (TRS) became subject to an activist campaign led by Engaged Capital, whose stake in TRS was announced in Nov. 2014. The HZN spin was announced in December 2014. In Feb. 2015, Engaged Capital was awarded one board appointee to TRS, with the potential for one more in 2016.  

Regarding the spin rationale, HZN’s organizational structure within Trimas was sub-optimal; there were no benefits from having these two businesses together. HZN, while the lower margin and lower growth business when compared to parent co, was also the “cash cow” within their parent.  In the old structure, HZN’s FCF would get diverted to TRS growth projects, preventing them from making more tuck-in deals or necessary investments in their business. Finally, TRS wanted to shed more light on, and lend greater flexibility to, HZN’s growth and margin improvement strategies largely underway but not yet evident in their operating results.

On July 1st, the spin-off was consummated and HZN closed its first day of regular-way trading at $13.75. In the subsequent trading sessions, HZN’s stock price came under extreme selling pressure due to its relative size and perceived business quality. As we studied the HZN spin, we saw an intriguing and classic combination of spin-off attributes and idiosyncratic value dynamics that together have created a unique and compelling investment opportunity.

The classic spin-off dynamics that we see in HZN include:

• Indiscriminate selling from TRS shareholders: On July 1st, TRS market cap was ~4.5x that of HZN, making many TRS investors deem HZN too small to bother with. In most cases, it was likely outside of their investment mandate, particularly as HZN’s market cap fell below $200mm, a key threshold for many small-cap funds. With 100% of HZN’s share count having traded hands as of 11/17, the forced selling is now complete. As small and micro-cap value investors begin to gain awareness of the HZN story, this orphaned stock will get to trade unencumbered from any overhang of legacy Trimas holders yet to sell.  

• Spin-co management team had a financial incentive for a lower stock price in the short-term: We believe management had an incentive to undersell the HZN story prior to August 14th, as the number of LTIP shares they were to be awarded was determined using the dollar amount of TRS stock they held divided by the average price of HZN between July 1st – August 14th (i.e. the lower the share price, the more HZN shares they would own). While this time period is now past us, it is relevant in understanding how HZN may have missed its first chance to gain a strong institutional following.

• Equitized, incentivized, and energized management team: In the medium and long-term, gaining independence through a spin-off and issuing direct equity incentives are powerful motivational tools for multiple layers of management. We see CEO Mark Zeffiro and CFO David Rice as a strong leadership team with the right vision for the future.

• Organizational structure revamped: As part of TRS, the HZN business lines were organized sub-optimally by channel (“Retail” and “Performance Products”, i.e. essentially every other channel). Now untethered from their parent company, HZN can optimize their organizational structure to better drive performance.  

• Logical acquisition candidate: We see multiple strategic buyers, both public and private, that would likely have significant interest in a deal for all or part of HZN.

• Niche business with limited sell-side coverage: Sell-side coverage is currently limited to three small shops (Barrington, Roth, and Seaport). HZN’s only true direct peer is private. The overall RV and Truck/SUV accessory niche is very under-followed. For example, Drew Industries (DW), which is peripherally related to HZN, in that it supplies components for RVs, has a market cap nearly 10x that of HZN and still only has research coverage from four small brokers.

In addition to the classic spin-off dynamics outlined above, there are idiosyncratic elements that have exacerbated HZN’s orphan status (we’ll elaborate on each in sections further below):

• Recent financial performance is misleading: Both full-year 2014 and Q215 (HZN’s first reported quarter out of the gate) were depressed by non-recurring factors including the temporary share losses noted below. Analysts are extrapolating forecasts off of these artificially low earnings. Further, as part of the spin HZN was saddled with debt that temporarily weighs on return on capital metrics.

• Headline EPS is misleading: HZN’s cash flow per share greatly exceeds its GAAP Earnings per Share, due mostly to non-cash amortization and to GAAP depreciation that far exceeds the ongoing maintenance capital needs of the business. HZN’s maintenance capex is $5mm (capex in recent years has been higher, $17-23mm in both 2012 and 2013, due to a plant realignment, chiefly moving some capacity to Mexico). D&A runs closer to $19mm, $8mm of which is amortization of intangible assets. Consequently, the $0.975 midpoint of management’s 2015 EPS guidance equates to $1.65 in Cash EPS (Net Income plus D&A less maintenance capex), a 69% increase. When we adjust the midpoint of 2015 guidance to include a full-year of GAAP interest expense, adjust for special items, and apply the 25% cash tax rate to the resulting Pre-tax Income, that would be 2015 EPS of $0.54, and $1.42 in cash EPS, a 161% increase.

• Recent share losses that were an outgrowth of HZN’s supply chain disruption may reverse: HZN’s plant/supply chain relocations resulted in the loss of high margin, fully priced peak season Installer sales. Our research in the channel suggests that HZN has strong brands and loyal customers and it should win back share. We estimate that direct aftermarket sales to installers are ~10% of HZN’s overall sales.

• Substantial cost-cutting opportunity: With proper incentives in place and HZN’s results no longer a rounding error within a much larger company, management is attacking costs and catching up to the competition in terms of cost-effective sourcing and logistics. We believe that, with conservative calculations, the potential size of the costs to be taken out over the next three years equates to a 13%[1] free-cash-flow yield without even considering the free-cash-flow of the business as it currently exists. This assumes that $6mm of management’s ~$33mm targeted savings should already be reflected in 2015 results.

Detailed Business overview: HZN has strong brands and global multi-channel distribution

Competition

Horizon’s chief competitor in towing and trailering is a privately-held company, Curt Manufacturing. In March 2014, Curt was purchased by the private equity firm Audax Group.

Our research suggests that together Curt and Horizon comprise about 50% of their total addressable markets, and are roughly equal size. The other 50% of the towing and trailer market is highly-fragmented. Other noteworthy brands include Blue Ox, B&W Hitches, Demco, and Hopkins. None of the companies that own these brands are publically-traded, making a pure comp to HZN impossible.

Chart 1: Horizon’s Key Competitors

Brands and Key Products

HZN, more so than Curt, has a portfolio of nationally and well-recognized brands, some of which are more than 60-years old. HZN’s most notable brands include: Tekonsha® (founded in 1964), Reese® (1952), Hayman Reese, and Draw-Tite® (1946). Their Bulldog® brand dates back to 1920.

Chart 2: Horizon’s Key Brands and Products

Horizon also owns some IP associated with some of these brands, which they have successfully defended via litigation in recent years.

Sales Channels and Key Customers

Horizon sells their products through multiple channels, where sales are evenly-split between: OEM/OES, Retail/e-commerce, and Aftermarket:

Chart 3: Horizon’s Sales Channels

The difference between OEM and OES is that OEM sales are products actually designed into an OEM platform – i.e. a brake controller or towing accessory is part of the design of the Ford F-150. OEM sales depend on platform design wins, the number of automobiles on said platforms that HZN products are on, and take rates for the given product/accessory. The majority of HZN’s OEM sales are in international markets.

Source: Trimas December 2014 Investor Presentation.

OES refers to installations that occur after the point of sale, and are essentially customized add-ons requested by the customer as part of their purchase. For example, a customer buys a new RV from a dealer, and as part of that purchase pays $1,000 to have a series of towing accessories added to their vehicle.

Based on Cequent (i.e. HZN as part of TRS) disclosures within Trimas filings, we estimate OEM and OES are about equal-size sales-wise (so each about ~17% of company-wide sales).

Aftermarket can be split into three sub-categories: RV Distributors (LKQ: Keystone & Stagg), Automotive Distributors (LKQ: Keystone), and Installers. HZN also enjoys a strategic partnership with U-Haul in the Aftermarket.

Finally, is Retail/Ecommerce (Autozone, West Marine, eTrailer.com, Amazon, Walmart).

Relative to Curt, Cequent/HZN has long had a better foothold with the retailers (like AutoZone for example). Curt – given their more efficient, just-in-time operational success in recent years has captured more of e-commerce business on sites like etrailer.com. But according to Horizon management, e-commerce is HZN’s fastest-growing and most profitable segment (as it essentially allows them to cut out the middle man, and they are able to maintain price in this channel too).

HZN’s omni-channel distribution (selling to distributors and direct to installer, dealer, OE, mass market retail, and ecommerce-only customers) can result in channel conflicts, which is a risk we are not quick to dismiss. This issue is one we have done considerable diligence on, and are comfortable that HZN is managing effectively. Long-term we think HZN’s traditional aftermarket customers will have to evolve and continually enhance and justify their value proposition to maintain their place in the supply chain. And long-term for HZN, we think the transition to more direct-to-consumer sales will be a slowly-evolving one, and ultimately a net positive, as it will mean cutting out a middleman and preserving more margin.

To gauge the strength of HZN’s online presence  we analyzed SKUs on web properties like eTrailer.com and streetsideauto.com (owned by LKQ Keystone Automotive),  which showed that HZN claims 40-75% of the SKU count within all their major product categories, well in excess of their market share in towing and trailering products (~25%).

Chart 4: HZN Brand and SKU representation on eTrailer.com

So as the ecommerce channel grows to be a larger part of HZN’s business, it should create favorable mix benefits.

Among HZN’s three primary selling channels, there is no significant difference in EBIT margins (except the aforementioned slightly higher margins enjoyed on ecommerce), according to management. OEM/OES carries lower Gross Margins, but requires less SG&A to support the same level of sales in the other channels. Aftermarket has higher gross margins, but also higher SG&A. And Retail sits somewhere in between.

Chart 5: HZN’s Key Customers

No customer for HZN represents more than 10% of overall sales.

Favorable Business Tailwinds

Demand for HZN’s products are ultimately a function of RV and truck/SUV demand.

Regarding RV demand, demographic trends are supportive, with the key RV demographic of consumers aged 55-70 is growing ~3% per year.

Second, the trend towards a more active outdoor lifestyle is a tailwind for the towing, trailer, and cargo markets. Recreational Off-Road Vehicles that are towed to the destination, mountain bikes that use HZN gear to attach to the back of a vehicle, and “tail-gating” for live events using an RV are all manifestations of the trend.

Third, North American SUV/truck sales have gained share of overall production volumes in recent years, owing to low gas prices. This will mean a greater “installed base” of truck/cars on the road potentially in need of aftermarket towing and trailering parts and accessories.

Finally, as wealth in emerging markets grow, recreational vehicle and SUV consumption rates rise. HZN is positioned well to capture this international growth.

Management believes their end markets can grow slightly greater than GDP, or 3-5%, on account of the above favorable trends.

Falling LME Prices to Provide Gross Margin Boost

Recent large declines in the commodity prices of key raw material inputs for HZN suggest a likely margin benefit in the coming quarters. LME steel, copper, and aluminum prices (key raw material inputs for HZN) are dramatically lower in recent months. The degree to which HZN has to pass-through these lower raw material costs to their customers varies by channel (for example, OE has a quicker pass-through mechanism then Aftermarket), but some benefit should be retained. HZN is naturally reticent to talk about this trend and thereby invite customer pushback.

Idiosyncratic Factors Create Opportunity  

Previously, we outlined a set of idiosyncratic dynamics that obscure HZN’s true earnings potential. Below we discuss each of these dynamics in more detail.

Recent financial performance is misleading

• As we will elaborate on below (see “Market share may mean-revert in HZN’s favor once their supply chain normalizes” section), 2014 was an anomalous year operationally for HZN as they reformatted and improved their supply chain. HZN posted 4.6% Adj. EBIT margins including a corporate overhead allocation - versus the 7.5%+ Adj. EBIT margin including corp. overhead allocation it was achieving during 2010-12, prior to their 2013-14 transition from their Goshen, Indiana facility (ultimately shuttered Q4 2013) to  their plant in Reynosa, Mexico. This transition continued to adversely impact results in 2014, as the new facility struggled with inefficiencies associated with ramping-up production. HZN invested $50mm into this plant transformation.

• Gross Margin gains experienced thus far in 2015 have been masked by $3.5mm of non-recurring charges associated with ‘Consolidation of Americas’ (see below), $3.9mm in FX headwinds, and some negative operating leverage. HZN’s first reported quarter as a standalone public company (Q215) was not pretty. Revenues dropped 11% compared to the prior year. However, 3.9% was due to currency translation, with the remainder of the weakness largely explained by two factors:

• First (and we believe most impactful), management eliminated a discounted pre-buy program in the aftermarket channel, which made for a difficult volume comparison. We see this as a sign of good medium-term profit maximization, and it may have also conveniently helped to provide a lower share price to the personal benefit of HZN management.

• Second, a major aftermarket customer (LKQ) reduced inventory in conjunction with a warehouse consolidation. We do recognize the risk that this decline in aftermarket sales could be a sign of burgeoning channel conflict issues, as HZN’s ecommerce channel grows in size and importance. We take comfort that no customer is more than 10% of HZN’s sales, and that the long-term shift to more direct-to-consumer sales is a margin positive development for HZN. Near-term, it is a contained risk, but one that we are closely monitoring in the channel. In the most recent quarter, reported on November 10th, sales were up 2.6% on a constant currency basis year-over-year, which is just below management’s targeted range of 3-5%, and supportive of the assertion that the factors impacting sales in the previous quarter were more transitory in nature.

• Reported results in the most recent quarter (Q315), -2.9% y/y sales decline and 2.6% y/y sales growth on constant currency basis, reflect currency translation headwinds of about 550 basis points, which will improve meaningfully by March 2016.

Market share may mean-revert in HZN’s favor once their supply chain normalizes

• It may be helpful to review the recent changes to HZN’s production and distribution footprint. Across 2013-14, HZN invested over $50 million in cash for restructuring or other initiatives and capital expenditures, primarily as follows:

• Closed and moved production from their former Goshen, Indiana manufacturing facility to a new lower-cost facility in Reynosa in 2013, relocating approximately 420 positions;

• Relocated the supply chain from the Midwestern United States to localized supply near Reynosa;

• As a result of the Goshen manufacturing move, relocated the main U.S. distribution facility from Huntington, Indiana to Dallas, Texas;

• Consolidated two former Australian facilities in into one newer one, and;

• Consolidated two former facilities in Brazil into one facility.

• More recently announced plans to close its manufacturing facility in Juarez, Mexico and its distribution warehouse in El Paso, Texas. Manufacturing from these locations will be moved to existing facilities in Reynosa.

• Such moves naturally cause temporary ripples, both big and small, through a supply chain like HZN’s – impacting things like order-fill rates, product availability, freight costs, etc.

Chart 6: HZN’s supply chain improvements over last 5 years