Description

M&A arb idea: Apollo take-private of Tenneco offering a 14.1% spread to cash offer of $20/share.  The deal continues to move forward for shareholder and regulatory approvals and is expected to close sometime in "mid-2022" based on investor communications and filings.  Assuming a closing date of 9/30/22 (the midpoint between today and the outside date in the merger agreement), the market is offering a 48.5% annualized return without using leverage. 

Deal summary: 

Despite its steady growth and size, Tenneco’s stock underperformed compared to its peers over the last five years primarily driven by a misguided transformational acquisition, expense management issues and excessive leverage. As a result, Tenneco’s share price lost >85% of its value from peak trading in 2017. The public equity market began to view Tenneco as a solely-focused internal combustion engine (“ICE”) supplier susceptible to disruption from battery electric vehicles (“BEVs”), losing sight of the fact that significantly less of its revenues (in reality ~30-40%) were exposed to potential changes driven by BEVs.

To improve capital allocation and performance, the Management team explored divesting parts of the business in 2H 2019. After failing agree on price to sell parts of the business and to re-organize the Company in 2H 2019 (including Apollo as a bidder), Tenneco’s stock declined from ~$30/share to a low of <$3/share in the depths of the COVID crisis of 1H 2020, losing >90% of its value from peak trading. Apollo reinitiated a bidding process in 2H 2021 and after multiple offers, the Board approved the take-private proposal in 4Q 2021.

The agreed-upon all-cash consideration expected to be paid to Tenneco shareholders at close is ~$7bn, including leverage. The purchase price of $20/share represents a ~100% premium from the undisrupted share price of $9.98 on February 22nd, a 71.6% premium over the Company's unaffected 90-day VWAP, or  ~30% of the peak price of $67/share.

Closing conditions:

Apollo and Tenneco have communicated a mid-year 2022 closing date.  The outside date in the merger agreement is December 31, 2022. Lazard issued a fairness opinion to the Board on February 22, and a definitive proxy was filed on April 26. A shareholder vote is scheduled for June 7 and is expected to be approved. Regulatory approvals are on track including China's most recent approval on June 1.

• Shareholder approval: With ~83mm shares oustanding, it is anticipated that TEN shareholders will follow the Board's recommendation in the proxy and vote for the deal.  28% of the shares are controlled by Vanguard, Fuller & Thaler, Pentwater (arb fund) and Blackrock.  The rest of the shareholding is unconcentrated.  Public challenges to the deal have been limited aside from standard ambulance chasing corporate shakedown lawsuits by de minimus minority shareholders suggesting shareholders like the deal.  The valuation for the deal is fair based on comps (see more below) and represents a significant premium to the recent years trading prices.
• Litigation: Per a June 1 amended proxy filing, a total of 10 complaints have been filed in State or Federal courts seeking to enjoin the merger until certain proxy statement discloure is made.  As mentioned before, these are typical securities law complaints really looking for out of court settlements to benefit the plaintiff attorneys.
• Antitrust: Tenneco has leading market positions (#1,2 or 3) across almost every product it sells, however, antitrust is not expected to be an issue.  Apollo does not have any direct holdings in the automotive parts space where Tenneco supplies to OEMs.  Their 2021 investment in ABC Technologies could draw some scrutiny from regulators but given its focus on plastics for automotive-related uses, the practical overlap is limited.  The U.S. and Canada, two of the most likely juridstictions to raise anticompetitive concerns, have already signed off on the deal as well as China.
• Foreign Direct Investment: Spain and Australia need to sign off on the deal regarding FDI.  Tenneco is already a foreign actor in these countries so replacing management with Apollo is not expected to be an issue.
• Other regulatory approvals: Remaining regulatory approvals for the deal are in the EU, Japan and Mexico.  A key item to consider is that Apollo has negotiated a unilateral right to carve out the required Russian and Ukraine approvals from the deal's closing conditions.  Obviously this can be used as an out by Apollo, but they would be subject to a reverse termination fee.
• Compliance with merger covenants, reps and warranties and material adverse effect clause

Termination conditions:

The merger may be terminated under the following conditions set forth below. Apollo will owe a $108 million reverse termination fee if it is deemed to inhibit the deal from closing, and Tenneco would owe Apollo a $54 million termination fee in the opposite.

• Mutual written consent of both parties prior to closing/outside date
• By Apollo or Tenneco if shareholder approval is not obtained on June 7 or if cosummation of the merger is in violation of law or injunction by regulators
• By Tenneco if merger is not completed by December 31, 2022 (outside date), a new, superior proposal to Apollo's is authorized by the Board prior to June 7, or there is a breach of contract or failure to close by Apollo prior to the closing/outside date.
• By Apollo if Tenneco breaches contract or fails to close by outside date or Tenneco effects a board recommendation for an alternative acquisition by a third-party.

Risks:

Based on actions and investor communication from Tenneco management, these appear to be low probability events.  The market appears to be overweighting some of these likely giving rise to the opportunity.

• Deteriorating economic conditions force Apollo to walk away from deal.
  • Light vehicle production in the U.S. is continuing to soften as a result of the chip shortage and other supply-side factors limiting production.
  • 2022E IHS projections are trending to 80-81 million and are still well above the 77 million units included in the base case projections in proxy filing.  
• Rising interest rates force Apollo to reconsider deal's economic value proposition.
  • When Apollo underwrote the deal in 1Q 2022, the consensus interest rate hike forecast was 7-8 25bp hikes (~200bps).
  • Based on the base case management projections and the ~$5 billion of debt in the transaction, assuming an additional 200bps of rate hikes (i.e. the Fed hikes rates 16 times), there would be roughly 70-80bps of IRR impact to Apollo's returns.
• Apollo or Tenneco walks away from the deal on valuation.
  • According to the proxy, on average acquirers paid ~7.3x EV/LTM EBITDA for similar target companies to Tenneco historically.
  • Apollo agreed to pay only ~5.6x 2021 EBITDA ($7.1bn EV/$1.3bn 2021 EBITDA) for Tenneco; Apollo likely views this as a good deal.
  • Tenneco is in an out-of-favor sector hamstrung by idiosyncratic operating issues; they are already transacting with the winner of an auction process most likely to pay a market price for an asset of this nature.
  • Finding another buyer at this point in the process (already nearly 3 years in) seems unlikely and not an efficient path for the Board to pursue. 

Downside analysis: In the event the deal did break, TEN shares would likely trade down to at least the pre-merger price of ~$10 per share, which is a 42% decline (or 127% on an annualized basis assuming a 9/30 close).  With ~$2bn of floating rate debt due in 2023 and rates rising, and the market's ~15% deterioration since then, it is not unreasonable to be even lower, perhaps in the $7-8 range.

Business summary:

Tenneco designs, manufactures, markets, and distributes products and services for light vehicle, commercial truck, off-highway, industrial, motorsport, and aftermarket customers. The Company’s business is broken out into two-core segments: New Tenneco, which focuses on manufacturing auto components that are required by ICE vehicles, and DRiV, which focuses on OE and aftermarket parts. Within the two segments, there are four divisions. New Tenneco: Clean Air, Powertrain DRiV: Motorparts and Performance Solutions.

New Tenneco (56% of 2022E Revenue)

• Clean Air (27% of Revenue) – Manufactures parts for regulation and management of emissions, heat and noise associated with ICE vehicles. Products focus on emission controls, thermal management, and acoustic performance.
• Powertrain (29%) - Includes key building blocks of ICE. Products include pistons, piston rings, cylinder liners, valve seats, guides, bearings, spark plugs, valvetrain products, seals and gaskets and others.

DRiV (44% of 2022E Revenue)

• Motorparts (22%) – Aftermarket business that designs, manufactures and distributes a broad portfolio of products to channels outside of the car manufacturers (e.g., wholesale distributors, “Big 4” auto parts retailers). Products include shocks & struts, steering & suspension, braking, sealing, emissions control, engine & maintenance products.
• Performance Solutions (22%) – Offers noise, vibration and harshness performance materials, advanced suspension technologies and braking systems. Products include shock absorbers, struts, NVH performance materials and brake friction to OEMs

Other valuation support:

 

Catalyst

Satisfactory completion of closing conditions for the proposed take-private of Tenneco by Apollo.