|Shares Out. (in M):||21||P/E||6.8||0|
|Market Cap (in $M):||459||P/FCF||0||0|
|Net Debt (in $M):||361||EBIT||0||0|
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Tower International Inc. (TOWR) is an auto supplier with a hard catalyst for ~150% upside by the end of this year. The biggest risk to TOWR is a downturn in the auto cycle. While I make the case in this write-up that there’s little chance of the auto cycle turning down this year based on historic cycles, an external shock (a 9/11 or Leman Brothers event) can kill the cycle, sending TOWR down 50%. Therefore, I recommend 1) shorting Magna International (MGA) against a long TOWR position, or 2) shorting a basket of auto suppliers against TOWR, to hedge the “earthquake” risk while remaining fully exposed to the company specific upside in TOWR.
A “Conspiracy Theory” Investment
Some years ago, I met an analyst from Greenlight Capital at an investor meeting. On the walk back to our offices, we talked stocks and he told me about an investment he referred to as a “conspiracy theory.” Joel Greenblatt wrote about such an investment in a John Malone-related security in his first book, without using this term.
A conspiracy theory investment is one where management has created a situation to enrich themselves, and an analyst, studying public filings, can piece together the conspiracy and profit alongside management. The most common types of conspiracies used to occur in spinoffs. Some management teams would low-ball guidance, exaggerate dis-synergies, not even go on roadshows and have their options struck 1-2 months after the spin, hoping the stock would go as low as possible as forced selling met ignorant (by design) investors. With spinoffs no longer an undiscovered land, one must look elsewhere for conspiracies.
In researching TOWR, the conspiracy theory “aha moment” comes when reading the CEO’s employment agreement which was amended in 2014. Mark Malcolm will retire on December 31, 2016 and is heavily incentivized to sell the company by that date. His stock appreciation incentive award pays him $5 million if Tower’s share price closes at $40.59 (89% higher) on the earlier of his retirement date or a change in control. In addition, he’ll receive an extra $1 million for each $1.00 above $40.59, up to $55.59. If he sells the company for $55.59 (159% higher), he’ll earn $20 million on this award, and walks away with $78 million in total value (all bonuses plus the value of his full vested shares and options).
TOWR first disclosed Malcolm’s amended employment agreement in a July 2014 8-K, and then expanded upon it in its 2014 and 2015 Proxy Statements. A-year-and-a-half after the conspiracy was first disclosed, the sell-side and much of the buy-side seem ignorant or uninterested in what is plainly about to happen at TOWR.
The green shoots of the unfolding conspiracy have already sprouted, as Malcolm has begun selling the company off in pieces. So far, two Chinese JVs and one Brazilian plant have been sold. Moreover, in November 2015 J.P. Morgan Securities was hired to explore a sale of the European operations, and multiple strategic buyers have been invited into the next phase of the bidding process. Management stated it will make a go/no go decision on selling Tower Europe by the end of March 2016, depending on the valuation it receives.
A SOTP value of $55.59 per share – where Malcolm maximizes his total value -- is very realistic in a piecemeal sale of TOWR as it equates to 7.3x LTM EBITDA at December 2016, and two recent auto supplier transactions took place at 7.6x and 8.8x.
Tower International is an automotive metalforming supplier, manufacturing engineered structural metal components and assemblies for automobile manufacturers (OEMs). Its revenues are split: 59% Body Structures -- which are components of the “exterior skin” of the vehicle -- 16% Chassis Structures -- which make up the inner “skeleton” of the vehicle -- and 25% Complex Assemblies -- where multiple components and sub-assemblies are welded together to form major portions of the vehicle’s body structure.
Watching the last 2 minutes of the following video (from 7:40 mins to the end) will give you a good idea of what TOWR’s assets produce and why the company is important to the auto industry:
Tower’s largest customers are Ford (22% of revenues), VW (15%), Chrysler (14%), Volvo (9%), Nissan (8%), Fiat (7%), Daimler (6%) and Toyota (5%). The company supplies products to 170 vehicle models globally.
Despite VW representing 15% of Tower’s revenues, the VW models named in last year’s emissions scandal -- the Jetta, Passat, Beetle, A3 and Golf -- collectively make up just 1% of Tower’s revenues, and only a portion of this 1% are diesel engine cars, where the scandal is focused. In addition, TOWR has no European exposure to Renault SA, whose offices and production sites were raided on January 14, 2016 by French anti-fraud detectives in a probe into emissions claims (like VW last year). TOWR has some exposure to Renault in Brazil, which is immaterial in the aggregate.
Table 1 details the top seven global metalforming competitors, and Table 2 shows Tower’s geographic mix of revenues and EBITDA. Note that the global metalforming industry also includes regional competitors who don’t appear in Table 1.
Table 1: Top Seven Global Metalforming Competitors
Table 2: Tower International, Geographic Revenue & EBITDA Mix
Tower’s predecessor (Tower Automotive) filed Chapter 11 bankruptcy protection in 2005. Cerberus Capital Management bought up its bonds, took control of the company in 2007 and brought in Mark Malcolm as CEO and James Gouin as CFO. Both Malcolm and Gouin are industry veterans who each spent 28 years in finance positions at Ford Motor Company (Tower’s largest customer). Tower shares began trading again in October 2010 after an IPO at $13. Cerberus completely exited its position in 2013, but retains a partner on Tower’s board.
Having executed an impressive turnaround -- and with the private equity firm who brought him in now gone -- it appears Mark Malcolm’s (61 years old) final move, in a consolidating industry, will be to place the various pieces of TOWR into the hands of the highest bidders.
Key Investment Points
1. A best-in-class company in a favorable niche of auto parts
In just 8 years, Tower’s management transformed a bankrupt company into the industry’s gold standard by making product quality a key focus. Defects per million parts were reduced by 88% to an industry-best 11 (0.001% defect rate); less-than-40 is considered world-class.
2014 2010 2006
Defects per million parts 11 39 91
Management also made operational efficiency a priority, committing to Lean Six Sigma principles and employing 116 certified black belts. Excellence in customer service was also a priority as TOWR opened a 24-hour engineering support center in India.
The above not only contributed to Tower being 1 of 4 companies which tied for first place in Forbes’ 2015 list of the “Most Trustworthy Companies” (out of 5,500 North American public companies), but also to the company winning three new contracts in the last 18 months which will boost 2015 EBITDA by 22% to over the next 4 years.
While auto suppliers are not great businesses due to the cyclical nature of auto production and the leverage OEM’s have over suppliers -- requiring annual price concessions from suppliers -- Tower’s metalforming niche is a less competitive space. Contract bidding is generally disciplined and business is sticky. It’s hard to gain share, but it’s also difficult to lose share as long as customer requirements are being met.
One of Tower’s recent contract awards was a “conquest win” -- an account taken away from a competitor -- as that competitor wasn’t meeting customer expectations. While such wins are rare in the industry, this win underscores Tower’s competitive advantages. Tower’s other contract wins are newly outsourced business, which will continue to drive Tower’s growth going forward.
Worldwide, automotive metalforming work is split 60%/40% between OEM in-house and outsourced production. Tower’s management believes 10 p.p. of share moved from in-house to outsourced in the last 20 years, and expects another 10 p.p. to be outsourced in the next 10 years. The acceleration in outsourcing is being driven by the OEMs’ desire to focus on areas that differentiate the car and drive sales, and outsource capital-intensive metalforming work (few people buy a car for its amazing chassis structure).
Tower’s contracts come with 1-1.5% annual price reductions, but the company has been able to partially price for this, as competition is disciplined, and offset the remainder with efficiencies and cost savings. The “unsexiness” of the business actually works in Tower’s favor, as suppliers that manufacture electronics components with a steep cost curve can face 2-3% annual price reductions. In addition, TOWR doesn’t have to worry about the take-rate of its parts – as a sunroof supplier would – since you cannot sell a car without the parts TOWR manufactures.
Finally, Tower’s primary raw materials, steel and aluminum, are pass-through costs, insulating the company from commodity price movements and resulting in relatively stable margins, assuming constant auto production volumes.
2. A consolidating industry
I’ll let the companies themselves tell the story here…
From Tower’s 2014 10K (pg. 9): “The number of our competitors has decreased in recent years and we believe the number will continue to decline due to supplier consolidation. We believe that OEMs are increasingly focused on global capability and financial strength of their supply base and that such scrutiny of suppliers will result in additional consolidation of the supply base.”
From Martinrea’s 2014 Annual Information Form (pg. 11): “Consolidation among automotive suppliers has occurred, is continuing, and is likely to continue as OEMs have increasingly entered into long-term supply contracts with the most capable and financially viable suppliers.”
From Magna’s 2014 Annual Report (pg. 5): “As the trend towards consolidation continues, we expect our competitors will be larger and have greater access to financial and other resources than is currently the case.”
The above comments make it clear that the smaller, regional competitors will be share donors to, and acquisition targets of, the Top Seven global competitors. It’s also clear that the industry’s competitive position would improve if the Top Seven consolidated down to fewer players.
The price pressure OEMs place on suppliers stems from their own pricing pressures, rooted in a large, global glut of auto capacity.
From Ford’s 2014 10-K (pg. 29): “According to IHS Automotive, an automotive research firm, the estimated automotive industry global production capacity of light vehicles of about 116 million units exceeded global production by about 29 million units in 2014 [33% excess capacity]. In North America and Europe, two regions where a significant share of industry revenue is earned, excess capacity as a percent of production in 2014 was an estimated 7% and 30%, respectively. In China, the auto industry also witnessed excess capacity at 45% of production in 2014, as manufacturers competed to capitalize on China’s future market potential. According to production capacity data projected by IHS Automotive, global excess capacity conditions could continue for several years at an average of about 32 million units per year during the period from 2015 to 2019.”
To offset this bleak pricing outlook, OEMs are focusing on manufacturing efficiency and consolidating global platforms, whereby multiple vehicle models share a manufacturing platform. Below is Ford’s platform consolidation plan.
Table 3: Ford Motor Company, Global Platform Consolidation Plan
OEM platform consolidation should drive supplier consolidation as scale becomes increasingly important and regional competitors become further marginalized.
If the Top Seven were to consolidate down to a Big Three, the margin structure of the industry would improve as suppliers could push back on the annual price reductions they need to give OEMs, or simply charge more for their services. OEMs saw suppliers push back during the financial crisis, and had to concede, as it meant the difference between bankruptcy and solvency for some of their suppliers. With consolidation, the push back can occur from a position of strength rather than one of weakness.
3. Recent new business wins lock in industry-leading growth
Three recent new contract wins will generate $340 million in revenues and $50 million in EBITDA once fully rolled out by 2019. These contracts have a projected 14.7% EBITDA margin versus Tower’s 9.9% margin in 2014 (the higher the capital requirements of new business, the higher the EBITDA margin).
The company will have to invest $130 million in capex to take on this new business, but with projected EBITDA of $50 million, Tower’s EBITDA-return-on-capital is a healthy 38%.
Table 4: Tower International, Recent New Business Wins & Acquisition
As shown in Table 4, Tower’s new business wins lock in a 5.1% EBITDA CAGR out to 2019, assuming flat auto production. When adding in expected end market growth of 2.5%, Tower’s revenue growth is 1.7x - 3.5x faster than end market growth for the next 4 years. As I’ll discuss below, Magna recently paid 8.8x EBITDA (2 turns higher than its own valuation) for Getrag due to Getrag’s above-industry growth outlook. Potential buyers of Tower will consider Table 4 carefully in valuing the company.
4. Tower has an industry-lagging valuation
Management included the following slide in a recent investor presentation, showing Tower trading near the very bottom of 23 public auto suppliers and well below the group average and median. After the recent sell off, TOWR now trades at 4.3x LTM EBITDA vs. the 5.1x shown below.
Table 5: EV/EBITDA Valuation of Auto Parts Suppliers
Source: Tower International Inc., East Coast IDEAS Conference presentation, June 3, 2015.
Tower’s valuation would be fair if it were a declining business, but the opposite is true:
Table 6: Tower International 3-year Financial Data (excl. Discontinued China JVs)
Tower guided to lower revenues and EBITDA in 2015 vs. 2014 due to FX headwinds (as almost half its revenues are generated outside the U.S.) but, in constant currency, 2015 would have been another year of solid growth. And with three new contracts coming on that will add 22% to 2015 EBITDA by 2019 (all else equal) continued industry-leading growth is virtually guaranteed.
In February 2015, Tower announced plans to sell two of its Chinese JVs and on January 11, 2016 reported that those sales were completed for $48 million in after-tax proceeds (~10% of its market cap). Table 7 shows the declining results of those JVs:
Table 7: Tower International, Held-For-Sale China JVs: 3-year Financial Data
Tower received 6.3x LTM EBITDA for its JV stakes -- a substantial premium to its own valuation of 4.3x EBITDA. Selling underperforming segments at a premium is not only value accretive but further underscores Tower’s undervaluation. Also on January 11, 2016, TOWR announced it sold one of its two Brazilian operations for $9 million. This business had $30 million in revenues and generated a small EBITDA loss. In my view, TOWR is cleaning up the undesirable pieces of its portfolio prior to a sale of the whole company.
Two recent auto supplier transactions further highlight Tower’s undervaluation. In September 2014, ZF Friedrichshafen AG (“ZF”), a private Germany company, announced the buyout of TRW Automotive Holdings Corp. (formerly, NYSE: TRW) for 7.6x LTM EBITDA. While there’s very little product overlap between TRW and Tower, their recent growth rates and margins appear comparable. In 2014, TRW had 1% revenue growth (vs. 5% for Tower) and 6% Adjusted EBITDA growth (vs. 5% for Tower). TRW had a 10.5% EBITDA margin, vs. 9.9% for Tower.
In July 2015, Magna International -- Tower’s largest competitor -- announced it was buying privately held Getrag Group, one of the largest suppliers of transmissions, for 8.8x EBITDA. Interestingly, Magna paid two turns higher than its own valuation, which management justified based on Getrag’s faster growth.
On its Q2:15 earnings call, Magna’s management stated that there’s currently a lot of activity in the industry with respect to M&A. Although Tower recently announced the acquisition of a small ($40 million in sales) Mexican competitor, it would be kidding itself to think it could be a consolidator. With just $2 billion in revenues versus its largest competitor, Magna, at $36 billion in total sales, the Tower story has only one logical ending.
5. Tower’s final chapter: A “change in control”
Tower already tried to “create a Magna” out of itself (diversify into other businesses), and got burned on its first step. In 2011, the company bought W Industries, a troubled defense business, out of bankruptcy, and renamed it Tower Defense & Aerospace. The thinking was that Tower would add defense as another vertical, to counterbalance the cyclicality of the auto industry. Soon thereafter, defense spending dried up and Tower sold the business in June 2013 at a 60% loss.
From that point forward, the company took a different path. The board hired Meridian Compensation Partners LLC, and in July 2014 the company filed an 8-K detailing an amended employment agreement with CEO Mark Malcolm. That employment agreement was expanded upon in Tower’s 2014 and 2015 Proxy Statements, in which the term “change in control” appears 25 times. After getting burned as a buyer, it seems the board felt more value could be created as a seller.
The employment agreement sets December 31, 2016 as Mark Malcolm’s retirement date and heavily incentivizes him to achieve a higher stock price, either organically or via a sale of Tower. Table 8 summarizes Malcolm’s employment agreement. The Stock Appreciation Incentive Award (shown in points 3a and 3b) pays him $5 million if the stock price closes above $40.59 on the earlier of his retirement date or a change in control. He’ll also receive an incremental $1 million for every $1.00 above $40.59, up to a maximum of $55.59 (for risk management purposes, these things aren’t left open-ended). In addition, if he’s terminated within 2 years of a change in control without cause -- presumably by Tower’s buyer -- he receives severance equal to 3x his annual salary and target bonus: $5.8 million based on his 2014 compensation (point 5).
Malcolm earns the maximum payout if he sells the company for $55.59, or higher, and is terminated without cause within 2 years of the deal. Under this scenario, his cash bonuses and fully vested shares are worth $78.2 million.
$55.59 a share represents 7.3x LTM EBITDA in December 2016, which seems achievable given the three deals mentioned above: 1) 6.3x for Tower’s Chinese JVs (declining businesses), 2) 7.6x for TRW Automotive by ZF, and 3) 8.8x for Getrag by Magna.
Table 8: Tower International, CEO Employment Agreement
Mark Malcolm also has another option: he can find a new CEO and retire at the end of 2016. He’ll still get his $3 million retention bonus (point 1 in Table 8). He’ll also get a $3 million CEO Succession and Officer Transition award (point 2), which he won’t get if he sells the company. But he’ll leave a lot of money on the table as it’s unlikely TOWR would organically close above $40.59 on December 31, 2016; a valuation of 5.7x LTM EBITDA compared to its high-water-mark of 5.4x in July 2014. If the stock closes at $40, he still walks away with $41.5 million in total value, but leaves $36.7 million on the table compared to a change in control at $55.59 (see bottom of Table 8).
What will Mark Malcolm do?
“Incentives are the cornerstone of modern life. And understanding them – or, often, ferreting them out – is the key to solving just about any riddle…” -- Freakonomics, Steven Levitt & Stephen Dubner.
On the last slide of TOWR’s June 2015 IDEAS Conference investor presentation, the company stated:
“Tower management is clearly aligned with shareholders,” and…
“We are confident that the near-term and long-term fundamental value of Tower’s business will eventually be much better recognized and rewarded.”
Furthering the conspiracy theory…
1) In August 2015, Mark Malcolm joined the Board of Directors of General Dynamics, possibly indicating how he’ll keep busy in retirement.
2) In November 2015, TOWR announced it hired J.P. Morgan Securities to explore a sale of Tower Europe.
3) On December 21, 2015, TOWR filed an 8-K disclosing amendments to the employment agreements of two key executives:
- Par Malmhagen, President of Tower Europe, had his base salary and target bonus increased, and will be granted a retention bonus of EUR 643,500 if he remains with the company through December 31, 2017. In addition, if a change in control occurs prior to December 31, 2017 and Mr. Malmhagen is terminated within 2 years of the change in control, he’ll receive a severance bonus of 2x his base salary and 2x his target bonus (total value = EUR 1.3 million).
- James Bernard, President of Tower Americas, also had his base salary increased and will receive a retention bonus of $792,000 if he stays on until December 31, 2017.
In my (obviously biased) opinion, TOWR’s board does not want any key executive departures to disrupt the sale process.
4) On January 11, 2016, TOWR announced it sold two of its Chinese JV’s for after-tax proceeds of $48 million and one Brazilian operation for $9 million. It also reported that multiple strategic buyers were invited into the next phase of the Tower Europe bidding process.
6. My mosaic theory regarding what will happen next
Mark Malcolm retired from Ford at the age of 52, roughly 10 years ago. Cerberus then hired him to do diligence on auto companies, as they saw a lot of distress in the sector. In 2007, Cerberus took control of TOWR and Malcolm became CEO.
For both Cerberus and Malcolm, TOWR was a 5-year investment idea. In 2012, Cerberus completely exited its investment and Malcolm wanted to retire, but the board convinced him to stay on for another 2 years. Malcolm asked for more shares in TOWR and his request was granted.
In 2014, Malcolm wanted to retire again and the board once again requested he stay on for another 2 years. The board’s goal was to get intrinsic value for TOWR shareholders, and Malcolm asked to have his compensation directly aligned with achieving a higher stock price. This resulted in his amended employment agreement.
The fact that Malcolm asked for his current incentive compensation plan is a key insight. In combination with the fact that he’s been trying to retire for the last few years, it tells me the only way to make his overtime at TOWR worthwhile is by walking away with a winning lottery ticket.
TOWR was never able to get much of a multiple since its 2010 IPO -- the stock’s high water mark was 5.4x TTM EBITDA -- and it always traded near the low-end of the auto supplier group. In my view, TOWR is one of those stocks that, for whatever reason, can’t get proper value in the stock market and it will take a strategic or financial buyer to realize intrinsic value.
I want to emphasize that what follows is purely my own mosaic theory. I am not in possession of any material non-public information, my theory may be dead wrong, and it simply reflects my educated guess as to what’s going on behind the scenes at TOWR.
It’s my belief that once Malcolm had his incentive compensation plan in place, he began private discussion with potential buyers of the company. In my view, Magna is the most likely buyer of TOWR. However, Magna wanted only TOWR’s North American operations (the gem asset, which is substantially outgrowing its end market). Hence, you’re seeing Malcolm sell off the pieces that MGA doesn’t want (Chinese JVs, Brazil, Europe).
Several months ago, before my mosaic theory formed in my mind, I had a call with MGA’s CFO to learn more about their Cosma (metalforming) division, which competes with TOWR. MGA had publicly stated it was actively evaluating acquisitions, but the CFO refused to tell me if acquisitions in the metalforming space were of interest to MGA. Well, I got my answer a couple of months later when MGA announced an agreement to buy Stadco, a U.K.-based metalforming supplier with ~$350 million in revenues. MGA paid 5.5x EBITDA for Stadco.
Magna, through its Cosma division, is the #1 global metalforming supplier, as shown in Table 1. While Gestamp Automacion and Benteler Automotive are almost as large as Magna in metalforming revenues, the latter two companies are heavily weighted toward Europe while most of Magna’s metalforming revenues are in North America.
Together with Tower North America, Magna’s Cosma division would become an even more dominant #1, making it virtually impossible for any of the remaining competitors to challenge them, no matter how much future consolidation takes place. In other words, Tower North America has high strategic value for Magna.
Magna is the world’s third largest auto supplier and has the industry’s broadest product portfolio. The company takes a portfolio view of its businesses, acquiring assets that are growing faster than auto production and divesting of slower-growth, lower-return segments. In April 2015, MGA sold its interiors division, which is in a very competitive space. In the press release, CEO Don Walker stated, “This transaction is consistent with our strategy of refining our product portfolio to focus on certain key areas of the vehicle.” Given the Stadco acquisition in October 2015, we know metalforming is one of those key areas.
In July 2015, Magna announced the acquisition of Getrag Group -- one of the largest global suppliers of transmissions -- for 8.8x EBITDA. Magna paid two turns higher than its own valuation because of Getrag’s far-above-industry growth.
At the beginning of 2015, Magna had a leverage ratio of 0.2x and set a goal of getting to 1.0 - 1.5x via acquisitions and share buybacks. The Getrag deal got them to 1.2x, and on the Q2:15 call management stated they were interested in more acquisitions to get to 1.5x (they’ll go above 1.5x for a deal and then delever to 1.5x). In fact, they said Getrag took up all of their time and attention, and they are now free to focus on other deals in their pipeline.
Going from 1.2x to 1.5x leverage -- including the divestiture of the interiors business -- leaves Magna with $1.4 in debt capacity. In addition, Magna throws off $1 billion in FCF annually. At the $55.59 share price where Mark Malcolm achieves maximum value, Tower’s EV is $1.8 billion, making it easily digestible by Magna.
Coming back to TOWR, in a slide presentation that accompanied Tower’s press release discussing the potential sale of its European business, management gave 2015-2017 projections for Tower North America, as follows: 9% CAGR in revenues, 11% CAGR in EBITDA, and 50 bps of margin expansion over the 2-year period. Since North American auto production is projected to grow by 3% annually over this time frame, Tower North America – growing at 3x its end market -- is clearly the type of asset Magna wants to add to its portfolio. The fact that Tower North America will make Magna’s Cosma division an even more dominant #1, only adds to its appeal. In fact, just keeping Tower North America out of someone else’s hands, ensures Magna’s dominance in North America for many years to come.
So here’s my mosaic theory. I believe one of the private European competitors -- Gestamp or Benteler – will end up buying Tower Europe, and will pay around 6x EBITDA. Tower Europe ($70 million in EBITDA) is twice the size of Stadco ($35 million in EBITDA), which sold for 5.5x, and offers greater cost synergies to the big European players than Stadco did for Magna, who did not have a presence in the U.K.
Shortly thereafter, I believe Magna will come in and announce an acquisition of what’s left of TOWR, namely the gem North American operations.
On the call discussing the potential sale of Tower Europe, management talked about a target leverage ratio, post-sale, of 1.0x and the possibility of a large share buyback to get there. As shown in Table 13 at the end of this report, if TOWR gets 6x EBITDA for its European assets and sells its remaining Chinese and Brazilian assets for just 0.3x revenues, it will be left with a net cash position of $89 million. With 2016 projected EBITDA of $151 million in its North American operations, TOWR could buyback $240 million in stock -- representing 52% of its current market cap -- to achieve its target leverage ratio.
Management also talked about Tower North America’s potential to grow into the clear #2 player over time. In my (highly biased) opinion, this is simply what management needs to say at this point, since the end game for Tower North America has not been disclosed publicly.
I recently learned that TOWR is well underway in its search for a new CEO -- as Malcolm is retiring at the end of 2016 -- and the process is internal only. If the board was truly interested in divesting of the slower-growth assets to isolate Tower North America as a public company, wouldn’t it seek out the best talent possible from inside and outside the company?
The fact that only an internal CEO is being considered confirms my belief that the end game for TOWR all along was to achieve the highest value possible – and for Malcolm to walk away with tens of millions of dollars -- via a sale of the company, and we are watching this plan unfold step by step.
I believe the final two steps of the TOWR story will follow a similar playbook to a recent set of transactions in the hotel industry. In October 2015, Starwood Hotels (HOT) announced it is selling its Vistana division to Interval Leisure Group (IILG). Less than a month later, Marriot International (MAR) reported it is buying Starwood Hotels (HOT). Obviously, HOT and MAR had been in discussions, and MAR did not want HOT's Vistana unit. Once a buyer for Vistana was found, MAR moved quickly to acquire HOT.
I believe a sale of Tower Europe, followed by a sale of Tower North America (to Magna) could follow a similarly quick timeline.
1. The automotive industry is highly cyclical
It’s hard to find many good things to say about the automotive industry. New auto sales are highly cyclical, have little long-term growth in developed markets, represent a big-ticket purchase highly dependent on consumer confidence and, as stated above, the industry is plagued by excess capacity.
Table 9: U.S. Light Vehicle Sales (Car & Light Truck), 1976-2015
Table 9 shows the cyclical and mature nature of U.S. light vehicle sales. Having any exposure to this industry post a cyclical peak could be painful as the peak-to-trough annual sales declines in the last 3 downturns were: 31% (1978-1982), 23% (1986-1991) and 40% (2000-2009). As can be seen above, 2015 marked an all time high for U.S. car & light truck sales.
For Tower, North America (90% of which is the U.S.) represents 49% of revenues and 65% of EBITDA. Without the catalyst of Mark Malcolm’s retirement on December 31, 2016 and his incentives to maximize TOWR’s value by that date, I would have a lot less interest in this stock. As cheap as it is, being long TOWR is playing chicken with a cyclical downturn.
But there are several mitigating factors that make a cyclical downturn less likely by the end of 2016:
1) Each peak in U.S. auto sales exceeded the previous peak by a decent amount: 6% (1978 vs. 1973), 7% (1986 vs. 1978) and 8% (2000 vs. 1986). While 2015 was a record year, it exceeded the 2000 peak by only 0.21%. Since 2000 was a bubble, if we conservatively assume the next peak will be only 3% higher, there’s upside of 484,000 units, or 2.8% from 2015 unit sales, to the next top. If sales grow at 3% annually – in-line with IHS estimates – 2016 should mark the peak of this cycle. Fortunately, Mark Malcolm only has until the end of this year to write his own lottery ticket. Moreover, 2016 being the peak of this cycle doesn’t mean a downturn is imminent.
The auto industry prefers to look at monthly SAAR (Seasonally Adjusted Annual Rate) unit sales data. The chart below reveals that in the last two cycles, monthly SAAR sales jumped above 20 million units at least once before the cycle turned down, and this has not happened yet in the current cycle.
In addition, in the early-1980’s upturn, once SAAR reached 15 million units in 1985, it averaged around that number for the next 5 years before turning down. In the 1991 to 2000 upturn, once SAAR got to 17 million, it averaged around that number for the next 6 years before turning down.
TOWR’s CEO believes the inevitable downturn is a few years away, and while I typically dismiss CEO comments as perpetually optimistic, his view is actually in-line with historic trend. Given the record age of the U.S. car fleet (discussed below), which is creating unprecedented pent-up demand, it would not be surprising to see SAAR average 17.5 to 18 million units for the next few years before turning down.
Auto stocks took a big hit (within the backdrop of a declining market) after the December 2015 SAAR number came out, which fell way below the +18 million units it had been running at from September to November. However, the table below showing monthly SAAR sales (in millions) for the last 3 years illustrates that such monthly declines are common. I shaded the months where sales hit a temporary peak, then declined (sometimes substantially) and then proceeded to rise to a new peak. The last 3 years of this cycle has been characterized by higher highs and higher lows. The December 2015 decline doesn’t appear to be any different especially with gas prices continuing to fall, enhancing new car affordability. Overshadowed by the decline vs. November is the fact that December 2015 SAAR sales were up 2.5% yr/yr.
2) The average age of the U.S. car fleet hit a new record of 11.4 years according to a January 2015 review of U.S. car registrations by R.L. Polk. The average age has been edging higher for 11 consecutive years (it stood at 9.8 years in 2002). Americans are holding onto their cars longer for economic reasons since the Great Recession, and because cars are made to last longer. Analysts don’t believe the average age can go much higher and expect it to level out between 11-12 years. The U.S.’s aging fleet is creating pent-up demand that has not existed, to this extent, historically.
There are 253 million cars and trucks on the road in the U.S. The average age is a record 11.4 years. Annual new vehicle sales of 18 million means the replacement rate is just 7.1%. With such an old fleet and a modest replacement rate, there is just as strong an argument to be made that the auto cycle should keep rising for years to come. If new vehicle sales rose to 20 million over a couple of years – something no one is calling for – the replacement rate would jump to just 7.9% annually.
3) The next chart shows that not only is consumer sentiment strong, but that since 1983 whenever sentiment has rose to the 90 level after a recession, it has averaged around that level for another few years. Since the Great Recession, sentiment first recorded a number above 90 in January 2015, and has not fallen below 89.5 since.
Finally, in a CNBC interview on January 19, 2016, Macy’s CEO Terry Lundgren, who is not only a top-notch retailing CEO, but essentially an economist in his own right, said that while consumer spending at retailers has been weak, the consumer is spending in other categories such as autos, restaurants and lodging. He said: “So they’re spending money on other experiences. All I will tell you is I’ve seen this movie a few times before, and these are cyclical things that do happen and do occur, and the cycle that we’re in right now is probably going to last for a bit of time…”
4) Most post-WWII recessions in the U.S. were preceded by a succession of interest rate hikes by the Federal Reserve, as can be seen below. While the Fed raised rates by 25 bps in December, I believe the sharp sell off in equities will give the Fed pause. After all, the Fed stated future rate hikes will be data dependent, and the U.S. economy is simply not growing fast enough for accommodative monetary policy to be removed.
Table 10: U.S. Federal Funds Rate
In its latest revision (on July 30, 2015), the Bureau of Economic Analysis estimated that real GDP from 2011-2014 grew at 2.0% (down from its previous estimate of 2.3%). In the first 9 months of 2015 growth averaged 2.2%. It’s been observed historically that when monetary stimulus is removed, an economy’s growth rate gets cut in half. With the U.S. economy growing around 2%, continued hikes in interest rates would cut growth to around 1%, at which point an external shock could easily send the economy into recession. This is why, in my view, the Fed took so long to make its first hike and will not be able to do much more than another token hike or two (if that).
Historically low interest rates are allowing buyers to finance cars at attractive rates. In addition, longer loans -- such as 6, 7 and 8 year car loans, versus the traditional 5 year loan – are more common today, reducing the annual payments for borrowers. On a concerning note, subprime originations reached a 10-year high, although 90-day delinquencies have remained stable at around 3% compared to 5% five years ago.
5) Americans recently got a boon in the form of $2.00 per gallon gasoline. The chart below shows that the last time Americans got such a benefit (gasoline falling from $4.00 to $2.00), the price they had to pay was the Great Recession. The most recent decline seems to have been relatively cost-free, except to those working in the energy industry.
6) While U.S. vehicle sales recovered sharply from the ‘08/’09 crisis, Europe continued falling post-crisis and bottomed in 2013. Europe’s rebound now appears to be accelerating as registrations were up 9.3% in 2015 and 4.8% in 2014. Europe reports car registrations, as opposed to sales and production like the U.S.
There’s some debate over the strength of the rebound since registrations are not sales, and there’s been evidence of car dealers in Germany, France and the U.K. registering cars themselves to meet targets. IHS estimates European production volumes increased 2.5% in H1:15, while registrations were reported up 8.4%. How “Europe” is defined may account for a portion of this delta -- between IHS and the European Automobile Manufacturers Association -- but the disconnect seems too wide to be explained by this alone. Regardless, IHS expects European production to rise 2% this year. There is clearly a recovery, but not as strong a one as registrations might indicate.
Table 11: European New Passenger Car Registrations (1990-2015)
In the 10 years prior to the financial crisis (1998-2007), European car registrations averaged 14.6 million. With 13.2 million new registrations in 2015, Europe has upside of 1.4 million vehicles, or 11%, to get back to pre-crisis levels.
The European Central Bank, through low interest rates and QE, is providing a tailwind to the recovery. In addition, reports of accelerating car registrations making the evening news in Europe – December 2015 was supposedly up 16.6% -- could become a self-fulfilling prophecy as people feel they should keep up with the (possibly fictitious) trend.
The fact that the U.S. and Europe are near opposite ends of the auto cycle creates somewhat of a macro hedge, mitigating the risk to Tower’s EBITDA.
7) Tower’s recent new contract wins provide a further offset to any cyclical weakness in the U.S.
2. A capital-intensive business where growth and FCF are mutually exclusive
An old boss of mine once said: “I don’t like businesses that make computers or smartphones or cars; I like businesses that make money.” He wouldn’t like Tower because Tower makes auto parts, first and foremost. It is not primarily in the business of making money, although it makes some. Oracle Corporation, for example, with its 46% operating margin, is in the business of making money. As an aside, it sells software.
Oracle can grow and generate FCF. Tower can either grow or generate FCF, but it can’t do both at the same time. Growth requires capital investment and working capital. In addition, tooling expense, which nets out to zero over time, is a use of cash at the beginning of new contracts (Tower buys the tools and bills the customer only when it passes the pre-approval process).
Finally, Tower’s pension plan is underfunded by $62 million, and the company plans to make at least a $9 million contribution this year.
Table 12: Tower International, Expanded 3-year Financial Summary (Continuing Ops.)
The table above shows the paltry Adjusted FCF Tower generated over the last 3 years: on average 1.0% of revenues. In addition, Tower has NOLs and has not been a cash taxpayer in the U.S., but expects to begin paying cash taxes in 2018 or 2019.
On the Q4:14 call, management gave guidance for $60 million in Adjusted FCF ($2.80 per share) in 2015, meeting its target of 3% of revenues. On the Q1:15 call, a major new business win (requiring growth capex) caused management to cut Adjusted FCF guidance to $25 million. On the Q2:15 call, an expansion of that contract resulted in Adjusted FCF guidance being cut to zero. (You can see why the OEMs are happy to outsource this capital-intensive business.)
But despite the near-term FCF hit, Tower is putting on higher margin business (a 14.7% EBITDA margin for the new business vs. 9.9% for Tower in 2014) and growing faster than the industry. In addition, TOWR management believes the company would generate FCF equal to 3% of revenues if it didn’t invest in growth capex. Under this scenario, TOWR would throw off $59 million in FCF, or $2.75 per share and has the following yields: FCF/market cap = 12.8%, FCF/EV = 7.2%.
Moreover, because the company is shopping Tower Europe, it recently disclosed that under a no-growth scenario and excluding corporate costs, Tower Europe would generate FCF equal to 5% of revenues. I believe North America would be similar, meaning that to a buyer who would take the company private, shut down its money-losing Brazilian operations and run it for FCF, TOWR would throw off $93 million in FCF, or $4.35 per share, and have the following yields at the current share price: FCF/market cap = 20.3%, FCF/EV = 11.4%.
3. Tower’s downside risk is substantial
In the 3 years following it’s post-bankruptcy IPO, Tower traded at an average valuation of 3.5x EBITDA. That multiple reflected its post-bankruptcy taint and skepticism over the recovery in auto production.
Even though Tower currently trades at the very low-end of the group, its stock still has large downside risk since, in a cyclical downturn, it will get hit with 1) falling growth projections, 2) multiple compression, 3) no FCF support, and 4) no tangible book value support (just $3.11 a share), leaving the market to value it on EBITDA un-backed by any FCF as it invests in capex to bring on new business. In addition, the revenue and EBITDA projections of its new contracts (shown in Table 4) assume IHS’s 3% volume growth outlook for North America. In a downturn, the return on those contracts will be far less attractive. Lastly, the illiquidity of the stock only adds to the downside risk.
In a worst case scenario, where 2016 EBITDA falls by 12% (it’s down even more excluding the new business wins) and TOWR’s multiple contracts to 3.5x, the stock would fall to $10.89, for 49% downside.
Warren Buffett did not get rich by investing in the TOWRs of the world. So I’d recommend hedging out the risk of a cyclical downturn by 1) shorting a basket of auto suppliers against a long TOWR position or 2) pairing long TOWR with a short position in one of its two publicly traded competitors.
Martinrea is Tower’s best comp, but Martinrea (MRE.TO) is a Canadian company and FX would have to be hedged as well. The company’s USD-denominated ADR, MRETF, makes for a better hedge, but since Martinrea reports in Canadian Dollars, USD strength would benefit the company while it would hurt Tower, lessening its effectiveness as a hedge.
While Magna only matches Tower’s metalforming business in its Cosma division (22% of revenues), since Magna trades on the NYSE (as well as the TSX) and reports in USDs, shorting the NYSE: MGA shares takes care of the FX issue. And since auto suppliers are ultimately tied to auto production regardless of what parts they supply, MGA, in my view, makes for the best pair trade.
While there is no perfect hedge, we’re trying to minimize our downside in the event 2016 turns out to be another 2008, while capturing the large gap between TOWR’s public and private market value.
TOWR Sum-of-the-Parts Private Market Value
Table 13 illustrates my SOTP valuation. I’m using the segment EBITDA projections (for Europe and North America) the company recently disclosed with its announcement that it’s exploring a sale of Europe. These EBITDA numbers exclude corporate costs, which I believe is fair because this is how buyers of the two segments will value the assets. I’ve made the following assumptions:
· Tower Europe is sold for 6x EBITDA. I believe this is fair considering Stadco, a U.K. metalforming competitor, was sold for 5.5x and Tower Europe is twice the size of Stadco, offering greater cost synergies to a strategic buyer. Management believes Tower Europe would throw off FCF equal to 5% of revenues if it didn’t invest in growth capex. The 6x EBITDA valuation equates to 12.9x FCF, or a 7.8% FCF yield, which also seems fair. With the $420 million in net proceeds from this sale, TOWR goes from a net debt position of $361 million to a net cash position of $59 million (13% of its current market cap).
· TOWR’s remaining assets in China and Brazil, which have combined revenues of $100 million, are sold for 0.3x revenues. I used the depressed revenue multiple TOWR recently got for one Brazilian plant. Although TOWR recently sold two Chinese JVs for 6.3x EBITDA and its remaining Chinese operations are profitable, for conservatism, I valued the entire $100 million in revenues at the multiple of the unprofitable Brazilian operation (Brazil is in a recession). With the $30 million in proceeds, TOWR’s net cash position rises to $89 million (19% of its current market cap).
· Post these two sales, Tower North America’s implied value is just 2.4x 2016 EBITDA.
· TOWR’s target leverage ratio is 1.0x. With $89 million in net cash and $151 million in EBITDA (2016) for its North American operations, TOWR can repurchase $240 million in shares – or 52% of its current market cap – to achieve its target leverage ratio, and management has talked about buying back stock post a potential sale of Europe. Given the sheer magnitude of the share repurchase TOWR can do, I see the announcement of a sale of Europe as a major catalyst for the stock.
· Tower North America is sold for 7x 2016 EBITDA. With an 11% EBITDA CAGR from 2015 to 2017, and the strategic value it offers Magna’s Cosma division (the most likely buyer), this valuation may prove conservative. Tower management recently stated it is working on new business wins for 2018, and if North America’s above-market growth continues beyond 2017, it bodes well for its buyout value.
· The above assumptions yield an equity value of $53.58, for upside of 150%. Since Mark Malcolm is retiring on December 31, 2016, I believe this private market value will be achieved by that date.
I’ve also assumed:
· TOWR generates zero FCF out to the end of 2016 as it continues to win large contacts in North America and invest in growth capex. Its best-in-class quality metrics give TOWR strong competitive advantages in winning new business.
· Per management’s guidance, TOWR will utilize its foreign NOLs, and gross proceeds from the sale of the European assets will equal net proceeds.
· I gave zero value to TOWR’s U.S. NOLs in the sale of its North American operations.
- Sale of Tower Europe
- Sale of remaining Chinese and Brazilian assets
- Share buyback with the proceeds; potential for a 52% share repurchase
- Sale of Tower North America by year-end
Table 13: Tower Sum-of-the-Parts Private Market Value
- Sale of Tower Europe
- Sale of remaining Chinese and Brazilian assets
- Share buyback with the proceeds; potential for a 52% share repurchase
- Sale of Tower North America by year-end
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