An Autoparts Firm With Some Shock Absorption

Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon, co-editor of Morningstar's OptionInvestor. Today it's my great pleasure to welcome Richard Hilgert, who is covering the automotive space here at Morningstar.

Rich, thanks for coming.

Richard Hilgert: Thanks for having me, Erik.

Kobayashi-Solomon: So, just within the last couple of days, I published a report on Tenneco. Tenneco is not the gas station that I remember using as a little kid, but an auto parts company that you deal with. Can you first, just at a 30,000-foot level, explain what products Tenneco produces and who their customers are?

Hilgert: Sure, the parts that they manufacture are for exhaust systems and for ride control. In particular, they have Monroe exhaust systems and mufflers, and they also have the brand name for their shock absorbers.

Kobayashi-Solomon: And just thinking about, let's say, exhaust system or shock absorbers, I understand that some of these products are more integral to the automaker platform than others. Which of their products do you think are relatively more, let's say, well integrated and which are kind of more snap-on?

Hilgert: Both are very crucial to vehicle manufacturers' platform. Both determine the characteristics of the vehicle, both the dynamics of ride and handling, as far as the vehicle is concerned to the driver and to the passenger for comfort – for ride comfort, and the type of sound that the vehicle makes. Obviously, you wouldn't want a Camaro to sound like a –

Kobayashi-Solomon: Like a Hyundai or something...

Hilgert: ...a small vehicle, from Hyundai or any other manufacturer of small vehicles. But for that matter, these are very important and require Tenneco to be very upfront and early in the development stage of these vehicles.

Kobayashi-Solomon: See, this is what I wanted to ask you about because you had made the point when we talked before that there really is a dynamic that these parts have to be designed into the platform. Can you go into more detail on that?

Hilgert: Exactly, they do need to be designed upfront. Again, very close knit relationship between the supplier and the manufacturer of the vehicle when developing a new vehicle for the market.

Kobayashi-Solomon: So, basically the supplier engineers are working with the OEM engineers to kind of design a sub-system within the autos, is that right?

Hilgert: Correct. And this needs to be done at a very early stage. Vehicle manufacturers typically take anywhere from 18 to 36 months to develop a vehicle. Once the vehicle is developed and in production, that production might last anywhere from five to 10 years. If a supplier is on that particular platform, once the vehicle comes up for redesign or a new program, that supplier is then the incumbent for the next program.

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Kobayashi-Solomon: It has the incumbent advantage.

Hilgert: Exactly. So, Tenneco has very close relationships with its customers.

Kobayashi-Solomon: Right. So, I guess this really helps in terms of the stickiness of the business, I think also the OEMs will have to set up manufacturing plants to specifically, let's say, implement the Tenneco subsystems into the cars, right? So, in other words, it means that they have to spend money to change from Tenneco?

Hilgert: It would cost manufacturers quite a bit of money if they decided to switch suppliers of those particular systems.

Kobayashi-Solomon: Especially the highly-integrated systems.

Hilgert: Yes, because of the close relationship with the customer and the uniqueness of the product that Tenneco makes relative to each individual production model. The company has very heavy equipment, very expensive equipments. The company has tooling that, in some instances, the manufacturer has provided, in some instances Tenneco has provided.

Either way, if you are going to switch suppliers, you've got to spend the time at the new supplier developing the product all over again in preproduction, and bringing that to market and qualifying that supplier to supply you.

This will cost the manufacturer anywhere from a few hundred million dollars up to a $1 billion to move the equipment and to get all of the preproduction done.

Kobayashi-Solomon: Sure. That really does help competitive advantage for Tenneco.

Hilgert: Absolutely.

Kobayashi-Solomon: So, the other thing that I wanted to ask about is kind of where Tenneco operates. I know that their operations are split over North America, Europe, and in Asia.

What do you see for vehicle demand in each of these areas? What's your projection for the health of that?

Hilgert: Sure. Tenneco's markets are split roughly 40:40:20, 40% in the United States, 40% across Europe, and 20% in Asia Pacific region. With that split we are looking for demand in the United States to be up somewhere around 11.3 million units this year in sales and 11.8 million for production. The OEs need to build a little bit of inventory to catch up with some of the sales that we had from incentives last year. So production will be a little bit higher than sales will be.

Over in Europe, they did have government incentives that were in the marketplace up until just a couple of months ago. So we are looking for sales to somewhat decline a bit. We are looking for total production over there to be up in the 5% range. In Asia…

Kobayashi-Solomon: Let me just interrupt for a second, because a lot of people are saying Europe has some economic problems, they've got some structural problems. Does that factor into your analysis too when you're thinking about auto demand?

Hilgert: Yes it does. Right now, Europe is somewhere in the 15 million unit range, whereas normal production pan-European is somewhere in the 20 million unit range, or had been earlier this decade. So, yes, we are keeping our estimates within that 15 million unit range for the next couple of years. After that we may see unit volumes creep up into the 17 million to 18 million unit range.

Kobayashi-Solomon: Okay. I interrupted you…

Hilgert: Yeah, that's okay.

Kobayashi-Solomon: How about Asia?

Hilgert: Asia Pacific is being driven by phenomena demand in China. The growth rates this year, looks like sales might come in 26% ahead of last year. And Japan is doing very well this year too. They've had a very difficult decade over there. And this year, though, it looks like sales are coming back a bit and maybe in the 8% to 10% range.

Kobayashi-Solomon: So, when I first started looking at Tenneco, it was trading for about $26 a share, now it's all the way up to around $30 a share. Can you just refresh my memory on what your fair value estimate is and "consider buy"? Where we do we stand in terms of valuation?

Hilgert: Right. Our "consider buy" target was $21 a share and our fair value estimate is $42. That $42 share price was based on new business that the company has coming in in a new market. With the diesel emission regulations that are currently just put in place, the company has 11 new commercial vehicle customers that it's supplying product for on its exhaust business.

Kobayashi-Solomon: I was just going to say, it's an exhaust specialist, so of course diesel emission regulations would really play to its strength.

Hilgert: Exactly.

Kobayashi-Solomon: Really interesting story. Thanks for coming in Rich.

Hilgert: Thanks for having me.

Kobayashi-Solomon: And thank you for joining us. Please stop by the OptionInvestor website, where you'll fund many more option ideas based on Morningstar's fundamental research.