Tenneco's Technology Drives Growth

The company holds one of the top two spots in each of its product markets. Tenneco’s total revenue is well diversified geographically, with around 45% in North America, one third in Europe, and the remainder from South America and Asia-Pacific. New technologies combined with a global presence enable Tenneco to increase its dollar content per vehicle as well as its penetration into new, adjacent markets.

Substantial new business should enable Tenneco’s average annual revenue growth (including catalytic converter precious metal substrate pass-through sales and excluding currency) to be approximately 6%. We estimate that Tenneco’s operating leverage will produce an adjusted EBITDA margin (excluding pass-through and special items) near 11% and a return on invested capital near 20%, 11 percentage points in excess of the company’s 9% weighted average cost of capital.

Automotive original-equipment manufacturers want vendors like Tenneco that can supply their parts requirements around the world. Automakers’ cost-reducing initiatives include building greater economies of scale and, as a result, they have been increasing their use of global vehicle platforms. Content laws in various countries require local production of parts, necessitating Tenneco’s presence in the local market. Vehicles with common platforms have the same underpinnings and are made in two or more factories in different global regions. Tweaks can be made to the exterior to accommodate local tastes, but because the basic structure is the same, high parts commonality improves economies of scale. Suppliers like Tenneco are able to provide common parts from multiple facilities around the world.

Global Presence Contributes to Moat The previous-to-the-last economic cycle was Tenneco Automotive's first since separating from its diversified parent late in 1999. After becoming a stand-alone company, Tenneco Automotive was left with about $1.3 billion in long-term debt and a $1.8 billion retained earnings deficit. Even so, this orphaned division generated returns that exceeded its cost of capital within three years of becoming a stand-alone operation. Given that Tenneco has a substantial global manufacturing presence, has highly integrated and long-term customer ties, enjoys steep customer switching costs, has relatively moderate pricing power, and benefits from a globally oligopolistic emissions market, we believe it has developed a narrow economic moat.

Automotive original-equipment manufacturers want vendors like Tenneco that can supply their global requirements. To reduce cost, the underlying structure of a particular vehicle sold in the United States may be the same as another vehicle sold in Europe, South America, or Asia. Also, some countries have local content laws that require a certain percentage of components be sourced from within that country. Winning a contract to supply a major component or system for a global vehicle program requires a supplier with a substantial global manufacturing presence. Developing a manufacturing footprint the size of Tenneco’s would require a high amount of capital investment, which is a substantial barrier to entry for potential competitors, particularly given auto suppliers’ uncertain prospects of economic profit.

Close ties with OEM customers (roughly 85% of total revenue) are integral to success in the automotive industry supply base and create another significant barrier to entry. New-vehicle lead times can be as long as 36 months. For emissions and ride control, Tenneco’s engineers are involved early in the vehicle-development process. An exhaust system plays a key role not only in vehicle emissions reduction, but also in engine development and even the end user’s perception of the vehicle. The exhaust system must be engineered in such a way that back pressure and airflow are maximized for optimum fuel efficiency and engine performance. Exhaust systems are also acoustically tuned with the engine to generate the kind of sound that the OEM customer wants its consumers to hear while driving the vehicle. Limited engine and exhaust noise from a Chevrolet Camaro SS, Ford Mustang GT, or Dodge Challenger Hellcat would be inconsistent with the visceral emotion these modern-day muscle cars are meant to evoke.

The same dynamics apply with Tenneco’s ride-control business—it involves highly engineered systems that determine the handling characteristics of a vehicle for the driver and ride comfort for passengers. Tenneco’s ride-control products provide resistance between the vehicle and the tires so that the tires maintain contact with the road surface, which is critical to safety under various road conditions and vehicle-handling maneuvers as well as varying and shifting weight loads. As a result, Tenneco’s early engineering involvement in vehicle development is vital to getting the ride control correct. Both emissions-control and ride-control systems require hundreds of hours of testing on dynamometers and constant re-evaluation (which Tenneco provides), all the while working side by side with OEM engineers.

Once launched, most vehicle programs have a 5- to 10-year lifecycle (the prior-generation Chevrolet Impala and Ford Ranger small pickup had the same underpinnings with modest tweaks for around 20 years), assuring Tenneco long-term contractual streams of revenue, albeit subject to volume changes depending on consumer demand. When a vehicle nameplate has a complete redesign and Tenneco is the supplier for the predecessor program, the company typically becomes the incumbent supplier for the redesigned successor vehicle program. In total, Tenneco has a 6- to 13-year tie-up with each customer’s vehicle program. While not all programs supplied by Tenneco are complete emissions-control or ride-control systems, the company supplies content on nearly 300 vehicle programs. We view Tenneco’s diverse, well-established, long-term, highly integrated customer relations supplying hundreds of vehicle programs as providing an invaluable barrier to entry, substantially hindering competitors’ encroachment on the company’s top market share positions.

Tenneco’s customers would incur prohibitively high switching costs should they withdraw business in the middle of a vehicle program, especially when Tenneco has a supply agreement for a complete emissions- or ride-control system. Costs for switching to another supplier would include the substantial lead time and investment to develop and validate a new system, the potential for production disruptions, and the cost of moving large, expensive heavy equipment and tooling. The whole process of changing a critical supplier like Tenneco might cost an OEM as little as a few million dollars to as much as $1 billion, depending on the size and scope of the components or systems being replaced.

For Tenneco’s aftermarket business (roughly 15% of total revenue), brand recognition is a key factor when customers evaluate their switching costs, especially among premium brands. The company’s customers (wholesale distributors, jobbers, and retailers) have to consider inventory-carrying costs and limited inventory space relative to end-user demand for specific brands. Tenneco’s well-established brands include Monroe shocks and struts, Walker exhaust systems, and Clevite elastomers. Premium brands include names such as Thrush, Fonos, and Sensa-Trac.

Tenneco’s consistent technology innovation and ability to find alternative vehicular applications enable more favorable pricing relative to many automotive industry suppliers, increasing the company’s dollar content per vehicle. Automakers are willing to pay for components and systems that provide substantial product differentiation, weight reduction, enhanced safety, or reduced cost, all while meeting regulatory requirements, as is the case with Tenneco. For example, the company has a new technology, computerized electronic suspension, which basically adds electrical and electronic content to shock absorbers and struts. A basic shock costs OEM customers around $15, while Tenneco’s CES shock absorber costs about $80 per unit. The emissions-control business has similar dynamics but with the added benefit of legislated improvements in technology.

Further demonstrating the point of added dollar content per vehicle as well as a globally diverse customer base, from 2000 (Tenneco’s first full year as a stand-alone company) to 2010, revenue grew at a 5% annual rate, comparing favorably against the backdrop of an annualized 4% decline in U.S. light-vehicle sales volume over the same time frame. From 2000 to 2007, Tenneco’s previous peak year, revenue grew at an 8% annualized rate, compared with an annualized 1% decline in U.S. light-vehicle unit sales. While U.S. light-vehicle sales units increased 11% from 2009 to 2010, Tenneco’s sales jumped 28%. For 2012, global production increased 4% compared with a 7% increase in Tenneco’s revenue, excluding substrate catalytic converter sales.

We view the global vehicle emissions-control market as possessing the characteristics of a rational oligopoly, meeting the criteria for an efficient scale economic moat source. However, we view the strength of this moat source as somewhat limited. Independent vendors that can effectively serve automakers’ needs for a complete emissions-control system on a global basis include only Tenneco, Bosal, Boyesen, Eberspaecher, and Faurecia. Magneti Marelli (owned by Fiat), has a limited geographic presence in exhaust, Benteler only makes certain components of an emissions control system and Calsonic Kansei is a Nissan keiretsu company. In our view, potential new competitive entrants are dissuaded from entering the market because doing so would depress returns for all players.

Profit Can Hinge on Commodity Prices Commodity costs and declines in global vehicle production present the biggest risks to Tenneco. Platinum, palladium, and rhodium have pass-through costs in catalytic converters, and exhaust systems are made from stainless steel. Ride-control systems are also made from steel and other metals. Fuel costs are a consideration due to just-in-time delivery to automakers' facilities. Economic profitability may be at risk if steel prices were to return to the highs experienced in the summer of 2008. However, in our view, commodity costs are likely to stay relatively moderate, given current global economic activity.

Annual contractual price reductions for OEM customers are an auto industry norm, so Tenneco has to aggressively employ kaizen, kanban, and Six Sigma lean manufacturing programs to advance cost savings. To maintain pricing and margins, Tenneco also requires continual investment in innovation. A loss of focus in cost reduction or technological development could result in an erosion of profitability and return on invested capital.

Additionally, the company operates in a capital-intensive industry subject to cyclical demand. As a result, Tenneco has a large degree of operating leverage, so sudden declines in volume can have a meaningful impact on profits. Conversely, any increase in sales following large cost-cutting measures significantly raises profits. The potential changes to profitability brought on by the company’s operating leverage and cyclical demand result in our high fair value uncertainty rating.

We view Tenneco’s financial health as relatively good, with solid cash flow and healthy liquidity. Historically, financial leverage had been above what we would consider optimal. In recent years, Tenneco has gotten its capital structure more attuned to the potential for cyclical demand. However, for an auto supplier that we rate with an economic moat, Tenneco is at the lower end of the range of profitability and returns.