Market Overreacts to Tenneco Disappointment

Tenneco TEN, which supplies emissions control, suspension, and powertrain components and modules to the global automotive industry as well as offering aftermarket parts, reported disappointing first-quarter diluted earnings per share before special items of $0.52, missing the $0.95 consensus estimate by a country mile and down $1.56 versus last year. Revenue did jump 74% to $4.5 billion, including recently acquired Federal-Mogul. Adjusting for currency, acquisitions, and divestitures, organic revenue increased 1%, representing an 8-percentage-point outperformance versus the 7% decline in global light-vehicle production.

Management lowered its 2019 revenue outlook to $17.7 billion-$18.1 billion from $18.2 billion-$18.4 billion. It now expects adjusted EBITDA margin (excluding pass-through catalytic converter business and special items) to be 10.0%-10.6%, down from prior guidance of flat with 2018’s 10.6%. Management also said it will postpone the spin-off of DRiV to mid-2020 from the second half of 2019, allowing additional time to integrate the respective businesses and deleverage the balance sheet while the operating environment remains unfavorable.

In our opinion, the market overreacted to the May 9 news, selling the shares down by a whopping 37% that day. We think the market has unfairly punished Tenneco’s valuation for what we view as transient issues. While postponing the spin-off indicates integration difficulties, we have already assumed as much in our Stage I forecast. Our 2019 revenue estimate was $18.2 billion, and our adjusted EBITDA margin assumption was already 10.5%. Lowering our 2019 revenue estimate to $17.9 billion with an adjusted EBITDA margin of 10.0%, while maintaining our normalized sustainable midcycle 11.2% margin assumption, caused little variance in our enterprise value. This 5-star-rated stock trades more than 80% below our $73 fair value estimate.

During the past 10 years, Tenneco’s high, low, and median adjusted EBITDA margin has been 12.5%, 9.2%, and 11.7%, respectively. Including catalytic converter pass-through business, Tenneco’s and Federal-Mogul’s EBITDA margins before acquisition were roughly comparable around 9.5%. With cost synergies identified by management, we estimated that the new entity’s EBITDA margin would expand to 10.5%. Even so, we maintained a 10.0% peak margin in 2021 and a 9.5% normalized sustainable midcycle assumption in year five of our Stage I forecast. Excluding catalytic converter pass-through business, our EBITDA margin peaks at 11.8% versus Tenneco’s 10-year historical 12.5% high, and our normalized sustainable margin of 11.2% represents a 50-basis-point contraction versus the 10-year historical median.

Our investment thesis on Tenneco is intact. We continue to believe the company has a narrow economic moat. We expect organic revenue to grow at 4-6 percentage points greater than our long-term global light-vehicle demand growth rate forecast of 1%-3%. The company benefits from tightening clean air standards for vehicle emissions and from increasing demand for electronically controlled suspensions. The growth of advanced driver-assist systems, along with the digitization of the passenger vehicle, enables an opportunity for Tenneco’s ride control group to capitalize on the need for suspension systems to interact electronically with ADAS. As world governments drive the use of more ADAS through European New Car Assessment Programme safety ratings, we expect automakers’ demand for Tenneco’s intelligent suspension products to outpace global vehicle production growth.