Federal Mogul: 40% Upside for Patient Investors

  • Federal Mogul (NASDAQ:FDML) currently trades at: $18.00
  • Buy this stock between $17 and $20. Potential value: up to $32
  • Market Capitalization: $1.7B
  • Shares Outstanding: Approximately 100M
  • Industry: Industrial - Auto
  • Situation: Post bankruptcy play
  • Trading timeline: 12 to 24 months
  • Main Shareholder: Carl Icahn, who acquired 75% equity through the bankruptcy process

Main catalyst

In March-2011, FDML hired Lazard to explore strategic alternatives. Although FDML commented in the most recent conference call that they are focused on organic growth "for now," they refused to further comment on a sale possibility which means its very much in the cards in the future. Additionally, structure of the CEO compensation where the CEO holds options to exercise 4% of company stock by 2014 at the strike of $19.50 provides floor to the stock price. Furthermore cost basis of the largest shareholder, Carl Icahn and debt covenants that restrict dividend payments to shareholders incentivizes the largest shareholder to sell the company and take some profits in the medium term. Moreover FDML has a large cash position and unique business model that gives FDML exposure to both the OEM's and after markets and thus providing hedge to the firm revenues with certainty in a down and an upcycle. Another catalyst is the improving fundamentals in emerging markets and improving auto industry business cycle where FDML has shown growth in double digits in the most recent quarter.

What can happen?

There are three scenarios' that can provide upside to investors. First, Carl Icahn, FDML's largest shareholder can potentially sell the entire company to entities wanting to participate in emerging market growth and capitalize on the upturn in the auto industry cycle in the US and EU. FDML registered double digit gains in 2Q-11 in BRIC countries including growth in U.S., where some are predicting the beginning of replacement cycle for automobiles. Second, Carl Icahn can give up his controlling shares and take some profits, thereby creating higher liquidity for FDML stock. This will help make the stock more liquid and creates opportunity for other potential bidders/ shareholders to participate in the FDML upside from improving fundamentals. Moreover, greater liquidity makes it easier for a potential buyer to build up a stake in the firm keeping M&A rumors alive and providing a floor for the stock. Third, FDML can possibly deleverage the balance sheet and make small acquisition that are not only accretive to FDML earnings but create greater growth opportunities for the firm making it an attractive target in 2012.

What are the catalysts for the owners to sell?

There are three different catalysts that might support a sale and give comfort to investors. First reason is the cost basis of Carl Icahn who has approximately $1bn invested in FDML since 2008 and has earned no dividend on his investments due to debt covenants. The only returns have been in the form of capital appreciation of stock. With his cost basis between $14 and $17 a share, this provides floor to the stock price and creates possible sale opportunities in the 20ies giving substantial upside to investors. Icahn is also the chairman of FDML's board and the firm hired Lazard in March. Second, reason related to the compensation structure of the CEO, Mr. Alapont. Mr. Alapont, the CEO, agreed to an amendment to the CEO compensation structure in 2010. In the new compensation structure, the CEO gave up the put options he held on the original call options of FDML. Currently, he holds options on "4%" or "4m shares" of FDML at strike price of $19.50. In addition to giving up the put, he extended his employment agreement until 2013. Mr. Alapont, the CEO, has been at the helm since 2005 and has led the company through bankruptcy. His options expire in 2014 and remain completely unexercised providing a sense of the CEO's faith in the company. In an event of sale or liquidation of stock, the CEO has an incentive to maximize the sale price, which I would imagine will be substantially above $19.50. Third is the turnaround in the auto cycle in the west and continued growth in emerging markets, especially China might lure some buyers to pay hefty premiums in the medium term.

What are the catalysts for the potential buyers or investors?

There are certain fundamental reasons for buyers to be interested in the company or why investors would make money in FDML. First, the company is doing really well. In the most recent quarter, FDML reported a substantial increase in its earnings. Additionally, FDML enjoys healthy margins of 10% and reported substantial growth, of 20% to 30% within its OEM segment in emerging markets while of 15% to 20% in U.S. and Europe. FDML has also reported substantial increase in net and operating income in addition to growth in YoY EBITDA margins. Company has $1bn in cash and $2.8bn in debt. High cash is an added bonus for PE bidders. FDML trades at a low P/E of 8.5x. Secondly, FDML's business model gives any buyer unique access to both side of the markets, namely the auto parts after markets and the OEM markets. This dual access creates a hedge during potential market downturns and gives certainty to the revenue stream. Thirdly, the board structure has been simplified since emerging from bankruptcy in 2005 under which FDML conducts annual shareholder meetings and has no poison pills. Moreover, the structure now allows for a sale of the company. Fourth, a upside in auto cycle with added global growth should serves as an added incentive. In the event of a downturn in auto markets, FDML's after market segment, almost 40% of total sales, provide the firm with the good hedge. Lastly, in addition to having board members from Icahn Capital, FDML's board consists of former executives from Dana and Lear Corp, FDML's direct competitors. They may help generate interest on the strategic side and position FDML for a potential sale in the medium term.

Potential Value if the sale occurs

Question becomes as to what is the fundamental value of FDML that has been growing since 2008 and has been beaten down along with the auto sector in general? For investors investing in the company between $17 and $20, FDML's 2011 fundamental value from competitive analysis and industry estimates can be approximated to be around $26 a share. Furthermore, an approximate 40% transaction premium for M&A deals within the industrial sector in 2011 remains undiscounted. Moreover, value beyond the 2011 fundamentals and potential M&A remains. This value is contributed from FDML's unique business model, continued restructuring of the business, emerging market growth, good management that's vested in the company and continued improvement in business fundamentals where FDML has been able to gain marketshare.

Downside hedge if the sale does not occur

FDML shares have already undergone major volatility in the past 2 months. If Icahn asks for a much higher price than what the firm is worth today, that might completely derail any chance of sale. In the event that management makes a definitive statement that they do not foresee a sale anytime in the medium term (which has not been clearly made yet), then the stock may continue to show volatility in the short term, however stable and vested management along with improving company fundamentals in addition to CEO compensation structure will provide floor to the equity price.

Disclosure: I am long FDML.