The past year may not have been especially great to auto and truck part manufacturers, but Tenneco (TEN) has fared worse than most. The company has been slow to realize the margin improvements that it has been promising for some time and analyst estimates have been heading steadily lower. All of that said, investors should not ignore the potential growth that could come as the company focuses on penetrating the commercial vehicle market.
A Leader In A Key Market
There is no question that the auto and truck markets are cyclical and Tenneco can do little about that basic fact. Nevertheless, countries around the world have gotten increasingly serious about emissions control and Tenneco is a leading name in emission control technologies for vehicles. Tenneco supplements this emissions business (which contributes about 70% of revenue) with a ride-control business that produces components like shocks, struts, and mounts.
Tenneco is a surprisingly diverse supplier. General Motors (GM) and Ford (F) are about one-third of the company's sales, but Tenneco sells to almost every major name in auto manufacturing, including Volkswagen (VLKAF.PK), Toyota (TM), and Daimler. Tenneco also boasts reasonable geographic diversity, though the fact remains that North America and Europe are key markets despite management's efforts to grow the business in emerging markets like Brazil and China.
Heading Off The Highway
Tenneco has long focused on passenger vehicles and light trucks, but that is beginning to change. Although the company has sold products to the makers of commercial heavy trucks, the company is looking to increase its commercial business for both on-road and off-road applications. Caterpillar (CAT) and Tenneco already have a close relationship, but there is huge potential in penetrating further into markets like agriculture, mining, and construction with builders like Deere (DE), Volvo (VOLVF.PK), and Komatsu (KMTUF.PK).
Certainly this is not a fait accompli. Competitors like Faurecia (FURCF.PK) and Eberspacher are not going to just surrender market share, and Cummins (CMI) has not only a growing presence in commercial vehicle emissions control but a sterling reputation as well.
There's also a broader concern for Tenneco's emissions control business. Namely, whether or not attention will shift to improving emissions through the engine and powertrain technologies of companies like Cummins (CMI), BorgWarner (BWA), Magna (MGA), and Honeywell (HON). Admittedly it's not an either/or option, but the risk is there all the same and it may limit pricing power for Tenneco and its chief competitors.
The Margin Issue
The size of the commercial market is certainly reason enough to pursue it, but Tenneco management is also looking for the higher margins that commercial emissions control can provide, to say nothing of the ready asset leverage. Unfortunately, achieving margin targets at Tenneco has recently seemed about as easy as nailing Jell-O to a tree.
Some of the trouble lies with customers. Some European companies have been slow to roll out vehicles with new higher-margin emission control products on board. There have also been problems with legacy products - Tenneco has incurred cost overruns producing products for customers that the company had expected to phase out. Here, then, was a tough choice for management - take the margin hit (and disappoint investors) or stick to the phase-out schedules and annoy customers. Tenneco was likely wise to choose the former.
All of that said, Tenneco trails the likes of Cummins and BorgWarner when it comes to margins. Bears will point to this as proof of Tenneco's inferiority; bulls will see it as dry powder for levered profit growth.
The Bottom Line
Based on management comments at the recent Detroit Auto Show, it sounds like the fourth quarter results and 2012 outlook could be disappointing. The market has already marked these shares down about 10% in the week since, but that cautious guidance does stand out from the fairly optimistic outlook provided by BorgWarner.
Magna and Tenneco sit almost side by side in the doldrums and trade a fair bit cheaper than the likes of Cummins and BorgWarner. It's hard to argue with the potential of BorgWarner's turbochargers in the growing global diesel market, nor the emerging market growth seen at Cummins recently. At the same time, Tenneco has a better plan in place than in past years and could offer a solid turnaround/catch-up trade.
Analysts are demanding a lot from Tenneco, but successfully moving into the commercial market could fuel low-teens revenue growth over the next half-decade. Match that with even modest free cash flow margin improvement and these shares could be worth something north of $40.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.