Tenneco: Pricing Disconnect Continues; 40% Upside To Fair Value

| About: Tenneco Inc. (TEN)

Summary

Tenneco has a history of irrational share price disconnects.

Q4 and full-year 2015 results show the leverage present in the business model.

Despite heavy capital expenditure spending to maintain market position, the company trades on a favorable free cash flow yield.

Fair value is $60.00/share, representing 40% upside.

Tenneco (NYSE:TEN) is a favorite of mine in the automobile parts and services sector, but the price movement has been nothing short of frustrating. I did, however, take a little solace in the fact that the stock has responded quite favorably to Q4 2015 earnings. Bucking the trend of a volatile S&P 500, shares are up 10% over the past five trading days as of this writing. Automobile stocks as a whole have underperformed considerably over the past two months, primarily on what seems to be concerns regarding a slowdown in the global economy. However, just like when Tenneco sold off on Volkswagen (OTCPK:VLKAY) fears (when the company had extremely minimal exposure to Volkswagen's diesel operations, instead selling diesel particulate filters to companies like Audi (OTCPK:AUDVF), BMW (BAMXY), and Ford (NYSE:F)) and during this recent market selloff, I believe the market continues to discount the earnings and cash generation power of the company. I remain firm in my $60.00/share price target.

Recap

Tenneco's total revenue in Q4 2015 was up 8%, currency-adjusted, over 2014 levels. What makes this number that much stronger are the results from light vehicle sales, which saw revenue growth of 11% in Q4. This has been the primary driver of growth in recent years, which is also a higher margin business than the aftermarket business. As a result, company adjusted EBIT margins have been improving every year since 2010, and the company has managed 11 straight quarters of EBIT improvement, despite headwinds from foreign currency.

In prior research, I highlighted how important the Clean Air segment is to the company going forward. We are entering a period of increasingly stringent emissions regulations as the United States rolls out new CAFE standards on automobile manufacturers that Tenneco supplies. The government has mandated emissions down and gas mileage requirements up. Non-compliance would be a stinging blow to a carmaker's ability to sell domestically, and Tenneco dominates the sale of emissions-related equipment sales not produced in-house at OEMs. The company's emissions control products (reported under its Clean Air segment) are sold to nearly every North American car seller you can think of: Ford, General Motors (NYSE:GM), Toyota (NYSE:TM), etc.

To be clear, it isn't just North America adopting stronger emissions regulations on light vehicles. Europe, China, and India all have more stringent regulations coming into play in 2017, which will affect the 2017 and 2018 model years sold there as well. As a result, these tailwinds are reflected strongly in its guidance. Revenue growth is expected to run 5% in 2016, 6-8% in 2017, and 7-9% in 2018. At the mid-point of this guidance, Tenneco would see $10B in annual sales in 2018. 8% operating margins would yield $800M in operating income and $700M in operational cash flow.

Conclusion

Tenneco generated $231M in free cash flow in 2015, representing a 7% free cash flow yield at current share prices. This yield comes despite significant foreign currency translation issues and a strong growth forecast heading into the next three years. As we see from current guidance, $350M in 2018 capital expenditures would yield 2018 free cash flow of $650M. This would be a nearly 11% free cash flow yield on cost. This represents an incredibly solid deal from a pricing perspective.

Historically, Tenneco has returned substantially all of its free cash flow to shareholders in the form of share repurchases if it isn't picking up value-add acquisitions. Tenneco bought back $213M in stock in 2015, and it isn't unreasonable to assume this to continue into the future. Trading at 4.21x TTM EV/EBITDA, you can't fault management's capital allocation strategy.

I still see fair value, at minimum, of $60.00/share. While I'm not one to cite the professional analyst community often, this target is in line with the median target of analyst share price targets. Tenneco traded above this level not too long ago in June of 2015, and with the company's current strength, I have a lot of confidence that it will recover to those levels over time. Buying in today represents a chance at 43% upside to that target, more than a fair return on investor capital. The company remains an integral part of my portfolio, and I have been adding to my position on dips when I can.

Disclosure: I am/we are long TEN.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.