Federal-Mogul Has Work To Do On Margins

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Federal-Mogul's Powertrain business is growing nicely, but margins are not coming along as quickly.

A refinancing relieves liquidity pressure, but at the cost of higher interest expense.

Acquisitions improve the portfolio and Powertrain is gaining share, but realizing the value in the shares is going to require ongoing margin progress.

There were some solid positives in Federal-Mogul's (NASDAQ:FDML) first quarter, as the company's Powertrain business handily outgrew the light vehicle markets in North America and Europe and the company successfully refinanced some large outstanding debt balances. There's more work to do on margins, though, and the company is facing increasingly difficult comps, higher interest expense, and integration expenses from three recent acquisitions. Federal-Mogul still looks undervalued today, but that's not exactly a consensus opinion and the company's high debt level increases the overall risk.

Q1 Comes Up Short

Federal-Mogul reported revenue growth of 7% for the first quarter, with the total result coming in about 2% below expectations. The company's Powertrain business was stronger than expected, growing 11% overall and about three times faster than the underlying light vehicle markets in North America and Europe. With that, Federal-Mogul also outgrew comparables like GKN (OTCPK:GKNLY), which saw vehicle parts revenue growth of 5% in the first quarter.

The company's Vehicle Components Solutions business was considerably weaker, up 1%, due largely to weaker aftermarket sales.

Margins did not improve as much as expected. Gross margin was up 30bp and EBITDA rose 20%, but the reported EBITDA number was still about 5% below the sell-side target. The Powertrain business improved nicely, with EBITDA up 33% and a margin above 10%, as volume picked up. The VCS business was a different story, though, as weaker volume and severe winter weather hurt performance. With the U.S. distribution network based largely in the Midwest, I can see how weather would have an impact, but customer price reductions appeared to create a roughly 10% headwind as well.

Was It Impatience Or Frustration Fueling The Sell-Off?

There is no doubt that improving margin leverage is key to the Federal-Mogul story. With that, shifting production to lower-cost regions is a key part of the bull thesis on Federal-Mogul, and the comps are not going to get easier from here. I suspect that some investors and analysts may have been a little too far ahead of the curve with their margin improvement expectations from this process, particularly in the VCS business where management claimed to be only about halfway through the process. It also looks as though some analysts had underestimated the work still to be done in improving the VCS distribution network in the U.S.

With a lot of distance left to cover with the VCS transition, additional quarterly volatility seems more likely. At the same time, the VCS business is unlikely to show strong incremental margins until it moves past the exit of a supplier contract and weaker customer pricing. I would also note that a lot of investors were likely sitting on sizable gains in Federal-Mogul and the appearance of plateauing margin leverage could offer a good excuse to take profits.

Refinancing Buys Time, But At A Price

With stronger revenue and EBITDA production in the second half of 2013, Federal-Mogul put itself in a better position to restructure its debt. This restructuring, announced on April 15, was essential as the company had $1.7 billion in debt maturities in 2014 and over $900 million in 2015, with nowhere near enough cash on hand to fund them.

Federal-Mogul refinanced the debt into a $700 million term loan due in 2018 and a $1,900 million term loan due in 2021. The company's free cash flow generation over the next five years may prove sufficient to retire that $700 million loan at maturity, but this refinancing is going to increase the company's effective interest rate by roughly 75%.

Acquisitions Improve The Portfolio

Federal-Mogul has been fairly active on the M&A front. The company acquired Honeywell's (NYSE:HON) friction materials business (brake components and disc brake pads), Affinia's chassis components business, and DZV, a Russian engine bearings business.

The Honeywell deal cost Federal-Mogul about $155 million, but the deal fits in well with its existing friction parts business. The deal also brings two relatively new manufacturing plants in China and Romania, which fits with Federal-Mogul's plan to shift production toward lower-cost regions. With the Affinia deal, Federal-Mogul expands its wheel and steering product portfolio and should see better manufacturing efficiencies.

Multiple Challenges Remain

Federal-Mogul still appears intent on eventually separating the OEM and aftermarket businesses. I am not sold on the long-term economic or competitive advantages to such a move, but the company adopted a new holding structure in mid-April to facilitate an eventual separation.

In the meantime, there's plenty for Federal-Mogul to do. The company's EBITDA margin has improved to over 9%, but it's still below the likes of BorgWarner (NYSE:BWA) and Dana (NYSE:DAN) and the company may find incremental margin improvements more challenging as the comps get tougher. While it won't impact the EBITDA results, the company's higher interest expense is also going to impact bottom-line profitability.

The company's business mix is also a potential challenge. The company needs to increase its exposure to faster-growing markets like China (about 10% of its sales are to BRIC countries). While the company is not all that heavily exposed to the Big Three U.S. OEMs, the company is overweight to diesel vehicles - not a problem in Europe where diesel passenger vehicles are more common, but potentially more of a challenge with the U.S. business.

Moderate Expectations Can Fuel A Higher Price

I'm looking for Federal-Mogul to generate long-term revenue growth of close to 5%. That will require ongoing share growth in established markets like North America and Europe, augmented by growth in emerging markets. I'm also looking for better margins and FCF generation over time. I think Federal-Mogul's FCF margin will likely stay in the low single digits for the next five years, but I see it expanding to as much as 5% over the next ten years. If Federal-Mogul can deliver those cash flows, even an elevated discount rate leads to a fair value of around $21 today.

The Bottom Line

Both discounted cash flow and EV/EBITDA suggest that Federal-Mogul shares may be undervalued. A 7x multiple to 2014 EBITDA leads to a fair value of $18, and while 7x is higher than other vehicle components companies (which can trade closer to 6x), Federal-Mogul's above-average EBITDA growth supports an argument for a slightly higher premium.

The stocks of vehicle component companies like Federal-Mogul are typically bought to be sold, as only a handful of stocks like BorgWarner, Cummins, and Allison seem like strong long-term stories. In any case, Federal-Mogul does appear undervalued today, but as the post-earnings reaction in the market shows, investors are nervous about the company's trajectory to better margins and won't wait around patiently for progress.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

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