Metaldyne Performance Group, Inc. (NYSE:MPG) just closed what I think is a really impressive IPO. I also think this IPO will be looked back at as one investors missed out on. MPG actually underpriced its IPO after it was only able to sell shares at $15, which was considerably lower than the $18-$21 price range it had targeted. I think the buying reluctance was stemming from the substantial amount of debt the company has and the overall macro-environment volatility uptick in recent weeks. But as with all basic materials, and MPG in my opinion is a basic material provider, oftentimes buying the dips pays off in the long run.
A Consistent Performer
What MPG does is provide "highly-engineered components for use in Powertrain and Safety-Critical Platforms for the global light, commercial and industrial vehicle markets (SOURCE: MPG S-1)" but that doesn't really tell the story of what MPG does or how its model fits in line with a basic materials provider.
You see MPG provides many of the components that are necessary to operate automotive, commercial, and industrial machinery (largely vehicles but also heavy machinery). In fact to give you some scale, at least one of MPG's products was found in over 90% of the 16.2 million light vehicles built in North America in 2013. When looking at just a light vehicle engine, I'm talking about components like the turbocharger housing, variable oil pump components, camshaft pulleys, variable cam timing products, etc. Again, MPG also provides products - still simply referencing light vehicles - for the driveline, transmission and chassis. I don't think I need to elaborate as to what MPG provides in the commercial and industrial machinery markets to make my point.
Further, MPG has a very mature and fragmented diversification of sales by segment, vehicle applications, and markets. It also sells to several different geographies and direct customers:
MPG's geographical footprint helps provide a secondary barrier to competition in that geographic location is one of the primary factors considered by OEM's when determining who to award a long-term platform contract to. If a supplier is located nearby, it can greatly reduce all-in refined product costs. Clearly, this is something important to the bottom lines of OEM's. This geographical footprint, which would cost hundreds of millions of dollars and take years to replicate, provides a physical barrier to entry to industry newcomers which further contributes to the general consolidation of the broader industry. Essentially, as it's absolutely paramount to be at least reasonably geographically located near the OEM customers, this is the straw that stirs the consolidation cycle drink. If you aren't near an OEM geographically, you're disadvantaged competitively on price, which makes the OEM less inclined to do business with you, which makes it harder for you to reach profitability and to survive. This is turn forces you to eventually exit the business and to sell to the only buyers willing to make a purchase: those companies that are already existing in the space and those companies that can integrate your skeletal operations into their models at pennies on the dollar.
This broader space has been consolidating since 2008-2009, a significant amount of capacity has been removed from the market in that same amount of time, and based on the specialized set of skills it takes to manage a company in the space PE firms have been very active in exiting the industry. This places MPG's broader owners, American Securities - a PE firm with approximately $10 billion in assets under management - in a unique position to acquire assets with value on the front end. In fact, MPG has made a very lucrative business of acquiring assets, refining them, expanding margins, and driving its business very cheaply (all things considered). After all, MPG is simply three standalone companies who've been chosen to operate together as a more efficient single unit. I'm very excited to illustrate MPG's pro forma financials which show just that.
Now I know what you're thinking: why would a PE firm exit the industry if it's so lucrative once you find out the formula? You're probably thinking I'm looking at this from some rosy, perma-bull, not fully looking at all the facts standpoint - but I'm not. I'm not saying the formula is easy to find, and I'm not saying that this model doesn't come with its own unique risks. Among them are the fact that it does require a high level of CAPEX, and it does require the model to become levered up at points. But once the formula is discovered the model itself seemingly can be grown each year and grown at a higher level of profitability.
We'll start with a look at the income statement:
This income statement's pretty cut-and-dried and it shows exactly what I've alluded to in the beginning of this article. Every single metric that you want to see grow has grown and they've grown sequentially. What you see here is a broader trend line of higher sales, higher operating profit, and higher net income. Again, even looking back as far as 2011, a year in which global economic uncertainty was at multi-year highs stemming from the very real fact that entire countries might fail, MPG was able to grow sales. I think this evidences the fact that MPG can grow net sales across multiple unlike environments and that while it helps to have expanding GDP (like in FY13) globally that it isn't absolutely necessary for MPG to grow its metrics.
Looking at year-over-year results, which are more reflective of recent changes including debt refinancing, and better contractual obligation management, you can see three very important metrics have grown:
- pro forma gross margins have expanded 400 basis points
- pro forma operating margins have expanded 190 basis points
- pro forma net margins have expanded 160 basis points
All of these are indicative of growing profitability. Also, keep in mind this was operating as three standalone companies, not taking into account any cost-saving synergies, any vertical operation furthering, any sharing of client books, and any access to infrastructural opportunities. I feel like with the results displayed on a pro forma basis MPG is just scratching the surface on margin expansion.
MPG also is now an integral part of larger OEM operations. Its relationships with its top five customers average 15 years each. Also, based on the dynamic of the actual business - primarily the fact that the platforms that are uniform to production require long lead times, significant amounts of R&D, and very specific tools to execute origination and finalized production, it would be very expensive to replace MPG. I feel like this provides MPG with excellent visibility into future revenues and the ability to model income several years out. For clarity, there are several variables that go into the end-market success (read: how many vehicles and large machinery are sold) but overall theoretical revenues have a high level of visibility.
Just as importantly, with its refinancing and restructuring of the scheduling of its debt, MPG now should have flexibility in its operations to do just about anything it wants to do. The primary benefit of these moves was to delay major capital outflows further down the road. In fact, these should be refinanced at the point of becoming due to move them even further down the road. If its PE ownership holds true to its historic operating refining expertise, this should bode well for MPG investors. I happen to think the moving of contractual obligations further down the road is the single most overlooked bullish point of this IPO.
You can see that MPG has no significant amounts of debt or cash outflows until after 2018. Again this should greatly contribute to MPG's efforts at driving metrics.
When backing out non-cash and one-time items MPG's margins get especially impressive with adjusted EBITDA margins coming in for the nine months ended September 30, 2014 at 17.6%, an expansion of 110 basis points year-over-year, and with EBITDA margins coming in at 17.3%, an expansion of 260 basis points year-over-year. I happen to think MPG can expand EBITDA margins another 150 basis points in the next 12 months if not more. I think MPG can expand Adjusted EBITDA margins approximately 300 basis points year-over-year as well. This would show significant undervaluing of the shares at this point.
MPG's balance sheet also looks good:
Now, I understand the scale needed to reach an economy of operations when investing in a basic materials provider; this often requires significant amounts of debt, and I mentioned that this model can become levered up at points. This leverage has created the pricing discount that I think investors should take advantage of. I've outlined the debt in red and also presented the contractual obligation table above as a way to make sure readers understand that in the interim they wouldn't be owning a levered up name as the only actual cash outflows stemming from this debt would be from minimal principal maintenance obligations and full interest payments. If debt isn't being serviced in full, technically it doesn't exist in full.
What I mean by this is that if you considered MPG's operations in total and if you looked at its balance sheet and all you saw was ~$235 million in cash outflows in FY15 and ~$234 million in cash outflows in FY16 that were tethered to debt (ex. non-debt cash outflows which are off balance sheet and not typically factored into debt calculations anyways) you wouldn't consider this a "levered up" name if you were completely unaware of the outstanding obligations due in 2019. The company isn't actually responsible for accounting for the bulk of its debt via cash outflows - and this is more a hole in modern accounting than anything - and most likely never will be outside of minimal principle and interest payments. The bulk of the debt in these cases can get continuously refinanced down the road until it's absolutely convenient for the company to pay it down - typically only doing this to be valued at a higher multiple because the general markets care about things like total debt to EBITDA, etc. As such, I don't believe the debt should be considered when thinking about investing in a name unless you plan on holding until the first scheduled maturity date. I may or may not hold this name until 2019 but at the present time I'm unable to make that judgment responsibly with any sort of accuracy.
This is a reason to want to own MPG in the early going in that it is less responsible for paying for the borrowings that are going to drive margin expansion. Early adopters will be able to enjoy the lubricating of operations provided by this debt without having to worry about repayment. I also anticipate as noted above that MPG will get to refinancing the debt due after 2018 sooner rather than later. In fact, I wouldn't think it too far a stretch of the imagination that once MPG can log a few quarters of growth in free cash flow, now that it doesn't have any massive acquisition on the horizon, that it should be able to deleverage a bit in advance of that post- 2018 obligation coming due and by way of that refinance at lower rates than it is currently getting. I think a debt upgrade over the next 4-6 quarters is very close to a certainty looking at the growth in operations, specifically the margin growth.
The one thing I would say about the balance sheet that is even semi-concerning is that a large portion of the assets are comprised of Intangibles and Goodwill. I don't anticipate any significant slowing of the automobile or heavy machinery markets globally based on the reduced capacity and a very productive, helpful lending market for these endpoint markets - meaning I think the subprime auto bubble globally (especially in the US) continues to be helpful to MPG and that global interest rates remain low outside the US for quite some time into the future. However, should there be a marked slowing in these markets that would put a significant portion of MPG's asset base at exposure for impairment. Now, it wouldn't be that hard for MPG to justify not impairing the assets by making claims it eventually it would recover its future expected cash flows so for clarity this isn't something I'm worried about in the short term but it should be noted that this risk does exist and it will remain in mid to longer-term risk of ownership.
All told, I think MPG is an easy story to tell and it even easier story to understand based on the simplicity of its operations and the consistency with which it is grown margins.
Where's the trade?
I really like MPG, and I think longer-term this is as close to a sure thing as you can see from the basic materials market and at an IPO opportunity. I think I can justify that statement by the fact that there is always going to be a market for vehicles in one class or another (commercial, industrial, light vehicle, etc.) and that at least as of right now there is a measured bottleneck on supply.
Is there going to be volatility? Sure. With cyclical businesses - although with the diversity of end-markets MPG's business has been everything but cyclical - this should be expected. I just think that owning this company in this space with the broader market demographics of consolidation and capacity removal that MPG is going to be fine as long as you have a longer time horizon. This doesn't mean I'm not expecting big things for MPG in the short-term, which I am. I think with the margin expansion I'm expecting - which again would come from cost-saving, synergies, leveraging of ancillary business lines from the business combinations, from a continuation of very accommodative financial markets for the endpoints that MPG services, and from the recurring nature of the underlying business, that buyers here will be rewarded over the next 4 to 6 quarters.
I'm long MPG and will look to add to share count on any major dips. If the shares remain stable or move higher I'm happy with my position I have on the board but would look to add on anything that I think would be an obvious immediate value-add like a refinance of debt further down the road or some type of major cost savings relief found in the near-term analysis of operations.
I recommend a long position initiation of MPG.
I look forward to providing continuing coverage it the future. Good luck to all.
Disclosure: The author is long MPG.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.