Johnson Controls International Plc Automotive Business Spin-Off: A First Look At Valuation

| About: Johnson Controls (JCI)

Summary

Johnson Controls International is spinning off its automotive seats and interiors business, the largest such business in the world.

The spinoff was originally intended to be tax-free, but is now taxable as a result of issues arising from the recently completed Johnson Controls merger with Tyco.

Tax impacts, business risks and typical spinoff trading patterns could put downward pressure on the stock after the spin.

Introduction

Johnson Controls International (NYSE:JCI) announced the spinoff of its automotive seating and interiors business on July 24th, 2015 and planned for the transaction to be structured as a typical tax free spinoff for JCI shareholders. Subsequent to that announcement, JCI entered into a merger agreement with Tyco International PLC that required it to restructure the spinoff.

While the details are too complex to get into here, the merger between Tyco and Johnson controls effectively removed the possibility of a tax-free spinoff for the seating and interiors business (subsequently named Adient). That's the bad news. The good news is that the spinoff plan was further revised to re-locate Adient's headquarters to London, a move that will cut its future tax rate substantially. The Wall Street Journal reported Adient's tax rate should drop to 10% to 12%, down from parent JCI's tax rate of 17%.

Business

In the most recent prospectus filed on September 20, 2016, Adient describes itself as "the world's largest seating supplier" by volume, citing IHS Automotive. Specifically, the company notes it "…designs, manufactures and markets a full range of seating systems and components for passenger cars, commercial vehicles and light trucks, including vans, pick-up trucks and sport/crossover utility vehicles. Adient also supplies high performance seating systems to the international motorsports industry through its award winning RECARO brand of products. Adient operates approximately 230 wholly- and majority-owned manufacturing or assembly facilities, with operations in 33 countries. Additionally, Adient has partially-owned affiliates in China, Asia, Europe and North America."

Investors should read the prospectus for all the details, I won't rehash them here.

Being the largest supplier of anything automotive is a real advantage given OEM customers' penchant for driving down costs and requiring complex global logistical compliance from their suppliers in order to meet the OEM's production schedules. Adient's market position within the large automotive supplier industry merits a closer look at the transaction.

Valuation - Expected Price at Debut

One of the tricky aspects of evaluating spinoffs is that we don't know what the valuation is going to be until shortly before the stock is distributed and it begins trading. Although Adient shares won't be distributed and begin regular trading for over a month from now, investors can get a head start on the market and estimate the valuation today using available information. This article will look at both a) the price I expect Adient to begin trading at and also b) the price at which Adient provides an attractive risk-reward tradeoff.

Looking at the valuation both of these ways is particularly helpful with spinoffs because often times after a spinoff begins trading there are technical reasons for the price to fall as I wrote about here.

In the valuation table below, we can see Adient will have approximately 93.5M shares outstanding based on the disclosed ratio of Adient shares to be distributed relative to JCI shares (after taking into account the recent closing of the Tyco merger). Further, we see debt and cash are expected to be $3.6B and $643M respectively after the spinoff is completed. Tying in some additional pro forma financial information from the Selected Financial Information table at the end of this article, we can estimate EBITDA for the 2016 fiscal year at just under $1B.

Although Adient will be the largest seat supplier to the global auto OEM industry, its margins are small even by auto supplier standards.

With a pro forma gross margin of 10.6% and an estimated EBITDA margin of 5.6% for the 2016 fiscal year, Adient trails a broad group of twenty auto suppliers who show current gross margins and EBITDA margins of 17.7% and 11.2% respectively. Combined with relatively flat growth and concerns that overall industry auto sales are near the top of the current cycle, it's reasonable to expect some downward pressure on the valuation. The benefits from company's relatively low capital requirements, the anticipated long-term tax savings from the move offshore (which will deliver more cash flow to the equity*), and the company's plan to pay a regular dividend following the spinoff should somewhat offset the downward pressure.

Looking at the net impact of these factors, it's reasonable to expect Adient to launch at an enterprise value roughly in line with the median peer group EBITDA multiple of 6.9x.

(*) In the short term, the tax savings will be more than offset by the cash interest expense of the $3.5B of debt incurred as part of the spinoff

Based on this approach, I would expect trading to begin at approximately $40 per share. As the valuation table below shows, $40 per share represents just over 6.8x 2016 estimated EBITDA.

Valuation

$000s, except per share amounts

JCI shares outstanding as of June 30

935,000

Ratio of ADNT to JCI shares

1/10

Estimated ADNT shares

93,500

Assumed share price

$40.00

Market capitalization

3,740,000

Debt

3,592,000

Cash

643,000

Enterprise value

6,689,000

Multiple

FY'16E Net Sales

17,190,667

0.4x

FY'16E EBITDA

981,333

6.8x

FY'16E EBITDA less Capex

565,333

Net Debt / EBITDA

3.0x

Valuation: Post-Transaction Downward Pressure

A common spinoff pattern that causes post-transaction selling could be amplified in this transaction because the spinoff is taxable to JCI shareholders receiving the stock, whereas most other spinoffs are tax-free. As such, the stock could see higher levels of post-transaction selling as holders look to generate cash to offset any tax liability.

Other fundamental risks loom large. Relatively low margins and auto market cyclicality are two such risks that could put downward pressure on the stock. The latter risk is especially important in light of Adient's 3.0x net leverage against its 3.5x covenant. The table below shows Adient's post-transaction debt and related important ratios.

Debt
Revolving Credit Facility ($1.5B, undrawn) $0
Term Loan A $1,500,000
4.875% Unsecured Notes due 2026 $900,000
3.5% Euro Unsecured Notes due 2024 € 1,000,000
Total debt $3,500,000
Important Ratios
Financial Covenant
Total net leverage ratio < 3.5 to 1.00
First lien secured net leverage ratio < 0.75 to 1.00
(Incurrence test)

Given these factors, a move down toward the lower end of the valuation range for comparable automotive suppliers is possible. At a multiple of just over 5.4x EBITDA, Adient would trade in-line with six of the previously referenced twenty comparable companies. Those six companies trade at or below a multiple of 5.5x EBITDA (Recall the group of twenty as a whole trades at a median of 6.9x EBITDA).

The table below shows Adient's valuation at $25.00 per share or about 5.4X EBITDA:

Valuation

$000s, except per share amounts

JCI shares outstanding as of June 30

935,000

Ratio of ADNT to JCI shares

1/10

Estimated ADNT shares

93,500

Assumed share price

$25.00

Market capitalization

2,337,500

Debt

3,592,000

Cash

643,000

Enterprise value

5,286,500

Multiple

FY'16E Net Sales

17,190,667

0.3x

FY'16E EBITDA

981,333

5.4x

FY'16E EBITDA less Capex

565,333

Net Debt / EBITDA

3.0x

Conclusion:

Adient plc could debut at a share price of close to $40 per share based on an automotive supply comparable group median of 6.9x EBITDA. Investors looking at the stock as a long idea or those who hold spinoff stock should consider the following fundamental risks at that level:

* Lower than average margins;

* Flat growth;

* Net leverage of 3.0x against a covenant of 3.5x

* Market is potentially situated at the top of the overall auto sales cycle

In addition to the usual selling pressure that many spinoffs experience, Adient may also experience additional pressure as a result of the taxability of the transaction.

To the extent Adient debuts and / or trades down to the low end of the comparable range with a stock price closer to $25 per share, the valuation at that level presents a more suitable risk-reward.

Transaction Notes:

Record Date: October 19, 2016 (When-issued trading should begin on or shortly after this date)

Distribution Date: October 31, 2016

Ticker: ADNT

Because the spinoff is taxable, whereas most spinoffs are tax-free, ADNT could see higher levels of post-transaction selling as holders look to generate cash to offset any tax liability.

Supplemental Data

Disclosure: I/we 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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