Titan International First Lien Bonds - A Great IRR To First Call And A Very Respectable Yield To A Second Call Later This Year

| About: Titan International (TWI)

Summary

Comfortable net leverage on a business that is durable.

TWI bonds trade very cheap relative to like industrial credits.

Asset sale program likely to unlock significant sums of cash, which provides optionality to a 105+ early call.

Investment Report - Fixed Income - Titan International (NYSE:TWI)

Focus Security - 6.875% 2020 First Lien Notes

Executive Overview

Titan International is a global off-highway tire and wheel assembly manufacturer and marketer. Due to the multiple-year downturn of the agriculture market, the company is choosing to deal with its fairly levered balance sheet (~40% D/Cap currently), and has several assets for sale for the purpose of debt paydown. From a valuation perspective, equity investors have firmly grasped onto the Trump Rally while debt investors of the company have seen subdued credit performance recently, trading up only a few points (in line with the HY market). Management is likely to refinance the notes this year. A refinancing could take place immediately after a sale of the track business (assuming 3/31 close & refi, this would be a 31% IRR) or in October allowing for the call price step-down to 103.438, an IRR of 9.7%.

Company History

Through its predecessors, Titan is more than 100 years old. Titan was incorporated in 1983, and in recent years, has grown through major acquisitions. Starting in 1993, the company moved into the off-highway tire manufacturing business. Major recent acquisitions include:

  • 2005: Acquired Goodyear Tire & Rubber Company's North American farm tire assets.
  • 2006: Acquired 'off-the-road' tire assets of Continental Tire North America
  • 2011: Acquired Goodyear Tire & Rubber Company's Latin American farm tire business.
  • 2012: Purchased 56% controlling interest in Planet Corporation Group - Australian farm tire business.
  • 2012: Purchased Titan Europe. All-stock deal on large European off-highway tire company.
  • 2013: Purchased 85% Voltyre-Prom with a consortium of buyers (One Equity Partners and the Russian Direct Investment Fund) - Russian farm and consumer tire manufacturer.

The company has been under the same leadership since its IPO.

Capital Structure Overview

Business Economics

Titan has a global tire and wheel manufacturing footprint, with 43 company manufacturing and distribution facilities and 6,000 people. Tire plants in the US are very old - most of them being originally built in the 1970s and earlier. Low returns on capital, permitting and regulatory hurdles likely create significant barriers to entry. Projects announced by other companies (most of which are in the $500mm+ range in size), suggest that Titan's plants are of high replacement cost. For manufacturing large, off-highway tires, shipping costs are probably high, so manufacturing should be fairly regional and positioned near target markets. Titan's two large US plants are in Iowa and Illinois, close to their agricultural target markets. The company runs these plants, has salespeople to market the tires to OEMs and to aftermarket OEMs - and independently-owned dealers. Gross margins run 8-16% (currently 11.5% YTD). SG&A runs 6-11% (currently 10%) which has left its current EBITDA = D&A (5.5%). The company notes that its cost structure is 55% raw materials, 20% labor and 25% overhead. Raw materials are steel, natural rubber, synthetic rubber, carbon black and nylon.

The business is durable - it needs to exist. Heavy vehicles are not going away and they will continue to need tires and wheels. Rubber tires are the long-established solution for vehicles. The low returns earned by incumbents likely deter new entrants and the industry leaders are generally long-lived companies; Titan's predecessor Electric Wheel Company was founded in Quincy, Illinois in 1890. The table below lists the largest tire manufacturers in the world and the year the company was founded. Notice that the newcomer, Hankook (OTC:HAOOF), was founded 75 years ago in 1941:

Tire Manufacturer

Year Founded

Bridgestone (OTCPK:BRDCY) (Japanese)

1900/1931[1]

Michelin (OTCPK:MGDDY) (French)

1889

Goodyear (NYSE:GT) (American)

1898

Continental (OTCPK:CTTAY) (German)

1871

Pirelli (OTCPK:PPAMF) (Italian)

1872

Sumitomo Rubber (OTCPK:SMTUF) (Japanese)

1889/1909[2]

Hankook (Korean)

1941

Yokohama Rubber (OTCPK:YORUY) (Japanese)

1870/1917[3]

[1] Bridgestone (Japan) was founded in 1931 and also owns Firestone (U.S.) founded 1900

[2] Sumitomo Rubber was a JV between Dunlop (U.K.), founded 1889 and Sumitomo Group

[3] Yokohama Rubber was a JV between BF Goodrich (U.S.), founded 1870 and Yokohama Group

Titan sells tires and wheel assemblies to OEMs (31%) and independents (69%), so most of its business at this point is in the aftermarket.

Since 1995, the year the company's revenues first breached $500mm, Titan's average operating cash flow was $45mm. Its average D&A was $42mm. Its average EBITDA over this period was $73mm. Its average assets employed was $500mm. For such a competitive, cyclical and capital-intensive business, (EBIT) return on assets of 5% has been weak.

At the same time, over the last 20-year period, the company's customers seem to have been doing just fine, if their equities are any judge of the situation. On the other hand, Titan (orange) seems to have lacked the scale and/or pricing power to grow its earnings power.

In the last two years, the company has suffered from the downturn in the agricultural market. EBITDA in 2017 is expected to be $84mm and with $30mm of interest expense, $15mm or so in cash taxes (difficult to estimate) and a fairly consistent $40mm in capex, makes the company FCF neutral.

Credit Backstops - People

Despite a track record of acquisitions that have not been particularly value additive, management has been reasonably conservative with its balance sheet. The refinancing of its 2017 notes (detailed in "Structural Value" below) was strong evidence of that. In addition, the company has run a cash balance that's averaged $200mm since Q4 2013, and most of the cash isn't consumed/sitting internationally or at opcos - $145mm sits at the holding company today. Acquisitions have been for cash, but financed debt and equity. Under Morry Taylor's leadership since 1990, this high yield company has a track record of keeping out of bankruptcy, a decent feat for such a cyclical business. It appears that Morry has a firm grasp of the importance of a good balance sheet. In December, Morry Taylor recently stepped down from the company's CEO position, but will remain chairman and should be very much involved with the company in the future.

In order to deleverage, the management has undertaken an asset sale program. Of most importance, the company expects to make a sale of its ITW segment, which manufactures tracks. A sale of that segment is expected around year-end[1].

[1] Q1 Conference Call:

"And as I said in the release, Goldman, Sachs is the banker for our track business, ITM, that we're looking at to see what success we have in that market. And we've, as I said, had an offer on it. So, they're putting everything together and we think that will be very successful and we think that will probably happen towards the - in the fall."

Q2 Conference Call:

"But as I said in the press release and I said earlier, I believe that they will have this thing wrapped up before the end of the year. And that means it goes to the board, and the board - if it's at the number that they think is fair for our shareholders and what they think, then it will proceed."

Non-core Asset Sale Overview:

ITW Segment - Track manufacturing. Goldman is running a process on the back of a bid for the business. Morry Taylor implied that the asset is worth 'nine figures'[1]. So we could estimate the sale to be for $100mm. It is worth noting that the process was initiated by a (presumably unsolicited) bid on the business.

TTRC Business Segment[2] - Titan Tire Reclamation Corp. Recycles giant mining tires in the oil sands. Its first customer is Suncor, which has previously just stockpiled these tires as there hasn't been a cost effective way to dispose of them. The company's making about C$3mm per month - $36mm per year with "50% EBITDA margins" on its first three-reactor plant, so this asset is arguably quite valuable considering its growth potential. $18mm * 6x = ~$100mm CAD (at least). Invested capital at this asset was $30mm, so this is possibly a 40-50% ROIC business that they are interested in selling, if what has been publicly disclosed thus far is representative.

[2] Q3 Conference Call:

"It is just like on TTRC, when you look at what's happened up in Canada, we have the opportunity where if the province of Alberta decides to put a 10% reclamation to the people selling the tire, at this moment in time, we're the only one who can honestly say there's zero pollution. And we take it to carbon black, oil, and steel, and it's been running. Actually, our friends at Suncor have said we have done such a good job, they want us to look at a bunch of other stuff."

Brownsville Facility - Tire manufacturing facility[3]. Leased out on triple nets. Will generate more than $2mm annually. Applying a 10x multiple to this NOI produces a $20mm asset value; presumably the facility is under/un-levered, so valuation is probably conservative.

[3] The plant originally opened in the late 1990s but it was a failure due to a $200mm four year labor struggle with union workers and the Company closed the plant in 2003. Its value is mostly as real estate as the Company reopened the plant in 2012, and is currently leasing it out with 800,000 out of 1mm square foot leased.

In total, asset sales could produce ~$250mm for the company. This would be consistent with management's comments in its Q2 call where Morry said "If you sell off ITM and God help, if we moved off TTRC, you're not talking a little bit of cash. We'll have more cash than when our market cap is worth." The company's cash balance at Q2 was 207mm. Adding $250mm to this would mean $450mm in cash. On the date of the conference call, the company's market cap was $420mm. These asset sale figures seem to be reasonable and should serve as good defense for the credit and arguably a catalyst for value in the bonds through a refinancing.

Finally, there could be other corporate puts in the industry, although this provides less option value than what's provided by management, above. The off-highway tire industry is fairly consolidated and the players have remained rather static. Titan cites its "Major" competitors to be GKN Wheels Ltd. ($7.5B EV $1.3B Debt - U.K.), Trelleborg Group (OTCPK:TBABF) (EV $6.3B $1.8B Debt - Sweden) and Topy Industries ($650mm EV; 0 debt - Japan). Other "significant" competitors include the large consumer tire manufacturers. All of the company's competitors are better credits than Titan. Because the space is consolidated and static, going concern takeovers are probably more likely than a liquidation or orphaning of assets in distress. Titan's global asset base may justify a breakup rather than a package deal which could complicate the likelihood of a clean 'put' to a third party. The company's US assets comprise 21% of the country's off-the-road tire capacity (see appendix).

Structural Value

Capital Structure Positioning: The 6.875% 2020 bonds are first lien obligations of the company. There is zero bank debt drawn and only $43mm available for drawing. The bonds, at a high level, are the dominant senior obligation of the company. However, the company has a material amount of non-guarantor subsidiaries (54% of revenues) owing to its international operations, which significantly reduce the collateral available to the 2020 notes and expose the notes to structural subordination. The protection afforded by the bond's covenant structure is below that of the typical first lien bond. Having said that, a first lien is quite helpful.

Redemption Optionality: Of most importance is the redemption optionality of the bond. Given the structure of the bond and the company's refinancing history, it should not be a surprise to see the bonds refinance in the spring 2017 at 105.156 (current call price) or in October at 103.438. The reason for this thinking relies largely on pattern recognition. While it is only a sample size of one, the company's prior chain of refinancing transactions (bank and bonds) provides a compelling blueprint for what should transpire over the next year.

Below outlines the salient facts regarding the company's refinancing of its bank and bonds in 2012 and 2013.

1. Titan refinanced its bank debt at the end of 2012, which had about a year left in its term. This is the same situation as today and the company in its recent Q3 10-Q stated "the Company has commenced renewal discussions involving its revolving credit facility and currently anticipates completion of the renewal by early 2017 in advance of the December 2017 termination." Given this information it is highly likely the company's (undrawn) bank facilities will be renewed and extended in a similar manner as last time (five years). The bank's maturity would then be 2022.

2. In December 2012, Titan termed out the bank debt to 2017. At this time, it had about five years left until the maturity of the notes, but the notes were not yet callable. However, they were first lien and inside the bank, which the bank probably didn't like. Credit markets were healthy then, and the bonds weren't callable until October 2013 so it was reasonable for the company to wait.

In what appears to be a very conservative move, Titan chose to launch a conditional (on a successful new bond issue) tender on the notes in September of 2013, agreeing to take the notes out at their first call date at 3/4 coupon (105.90). This call price was at very large premium, considering the company was only saving 1 point of interest expense on the new coupon. This highlights just how conservative its refinancing approach might be in 2017.

There may be many reasons for this "early" tender/call, but the conclusion was that it was a sign of conservatism.

Reasons why management is likely to call the bonds in 2017:

- It has already engaged in discussions with the banks regarding the credit facility, just like it did in 2012/2013 before it called the notes.[1]

[1] Q3 10-Q: "The Company has commenced renewal discussions involving its revolving credit facility and currently anticipates completion of the renewal by early 2017 in advance of the December 2017 termination."

- Management may be shell-shocked at what happened to its bonds early this year (went to 70) and wants to refinance its bonds whenever it is reasonably able to do so.

- The company has less years to maturity left on its first lien notes than in the 2013 refinancing, which should make them more motivated to call the notes in 2017. The delay is likely because of the convertible bonds (just converted into equity) and asset sale being spring-time events.

- The banks may have the power to demand a high yield deal be done concurrently with the bank debt refinancing because Titan has a weaker credit profile than in 2013. The banks may not want a bond maturity sitting inside their credit facility.

- The company is likely to complete an asset sale in early Q1 and will probably use the debt to tender or call the bonds[2],[3],[4].

[2] Q1 2016 Call:

"Well, the cash [from the divestiture], the cash will come in and then - well, the first thing is, the end of this year, I think it is, right close at the end, we are going to pay - we'll pay off our $60mm in converts. All right? That still leaves us an awful lot of cash. And we will probably - I'm just one vote in a group, whether you buy back your bonds, a big chunk of your bonds, or depending on how you have all these various things in bond covenants, my own personal belief is that if we have excess cash, to just pay it out with dividend. So, there is no big acquisition that we are looking at as of today. I mean, we believe we've got ourselves pretty well situated. We believe our internal cash and what we are doing with that, we think it will be very positive over the next couple years."

[3] Q3 2016 Call:

"Well, the situation is, let us just assume you have the - ITM closes right after the first of the year"

[4] Q3 2016 Call:

"So, then, all of a sudden, that $60mm that you're not pushing out [the converts], well, now, holy man, you've got a tremendous amount of cash. So, then I would figure at this point - and it's all up to the board and what they wish to do, but we would probably increase our ownership a little bit in Russia, and we'd probably look at the 2020 bonds, look at bringing those in, or whatever we do, or restructure that, go for longer periods. All these things are available to us. And that's up to the board."

- Even if a refinancing has to cost the company slightly more in coupon, a 3.94% call premium in October to term out its debt is undoubtedly reasonable. Titan could even call the notes at the current price of 105.156, about 5% higher than current prices as an upside scenario for the notes. Based on its proactive history, an early call would not be a surprise.

- Between the company's $60mm convertibles having moved into equity and debt paydown from a potential asset sale, high yield investors are likely to view this as a credit comparable to Terex (NYSE:TEX) or Manitowoc (NYSE:MTW), which yield between 5% and 7.5%

- Post Trump's election win and its related construction/blue-collar implications, industrials have appreciated and cost of capital has much improved.

- A new issue today for Titan likely is in the 7% area which should result in a call of the current bonds in 2017 and perhaps earlier in the year.

Debt Valuation

Valuation of the 2020s are really related to the probability of an early call, which is in turn a function of where a new issue should price. So where should a new issue price on Titan in today's market?

I believe a B-rated first lien 2024 credit with:

- 60%+ market cap cushion

- 3x (net) levered business (2017)

- Not burning cash flow and has an improving earnings profile…

Should trade in the 7 area.

How does this compare relatively?

- Manitowoc is near "trough" levels, has a similar first lien position and capitalization trades in the 7s.

- Terex - has similar capitalization (35% debt/cap) and leverage (5.1x, net) and recently priced a new issue due 2025 at 5.625%, which currently yields 5.15%.

Given Titan's debt-friendly capital strategy and similar business economics (but somewhat offset by size), to see new Titan paper in the 7 area (~200 wider) would seem appropriate/cheap.

Conclusion:

History tells us that the company tends to decide it is simply time to refinance. That time seems like it is upon us, particularly if the company completes an asset sale. Refinancing its debt by paying 3-5 points of premium to extend its maturity runway another four or five years at a roughly even coupon seems like a prudent thing to do, and squarely within the character demonstrated by the company's prior refinancing activities.

If the company chooses to call the notes in the spring following asset sales and a bank refi, IRR is above 30%.

If the company chooses to wait until its 2017 call price step-down in October, IRR is 10%.

If things don't work out as expected here and asset sales don't happen and the business climate worsens and the notes fall in value, due to the bonds' low duration and high capital structure position, the bonds start to look attractive quickly. If the bonds fell 7 points over the next year (so, a zero total return), then their yield increases to 11.5% for three-year first lien notes which would be quite attractive.

Risks

Weakness in financial controls; timely statements. The company has some weaknesses in financial controls and has an interim CFO in place. This has been ongoing for years since the company made international acquisitions. The Morry Taylor doesn't seem like the type of character to deliberately play with accounting, and this is likely resolved over the next year.

Quick commodity price increases can compress margin through lags in pass-throughs to customers. The company generally does not hedge its raw materials.

Unions. Collective Bargaining agreements at three of the company's facilities which account for 43% of the company's US employees expire in March 2017. The CEO has had adversarial relations with unions in the past.[1]

[1] Source

Disclosure: We are long TWI 2020 bonds.

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

Additional disclosure: The author's fund have a long position in this security at the time of posting.

Disclosure: I am/we are long TWI 2020'S.

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

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