Stricter Regulation In Terms Of Carbon Emissions Provides Significant Growth Opportunities For Tenneco

| About: Tenneco Inc. (TEN)

Summary

Tenneco offers a great long-term growth story while being significantly undervalued to its peers.

My recommendation is to buy the stock on the pullback, which was encouraged by 4Q 2016 margin miss.

My target price for Tenneco is set at US$ 73.9, which corresponds to an upside of ca.14%.

Introduction

I discovered Tenneco (NYSE:TEN) while reading about one of the Russian private-equity funds focusing on undervalued companies worldwide. One of the managing directors of the fund highlighted this opportunity in his interview. The basic idea behind it is that new regulation concerning gas emissions will be a dominant growth driver for this company and boost its financial performance. This idea attracted many investors at the end of 2016, and, as a result, the stock price skyrocketed from US$ 53.2 in November of 2016 to US$ 68.3 in February of 2017 (an increase of 28%). In my opinion, this opportunity did not receive sufficient coverage on SA - no articles since 4Q 2016 results announcement in February. Therefore, I decided to drill into the Tenneco's story and prospects.

Tenneco's story

For those not familiar with the company, Tenneco manufactures clean air and ride performance solutions for light vehicles and commercial trucks. Clean air business line comprises such auto parts as converters, particulate filters, valves, waste heat recovery systems, exhaust system components, manifolds, etc. In its turn, ride performance business line consists mainly of passive damping systems.

As for the customer mix of Tenneco, it is well balanced and diversified. Below, you can find a short diagram based on information from the latest quarter results presentation of the company, highlighting this thesis.

Fig. 1 - Tenneco customer mix (as % of 2016 revenues)

As it was stated earlier, the main reasoning behind this opportunity can be outlined by two trends - increasing vehicle production (apart from light vehicles, the company has a large share of the commercial vehicle market) and hardening regulations in terms of gas emissions (see Tables 1, 2, 3 and 4).

As you can see, the regulations are becoming more and more strict in terms of carbon emissions. Thus, carbon monoxide minimum requirement decreased five times in the EU and ca.20 times in the U.S. Moreover, forecasts of future minimum requirements incorporate this trend in both regions. Needless to say, this will be a significant growth driver for Tenneco in the future.

Table 1 - Evolution of EU Emission Standards for Passenger Cars (emissions expressed in grams/kilometer)

Stage

Year

CO

HC

HC+NO2

NO2

PM

Compression ignition (diesel)

Euro 1

1992

2.72 (3.16)

-

0.97 (1.13)

-

0.14 (0.18)

Euro 2

1996

1

-

0.7

-

0.08

Euro 3

2000

0.64

-

0.56

0.5

0.05

Euro 4

2005

0.5

-

0.3

0.25

0.025

Euro 5

2009

0.5

-

0.23

0.18

0.005

Euro 6

2014

0.5

-

0.17

0.08

0.005

Positive ignition (gasoline)

Euro 1

1992

2.72 (3.16)

-

0.97 (1.13)

-

-

Euro 2

1996

2.2

-

0.5

-

-

Euro 3

2000

2.3

0.2

-

0.15

-

Euro 4

2005

1

0.1

-

0.08

-

Euro 5

2009

1

0.068

-

0.06

0.005

Euro 6

2014

1

0.068

_

0.06

0.005

Table 2 - Evolution of the US Emission Standards for Light Duty Gasoline Vehicles (emissions expressed in grams/mile)

Model year

Carbon Monoxide

Non-Methane Hydrocarbons

Nitrogen Oxides (NO,)

Pre-1966 (uncontrolled)

80.0

10.6

4.1

1967

34.0

4.1

n/a

1972

28.0

3.4

3.1

1975

15.0

1.5

3.1

1977

15.0

1.5

2.0

1980

7.0

0.41

2.0

1981

3.4

0.41

1.0

1994 (Tier 1)

3.4 (4.2)

0.25 (0.31)

0.4 (0.6)

2004 (Tier 2, Bin 5)

3.4 (4.2)

0.075 (0.09)

0.05 (0.07)

Table 3 - Evolution of the EU Emission Standards for passenger cars and light trucks

2016

2017

2018

2019

2020

2021

2022

2023

2024

2025

GHG Standard
(grams / mile)

250

243

232

222

213

199

190

180

171

163

GHG- Equivalent Fuel Economy (miles per gallon equivalent)

35.5

36.6

38.3

40.0

41.7

44.7

46.8

49.4

52.0

54.5

Fuel Economy (NYSEARCA:CAFE) Standard
(miles per gallon)

34.1

35.4

36.5

37.7

38.9

41.0

43.0

45.0

47.4

49.7

Table 4 - Evolution of the EU Emission Standards for passenger cars and light trucks

2015

2020

GHG Standard
(grams / kilometer)

130

95

GHG- Equivalent Fuel Economy (miles per gallon equivalent)

45.5

60.6

Past stock performance

2006 - present

Tenneco underperformed the S&P 500 Index during the crisis in 2007-2008, but managed to outperform the market in the future with some setbacks.

Fig. 2 - Stock performance of Tenneco vs. S&P 500 in 2006-2017 (source: Bloomberg)

2016

Fig. 3 - Stock performance of Tenneco vs. S&P 500 in 2016 (source: Bloomberg)

Financials

At the first glance on the company's latest announced financials: revenues grew by 5% in 2016, EBITDA - 7.5%, whereas operating cash flow decreased by US$ 28m (or 5.4%). One should highlight that 2016 is the highest ever year for the Company in terms of revenues, adjusted EBIT and adjusted net income (though, here, a more detailed analysis is warranted to drill into the reasons behind these adjustments).

Moreover, what is quite important is that growth of Light Vehicle related revenues outperformed growth of the Light Vehicle production output. This means that demand for the company's products is not explained merely by growing production of cars, rather by increased demand for clean air and ride performance solutions, which proves our hypothesis. However, an increase of 28% in share price over just three months proves it already. The question is if this price already incorporates all the growth factors.

By the way, referring to the signaling theory of the stock market, Tenneco buying its shares back throughout the year 2016 (some 4.2m common shares in 2016; moreover, the board of directors authorized a buyback program of US$ 400m in the next three years) can mean that, in the Company's opinion, its shares are undervalued.

Analyst recommendations

I like to give a brief overview of analyst recommendations on covered companies just to provide an insight of how an investment community sees the stock in the moment. The situation is mixed with seven "Buy" recommendations (incl. J.P. Morgan and UBS) and six "Hold" recommendations (also, there is one "Sell" recommendation). Consensus target price for the stock is US$ 70.3, which corresponds to a ca.8% upside.

Valuation

In this case, as we see, the story is ambiguous due to the possibility that the upside potential of this opportunity is already drained. In order to quantify the story and make a conscious decision, let's turn to various valuation tools.

According to management guidance for the year 2017, the company's revenues will increase by 5%. Moreover, the company promises to outpace the automobile industry output growth by 3-5% each year since 2018. If we believe the first thesis to be true, but not the second one. Thus, increasing revenues by 5% each year and leaving the margins constant, we get to the target price of US$ 73-74 for the end of 2017 (an upside of 12%). My DCF analysis is attached.

Table 5 - Valuation of comparable companies (source: Bloomberg)

EV / Sales (2016FY)

EV / EBITDA (2016FY)

Tenneco

0.5

6.3

American Axle

0.6

4.2

BorgWarner

1.2

17.3

Cummins

1.5

10.6

Lear Corp.

0.5

5.9

Meritor (NYSE:MTOR)

0.8

8.6

Sample average (excl. Tenneco)

0.9

9.3

Sample median (excl. Tenneco)

0.8

8.6

As you can see from the table above Tenneco is now undervalued to its peers in the industry (American Axle (NYSE:AXL), BorgWarner (NYSE:BWA), Cummins (NYSE:CMI), etc.). EV/Sales multiple for the data sample of comparable companies is practically 2 times higher than for Tenneco (EV/EBITDA multiple is 1.5 times higher). This and the abovementioned pricing via the DCF method gives us the following football field:

Fig. 4 - Football field for Tenneco

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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