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Shiloh Industries Priced For Zero Growth With Numerous Tailwinds

|Includes: Shiloh Industries, Inc. (SHLO)
Summary

Niche auto supplier priced at a ~15% cash flow yield to equity that has numerous tailwinds to drive above market growth despite domestic OEM auto production declines.

Management provided flat guidance on 1/5/18 driving shares down to $7.41 from $9.01 the prior day.

Although growth will be muted in the near term, numerous automotive mega trends and SHLO specific tailwinds exist to drive long-term growth.

Valuation implies $11-$12 share price versus $7.43 currently.

Thesis

Niche auto supplier priced at a ~15% cash flow yield to equity that has numerous tailwinds to drive above market growth despite domestic OEM auto production declines. Management provided guidance on 1/5/18 that EBITDA is projected to be approximately flat to current year (guidance of $73-$76MM versus $75.6MM in 2017) along with flat capex spend. This drove share prices down to $7.41 from $9.01 the prior day. Although growth will be muted in the near term, numerous tailwinds exist to drive long-term growth.

Drivers of growth to include: (i) automotive megatrends underway (safety/driver assist, automated driving, connectivity/infotainment, and electrification/emission control) that add weight and content to vehicles that must be offset by lightweight auto components, (ii) the current backlog momentum / new business wins have 3-5 year lead times, (iii) the China facility build-out is currently burdening both capex and SG&A without any revenues until the facilities start production in late 2018, (iv) management believes EBITDA margin will reach double-digits compared to the current margin of 7.3% as product mix shifts to higher value-add components, (v) increased car parc penetration of HEV and EV vehicles which have both increased weight and eligible content per vehicle for SHLO’s products, and (vi) increasingly stringent emissions standards will cause OEMs to reduce weight as a means of increasing fuel economy.

Overview

Headquartered in Ohio, SHLO is a global supplier of lightweighting, noise, vibration, and harshness solutions to the automotive, commercial vehicle, and industrial sectors. SHLO designs and manufactures products in body structure, chassis, and propulsion systems for original equipment auto manufacturers and suppliers. This includes combining castings and stampings or innovative, multi-material products in aluminum, magnesium, steel and steel alloys. The Company has a global manufacturing and technology footprint, with over 3,600 employees in 28 locations serving clients in North America, Europe, and Asia.

SHLO bids on and wins the production and supply of parts for auto models that will be newly introduced to the market by the OEMs. New program development generally begins 3-5 years prior to the marketing of the underlying vehicles to the public. Redesign of existing programs begins during the life cycle of a platform, usually at least 2-3 years before the end of the platform’s life cycle.

Merits

Quantifiable Value Proposition & Product Differentiation

SHLO’s products are satisfying the demand for cleaner and safer mobility via reduced weight, complexity, emissions, overall cost, and fuel consumption. As an example, (I) an aluminum frame structure from SHLO is both lighter and stronger than alternative products (reduces machining requirements by 50% and weight by 10 lbs. per application), and (ii) a rear beam axle housing provides equivalent performance at 50% of the weight (24 lbs. lighter than iron) and requires 30% less machining.

SHLO holds 102 issued patents on a worldwide basis, approximately 28% are in production use and/or are licensed to third parties, and the remaining 72% are being considered for future production or provide a strategic technological benefit. SHLO does not materially rely on any single patent, nor will the expiration of any single patent materially affect the business.

Product Tailwinds

Various mega trends will provide opportunity for SHLO to grow at above market rates. Aluminum and magnesium products are expected to grow at a significantly higher rate than overall auto production volumes due to market share gains and replacement technology opportunities. Autonomous, Connected, Electric, Hybrid, and ICE vehicles use SHLO’s lightweight products to offset the growing technology content per vehicle.

Shiloh’s average content per vehicle in 2016 was ~$180 and in 2017 was ~$195 (total content per vehicle that SHLO could target is ~$1,500 across body structures, chassis systems, and propulsion systems). Recently expanded portfolio and new product strategies create additional content potential, regardless of propulsion system.

Margin Improvements

SHLO’s increasing focus on differentiated, high value-add products has increased margins significantly in recent periods, while low margin undifferentiated products are sun-setting and rolling off. This results in increased productivity (higher profitability volumes) while existing assets can be redeployed for this purpose. Gross margin has increased from 8.0% in TTM Q3-16 to 11.0% in TTM Q4-17, while Adjusted EBITDA has increased from 4.9% to 7.3% in the same period. Management believes this will be a low double-digit EBITDA margin business (improving mix over time and gaining further manufacturing efficiencies).

The continued increase of EBITDA margins, while capex spend is 4-5% of revenue, will create additional cash flow captured and increase the cushion between operating cash flows and capex, along with lower working capital from sun-setting, low margin, undifferentiated products.

Lack of Commodity Risk

In most instances SHLO does not purchase steel for inventory, customers negotiate steel purchases with their steel suppliers then SHLO takes possession of the material to develop its finished products. SHLO has limited contracts with commodity exposure that are in the process of rolling off and removing commodity risk upon renewal. The primary raw materials required for operations are hot-rolled and cold-rolled coated steel, rolled-aluminum, and aluminum and magnesium ingots.

Customer and Platform Diversity

Strong representation with OEMs from all three major regions of the world, as well as technology-led Tier 1 suppliers. SHLO is growing relationships across product lines via deeper and wider content with customers.

Global Manufacturing Footprint

SHLO has a local manufacturing footprint in the geographies in which it sells its products to avoid exporting. 17 facilities in the USA (83% of revenue), 6 in Europe (13%), 3 in China, and 2 in Mexico.

Risks

Customer Concentration

Revenue from the top 6 OEM customers comprise 52% of TTM Q3-17 revenue (BMW, Fiat-Chrysler, Ford, GM, Nissan, Volvo) which is an improvement from 2013 when the top 3 customers represented 50% of revenue. The top 2 customers represent 17.9% and 15.0% of revenues in 2017 (GM and Fiat-Chrysler, respectively). Large volume customers can create lumpy results if there is reduced/delayed demand from a single brand, strikes or other work stoppages affecting production of the customers, reduced popularity of that brand’s products for end customers, or loss of business to SHLO’s competitors.

Competition

The automotive parts industry is highly competitive. Bankruptcies and consolidation among automotive parts suppliers are reducing the number of competitors, resulting in larger competitors who benefit from purchasing and distribution economies of scale. The principal competitive factors include price, quality, global presence, service, product performance, design and engineering capabilities, new product innovation, and timely delivery. SHLO can also face pricing pressures from automotive customers. Because of their purchasing size, the OEMs can influence market participants to compete on price.

Cyclical End Market

According to industry statistics (published by IHS Automotive in November 2017), North America and European auto production volumes for the year ended October 31, 2017 was -2.4% and +3.5%, respectively. As North American car production is coming off all-time highs, results for the industry can be considered to be peak earnings. SHLO’s business model has some operational flexibility in case of a downturn and SHLO has the opportunity to significantly increase its content per vehicle in spite of declining auto volumes in the U.S.

Cyclicality could also lead to pricing pressure from large, multinational OEMs and Tier 1 suppliers during times of industry contractions. It appears that SHLO has been successful in recent periods winning high margin projects from these OEMs which have a lead time of 2-3 years in the future. This seems to suggest that SHLO is not seeing significant pricing pressure, or at least is not disclosing it to shareholders.

Capex Spend

Capex spend of $48.4MM in 2017 and EBITDA of $75.6MM equates to FCF retention of ~35%. Per management, the target capex spend of 4.0-5.0% is comprised of 1.0-2.0% maintenance, 1.5-2.0% productivity gains, and the remainder is growth capex. The equity would have to be priced appropriately to account for the low margins and high capex spend, as well as the possibility of any increased capex spend due to product obsolesce, changes in technology, etc.

Commodity Risk

Although the majority of SHLO’s contracts do not contain commodity exposure, there is a small amount of revenue declines attributable to contract renewals at lower pricing which remove commodity risk (SHLO pushing commodity risk onto the customer). Revenue declined by $10.5MM in 2017 on account of this dynamic (1.2% of revenue). This is not an insignificant amount, but it does increase the attractiveness of the business model long term and reduces COGS volatility (which, all else equal, increases valuation).

Ownership

MTD Holdings Inc. and affiliates own approximately 37% of the common stock as (former joint venture partner for steel pickling and steel processing capabilities in the 1970s). There is limited disclosure regarding their current and future intentions.

 Valuation

Management provided 2018 guidance on 1/5/18 that EBITDA is projected to be approximately flat to current year (guidance of $73-$76MM versus $75.6MM in 2017) along with flat capex spend. This drove share prices down to $7.41 from $9.01 the prior day. Although growth will be muted in the near term, numerous tailwinds exist to drive long-term growth.

Per management, the target capex spend of 4.0-5.0% is comprised of 1.0-2.0% maintenance, 1.5-2.0% productivity gains, and the remainder is growth capex. As such, you can value SHLO with a 0% growth rate burdened by only maintenance capex ($11-$12/share valuation). As a point of reference, cash from operations would have to decline by ~20% in order for a 15% annuity to be worth the current share price of $7.43.

Similarly, under modest growth scenarios, SHLO is substantially undervalued. A 0.50% perpetual growth rate implies a ~$10+/share valuation, and 2.0% growth implies a ~$12/share valuation.

The growth cases assume that the incremental capex spend actually drives growth and results in a slightly lower long-term cost of equity. Future growth may come from numerous sources: (i) automotive megatrends underway (safety/driver assist, automated driving, connectivity/infotainment, and electrification/emission control) that add weight and content to vehicles that must be offset by lightweight auto components, (ii) the current backlog momentum / new business wins have 3-5 year lead times, (iii) the China facility build-out is currently burdening both capex and SG&A without any revenues until the facilities start production in late 2018, (iv) management believes EBITDA margin will reach double-digits compared to the current margin of 7.3% as product mix shifts to higher value-add components, (v) increased car parc penetration of HEV and EV vehicles which have both increased weight and eligible content per vehicle for SHLO’s products, and(vi) increasingly stringent emissions standards will cause OEMs to reduce weight as a means of increasing fuel economy.

Disclosure: I am/we are long SHLO.