LAKE FOREST, Ill.—Auto parts maker Tenneco is caught in a cul de sac of its own design.
The Lake Forest manufacturer bought competitor Federal Mogul last year from billionaire investor Carl Icahn for $3.7 billion and assumed $3 billion of the Southfield, Mich., company's debt. Tenneco planned to realign the companies' divisions, then break apart again in late 2019 to form two enterprises that might fetch higher stock market valuations.
But the debt Tenneco took on to complete step one of the strategic metamorphosis has become an obstacle to completing step two. Tenneco announced this month that the breakup won't happen until next year. With demand from auto makers slumping, neither of the smaller companies to be created in the split would be able to handle its share of the overall debt burden. Tenneco stock plummeted nearly 40 percent, when co-CEO Brian Kesseler broke the news May 9.
Tenneco's predicament underscores the risks of complex corporate re-engineering projects that require precise timing. External changes since the acquisition was announced in April 2018 have derailed the "merge-and-split" game plan, leaving Tenneco a heavily indebted company struggling to maintain profitability in a slowing industry. Some wonder if the split will be delayed even longer, if it happens at all.
"The math doesn't really work," says Bloomberg Intelligence credit analyst Joel Levington. "Being caught with a hot potato of having an overleveraged balance sheet going into an auto downturn is something no one wants, because they remember how things were with the Great Recession. . . .They took a gamble, and for right now, they've lost pretty bad on it, and so have all their stakeholders."
The delay wasn't the only bad news. Tenneco swung to a $117 million loss in the first quarter from a profit of $60 million a year earlier, and management lowered the 2019 revenue forecast to a range of $17.7 billion to $18.1 billion. The stock dropped to $12.59, its worst day in nearly a decade. It closed at $12.13 May 16. Tenneco's stock price has declined 80 percent in the last five years, while the S&P 500 rose 49 percent.
In a news release blaming the postponement partly on the weak market, Kesseler says, "The additional time will allow the two new organizations to align and stabilize business processes and systems, solidify margin and cash flow performance metrics, and strengthen their balance sheets."
Tenneco once belonged to a Houston-based conglomerate of the same name that owned businesses ranging from shipbuilding to packaging to chemicals to automotive. The automotive business was spun off in 1999, saddled with $1.7 billion in debt.
The company makes shock absorbers, mufflers and emission-control devices for auto manufacturers like General Motors, Ford and Volkswagen, as well as replacement parts for sale to consumers and repair shops. Federal Mogul manufactures powertrains, brakes and other vehicle components, including Fel-Pro brand gaskets produced by workers in Skokie.
Tenneco plans to marry the powertrain and emissions-control businesses together in a company still named Tenneco with $10.7 billion in revenue and headquartered in suburban Detroit. Meanwhile, a separate company called Driv, based in Lake Forest, will keep the suspension system and replacement part businesses, with about $6.4 billion in revenue.
DEBT ON THE RISE
Before buying Federal Mogul, Tenneco's debt was 2.4 times the amount of its earnings before interest, taxes, depreciation and amortization. Since the deal closed the leverage ratio has increased to more than four times the amount, up from $1.36 billion in 2017 to $5.42 billion at the end of the first quarter. That unnerves investors because auto suppliers need strong balance sheets to convince car makers they can be trusted with multiyear contracts to deliver parts to assembly lines.
But Tenneco made its big deal just before the auto industry headed into a decline after years of expansion. Vehicle sales fell in the first quarter of 2019.
Co-CEO Roger Wood said on the May 9 earnings call that the company aims to lower its leverage ratio to 3.3 by the end of 2019, higher than its previous guidance of 3.0, or the 2.5 target it announced along with the deal in April.
"EBITDA reduction is the primary reason for the change in the outlook," he said. "We are working diligently to improve margin and cash flow over the balance of the year."
Tenneco may generate less free cash flow than necessary to pay its dividend, analyst Levington says. Cutting the dividend and deploying that money toward the balance sheet may be the wiser choice. Shareholders are "more worried about financial risk than they are about returns right now. . . .It's a necessary evil," he says.
The balance sheet "is not going to be straightened out (by 2020), but it could be improved," says KeyBanc Capital Markets analyst James Picariello. The company doesn't need "heroic" progress on its leverage, just debt within three times EBITDA. Growing earnings would help that, because it would generate more cash, which could be applied to debt—but it's hard to improve earnings if the auto industry is headed for a global downturn.
"The company has said financials are going to improve from here," he says. "That's a big if, especially when you have as high a leverage as they do now. . . .I'm skeptical of that, but I'm also not convinced it's not going to happen."
To be sure, some analysts think the market overreacted to the May 9 news. Morningstar analyst Richard Hilgert writes in a note that the company's valuation was "unfairly punished . . . for what we view as transient issues." Revenue jumped to $4.5 billion in the first quarter because of the Federal Mogul acquisition, but taking out that factor, Hilgert writes that Tenneco's organic revenue grew 1 percent even as global light vehicle production declined 7 percent.
But Deutsche Bank analyst Emmanuel Rosner writes that the stock "could face difficulty capturing market attention as investors worry about lackluster margin performance and high leverage," plus long-term concerns, like how electric vehicles will affect Tenneco's business. Meanwhile, the company's stock, which in the last year has traded as high as $48.35, is knocking around its 52-week low.