Sep 24th, 2010 by aboveaverageodds
Hat tip to mwhitman for doing all the heavy lifting
The Visteon Corporation is a classic post reorg/special situation with a large margin of safety and substantial near-term upside potential.
Brief Business Description:
Visteon Corporation is a global Tier 1 supplier of automotive products to original equipment manufacturers (OEM’s). Visteon is a market leader in each of its three core product groups: climate, electronics, and interior systems. Visteon is geographically diversified and is not overly reliant on any one particular OEM. The company’s three largest customers are Ford, Hyundai/Kia, and Nissan/Renault (which make up 29%, 27%, and 9% of the company’s revenues respectively).
Visteon’s shares are currently trading on a “when issued” basis at roughly 3x 2011 EBITDA, and after backing out the company’s significant ownership in high growth subsidiaries, we believe the core Visteon business trades for between 1.5x and 1.7x EBITDA. Given Visteon’s multiple internal and external catalyst’s, highly attractive absolute valuation and the outsized spread between the company’s “when issued” shares and the already depressed valuation’s of its global competitors, we think that the stars are aligning for bargain hunting investors to generate spectacular returns of 30%+ in a short period of time with relatively low risk. Keep in mind that this isn’t “your father’s” Visteon, as the company will exit bankruptcy permanently improved and completely transformed, offering investor’s both a 1) quick, high-return, relatively risk-free arbitrage and/or 2) an inexpensive way to play any upturn in – or at least the stabilization of – global auto sales and economic activity in general.
The idea here is simple. As Visteon exits chapter 11, the near to medium-term upside will likely be driven by a combination of 1) a couple of imminent, high probability catalyst’s that should force the market to assign this company with a much more appropriate valuation on an absolute basis and relative to its peers and 2) various operational and financial enhancements that the company recently undertook while in bankruptcy should continue to yield visible and increasingly positive operating results for the foreseeable future.
Our expectation is that the initial roughly 30%+ will come almost instantaneously (within a month or so) as 1) the stock begins to trade regular way 2) equity analysts initiate coverage and 3) various institutional and index funds that have been unable to purchase the stock up until this point (due to restrictions on purchasing company’s in Ch. 11), begin buying in droves. Notably, the return assumption above assumes that upon re-emergence the company trade’s at an incredibly non-demanding multiple of 3.75x EBITDA or, to put it another way, in line with the cheapest automotive suppliers within the industry as a whole. Keep in mind that we think this estimate is very (almost unjustifiably) conservative given that on average Visteon’s peers tend to be considerably more levered, and typically possess both lower EBITDA margins as well as less attractive long-term growth prospects.
A Quick Primer on the Investment Attractions of Bankruptcy:
The primary reason we tend to be attracted to investments in distressed and/or bankrupt securities is because it is another “secret hiding place of stock market profits” or put another way, one of those areas of the market that consistently tends to mis-price assets, and hence tends to offer investors every now and again the opportunity to generate outsized returns, with very little risk.
Additionally, like all special situation investing, distressed and/or bankrupt securities 1) are often not very sensitive to fluctuations in the general equity and debt markets. This is important, as the behavioral characteristics of “when-issued” post-reorg equities are actually very much like merger arbitrage investments, as their price fluctuations are driven much more by the progress of the reorganization than they are by the vagaries of the overall stock and bond markets and 2) in bankruptcy investing, the emergence from the reorganization process usually serves as a high probability catalyst for the realization of underlying value. We think an investment in Visteon at or around the current price provides investors with a short duration, non-correlated event-driven investment, where an imminent catalyst is more likely than not to unlock substantial value regardless of what happens in the stock and bond markets.
Why is it mis-priced?
Historically investors have tended to perceive securities of financially distressed and/or recently bankrupt companies as highly risky, and therefore as unwise and irresponsible investments for the risk-averse investor (or so the story goes). We think the reality here is considerably different than what the conventional understanding would have most investors believe (surprise, surprise). Again, the paradox here is that contrary to what most think, the facts actually tell a much different story – as numerous studies have shown that distressed investing (properly implemented of course), actually results in the opposite outcome – i.e., it subjects investors to less risk and volatility, while offering significantly higher returns in comparison to more conventional forms of investing (a rather nice combination, no?).
Also, distressed securities are often illiquid, analytically complex, and typically require specialized knowledge to intelligently analyze, so most professional investors tend to be uninterested and/or reluctant (if not flat out unwilling) to put the requisite time in to understand and exploit this lucrative niche.
Other notable reasons for the mis-pricing include…
No Ticker Symbol – the company is currently trading on a when-issued basis and therefore does not as of yet have a ticker symbol and isn’t currently registered. This is obviously a temporary issue and we expect it to be at least partially resolved on October 1, when the company will receive a five symbol ticker listed on the pink sheets. Quickly thereafter (possibly as soon as November) the company should receive an NYSE listing, resolving the issue entirely. Fwiw, we think this is much more of a blessing than a curse given that most institutional investors cannot purchase when-issued stock, which in turn provides investors with the opportunity to essentially “front run” what will almost certainly be a large amount of institutional equity buying.
Economic Concerns/Fear of a Double Dip – another reason(s) for the current mis-pricing stems from concerns over the broader economy, but specifically worries about the potential for a double dip and the impact such an outcome would have on worldwide car demand. Clearly whether or not we actually experience a double dip is anyone’s guess, and the probabilities of such an outcome are open for debate – that said, we think that investors with longer-term time horizon (i.e., those who are interested in VSTN for more than just a quick arbitrage) are likely to do well either way, given we think the company’s current valuation already discounts a pretty unfavorable (and very unlikely) outcome. That said, it’s always possible to hedge most of the market risk here by simultaneously shorting Visteon’s more expensive peers.
Non-Economic Selling Pressure – a common problem/opportunity with investing in post reorg equities is the potential for a significant amount of non-economic selling pressure to take place once the company in question has been relisted and begins to trade again. This typically happens when the newly “equitized” former creditors cannot (due to institutional rules) and/or have no interest in (i.e., as former creditors they are just glad to get their money back) holding the new company’s shares upon re-emergence. So given this 1) ever-present reality and 2) the fact that so many of the recently listed post reorg stocks have traded down upon re-emergence of late, we think it would be foolish to completely discount the possibility. That said, we think any near-term downside volatility due to creditors selling would be a temporary issue and hence a non-concern. Fwiw, in Visteon’s case we actually think it isn’t likely to happen at all (or at least if it does, for any meaningful amount of time) given the oversubscribed rights offering and the fact that the current board/new shareholder base consists primarily of pre-petition bond holders who have every incentive to stick around and help bring about the continued realization of equity value. So given that, an enticing absolute valuation, and what we believe to be a considerable amount of pent-up demand from various sources this isn’t an issue that keep us up at night.
A Limited and Misleading Operating History – In our experience, any time a company’s future operating performance is unlikely to look anything like its past there is usually a good chance the market will mis-price the opportunity in question. We think that’s definitely the case here.
For those of you who are unfamiliar, Visteon was the result of a poorly conceived spin-off from Ford in 2000, so the track record that does exist for the company is limited and (for reasons explained below) entirely unimpressive. Much of the poor historical operating performance of the company wasn’t so much caused by permanent issues endemic to the business itself, but was more a function of both problems related to the spin (which have since been resolved) and other temporary, more macro orientated cyclical issues. For example, on the company specific side of things Visteon was originally spun-off with unprofitable Ford contracts, inadequate financial and admin systems, an overpaid union workforce and a debt load so large that the company never really had a real shot at viability, which actually almost got Ford sued for fraudulent conveyance after the fact. The only reason it didn’t was because by 2005 Ford essentially admitted as much and in an attempt to make amends ended up voluntarily agreeing to buy back a large chunk of Visteon’s money losing operations (and the large pension obligations, amongst other ongoing expenses/liabilities that came along with them) that were strangling the company to death at the time.
The reprieve was short lived though, as various macro/cyclical/financial issues facing their OEM’s began to overwhelm any of the relief that the 2005 restructuring provided. Like nearly all of the auto suppliers over this period, a few of Visteon’s bloated hugely indebted OEM’s began to squeeze them in a desperate attempt to stay afloat, which obviously had a negative impact on the company’s profitability over the period in question. For reasons discussed below, we actually think these issues won’t be nearly as large of a concern over the next few years, although it is undoubtedly something to keep a close, watchful eye on in the years ahead.
A Classic Low-Risk, High-Reward Investment Opportunity
Whether or not the company actually trades higher upon re-listing, we think it’s pretty hard to lose money (under nearly any outcome we can imagine) purchasing VSTN at $48/share or roughly 3x EBITDA when its margins are expanding and 2/3rd of its revenues are coming from Asia. After all, Visteon is an established and fast growing market leader with rapidly improving fundamentals and a sticky and above average customer base. Granted this isn’t the best business in the world, but given the nature of how the industry operates (LT contracts, etc.), the company does have a pretty defensible niche – especially given its improved financial position, revamped operations and its diversified client base (who are for the most part healthy and growing ). Again, the current price is simply way to cheap all things considered.
Granted, most investors familiar with the company probably think of the company as it was in its pre-bankruptcy days – where the company had a bloated cost structure, a large amount of debt, a more concentrated customer base, and the majority of its business was derived from slower growth, lower margin U.S. and Western European markets. But that was then and this is now and as of today (i.e., post bankruptcy) the company is a very different animal as it possesses (we don’t think it ever hurts to reiterate it one more time) a lower “lean and mean” cost structure, a net cash position, a stronger, more diversified client base and best of all, the majority of the company’s business is now derived from rapidly growing, higher margin Asian markets.
The bottom line here is that the company is cheap, its fundamentals have clearly stabilized and it’s growing, margins are improving, and barring any worldwide catastrophe we think these trends will in all likelihood continue for at least the next couple of years. If not, the sizable margin of safety embedded in Visteon’s current price will likely ensure investors do okay regardless. The way we look at it is that if things get better, the upside from here should be spectacular. If they’re okay i.e., both economic conditions and global vehicle sales purely stabilize, we will likely still do very, very well. If they get worse, we will probably at least get our money back (or maybe even lose a little). All in all we like the risk/reward here.
We agree with MWhitman that the most appropriate way to value Visteon is on a Sum of the Parts basis, given the majority of Visteon’s current EV consists of a 70% interest in Halla Climate control (a publicy traded company in Korea) and a 50% interest in Chinese JV Yanfeng Visteon. In order to do that, one needs to separate the cash flows between the company’s Asian interests from the rest of the company and then apply an appropriate multiple to each piece. That way we can add up the pieces and adjust the balance sheet for the sources and uses of cash associated with the reorganization and hence, get an idea of what the consolidated company’s total value is at our base case multiple of 3.75x EBITDA (i.e., the low end multiple of Visteon’s comps).
Let’s begin with the value of the non-Asian segment. With consolidated 2011 EBITDA of roughly $675m, we need to subtract the 92.2m & 26.2m in net income from the Yanfeng and other JV’s. After that, we will need to add back 100m associated with the minority interest deduction and then last but not least, subtract Halla’s 325m in expected 2011 EBITDA. If we do the associated math, we find that our adjusted non-Asian 2011 EBITDA comes to 331m, which, if we then apply our chosen multiple of 3.75x 2011 EBITDA we will get a TEV of $1,243.7 for Visteon’s non-Asian assets.
As far as the values of the Asian assets are concerned, we think it makes sense to value Visteon’s 70% stake in Halla Climate at market, or roughly $1.1B. Probably due to the stigma associated with having a bankrupt parent, Halla trades at only 10x its 2010 after-tax earnings which is cheap from an absolute standpoint but especially so given Halla’s competitive position, above average growth prospects and improving profitability. Keep in mind that the health of Halla is a function of the health of Hyundai, which notably has a long history of steady growth and market share gains (which we expect to continue).
We take a similar tact with Visteon’s 50% stake in Chinese JV Yanfeng Visteon. With Yanfeng, we apply a multiple of only 9x after tax earnings or $829.7m – which again we feel is almost unjustifiably conservative given the qualitative and quantitative characteristics of this business (after all, JCI didn’t try and steal it in bankruptcy for nothing). On a relative basis, Yanfeng is also very cheap as all of its Shanghai, Japanese, and Hong Kong traded comps currently trade hands between roughly 10 and 15x after tax earnings. Anyhow, if you are not as of yet sufficiently convinced with the conservatism of our valuation, did we mention that Yanfeng is a global industrial powerhouse with a diversified client base and 70 production facilities in China and elsewhere around the world (which explains why the company is currently ranked #4th out of 100 of China’s automotive component businesses)? How about the fact that it has been growing at over 60%? Now no business can grow that fast over the long term, but given the absolutely gigantic runway still ahead of it and the structural tailwinds firmly at its back, 15x after tax earnings certainly seems like a more rational multiple all things considered – but for conservatism’s sake, we will stick with or original 9x estimate. The only other piece of the puzzle in this regard is adding in Visteon’s 50% interest(s) in their other JV’s – and again, for conservatism’s sake we valued these additional JV’s at a conservative 5.5x after tax earnings (or $143.9m).
Last but not least we want to point out that the valuation below (again for conservatism’s sake) assumes 1) the billion plus NOL’s the company has are worthless, and 2) that the company doesn’t benefit from any future working capital releases associated with the restoration of trade terms. Obviously both should generate considerable amounts of value for shareholders.
Sum of the Parts
Non Asian Visteon EV = $1,243.7
70% Stake in Halla Climate = $1,122.1
50% stake in Yanfeng = $829.7
Other JV Interests = $143.8
TEV = 3,339.3
Exit Cash(1)= 785
Less: Cash at Halla = (100)
Warrant exercise Proceeds = 114.2
NOL (2) = 0
W/C Source of Cash (3) = 0
Exit Debt = (500)
Other Debt = (143)
Equity Value = $3,495.8
Shares Outstanding (mm) = 54.2
Value Per Share = $64.45
(1) See sources and Uses of Cash
(2) Book value of NOL’s were $1.6B as of 12/39/09
(3) There will be a material amount of cash from restoration of trade terms
Sources & Uses of Cash
Equity Right’s Offering = $1250
Cash 6/30/2010 = $1160
New Term Loan Proceeds = $500
Additional Cash Generated since 6/30 = $60
Total Sources = $2,970
Prepetition Term Loan = $1659
Cash on B/S on Exit = $785.3
Administrative Claims = $105
ABL Claims = $ 127.2
DIP Facility = $75
Priority Tax Claims = $5.3
Other Claims = $5.4
Cash to other UnSec. Claims $83.4
Backstop Fee’s @3.50% = $43.8
Other Fee’s and Expenses = $80.5
Total Uses = $2,970
Thoughts on the Rearview & the Road Ahead:
We think that one of the silver linings of the turmoil of ’08 and early ’09 – and the restructuring’s and bankruptcy’s that followed – was that it caused many of the biggest OEM’s to fix their balance sheets, wring out unnecessary costs and rationalize their excess capacity, all of which have set the stage for a period of significantly improved profitability (for both the OEM’s and indirectly, the auto supplier group as a whole). This is important as this new reality should make OEM’s considerably less likely to try and squeeze their suppliers (and hence depress their profitability), at least over the next few years or so.
Additionally (as odd as it may sound), the secondary effects of the great recession turned out to be even more positive for Visteon, as bankruptcy forced it to lower its cost structure, right size its capital structure (post reorg the company has zero net financial leverage) and revamp and transform its operational footprint, all of which should result in permanently improved operating performance and significantly better long-term growth prospects. We don’t think it’s a stretch to say that for all intents and purposes old Visteon and new Visteon are essentially completely different companies. We want to also quickly mention that it’ likely no small thing that for the first time since its arrival as a public company nearly a decade ago, the company as well as a significant amount of its customer’s/end markets are simultaneously healthy (or at least healthier).
So in sum, given the above in conjunction with the fact that global auto production has stabilized and that – at least for the moment – appears to be solidly growing again, it may be that Visteon’s next few years will actually be quite bright. In fact, we think the next few years likely will be, barring of course any sort of scorched earth scenario where global growth in vehicle production falls of a cliff. Again, Visteon is a materially better business today than it has ever been (and should trade at a materially higher valuation than an examination of its history would suggest), as the company should not only generate higher margin cash flows, but it should actually be able to grow those cash flows at a much faster clip given the large and faster growing runway ahead of it.
JCI Bid/Potential Asset Sale’s – Given that Johnson Controls has publicly stated that it is essentially chomping at the bit to make an offer for the company’s interior’s and electronics businesses (JCI recently mentioned that they are simply waiting until after the Visteon’s emergence from bankruptcy to re-start talks), we wouldn’t be at all surprised to see a significant amount of the company sold in the near-term.
Difficult Industry/Global Sales Decline – At the moment the rebound in global SAAR is a tailwind, but obviously if there was any significant decline in global vehicle sales from where we are at it, Visteon’s OEM’s would suffer and hence so would Visteon. Investors who intend to own the company for the long-term should always keep in mind that Visteon operates in a difficult industry. The auto parts industry is a cyclical, brutally competitive industry that is both labor and capital intensive. That said, given their position in the industry, any uptick or unexpected strength in global vehicle production should quickly benefit the company’s bottom line.
Management Incentives/Recent Sandbagging – As with all reorganizations, it’s helpful to have a solid understanding of the incentives of insiders/management when analyzing the opportunity. So given their options and the current global economic uncertainty, we don’t think it’s at all surprising that they have been grossly low-balling estimates over the course of the reorganization and will likely continue to do so at least for the near future (fwiw, this reality provides us with further confidence in the conservatism of our valuation).
When Issued Eligibility – In our opinion, given the cleaner arbitrage associated with the when issued shares, we think they are the ideal way to exploit the current mis-pricing. The problem though – at least for funds with less than 100m in AUM – is that smaller funds can’t effectively take advantage of it. For those of you without the requisite size and who are also attracted to the opportunity on a longer-term basis, one can always purchase the old equity (VSTNQ.PK). Interestingly the old equity will receive 1m shares and 1.57m warrants with a $58.80 strike price upon the newco’s relisting, so although not as cheap as the “when-issued” shares, at the current $0.52 they are still attractive. It’s important to know though that the trading dynamics of the old equity will likely be a lot different (i.e., less efficient, more volatile, etc.) than the new equity. Below is a sensitivity table regarding the trade-offs between the new and old equity.
|SENSITIVITY ANALYSIS: IMPLIED ABSOLUTE RETURN|
|NEW EQUITY/WHEN ISSUED SHARES @ $49|
|VISTEON CORE EBITDA MULTIPLIER|
|OLD EQUITY SHARES W/ WARRANTS @ $0.515|
|VISTEON CORE EBITDA MULTIPLIER|