Description

"We believe in God, we mind our business and we work like hell."

                                                            -Ray Herrick, Founder, Tecumseh Products

Tecumseh’s raw potential jumps out when viewed with a fresh set of eyes:   $820+ million in annual sales;  7,700+ employees;  significant PP&E in the US, Brazil, and India…..and an enterprise value of less than $140 million (good for a laugh:  compare TECUB’s EV per employee to that of WhatsApp).  Interestingly, TECUB holds a #2 market position in the commercial refrigeration compressor industry, with about 17% of the global market (Embraco is #1) according to the company’s May, 2013 presentation. 

The company has a long history, in both the annals of American business and on VIC (many thanks for the previous write-ups of straw1023, jak, goob392, and tickles879).   A leading supplier of compressors to commercial and residential refrigeration (and A/C) markets, Tecumseh once provided components for the first residential window air conditioning unit in 1947; earlier in the decade, the company produced artillery shells for Allied forces;  and founder Ray Herrick was a friend/ colleague of the original Henry Ford in the 20’s and 30’s. 

With the stock scraping along near 52 week lows, TECUB is due for an update.  For those new to the company, Tecumseh (through April 2014, at least) has a dual class structure, originally implemented to protect the interests of the Herrick family.    TECUB (about 5MM/ 18.5MM total Tecumseh shares outstanding; thinly traded at avg. volume of 22,000) carries voting rights, while TECUA (roughly 13.5MM shares, avg. volume 69,000) does not.    

For those working on an egg timer, here’s a synopsis of the investment thesis that applies to both TECUB and TECUA:

• Buying opportunity created by changing of the guard; story has shifted from event-driven / M&A / asset disposition focus to a deep value, cyclical turnaround (duly rewarded with a c. 28% decline in TECUB since January 23, 2014, and a c. 45% decline since July of 2013, despite modest improvement in EBITDAR).
• Disproportionate upside potential:  currently c. $820MM ttm sales, EV of less than $140MM (EV/Sales of 17 to 18%).  Company publicly aspires to 8 – 10% EBITDA margin; applying a significant haircut, at 5% margin on flat year-over-year sales and a 6X multiple, TECUB offers 80%+ upside.
• Company currently trades at less than 6X EV/ EBITDAR ttm, and about 10X EV / (EBITDAR – ttm Capex).
• Asset-rich balance sheet provides backstop for turnaround and insurance against worst case scenarios: 
  • Significant land holdings in Brazil and high tech corridor of India; consultants hired by company’s former largest shareholder valued the company on a liquidation basis at $237 to $334 million (PP&E is carried at $123 million vs. historical cost of $812 million at 12/31/13).  See 13D filed 5/14/12.
  • $55 million unrestricted cash, $12 million net debt at 12/31/13 (zero debt including restricted cash).  From a cash standpoint, the company essentially broke even in 2013.
  • $293 million of operating loss and tax credit carryforwards
• Ongoing shift to aluminum in its compressor designs to reduce hard cost.
• Exit of the company’s largest shareholder is counter-balanced by a) Fall 2013 addition of investor with history of 13D activity and concentrated portfolio; and b) 2014 increase in ownership of company’s second-largest shareholder (10+ year holder).
• Executive team changes:  company has announced hiring of a Chief Restructuring Officer, who reports jointly to the CEO and BOD, as well as a senior ops executive.  Executive incentives have been significantly re-vamped, shifting from RSUs settled in cash to RSUs settled in common stock.
• Pending combination of TECUA and TECUB (shareholder vote scheduled for late April of 2014) will improve liquidity and erase discount for TECUB (TECUB recently has traded at 3 – 5% discount despite voting rights).
• Zero analyst coverage

Brief Company Overview

A complete history is beyond the scope of this write-up, but here’s the quick synopsis.  Ray Herrick, a master toolmaker with roots in the early American auto industry, founded the company in suburban Detroit in the 1930s to build refrigerator and automobile parts.  After a brief hiatus into the manufacture of 40mm shells to help drive the Allied supply effort in WWII, the company grew organically and via acquisition to become the major independent manufacturer of hermetically sealed compressors for commercial and residential refrigeration and air conditioning.  The company also competed in small engine manufacturing (think lawn mowers, snow blowers, etc.) before divesting that business in 2007.  Over the years, the company expanded its presence globally (compressors are expensive to ship…), with significant manufacturing and assembly presences in the US (Tennessee and Mississippi), Brazil, Mexico, France, India, and China.

Fast forward to a snapshot of the company in recent years.   The influx of foreign competition—coupled with the baggage that sometimes accompanies multi-generational leadership & succession in family-led companies, to put it charitably—has significantly hurt TECUA over the past 10 years or so.  The financial crisis certainly didn’t help.  3 CEOs breezed through for a cup of coffee in four years.  As the company dipped into the red, in 2007 it disposed of its small engine business to focus on compressors.  Following the exit of the Herrick family, Jim Connor, a former managing director of BBK, Ltd (a turnaround management consulting firm) has served as Chairman and CEO since mid-2011. 

The bulk of the business (and profits) are generated by the commercial refrigeration division, which accounted for 59% of sales in 2013 (same % as 2012); residential refrigeration was 22% of sales, and 19% came from specialty Air Conditioning.    The latter two divisions are particularly competitive, low-margin businesses that have been the target of activist concern.  The aforementioned former largest investor pushed—not unreasonably—for the company to divest its smaller divisions to focus on Commercial. 

Intellectual property is not a focal point here; this is a business in which technological advancements (and therefore, individual players’ capital expenditures) ultimately benefit everyone in the industry.  For this reason, the winners will be determined by cost structure and, to put it bluntly, hustle in the marketplace.  For Tecumseh, the name of the game is efficiency.

This is an international company; in 2013, about 18% of sales came from North America, 34% from South America, 25% from Europe, 14% from Asia, and 8% from Africa and the Middle East.  The company has plants in Brazil, the US (Mississippi and Tennessee), France, and India, and also maintains a presence in Mexico, China and Malaysia.

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Let’s start with the challenges (there are plenty).

In fairness, there are plenty of things that are NOT attractive about Tecumseh.  The company has left a trail of tears with investors in general, and on VIC in particular; quoting goob392, “TECUA was previously recommended on VIC in 2006, although tickles879 may not be laughing as the price was then $17.76.”   Frankly, I doubt TECUA brought much joy to goob392 either ($11.56), unless he/she flipped it after a few months. So there’s a history that reeks of “value trap.”

Secondly, I’d love to stand here and say this is a fantastic, misunderstood business with extraordinary economic characteristics, but it clearly is not.   It resides in an intensely competitive industry, with negative returns on tangible capital, featuring weak entry barriers and generally weak pricing power, subject to fluctuations in material costs (copper and steel) that can be difficult to hedge against (steel).  To top it off, they deal with organized labor in certain locales and are routinely batted around by currency fluctuations.  [How’s that for an investment pitch?]

Moreover, many of the same bullet-pointed elements I listed above have been in place for the last couple of years.  The “liquidation story” should be well-known to older hands on VIC (I refer you to straw1023’s write-up for a detailed account), but for those who are new to the company, here’s the gist of it.  Long-time shareholder Roumell Asset Management (albeit short-time activist… TECUA was its second effort ever, according to the fund’s 13/D) established a c. 20% position over a lengthy period, with ownership apparently peaking in early 2013.   Beginning in 2012 and extending over the course of 2013, they put forth a plan for the company to strengthen its Board, to divest selective PP&E (Brazilian foundry and Indian real estate) and to focus exclusively on the higher-margin commercial business.  A reasonable plan indeed, but it clearly did not pan out.  In this case, I believe it says more about the market for assets in the residential compressor market and Brazil’s turbulence than it does about the skill or motivation of management.  The stock market has reacted by sending TECUB down about 28% since January 23, 2014. 

So what has changed since the last VIC write-up in February, 2013 (other than the price)?

1)     Early in 2013, the company hired Sageant, an investment bank, to review strategic alternatives.  Little if anything came from those efforts, a fact which should not be taken lightly; one should not assume that this is an easy company to dismember, particularly when a large chunk of assets are based in a turbulent market (Brazil in 2013).  The company did sell a couple of million dollars’ worth of real estate last year, a relative pittance.

2)     The company announced the hire of a Chief Restructuring Officer, Igor Popov, on March 4, 2014, as well as a new senior operations executive.  Popov reports to the BOD and the CEO.

3)     At the behest of shareholders, the BOD was strengthened with the addition of two independent directors (one of whom made a cash purchase of about 58,000 shares of stock); as a reminder, the founding Herrick family is no longer on the BOD or management team.

4)     Management’s long term incentives have been overhauled & shifted from cash to equity ownership; salaries unchanged (see 2014 proxy).

5)     Significant changes in shareholder base, now led by historically long term, deep value investors that should be familiar to most on VIC.  One value-oriented shareholder with a history of activism and concentrated portfolio joined the fray in the Fall of 2013.  Roumell reported complete exit of its position in February of 2014.  Concurrently, the company’s second largest shareholder (a 10+ year owner) significantly increased its ownership in the B shares.

6)     At the forthcoming shareholder meeting, shareholders will vote on an initiative to combine the two classes of stock.  The Herrick family (largest holder of TECUB, the voting class, has publicly encouraged the consolidation in SEC filings).  The Herricks have expressed some interest in selling shares in the past, which could pose a short-term headwind for the stock if handled clumsily, but they now own less than 1.7 million B shares vs. 18.5 million shares total in the two classes.

7)     After an initial dose of good cheer early in 2013 (Tecumseh intially expected 3 – 8% topline growth), the company softened its outlook, and wound up with essentially flat sales in 2013 after adjusting for FX impact.

For Tecumseh, the game has shifted from exploration of strategic alternatives to a decidedly less-sexy drive toward efficiency.  In an industry devoid of serious, durable competitive advantage, the mission is to focus relentlessly on efficiency and cost reduction.  Having invested over the past few years in a new US-based R&D center and a Mississippi plant that can wean the company off its Brazilian production presence if need be, the heart of the thesis is that Connor, Stipp, and Popov can squeeze a 5% EBITDA margin out of TECUB without the need for huge capex.  It could very well take 2 years or more, and I’m fine with that, given the potential payoff and the downside protection provided by the asset base.  As the saying goes, you pay a lot for a rosy consensus (or an imminent catalyst).

It’s worthy of mention that TECUB’s revenue is levered to the commercial real estate cycle—which has yet to fully rebound in the wake of the financial crisis.  Pulling the divisional revenues out of the old 10Ks (prior to 2008, Tecumseh ran a small engine business--snow blowers, lawn mowers, etc.), we find that TECUB’s refrigeration compressor sales peak in concert with the commercial real cycle.  At the first of two most recent cyclical peaks, in 1998 – 1999, TECUB’s compressor division generated $1.05 billion (’98) and $0.97 billion (’99) in revenue.  After compressor sales dropped to $0.78 billion in the downturn of 2002, they rebounded to over $1 billion in both 2006 and 2007.  I’m not a top-down investor, but I think those numbers inform TECUB’s results in subsequent years, when sales dipped to $0.73 billion in 2009, followed by a bounceback year in 2010 ($0.97 billion) and three years of $825 - $865 million thereafter. Despite the downtick since 2010, on the 3Q13 conference call, Connor said that he was confident TECUB’s market share had not slipped.  An upswing in commercial real estate development is not central to the thesis here, but it would provide a nice tailwind.

What IS central to the thesis in this intensely competitive business is margin improvement.  The company took modest steps in that direction under CEO Jim Connor’s leadership in 2012- 2013— for example, TECUB reduced retirement benefits substantially, eliminating defined benefit retirement plans to new employees and curtailing ongoing benefits to long-time employees in 2012 (this restructuring produced a gain on curtailment of $45 million).  The company has also scaled back its presence in certain high cost geographies, e.g., France, after a lengthy negotiation.  But perhaps the greatest benefit may come from an ongoing shift to aluminum components in Tecumseh’s compressors.  I mentioned this earlier:  one of the risks/ weaknesses of Tecumseh is its limited control over raw input costs, namely copper and steel (despite the effort to hedge against increased copper costs).  The company is increasing its reliance upon aluminum components in lieu of copper.  In 2006 – 2007, TECUB’s copper costs spiked by 40%, which, along with currency headwinds, accounts for the weak results in those years.

I don’t want to overstate this, but while the stock price has declined in recent months, EBITDA from continuing ops has shown improvement before the impact of restructuring costs.  Gross margins have shown nominal improvement (from $65 million in 2012 to $78 million in 2013), but a lot of that is due to FX effects.  EBITDAR from continuing ops improved from $16 million in 2012 to $28 million in 2013.

From a cash standpoint, the company essentially broke even in 2013—a feature that I find attractive in a turnaround play.  Capex was $11- $12 million, equivalent to CFO.   Note the disparity between capex and D&A ($33.5 million in 2013).

The asset side of the balance sheet (particularly PP&E) was well documented by straw1023 in his February, 2013 write-up, and the story has not really changed; I would refer you there as well as to the May 14, 2012 13D filing for further information.  To summarize: 

• Total land and improvements carried on the 12/31/13 balance sheet at $10.1 million.  Roumell consultant estimated value of TECUB’s India holdings alone at $92 – 97 million, and Brazilian PP&E at $40 - $60 million.  Estimates at that time were well off the peak values of 2007.  On a liquidation basis, the consultant valued Tecumseh overall at $237 million to $334 million, vs. today’s EV of less than $140 million.  It’s dated information (2011), and it’s one firm’s opinion, but it’s an interesting data point.
• Gross PP&E was $812 million at 12/31/13, net PP&E was $123 million.
• Unrestricted cash was $55 million at year end 2013, the same level as year-end 2012.

I view the net asset value as a backstop for the turnaround play.  If the company decides to shift production out of Brazil, and the market accommodates the sale of those assets, wonderful… but I’m not counting on it.

Similarly, the company’s $293 million of operating loss and tax credit carryforwards at 12/31/13 would be an interesting boon to a potential acquiror.  But that acquiror has apparently been tough to find, judging by the inconclusive engagement of Sageant in 2013. 

On the liability side of the balance sheet, total debt stood at $67 million at year end, versus $55 million of unrestricted cash and $14 million of restricted cash.  I note the significant uptick in warranty liabilities ($19 million total) due to a manufacturing defect in 2013 (CEO Connor, to his credit, has not shied away from this).  Pension liabilities in the wake of the restructuring over the past couple of years were $20 million.

Valuation

This is fundamentally a bet on a return to the EBITDA levels of 2007, when the company faced currency headwinds (Brazil +17%, India +11%) and extraordinary spikes in commodity prices (copper +40% from 1/1/06 to 12/31/07).  Despite those headwinds, and despite the squabbles with the Herrick family, and despite the lack of properly aligned incentives… the company had an EBITDA margin of 5%.

At a 5% EBITDA margin (again, applying a 40 – 50% haircut on management’s target margin), assuming flatlined sales, Tecumseh would generate $40 million in EBITDA.   With $15 million in capex, we’re looking at $25 million in owner’s earnings; I’m assuming no further investment in working capital.       I think 6X EBITDA or 10X EBITDA-Capex is a reasonably conservative estimate of value.  That’s more than 80% upside from the stock price today.

Another way to get there:  find a way to dispose of the residential compressor and A/C businesses if the market accommodates; an 8% margin on $500 million of commercial compressor sales gets you to the same place.

The disproportionate upside is obvious; if management hits its margin targets, this could be very interesting…                                        

Catalyst