Segmenting The Business Doesn't Solve Federal Mogul's Biggest Challenges

By Stephen D. Simpson, CFA | September 20, 2012 AAA

Although the passenger vehicle market has stayed relatively healthy in the United States, slowdowns in Europe and emerging markets have left many auto parts companies drifting this year. In the case of Federal-Mogul (Nasdaq:FDML), it could be argued that macro pressures have hidden some of the cost improvements the company is trying to make, while the weak performance of the aftermarket business has likewise weighed on the numbers. Although Federal-Mogul likely can do better from here, investors should not lose sight of the risks that accompany the stock.

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The Split Is in, but Will It Help?
Earlier this year the board of Federal-Mogul decided to restructure and effectively split the business of the company. That split was executed earlier this month, dividing the company into "Federal-Mogul Powetrain" and "Federal-Mogul Vehicle Component Solutions," the latter largely being the company's aftermarket and friction businesses.

The company has gone all out with this split, including the hiring of co-CEOs. Rainer Jueckstock runs the Powertrain business, while Michael Broderick is charged with turning around and improving the new Vehicle Component unit. While the company has said that they are not anticipating selling the Vehicle Component business, the emphasis on the independence of the two segments calls that into question for me. A healthy (or at least healthier) aftermarkets business could definitely add value for the company, but selling it could bring in over $1 billion and that certainly wouldn't hurt the balance sheet any.

SEE: How To Evaluate A Company's Balance Sheet

Good Underlying Trends, but Is It a Good Business?
On the surface, Federal-Mogul looks like a business well worth researching further. The company is a diversified player in product categories like pistons, piston rings, seals, bearings and so on. While the company's 10% exposure to BRIC countries is a little light, the overall diversification between vehicle types and manufacturers is attractive, with the Big Three ((Ford (NYSE:F), General Motors (NYSE:GM) and Fiat-owned Chrysler)) less than 20%, but most major manufacturers ((including Toyota (NYSE:TM) and Volkswagen)) represented.

What's more, Federal-Mogul should be in position to take advantage of ongoing demand for better fuel efficiency and lower emissions. Areas like improved exhaust energy and reduced engine friction play into the company's Powertrain offerings, and the company has some exposure to improved gas exchange as well (the "big three" of improved engine performance). Now, for the other side of the ledger. While Federal-Mogul doesn't have high customer exposure, auto makers in general are not too willing to let their suppliers thrive at their expense. So, while a lot of Federal-Mogul's competitors are not exactly household names to non-gearheads ((names like Kolbenschmidt and Mahle, along with better-known companies including Dana (NYSE:DAN), Honeywell (NYSE:HON) and TRW Automotive (NYSE:TRW)), there's more than enough competition to weigh on margins and returns.

In fact, at no point in the last decade has Federal-Mogul come close to earning its cost of capital, and it's hard to imagine that the company can lift its free cash flow margin above the mid-single digits. Couple that with a debt-heavy balance sheet and the financial outlook isn't as appealing as the company's market share or business exposures may suggest.

The Bottom Line
I do like the company's leverage to fuel efficiency and emissions, but I believe BorgWarner (NYSE:BWA), Honeywell and Cummins (NYSE:CMI) are better plays on that theme (with Cummins much more focused on commercial vehicles). Likewise, I like the company's strong market share, particularly in aftermarket parts, but it's pretty clear that strong share has not yet translated into good financial returns, and it may never do so.

On a discounted cash flow basis, forget about Federal-Mogul - the huge debt load just saps any DCF-derived fair value to almost nothing. On an EV/EBITDA basis, though, maybe this could work as a turnaround play. Federal-Mogul's EV/EBITDA is around 5.5 today, and I think there's a pretty fair chance that the company can deliver EBTIDA growth in excess of 6%, though probably not this year or next. Accordingly, this is a risky stock with questionable fundamentals, but some upside for more aggressive investors who believe that the global passenger vehicle market can improve and that Federal-Mogul's restructuring efforts will pay off with better margins.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.

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