A market leader is not often priced for permanent profit decline amidst improving market conditions. Throw in rising profits, an executive compensation plan aligned with creating shareholder value, and regulatory tailwinds, and this stock could be the next hidden gem. Tenneco Inc. (TEN: $63/share) is this week’s Long Idea and on April’s Most Attractive Stocks list.

Tenneco’s Impressive Profit Growth

Since 2008, Tenneco has grown after-tax profit (NOPAT) by 20% compounded annually to $488 million in 2016. The company has grown revenue by 5% compounded annually over the same time. Per Figure 1, the company’s NOPAT margin has improved from 2% in 2008 to nearly 6% in 2016. Longer-term, Tenneco has grown NOPAT by 13% compounded annually since 2000.

Figure 1: TEN Profit Growth Since 2008


Sources: New Constructs, LLC and company filings

In addition to NOPAT growth, Tenneco has generated a cumulative $1.1 billion (33% of market cap) in free cash flow (FCF) over the past five years. Tenneco has also exhibited good stewardship of capital amidst multiple economic cycles. The company has earned a positive return on invested capital (ROIC) every year since 1998 and currently earns a 14% ROIC, which is in the second quintile of our coverage universe.

Executive Compensation Plan Is Aligned with Improving ROIC

TEN’s executive compensation plan includes base salary, annual bonuses, and long-term stock-based compensation. 75% of annual cash incentives are tied to improvements in Economic Value Added (EVA), aka economic earnings. EVA has been a target metric in Tenneco’s executive compensation plan since at least 1997, which is the earliest available electronic filing. Tenneco’s compensation committee uses EVA because “EVA improvement performance is correlated with stockholder returns and that making business and investment decisions based on EVA balances cash-oriented and earnings-oriented results.”

The focus on EVA helps ensure executives continue to be good stewards of capital. Per Figure 2, TEN’s ROIC has improved from 4% in 2008 to its current 14%. More importantly, TEN has grown economic earnings from -$15 million in 2008 to $227 million in 2016.

Figure 2: Tenneco’s Rising ROIC Showcases Proper Executive Incentives


Sources: New Constructs, LLC and company filings

We know from Figure 3 below, and numerous case studies, that ROIC is directly correlated to changes in shareholder value. ROIC is, by far, the most important driver of EVA. Accordingly, TEN’s use of EVA to measure performance ensures executives’ interests are aligned with shareholders’ interests.

Improving ROIC Correlated with Creating Shareholder Value

Per Figure 3, ROIC explains 63% of the changes in valuation for the 24 Auto Components firms we cover. Despite TEN’s 14% ROIC, above the 11% average of the peer group, the firm’s stock trades at a discount to peers as shown by its position below the trend line in Figure 3. If the stock were to trade at parity with its peers, it would be at $122/share – 96% above the current stock price. Given the firm’s higher ROIC and impressive profit growth, one would think the stock would garner a premium valuation.

Figure 3: ROIC Explains 63% Of Valuation for Auto Components Firms


Sources: New Constructs, LLC and company filings

TEN’s Profitability Helps Maintain Market Leading Position

The automotive component industry is highly fragmented, with many firms manufacturing one specific piece of the entire automobile puzzle. In the clean air and ride performance subsets, Tenneco faces competition from foreign firms such as Faurecia and Hitachi Automotive Systems. The firm also faces competition from vehicle parts manufacturers such as BorgWarner (BWA), Dana Incorporated (DAN), and U.S. Auto Parts Network (PRTS). Per Figure 4, TEN has the highest ROIC and one of the highest NOPAT margins versus peers.

High margins have allowed TEN to build a market leading position across the globe. The company estimates it holds the top market position in its ride performance segment and is one of the top two suppliers of clean air products worldwide. TEN’s profitability gives it the flexibility to invest in research and development to build new technologies such as active suspension systems while maintaining profitability. Most importantly, TEN is able to competitively price its products to maintain or take market share without compromising profitability.

Figure 4: TEN’s Profitability Among Peers


Sources: New Constructs, LLC and company filings.

Bear Concerns Assume Emission Regulations Cease to Exist

As a manufacturer of clean air and ride performance products, such as exhaust systems and suspension products, TEN is reliant on a strong auto market. Bears will argue that auto sales are peaking and that Tenneco’s impressive profit growth cannot continue. However, automotive regulations, particularly emissions and safety standards, provide a clear demand for Tenneco’s products for many years to come. Add in expected investments to improve margins and prudent cost management, and the bear case has some large holes.

Each country sets emission standards for different vehicle types. More stringent requirements create the need for advanced technology that can more effectively limit emissions from combustion engines. In the United States, where Tenneco generates 50% of total revenues, the current emission regulations call for a steady reduction in non-methane organic gas plus oxides of nitrogen (NMOG+NOx) from 2017-2025, per Figure 5. These standards must be met, on average, across each manufacturer’s fleet of all vehicles.

One of the largest concerns regarding emissions standards in the United States is whether President Trump will roll back these regulations or stop any further increases in standards. Rolling back current regulations would be tough since they are locked in through 2021 and will be re-evaluated for 2022-2025. To change the existing standards, the Department of Transportation would have to rewrite average fuel economy standards and the EPA would have to re-write greenhouse gas emissions laws. Any changes by the EPA must go through the formal rulemaking process, complete with public comment periods and agency analysis. Those changes could be challenged in court just like some of President Trump’s current executive orders.

By 2022, when U.S. standards could be relaxed, automakers will have made significant investment in manufacturing processes to support emission improvements and rolling back would be more expensive than maintaining.

Meanwhile, across the globe even higher standards are becoming the norm. In China, new emission regulations are being phased in from 2013-2023. By 2023, CO levels must be below 0.5g/km, down from 1.0g/km in 2018. Across the European Union, new real driving emissions standards will be applied between 2016-2022. Over this time, the standards require a 90% reduction in particulates per kilometer and 95 grams of carbon dioxide per kilometer, down from 130g/km in 2015. Lastly, in India, new regulations are being rolled out from 2010-2020. The Bharat Stage 6 regulations, have been expedited to 2020, ahead of the original implementation date of 2024.

Both the Chinese and Indian standards are based on European Union 6 (Euro 6) standards, and in some cases, are more strict for certain specific pollutant levels. The Euro 6 standards, rolling out through 2022, require no more than 95 g/km in carbon dioxide (CO2) pollutants. Under the

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