Superior Industries (SUP US)

Charlie Munger had Tenneco, could I have Superior?

Company description

Superior Industries is the largest designer and manufacturer of aluminum wheels worldwide. They sell them to automotive OEMs in North America and Europe and sells them to aftermarket resellers in Europe.

Their largest customers are General Motors (26% of revenue), Ford (16%) and Volkswagen Group (14%), but they work with a variety of OEMs like Toyota, BMW, Honda, Lucid Motors, PSA and Mercedes.

Their business model is to take in aluminum, transform it into wheels at their factories in North America (Mexico) and in Europe (Germany and Poland). The aluminum is a pass-through, so they don’t take a risk on aluminum prices, the revenue net of the aluminum pass-through is defined as Value-Added Sales. Whenever I mention EBITDA margins they’re based on Value-Added Sales and not Revenue.

Why is the stock down so much?

In March 2017, Superior Industries announced the acquisition of Uniwheels AG, a very large German aluminum wheel manufacturer, with a total transaction value of $715M.

It was a transformational acquisition that took them from a large North American supplier to a now global supplier and the largest in the World.

The problem is that they over-extended on that deal, it forced them to take on a lot of leverage and added a lot of complexity to their capital structure. It added $660M of debt and two tranches of preferred shares worth $150M by TPG (PE fund).
On top of that they announced they were cutting their dividend in half to de-lever post deal.

After the deal announcement the stock brutally sold off about 40% from $26 to $15 where it stabilized for a couple months.

Then in 2018 after the stock had started to rehab on strong auto volumes in 2018, it sold off alongside the market, accentuated by the leverage on the balance sheet, due to rate hiking cycle in 2018.
Then 2019 came around, and with weaker industry auto sales and a compromised balance sheet, the stock kept doing poorly.

In May 2019 the CEO was replaced by Majid Abulaban, a veteran of Aptiv, formerly Delphi Automotive, a much larger Tier 1 supplier. He started trying to right the ship, but COVID put the nail in the coffin of Superior Industries. First the combination of compromised cap structure + COVID uncertainty made the stock go into the $1-2 range. Then the stock rallied alongside the rest of the market in 2021, but promptly sold off again as they operated in a terrible auto environment. The chip shortage caused new vehicle sales to be recessionary for the past 3 years, making SUP’s volumes be subdued for 3 years with a still compromised capital structure.

The last hit came in Q1 2023, when the company reported decent but subpar vs expectations Q1 results, and narrowed the guidance down by $10M, a minimal guide down but considering the capital structure it made the stock sell off 30%, that and interest rates continuing to rise on a variable rate capital structure leaves us to where the stock is today, $3.5, left for dead.

On November 22^nd, 2022, UK PE fund M2 Capital offered to acquire SUP for $5.85, a 36% to closing price back then,

Capital structure details

$615M of debt

                $383M term loan due 2027/2028 at SOFR +8%

                $234M 6% fixed rate EUR denominated senior notes due 2025

                $5M capex loan and finance leases

$223M (book value) redeemable preferred shares with redeemable par value of $300M due September 2025. The holder (TPG) has the right to redeem it but not the obligation in September 2025. It’s way out of the money but theoretically convertible into 5.3M shares

$181M of cash

28.1M shares outstanding

Translates to $100M market cap at $3.6/share, $434M of net debt, and $300M of preferred face value, so an Enterprise Value of $836M. As you can see very little value ascribed to the equity. 

Investment thesis

1 – Secular growth story in content per wheel makes me confident that post-COVID their earnings power has tremendously improved.

I’ll start with the outcome and then explain the reason:

As you can see, since 2019, content per wheel which is defined as value-added sales divided by total wheels shipped has been growing significantly, now 30%+ higher than pre-COVID as of the latest quarter.
This means that despite the 20% drop in volumes shipped value-added sales have managed to remain constant.

Now what’s driving this? There’s two main reasons:

• Electric vehicles: the main problem that EVs have is battery range, so a lot of the engineering work revolves around gaining range. One of the core ways to do that is to have the vehicle be lighter, and lighter wheels are a premium product that Superior earns more on, since there’s more difficulty in building a wheel that’s lighter but just as strong.

• Consumer preference: if you’ve seen roads recently, you can tell that the new norm is SUVs, nowadays everybody wants an SUV and they all tend to come with larger diameter wheels which once again carry a higher content $ per wheel vs traditional sedans.
  Premium finishes tend to also become more and more common, things like physical vapor deposition (alternative to chrome) or painted wheels.
  It's also important to note that light-weighting doesn’t only apply to EVs, a lot of ICE vehicles also want greater fuel efficiency, which is often mandated by regulatory bodies.

• The best example of this trend is that 50%+ of new car designs have lighter and larger wheels that carry a premium vs a much lower chunk in Superior’s current revenue mix, so the more these new models grow in their mix, the higher the content $ per wheel.

2 – Don’t think they’re at risk of Chapter 11 on current EBITDA run rate

The big worry around the stock is the capital structure. With the market cap representing only 12% of the total EV, the market is currently pricing in a fairly significant probability of default.

Here’s where I think the market is overly punitive. At the midpoint of the guidance, management is guiding to 15.6M wheels shipped, 19% below 2019 levels and 26% below 2018 levels, and in line with 2022 which suffered from the combination of still a lot of supply chain issues and rising rates.
To get to their Value-Added sales guidance midpoint of $785M, you have to assume $50.3 of content per wheel. I believe that’s quite conservative considering in Q1 they achieved $53.7 per wheel, and $52.4 in Q2. And last year you could see no major drop in content per wheel in the back half of the year, quite the opposite with higher content per wheel but skewed by a higher-than-normal Q4 due to cost recoveries.

All of that gets you to the midpoint of management guidance at $180M of EBITDA, or an implied EBITDA margin on Value-Added Sales of slightly below 23%, once again conservative considering they just reported 26% in Q2 and 22% in Q1, and just announced cost reduction actions in Germany (more on that later).

Essentially, at volumes 20-25% below pre-COVID levels, they’re generating $180M of EBITDA on conservative assumptions. That puts the Net Debt/EBITDA at 2.4x ex the preferred, and 4.1x including the full redemption value of the preferred.
Also note that European aftermarket volumes were down 50% YoY in Q2 due to poor demand and inventory destocking, and SUP still generated $52M of EBITDA.
While that’s not ideal, I think it’s definitely a manageable level.
And despite their high cost of capital (bulk of the debt priced at SOFR + 8%), they still expect to generate $120M of Cashflow from Operations at the midpoint, and $55M of FCF. Not nothing considering that this can allow them to theoretically pay down $55M of debt that costs 13.3% pre-tax, so saving you $7.3M in yearly interest expense.
On top of that there was a significant accounts payable drag in Q2 that’s set to reverse in Q3 worth about $30M.

Now the big question is the maturity profile. Both the preferred shares ($300M) and the euro denominated term loan ($234M) are due in 2025. The term loan is manageable in my opinion, they’re probably going to generate at least $40-50M of FCF before the maturity, helping lower the burden, and can then take care of the refi. The bigger chunk and danger is the preferred. It’d be very costly and difficult to replace the $300M preferred if the EBITDA doesn’t have a significant lift by then (I believe it will but more on that later).
I do believe however that TPG will be accommodating, they can see numbers and results are going in the right direction, they’ve extended the facility and even upsized it in the past. They have no incentive to push them under, especially considering they own 20% of the common shares. I believe the most likely outcome is an extension of the facility in 2024 with some kind of agreement to have FCF allocated to pref paydown until a certain threshold.

It's also worth noting that Superior Industries owns every single facility they operate out of, both in North America and Europe, so if the debt markets were to close up or high yield spreads were to blow out, a sale & leaseback is always on the table tho management has never brought it up.

3 – Recovery in auto volumes combined with internal efforts makes for explosive upside

Ok so, the stock is priced like they’re very close to bankruptcy, I don’t believe they are. On top of that there’s an attractive secular story that makes me confident in their ability to earn more in a normalized market than they used to which bodes very well for the stock considering how levered the company is. But let’s try and truly assess what the upside potential is here.

First let’s talk about the latest bit of news. The management team has announced earlier this week that they’re taking action in German courts to restructure their underperforming German facility. Now if you know anything about European manufacturing, it’s always very difficult and costly to deal with turnarounds and cost cutting.
Management is undergoing a legal process to improve operations as a first step, they believe it’ll cost them about $18M in one-off costs which will have a 1-year payback, so cost savings of $18M a year, very significant news considering the EBITDA base of $180M and the incremental value of that FCF.
If that doesn’t work they also have the option of considering larger actions, like closing down the plant, which they believe would be accretive to EBITDA, but costly in the near-term since you need to pay significant furlough compensation.

That opportunity alone adds a lot of upside. The European business used to generate better margins than North America, but now earns EBITDA margins 400bps below North America.
The new management team has taken an 80-20 approach to fixing operations. If they achieve the cost savings they guided to, this could add $3/share of value at the current trading multiple of 4.6x EBITDA.

Now that’s almost a double, but that’s scratching the surface. What does the upside look like if we go back to pre-COVID shipment volumes on the new content per wheel?
For the sake of the example let’s say in FY25, since I don’t believe we’ll get there in FY24 since rates are high and the economy is in a tough spot:

Now if you take these numbers and apply 5x which I believe is reasonable for the largest player in its industry with a secular growth story in light-weighting and specialty wheels and a multiple only 0.4x higher than today despite the improved capital structure:

Now I could make the case for more margin expansion if the cost cutting is successful, higher volumes than 2019 levels, a higher multiple or even give them credit for the FCF generated in the next 2 years, but point is, even with what seems to me like reasonable assumptions I get very significant upside vs what I believe to be a limited risk of bankruptcy.

Risks

1 – Short-term issues can have a big effect on the stock because of the 2025 maturity wall.

The stock has shown that in the past, whenever there’s a short-term hiccup that might be ignored for other stocks, this one tends to have an outsize reaction. We saw that in Q1 which I thought to be a minor guide down driven by issues at a customer’s plant for the most part, yet the stock sold off significantly. I do believe tho that at these levels we’re safer, in Q1 it happened after the stock had close to a 100% rally in 3 months.

Now what hiccups could we see here?

• General Motors is having issues and it’s 26% of revenue and the largest customer. Since mid-2022 they’ve been having issues at their Silao plant in Mexico which manufactures some of their most profitable trucks like the Silverado and the GMC Sierra. They’re having supply chain issues sourcing a particular component that they haven’t named. It seems like these issues haven’t gotten better and could get worst which could pressure near-term results.
  Going off of little information here but seeing how much better supply chains are today vs a year ago when the problem started, I think it’s realistic to think that problem will be alleviate in the not so distant future.

• Potential strikes. The United Auto Workers “UAW” union is in the process of renegotiating their contract with the big US OEMs which expire September 14^th, 2023. They’ve requested a fairly egregious package with a 40% pay increase and a 32hr workweek. Now it’s common for unions to ask crazy packages in order to negotiate, but not unlikely that to try and strong arm the OEMs they go on strike for 1-3 months, which has happened in the past.
  This would impact North American volumes (half the volumes).
  It's good to note however that a strike is fairly consensus by now, latest Morgan Stanley survey shows 58% of investors think it’s extremely likely and 24% think it’s somewhat likely, so it’s definitely priced in to some extent, the question is how long of a strike.

• Competition from cheap foreign entities. In North America about 50% of wheels consumed come from China, so there’s always a worry with foreign competitors that they get too aggressive on price. I do believe this risk to be very limited for one reason. US OEMs are tired of China, they want to reshore as much of their work as possible to not suffer from the same supply chain issues they’ve had the past 3 years, having a $50,000 car get held unfinished because your Chinese suppliers is having issues is just not sustainable, so I don’t believe that risk to be real, I even believe it can be an opportunity.
  On the European side, Chinese wheels have never been a big part of the market because of anti-dumping duties that have been in place for the past 15 years. Some Chinese companies have tried building a presence in Morocco as a form of cheap manufacturing footprint that still circumvents tariffs, but the EU imposed tariffs on those too at the beginning of 2023.
  The reshoring dynamic also applies to Europe.

• Economic outlook deteriorates significantly. New vehicle sales have been going up fairly significantly off the lows year to date, but if the economy was to sour even more, this number could start being pressured.
  I would say tho that after 3 years of recessionary new vehicle sales, there’s a significant amount of pent up demand and a very old car park, so while I think this could hurt my upside case, I don’t think this affects my base case.

To quickly conclude, SUP to me feels like a high risk high reward situation where the rewards greatly outweigh the risks and their respective probabilities, but it could still very much be a zero so be careful, it’s not investment advice, just my opinion.