Icahn or they can?

Minority shareholders are gearing up to take on Carl Icahn-owned Tenneco for undervaluing the Indian operations of Federal-Mogul

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Wall Street’s legendary activist-investor, Carl Icahn, has a reputation of investing in undervalued companies, later unlocking their value by either turning them around, or forcing the existing management to divest businesses or assets. Typically, the billionaire investor buys undervalued assets through his investment firm Icahn Enterprises and eventually sells them at a profit. Hence, it was not surprising to see Icahn selling his investment in the Michigan-based auto parts maker, Federal-Mogul, to Tenneco for $5.4 billion in April 2018. Icahn had first invested $1.1 billion in 2001 in the then-bankrupt Federal-Mogul through convertible bonds, and took it private last year.

The deal is a synergistic fit — while Federal-Mogul makes powertrain components such as pistons, ignition coils and spark plugs, Illinois-based Tenneco is a global leader in exhaust products. As of 2017, the combined entity, in which Icahn will hold more than 36% stake, clocked $13.67 billion in sales. The deal, which has received regulatory and shareholder approvals, is expected to be consummated on October 1. Interestingly, while Tenneco shareholders are happy about the win-win deal, minority shareholders of Federal-Mogul Goetze India (FMGI) are peeved. A look at how it all began reveals what has elicited such reaction.

Off the line

Goetze began operations in India in the 1950s, when Goetzwerke of Germany formed a joint venture with the Nandas of Escorts group. The company set up its first plant at Patiala, and started commercial production in 1957. In 1977, it established its second unit at Bangalore. Goetze went public in the same year and, incidentally, so did Reliance Industries. In 1998, Federal-Mogul bought out the German company and, in 2001, merged its then-Indian arm Federal-Mogul Sintered Products with Goetze-India. In 2006, when Anil Nanda sold his 24.64% stake to Federal-Mogul, the company acquired its present name as Federal-Mogul’s stake increased to over 50%. 

What makes FMGI unique is that it is the biggest manufacturer of pistons, piston rings, sintered metal products and cylinder liners globally. Its clients in the country comprise prominent manufacturers of two-wheelers, cars, tractors, LCVs, HCVs, stationary engines and high output locomotive diesel engines. The Rs.13.62 billion company generates 70% of its turnover from pistons, while piston rings and sintered products account for the remainder.

Madhusudan Kela Ex-CIO, Reliance MF and investorIn essence, FMGI provides critical engine parts that deal with emission and fuel efficiency for conventional internal combustion engines. Looking at the boom that the automobile sector has seen, it is not surprising that post 2001, the country’s top fund managers, Madhusudan Kela, then at Reliance MF, and Prashant Jain at HDFC MF, began buying into the stock. The first time that Reliance and HDFC drew attention was when their holdings crossed the 1% mark in June 2004, with Reliance Growth Fund holding 1.8% stake and HDFC Prudence Fund holding 1.46%. When Federal-Mogul acquired majority stake post Nanda’s exit, the funds ramped up their holding to nearly 7%, expecting the multinational company (MNC) to do wonders. When the stock hit a high of Rs.438 in early 2007, from Rs.70 in early 2004, HDFC MF exited the stock, while Reliance MF stayed put.

Post Federal-Mogul’s takeover in 2006, FMGI sales went up 2.93x, while it bounced back from a loss of Rs.27 million in 2006 to a profit of Rs.961 million in FY18. However, over this period, the stock fell to a low of Rs.33 by November 2008 after hitting a high in 2007, following the global crisis. After the crisis, even as the parent company ended up with 75% stake following two rights issues (2007 and 2009), the introduction of BS-IV norms in the country and a robust auto cycle ensured that growth kept ticking.

In the ensuing years, FMGI managed to recover lost ground. Around 2009-10, Pune-based entrepreneur-investor, Bhavook Tripathi, entered the stock. From running an auto parts company in Aurangabad, Tripathi had moved up the value chain by acquiring special machining tool companies abroad, and today runs a much-diversified business under the aegis of Brahm Group. Known for making a killing in FAG Bearings and Solvay Pharma by picking them cheap, Tripathi saw yet another bargain in FMGI. “It was a no-brainer, as companies such as FMGI have the technological edge given their parentage, a world-class brand and a strong franchise in India. These are irreplaceable stocks,” says Tripathi, who owns close to 2% in the company now.

Bhavook Tripathi Founder, Brahm Group and investorInterestingly, such was Kela’s conviction in FMGI that he, too, went on to buy the stock in his personal capacity, after moving out of fund management. “Apart from being the global leader in piston technology, the integration with Tenneco will further embellish its positioning as a unique auto component maker,” explains Kela, who holds a 0.39% stake. Similarly, Mohan Krishnaswamy, who quit after a 20-year stint on the sell-side at Barclays Bank, ABN Amro Bank and RBS, today holds 1.32% stake in the company. As of June 2018, while the parent holds 74.98% stake, public holding is around 25.02%, of which Reliance MF, LIC and Aditya Birla Sun Life MF hold over 12.04%, individual investors hold 6.09% (see: Up in the air), and the balance 6.89% held by retail investors. As a consequence of the concentrated holding, liquidity in the stock is thin, which has triggered a controversy over Tenneco’s proposed open offer.

Offer blues

As per Sebi regulation, 10% of the total outstanding shares must trade on any exchange in the preceding 12 calendar months, to qualify as frequently traded. FMGI failed to clock this trading turnover on either of the exchanges or on both put together, despite having reasonable daily volume. If the volume traded in one-year period is less than 10%, and in FMGI’s case it turned out to 7.5%, the shares are deemed to be infrequently traded.

On April 16, Tenneco made a public announcement on the BSE to purchase the entire free float (25%) of FMGI at Rs.400/share or Rs.22.25 billion. In response, SES, a governance advisory firm, came out with a report which stated that as per available trading data, the volume weighted average price (VWAP), as calculated by SES, for the past 52 weeks (preceding April 11, 2018) comes to Rs.529.64/ share and that of VWAP for the past 60 trading days comes out to Rs.518.03 share. “In the present offer, shareholders tendering shares, potentially, could incur a loss of almost Rs.118 per share, just because the stock is infrequently traded. Such wide price difference makes it absolutely clear that open offer is just a theoretical exercise as no rational shareholder will tender shares under open offer,” stated the report.

Sebi’s takeover regulation 8 (2) (3) states that: “where the shares are not frequently traded, the price determined by the acquirer and the manager to the open offer taking into account valuation parameters including, book value, comparable trading multiples, and such other parameters as are customary for valuation of shares of such companies;” Furthermore, regulation 8 (4) mentions: “In the event the offer price is incapable of being determined under any of the parameters specified in sub-regulation (3), without prejudice to the requirements of sub-regulation (5), the offer price shall be the fair price of shares of the target company to be determined by the acquirer and the manager to the open offer taking into account valuation parameters including, book value, comparable trading multiples, and such other parameters as are customary for valuation of shares of such companies.”

Given that both the regulations are widely open to interpretations, CKP Financial Services — the manager appointed by Tenneco for the open offer — arrived at what it deems is the right open offer price. Brijesh Parekh, who leads the investment banking division at CKP, says, “The stock is infrequently traded. Hence, we went as per the prescribed law of Sebi and got a reputed CA to arrive at the valuation.” Parekh refused to comment on who the CA is, and what metric was used to arrive at the offer price. “We will be coming out with a public announcement soon and then it’s for Sebi to decide. As a merchant banker, I cannot say whether there will be a change in the price or not,” he adds. While SES maintains Rs.518 should be the price, minority shareholders believe it is significantly higher.

Peer connect

Since 2009, FMGI has cumulatively paid Rs.2.26 billion to the parent as royalty for R&D cost sharing and technology transfer, which, on average, comes out to 36% of PBT and 2% of sales during this period. In fact, among all other component makers, FMGI has been preparing well in advance for the BS-VI transition that will come into effect from April 2020. The company has invested in augmenting its capacity to produce BS-VI components and, in 2016, FMGI showcased its key emission-reducing products, including bearings and bushings, pistons, piston rings and valves at the Auto Expo. These parts are expected to result in improved fuel economy, reduced CO2 emissions, lower friction and shrinkage in engine size. “At a time when the competitive advantage of being a global technology leader will manifest in terms of market share and margins, Tenneco wants to unfairly delist the company at a cheap valuation,” says investor Vanaja Sundar Iyer.

Tenneco has valued FMGI at trailing 10x FY18 EV/Ebitda despite it incurring high research and development spend at 34% of PBT (see: Going cheap). “All these multinationals trade at significant premium to Indian auto components companies as they provide technology solutions to OEMs,” mentions Tripathi. The minority shareholders believe that if FMGI gets valued at the average multiple of its peers, its market capitalisation would come to Rs.68.40 billion on EV/sales or Rs.63.56 billion on EV/Ebitda, which are the right basis for valuation of companies. “This translates to Rs.1,127-1,208 per share,” points out Tripathi.

More importantly, over the past three years, the company has consciously been moving away from BS-II and BS-IV clients, and focusing on working with top OEMs that are gearing up for BS-VI. As a result, over the past couple of years, although sales fell and recovered marginally by 3% in FY18, net profit has grown at an average of 25% over the past three financial years. “It’s because of the high-margin business that they are focusing on,” reveals Iyer.

Sandeep Jain MD and portfolio manager, IndiaNiveshSandeep Jain, managing director and portfolio manager, IndiaNivesh, which holds the stock in its PMS scheme, points that the company has operationally improved itself over the past three years, after spending over Rs.1.2 billion to become BS-VI-ready. “Despite having spent on capex, the company has also managed to become debt-free by paying off its long-term loan of Rs.2 billion,” points out Jain. He adds that the return ratios are also comparable, with FMGI, Bosch and Schaeffler clocking around 15% return on equity (RoE) in FY18.

Passenger vehicle (PV) sales in India have been growing at the fastest rate among all countries, producing more than 4 million cars in FY18. Given this factor, the country is projected to become the third-largest PV market by 2020. In 2017, it ranked fifth after China, USA, Japan and Germany. Jain believes, all MNC subsidiaries are trading at much higher valuations than their parents, and it’s not without reason. “India will always be a growth market and, hence, assigning it a multiple similar to the parent [7.2x EV/Ebitda] is unjustified,” feels Jain. Vinod Hans, managing director of FMGI, chose not to comment. “Till the deal is formally completed and open offer is made, we are not in a position to comment as we are a listed entity,” says Hans. Emails sent to Keith Cozza, CEO, Icahn Enterprises and Tenneco management went unanswered. 

Testing times

Could the desperation of minority shareholders also be an outcome of the fact that a decade ahead, the era of pistons in engines might be over owing to electric vehicles (EVs)? Federal-Mogul’s global management believes that hybrids and plug-in hybrids will be how EVs will take off and they would still need IC engines with pistons. Kela is not too worried about the EVs killing the piston industry, either. “I am not paranoid, as in the Indian context, EVs becoming par for the course is still sometime away. I don’t think we are going to see any meaningful disruption for the next 10-15 years owing to EVs, in a scale that could sound the death knell for traditional engines.”

For now, the minority shareholders are engaged in back-door conversations with each other. However, it’s not clear whether all of them would come together and put up a united front. An investor, who wrote to LIC, was disappointed with the response. “It wasn’t exactly surprising, but LIC wrote back stating that the open offer was as per Sebi guidelines and no action was warranted in this case,” says the investor. Kela is playing it by the ear. “I haven’t taken a stand yet and neither have I approached the regulator. But if things come to pass, I won’t hesitate,” he says.

JN Gupta Founder and MD, SESJitendra Nath Gupta, founder and MD, SES, believes that if the regulator goes by the book, the minority shareholders don’t stand a chance to win. “If I were a member of either Sebi, SAT or HC, I would always rule in favour of the company because they are following the law. Having said that, a good law doesn’t necessarily translate into good governance, and good governance cannot be adjudicated in a court,” says Nath.

However, he does believe that it is a wake-up call for the regulator, which should consider amending the law that governs price discovery, based on the liquidity of a stock. Nath, in his report, mentions that liquidity should be considered based on the floating stock, and not the total stock. This is because promoter shareholding is never traded in the market. “What Sebi or any law-making agency cannot do is change a law based on one request. Neither can you apply the law retrospectively, but the regulator has the power to amend laws,” says Nath.

The only hope for the shareholders is if they can convince the regulator of a fraudulent intent by the management. It is here that the shareholders could have an edge. One of the company’s three manufacturing plants is located in the prime area of Yelahanka in Bengaluru, Karnataka. While the plant is spread across 50 acres, it is becoming increasingly residential and turning into a service sector hub. Hence, sooner than later, local pollution norms may force the company to relocate, as it runs a foundry in the area. According to Tripathi, a recent deal saw L&T selling 13 acres of land in North Bengaluru for Rs.7 billion, or Rs.530 million per acre.

Taking this transaction as the benchmark price, shareholders believe that the tract of land is effectively valued at Rs.26.50 billion, which works out to Rs.480/share, over and above the current stock price of Rs.436 (see: Under-tilled). Kela affirms, “At the current market cap (of Rs.24.25 billion), the entire business is coming for free if one considers the value of the real estate.”

Sandeep Parekh Founder, Finsec Law AdvisorsSandeep Parekh, founder of Finsec Law Advisors, opines that in a case of undervaluation, shareholders stand a fair chance of strengthening their case. “Typically, companies value land at historical cost and not at market price. In such cases, there is a good chance that the regulator could ask an independent valuer to be appointed to look into that aspect,” opines Parekh. 

While there is some hope, the bigger worry for individual investors is if prime holder, Reliance MF, does not want to pursue a protracted legal recourse. Reliance MF chose not to comment, though sources say the fund has raised its concern in a letter to Tenneco. “If the stock market suddenly goes into a downward spiral over the next couple of months, mutual funds may get desperate to shore up their performance. There is always a chance that Reliance may offload either a significant part or the entire holding,” opines an investor holding less than 1% stake. If that happens, it could well be a big dampener, and if LIC and other insurers were to offload their stake as well, then the Icahn-owned Tenneco could end up with an opportunity to delist the company and take it private. 

Tripathi, though, is not giving up easily. “Given a chance, I am willing to buy out Tenneco’s entire stake. Even without their technology and land, the value is much more.”

Even as battle lines are drawn, a lot depends on which way the regulator rules, and as far as Carl Icahn is concerned, for all his posturing on shareholders’ interest at the end of the day, he is just an astute investor who once said, “I’m no Robin Hood. I enjoy making the money.”