Auto parts manufacturer Tenneco Inc. (TEN, Financial) announced on Feb. 24 that it has entered into an acquisition agreement with funds managed by affiliates of private equity and asset management firm Apollo Global Management Inc. (APO, Financial). The all-cash transaction was given an enterprise valuation of approximately $7.1 billion, including debt.
This is a rare case in which a stock is still trading below its acquisition price, even though there is a very high probability of the deal going through. Let's take a look at this company and why I believe it presennts an appealing arbitrage opportunity.
About the company
Tenneco designs, manufactures, markets and distributes products and services for light internal combustion engine vehicles, commercial trucks, off-highway, industrial, motorsport and aftermarket customers. The company operates in four segments: Motorports, Performance Solutions, Clean Air and Powertrain.
The Motorports segment designs, manufactures, sources, markets and distributes a portfolio of brand-name products in the global vehicle aftermarket, while also servicing the original equipment service market. Its products are marketed and sold under the Monroe, Champion, MOOG, Walker and Fel-Pro brands, among others. The Performance Solutions segment designs, manufactures, markets and distributes a variety of products and systems designed to optimize the ride experience. The Clean Air segment designs, manufactures and distributes a range of products and systems designed to reduce pollution and optimize engine performance, acoustic tuning and weight on various vehicles.
Tenneco had previously acquired Federal-Mogul (which was in turn owned by Carl Icahn (Trades, Portfolio)) in October 2018. The company subsequently combined its emission-control business with Federal-Mogul’s engine parts business, creating a powertrain auto parts supplier that had 2020 revenue of $10.4 billion. This new Tenneco has a suite of engineering development offerings that improve engine efficiency and reduce emissions, providing customers with product solutions to meet clean air legislation requirements in a one-stop shop package.
The acquisition agreement
Apollo Global Management is a global, high-growth alternative asset manager. Its business includes asset management, global wealth management solutions and retirement services. The company's asset management business seeks to provide its clients with returns along the risk-reward spectrum from investment grade to private equity with a focus on three business strategies: yield, hybrid and equity.
The yield business helps companies access capital solutions to fund their growth and achieve their corporate objectives. The hybrid business provides companies with equity and debt solutions at scale and invests in all market environments. The equity business is focused on opportunities that drive financial and operational performance to build companies. Its retirement services business, Athene, provides a suite of retirement savings products to help clients achieve financial security.
At the time of the announcement, the purchase price of $20 per share represented a 100.4% premium over the company's closing share price of $9.98 on Feb. 22 and a 71.6% premium over the unaffected 90-day volume-weighted average price. Upon completion of the transaction, Tenneco will become a private company, but it will continue to operate under the Tenneco name and brand and maintain a global presence.
I think Apollo is getting a pretty good deal here. Tenneco (though highly leveraged) traded above $60 per share in 2017 before all the talk and excitement of electric vehicles taking over the world and Tesla (TSLA, Financial) and the like crushed sentiments of Internal Combustion Engine (ICE) part makers. However, In my opinion, Internal Combustion Engine vehicles have a long sunset period, and Apollo is betting that the market sentiment is wrong.
Just look at cigarette companies like Altria (MO, Financial), which was given up for dead in the 1990s, but two decades later is still very profitable even in the face of declining cigarette consumption. All that negative sentiment and regulatory barriers prevented any new company to enter the cigarette market, and the remaining companies (and their shareholders) made out like bandits.
Prior to the acquisition announcement, the Morningstar (MORN, Financial) fair value of the stock was $31. The chances of any regulatory impediments to the deal are low. The GF Value chart rates the stock as modestly overvalued, but a big part of that equation seems to be that the stock price used to be so high:
I think given the negative sentiments surrounding ICE vehicle auto-part manufacturers, it's unlikely anyone will be making major investments in this segment, and over the next decade or so these companies will be minting money as a result. There is little doubt in my mind that two decades from now we will still be driving around ICE vehicles, particularly in rural areas and third world countries where charging infrastructure is not ubiquitous. In short, there is a lot of money to be made in this business.
Approvals and timing
The transaction with Apollo, which has been unanimously approved by the Tenneco board of directors, is expected to close in the second half of 2022, subject to customary closing conditions, including approval by Tenneco shareholders and receipt of regulatory approvals. The transaction is not subject to a financing condition.
The arbitrage opportunity
As of the time of writing, the stock is at around $16, which is a 20% discount on the deal price. In other words, if you buy the stock now, assuming the deal closes on Nov. 30, you could make 23% on your purchase. (i.e., over 34% annualized). Not a bad return for six months or so!
Of course, there is some risk of the deal not closing, i.e., Apollo finding something that would cause it to back out from the deal (the breakup fee is $108 million), or a majority of Tenneco shareholders rebelling against price, which is unlikely given the 100% premium Apollo is giving them from the February 2022 price and the negative book value of the company.
So far, there is no indication that there is any hindrance to the deal closing nor any news of a competing offer given recession fears. I think the probability of the deal closing is in the order of ~80% or so. Therefore, even if we were to apply a 20% haircut to the 25% arbitrage opportunity, we get an approximately 20% probability-adjusted return potential. That looks sweet to me and worth the risk.
