Advantage Industries: Mill Road Continues to Buy, Should You? (NYSE: SUP)

Competitive industries(NYSE: SUP) is an original equipment manufacturer (“OEM”) that manufactures aluminum wheels for vehicles in North America and Europe.The company has a complex balance sheet and its business has been impacted by leverage issues as well as low vehicle production levels since Covid. Common shares are trading at $3.50 per share today, down from more than $30 per share in 2016. The business is currently priced at 4.8x EV/EBITDA and should generate solid cash flow in FY2023. Superior should benefit from future deleveraging and balance sheet simplification, with shares now poised for substantial appreciation.Mill Road Capital seem to agreeand bought share on the open market.

background

Superior was founded in 1957, but their leverage issue is new.From 2002 to 2016, Superior had no net debt, but they increased their leverage in 2017, by buy Superior Industries Announces Transformative Acquisition of UNIWHEELS AG in Germany. Revenue and EBITDA roughly doubled as a result of the acquisition, but the situation was complicated by the issuance of redeemable preferred stock to TPG. Superior is currently working to clean up its balance sheet ahead of the debt and convertible preferred stock maturities in 2025.

Most production takes place in Mexico and Poland, with limited operations in Germany. Superior believes their business is well positioned to take advantage of the reshoring tailwind. They have their own manufacturing base, which they should be able to tap into for liquidity through a sale-leaseback if traditional financing is too expensive for their business. Superior will retain more flexibility to deal with maturities if the land and buildings are sold for closer to their book cost of $150 million and leased back at 8-10% per annum. Based on comments on the second-quarter conference call, there may be some rationalization in Europe:

Last quarter, we discussed our 80/20 approach and we are further evaluating our current business to strategically prune underperforming segments. We’ve done this in our North American business and are now shifting our focus more fully to our European business.

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If you look at Europe and the complexity we have there, it’s a lot more complex than our North American business. The technique is complex. The competitive landscape is different. Gary, our focus right now is, 400 basis points of margin improvement, and frankly, if you look at the numbers, you see a lot more opportunity. So our goal is to get as close to that as possible.

Capital Structure

Superior has about 27 million shares outstanding and is currently trading at about $3.50 per share, giving it a market cap of about $100 million. Superior also holds $399m in term loans, €217m in senior notes (approximately $236m @ 30 June 2023) and $5m in other debt vs $181m in cash and net debt of 458m Dollar. Finally, they have preferred stock, convertible at $28 per share, with an initial value of $150 million, redeemable after September 2025 for $300 million in cash or up to 5.3 million shares.

NOTE – According to its 10-K, the company may defer preferred stock repayments after 2025: “In accordance with Delaware law, any redemption payments will be limited to those that our Board of Directors determine can be used to finance all or part of a redemption” Surplus “without rendering us insolvent.” Due to the current term loan agreement with Oaktree, nonpayment of the notes would accelerate repayments of $400 million, so Superior would need to enter into a waiver agreement with Oaktree to defer that amount.

If we value the preferred stock at $300 million, the total enterprise value (“EV”) is $100 million + $458 million + $300 million = $858 million, which is the amount needed to buy the entire company today, Does not include any equity premium and does not give them any credit for owning a lot of real estate.

FY2023 Guidance

Superior’s adjusted EBITDA midpoint is $180 million (4.8x EV/EBITDA), cash from operations is $120 million in 2022, and capex is $65 million. Subtracting the $14 million in preferred stock dividends, the median 2023 equity free cash flow should be $41 million, yielding about 40% for common shareholders and nearly 15% for unlevered yield. Given that the current supply of vehicles is not at an all-time high, these indicators are not asking too much for the expected subdued earnings. The guidance also suggests that they will reverse their negative year-to-date free cash flow due to some volatility in aluminum payables (on the 2Q call).

car production

I don’t like making macro forecasts, i.e. forecasting the direction of car manufacturing. My goal is to show that I think the most likely direction of demand for the Superior product is upwards.

There is a relative scarcity of vehicles in the U.S. at the moment, and I expect the result will be steady or increasing demand for wheels. Sales in Europe also remain well below pre-pandemic levels. If new car prices are too high, then the aftermarket demand can be expected to increase (although this only accounts for about 6% of Superior’s business). GM, Ford and VW account for 26%, 16% and 14% of fiscal 2022 sales, respectively, making their production volumes key drivers for Superior’s investors.

Talk of a looming UAW strike is sure to hurt Superior’s key customers.

Valuation

Auto suppliers aren’t typically great businesses, and I wouldn’t be surprised if Superior trades at close to 5x forward EBITDA, but the stock has room to run if it maintains its current multiple.

If FY2024 EBITDA can reach $200M with European restructuring and no additional growth, and the stock trades at 4.5x, the resulting EV of $900M is only $42M higher than the current EV, but The drive to reduce leverage that would lead to cash generation is created by the business, with all value added going to equity. In this case, between debt repayment and EBITDA growth, the current share price could easily double to $7.

If we go forward to FY25, when 6% of the senior notes mature and the preferred shares are redeemed, Superior appears on track to pay off the notes in full or partially refinance. Interestingly, in this case, Superior might be able to settle the preferred stock using only the 5.3 million redeemable shares.

Assumptions:

• Oaktree’s $400 million in debt remains outstanding

• 2025 Notes Paid From Cash Balance and Continuing Operations

• If ($300/5.3) * share price > $300 million, priority conversion of shares means Superior needs to trade up to $57/share

• Vehicle production in 2025 is roughly equivalent to 2019, with higher earnings per round for Superior as capacity utilization increases

In fiscal 2019, Superior was able to sell about 19 million wheels, compared to 35 million vehicles produced in Europe and North America, at an EBITDA of nearly $9 per wheel. In fiscal year 2022, profitability has improved, revenue from 15 million wheels is about $12.50/wheel, and vehicle production is down about 10% from fiscal year 2019. If we assume Superior can return to 2019 production levels but maintain better earnings per round ($12.50-$15 per round), FY25E EBITDA could be $250m-$300m. I expect margins to increase towards the top of the range as factory utilization improves, but it remains to be seen whether Superior’s production can recover.

If there is a clear path to clearing the preferred overhang and leverage returns below 2x EBITDA, the stock seems likely to trade at 7x EBITDA. So, 7 * 300m = $2.1B EV, minus $400m debt plus $150m cash generated, or $1.85B valuation/converted 32.5m shares = $57/share. It’s a beautiful scenario, but perhaps not as outlandish as you might think for a stock trading below $4 today. This outcome may also be part of some sort of compromise with TPG to clear outstanding issues more quickly.

risk

If I’m going to imply that a stock has this much upside potential, there must be some risk involved.

1. The leverage is significant. If operations deteriorate, Superior could have difficulty repaying or refinancing the 2025 notes, or releasing its debt covenants. Investors in Superior should be aware that in this scenario, the shares could end up as donuts, or they could face significant dilution from resolving their debt.

2. According to Superior 10-K, “In March 2022, the German Federal Cartel Office launched an investigation into European light alloy wheel manufacturers including Superior Industries Europe AG (a wholly-owned subsidiary of the company) on the grounds of alleged anti-competitive practices. The company is cooperating fully with the German Federal Cartel Office. If Superior Industries Europe AG is found to have violated applicable regulations, the company may be subject to fines or civil action. At this time, we cannot predict the duration or outcome of the investigation.” If Superior is Found liable for anti-competitive conduct, they could face significant legal consequences. If Superior does not comply, the maximum fine appears to be 10% of annual sales (<$70 million).

3. Superior disclosed two other legal matters in its filing, including an $14 million dispute with a Polish energy distributor and an $11 million dispute with an OEM customer over a previous wheel order. These claims are small relative to Superior’s enterprise value but are significant in its equity valuation.

4. There is no guarantee that sales in the Superior market will recover, or that current profit margins will be maintained. The market shift towards electric vehicles (“EVs”) is seen as a tailwind for Superior, as EVs use premium wheels due to their weight, but they risk losing share to emerging peers in a growing market.

5. If Superior streamlines the business or grows revenue, there’s no guarantee they’ll command better market multiples. If they cannot efficiently translate EBITDA into shareholder returns, they will be at the mercy of external market forces.

6. After Superior’s first-quarter report, the stock rallied above $7 as insiders sold some shares, including the CFO filing a 10b-5 plan to sell 75,000 shares. Insiders sell for a variety of reasons, and I wouldn’t hesitate to cut your holdings by 1/3 after the stock doubled recently. The Mill Road acquisition helps alleviate that dilemma.

7. In November, M2 Capital made an odd takeover offer at $5.85 a share. The company has not responded to the offer beyond acknowledging a lack of genuine interest following two press releases. A true tender offer would be complicated by outstanding preferred stock.

8. If Superior’s stock price could hit $57/share by 2025, Mill Road, Oaktree, or TPG would likely buy the entire company at a much lower premium before then. Paying around $1 billion for a business that they could flip hands for $2 billion in 3-5 years sounds pretty good, especially considering they’ve all already invested money in the business. Shareholders could be in for a nice payout at current prices.

in conclusion

Superior’s acquisition of UNIWHEELS in 2017 delivered significant revenue and EBITDA growth, but the complexities of its capital structure, including the redeemable preferred stock transaction, presented challenges to overcome before the debt and convertible preferred stock maturities in 2025 obstacle. This presents an opportunity for the company to unlock value for shareholders as the maturity date approaches. Monitoring the changing automotive landscape is critical for potential investors. A tailwind in the industry could be extremely beneficial to Superior shareholders, and Mill Road is seizing its moment.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.