This idea came to me after reading through a recent new subscription to a site, Insider Arbitrage. They track M+A, spin offs, insider buying and selling and other useful information. These events can set up what have been termed special situations, which are usually based on one off corporate actions that can in some cases create mispricing in the market. I need to disclose that by no means am I a professional investor, I’m a retail investor who takes interest in finding special situations and value opportunities. Information provided should not be construed as recommendation to buy or sell any security, and I highly recommend you do your own research and/or consult with a professional before taking any position. That said let’s move on.

To understand why this opportunity exists it’s important to point out that many of the automotive supply chain analysts expect a decline in revenue for suppliers that provide components for ICE based vehicles. Some projections say that by 2030 most new vehicle production will be EV based. Of course it’s very difficult to figure out exactly how the transition will play out. But when it comes to investing if the market is shrinking this is generally a turn off for most money managers. If however as I’m expecting the EV transition takes longer to play out then what is commonly believed, this investment could work out well. There are some reasons to think this may be the case. For mass adoption the infrastructure for EV charging will have to be built out. Many areas of the country have vast distances that are driven daily and make it very inconvenient to constantly be charging. Towing uses alot of energy, and currently EV’s are not very good at it, the Ford Lightning went about 100 miles with a camper. https://www.motortrend.com/reviews/ford-f150-lightning-electric-truck-towing-test/ Similar to this is any application that uses massive amounts of energy is not currently well suited to EV, such as construction equipment, marine equipment, long haul trucking and probably others I’m not thinking of. Finally much of the EV analysis is US centric. It should be obvious that other less developed regions in the world are very far from EV adoption, and that significant ICE use will be common well into the future on a global basis. With that said let’s continue on.

Introduction

Phinia (PHIN), was spun off from Borg-Warner on 3 July 2023. The decision to spin the company off was made to allow Borg-Warner to focus on and become more of a pure play in the EV space. The company trades under the ticker (NYSE:PHIN). The company specializes in the production of fuel system and charging system components for internal combustion (ICE) applications. This includes electronic control units (ECU), fuel injectors, fuel pumps and alternators.  The company operates under three main brand names, including Delco Remy, Delphi, and Hartridge. Phinia is a Tier 1 OEM supplier, to companies such as Ford, GM, Caterpillar, Stellantis among others. Phinia’s largest customer is GM which makes up about 12% of revenue. Diverse customer base is important, because it helps to spread the risk that any one customer is lost. It should be noted that the Delphi assets were acquired by the company in 2020 for 3.3 billion, which included both the fuel system business as well as electronic ignition business.

Business Lines Summary

Fuel Systems represent the largest portion (66%) of the company’s revenue. Fuel systems have evolved over the years, the modern fuel system is combination of fuel pump, fuel injectors, and electronic control module. Many manufacturers have moved to utilization of direct injection technology. Direct injection creates a finer atomization of the fuel particles, which allows for a more efficient burn, and ultimately lower carbon footprint. Further efficiency gains in the direct injection process may be possible with increasing fuel pressure/Improved atomization.  PHIN is one of the few industry players still performing R&D in this area which may lead to further efficiency gains in traditional diesel engines. The company also makes hydrogen injectors, although this is a very small portion of their business.

Supporting the maintenance of fuel systems requires test equipment, which falls under the Hartridge brand. Fuel injector test benches are large six pieces of equipment which allow testing multiple injectors simultaneously. They also allow for calibration of the injectors, ensuring consistency. Injector calibration is a routine part of maintenance for both light and heavy diesel applications. Finally Delco-Remy provides starters and alternators primarily for heavy vehicle market. These go into semi trucks and construction equipment.

The company also has an aftermarket business which supplies the same products to aftermarket suppliers as replacement parts for existing vehicles. This represents the second largest source of sales for the company. This includes remanufacturing existing parts back to original specifications, that are resold.

Competitive Position

PHIN has many competitors, the two main competitors in the automotive parts tier 1 space are Bosch (GmbH) and Denso. Both companies are much larger than PHIN with more diverse product offerings. In the aftermarket space there are many more competitors. Part of the company strategy is to continue to focus on developing technology for ICE, as the competition continues to reduce spending and focus in this area. The company guides that consolidation is likely over the next 5 years. This seems plausible given the business mix of the main tier one competitors. The second part of the company’s strategy is to capture more of the aftermarket as legacy suppliers discontinue support or are acquired. PHIN is targeting service of competitor parts through remanufacturing, anticipating existing competitors will continue to transition away from this type of business.

Thinking about the competitive advantages for PHIN, the business lines should be separated and considered independently. In the fuel systems business (Delphi), the main moat is existing Tier 1 OEM contracts. Given that the price of the fuel components, are small in relationship to the overall cost of the vehicle it would be difficult for a competitor to lower the price enough to prompt a shift. In the aftermarket segment similarly fuel components are relatively cheap in relationship to the amount of labor cost required for their replacement. Given this it is unlikely mechanics and other end consumers would be likely to switch brands for modestly cheaper alternatives and accept the possibility of failure and overall increased cost for replacement. The Delco Remy business follows similar dynamics. In the Hartridge business the main competitive advantage is switching costs. Fuel testing equipment is relatively capital intensive, bulky and requires training for technicians to use properly. The main differentiator for selecting fuel testing benches is the ease of use and the time necessary for the injectors to be tested.

Again the current thinking of the market is that ICE is going extinct, and some have projected this will occur in the next 7 years, at least in the US. I think for many of the reasons I listed above this transition will take longer then anticipated, and that will benefit PHIN.

Valuation:

I used to think valuation was the most important part of the story. In a way that is true, however I have found that there is not much competitive advantage in spending an inordinate amount of time on valuation. Graham and Buffett of course figured this out long ago, Graham said in the Intelligent Investor (I’m paraphrasing) that you don’t need to know a man’s exact weight to know he is obese. It is similar in company valuation, if it’s not a screaming value then it’s best to move on. That said this company is a pretty decent value at current prices (28$/share)

For the value model I used a FCFF model with credit due to Professor A. Damodaran for providing free access to and creating the template. His website https://pages.stern.nyu.edu/~adamodar/New_Home_Page/spreadsh.htm has all sorts of useful spreadsheets that can help valuation.

For assumptions I used a sales growth of 2%, operating margin of 11%, and a sales to capital ratio of 0.7. For maintenance CapEx I have used roughly 3% of sales which is in line with management guidance. An additional 1% of sales will be used for research and development. It’s not clear to me based on my reading of the 10-Q that significant money will need to be spent on research and development, the final frontier as described by the company seems to be increasing fuel injector pressure which may require some re-engineering of components but should not require massive expenditures. Based on these assumptions I come up with a value of 52$/share for the equity which is 45% below the recent market price. The company carries about 730 million of debt, with annual interest payments of 42 million and a healthy interest coverage ratio of 9.7 times. The company is low overall debt burden is important in this case because many of the other industry players are highly leveraged as a result of the supply chain shortages related to the covid pandemic. Higher leverage obviously increases bankruptcy risk. Being one of the least levered plays in the spaces to the company’s advantage as competitors may run into financial trouble and be targets for acquisition in the future as the industry consolidates.

To discuss the strengths and weaknesses of the valuation I think it’s important to first note that the valuation is based on only about a year and a half of data is provided by the company, given that it’s a recent spinoff we don’t have a robust history to go off of as a standalone company. The sales to Capital ratio is a proxy for reinvestment necessary in the business, essentially a combination of the maintenance capex and growth capex measured off of a percentage of sales. The ratio is somewhat arbitrary but is consistent across Industries generally speaking. In this case I chose a ratio of 0.7. Industry average according to spreadsheet is 1.5, so this is certainly a conservative assumption. A sanity check for the ratio that I used is comparing the capital expenditures that it generates against the company’s own projections. Company is projecting somewhere around 100 million a year, which is very similar to what a ratio of 0.7 generates.

To summarize for the next operating year I’m projecting a revenue of 3.5 billion within 11.8% operating margin which slowly down trends to 11%. This generates $313 million of free cash flow of which 100 needs to be spent on maintenance and R&D. This leaves about 213 million of free cash flow for Capital allocation, ie owner earnings.

Discussion

PHIN represents a reasonable value at current market prices, with a decent margin of safety. Well it’s always unclear exactly what will unlock value, value convergence will likely be driven by a management capital allocation strategy which is heavy on capital return to shareholders. This strategy seems reasonable given that opportunities for reinvestment are minimal at present but may improve as the industry consolidates. If the company is successfully able to position itself as one of the few last standing companies to service fuel and charging components for ICE this will drive the stability of the cash flow further into the future.

Hydrogen applications for injectors provide some possibility of ‘sizzle’ as Michael Price would say, but despite company enthusiasm significant challenges around the technology remain. That said the company has a very stable cash flow platform to drive value creation for shareholders with smart capital allocation decisions. At current prices I would like to see all excess FCF used for share repurchase, but the recently announced dividend (0.25/share) will possibly bring positive institutional attention to the stock.

Listening to the most recent conference calls, the company seems to understand its position fairly well. While there are some marginal opportunities for reinvestment, most of the excess free cash flow is going to be used to buy back stock and pay dividends. The company is a slowly shrinking Ice Cube, but the question is how slow, I think based on my research it’s going to be much slower than what’s predicted by the market and therein lies the value opportunity. Risks would include poor Capital allocation strategies by the company, bad acquisitions, free cash flow shrinking faster than anticipated. All of these will require monitoring, but assuming the company sticks to what they have articulated the stock could be a double in roughly 2 to 3 years. If things turn out better than expected, the stock could be a triple Within 5 to 7 years.