After three major acquisitions that mark the fastest growth spurt in Federal-Mogul Corp.’s 99-year history, the auto-parts maker deserves a break. But it is unlikely to get one soon. By 2002, CEO Richard A. Snell has promised, the Southfield, Michigan-based company will ring up $10 billion a year–a fivefold increase over sales in 1996, when he arrived from Tenneco. Snell is the first to declare that the objective is extremely ambitious. In fact, he calls it “The Big, Hairy, Audacious Goal.”
The most recent deal, in October, added Cooper Automotive to the fold, for $1.9 billion. With sales of nearly $2 billion, Cooper Automotive lifts Federal-Mogul to $7 billion in sales, within striking distance of the $10 billion bogey. It also bolsters Federal-Mogul’s brand- name presence in several critical automotive markets for brakes and friction products, lighting, chassis parts, ignitions, and windshield-wiper blades.
Last February, Federal-Mogul purchased closely held, family-owned Fel-Pro Inc., in Skokie, Illinois, for $720 million. The sellers received $500 million in cash, and the balance in Federal-Mogul stock (the kind of arrangement that is sensitive to a seller’s concern about the tax bill). The gasket manufacturer added $500 million to Federal- Mogul’s top line.
Federal-Mogul then continued its dramatic growth strategy when it paid $2.9 billion in cash for T&N Plc in March. The price tag included $500 million of assumed debt. T&N, based in Manchester, England, manufacturers a host of products consumers seldom see without opening the hood of an automobile. It sells $3 billion worth of piston rings, gaskets, and camshafts a year.
In an industry ripe for global consolidation, Snell ought to be able to hunt down another $3 billion in sales. To CFO Thomas W. Ryan falls a thornier task: restoring an already-battered balance sheet in the midst of this acquisition binge. Routine acquisitions can wreak havoc on investment-grade balance sheets; Ryan must start with a balance sheet that lost its investment-grade status in 1997, after Federal- Mogul took $302 million in charges to dispose of underperforming and im-paired assets.
The loss of investment-grade status put Federal-Mogul on a slippery slope just when it required the best traction. Already viewed by lenders as less than pristine, Federal-Mogul cannot afford further erosion of its balance sheet in the wake of acquisitions. Increased cost of capital could undermine returns on previous acquisitions and derail others. In view of its much-touted growth strategy, the stock market might not take kindly to a retreat. The result: a high-stakes trade-off that could spell the difference between market leadership and a perilous loss of momentum while competitors with deeper pockets snap up the industry’s most valuable assets.
So far, Ryan has managed to keep the cash spigots open and the balance sheet in reasonable order. “We’re trying to finance that growth and keep a good financial sheet at the same time,” Ryan says, sounding unfazed by the challenge of pursuing these two divergent objectives at once. “It is possible to grow the company and still have the objective of investment grade,” he says. “I would call it practicing the genius of the ‘and.’”
Or you might also call it practicing the genius of dilution. In addition to raising $1 billion of new debt this year, Federal-Mogul sold 11 million shares in June for just shy of $600 million. Proceeds mainly retired senior subordinated loans indebtedness stemming from the Fel-Pro purchase. And going against common practice, the company has announced plans to raise an additional $800 million by selling more of its stock no later than the first quarter of 1999.
Federal-Mogul intends to outrace dilution and win back its investment-grade status by singling out acquisitions that add value in excess of the cost of capital needed to sustain them. In other words, Federal-Mogul will not buy a company unless it can predict favorable impact on Economic Valued Added (EVA), a concept the company embraced in early 1997, with guidance from Stern Stewart & Co.
Then Ryan taps the capital markets for a mixture of debt and equity that aims to keep the company’s debt/ equity ratio in the vicinity of 40 percent. Besides delivering optimal cost of capital, in Ryan’s judgment, this capital structure enjoys another virtue: “I don’t want to go to bed worrying about being overleveraged,” he explains.
What would happen to shareholder value, though, if Federal-Mogul rescinded its intention to sell stock worth $800 million? “If we were to say, ‘Sorry, it’s a big joke; we won’t issue equity,’” Ryan speculates, purely to illustrate a hypothetical point, “the share price would go up.” A gain would be short-lived, though, in his view. The price would come back down as soon as stock investors noticed an increased reluctance by lenders to help fuel further growth. “If we do not do the equity issue,” Ryan observes, “we’re really signaling the market that the growth strategy is over.”
Climbing to $19 Billion
To reach its twin goals–$10 billion in sales and investment-grade status–the company must keep on track in the integration of its acquisitions. Ryan believes the company has done well on that score and is ahead of schedule. “In six to seven months,” he says, “we integrated T&N and Fel-Pro, and realized the synergy benefits we expected to have in that time frame.”
Momentum got a boost a year ago, after Snell closed 123 retail outlets–the legacy of a predecessor’s ill-fated growth strategy–and consolidated distribution and manufacturing facilities in North America, handing out 2,400 pink slips in the process. Recapitalization followed last December. In conjunction with the bid for T&N, Federal-Mogul Financing Trust raised $575 million by issuing convertible preferred securities, paying a 7 percent dividend.
The timing of the Cooper Automotive deal briefly jostled the 40 percent target for the debt/equity ratio. After reaching a $72 high on July 10, Federal-Mogul’s stock price plunged to 463/4 by the end of September. The slide drove the company’s debt-to-total- capitalization ratio way up, as it was seeking a $2 billion bank lending facility, led by Chase Manhattan Bank, to finance the acquisition.
Undeterred, lenders flocked to the offering. The credit facility was oversubscribed by October 1, as banks focused on Federal-Mogul’s improved earnings and the growing ability of its earnings before interest, taxes, debt, and amortization (EBITDA) to cover interest payments, explains Federal-Mogul vice president and treasurer David Bozynski. The Cooper deal closed on October 9. The bank credit facility has two portions, a $350 million, eight-year lending facility and a $1.6 billion, 18-month portion.
Paying Down the Debt
Federal-Mogul’s current task is to pay off the $1.6 billion short-term bank debt from the proceeds of $800 million in debt and $800 million in equity offerings that are yet to be issued. Explains Ryan: “We promised the Street” that 40 percent of the $1.95 billion loan facility would be converted to equity.
Federal-Mogul is also moving to pay down its debt with proceeds from the sale of nonstrategic assets. On October 27, it was able to sell, for $430 million, a bearings business it acquired last spring when it bought T&N.
Selling equity won’t guarantee Federal-Mogul a return to investment-grade status. At the current level of leverage, fixed-income analyst Debbie Downie of Miller Tabak Hirsch & Co., in New York, sounds cautious. “They’re on track to getting an investment-grade rating,” she says, but the company “is walking a fine line with debt.” She warns that “any letup in earnings could leave it vulnerable to quick downgrades.”
Dilution notwithstanding, equity analysts appear to like what they see. “What they’re trying to accomplish makes sense,” declares automotive industry analyst Philip K. Fricke of CIBC Oppenheimer Corp., in New York. “They’re big, big players in consolidation. They are the prototype of what is going on and what ought to be going on.” But Federal-Mogul is still far from the finish line. “They’ve bitten off a lot,” Fricke warns. “As good as they are, it becomes a challenge to efficiently integrate the systems and modules of all these companies.”
Provided the equity issue closes as planned and cash flow meets expectations, Ryan predicts that the company “ought to be in the range” of generating a debt-to-EBITDA ratio of about 2.3 to 1 by the end of 1999. That, coupled with favorable interest-charge coverage and a good debt- to-equity ratio, should do the trick. “Then we can legitimately knock on the door of the credit agencies seeking an upgrade,” he says.