We closed this position on October 3, 2019. A copy of the associated Position Update report is here.
Truck manufacturer Navistar (NAV) is in the Danger Zone this week. NAV has gone though a rough couple of years after making a big bet on exhaust gas recirculation (EGR) engines that backfired after the engines failed to pass EPA emissions standards. The scramble to replace these failed engines (along with secular industry headwinds) caused NAV’s revenue to decline by 23% between 2011 and 2013. Meanwhile, fines and warranty costs have helped to swing NAV from an operating profit (NOPAT) of $590 million in 2011 to a loss of $410 million in 2013.
One would expect such a poorly performing company to have a similarly embattled stock, but NAV actually went up 73% last year as investors (including Carl Icahn) gained optimism over a potential turnaround. NAV bulls believe the company will regain much of its lost market share and return to profitability as its warranty liabilities from EGR engines goes away. Despite the market’s optimism, NAV is much further from success than its stock performance suggests.
Where’s The Cost Leverage?
The bull case for NAV relies on the company being able to restore its revenues and margins from before the EGR fiasco. Unfortunately, NAV is in a much less advantageous position now than it was only a few years ago. The most troubling issue facing NAV is its significant loss of market share.
In 2011, NAV had a similar market share for Class 8 trucks to its competitor PACCAR (PCAR). Now, PCAR has nearly double the market share of NAV in this important category. Higher market share means more pricing power and greater scale, both of which help to drive higher margins. NAV is not going to be able to achieve the same margins with an 18% market share as it could with nearly 30% of the market.
NAV also faces the disadvantage of relying on a competitor for the engines it puts in its trucks. After its issues with EGR engines, Navistar went back to using Cummins (CMI) engines in its signature ProStar+. Relying on a third party for such a large and important part of its truck means NAV has structurally higher costs than key competitors like Daimler and PCAR.
Cutting Costs Undermines Profit Potential
The new NAV executives have cut costs aggressively. They slashed SGA costs by 16% in 2013 and cut product development spending by 24%. NAV plans to further cut costs in 2014 according to COO Jack Allen, who said, “We will take steps this year to consolidate our manufacturing capacity. We have three plants for engines today. We don’t need three.” Large reductions in capacity mean the market share losses are likely permanent.
Cost-cutting measures help mitigate losses in the short-term, but they also undermine long-term growth potential. The elimination of warranty costs alone won’t get NAV back to its earlier levels of profitability. It needs revenue growth. Cutting manufacturing capability and product development spending is not conducive to revenue growth, to say the least.
Red Flags From Footnotes
In addition to the competitive pressures, NAV faces several issues that can only be unearthed through detailed examination of the financial footnotes. The largest of these issues are:
1) Military sales eroding: In 2011, NAV sales to the U.S. military totaled $1.8 billion. In 2013, NAV earned only $540 million from the military, and the company expects its military sales to keep declining. Along with the tightening of the federal defense budget, NAV appears to be losing ground to its competitors in this segment as well. Recently, NAV was awarded a $7 million contract from the Army while competitor Oshkosh (OSK) landed a $105 million contract. NAV’s reliance on federal dollars that don’t appear to be coming back put a damper on the idea that it can return to past profitability.
2) Debt and pension liability: NAV has ~$3.6 billion (118% of market cap) in adjusted total debt, which includes $250 million in off-balance sheet debt. NAV’s pension plans are also underfunded by $2.7 billion (86% of market cap). NAV has already been forced to dilute the stock through a secondary offering once in 2012, and if the current cash drain isn’t reversed soon these liabilities could force NAV to turn to the market once more for another equity-diluting cash injection.
3) Unreliable accounting: NAV disclosed two material weaknesses in its 2013 Form 10-K, but conveniently put them down on page 147. The most concerning revelation for investors is this: “Navistar does not have sufficient controls designed to validate the completeness and accuracy of underlying data used in the determination of significant estimates and accounting transactions.” This suggests that the company’s estimates of its future warranty costs could be significantly understated.
4) Collective bargaining agreement: Roughly 6,000 of NAV’s part and full-time workers are represented by labor unions, and NAV’s master collective bargaining agreement with the United Auto Workers expires in October. Given that NAV has been closing plants and laying off workers to cut costs over the past year, one has to believe negotiations on a new agreement could be difficult for the company.
NAV is a value only if one believes past profitability levels will return. If the company could immediately regain its 4% NOPAT margin from 2011, NAV would be in great shape. However, operating margins across all commercial vehicle makers, even those not dealing with huge warranty issues, have decreased from 7.7% to 1.7% over the past two years. Commercial vehicles are increasingly being considered as commodity products. The increasing commodification of commercial vehicles, combined with NAV’s lower scale and market share, make the high margins of 2011 unattainable.
If we assume a 2% NOPAT margin going forward, NAV’s valuation of ~$38/share implies 14% compounded annual growth in revenue for 14 years. This model is actually generous, as it ignores the downward pressure warranty costs will continue to have on NAV’s margin for 2014 and 2015. Considering that commercial vehicles are projected to see sales growth of only 5% in for the next three years, it’s hard to believe that NAV can meet those optimistic projections.
If NAV actually met the revenue growth projections and margin goals implied by its stock price, it would achieve a return on invested capital (ROIC) of 30% in year 14. The highest ROIC NAV has earned in any year in our model was 18% in 2008. In other words, NAV’s current valuation does not only imply the company will return to profitability it implies the company will become significantly more profitable than it has ever been.
Investors should not try to ride the momentum on NAV. Take profits on last year’s 73% gain.
Avoid These Funds
Investors should avoid the following mutual funds due to their 3+% allocation to NAV and Dangerous-or-worse rating.
1) Pacific Advisors Fund: Mid Cap Value Fund (PAMVX): 5.7% allocation and Very Dangerous rating.
2) Pacific Advisors Fund: Small Cap Value Fund (PASMX): 3.8% allocation and Very Dangerous rating.
3) Investment Managers Series Trust: Towle Deep Value Fund (TDVFX): 3.4% allocation and Dangerous rating.
Sam McBride contributed to this report.
Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.
Photo credit: Frank Deanrdo
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