Navistar Has A Tough Road Ahead

Jan 13 2014, 12:24pm CST | by

Navistar Has A Tough Road Ahead

Truck manufacturer Navistar has gone though a rough couple of years after making a big bet on exhaust gas recirculation engines that backfired after the engines failed to pass EPA emissions standards. The scramble to replace these engines, along with secular industry headwinds, caused Navistar’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.

Figure 1: Market Share in U.S. and Canada

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 inoff-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.

Rich Valuation

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.

Sam McBride contributed to this report.

 

Source: Forbes Business

 
 

Don't miss ...

 

<a href="/latest_stories/all/all/30" rel="author">Forbes</a>
Forbes is among the most trusted resources for the world's business and investment leaders, providing them the uncompromising commentary, concise analysis, relevant tools and real-time reporting they need to succeed at work, profit from investing and have fun with the rewards of winning.

 

blog comments powered by Disqus

Latest stories

Fareed Zakaria faces fresh plagiarism charges
Washington, Aug 20 (IANS) Indian-American journalist Fareed Zakaria, who two years ago got away from a plagiarism controversy claiming he made a "terrible mistake", is facing fresh plagiarism charges from anonymous internet watchdogs.
 
 
Ukraine seeks combined IMF aid tranches
Kiev, Aug 20 (IANS) Ukraine Wednesday voiced hope that the International Monetary Fund (IMF) will consider a possibility of combining the third and fourth tranches of its aid programme for Kiev.
 
 
Investments pouring in from Singapore: Bengal minister
Singapore, Aug 20 (IANS) Camping here to woo investors, West Bengal Finance Minister Amit Mitra Wednesday said many companies have signed joint ventures and letters of intent promising to pump in at least Rs.1,200 crore in his state.
 
 
111-year-old Japanese officially declared world's oldest man
Tokyo, Aug 20 (IANS/EFE) Sakari Momoi, a 111-year-old Japanese citizen, was Wednesday officially recognised in Tokyo as the oldest man in the world by the Guinness World Records award committee.
 
 
 

Latest from the Network

43 killed in fresh clashes in Ukraine
Kiev, Aug 20 (IANS) At least 43 people, including 34 civilians, were killed in fresh clashes in eastern Ukraine over the last 24 hours, authorities said Wednesday. Nine government troopers were killed and 12 others...
Read more on Politics Balla
 
INS Sahyadri reaches Philippines to enhance naval ties
Manila, Aug 20 (IANS) The Indian Navy's INS Sahyadri arrived in Manila, Philippines Wednesday and made a courtesy port call to reinforce naval ties, a defence ministry statement said. Navy officials said the...
Read more on Politics Balla
 
40 soldiers in Nigeria face execution for mutiny
Abuja, Aug 20 (IANS) Nigeria's Chief of Army Staff Kenneth Minimah has said some 40 soldiers in north-eastern Nigeria, who refused to fight the Islamist Boko Haram group, would be court-martialled and sentenced to...
Read more on Politics Balla
 
Wife, workmate charged with Sikh man's murder
Wellington, Aug 20 (IANS) The wife of a Sikh man and her workmate have been charged with murdering him in New Zealand, media reported Wednesday. Gurjinder Singh, 25, and Amandeep Kaur, 31, appeared in the Auckland...
Read more on Politics Balla
 
Hamas military head alive as Gaza conflict continues (Roundup)
Gaza, Aug 20 (IANS) Islamist movement Hamas said Wednesday its military wing commander Mohammed Deif is alive and still issuing orders in the fight against Israel in the Gaza Strip, according to media reports. Israeli...
Read more on Politics Balla
 
Three policemen shot dead in Yemen
Sanaa, Aug 20 (IANS) Three policemen were killed by unidentified gunmen in Yemen's southern province of Abyan late Wednesday, a government official said. The gunmen with assault rifles opened fire at military police...
Read more on Politics Balla
 
West Indies sever ties with Gibson
St. John's (Antigua), Aug 20 (IANS/CMC) Ottis Gibson's tenure as head coach of the West Indies cricket team has ended and team manager and former captain Richie Richardson will take interim charge for the ODI series...
Read more on Sport Balla
 
Windies officials fine-tune plans to host international matches
Kingstown (St. Vincent), Aug 20 (IANS/CMC) Cricket authorities in St. Vincent say they are fine-tuning preparations to host four international matches here next month. The West Indies and Bangladesh will play their...
Read more on Sport Balla
 
Nigeria football federation headquarters gutted
Abuja, Aug 20 (IANS) A fire gutted the headquarters of the Nigeria Football Federation (NFF) Wednesday but no one was killed or injured in the incident, an official said. Spokesman of the NFF Ademola Olajire said the...
Read more on Sport Balla
 
Kipchoge aims at Chicago Marathon course record
Nairobi, Aug 20 (IANS) Kenya's Rotterdam marathon champion Eliud Kipchoge will make another attempt to run under the two hours and four minutes when he lines up at the fast course of the Chicago Marathon slated for Oct...
Read more on Sport Balla