Description

Briggs & Stratton has two businesses: the well-known small lawn motor manufacturing division, and the newer “power products” division which manufactures pressure washers, generators, and snow blowers. In the engine market, growing at 3% p.a.(essentially grows at GDP), they enjoy a 70% market share. In the “power” market, where pressure washers grow at 11% p.a. and generators grow at 5% p.a. they have a 50% market share. Traditionally they have a combined 10% operating profit margin, and project 9%-10% in FY2006 (June). However, both businesses are seasonal, and highly dependent on weather patterns (and timing). Additionally, they have missed their last two quarters, and have the classic mid-western hostility to and mistrust of Wall Street – issues that I believe are inter-related. The primary cause of the dual earnings misses was raw material cost in the engine business. Scrap aluminum and steel are the primary inputs – both of which spiked in F2005 and added about $50.0m to cost of goods sold. Quite surprisingly, the financial community never saw it coming; prices are set in September and October – and then never changed through out the production cycle. When costs rose, there simply was no established precedent of raising prices to reflect rising material costs sales. To complicate the financial analysts’ problems, one of the three big OEMs went bankrupt, owing BGG about $40m. BGG decided to take control of Murray and work out of the problem, a decision which has peppered the quarterly results with unusual costs. (In F06Q2, $3.0m pre-tax losses, and $20.0m in sales.) Both of these one-time issues are behind them: aluminum costs are now hedged (the hedges are under water Y/Y), and Murray has ceased to be a responsibility of BGG. Steel and copper are still raw material risks, and are at levels comparable to last year, but could provide upside to earnings if they decline. What remains to terrify us are the two grow-to-the sky phenomenons, China and Wal-Mart.
Management has stated (and I buy the argument) that in the power products division sales are relatively insulated from Chinese production by virtue of the high costs required to support the products, and the “event” driven dynamics of the market (hurricanes, floods, etc.). These are products which consumers want in a hurry, and in specific locations, and demand a very high level of reliability (and quick service when the product malfunctions). Quite significantly, the hurricanes of 2004 demonstrated to customers and retailers alike that the foreign products (principally Chinese), were highly unreliable, and completely unserviceable. Support for these products is now a critical input for retailers and commercial users. At the moment, and for quite some time, this manufacturing game can be played only by the “big guys”, all of whom have high labor content.
The engine business is a slightly different animal; low labor cost producers will get here eventually (even if the replacement is 6-7 years, price will be an issue), but not in the immediate future. Chinese producers made a big push into the US in the mid-1990s, but the quality was so poor (engineering flaws) that they failed to make inroads. The Japanese made a big push in the 1970s, and came away with very little. But the recognition that “integration” is essential to BGG is not lost on management. In July 2004, they acquired the Simplicity and Snapper business (now about 90% of brand name product), which together constitute about $400m, or 6 ½% of sales. Other acquisitions are likely. Branded BGG product is not only essential, but also rests on an existing great brand: Briggs & Stratton. One might expect that OEMs like AB Electrolux, MTD Products, and Global Garden Products would be in open revolt to a supplier becoming a competitor. So far that has not happened, I believe because of the overwhelming logic (and exigency) of BGG’s expansion, and because the alternatives to buying from Briggs are not that attractive. A much more likely outcome is that BGG will continue to forward integrate, probably by way of acquisition: MTD (a private company) or AB Electrolux home products division, which is up for sale, and does about $2.0b in the US. Brigg’s sold 12.8m engines last year, and projects it will sell the same number this year – albeit at a price 4 ½% higher than last year. This year’s price increase has resulted in yet another worry for Wall Street. By historical standards, this is a large increase. As a result, the large box retailers (who constitute 80% of sales) have delayed their orders (the price increase went into effect 11/1). Management was quite confident, on the last conference call, that the longer the delay, the more likely it is that the orders go to BGG. While this is intuitively appealing (foreigners can not deliver product quickly, and a 70% market share producer has all sorts of other advantages), it is a risk not easily handicapped. In push mowers, where the final product is relatively inexpensive, the engine may be 60% of the cost, while in riding mowers, the engine may be only 10%- 20% of total cost (the engines cost about $275 per unit). The 4 ½% increase will probably stick – and BGG is playing hardball. Only Honda, Kohler, and Tecumseh could step-up. Even Honda manufactures in the US, and none of them alone has any significant capacity. Honda sells only 1.5m “bear engines” and might have a couple hundred thousand in extra capacity, and Tecumseh is now spewing red ink. Neither has raised prices as of yet, but it makes little sense for either to hold out long term (that is not to say they won’t).
Management guidance is $3.17 to $3.27 for F2006 June. If BGG can earn $3.17, and trade at one times growth (est. at 12 1/3%), then it will trade at $39 p/s. If it earns $3.27 and trades at 14x, then it’s worth $46.50, an outcome I regard as somewhat unlikely. EPS of $3.21 trading at 14x would result in a stock price of $45. A few other numbers may give you comfort: ROA= 8%, ROE= 17%, ROC= 13%, WACC= 9%, P/ 12M EPS= 14x, P/ FYO7 EPS= 10x, P/ EBITDA= 7x, EV/ 12M EBITDA= 8x, P/ FYO6 FCF= 10x (depr= capx), P/ SALES= 0.6x. The balance sheet is solid.
Assuming that $40 to $45 is a realistic bound for the stock (gains of 18%-32% in the next 12 to 18 months), what if anything would suggest a favorable tilt toward the high end? Transportation costs have increased substantially in the last several years: to $4.1m in F05 from $1.8m in F04. Vested benefit obligations were $106m last year, and may subside, but realistically only lower raw material costs, or continued price increases will be substantial enough to significantly move the needle. By closing Murray (and eliminating their capacity), by raising pressure washer prices 4% last year and raising engine prices 4 ½% this year, by forward integrating they have set the stage for higher growth at higher margins. Now all they need to do is execute, and wait for raw material costs to decline. In my view they will buy back shares, and they will buy MTD or AB Electrolux USA at a favorable price (who else wants to step into the shoes of experienced players getting squeezed by a 70% market share producer). In the meantime, this is very cheap stock, yielding 2.6%, which will benefit from the housing construction boom of the last several years.

Catalyst

A decline in steel prices or a sensible forward acquisition.