Description
BGG is the world’s leading producer of air-cooled gasoline engines, which are used primarily for outdoor power equipment (OPE: lawnmowers, portable generators, pressure washers, etc.) A nearly “perfect storm” of issues has caused demand for OPE to remain at below normal replacement levels for an unprecedented third year in a row. Coupled with raw material cost pressures, this has depressed earnings and caused the stock to trade at record low valuations. Based on valuation metrics going back twenty years, the stock has in some respects traded off the map. The downside risk is probably to about $11.30. BGG has generated just over $2 per share in free cash flow (in a range of $1.07 to $2.94), on average, in the ten years through FY 07. I see appreciation potential over the next year or two to something closer to $30 than to $20 (12-15 times FCF between $2 and $3 per share). In the mean time, BGG has a dividend yield of 6% that does not appear to be at risk and a decent balance sheet. The stock would also probably respond positively if a hurricane made landfall at a populated area of the US.
The Business
The market for engines (air-cooled, four cycle, 3.5 to 25 horsepower) used for OPE is mainly the Western world (US, Canada, Europe). In a normal year, the market is just over 20MM engines (this includes a few MM used in industrial applications). In that normal year, BGG would ship about 12MM (they shipped about 10.6MM in FY 08). They have maintained a 50% share of the global market for these engines and roughly 70% of the market for lawn & garden end uses. The next largest producer is Honda, whose 6MM engines are aimed at industrial applications all over the world and that 15% of the OPE market that is described as “premium”. Until recently, Tecumseh delivered about 3MM engines, but they have exited the vertical shaft market. (A Tecumseh plant that built horizontal shaft engines for snow throwers is still potentially in the game) The next largest producer would be privately held Kohler, which has its hands full with its main business of plumbing fixtures. Subaru-Robin and Chinese companies play at the margin.
Inroads by Chinese engine makers have been a much talked about threat for a number of years but have been limited by a number of factors. Highly automated assembly (e.g., <30 minutes of labor in a walk mower engine) means that whatever labor cost advantage the Chinese might have is more than offset by shipping costs. The seasonal nature of lawn and garden assembly means that reliable delivery is absolute essential. (Many years ago, Honda opted to build a plant in the US for this reason.) Chinese product has been plagued with inconsistent manufacturing (a killer for product warranties), an ability to meet clean air mandates, and a bad habit of infringing on BGG’s patents, for which the OEM ends up “on the hook” when they get caught. BGG has been in China for many years, including engine production for the last several. They have had some success in displacing Chinese competition at retail in both the US and Europe. They continue to grow their presence in China for both engine production and component sourcing, but they note that a number of factors including currency and regulations have been making it harder for the Chinese to compete.
Both the manufacture and retailing of OPE has seen considerable consolidation. The largest OEMs are Husqvarna, which builds Craftsman for Sears as well as under its own name, and privately held MTD, which has rolled up a number of brands like Cub Cadet and Troy-Bilt. BGG moved into equipment manufacturing when it acquired the consumer product line of Generac in 2001. In 2004 they purchased Simplicity, which included extensive dealer networks for several other brands including Snapper. In 2005 they purchased the assets of Murray, which had once been the third largest lawn care producer but had lost its way, and liquidated it at a profit. The retailing of OPE has concentrated around Sears, Home Depot, Wal-Mart and Lowes. Dealer networks and the likes of Tractor Supply are still important in less densely populated areas. Lawn & garden is by far the largest component of OPE, and breaks down into Walk and Ride. Demand for Walk mowers in the US rose above 6MM units in FY 04 but has declined by several 100K units since. Demand for riding mowers, which use larger engines and so have more profit contribution, peaked at about 1.75MM and have declined (percentage wise) even more. Other end uses include portable backup generators (which have had an outsized impact on the bottom line, both ways, and will be described in turn), pressure washers, snow throwers and numerous other devices that are used by home owners, landscapers, ranchers and construction workers to “get it done”.
BGG could be compared to a solidly built house in a neighborhood that you would think twice about living in. A 70% market share puts them in a position where the OEMs and retailers don’t want to see them get any more powerful. To assert their position as low cost producer, they have invested in highly automated facilities. This means high fixed costs, a high breakeven point but excellent incremental profitability when they run full. Their ability to be the most reliable supplier to a customer base that lives or dies on timely delivery also requires a seasonal capital build. These issues become problematic because of the nature of demand for the end products. Over a full business cycle, there is solid demand for OPE but in any given year, circumstances might dictate that some of the demand gets postponed or otherwise reduced. Perhaps the worst thing about BGG’s place in the world is that they need to produce to meet the perceived needs of the big retailers, who have to anticipate and respond to consumer demand for relatively large ticket items. With reliable delivery a key competitive differentiator, they cannot risk being out of stock on a SKU if demand exceeds expectations. It is therefore very difficult to plan and produce in an optimal way, and easy to end up with disappointing results.
What Really Drives Demand BGG has been making engines for nearly a century and has devoted considerable resources to understanding what drives demand. Their models, which are based on decades of experience, indicate that replacement is by far (perhaps 70-80%) the biggest driver. How is this so? While huge variations will occur based on product quality, how many times a homeowner has to mow how big a lawn each year, and the owner’s inclination to maintain and ability to make repairs, on average, lawn mowers needs to be replaced about every seven years. There is a huge installed base out there, a major fraction of >100MM households in the US alone where when the grass starts growing it needs to be cut, and the equipment will be used, abused and eventually worn out. The combination of rampant photosynthesis and that societal norm that dictates that someone else’s home should be the neighborhood eyesore, not to mention the satisfaction that most of us derive from taking good care of what we own, is what ultimately drives demand for lawn & garden equipment. Over a long enough time, the wear and tear of normal and abnormal usage dictates that there will be a highly reliable need to replace equipment. A year at time, though, there is the compound fickleness of retailers plans and consumer discretionary income. The decision to replace a mower is driven less by outright failure of the equipment (BTW, if the engine gets even cursory maintenance, something else on the mower usually ends the life of the mower before the engine does) than the way that as equipment gets older it gets harder to work with and needs the attention of someone with skills that are not as available as they used to be. So when discretionary dollars get tight or disappear altogether, many homeowners who might otherwise replace equipment find ways to beg, borrow, steal or repair. Another response is to trade down, which more often than not will result in replacement sooner than it otherwise would have been, but in the short run is not a good thing for BGG. Weather can also be a big factor, such as the drought that occurred in Southeast last year, or even more so, that miserable excuse for a spring in the Northeast and Upper Midwest this year. Considering what happened to the less discretionary part of so many household budgets in the last year, it is not surprising that demand for OPE in the just ended FY came in at less than normal replacement. The silver lining in this is that unless something has permanently and substantially impaired the purchasing power of most of these households, there is significant pent-up demand waiting to be realized.
The Generator Issue BGG acquired the consumer operations of Generac in 2001, adding considerable goodwill to its balance sheet and, ultimately, even more volatility to its earnings. This is because the most important driver of generator sales has been landed hurricanes. There was only one in the first two years that BGG owned Generac, and the acquisition was deemed suspect. Then hurricanes picked up, culminating in 2005 (actually FY 06 for BGG) with Rita, Katrina and two others. Over 1MM generators were sold in 2005, twice the level of 2001. The channels to market were depleted and had to be rebuilt. There have been no landed hurricanes since. (Update: Dolly hit South Texas on July 23, but its path barely qualifies as a populated area.) Coupled with the need to reduce the channel inventories that got rebuilt in anticipation of at least one hurricane in 2006, this has been a significant drag on BGG’s earnings. It is estimated that generator sales last year were about 700K units less than in FY 06, of which more than 500K were Generac. It is also estimated that each generator contributes about $100 in gross profit, including the gross profit on the engine that is “sold” to the Generac operation. Overhead absorption is estimated at $25 +/- per unit. This goes a long ways in explaining the big drop in BGG’s profitability over the past two years. Fortunately, the inventory in the channel has been depleted, and eventually there will be another landed hurricane. It also helps that Coleman, which once had 30% of this market, has filed Chapter 11 and exited the market, (A private equity group bought the brand and is attempting to develop a Chinese source. At least one major retailer had a terrible experience with Chinese sourced generators in 2005), leaving Honda as the only branded competitor. This will be the basis of incremental earnings in the next year or two, significantly so if there if a hurricane makes landfall at a populated area along the East Coast. Longer term, the added earnings volatility of Generac does not square well with the companies commitment to Economic Value Added (EVA). It would not be surprising if at some point they sold Generac along with a long term engine sourcing contract.
Earning, etcetera At its present price, there is significant appreciation potential based on the seemingly low hurdle of the company being able to generate FCF in line with the average of the past decade ($2+) and the Market being willing to pay a double digit multiple for that FCF. I do not consider this a stretch, and the dividend yield while I wait is not shabby. This is based on just a bit of a cyclical snap back (pent up demand) and hardly any secular growth at all. I am presently projecting FY 10 only a few $MM higher than in FY 05. With an EBIT margin of 8.2% (it was 12%+ in FY 04), FCF would be $2.88. If the EBIT only improved to 6%, FCF would still exceed $2.00. For the FY ending June 2009, I am estimating earnings of $1.12 which based on my understanding of capex plans and D&A will mean FCF on the order of $1.55 per share. Absent a relapse into a very nasty recession, earnings should go significantly higher over the next two years at least.
Nearer term, how well BGG does in the FY that just started will depend more than anything on where consumer sentiment is next spring. It is unlikely to be worse than it was in 2008, how hard will it be for it to be just a little bit better? After three years of below normal replacement demand, the stage is set for some decent volume recovery. Prices are going up, as BGG and all of its competitors have been struggling with higher costs for raw materials and are starting to pass them through. Besides these basic factors and that potential landed hurricane, BGG has other revenue growth opportunities. The Brute mower seems to have exceeded Wal-Mart’s expectations in its first year, which opens the door for some additional SKUs. The snow thrower season will be a good one. Over 1MM units were sold in 2005, the last “good” year. This market does best in a year following a tough winter, when dealers sell out early and customers use the equipment a lot. 2007-08 saw a long tough winter that sold out very early. This is a market that Tecumseh was big in. It is reasonable to expect that BGG will ship a couple of 100K more engines in this category than it did last year.
The company has been wringing costs out (an estimated $143MM over a five year program through FY 08) and has targeted more cost reductions ($34MM) for FY 09. Significantly, they will exit their last union plant in Wisconsin later this summer. Other steps have included building a plant in the Czech Republic to better meet European demand, and sourcing more engines and parts from China, where they have operated for more than a decade.
The balance sheet is reasonably strong, but it important to note that BGG has a very seasonal need for borrowing. In addition to $266MM in LTD, the company has a $500MM revolver that expires in July 2012 that is used to fund a working capital build that peaks in about February. It reached $300MM during FY 08, when the company had some LTD come due. The most restrictive covenant is that borrowing must not exceed 3.5 times TTM EBITDA during Q1 and Q4 (Sept. & June) and 4 times during the other two quarters. I think there is a slight chance that BGG will be in technical violation of this covenant in the December quarter (unless we get that landed hurricane), but the “cure” would not be onerous. As I understand it, such an event would not require the company to omit its dividend.
The management team has tried to be good stewards of capital. The present impact of the Generac acquisition would be the most questionable issue in this regard. They were early adopters of EVA (the CEO co-authored a book on it) and other than making an acquisition of a business that added volatility they have “walked the walk”, globalizing (actually going south, and then establishing toeholds in China and Eastern Europe) what was for generations a classic “Rust Bowl” manufacturing presence in and around Milwaukee, spinning out Strattec, growing the dividend as the earnings grew and occasionally buying back stock. They told me when I first started talking with them that if the acquisitions could not earn an economic return that they would sell them and redeploy the proceeds.
Downside Risk Before describing my evaluation of what the downside might be, we have to consider what could get worse for BGG. Considering how stretched and shocked most US consumers are this year, the higher raw material costs and the unfavorable weather conditions that characterized the recent past, it it’s hard to get to something much uglier than where we already are. Macro trends like outsourcing of lawn care or “the end of suburbia” are very slow moving and might actually work the other way (e.g., retiring baby boomers start to take back lawn care from the company they used to pay to do it) I am at least somewhat concerned about what replacement demand might actually be for generators and, to a less extent, pressure washers, but this should not affect BGG’s ability to generate more normal FCF over the next few years, if it is an issue at all. It is also likely that with the advances that have been made in motors and batteries, electric lawn mowers will become more widely used. BGG can participate in this (over the past 20+ years they have offered an electric more than once, but the market was not ready for it), but if it happened to a significant degree it would be detrimental to the value of the engine franchise. Barring a fundamental change in the standard of living for all but the richest and poorest in the Western world, it does not seem likely that the current share price can remain at its recent level indefinitely.
I think downside risk is limited to about $11. The stock has not traded below BV since 1987, when it traded at .99 times. The book now has a large intangible component due to the acquisitions made in 2001 and 2004, so a discount to BV should be more likely to happen than in the past. At 95% of tangible BV, though, BGG would trade at $11.35. At $11, it would also be at about 25% of sales, worse than the 30% of sales it hit in 1990. A P/CF ratio of only 5.5 estimated FY 08 CF would put the stock at $11.32.
Appreciation Potential As implied in earlier statements, I believe that with demand for OPE at well below normal levels, earnings and FCF are at below normal levels but will not remain there. It is very unlikely that given the improved cost position, the demise of competitors (including a reduction in whatever cost advantage Chinese engine makers might have had), reduced need for capital spending and pent up demand that FCF cannot return to, or even exceed, the range that was normal for the preceding decade. All that would be necessary for a 30%+ total return from $12 would be for BGG to trade at twelve times FCF of $2 per share sometime within the next three years. FCF in excess of $3 per share is doable without heroic revenue growth or a return to past peak margins.
Conclusion: Based on my understanding, it would seem that at its present price, BGG has risk of a couple of points and well above average appreciation potential over the next year or two. Absent a landed hurricane, it might be dead money through the next couple of quarters (September and December tend to be nominally profitable at best.) while investors wait for clues about consumer confidence during the next OPE selling season, but then again it might not. The 6% dividend will kind of take the edge off of that possibility.
Catalyst
BGG is the world’s leading producer of air-cooled gasoline engines. A nearly “perfect storm” of issues has caused demand for OPE to remain at below normal replacement levels for an unprecedented third year in a row. Coupled with raw material cost pressures, this has depressed earnings and caused the stock to trade at record low valuations. The downside risk is probably to about $11.30. BGG has generated just over $2 per share in free cash flow (in a range of $1.07 to $2.94), on average, in the ten years through FY 07. I see appreciation potential over the next year or two to something closer to $30 than to $20 (12-15 times FCF between $2 and $3 per share). In the mean time, BGG has a dividend yield of 6% that does not appear to be at risk and a decent balance sheet. The stock would also probably respond positively if a hurricane made landfall at a populated area of the US.