Description

Generac is the leading manufacturer of residential generators in North America. It has a dominant market share (70%) in automatic stand-by generators as well as the leading share (~25%) in portable generators. Generac also manufactures generators for Industrial & Commercial Markets. The company underwent a $2 billion LBO in '06 and was IPO'd at $13 per share in '10. Private Equity exited its position last year. Generac has clocked outstanding financial and shareholder returns since its public debut. In addition to the ~400% increase in price, the company has also distributed $11 in special dividends. The company's complete dominance of the standby generator market is reflected by its world-class profitability (26% EBITDA margins and 2% cap. ex/sales, 90% pre-tax return on tangible capital).

Yet we believe results have been inflated by a unique confluence of events that occurred on the East Coast in the roughly 14 month period from Summer '11 through Fall '12. The incredible proximity - both in time and geography - of three major, weather induced outage events (Hurricane Irene, Halloween Nor’easter, and Hurricane Sandy) triggered a wave of demand that, both in intensity and longevity, far eclipsed anything previously experienced. As the "afterglow" from those events recedes, we anticipate a substantial decline in residential generator shipments. Whereas the street anticipates a weak Q1 '14 followed by a resumption of Residential growth in 2H '14, we expect Residential Revenues to decline considerably throughout ’14. Put simply, we believe the street is putting a normal multiple on what we deem to be "windfall" earnings. As earnings normalize, we expect the shares to under-perform. Our price target is $28, suggesting over 50% downside.

Overview of Generac's Residential Generator Business

Generac's Residential Segment (57% of '13 Revenues) is comprised of automatic stand-by generators, portable generators, and, to a much smaller extent, power washers. The company does not break out the contribution of each to total revenue. As it only re-entered the portable market in '08 (after a 10 year non-compete), the largest % of Revenue is from its most dominant product - its automatic standby generators. In terms of profitability, automatic standby generators offer much  higher gross margins than  portables.

(1) What are automatic standby generators?

Automatic Stand-by generators provide back-up power to a utility power source. They are permanently installed outside a home. When primary utility power fails, an automatic standby generator automatically starts and provides electrical power until primary power returns. There are two types of stand-by generators - air-cooled (8kw-20kw) and liquid-cooled (22kw-60kw). They run on natural gas or propane. They cost anywhere from $3k-$15k. In addition to product cost, there are upfront installation costs. Generac distributes automatic standby generators through a "multi-layered” distribution network including experienced contractors, dealers, wholesalers, and retailers.  They have an economic life of 12-15 years.

Generac offers very limited granularity on the automatic standby market. They have a 70% share and estimate the overall addressable market is 50 million homes. The current penetration rate is roughly 3% (up from 2% in 2010). Every 1% increase in penetration is $2 billion in industry revenues, and $1.4 billion for Generac. Generac installed its 1 millionth automatic standby generator in '13.

Management sees a very strong secular opportunity in the automatic standby market. An aging demographic (more vulnerable to outages), multi-decade underinvestment in the grid (more outages), and ever-increasing electrical dependence (increasing cost of downtime) make an increase in penetration rates inevitable. They cite the growth in penetration of other major residential products – most notably, central air conditioners - as a potential example of the opportunity in front of them.

Automatic stand-by generators are relatively new. Generac began installing them in late 90's. From that time until Q2 '11, the penetration rose to roughly 2% from 0%. From Q2 '11 through 2013, penetration rate climbed to 3% from 2%. In other words, penetration growth was roughly 18-20 bps per annum from late 90's through 1H'11, and 40-50 bps per annum from 1H '11-'13.

(2) Portables

Gasoline-fired portable generators have been around longer than automatic standby generators. They have a roughly 12%-14% penetration. Generac re-entered this market in '08 after the expiration of a 10 year non-compete with Briggs & Stratton. Since that time, they have grown share from 0% to ~ 25%. Much of this increased market share occurred during the demand explosion from 2H '11- '13, thereby enabling the company to outgrow already unprecedented growth in the portable generator market. Management has recently said that “the growth in share has slowed as they approach steady –state in mid to upper 20% range.”

Residential Segment Growth – Cyclical Peak or New Baseline?

As shown below, Generac experienced a phenomenal 31% organic revenue growth rate from ’10-’13.

For FY ’14 and FY ’15, expectations in Residential are as follows,

So Consensus estimates point to a mild decline in ’14 Residential Revenue (especially in relation to the previous boom) followed by a resumption of growth (+10% YoY) in ’15 to levels exceeding the ’13 peak. These estimates assume no major power outages. The assumption, then, is that the level of sales in ’13 can be sustained and improved upon even in the absence of subsequent outages. This is because permanent shifts in awareness and availability (more distributors) have altered the growth rate of automatic stand-by penetration. (With no recurring revenue and an extremely young installed base, a secular shift in penetration rates has to occur for the Residential Revenue estimates to be realized).

We believe this outlook reflects confusion surrounding the drivers of Generac’s recent growth. Underlying this confusion is a dual narrative that management has shaped to explain the performance of its Residential Segment. On the one hand, management has offered fairly incisive commentary about the short term effects of outages on demand for both portable and standby generators. Yet they also have – understandably -- sought to emphasize the contribution of internal initiatives and longer term secular dynamics in generating demand. As management has said, “it’s a really bad strategy to sit around and watch the weather channel.” While commendable, we believe these efforts have led to investor complacency around the indisputable fact that the residential generator business is largely driven by elements outside of management’s control. Indeed, far from disproving the cyclicality inherent in the business, the events of the last 30 months have served to confirm this.

The Effects of Irene, Halloween Nor’easter, and Hurricane Sandy on Generac’s Residential Business

As shown below, 3 major power outages hit the Northeast region within 14 months from 8/30/11 through 10/31/12.

Even before these events, the Northeast was Generac’s most established distribution channel. As a result, according to management on its Q3 ’11 call, its efforts (in responding to Irene and Halloween Nor’easter) would be “less about new dealer acquisition as they might be in a region that is dealer light.” This was important because outages in dealer light regions – like Hurricane Ike in Houston – had not benefitted Generac. Outages in the Northeast would.

In terms of how the effect from Irene and the Halloween Nor’easter would play out, management expected that “the immediate surge in demand would be about portable generators- the first wave” but this would “turn very quickly to focus on home standby generators, and that (the elevated demand for home standby generators) can last, depending upon the severity of the outage and concentration of distribution in a particular region where outage occurred, between 6 to 12 to even 18 months.”

On the Q4 ’11 call, management re-iterated this view, saying that “the close timing of these events occurring in similar regions of the country coupled w/strength of our regional distribution in those areas led to greater acceleration of demand for residential products.” This strength (in standby in particular) would persist well into ’12 “due to the afterglow the company historically experiences after major outage events.” Asked about what made this different from other outages, they said that “what was unique is when you overlay the geography of where the snowstorm occurred, you overlay that on Hurricane Irene path and it really was a – it was kind of a double whammy for that part of the country, and probably our most mature and tenured dealers as well.” Note these comments only reflect the situation following Irene and Winter October – before Sandy!

Asked on the Q2 ’12 call (eerily in light of Sandy) whether “business would be more impacted if there was a similar size event (to Irene) in a different geography or in the same geography?” Management pointed out that, “it is the time delta between events in a particular market that has a significant impact. It’s really a compounding effect. You get an event in a region where there has not been an event in a long time, and what happens is, because the category is still so new, we do not have the distribution channel that can handle an increase in baseline demand. So the first step, when an event happens, is building out distribution. It takes a second event within a couple of years after that event (to see penetration ramp). That compounding effect, it gets magnified because you have additional distribution partners in the market that you didn’t have the first go around.”

So Generac is saying that to experience this blissful “compounding” effect, several outages had to occur not only within a compressed period of time, but also within a confined geographic region. For example, a Northeast outage in year 1 followed by a Gulf outage in year 2 would not cut it.

The crucial link is that each outage boosts distributors in a particular region. This is exemplified by the growth in Generac’s dealer base. Whereas Generac had previously sought to add 300-400 dealers per annum, it added 500 in the 6 month period from 9/30/11-3/30/12 alone. While Generac does not disclose dealers by geography, management’s observation that, “when you get events like we had (Irene and Halloween Nor’easter), we also get quite a few parties interested in being dealers for the company and so we have expanded our distribution nicely in the first quarter of this year beyond where we normally would” leads us to assume most of the additions were in the Northeast. These new dealers would be “points of light” and “points of distribution” that would lead to a higher baseline of revenue even after outage effects subsided. This comment – that an increase in distribution would boost the secular penetration of the category beyond just the effect of the outages— is consistent with previous management strategy. However, management’s previous focus had been on adding dealers in “underserved” regions (Northeast was not “underserved”). In fact, Generac had expressed reservations about “dealers getting into this opportunistically because there is a demand surge in their market” and, in contrast, sought dealers that “could build a sustainable business model around residential standby generators.” ’ So while the dealer additions were welcome, it is not altogether clear that –over the long term—these are the types of dealer additions that will lead to a higher baseline of demand.  Perhaps it was the PE sponsor’s desire for an exit that influenced the decision to aggressively add so many dealers during a temporary demand spike. Our research in the channel suggests that these newer dealers serve much more to create competition for existing dealers than to generate incremental demand.

These new distributors were immediately rewarded with Sandy in fall ’12. The combination of massive capitulation by non-owners coupled with this increased distribution capacity led to a huge surge in penetration. Both the magnitude and duration of demand were unprecedented. Whereas demand for portable generators usually surges during and immediately following a power outage before dying down after 1 quarter, Generac saw a “longer tail of demand following Superstorm Sandy”, or an “extended period of elevated demand.” They were even more impressed with the “tail on the standby business from Sandy. The echo effect of Sandy happening in the same region as Irene the year before has had a more substantial impact on the length of the tail. Whereas we’ve said in the past that we would normally expect to see an elevated period of demand for about 6/12 months after an event, I think now we’re going to see all of the 12 months, maybe longer with this event.”

We believe this afterglow effect has been neglected by analysts. Numbers were far too low for ’13 owing to this, leading to enormous beat after enormous beat. Yet just as analysts missed the upside from the afterglow, we believe they are now missing the likely hangover from the same event. Estimates seem to be anchored to ’13 results.

While portables did (finally) begin to roll over in Q3 ’13, this was masked by the continued afterglow from standby generators. Again, this sequence of events—portables rolling over a few quarters before standby—is entirely consistent with management’s analysis of prior outages. We believe that the afterglow from Sandy has ended in Q1 ’14.

In channel checks with generator dealers throughout the Northeast (mostly Connecticut and New York), they emphasized that standby business had been decent in January but had collapsed in February and March. They did not see winter weather (making installations more difficult) as the culprit, but rather an ebbing of interest after last fall produced no major outage events. Inventories (even for standby generators which historically had little inventory due to size) were elevated as new dealers, who had “grown like mushrooms” post-Sandy, according to one long tenured dealer, had bought generators in advance of actual demand. The build-up of extra inventory in the channel represents another pocket of unsustainable demand  that may have boosted Generac’s recent results. This channel inventory co-exists with the high level of inventory that Generac seems to be sitting on.

This combination of elevated inventories at the dealer and company level coupled with weakening end-customer demand should pressure Generac going forward.

We also note the increase in DSO. This could be indicative of the extension of more lenient terms to dealers as the afterglow began to show signs of fading.

“Normalized” Results for Residential

If indeed the boom of recent years has set the stage for a prolonged period of challenging conditions, how do we quantify the impact?

Trying to discern the underlying trend growth rate in Residential Revenues is complicated due to

(1)     Data only from ’06 forward (IPO in ’10 with company family owned pre-’06 LBO)

(2)     ’06 was huge peak w/28% drop in ’07 caused by both lack of power outages and less resi. Investment

(3)     ’08 saw a +8% YoY increase but this was influenced by the mid-year re-entrance into the portable market

(4)     ’09 saw a +11% YoY increase but this again was influenced by additional months of portable sales

(5)     ’10 saw a +1% YoY increase after 10% increases of previous two years,

(6)     1H ’11 saw a -6% YoY Revenue Decline

Management said that organic Revenue was 15% from 2000-2009, but this is also not helpful because automatic standby was starting from such a small base.

To get around this, we ran a wide range of scenarios for trend growth using 2010 Residential Revenue as our point of departure because it was the last year prior to major outages.  The ’14 Residential Revenue implied by the trend growth rates is compared with the consensus estimate. A 45% incremental margin is applied to this difference to get the EBITDA delta.

45% incremental margins (higher than incremental corporate margins) are used for two reasons. First, management has said that residential profitability in general and automatic standby in particular is higher than C&I profitability. Second, the recent strength in residential generator demand meant that the normal promotional activity (to get dealers to purchase Generac product) did not need to occur. As conditions normalize, these promotional activities should resume, pressuring price realization.

Below are 3 scenarios with 5%, 10%, and 15% trend growth from ‘10 and a 9x ’14 EBITDA multiple. We then deduct Net Debt and add back the NPV of Generac’s roughly $280 million tax asset. We also include a table with a wider range of both multiple and normalized growth assumptions and the resulting share price.

So returns range from -70% to -30%. We expect this to be realized within the next 12 months or so. The street will give GNRC a pass on Q1 ’14 as Generac has said that elevated lead times entering ’13 in comparison with normal lead times in entering ’14 will cause a $140 million revenue headwind in Q1’14. Yet forecasts beyond Q1 are fairly robust and not nearly as forgiving and this is where issues should arise.

Risks

(1)     Major outage event – This is the most obvious risk to shorting GNRC. While our analysis indicates that such a major outage would have to occur in the Northeast for the “compounding effects” to really take hold, a severe and sustained outage anywhere would influence sentiment. By major, we are thinking of events at least on par with the Halloween Nor’easter (over 3 million for several days). Smaller outages-like those in PA and the Southwest this winter—will not be enough to really move the needle.

(2)     C&I—I have not talked about Generac’s C&I segment. It is not nearly as dominant or profitable as Generac’s Residential Segment. I implicitly assume that it meets street expectations. Even if it outperforms estimates, the pull back in residential we are anticipating should still have a much larger impact on stock price. Only huge outperformance in C&I could offset the Residential weakness.

(3)     Management is right and they really have created what they call their “own storm” via targeted marketing, improvements in home selling solutions, and Generac’s new infomercial campaign. This has created a secular shift in awareness that extends well beyond the afterglow of major outages. This awareness coupled with enhanced “availability” due to added dealers has permanently increased the baseline level of demand. Our view is that frequent major outages are needed to drive sustained interest from both consumers and dealers. We also believe that standby generators as a product have a market limited by geography and by wherewithal ($5k -$15k before installed cost) such that the 3% penetration rate is quite misleading.

Catalyst

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