Description

Navistar International Corp. (NAV)

Current price: $23.50

Target price: $60+

I am recommending the purchase of Navistar (NAV), an out-of-favor manufacturer of trucks and engines with well-known issues that are more than reflected in its depressed stock price.  I believe that NAV offers substantial upside relative to downside risks with a fairly near-term catalyst.  In the days since I submitted this as my application pitch, the company has changed their engine strategy to include an SCR after-treatment, and is no longer pursuing certification of their EGR engine.  I believe this is the most-sound course of action.  The company has indicated that certification of the SCR engine could take as little as 30 days after submission to the EPA and that it will be in the hands of customers for testing very soon.

The change in strategy was driven by new COO Troy Clarke and I believe that this increases the likelihood that CEO Dan Ustian is on his way out.  Importantly, the timeframe for nominating new directors is this fall, and I expect the two activist investors to nominate several new directors.  The rest of the thesis is still intact. 

Overview

NAV is an international manufacturer of trucks, including heavy duty, medium duty, severe-service/vocational, military trucks/specialized military vehicles, RVs, and buses.  The company manufactures engines and parts for internal use and external sale, and provides retail, wholesale and lease financing.  Navistar was founded in 1902, is headquartered in Lisle, IL, and is run by Chairman and CEO Dan Ustian.

NAV’s traditional market is for Class 6-8 trucks and school buses in the US and Canada.  NAV sells its Class 8 heavy duty trucks under the International brand through a worldwide network of over 970 dealers.

Investment Thesis

While there is a general truck industry investment thesis surrounding the aging fleet and imminent replacement cycle, the crux of the NAV story lies in their engine segment.  Effective January 1, 2010, new diesel engines sold in the US must comply with a stricter EPA emissions mandate that reduces permissible NOx emissions from 1.2 g/hp-hr to 0.2 g/hp-hr.  Contrary to the rest of the industry, NAV chose to pursue a compliant EGR (exhaust gas recirculation) engine to meet the new standards, rather than switch to SCR (selective catalytic reduction) technology.  NAV touts its engine solution on the benefit that there is no extra effort required from the operator to meet the new emissions standard, whereas SCR technology requires the driver to periodically refill another tank (containing a 32.5% urea solution).  SCR is generally more fuel efficient, but NAV’s trucks are more aerodynamic and lighter.

The rest of the truck industry has adopted SCR technology in order to meet the new standard.  SCR technology has been used in Europe for several years to reduce NOx, but it is slightly more expensive and requires additional hardware on the engine.  An SCR-equipped engine is essentially an EGR engine where the exhaust is run over a catalyst (in this case liquid urea) and the ensuing chemical reaction removes the NOx.  These engines require heaters and coolers and a tank of urea, which needs to be filled once every three diesel fill-ups.  The extra equipment adds 1,000 pounds to the truck, not to mention the fact that liquid urea tends to freeze around 12 degree Fahrenheit and boil around 100 degrees.

NAV’s all-EGR solution uses software to manage the fuel injection, which allows for a cleaner burn within the cylinder.  EGR requires fewer changes to the engine, which lowers costs for parts and retraining of mechanics.  NAV is assuming that liquid-urea SCR will prove to be a stop-gap technology and that EGR will prove to be the more enduring solution to meet stricter emissions standards.

The problem is that NAV still does not have a compliant engine and it has been affecting their recent results (more on that in a bit).  NAV submitted their EPA-2010 compliant 13-liter engine to the EPA in January for certification.  The engine had been tested and certified by a third party and the company had been in communication with the EPA for months prior to submitting their engine.  Management has said that they expect approval of the engine in the late spring/early summer and that production can start within 30 days following approval.  Meanwhile, NAV is selling non-compliant engines using a combination of environmental credits and noncompliance penalties (NCPs).  They have paid about $10 million in fines during the first two quarters of fiscal 2012.

So here we are five months later and still no word from the EPA.  Did I mention that right before NAV submitted their engine, they sued the EPA?  You see, SCR engines are not compliant with the 0.2 NOx limit at all points in the duty cycle.  At some points, such as when the diesel exhaust fluid (DEF) is warming up or cooling down, the engine is over 0.2 and is granted exceptions.  NAV basically contended that it is unfair that other manufacturers get to sell engines that are technically non-compliant without penalty while NAV is racking up millions in fines for selling its own noncompliant engine.  The EPA has vetted the emissions data that NAV submitted with their engine and the two parties are likely in negotiation regarding how the engine will be scored.  Like SCR engines, NAV’s engine is under the 0.2 NOx limit at some points in the duty cycle and above 0.2 at others, but the weighted average over the entire cycle is likely under 0.2.

NAV disclosed in its 2Q report that it resubmitted the engine to the EPA in May after making some adjustments.  I believe that the tweaks and subsequent resubmission were a direct result of negotiations between the two parties (i.e. the EPA indicated what changes would need to be made in order to receive certification).  This makes it MORE likely that NAV receives certification for the 13L engine.

The multi-year promise by management that NAV could deliver a 0.2g EPA-certified 13L EGR engine has worn thin with investors.  The market no longer views certification as inevitable and many investors have chosen to throw in the towel.  Meanwhile, the market is anticipating that they will have to pay significant fines when NAV’s credits run out and the 13L engine fails to gain approval.  If that is not enough, investors are also hugely skeptical about NAV’s ability to maintain its 18-20% historical market share of Class 8 trucks.  However, it is important to remember that customers are careful to build and maintain fleets around long-term brand decisions, and it would take a long-term quality, cost, or service shortfall to get loyal customers to wholesale switch to a completely new supplier.  Trucking companies typically have a lot invested in parts, service, training, and other infrastructure to support their fleets.  Despite some industry reports that would appear otherwise, NAV has not necessarily lost market share – people are just waiting to buy until they get EPA certification.

NAV dealers and suppliers continue to support the company’s engine strategy.  However, only larger fleets appear to be buying NAV trucks right now, while owner-operators and small (1-5 truck) fleets are waiting for certification.  Celadon actually loves the engine but is waiting on a compliant version, while Heartland is raving about the fuel economy on the noncompliant engine.  The bottom line is that truckers buy products because of the trucks, not the engine – and truckers resoundingly love NAV trucks.

There are three likely scenarios with regard to engine certification:

1. Certification is received
   1. Because the tweaks made in May were likely the result of negotiations with the EPA, I think this is the most likely scenario.
   2. Certification is denied or approved in a way that significantly degrades engine performance
      1. This scenario would likely force the company to redesign the truck to fit an SCR engine.  They could either return to Cummins as an engine supplier (unlikely) or adopt their own version of the SCR technology (more likely).  Given the lower base level of emissions on the new EGR engine, it is likely that the urea tank and dosing could be smaller, or at least filling less frequent.  Meanwhile the company could continue to pursue a compliant EGR engine.  Because it is a question of tweaking the software and the pressures within the valve to get the right combination of emissions and fuel economy, it is a question of when, not if, they get the EGR engine right.
      2. Certification is delayed indefinitely
         1. I view this scenario as the least likely, given the fact that the two parties have been negotiating for months, NAV has already tweaked the engine as a result of those negotiations, and the EPA is set to issue a final ruling with regard to NCPs soon.

Any scenario that does not result in a fully-compliant EGR engine would put pressure on the board to effect management change, which would be viewed favorably by investors.

Fiscal first quarter results were much worse than expected.  NAV suffered a $153 million loss and disclosed a $112 million warranty expense that nobody was expecting.  Meanwhile, they lowered full year EPS guidance from $5.50-5.75 to $4.25-5.25.  At the time, they expected to exit 2012 at a run rate of 8% EBIT margins (versus 5% in 2011).  NAV followed up that stellar performance with a 2Q bomb.  The company suffered a GAAP loss of $172 million and took an addition $104 million of warranty expense.  Management lowered guidance again, to $0.00-2.00.  As part of a broader reorganization announced in conjunction with second quarter earnings, Troy Clarke was named COO of manufacturing.  Clarke ran GM’s truck business for a long time, and he is the most respected member of the management team.  This move puts Clarke in position to succeed CEO Dan Ustian.

NAV is now the target of more than one activist investor.  Carl Icahn purchased about 10% of NAV shares in the Fall of 2011.  At the time, he was interested in combining NAV and OSK.  He agreed not to seek seats on NAV’s board, and in exchange NAV eliminated staggered terms for its directors and refrained from increasing the size of the board above 11 directors or adopting a poison pill.  Following the 2Q earnings report, Icahn increased his holdings to 12%.  Meanwhile, Mark Rachesky disclosed an almost 14% stake in the company following the 2Q earnings release, making him the company’s largest shareholder.  The amended 13D indicates that MHR intends to engage in discussions with management to maximize shareholder value.  Rachesky is a former protégé of Icahn and the two sparred for control over Lions Gate a few years ago.

There has been an abundance of takeover speculation as the stock price has cratered.  Fiat chairman Sergio Marchionne indicated Fiat’s interest in entering the US truck markets and did not rule out making a play for NAV.  Meanwhile, the Financial Times Deutschland reported on June 10, 2012 that Volkswagen is in the early stages of examining whether to take a stake in NAV.  Volkswagen believes that entering the US truck market via NAV would enable it to better compete with rival Daimler.  However, there are several obstacles to a takeover by either Fiat or Volkswagen.  First NAV’s military business (14% of revenue) would likely have to be shut down due to DoD FOCI rules against foreign ownership of cleared facilities.  Second, NAV’s underfunded pension raises the cost for an acquirer.  Strategically, a NAV purchase makes sense for both companies, though each is already going through its own integration issues (VW with MAN and Scania; Fiat Industrial with a potential CNH reverse merger).

Needless to say, the board recently adopted a shareholder rights plan which is triggered in the event a holder accumulates more than 15% of the shares outstanding.  The poison pill seems to be primarily a mechanism by which the board is taking control of the process and forcing activists and would-be acquirers to involve the board in any discussions.  It also does not rule out changes to management or a sale of the company.

Valuation

Regardless of the outcome of the EPA certification, I expect NAV’s manufacturing revenue to increase at a CAGR of 6.6% over the next five years.  As the engine issues are resolved and the Class 8 replacement cycle picks up, I would expect EBITDA margins to gradually expand to ~9% (from 8.4% in 2011).  No doubt, 2012 will be a challenging year for the company.  Given where the stock is trading, however, I think it is prudent to think about what the company can earn in 2-3 years.

Using these revenue growth and margin assumptions, and assuming a 10% discount rate and 3% FCF terminal growth rate, a discounted cash flow analysis yields a value of $60 per share.  These assumptions imply EPS of $6.95 in 2014.  Applying a modest 10x multiple yields a value of $69.50 per share.  The Street estimate for 2014 is $5.85, which, using the same 10x multiple, yields a value of $58.50 per share.  Management believes that earnings can peak out at $12-15 this cycle.  Let’s infuse a healthy dose of skepticism and assume that number is really $6-8.  Again, using a modest 10x multiple yields a value of $60-80.

What is the stock likely to do in the near-term?  That depends on the three likely outcomes I outlined earlier:

• Engine gets approval from the EPA – 50% chance – stock is UP
• Engine does not get approval or gets approved at higher NOx levels – 40% chance
  • 50% chance stock is UP (provided that management gives some insight into the road ahead, i.e. SCR solution)
  • 50% chance the stock is DOWN
  • Engine certification is delayed several more months – 10% chance – stock is DOWN

So, there is a 70% chance that the stock is up on ANY engine news and a 30% chance the stock is down.  $24-25 looks to be the likely downside support level.

What is NAV’s value to a strategic buyer?  Instant synergies could be recognized by either Fiat or Volkswagen.  NAV’s purchasing power would immediately improve, with each 100 bps improvement in COGS adding ~$8 per share.  Should either buyer choose to use an in-house SCR engine (or switch to CMI), NAV’s R&D budget could be reduced, with each $100 million reduction adding ~$7 per share.  NAV’s (currently) unprofitable JV’s in Asia would be closed in areas where a local presence already exists.  Finally, NAV’s US federal NOLs add another $1 per share.  Using my 2014 EPS estimate and a 10x multiple, plus the synergies listed above, yields a value to a strategic buyer of over $85 per share.

Risks

• Class 8 replacement cycle fails to materialize
• EPA’s final ruling on noncompliance penalties  turns out to be extremely punitive
• Certification process drags on indefinitely and company begins to run out of liquidity – they have at least a year’s worth of liquidity left at the current pace
• The biggest drag on the stock right now is uncertainty around engine certification.  Any kind of ruling – positive or negative – would remove a major overhang

Catalysts

• EPA approval of 13L engine and recapture of lost market share
• Rapid uptake and growth of NAV’s natural gas-powered engine
• Significant pickup in residential construction and medium duty truck demand
• Emergence of Class 8 replacement cycle
• Activist involvement, management shake-up, or ultimate sale of the company

Summary

In summary, NAV is trading at a material discount to intrinsic value for several reasons.  First, the investor community is skeptical over whether NAV will ever get their 13L engine approved by the EPA.  I believe that it is a question of when, not if, NAV will get approval.  Second, Investors are weary after years of unfulfilled management promises regarding the 13L engine.  The perception among the investor community is that these guys are idiots.  However, they have executed very well on the strategy they embarked on ten years ago to transform the company – and truckers love the product.  There is no doubt that they are bad at managing the Street, but communication has gotten better.  Investor patience is definitely wearing thin.  Several of the company’s long-term holders have been reducing their positions and sellside support has evaporated, presenting value investors with a favorable risk/reward scenario.  Finally, general weakness in Class 8 truck order over the past few months has weighed on trucking company shares as a whole.  However, the fleet is old, setting up a multi-year secular growth story.  Much of that weakness has also come from Europe, where NAV has virtually no exposure.

Given all this, I am recommending the purchase of NAV shares with a price target of at least $60.  I believe the stock presents a favorable risk/reward scenario with multiple ways to win.

Catalyst

• EPA approval of 13L engine and recapture of lost market share
• Rapid uptake and growth of NAV’s natural gas-powered engine
• Significant pickup in residential construction and medium duty truck demand
• Emergence of Class 8 replacement cycle
• Activist involvement, management shake-up, or ultimate sale of the company