Description

Company: Oshkosh Corp (Ticker OSK US)

Recommendation: Short

Thesis: Oshkosh Corp is an equipment maker about to experience a severe cyclical downturn in its biggest segment. The company’s valuation currently reflect near top of the cycle valuation and the cash flow profile of the business is likely to deteriorate very rapidly in the coming years. The equity value has a 80% downside to my target price over a two year period.

Company Description:

Oshkosh manufactures specialty access equipment and vehicles for the municipal markets as well heavy duty defense trucks for the U.S. and foreign militaries. The company reports in four segments. Access equipment (51% of sales) was formed from Oshkosh’s largest and most recent acquisition of JLG Industries in 2006. Defense (25% of sales) produces tactical wheeled vehicles for the military and security forces globally. The Commercial segment (13% of sales) offers concrete mixers and batch plants, refuse collection and field service vehicles and truck-mounted cranes. Fire and Emergency (11% of sales) focuses on firefighting and snow removal vehicles. These segments have no or limited synergies and these businesses are best discussed separately.

ACCESS EQUIPMENT SEGMENT:

Oshkosh acquired JLG in 2006. JLG manufactures aerial work platforms and telehandlers used in a wide variety of construction, agricultural, industrial, institutional and general maintenance applications to position workers and materials at elevated heights. Access equipment customers include equipment rental companies, construction contractors, manufacturing companies and home improvement centers.

The business is highly cyclical and has historically been linked to non-residential construction demand in the US as there is not much used of access equipment for residential. The business is primarily (about 70%) domestic, so important to understand that market first.

US Construction Activity

The US construction spend as a % of GDP had been declining for a few decades and nosedived after the 2009 recession to settle at a lower level.

So even as US GDP had surpassed the 2008 highs by 2010, US construction has not reached its previous peak of 2006.

Breaking down this total construction spend into its Resi and non-resi components shows that a very slow residential recovering is largely to blame, which partly reflects the scale of the overbuild in the 2006 period and also the effect of other factors like demographic trends, etc. See below for breakdown (in $b)

So non-residential activity only collapsed after the overall economy went into a recession and has recovered since then to its previous highs. See below for the components of the non-resi spend (in $b).  

It’s a busy chart but most of the Non-res rebound has come from 4 of the components, Manufacturing, Lodging and Commercial from 2011 onwards and Office from 2013 onwards. The rest of the categories have largely shown little to no growth. See below to illustrate that fact (in $b)

Lodging is a cyclical sector and we are experiencing peak supply growth right now as occupancy rate is just starting to go negative which usually signals peak cash flows for the industry as well as the end of approvals for further capacity additions.

For Offices, conversations with Ashtead (one of the largest rental companies for construction equipment) reveal that last few years have seen a number of approvals for new headquarters, which is borne true by the data shown above. This upcycle in office construction lasted from 2005-2008 in the last cycle and 1998 to 2001 in the cycle before. It’s currently lasted from 2013-2016 and we are unlikely to see a further major inflection upwards in the data. 2016 should still be decent but activity will likely start declining after that.

For Commercial, going into its sub-components shows the biggest improvement has largely been in Multi-Retail and Warehousing, and again the square footage added in those segments has slowed recently as supply growth exceeds demand growth. This is borne true by recent declines in the Construction Backlog Indicator

Meanwhile for Manufacturing, which had registered by far the largest increase in non-residential spending growth, the main growth component over the last few years had been energy related which turned negative in 2015 leading to a contraction in the manufacturing activity for the first time in 6 years. I expect the downturn in manufacturing activity as a result of commodity related downturn to exacerbate going forward causing manufacturing related construction to roll.

As of result of these factors I expect US non-residential construction activity to start declining in the coming years as a number of the cyclical growth segments like Lodging, Office, Commercial and Manufacturing roll over. Even bullish forecasters expect a 10% decline in non-res activity now.

This is differentiated from the market which mostly believes in a benign construction environment in the US. Ashtead (a large equipment rental company) guides to charts like the one below by or the next one by Neff (another rental company)

These kind of misleading assumptions about long-term growth outlook are keeping buyside and sellside fairly optimistic on the market conditions. Hence the reason Ashtead fell 11% on its results last month when it drastically cut its capex and capex guidance due to deteriorating market conditions and Neff fell 17%  on March 8th when it reported annual results which reflected sharply falling used equipment prices due to a worsening supply demand balance. Other houses point to atleast a 10% decline in non-resi capex due to the reasons I pointed to.

Aerials and Telehanders - Segment Dynamics

The aerials and telehandlers market has experienced some changes over the last few years. One prominent trend has been the move in the industry from owning to renting equipment. The overall construction equipment market experienced this in all categories as shown below. Discussions with management have verified that the situation in aerials and telehandlers is even more extreme with 96% market share of the rental companies (also confirmed by Neff’s presentation). This largely means Oshkosh’s Access Segment’s main customers are the biggest rental companies, e.g United Rentals and Sunbelt (owned by Ashtead).

Furthermore the largest players have been consolidating the segment with acquisitions leading to higher customer concentration for Oshkosh. More importantly, the trend towards renting instead of owning is driven by increased scale of the bigger rental players allowing better overall utilization of the assets. While in the past the equipment might have stayed idle as construction activity ebbed in a certain region, the nationwide rental players are able to move idle equipment quickly to where it can be utilized. It also increased revenues per branch at both URI and Ashtead, which allowed them to take advantage of their scale. This should eventually lead to a decline in overall amount of equipment required for any given amount of construction activity, hence shrinking Oshkosh’s potential market size.

Another problem is that the largest players have become better at squeezing more life out of the equipment. Average age till retirement of aerials and telehandlers used to 7 years almost a decade ago but has increased to almost 10 years now according to Ashtead management (I had a chat with the Ashtead CEO). According to Ashtead’s CEO the biggest reason they are able to do this is that the equipment largely does not experience any high impact wear and tear, e.g. like an excavator. In contrast aerials and telehandlers usually do not experience high impact endurance and all the parts can be swapped and retro-fitted as need be over the years to get more life out of the equipment. As the average age of the equipment increases, this also decreases the overall annual market size (through cycle) for Oshkosk. This should get reflected in lower maintenance capex figures for the big rental players.

The reason we haven’t see these trends manifest into lower order intake yet is that as the trends to renting over owning accelerated and the biggest rental companies increased market share, those companies also went on an ordering spree as they anticipated taking ever bigger market share. This led to a massive increase in ordering cycle at these rental companies well above the overall non-residential activity, which still hasn’t reached the prior peak of 2007. As these companies went on an unprecedented ordering spree, the average age of their equipment has declined to all time historic lows. Also the average residual price of the equipment has increased significantly above long-term average as the equipment is much younger. This has started reversing as underlying demand ebbs and we are left with surplus equipment.

Ashtead’s US business is called Sunbelt and it has gotten its biggest exposure to the Aerials segment which is the segment Oshkosh operates in. Ashtead in particular went on an even bigger capex spree since it tried to grow even more aggressively than United Rentals. Please note below Sunbelt’s fleet composition and US market share for rentals.

Effectively the capex for the rental companies reflects the revenues for the two main Aerials equipment providers, namely Oshkosh and its main rival Terex. I have extracted the capex for United Rentals and Ashtead below and compared it to the revenues for the Aerials segment at Terex and the Access division at Oshkosh (in $b). I have included the capex forecast for next year for United Rental and Sunbelt and further extrapolated it based on discussions with management and views on non-resi construction activity in the US rolling over and mean reversion of the equipment age.

Note below Sunbelt’s gross capex compared to Sunbelt’s average fleet age which has fallen well below long-term averages and will likely mean revert over the rest of the decade (in $b and months). And that’s assuming long-term fleet replacement age remains closer to 7 years. If my discussions with Ashtead CEO are accurate, we could see fleet replacement age relating to Aerials (which is a third of Ashtead’s US fleet) actual trend upwards closer to 10 years and long-term fleet average move up towards 60 months. In that scenario Oshkosh and Terex will experience a severe lack of orders for the foreseeable future. Also note that with rental penetration in Aerials now approaching 96%, there’s limited to no capacity for current players to take share from equipment owners anymore and hence the massive ordering cycle has done its job and is coming to an end.

Meanwhile in line with the expectations of weakening demand, which are dictating capex cuts at URI and Sunbelt, we are starting to see used equipment prices peak and start to decline. Note below residual values of equipment well above historical levels, and rolling over.

Last month Neff reported results which missed largely as a result of a surprise downside in used equipment prices and recent auctions. Rentals companies need to move the used equipment to purchase new equipment and the proceeds go towards new capex. As used equipment sales start declining, it usually portends drastic capex reduction. Note below used equipment sales and capex for URI and Sunbelt.

In its attempts to explain the declining capex Ashtead pointed to a dearth of new equipment orders at the bottom of the last cycle but this in effect just confirms the cyclical nature of these businesses.

Access equipment division’s financials

Oshkosh’s access division is the least integrated of its 4 divisions. The company effectively buys all the equipment from its suppliers to build these machines. 85% of its costs represent materials including engines, tyres, cogs and components etc. Ashtead management pointed out to me that they themselves are able to calculate the input costs of these components and see e.g. how the fall in steel or rubber prices are affecting these. A drop in the capex will lead to even more price competition and further price drops. Oshkosh management confirmed to me that they are infact forced to pass through all these cost savings to their rental equipment customers and can’t hold any of it themselves. Infact they do have some fixed costs still and their margins fall in %age terms in the downcycle. Coupled with declining revenues, this has a devastating effect on EBITDA in the downcycle. Pair that scenario with stubborn corporate costs and leverage on balance sheets, and often these companies see earnings disappear and go negative, and equity values drop precipitously.

Note below Oshkosh’s Access equipment EBITDA and margins over last few years.

Putting it all together note below the sales and forecast, I’ve dropped the sales in line with guided capex from Ashtead and URI for 2016/2017 and for my forecast for 2018 based on discussions with management and analysis or fleet age and non-resi activity. This is the base scenario without a big catastrophe like a US recession. This is just a 10% pullback in non-resi activity due to the sectors I mentioned, continued activity in resi sector and decent overall activity. If there’s a US recession, growth capex is likely to drop to close to zero and stay there for a few years while maintenance capex will surprise to the downside due to increased fleet age, higher overall utilization of equipment due to 96% penetration by rentals and equipment lasting longer than expected.

On top of this Oshkosh is experiencing issues in the international component of the business. While 70% of the Access Equipment is in US, the rest is scattered across Western Europe, LATAM including Brazil, and Asia.

Sales across some of these regions (like Western Europe) have held up better than in the US since they are not exposed to an energy capex related downturn and also didn’t experience as robust an ordering cycle leading to oversupply and decline in rental rates. Still even across these better businesses Oshkosh is facing translation issues due to USD strengthening as well as transaction issues as a significant component of the costs are in USD (e.g. 50% for Western Europe and the remaining being manufactured locally in Netherlands and Romania).

Other regions like Brazil etc are in full blown recession and not only the translation and transaction issues still exist, but also overall sales are in steep decline.

Besides Aerials and Telehandlers, Oshkosh’s Access Equipment division has another subdivision called Other. This sub-segment had $566m in sales last year which have been growing over last few years. Other includes a $100m approx. tow truck business which has been very steady and stable, while the rest of the sub-segment comprises of parts and spares sales. Infact if the thesis across average fleet age of Aerials to increase from about 7 years to 10 years is correct, we should be seeing increased sales of parts and spares in Other which would be used to keep retrofitting the existing fleet to eke out more life from it. This is a major concern as the Other segment has significantly lower margins than the main Aerials and Telehandler segments, and also is major cannibalizing future sales from the other bigger segments by allowing increased life of the equipment. It’s not much Oshkosh can do anything about though as this is being dictated by their clients. Hence I expect the Other segment to continue to grow.

Management wouldn’t give much guidance to split in margins between fixed and variable costs but it can be teased out from the historical financials. I took the operating revenues of the Access Division and applied to it certain fixed costs (which I grew by the rate that the Corporate Costs grew over the last 7 years, namely 2.1%) and certain variable costs and used the Solver optimization function in Excel to figure out the best fit for Fixed Costs (absolute) and Variable Costs (as % of segment revenues) for the division to match historical data. Results are below.

Sense checking these, it makes sense and pretty close to expectations on variable costs and fixed costs. Using this I am forecasting declining margins for the segment in the coming years, not as bad as the 2009 decline ofcourse since that was a recession but still severely eroding profitability. This would be my base case and bear case would represent a severe fall in non-resi construction, leading to recession like conditions in which case margins would get more severely hit.

DEFENSE EQUIPMENT SEGMENT:

Oshkosh Defense is a very lumpy business. It has in many ways been the best performing business of Oshkosh even though in 2015 it produced only $6m of the firm’s $398m Net Operating Profits. Comparing cumulative Operating Profits from 2007-2015 reveals how this business outperformed even the unprecedented bull cycle in Aerials recently

What Oshkosh does is produce a family of Light and Heavy combat tactical vehicles. Unlike the Aerials segment where Oshkosh has very little vertical integration and hence almost no technological advantage or differentiation and hence little pricing power and razor thin margins, Oshkosh Defense is continually investing in newer technologies and is much more vertically integrated. With comes the ability to provide a lot more customization and command higher margins. But it also comes with much higher fixed costs which for a lumpy business with wildly varying and unpredictable order timing means fluctuating operating profits and margins.

Oshkosh Defense has also benefitted handsomely from operations in the Middle East and Afghanistan. The rugged terrains of these theaters were perfectly suited for the family of relatively low-tech and rugged vehicles that Oshkosh produced. In particular in Jun 2009 Oshkosh won a massive contract for its M-ATVs (Mine Resistant Ambush Protected All-Terrain Vehicles). It delivered almost 9000 of these vehicles within the next 3 years. As major operations wind down, and this massive contract has been delivered, Oshkosh Defense has experienced a significant slowdown in activity. But it has been unwilling or unable to downsize to its size prior to combat operations in Afghanistan and Middle East and the high fixed costs have eroded away the margins of the business. See below.

The success of the M-ATVs with the DoD in Middle East has led to Oshkosh winning some other international orders from Middle East countries. In 2013 Oshkosh Defense delivered 750 M-ATVs to UAE and another 250 or so M-ATVs in 2014 and 2015 to an undisclosed international client (likely in Middle East). In Aug 2015 Oshkosh reported an order for another 273 M-ATVs that it will deliver in 2016. Oshkosh expects to be in the running for another order of 1000 M-ATVs in 2016 that will be delivered over 2016/2017. Each M-ATV was priced at approx. $500k with Oshkosh Defense reporting margins on these vehicles at high teens (approx. 17-18% in discussions with management). So this was a highly lucrative program. All the ongoing international orders are relatively small (and getting smaller) to the size of the original DoD order of 9000 vehicles and hence overall sales continued to decline and margins erode as the facilities are operating at sub-scale.

In addition to the lumpy M-ATV program, the segment was also awarded another lumpy re-buy program for FMTVs (Family of Medium Tactical Vehicles). This was awarded in 2009 and was originally a 5 year program. The company started delivering the vehicles under this program starting in 2011. The program was extended till 2017 and will wind down over next two years. Margins of these vehicles are approx. 2% according to management.

Continuing the winning streak, Oshkosh Defense managed to get another jumbo contract in the form of another massive order from DoD for JLTVs (Joint Light Tactical Vehicle). The JLTV program is expected to be a 20-year, $30 billion program for the production of up to 55,000 vehicles. The initial contract is for 8 years and 17,000 vehicles for which will ramp up slowly over the next 3 years and reach full production capacity from 2019. Oshkosh Defense will produce about 2,000 vehicles, (approximately 350, 650 and 1000) during the 3 year ramp-up phase FY 17-FY19 and then produce 3,000 vehicles per year for 5 years FY20-FY24 to conclude the 17,000 vehicle 8 year program. Each vehicle is priced at approx. $300k and should see “high single digit margins” according to discussions with management once ramped up. The company expects the program to continue at the end of the 8 year contract and expects to win any renewal as well, for a subsequent 30,000 or so vehicles for another 10 years.

Removing these M-ATV, FMTV and JLTV contracts (according to management provided/guided stats), one can deduce what the Core defense business has been earning in revenues and operating profits. See below.

The Core Business is more closely tied to the DoD budget. As that Budget has been pared back, so has the revenues for the Core Defense business. The Defense Budget has now bottomed and after the agreement for a 2 year lifting of the sequester, we can expect to see a small growth in the Defense spending, but this is still minimal growth from current levels compared to the past decade of combat operations and most of the spending growth still goes towards personnel.

In addition, the growth is US DoD spend will be minimal from here. Most of the growth in overall Defense spending globally is either coming from countries not approved for sales (like China etc) or from Middle Eastern and Asian countries. Even the Asian countries have lots of strings attached for sales and Middle East is the only region that was stably growing defense spending. Infact Oshkosh has benefitted from this with recent sales for M-ATVs in the region.

Unfortunately with the collapse of Brent, which is likely to stay low for the foreseeable future, the Saudi budget has collapsed into a 25% deficit leading to significant spending cuts across the board, including in defense. Oshkosh was expected to sign a 1000 M-ATV contract (which the management was confident of signing in 1Q CY16) but seems less certain around the timing now. I expect Middle Eastern defense budgets to disappoint in terms of expected growth. Almost all of Oshkosh’s sales are generated with the US DoD whose budget will not grow much in coming years, although it’s not going to fall further either. Oshkosh Defense produced 91% of its sales on average over the last few years with the US DoD.

I have grown the Core business in-line with US DoD budget growth and reverted it’s margins back to 5% from negative in 2015. I have run the M-ATV and FMTV programs to completion at their current margin levels. I have given the company credit for the 1000 M-ATVs they are saying they have been having discussion with a customer with currently although management indicated to me that recent budget constraints at the customer is causing some delays on this moving forward. I have ramped up the JLTV program as indicated.

FIRE & EMERGENCY SEGMENT:

Oshkosh produces and sells custom and commercial firefighting vehicles in the U.S. and abroad under the Pierce brand and broadcast vehicles in the U.S. and abroad under the Frontline brand. Frontline is a much smaller business. This segment also includes Airport fire fighting vehicles (ARFF vehicles).

Firefighting vehicles and ambulances normally come out of local municipal budgets. These budgets have very high degree of correlation with local property taxes, which form a big chunk of the overall budgets. Large parts of the municipal budgets are untouchable including liabilities related to pensions etc, leaving budget cuts to fall on equipment upgrades like firefighting trucks etc.

During the housing boom in the US of 2003-2008, lifting house prices and house building activity massively swelled local municipal budgets and they splashed out on lots of new toys including upgrading their firefighting vehicle fleets as well as new ambulances and ARFF vehicles. Furthermore, almost all such vehicles were heavily customized by the local stations and lots of bells and whistles were added to them which pushed up their price and also lead to much higher margins for Oshkosh on these highly customized vehicles.

After the housing market crash, local municipal budgets have gotten squeezed and the axe fell on the fire fighting equipment and ambulances etc. Once these vehicle fleets started ageing and necessitated replacement, local municipalities only approved the most bog-standard stripped down version of these fire fighting vehicles causing prices to fall, as well as Oshkosh’s margins to get crushed as they dropped from 10% to -4% as Oshkosh initially failed to adjust to the new reality of standardized not customized vehicles and didn’t adjust its fixed cost structure accordingly. It has since worked on the issue and Firefighting vehicle margins have recovered from -4% to 2% and are likely to settle at mid-single digit levels.

ARFF vehicles is a better more stable business which has maintained 10-11% margins and continues to do so although there’s no growth in this segment.

COMMERCIAL SEGMENT

Oshkosh is a leading manufacturer of front- and rear-discharge concrete mixers and portable and stationary concrete batch plants for the concrete ready-mix industry as well as a leading manufacturer of refuse collection vehicles for the waste services industry. The concrete mixers are highly cyclical and levered to the non-resi cycle as well and sales for the segment collapsed in 2008-2009 by 80% just like the Aerials business in Access Equipment segment. I have reflected the sales to be peaking now and declining going forward reflecting my view for US non-resi activity as well as exposure to the energy sector. High-ish fixed costs dictate margins will go negative just like they did for 4 years between FY08 to FY 11 for concrete placement. Refuse collection vehicles are much more steady businesses and have held on to their margins. The sales for Refuse are also much more steady, operating on a constant replacement cycle.

FINANCIALS & VALUATION

Putting together all the operating profit assumptions for all the segments results in the following forecast.

As the EBITDA of the overall business collapses from $523m in 2015 to $60m in 2019E and FCFs go negative, the stock will react very negatively if my forecasts come true. Current consensus for EBITDA for FY17 and FY18 is $488m and $478m compared to my forecasts of $307m and $163m, and FY19 is worse, a very differentiated view. Meetings with management indicates a high level of complacency and discussions with sellside analysts indicate the same. I expect the company to pull back on capex significantly to preserve cash, like it did in 2009-2013. I also expect some corporate costs to be pared back but not much as they didn’t budge much in 2009-2011 either.

Looking at some valuation metrics and things look pretty grim. EV/EBITDA and Debt/EBITDA metrics will blow out. Going by 2015 FCFs or consensus FCFs for 2016E, Oshkosh might even appear cheap at a 7.4% FCF yield, but this is deceptive as the business is about to experience severe deterioration. EV/EBITDA has traditionally been used to value these businesses and they tend to trade at trough EV/EBITDA ratios of 5.0x ish at the bottom of cycle on trough EBITDA compared to 8.5x at the top of the cycle on peak EBITDA, unless EBITDA gets too impaired or goes negative in which case you have to use Book Value or NAV related valuations to figure out through-cycle valuation. Even by 2018E if this business de-rates from 8.5x on consensus EBITDA currently to 5.0x that I expect, on my EBITDA forecast would leave a share price target of $2.3 compared to $36.9 currently, due to the significant financial leverage in the business.

The company has a maximum allowable Debt/EBITDA covenant of 6.5x and LTM EBITDA/LTM Interest of 1.56x both of which it will breach by FY19 on my forecasts. The company managed to issue a couple of long-dated bonds so won’t have refinancing hurdles as it experiences this cyclical downturn and will have to keep an eye on these covenants to avoid breaching them. The debt is currently trading above par and spreads will likely widen as FCFs dry up.

On trough P/Book calculations these companies tend to bottom out well below book value with the discount depending on severity of the cash flow decline. I expect OSK to bottom at close to 0.5x P/B compared to 2009 crisis when Terex and OSK bottomed out close to 0.3x. This would indicate a target price closer to $12. Either way downside is significant. Averaging the two methods would give a target price of $7, which would be 80% downside to current share price.

The share price of OSK appears to be remarkably resilient in the last downturn where it bounced back hard.

This was largely the result of the enormous M-ATV vehicle contract awarded in Jun 2009 which caused a high rally in the stock and masked the downturn in the Access equipment market. Compare this to Terex, which did not experience any one-off boom in another division like Oshkosh did.

Catalyst

Main business falls off a cliff.