Description
Description
We believe PCAR represents a compelling short opportunity with at least 1/3 downside.
Paccar Inc. (PCAR) is a manufacturer of heavy-duty diesel trucks with 35% of its business in the U.S. & Canada, 49% in Europe, and the remainder primarily in Mexico and Australia. The company also operates a financial services subsidiary, through which it provides financing and leasing arrangements for its manufactured trucks.
PCAR is a world-class business with a long record of profitability and high returns on capital, but its near-term outlook is extremely weak and continues to deteriorate. Industry sales and order data that became available throughout 1Q09 point toward a nasty year for heavy truck sales. In the middle of March, the company announced that first quarter global sales would be down 30% form the prior year. Following this announcement, analysts universally brought in their numbers, and 2009 consensus EPS fell by more than 25% to $0.88. Despite this negative news flow, the stock is up more then 30% since this announcement was made.
We believe PCAR is compelling short opportunity for three primary reasons:
1) The company's valuation has gotten way ahead of itself. It is now trading at 36x 2009 and 21x 2010 consensus EPS, which represents a significant premium to its direct peers and other heavy equipment manufacturers.
2) First quarter results are likely to be a disaster - perhaps worse than the street has modeled.
3) Results will be challenged for the foreseeable future and 2009 and 2010 estimates may still be overly optimistic.
The North American heavy truck market is poised for another weak year
US & Canadian Class 8 retail sales fell more than 50% from 2006 to 2008 and these markets now represent 35% of PCAR truck sales. As late as February 2009, some analysts pointed to pent-up replacement demand in this market to build a bull case for PCAR, and the company projected 2009 industry sales to be roughly flat at the end of January.
Early data indicate a much bleaker outlook for 2009. US heavy truck sales, as reported by the Bureau of Economic Analysis, fell 41% in 1Q09 accelerating from the 18% decline in 4Q08. Volvo reported a 55% decline in North American truck orders during the December quarter, and Navistar reported a 38% order decline in the January quarter (excluding military & school busses).
More importantly, conditions in the carrier market do not suggest that pent-up replacement demand will drive a snap-back in new truck sales. Bankruptcies and widespread capacity reductions have cleared out some aged equipment. More importantly, these measures have created an oversupply of used inventory, and used truck prices have fallen dramatically. Discounted used truck sales have displaced new unit sales, and idle used inventories will continue to be an overhang even when the carrier market does begin to recover.
The European heavy truck market is entering a sharp down-cycle
PCAR results in 2007 and 2008 were buoyed by a very strong European truck market. European unit sales were at peak levels in 2007 and the first three quarters of 2008, and this market grew to 49% of PCAR truck sales in 2008.
Data from the European Automobile Manufacturers Association shows heavy truck unit sales to have fallen 21% in 4Q08 and 37% in January and February of 2009. Amazingly, Volvo reported net orders of European heavy trucks of only 115 in 3Q08 negative 1,550 in 4Q08 (meaning cancellations exceeded orders in the period), from 42K and 41K in the prior year periods. In January, PCAR forecasted European heavy truck sales to fall 28-40% in 2009, and the low end of that range is now clearly a possibility.
Truck segment margins may have a long way to fall
Truck segment EBIT margin fell to 4.0% in 4Q08, but still averaged 8.5% for the full year (down from 9.7% in 2007). In 2001, truck segment EBIT margin fell to 3.5%, and in the early 1990's it bottomed out at 0.6%. The company has improved profitability over time, but there is risk of further margin erosion, particularly given the severity of this cycle.
Financial services earnings are at risk as well
Financial services income represented 15% of PCAR pre-tax earnings in 2008, but is likely be meaningfully lower next year. First of all, the pool of earning assets has begun to shrink as a result of weak sales activity and higher charge-offs. PFS earning assets (finance receivables and operating leases) fell 8% sequentially in 4Q08 after growing at a 14% CAGR between 2001 and 2007 and peaking in the second quarter of 2008.
Additionally, growing receivable loss provisions are likely to reduce the profitability of these assets. Loss provisions ticked down slightly in 4Q08, but remain well below levels seen in prior cycles. If loss provisions rise to the level they were at in 2001 or in 1990 and 1991, financial services income could be cut in half.
Currency translation and benefit plan contributions will introduce additional headwinds
Currency translation provided a mid-single digit tailwind to company wide revenue growth throughout 2007 and the first three quarters of 2008. This trend reversed itself in 4Q08, when currency translation created a 6% headwind to revenue growth. Currency will have a greater impact on Q1 results, and will continue to be a drag on revenue growth through 3Q09 if exchange rates remain at current levels.
The company's employee benefit plan recognized $336mm in losses in 2008, which represented 26% of its assets. PCAR must backfill these losses over time with higher contributions, which will have a marginal impact on SG&A costs.
Street estimates have come in, but there is still room for disappointment
2009 consensus of $0.88 is consistent with a downturn scenario similar to 2001. In that year, PCAR global unit sales fell by roughly 30%, truck segment operating margin fell to 3.5%, and finance income as a percent of assets fell to 0.7%. If those circumstances were to repeat themselves in 2009, we estimate that EPS would be $0.93. If this cycle is more severe than that in 2001, 2009 EPS could be meaningfully lower than consensus. Additionally, 2010 consensus of $1.52 assumes a relatively quick recovery, which we think may be pre-mature.
PCAR now trades at a significant premium to comps and other heavy equipment manufacturers
Company Ticker Price 2008 EPS 2009 EPS 2010 EPS 2008 P/E 2009 P/E 2010 P/E
Navistar International Corp. NAV 35.65 7.23 4.89 6.02 4.9x 7.3x 5.9x
Volvo AB VOLVY 6.30 0.62 (0.12) 0.24 10.2x N/A 26.3x
Daimler AG DAI 32.71 1.96 0.63 2.18 16.7x 51.9x 15.0x
Cummins Inc. CMI 29.69 4.08 1.87 2.16 7.3x 15.9x 13.7x
ArvinMeritor ARM 1.20 0.38 (0.13) (0.24) 3.2x N/A N/A
Oshkosh Corporation OSK 9.74 3.37 (0.17) 0.90 2.9x N/A 10.8x
Caterpiller, Inc. CAT 33.85 5.66 1.98 2.10 6.0x 17.1x 16.1x
Deere & Co. DE 38.21 4.70 3.32 3.08 8.1x 11.5x 12.4x
The Boeing Co. BA 37.18 3.69 4.92 4.72 10.1x 7.6x 7.9x
Mean 7.7x 18.5x 13.5x
Median 7.3x 13.7x 13.1x
PCAR PCAR 31.33 2.78 0.88 1.52 11.3x 35.6x 20.6x
Risks to short thesis
• Faster than expected recovery of US heavy truck market
• More moderate down-cycle in European heavy truck market than currently projected
Catalyst
• First quarter earnings results (late April). Q1 earnings are expected to be off more than 90% from the prior year, reflecting severe sales declines across all markets. This announcement should draw attention to attention to the company's outsized valuation and may cast doubt on full year expectations.
• Continued negative news flow from the heavy truck market
Catalyst