Description

SAF-Holland SE (ETR: SFQ)

Elevator Pitch

SAF-Holland is a German manufacturer of heavy-duty truck and trailer systems and components. Years of underperformance in its Americas and APAC division, numerous guidance reductions, and a dividend cut combined with weakness in the heavy-duty truck and trailer market have led investors to write off SAF-Holland as a structurally impaired cyclical with weak results extrapolated indefinitely into the future. As a result, shares of SAF-Holland have declined 60% from €20.00 per share in 2018 to €8.00 a share today. Our view on SAF-Holland is different for several reasons: an entirely new management team led by Alexander Geis, who led the company’s best performing EMEA segment and high margin aftermarket business; a rebound in the global heavy-duty and trailer market in 2021; successful restructuring in EMEA & APAC; and a replacement cycle of high-margin aftermarket parts will result in dramatically higher earnings power going forward.  Management will provide a longer-term business outlook during its upcoming Investor & Analyst Day on November 25, 2020 which we believe will support our view of SAF-Holland’s true earnings potential.

Description

German based SAF-Holland is one of the world’s leading manufacturers of chassis-related systems and components primarily for trailers, trucks, buses, and recreational vehicles. Its products include axle systems, suspension systems, fifth wheels, coupling systems, king-pins, and landing gear.

Source: SAF-Holland August 2020 Investor Presentation

In 2019, SAF-Holland’s geographic sales breakdown was 49% EMEA, 42% Americas, and 10% APAC. 75% of all sales were to OEMs and 25% were aftermarket. Prior to 2016 SAF-Holland reported aftermarket as its own segment which historically earned an adjusted EBIT margin of around 15%. Although the company no longer provides this information in its reporting, based on management comments it is safe to assume that those sales have a similar EBIT margin today and are responsible for over 50% of total EBIT earned each year despite typically being only around 25% of sales.

Investment Setup

Underperformance in the Americas and APAC segments, numerous guidance reductions, and a dividend cut have weighed on SAF-Holland for the past three years.  Since early 2018 shares have declined 60% from roughly €20.00 in early 2018 to €8.00 today.

1.       The Americas and APAC segments have been materially underearning

Compared to the EMEA segment, which consistently earns around 10% EBIT margins, the Americas and APAC segments have significantly underperformed.  In North America SAF-Holland began an ill-timed plant consolidation in the second half of 2017, which was complicated by an unforeseen industry-wide spike in demand. Management was committed to filling customer orders to maintain long-term relationships despite the production bottlenecks caused by the consolidation, and the measures taken to guarantee timely and error-free delivery significantly impacted margins. These production bottlenecks continued through 2018 which led to a second consecutive year of poor performance and the worst EBIT margins since 2008/2009.

APAC was SAF-Holland’s fastest growing segment prior to 2019, growing at a 22% organic CAGR from 2015-2018. However, most of this growth was from Chinese manufactured exports to the United States. When the US-China trade war began in 2018 the export business rapidly declined, leading to an operating loss in the APAC segment in 2019, until it eventually ceased in the second quarter of 2020. 2019’s poor operating performance was exacerbated by €8.1mm of non-recurring expenses that were not excluded from SAF-Holland’s adjusted numbers related to impairments, disposals of non-current assets, and strike-related costs in that export business.  

Accounting for these non-recurring expenses, the APAC operating loss in 2019 was in reality closer to breakeven.

2.       Management has repeatedly cut guidance and set near term expectations for the business lower and lower

Over the last 18 months management has cut guidance on three separate occasions which has led to the current rock bottom consensus expectations. Management cut guidance for the first time in November 2019 due to an unforeseen drop in sales volume during the third quarter of that year, particularly in the EMEA and APAC regions. Guidance was cut a second time in March 2020 due to the uncertainty surrounding the coronavirus. Guidance was cut again in May 2020 once the magnitude of the economic fallout caused by the coronavirus was fully understood.  2020 operating margin expectations have essentially been reduced by half from 8% in Q4 2018 to 4.0% currently.  

*Margin guidance represents at the mid-point.

On October 20, 2020 SAF-Holland issued a press release where the company provided its actual Q3 EBIT which was materially higher than both guidance and consensus expectations. Surprisingly, despite the strong results, management maintained its conservative 2020 guidance for full year EBIT margins of between 3-5% despite already achieving a year-to-date EBIT margin of 5.4% (or 6.2% accounting for non-recurring expenses).

We believe these numbers are simply too low and reflect an overly conservative posture from a management team who would prefer to set a low bar than potentially undershoot guidance.  In addition, it has become clear that consensus has adopted this conservative guidance.

3.       On May 20, 2020 the dividend was suspended

In March 2020, it was announced that management and the Board of Directors would propose to the Annual General Meeting in May not to pay a dividend for the financial year of 2020. At that meeting the dividend was officially suspended to preserve liquidity. The dividend has still not been reinstated despite the improving economic environment and SAF-Holland’s solid balance sheet. With improved financial results, a flexible balance sheet, and improved visibility, we expect the dividend to be reinstated in the near term.

What Has Changed?

An entirely new management team, a rebound in the global heavy-duty truck and trailer market, restructuring in EMEA & APAC, and a replacement cycle of high-margin aftermarket parts will result in dramatically higher earnings power which is not being appreciated by investors.

1.       A new management team

Over the past 24 months an entirely new senior management team has been put in place as the CEO, CFO, COO, and all segment presidents have been replaced. Here is the timeline of those changes:

-        December 17, 2018: Dr. André Phillip hired as COO with focus to fix margins in the Americas and APAC segments

-        January 28, 2019: Mike Ginocchio appointed as President of the APAC region, relieving CEO Detleft Borghardt from his additional role as President of the APAC/China region

-        February 25, 2019: Alexander Geis appointed to replace CEO Detlef Borghardt due to overall poor performance and a 50% decline in SAF-Holland’s share price with. Prior to his role as CEO, Mr. Geis was President of SAF-Holland’s Aftermarket segment from 2011 – 2015 and the EMEA segment from 2016 – 2019

-        May 31, 2019: Jürgen Knott hired to replace Guoxin Mao as President of the China segment

-        August 28, 2019: Christoph Günter appointed President of the EMEA segment, the position Alexander Geis vacated to become CEO

-        September 5, 2019: Kent Jones hired to replace Steffen Schewerda as President of the Americas segment

-        May 5, 2020: Inka Koljonen hired to replace Dr. Matthias Heiden as CFO after he accepted an offer to become the new CFO of Software AG (ETR: SOW)

It should be noted that the new CEO, Alexander Geis, has been with the company for over a decade and was able to achieve over 10% EBIT margins each year he was running the EMEA segment.   Geis also was responsible for developing and growing the high-margin aftermarket business. He believes that he can drastically improve margins in the Americas and APAC segments and has the track record to back that up. Moreover, he and the COO have aggressively purchased shares in the open market this year.

2.       The global truck market has bottomed and the upcycle is expected to start in 2021

2020 was already forecast to be a weak year for global truck demand, and the coronavirus took it from bad to worse. Demand plummeted as countries locked down and utilization fell. Volvo, which tracks the utilization of its truck fleet, saw utilization bottom over Easter weekend but has since seen it recover to almost pre-pandemic levels as countries have emerged from those lockdowns. Europe is currently experiencing a second wave and while some countries are reentering lockdowns they are not as draconian as the ones put in place in the first half of the year.

Utilization is a leading indicator of truck sales

In the US, the recovery of the truck market can be seen by tracking spot rates which are up over 100% vs 2019.

The short-term recovery in utilization and demand was further proven after SAF-Holland reported sequentially better sales in Q3 vs Q2, a seasonally weaker quarter, which has not happened since the recession of 2008/2009. Furthermore, many of SAF-Holland’s peers and customers have made public comments detailing how they are experiencing a recovery in demand and an improving market environment:

-        “The global truck market outlook deteriorated dramatically in Q2 but Q3 sales and OEM-order intake has been stronger than expected” – Haldex Q3 Presentation

-        “In Q3, utilization of trucks and machines gradually improved as COVID-19 restrictions were eased. Towards the end of the quarter transport activity was back on roughly the same level as a year ago in most markets.” – Volvo Q3 Earnings Report

-        “Since the end of the summer vacation we have seen a clear recovery in truck production in Europe and the USA” – Peter Laier, head of the truck division at Knorr-Bremse to the newspaper Handelsblatt

-        “PACCAR’s third quarter results reflect rebounding global truck production and aftermarket parts revenue… PACCAR is increasing its estimate of U.S. and Canada Class 8 truck industry retail sales to a range of 190,000-210,000 vehicles in 2020. Class 8 truck industry retail sales for 2021 are estimated to be in a range of 210,000-250,000 vehicles.” – PACCAR 10/20/2020 Press Release

Looking out further, the global truck market is expected to rebound in 2021 and beyond, which should provide a tailwind to SAF HOLLAND’s recovery.

ACT’s North America Class 8 production forecast calls for ~30% year-over-year growth.

Globally, LMC Automotive’s 2021 global truck market forecast calls for +8% growth.

3.       Margin initiatives in the Americas segment should drive earnings

The worst is now behind SAF-HOLLAND’s Americas segment as it successfully completed the plant consolidation and managed to improve EBIT margins by almost 370 basis points in 2019. Following the completion of the plant consolidation, management announced a new program that will be executed between 2019 and 2021 to drive efficiency through increased automation and changes to its product portfolio. If this segment can achieve EBIT margins similar to the EMEA segment (and according to management there is no structural reason it cannot) then it could reasonably earn closer to €50mm in EBIT per year vs. the €29.2mm it earned in 2019. There is execution risk but with the CEO’s track record of already achieving these margins in EMEA it seems highly feasible.

4.       The APAC segment has hit rock bottom and is all upside

Despite the cessation of the Chinese export business and an incredibly weak demand environment in India, partly due to the coronavirus, the APAC segment is on the path to breakeven. According to management the Indian business is still currently profitable so all of the losses in 2020 are attributable to the China business. That business is currently in flux and in the process of pivoting from export sales to the US to domestic aftermarket sales in China. If management can execute and penetrate the Chinese aftermarket there is a tremendous upside opportunity as China is the world’s largest truck market. At the end of 2019 SAF-Holland completed a new state-of-the-art facility in Yangzhou with the capacity to generate €80mm in revenue. Assuming a 15% EBIT margin (it is an aftermarket business), the new facility could contribute an additional €12mm of EBIT. On the other hand, the China business does not even need to be profitable to materially improve earnings as just getting back to breakeven would increase consolidated EBIT by €13mm from the 2019 results. With the completion of the Yangzhou plant this goal has become much more attainable as SAF-Holland has significantly lowered its cost structure in the region by decreasing its physical footprint in China from five facilities to one and reducing its workforce by 80%.

Variant Perception

1.       Consensus expectations

As mentioned above, the street has been modelling in-line with management’s conservative and easy-to-hit guidance.  Consensus earnings expectations are simply too low and severely underestimate SAF-Holland’s earnings power. 

On October 20, 2020 management pre-announced Q3 revenue and EBIT results,  which was significantly higher than expectations.  Despite strong results, management maintained its existing 2020 guidance for annual sales to decline 20-30% with a 3-5% EBIT margin. Looking at those results it immediately becomes clear how conservative managements’ guidance is:

*Implied Q4 assumes midpoint of guidance: 2020 sales decline by 20-30%, Adj. EBIT margin between 3-5%.

Through three quarters SAF-Holland has already earned the midpoint of its annual EBIT guidance. With an entire quarter to go, this implies breakeven Q4 results in a quarter that should be significantly less impacted by covid-19 than Q2 when the business still managed to earn €5.2mm of EBIT. SAF-Holland has only had four quarters of negative EBIT over the past twenty years and all four of those quarters occurred in 2008 and 2009 during the Financial Crisis. But despite strong performance coming out of the worst of the pandemic, the street has essentially adopted management’s conservative guidance, modelling to €2.5 in EBIT in Q4, which implies even worse margins than in Q2 when the strictest lockdowns were in place.

Looking out to 2021, the street is modeling improved performance but in light of year-to-date performance and improving trends, even these forecasts are irrationally conservative. 2021 Consensus adjusted EBIT margins are roughly in line with those of the first three quarters of 2020, despite a dramatically improving global heavy-duty trucks and trailer market and easy covid-19 compares.

It becomes even more apparent how conservative the consensus forecast is when you adjust out non-recurring expenses incurred in the first three quarters of 2020 that have not been added back to the reported adjusted EBIT. Management did not add back €5.6mm of impairments on inventories that were the result of the unexpected sharp drop in demand in Q2:

If SAF-Holland could operate at an adjusted EBIT margin of 6.2% during a historically bad market environment then it seems safe to say that they could achieve even higher margins in a more normal operating environment with industry tailwinds.  To put 2021 expectations into context: in 2018 management provided a 2020 target for €1,500mm in revenue at an 8.0% margin (€120mm EBIT) which would be 100% higher than the current 2021 consensus expectations.

2.       Our expectations

In an improving market environment with a new management team in place we believe that SAF-Holland can exceed the 6.2% EBIT margin (adjusted for non-recurring expenses) they have achieved year-to-date in 2020. Looking out further, we think that this can be a €150mm EBITDA business just by fixing the Americas and APAC segment without any top-line growth. From 2016 to 2019 the consolidated business has earned around €110mm in adjusted EBITDA annually, despite the issues in the Americas and APAC segments outlined above. If the Americas segment can achieve EBIT margins in-line with the EMEA segment (and management has assured us that there is no structural reason it cannot) and the APAC segment can simply breakeven, the earnings power of the business increases dramatically.

In addition to the forecasted rebound in the OEM truck and trailer business, SAF-Holland’s aftermarket business is also likely to see a jump in demand in 2021 because the business lags the OEM business, which peaked in 2018, by about 3-4 years. Growth in the higher margin aftermarket business in 2021 from OEM sales in 2017 and 2018 should drive material earnings growth as that business has typically contributed at least 50% of total EBIT despite only making up around 25% of sales.

Assumes a 15.5% Aftermarket EBIT margin, consistent with prior disclosure

2021 consensus estimates call for roughly €120mm of revenue growth year-over-year.  We believe roughly half of this could easily be bridged via growth in the aftermarket business alone.  A recovery in the aftermarket business is already taking place, having had grown 3.8% year-over-year in Q3 versus a 15% decline in H1. 

With a current enterprise value of €600mm and a conservative multiple of 7x EBITDA, SAF-Holland is being valued like it can only generate €85mm in EBITDA even though there is a clear pathway to €150mm. If the aftermarket business sees growth from the 2017-2018 OEM sales and they achieve increased market penetration in China normalized earnings could far exceed €150mm.

Valuation

SAF-Holland currently trades at a 20% discount to peers, trading at less than 7.0x 2021 EBITDA vs. 8.5x for global truck/trailer parts manufacturers. We believe SAF-Holland will earn at least €78mm in 2021 EBIT (€1,150mm in sales at 6.75% EBIT margin), which is ~30% higher than consensus. This translates to around €115mm in 2021 EBITDA. Our assumed 6.75% EBIT margin for 2021 is slightly higher than year-to-date margins of 6.2% (including covid-19 disruptions) and meaningfully lower than management’s initial 8.0% margin target for 2020.  Even maintaining its low 7.5x multiple would value SAF-Holland at €13.42 per share which implies 65% upside.

SAF-Holland has the runway for earnings growth far past €115mm, and it should be noted that management’s original target for 2020 EBITDA was around €155mm.

Catalysts

-        Management will provide its strategic 2025 plan at its November 25th Investor & Analyst Day, revealing strengthening underlying trends and SAF-Hollands true earnings potential.

-        Management guides to an improved EBIT margin in 2021. The current consensus view is that the company will achieve a 5.5% EBIT margin despite already achieving that year-to-date in 2020 in a much worse industry environment with a higher cost structure and a new management team

-        Reinstating the dividend

Risks

-        A second round of Coronavirus lockdowns could impact consumption which would in turn decrease demand for trucks and trailers or potentially force SAF-Holland or their customers to shut down their manufacturing facilities

-        Foreign exchange risk as SAF-Holland does ~35% of its business in US dollars but reports their earnings in euros. If the dollar continues to weaken there may be a material foreign exchange impact

-        The APAC business may continue to operate at a loss. That said, the Chinese operations have degraded so much that if the business continues to operate at a loss it may exit the region and reclassify the segment as discontinued operations

-        There could be an unexpected downturn in the heavy-duty truck and trailer markets, similar to the second half of 2019. These markets can be tracked more or less in real time by looking at class 8 truck build/order indexes, trucking spot rates, utilization rates, and customer press releases and filings 

Catalyst

Management will provide its strategic 2025 plan at its November 25th Investor & Analyst Day, revealing strengthening underlying trends and SAF-Hollands true earnings potential.

-      Management guides to an improved EBIT margin in 2021. The current consensus view is that the company will achieve a 5.5% EBIT margin despite already achieving that year-to-date in 2020 in a much worse industry environment with a higher cost structure and a new management team

-      Reinstating the dividend