Description

I recommend a short position in Terex (TEX) for several reasons:

1.       Cyclical companies late in an economic cycle have a high probability of big drops. Additionally, late in the cycle, the probabilities of outsized negative returns increase every year. 

2.       The drop in oil prices is clearly causing TEX problems. I doubt oil will be a temporary problem because the world has way more oil than it thought it did just 6 months ago. Rig counts are dropping everyone but supply somehow managers to stay relatively high. This trend implies that global oil related CAPEX will be much lower for years to come creating a non-cyclical problem for TEX. And, if a recession develops, the price of oil would probably head even lower creating an even deeper drop in oil related CAPEX.

3.       Several large construction markets could be headed for trouble. These dynamics are definitely secondary to the thesis but could create long-term problems for TEX. A few problem spots include:

a.       Canada

                                                               i.      Canada’s economy is clearly in trouble in the near term due to oil price drops. Additionally, the country’s real estate market could be headed either for a major drop or a long-term correction of some kind (see the many online sources for why Canada’s real estate market might be a bubble). Canada’s $1.8 trillion in USD GDP would hurt TEX sales long-term if the market drops and stays at low construction levels for several years (long recoveries are the norm post real estate bubbles).  

b.      Texas

                                                               i.      See this article - http://www.wsj.com/articles/falling-oil-prices-threaten-houston-building-boom-1423594984

                                                             ii.      Houston’s office construction is well over double that of New York’s. Austin’s office construction is about half of New York’s. These numbers implies that Texas could face years of below trend construction levels as demand catches up with supply or a complete collapse of some kind in the event of a major recession.

c.       China

                                                               i.      China could be the most overbuilt economy in the history of the world. They build empty Chicago’s like we build parks. See my FXI write-up for more details. And, the latest data out of China shows things continue to get worse in China.

d.      Europe

                                                               i.      Europe is doing fine now but its structural problems are not getting solved. As a result, the world’s largest economy is always at risk for a severe downturn. At a minimum, Europe’s economy is likely to remain below trend for several years.  

e.      If even one of the smaller economies like Texas or Canada play out, TEX long-term revenue run rate would take a permanent hit as overbuilding takes years to recover from.  

4.       The bull case for TEX is that crane demand is at low levels relative to peak demand. The problem with this argument is that peak levels are never coming back:

a.       The U.S. construction market (~40% of sales) is doing fairly well and is unlikely to achieve a higher run rate without substantial improvement in the overall economy.

b.      Europe (31% of sales) is actually doing fairly well now given the circumstances. Based on this, the current run rate is likely the new normal until the continent can overcome its serious structural issues (5-10+ years away).

c.       China (~6-10% of sales) construction at these levels builds years of inventory. At a minimum, there is no way the government will accelerate large building construction. It is more likely China demand will drop. Longer-term, one of China’s big problems relates to its demographics. The below chart implies that crane demand out of China can only head lower. Also note that a severe downturn in China woud impact TEX by more than the sales mix would suggest. The company's global competitors with more exposure to China would need to buy market share quickly (i.e. low gross margin sales...) causing volume and profit problems for TEX. 

5.       From a valuation standpoint, TEX would clearly drop in an economic downturn. Here is my estimate for how much:

a.       If the economy heads into a recession, sales could drop by 20-40%. However, in the absence of a 08’ type panic, the market will probably price in a less severe long-term drop in run rate (i.e. pricing in some kind of recovery which makes sense).

b.      If the crane market contracts, gross margins will likely come in as firms try to use gross margin dollars to buy market share (to survive…). As gross margins drop, the lower volume will probably increase SG&A as a % of sales.

c.       TEX’s current multiple on net income is around 10x. If the market realizes the new “peak” is much lower, I would expect at least losing 1 turn.

d.      All of these factors imply a 40%+ drop in the stock (I see no reason to be precise here). If the company’s debt becomes a problem, there is more downside.

The basic idea is to short a highly cyclical stock at a time when the probabilities of a recession are rising. Additionally, there are large pockets within the construction market that could add to the severity of the next economic downturn for large scale construction. Furthermore, oil related sales could be entering a secular bear market.  

The long-term timing for this category of short is ideal because the stock market’s valuation is well over 1 standard deviation from the mean. Valuation is a poor short-term timing mechanism but it is an excellent way to allocate capital for a long-term value investor.

The risks to the short include:

1.       TEX could execute on their cost saving initiatives: This risk is relatively small. The market is clearly expecting some improvement. Additionally, cost cutting can’t replace top line growth. As long as top line growth is flat to down, the market is unlikely to dramatically revalue the company. 

2.       TEX could get bought out: 1) Most buyers try to avoid late cycle acquisitions of highly cyclical names (companies got burned badly in 06’ and 07’ because of this). 2) TEX already has ~2.5x debt/EBITDA adjusted for needed cash.

3.       The economy could accelerate, causing a rebound in the crane market. This outcome is both unlikely and positive overall for most investors.

Catalyst

1) Recession 2) Construction downturn especially in China and Canada 3) Further oil CAPEX declines globally