Description

Thor Industries is the largest RV manufacturer in the US, they hold roughly 48% of the market followed by Forest River (Berkshire owned) with 36% and Winnebago (WGO) with 6%.  Thor is levered to the cheaper towables segment of the market which makes up about 75% of their revenues, motorhomes are the other 25%.  The industry has consolidated further this year with Thor acquiring JayCo and Winnebago buying Grand Design, more on this later. We believe the cycle will peak in 1H 2017 in terms of wholesale shipments and think the stock is priced to perfection even if the cycle manages to hit the bull’s aggressive estimates.

This thesis is going to look fairly similar to the LCII (formerly DW) pitch we posted last fall, however, Thor has become our favorite way to play the RV space short side.  We also attended the Louisville RV dealer show last December which provided some incremental insights which are not very well understood among bulls and the sell side.

The short thesis rests upon these points:

• ·      2016 towable unit sales of 376k have surpassed the prior peak of 335k units in 2006 (bulls point to the 466k units that we saw in 1972 but more on that later), a generous view of normalized shipments would be more in the 275k range
• ·      The fallacy that the recent surge in units is driven by younger buyers.  We met with BofA’s head of retail credit for RVs and they’ve loosened terms materially over the past 2 years
• ·      The industry is adding roughly 10% of incremental capacity in 2017 which will add to fixed costs and go underutilized when the cycle normalizes
• ·      Margins will be capped going forward even if the cycle extends by rising labor and material costs as well as a negative mix impact from JayCo’s lower gross margins
• ·      Frothy M&A in 2016
• ·      Even on bull estimates of roughly $7.50 in earnings the stock is rich, why should a high ticket consumer discretionary assembly business get even 12x this?

We think fair value for THO is closer to $60 in a normalized environment assuming 300k industry level shipments, $4.25 in earnings, and a 14x multiple.  My guess is that once the cycle loses steam the stock will overshoot to the downside, looking at boating/housing/ATV stocks these businesses can easily trade at 10x when investors lose confidence in future growth.

First, a bit of a primer on the industry dynamics

The RV dealer network is highly fragmented with the largest player Camping World only having about 13% share.  Dealers order towable inventory on spec since there really isn’t much in the way of customization for these lower priced towable products.  Dealers have told us that once an order is placed nobody cancels it even if business slows in the shorter term for fear of getting cut back on the next order if they offend the OEM.  We also understand that the lead times are about 3 months.  All that being said we think there are three main takeaways: visibility is fairly limited from the OEM’s point of view (THO’s backlog is a little more than one qtr), it’s very easy for dealers to get wrong footed on inventory because its all spec, and once retail slows (CWH comps are a good proxy) we’ll have a good window of time to press the short while analysts defend the stock.

The cycle…..millennials or credit?

As mentioned above and in our DW report last fall the towables cycle has gone above prior peak and is the only high ticket consumer discretionary item to do so (see below from Baird). 

This begs the question of why?  The industry will tell you its because the millennials are taking up Rv-ing en masse.  We believe this is probably true at the margin but not nearly enough to drive units as far up as they have gone.  We’ve asked THO/LCII/WGO and they all admit they have no data to back this up.  The answer more than likely is credit terms.  We met with BofA’s head of retail (they write about 1/3 of retail loans for the industry) lending for RVs while down in Louisville for the dealer show last December and she shared some pretty interesting data points.  While they haven’t really loosened FICO terms (which are strong in the mid-700s) they have gone back to doing zero down payment loans and negative equity trade ins up to 140% of wholesale.  She said that zero payment loans make up about 45% of their credit book up from 0% two years ago (you can see this data point in a Baird note published Dec 1^st) and peaked out at these levels in 2005.  We think this is the real driver of the cycle and believe the terms will stop getting easier at the margin and exacerbate the downturn when it comes.

A common bull argument is that the industry shipped 460k units in 1972 so this is the “real” peak number and we’ve got another 25-30% of growth before we top out.  A few thoughts, first would be I can’t think of the last time I stretched back 45 years to come up with a realistic forecast for current reality.  Second, the unit average for the past 45 years has been 227k.  Finally, after the industry had those two epic years in unit sales fell by almost 40% and eventually bottomed out at 78k.

Capacity additions in 2017

Thor is going to spend about $130m in capex during 2017 vs $40-50m for the past 5 years to add roughly 10% to their capacity.  The rest of the industry is doing to same as suppliers like LCII have been told there will be a total of 30k units of capacity coming online this year.  When a cyclical industry decides to add capacity for the first time in a decade its typically a decent contrarian indicator.  Obviously for THO to maintain leverage with that kind of capacity retail sales need to go up by at least 10% from these levels or they’ll suffer from underutilization.  That isn’t even factoring in the start up hiccups that almost always come along with a string of new plants, especially since they can’t build them near Elkhart, IN, where most of the industry footprint is because labor is too tight. 

Margins appear to have peaked

THO was down more than 10% when it reported Q1 earnings a few weeks ago.  A lot was made about their commentary in the slide deck that growth may slow in the 2H of the year and botched Cramer interview with CEO Bob Martin but we think the real reason some investors got spooked was their margin commentary.  Gross margins were down approximately 200bps y/y due mostly to JayCo mix (their GM is roughly 10% vs core THO in the mid teens) but also due to cost pressures mostly from labor. 

We think margins will be strained further due to:

• ·      Another 5 months negative JayCo mix
• ·      Steel/aluminum are both up in big way y/y and these are the largest input costs for their suppliers who will no doubt try to pass it along
• ·      The unemployment rate in Elkhart, IN, in <2% right now, and especially with new capacity coming on labor costs will be pressured further
• ·      Deleverage from the new plants being brought on in the 2H

Frothy M&A in 2016

After the two deals in 2016 the industry is effectively consolidated with two major players owning close to 85% of the market.  While it’s a more stable industry structure it also means that there is no more room for inorganic growth, both THO and WGO stocks ripped off the news of their acquisitions.  But obviously for every buyer there is a seller and they hold as much (or more in the case of Grand Design) information as the buyer.

Thor’s purchase of JayCo doesn’t really shoot up any red flags, they only paid 6.5x EBITDA and there is no doubt some synergies to extract.  The question would be why the Bontrager family decided to sell at this particular moment after owning the business for 46 years, but families can have many reasons for wanting to pull trigger.  The deal that really stuck out to us was the WGO/Grand Design transaction for the following reasons:

• ·      Grand Design was only founded in 2012 and WGO paid the same price tag as THO did for the 45 year old JayCo, about $500m
• ·      The founders of Grand Design were the Fenech brothers, they’ve been in the industry for 25 years and sold their last start up, Keystone, to Thor in 2001.  On the other side of the table was the brand new CEO of WGO who came from Toro earlier last year.  Pretty sure WGO was the new face at the poker table.  We talked to the Fenech brothers after the transaction, lets just say there was some giggling.
• ·      They paid 7x EBITDA but Grand Designs margins were/are 15% vs the scale player Thor at a hair less than 10%, even WGO admits they will be heading South

So how does it play out and what is fair value

As mentioned above we think the stock is too expensive even if the industry has another 10% of unit growth left which the bulls think will allow THO to earn $7.50 in 2018.  We think 10x would be the right multiple on peak earnings but even a more aggressive 12-13x gets you to $94.00, roughly 3-4% lower than today’s price.  Our estimates are for earnings of $6.85/$5.10/$4.25 in 2017/2018/2019 and we think towables shipments in those years will be 405k/330k/300k.  The right multiple on the $4.25 is probably lower than 14-15x but for arguments sake lets use that to come up with a $60 target about 40% downside from here.

As laid out above I think the margin pressure will cap upside to earnings even if retail sales increase in the mid-high single digits this year.  The trade starts to pay off big when comps slow and dealers start to cut orders a few months later due to the lag mentioned at the beginning of this piece. We will be watching CWH comps and industry retail data that is released each month.

Catalyst

-montly retail data, CWH comps, interest rates