Description

Note: This writeup is based on a stock price of €26.76

Traton SE ("Traton", or "the Company"), with a €13.4 billion equity cap and €12.8 billion TEV, is European truck and bus manufacturer that produces light, medium, and heavy-duty trucks (and buses), principally in Western Europe and South America.  The Company was formerly part of Volkswagen AG (i.e. VW Truck & Bus operations) and resulted from the combination of the well-known brands Scania and MAN with VW Caminhoes e Onibus (VWCO).  Recently, the Company was carved out of Volkswagen AG (“VW”) through an IPO which took place on June 28 at €27/share, the low-end of the initial price range.  After the offering VW continues to own 88.5% of Traton and sees itself as a long-term majority shareholder.  We suspect the low valuation and initial poor public showing are the results of Traton’s uneven financial performance under the VW umbrella as well as the general investor skepticism and distaste for cyclical stocks.  The VW management team has historically put out ambitious targets for the truck business, only to fall well short of these goals, with MAN’s margin performance still significantly lagging competitors.  Investors are wary that even with Traton as an independent company, we will simply see “more of the same”.  The sell-side analysts share the same sentiment and are highly skeptical about the intermediate margin goals set out by the Company.

We see an opportunity in this “broken” IPO / carveout.  Several of factors should drive a re-valuation of the name in the coming years.  First, the vast majority (almost three quarters) of Traton’s profits comes from Scania, a premier brand that, unlike its counterpart MAN, has historically performed well.  We view Scania as the crown jewel whose spotlight has been stolen by the underperformance of MAN, which can quickly reverse with the better disclosure of the newly public parent.  Second, margin goals look achievable.  Traton is in the midst of a much-needed product refresh for Scania and MAN, as the previous refreshes were in 1995 and 2000 for Scania and MAN, respectively.  These next generation products carry higher ASPs, which should naturally lift margins and provide an opportunity for market share gains.  In addition, the cost savings outlined by management (€700 million) from integration of the brands, as well as its strategic alliances with Navistar, look achievable and potentially even conservative.  Lastly, the CEO who took the reins over the business about four years ago, seems to be more competent and customer-focused than his predecessors.  Turnarounds in the truck businesses can take a long time because of the lengthy product cycles, but it seems at this point the timing is right for the numbers to finally start moving in the right direction, and for Traton to finally start delivering on promises.

At Traton’s current valuation, the market is not factoring much in the way of a turnaround.  The Company can generate €2.50 of EPS this year with little margin improvement and relatively normal end-market demand; thus, we see limited downside from current trading levels.  Traton is capable of generating north of €3.50 in EPS if it just comes reasonably close to (but not completely hitting) its margin goals.  Our target price for the stock is €42, or 12x $3.50 “mid-cycle” EPS, which represents >57% upside.  Coupled with a strong balance sheet (net cash, pension obligations of €1.5 billion, and Associates Investments at €1.1 billion), the risk-reward is quite favorable.  Lastly, Traton is believed to be interested in acquiring Navistar, in which it owns a 17% equity stake, at some point in the future.  Traton would gain access to Navistar’s dealer network and the North American truck market where it currently has no presence.  If that were to occur, the synergies could be sizeable, providing a further boost for the shares.  Today, investors are getting that optionality for free.

I.                   General Overview

Volkswagen, through a set of complex maneuvers over the years, acquired control of Scania, which sells heavy-duty trucks, and MAN, which specializes in light and medium-duty trucks. The combination has allowed VW (now Traton) to target the entire spectrum of the trucking space and be competitive with peers - the handful of players that dominate the Truck OEM space (Daimler, Volvo, PACCAR).  The hope has been to have a common, integrated platform for engines, transmissions and axles but to-date the Company’s two platforms (Scania and MAN) have not been fully integrated.  The margin uplift from this streamlining (estimated to be a €1 billion benefit) is substantial and for the most part has not been realized as new product launches take multiple years to execute on.  We believe the Company has only extracted €300 million so far.  MAN margins would benefit the most if the remaining integration benefit were to come to fruition, as the key fulcrum of the combination is to leverage off Scania’s well-respected technology and operational best-practices and implement those throughout MAN.  Investors have been disappointed with the progress of margin improvement so far, given the time window (VW has been involved with MAN since 2006 and Scania since 2000).

II.                Scania is a Premier Brand that Accounts for Nearly Three Quarters of Traton Profits

We believe Scania’s brand is underappreciated, despite generating the vast majority of the Company’s EBIT.  While Traton’s revenue is roughly equally split between Scania and MAN (we include VWCO in MAN), Scania’s EBIT margin is more than twice MAN’s.  Scania is a well-regarded operator that specializes only in heavy-duty trucks.  Prior to being part of VW, it traded at a premium to its truck OEM peers, stemming from better-than-peer margins, higher captive distribution, and strong brand recognition and loyalty.  Its brand recognition is the equivalent to Peterbilt’s (owned by PACCAR) in the US, i.e. the top brand.  Its trucks are noted for design, drive comfort, reliability and overall aesthetic looks, as well as the efficiency, performance, customization ability and lower noise of the V8 engines.  The division has performed well, and after spending north of €2 billion on its truck model refresh, we believe it is entering an important harvesting phase.

The new truck launch is the NTG series.  Scania has a simple modular development and production profile that uses fewer components across its product line. With each new truck refresh, it uses even fewer parts.  NTG, for examples, uses 3,000 fewer parts than the prior P/G/R series.  The fewer parts / lower weight, in turn, allow for better fuel economy (1.5%-2% TCO savings for operators).  Importantly, the higher value-added truck platform permits the Company to raise prices (5% price increase).  The NTG was launched in 2017/2018.  Customers have been testing it out and reviews have been overwhelmingly positive.  We anticipate orders to increase in 2019.  The Company has been running dual production lines (legacy P/G/R and NTG) during this transition, before shifting to 100% production on NTG at some point this year.  Margins have been negatively impacted as a result, but this is just a temporary effect.  The higher selling price, as well as moving to one production format (NTG), should allow Scania to increase EBIT margin from 10% currently to north of 12%, although even before that Scania’s margin has remained at the high end of the peer group.  We should start to see evidence of this once Traton reports Q2 2019 results.  The positive momentum in the brand in the coming quarters should draw investors’ attention and allow Scania to come back into the spotlight.

III.             Margin Opportunity at MAN

MAN is a long-established player in the medium-duty truck market in Europe with a historical reputation of being a mid-value brand.  VWCO was MAN’s subsidiary in Brazil that manufactures commercial vehicles for South America; we include VWCO in MAN for simplicity.  MAN represents a little over 40% of Traton’s revenue and VWCO comprises roughly 5% of total revenue. MAN has faced challenges since 2009, including a technical problem with its engines in the UK and a lack of significant investment in its trucking platform. MAN’s current operating margin of 5% is underwhelming.  Traton’s management goal is to bring it to 8%, which no one on the sell-side believes to be achievable.  The 8% margin goal would bring it in-line with peers’ medium-duty truck margins.

The margin uplift story is contingent on the financial success of the MAN’s NTG product launch, slated for 2019-2021, which has long been in the works.  This is the first refresh since the 2000 launch of the TGA.  Even by management’s own admission, the MAN brand image has suffered since 2009, and the refresh is sorely needed.  MAN faces low residual values on its older models due to the brand’s low perceived desirability.  It has been slow to introduce connectivity and other digital service offerings into its models.  Connectivity is an important feature for truck operators, and NTG addresses this shortcoming.  The NTG refresh for MAN is designed to share a lot of commonalities with Scania’s NTG.  Both refreshes share a common platform, an essential part of the integration story of Scania and MAN.

By 2021, Scania and MAN should be fully integrated on one common platform. We expect at that time the sizeable cost savings to begin to flow through the income statement, and in particular boost MAN’s margin.  As part of the IPO process, the Company provided details on the €700 million planned cost savings/improvement and in our opinion the targets look achievable.  More than half comes from purchasing (€430 million).  Powertrain integration of €200 million is the next sizeable bucket.  Within this bucket, the Company should benefit from the following: sharing transmissions from Scania with MAN, a common engine platform by 2021, and shared common technologies.  The remaining cost savings stem from modularization.  The €700 million cost savings goal does not include future savings from NTG production footprint rationalization, which would definitely move the needle if it materializes.

If the Company demonstrates progress on margin expansion at MAN, Management’s reputation and stock sentiment would clearly improve.  We should begin to see the benefits manifest themselves in the second half of 2020, with MAN margins eventually above 6.5% in a mid-cycle environment.  Our 6.5% base case figure is more conservative than management’s projection of 8%.

IV.             Option Value

Traton has made it a mission to be a global trucking company. It owns 25%+1 share in Sinotruck, which is a long-term play in China.  The Company has also signed a procurement and technology cooperation LOI with Hino, the leading heavy truck player in Japan.  Traton’s intermediate to long-term focus, however, is believed to be the US market, where, unlike its peers, it lacks a true presence.  The Company owns 16.8% of Navistar, and many in the industry expect it will acquire the remainder of Navistar in the future, finally entering the US market.  Although the Company does have an existing procurement JV and technical cooperation agreement with Navistar, the strategic rationale of an outright acquisition is compelling with substantial potential for additional synergies.  Navistar has a formidable dealership network (largest and extremely loyal) in the US but lacks the strong product offering that Scania would provide for the heavy-duty truck segment.  Conversely, Navistar has a strong market presence and brand in medium-duty trucks that would complement / replace MAN’s offerings that aren’t as well-regarded.  The combination would be a formidable competitor that will have the top marquee brands in both heavy and medium-duty trucks, spanning both key markets of US and Europe. 

We do not think Traton will attempt to buy out the rest of Navistar in the immediate future, especially considering the US truck market is currently at a cyclical peak.  However, we think it is more likely than not that this will occur in the next couple of years, as the Company should complete the integration of Scania and MAN’s NTG by 2021.  If a transaction were to occur, both the synergies and the longer-term strategic benefits for Traton could be material, likely providing a significant boost for the shares.  Today, investors are getting that optionality for free.

V.                Valuation and Risks

The trucking space is driven by the macro outlook and changes in emission standards, both of which cause swings in orders patterns.  Traton, of course, is subject to the peaks and valleys of the trucking cycle.  In Europe, 2018 and forecasted 2019 volumes look to be “normal” / mid-cycle and remain roughly 15% below peak levels.  There is a risk that 2020 could see a decline given the macro softness in Europe, but we would expect any decline to be relatively minor. Historically, European volume doesn’t have the same wild swings as the US, where emission standard changes are a bigger demand driver.  Also, about 20%-25% of the Company’s revenue (~40% of EBIT) come from service and parts, which is more recurring in nature, and blunts the impact of manufactured volume declines.  The market is fairly consolidated with the top three manufacturers controlling 76% of the European market, so we expect rational pricing discipline even in a downturn. Although the outlook for the South American truck market remains uncertain, it is closer to the bottom than the peak with current volume needing to increase close to 50% to reach peak levels.

We think it is appropriate to value Traton on a mid-cycle earnings power.  We believe the Company can produce €3.50 in EPS, given the expected by us margin improvement.  We assume 6.5% EBIT margin for MAN vs guidance of 8%.  Peer valuation comparison is difficult for the Company, as we expect it to have above average EPS and revenue growth, not to mention one of the best balance sheets.  The two pure-play truck peers of relevance here are Volvo and PACCAR Inc. but PACCAR derives most of its revenues from the US, and we expect Volvo to cede market share to Traton over the coming years.  For these reasons, we think Traton deserves a premium to the space.  We conservatively ascribe a 12x multiple (a slight discount to PACCAR and a modest premium to Volvo) to our €3.50 EPS estimate to get a price target of €42, a 57% increase from current levels.

Disclaimer: This report is neither a recommendation to purchase or sell any securities mentioned. The author or affiliated funds  presently has a position in securities of this issuer and may trade in and out of these positions without notice. The data contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. Please do your own work.

Catalyst

Product refresh cycle through 2021

Cost savings

Improvement in MAN margins

Potential M&A