Description

BACK UP THE TRUCK

Williams Controls (WMCO) is the leading global producer of electronic throttle control (ETC) devices for the heavy vehicle (trucks, buses, off-road vehicles) market.  The Company is not followed by the Street and is out of favor after a weak performance the past few quarters due to a severe decline in heavy vehicle demand and production. However, if you check under the hood and look beyond the current environment, you will find an engine in strong working order. WMCO has an attractive underlying business with the following characteristics:  

  - Leading market position with high barriers to entry
  - Strong balance sheet with $8M in cash and zero debt
  - Capable management team with good capital allocation skills and solid insider ownership
  - Growth potential within its core business

Applying a 14x multiple to my estimate of 2011 earnings, WMCO's intrinsic value is approximately $14 per share, about double today's price.  Given the growth opportunities discussed below, I believe this estimate will prove conservative.

COMPANY SNAPSHOT
WMCO primarily produces and sells ETC devices for use in heavy vehicles (trucks, buses, off-road vehicles) with electronically controlled engines. The ETC device contains an electronic sensor that sends a message to the engine to adjust the speed of the vehicle. Electronically controlled engines produce less emissions, and the share of these engines is increasing worldwide due to more stringent emission standards. WMCO's major customers are Volvo, Paccar, Freightliner, Navistar and Caterpillar. WMCO works closely with customers to customize the ETC device to the exact specification of the customer. WMCO owns a manufacturing plant in Portland, Oregon and leases a manufacturing plant in Suzhou, China. 

Stock price:            $7.15
Diluted s/o:            7.27 million
Market cap:            $52.0 million
Cash:                    $8.1 million
Debt:                     $0
Pension deficit:       $4.4 million (fund is closed but deficit increased during the 2008 market decline)
EV:                        $48.3 million

WMCO'S CORE BUSINESS IS ATTRACTIVE
High switching costs:  At first glance, one might think that WMCO's core ETC devices could become commoditized. However, as truck manufacturers continuously alter their engines and the emission requirements change, ETC devices have to be constantly improved and customized to the evolving engine which ensures they will not become a commodity.  Unlike ETC devices in cars, heavy vehicle ETC devices are not assembly line products. WMCO customizes its ETC devices to each of its clients' various engine types. This customization process raises the barriers to entry and locks in the recurring business.  

Economies of scale: WMCO has >80% share of the U.S. heavy vehicle market for ETC devices. My research indicates that it has >90% of the Class 8 truck segment and ~75% of the Class 5-7 segment (and this should increase - see growth opportunities below). WMCO also has ~50% market share in Europe and ~50% of the small, yet growing China market. As a result of its market position, WMCO has economies of scale which prevents other players from entering the market. 

Trust/Reputation/Expertise: The ETC device is a critical truck component. WMCO has significant experience and has built great trust with each major manufacturer. WMCO has also continually invested in R&D to ensure its products evolve with the evolution of heavy vehicle engines. One Paccar engineer I spoke with asserted how "we are impressed with WMCO's ability to always adapt to our engine changes." The average truck lasts >500K miles and the ETC device must operate equally as long. Any new entrant would have to convince the truck manufacturer that their device could provide that level of endurance. Displacing WMCO would prove extremely difficult for a new entrant. It would require that customers not only trust an unproven entrant, but also be willing to disrupt their production process for an extended period of time as they work with the new entrant to customize the product. For such a low cost product per vehicle, WMCO's customers would have little incentive to undergo such a risky process.

WMCO HAS SOLID GROWTH OPPORTUNITIES
Core business expansion in the U.S.: Until December 31, 2008, WMCO had a non-compete agreement with Teleflex which precluded WMCO from selling into part of the light commercial vehicle segment. Given that a number of WMCO's current customers (e.g. Freightliner, Volvo) use WMCO's ETC device in their other vehicles, WMCO is well positioned to capture part of this sub-segment now that the non-compete has expired. Management is enthusiastic about this opportunity.

Sensor business line opportunity: Historically, the sensor component of WMCO's ETC device was outsourced. WMCO now produces its own high-quality sensors. WMCO benefits from in-sourcing its sensor as it improves margins and the production schedule is never delayed due to supplier issues. Moreover, management has identified other applications for its sensors and has received preliminary orders for its sensors from customers in other segments which will create incremental revenue.

Real opportunity in India/China: India and China's combined heavy vehicle production is 3 times that of the U.S., providing WMCO a tremendous growth opportunity. Currently only a small percentage of trucks produced in India and China are electronically controlled. As Euro-III emission standards are phased in over the coming years, the number of electronically controlled trucks, all of which will require an ETC device, will increase significantly. Many management teams discuss the India/China opportunity but few are positioned to penetrate these markets. After significant investment over time, WMCO is well positioned to take advantage of increasingly strict emission standards in both these markets. 
                   - India: WMCO has committed to investing in a manufacturing plant in Poona, India and will begin shipping commercial quantities in mid-2010 (currently minor quantities are shipped). WMCO has sole source relationships with the two largest Indian truck manufacturers, Ashok Leyland and Tata. Euro-III standards have been tabled by government bodies and are expected to be implemented and phased in between 2010 and 2014. Moreover, the large truck manufacturers are already developing new generation electric fuel-injected trucks which will incorporate the WMCO ETC device. Tata, for example, is heavily marketing its new 'world truck' which it believes represents the truck standard for India's future.
                   - China: WMCO has over time forged a sole sourcing relationship with 2 of the 3 largest Chinese truck manufacturers (including China National). These manufacturers increasingly produce a larger proportion of electronically controlled vehicles in advance of Euro-III standards which will be implemented over the next few years. WMCO has ~50% market share with the two next largest competitors (Gofa and Alion) accounting for ~15% share each. WMCO's quality, testing and design are superior to these competitors. On the most recent conference call management stated that "we were the recipient of the key supplier quality award from the largest heavy truck company in China, where we are sole-sourced".

Gross Margin expansion: Over the past 3 years WMCO has expanded its Chinese operations in order to reduce overall production costs. Prior to the downturn, gross margin improvements were expected in 2009 from the rationalization. The Chinese operations are now running efficiently. I believe that at normalized revenue levels, the Chinese operation will enable WMCO to achieve better than historical gross margins. I have not included gross margin improvements in my forward estimates but do consider their realization likely.

Other product innovations: Following requests from a couple of customers, WMCO has also started to develop a couple adjacent products (e.g. an electro mechanical joystick) that will require limited incremental investment but will provide additional revenue streams.

Acquisitions: Given its strong balance sheet, management is open to small tuck-in acquisitions if extremely attractive opportunities are presented. Management understands the concept of ROIC and I believe will not overpay for acquisitions. 

WILL U.S. HEAVY VEHICLE DEMAND RECOVER?
I can discuss WMCO being a great business with great management, but for it to be highly profitable again demand for heavy vehicles must recover. The economic slowdown has negatively impacted WMCO's customers and the end markets for its products. In the past nine months there has been an unprecedented reduction in demand and in heavy vehicle build-rates. This recession might cause permanent changes in some industries but no one has yet identified a way to make a truck such that replacement is not necessary. Truck demand ultimately depends on tonnage growth and scrappage (driven by the age/mileage of the fleet). Tonnage growth was slightly negative in 2008 and will be negative in 2009. As to scrappage, the US truck fleet is the oldest it has been in over 20 years with an average age of 6.3 years although it is important to note that some contacts suggest that average mileage is not at its oldest. To give a sense of how weak demand currently is, below are the Class 8 truck sales over the past decade and an estimate for 2009:

2009 Class 8 truck sales are forecasted at ~60% lower than the average 198K sales over the past decade. Large pre-buying was expected in 2009 ahead of stricter 2010 emission standard changes but due to the environment, capital expenditure is constrained and demand is at unprecedented lows. However, with the fleet aging further, new emissions standards being implemented and end truck users not able to push out purchasing too far, heavy vehicle demand will recover to normalized levels in the coming years. 

FINANCIALS AND VALUATION
Below are WMCO's financial results and my estimates until 2011.

Revenue declined in 2007 due to large pre-buying that occurred during 2006 prior to emission standards that commenced at the start of 2007. Revenue declined further in 2008 as truck demand began to decline in 2008. I project 2011 revenue of $62M and earnings of ~$1 per share. I believe these results are easily attainable, as the replacement cycle and orders return to normalcy in the coming years. Applying a 14x multiple to my 2011 estimate, I value WMCO at ~$14 per share.

WMCO HAS MINIMAL FINANCIAL RISK DUE TO TIGHT COST CONTROLS AND A STRONG BALANCE SHEET
As mentioned above, WMCO lost money in the past few quarters following the sudden severe decline in heavy vehicle demand. Management responded swiftly and right-sized the business for the current environment such that, even at the current  low volumes, WMCO is cash flow positive. Management is managing costs with executive salary cuts of 20%, a 4-day workweek for many employees, and focused discretionary spending cuts. If heavy vehicle production declined even beyond my low-case scenario, WMCO has additional options to get through the cycle. In addition to its strong balance sheet ($8.1M cash, no debt), management could cut costs further. To date, management has not made any cuts to R&D or Sales & Marketing as management remains adamant that with continued investment WMCO will be relatively better positioned following the downturn.

OTHER POINTS WORTH MENTIONING
- Since October 2008 the company has repurchased 311K shares at an average price of $7.58 per share.
- Insiders own 9% of the company and have been fairly active buying in the open market over the past 12 months.
- WMCO owns its Portland facility which is on the books at ~$850K. Local realtors inform me that that the facility is worth ~$6-8 million (and this takes in to account a hit in the property downturn).

RISKS
- Concentration of customer base: Top 4 customers accounted for 46% of revenue in 2008.
- A prolonged depression with truck production volumes falling even lower than the current low for an extended period of time.

Catalyst

Any sign of recovery in heavy vehicle demand and/or production