The analysis of candidates for Montaka’s short portfolio follows a rigorous process that requires stocks to exhibit at least one characteristic of our four-point framework: (i) thematic/structural changes; (ii) divergent expectations; (iii) asymmetries; and (iv) misperceptions.
Navistar International (NYSE: NAV), a US-based manufacturer of International brand commercial and military trucks, buses, and engines, filled the requirements of all four categories that make a great short.
Although not a major point in the NAV short thesis, the company’s decision to shelve its own EGR emissions reduction technology in favor of a competing SCR technology, in order to comply with emissions standards, led to a collapse of NAV’s margin. NAV’s gross margin fell from 19.8% in FY11 to 10.2% in FY12, with the margin since failing to recover to historical levels. Furthermore, tougher emissions regulations remain a risk to the downside going forward.
Consensus was forecasting a return to positive revenue growth by late-2016. This appeared overly-optimistic, given the emergence of data suggesting that the U.S. Class 8 truck cycle may be reaching a peak. (N.b.: Class 8 trucks refer to large trucks that are 33,001 lbs and over).
Between 2007-2013, Class 8 truck builds averaged 210k units, c.15k/year below estimated replacement demand as truckers delayed new truck capex and allowed their fleets to age. This is the equivalent of a cumulative c.105k unit shortfall. The below chart from UBS illustrates this dynamic:
However, strong production in 2014 and 1H15 was estimated to have more than met the pent-up demand, creating a situation of oversupply in the U.S. truck market. This has manifested itself in swelling dealer truck inventories and commentary from trucking companies around less future truck purchases from companies such as Navistar. Furthermore, Class 8 truck cancellations had begun to spike up, reaching a 20% cancellation rate of new orders in November 2015.
North American Class 8 truck orders started to show weakness in 2H15 but the decline has since accelerated. North American Class 8 truck orders printed YoY declines of 45%, 59%, and 36% in October, November, and December, respectively. Given the headwinds to NAV’s revenues, we formed the view that market expectations for a margin recovery were highly-unlikely to be achieved.
Consensus was forecasting by 3Q16 that the EBIT margin would return to 5.0%+, quite a feat given that top-of-the-cycle EBIT margins were 5% in FY11. This was difficult to believe in light of the emerging pressures to NAV’s top-line as well as a greater reliance on third-party truck engines after NAV abandoned its EGR emissions reduction technology in 2012.
At Montaka we try and take a probabilistic approach to each investment thesis and avoid predictive statements that require us to forecast variables. With that in mind, it is interesting to examine the consequences if our thesis was wrong and consensus numbers were in fact achieved. Even if FY16E consensus EBIT was reached, the presence of an enormous debt burden and unfunded pension liability rendered the equity worthless.
Navistar is highly levered, with $3.2bn of debt attributable to its manufacturing operations. This is an extraordinary amount of debt in light of NAV’s current market capitalization of $650m. Furthermore, NAV has an unfunded pension liability of approximately $3bn which requires estimated ongoing contributions of $100-150m p.a. The significant financial leverage is an important component of the Montaka short framework; coupling this debt load with the operational leverage inherent in Navistar’s manufacturing operations helped accelerate the business decline.
NAV’s used truck inventory had swollen to $390m in 4Q15, up from $155m in 4Q13. This was a red flag, given the material sales decline over the corresponding period. Navistar had been taking in used trucks to drive new truck sales, a somewhat risky strategy given the U.S. truck oversupply and pressure on used truck values. ACT Research estimated that truck dealer inventories in September were 2.8x sales and commentary from NAV’s 2015 10-K suggested a saturated U.S. used truck market and desperation on the part of management to move the inventory off their books: “Throughout 2015, we continued to seek alternative channels to sell our used trucks, including certain export markets which result in a lower price point as compared to our domestic channels”.
NAV’s used truck inventory growth appeared unsustainable, given the backdrop of pressure on resale values in the U.S. used truck market. Resolving the situation of ballooning used truck inventory is likely to follow two paths, both of which result in unfavorable consequences: 1) NAV could allow the used truck inventory to continue to increase but it risks not being able to shift that inventory, potentially resulting in write-downs; or 2) NAV could reduce trade-in activity which would most likely pressure revenue growth. Ultimately, NAV’s trade-in activity masks the true extent of the sales decline.
In an attempt to shore up free cashflow, capex had been reduced to an unsustainable level and was materially below depreciation (capex/depreciation was a mere 0.4x in FY14). This provided yet another headwind to NAV as delaying capex can only last for so long; future free cashflow numbers would be negatively impacted to the extent that capex mean-reverts.
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Montaka was short the shares of NAV however recently covered its position. The below chart illustrates the negative share price performance for NAV over the last twelve months.