I found it a little odd late last year that Oshkosh (OSK) was trading at a 52-week high amid a pretty widely-held expectation that the company’s business was looking at a cyclical downturn. While the downturn was expected to be brief at that point, the advent of the COVID-19 pandemic threw all of the company’s markets outside of defense into chaos, prompting a severe downturn in the highly economically-sensitive Access Equipment business.
The share price performance has been decidedly mixed since then. Down about 20%, the shares have outperformed the broader industrial sector, as well as some peers/comps in construction like Caterpillar (CAT), Komatsu (OTCPK:KMTUY), and Volvo (OTCPK:VOLVY) but have also outperformed others like CNH (CNHI), Manitowoc (MTW), and Terex (TEX). I’ve been impressed by management’s ability to hit its sub-20% decremental margin target, and while there is a lot of uncertainty about Oshkosh’s core markets over the next couple of years, I think the risk/reward is appealing today – one of the few machinery stocks where I can say that.
Looking Back At The Last Quarter
Like many industrials, including fellow heavy machinery companies, Oshkosh managed a modest top-line beat in the fiscal third quarter (the June quarter) but a substantially larger beat at the segment profit line (around $0.45/share relative to my model), as the company has done a very good job of not only responding to COVID-19 with accelerated cost cuts but also as it reaps the benefits of past restructurings and improvement initiatives. If cyclical companies prove their quality in the downturns, then I believe Oshkosh management has earned a lot more credibility this time around, particularly with respect to costs/margins.
Revenue was still down 34%, with a sharp 61% decline in the highly cyclical Access Equipment business, driven by similar 60%-plus declines in telehandlers and aerial work platforms. Defense was actually the largest contributor to revenue this quarter, growing 7%, while Fire & Emergency declined 9%, and Commercial declined 16%, as a 21% decline in garbage trucks was partly offset by an 11% decline in cement trucks.
Gross margin declined 170bp from the year-ago period, while EBITDA declined 49% and operating income declined 50%. Operating margin declined 270bp, but the decremental margin this quarter was just 16%.
Defense and Commercial both saw profit improvements, with Defense up 36% (margin up 150bp to 7.3%) and Commercial up 18% (margin up 290bp to 10.2%). Fire & Emergency hung in there, with profit down 4% (margin up 80bp to 15.7%), while Access got hammered with a 78% profit drop (margin down 680bp to 8.4%). Still, relative to past cycles, investors weren’t wrong to expect even worse from Access.
A Very Hazy Outlook
There’s still tremendous uncertainty about end-market development, and it’s perhaps even worse than average for Oshkosh given the end-markets that the company serves.
Non-residential and infrastructure activity are clearly important to the Access Equipment business, as non-residential construction alone has historically been more than half of that business. Non-resi activity has actually held up better than expected so far this year, but rental fleets have been very tight with capex, and the pipeline of future non-resi projects has noticeably thinned out. I’m expecting non-resi new-builds to be weak for a couple of years, with hospitality/leisure and office seeing more significant weakness, while institutional is a harder call (weak budgets vs. decent balance sheets that could support municipal debt).
Infrastructure is no easier. Road and highway activity has actually grown through the first half of 2020 as projects wrap up, but new lettings have been weakening and funds are starting to dry up. There’s been talk of a comprehensive infrastructure bill that could worth $100B/year or more, but it would seem that nothing is going to happen before the election, meaning that there won’t be much federal support in 2021.
Municipal budgets, which drive demand for Fire & Emergency, are likewise looking a lot weaker heading into 2021. Oshkosh has a strong backlog (up 21% to $1.16B, or about 90% of a year’s revenue at this quarter’s run-rate), but new orders could well be weak next year as municipalities struggle with lower tax receipts and overhangs from new burdens created by COVID-19.
Commercial is no easier. The security of municipal contracts should support spending on garbage truck fleets, but these purchases can easily be deferred a year or two. With cement trucks, the issue circles back to the outlook for non-resi and infrastructure; resi activity has been quite strong, but it won’t be enough to offset weakness in non-resi and infrastructure.
On a more positive note, Oshkosh is in the earlier stages of a multiyear cost improvement plan here similar to what they’ve successfully executed in AE and F&E, so positive margin leverage even in the face of weak sales is a plausible near-term outlook. Management has also bid on a large USPS vehicle order that I believe would be executed/delivered through Commercial.
Defense concerns me least, as government spending remains healthy. There are some longer-term risks to the JLTV business (bids for a competitive follow-on contract in a couple of years) and also opportunities from sales to other governments.
I had already been expecting fiscal 2020-2022 to be weaker relative to FY’19 on a cyclical downturn, but COVID-19 has certainly exacerbated and accelerated that downturn. I was only expecting a single-digit decline (maybe double-digit at the quarterly trough), but, now, I’m looking for fiscal 2020 revenue to be down close to 20%, with only a modest rebound next year ahead of a stronger rebound in 2022 as non-resi and municipal spending start improving. Not surprisingly, my margin, EBITDA, earnings, and free cash flow estimates for the next few years are also meaningfully lower than before.
It’s worth remembering, though, that estimates often over-correct through the cycle. During the upturns, analysts seem to forget that the businesses are cyclical and they project unreasonably high long-term revenue growth. During the downturns, analysts seem to forget that the businesses are cyclical and they project only modest recoveries from the trough (Oshkosh has seen double-digit annual growth in past recoveries). I mention this because I haven’t changed my out-year estimates (2027 and beyond) as much through the pandemic revisions, as I assume the long-term growth rates for non-resi assets-in-place, municipal spending, and so on aren’t going to change that much.
I’m expecting long-term revenue growth in the low-single digits, with annualized growth in the three years after FY’20 on the high side of the mid-single digits. I’m expecting long-term FCF margins to average in the mid-single digits, driving FCF growth in the mid-single digits.
The Bottom Line
Between discounted cash flow and margin/return-driven EV/EBITDA, I believe Oshkosh is priced for an annualized long-term total return in the low double-digits. That makes it one of the very few heavy machinery stocks that looks undervalued today (and that fact alone makes me a little paranoid…). Given demonstrated success on restructuring costs and improving full-cycle margins, I’m willing to accept the cyclical and near-term forecasting risks and I think this is an interesting name to consider now.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.