Oshkosh Corporation (NYSE: OSK) is a designer, manufacturer and marketer of specialty vehicles, including firetrucks, snow removal vehicles, ambulances, dump trucks, and a variety of army vehicles. The company was an early pioneer of four-wheel drive technology and maintains off-road vehicles as its core strength in supplying the US Department of Defense, its largest customer.
In 2011, the company took steps to strengthen its balance sheet, reducing net debt by approximately 1/3 to $630 million. Additionally, the company grew its backlog by 20%, to nearly $6.5 billion, the highest level in its history. Unfortunately, on other metrics the company had a poor year. Revenues declined by 23% in F2011 from F2010, and margins contracted. Both of these metrics had tough comparables, with 2010 a banner year thanks to certain US DOD contract awards for M-ATVs. The following chart shows the anomaly of 2010 and provides some context for 2011 performance.
In this context, we see that the the company’s 2011 revenues were not as dismal as one would believe based solely on single-year comparables. We see modest growth from pre-recessionary levels, which might even be considered good performance given the ongoing macroeconomic weakness in the company’s sales regions.
One point to note here is the whipsaw action resulting from the DOD contract awards. This highlights a troubling fact about OSK, namely the revenue contribution of the US Department of Defense. From the company’s 10-K:
The Company made approximately 56%, 72% and 53% of its net sales for fiscal 2011, 2010 and 2009, respectively, to the U.S. government, a substantial majority of which were under multi-year contracts and programs in the defense vehicle market.
There are several reasons to worry about this level of revenue concentration. First, regardless of the customer (public or private), high revenue concentration means increased power in the hands of that customer which can be explicit or implicit. In the case of the DOD, this is likely to be implicit, with OSK management working to do whatever it can to maintain those contracts without the DOD necessarily demanding concessions (something we see more from large private sector customers). All else equal, when revenues are spread among many smaller customers, management is in a better bargaining position.
Second and more specific to this case, the DOD is likely to face intense pressure to cut its capital budget. Given the US fiscal situation, I would be highly reluctant to invest heavily in a company that receives such a staggering percentage of revenues from the US Government (really, any government). To do so would be to bet that my insight into the budgetary machinations of a government will produce superior predictions (in other words, to do so would be pure folly).
Third, the revenues derived from the DOD are based on specific contracts with definitive deliverables. For example, in 2009, the DOD awarded OSK a sole source contract for 2,244 M-ATVs, later increased by an additional 3,975 M-ATVs. These were big wins, and amounted to approximately $3.3 billion in expected revenues. However, once these are completed, the company has no guarantee that the DoD will have contracts worth this amount, and if it does, the company has no guarantee that OSH will win the new contracts. A substantial portion of its revenues could disappear. If the DOD were not such a large portion of revenues, or if the company’s products were integrated into the DOD’s operations in some manner that would make OSK difficult (or highly costly) to replace, this would be less troubling. In the absence of these things, the company carries with it increased risk.
There are several things investors can do to value a company in OSK’s situation (with relatively risky revenue sources). The method I chose was to value each of the company’s four operating segments (Defense, Access Equipment, Fire & Emergency, and Commercial) separately, each under a variety of scenarios. By separating the segments out, we can assign different performance under different scenarios based on our expectations for the more variable segments, like Defense. Don’t forget to subtract a value for the ongoing cost of corporate overhead. I always start with actual past performance over a business cycle and then adjust based on future expectations. The result of my valuation was that the company appears to be quite undervalued unless we make extremely bearish assumptions for Defense. If Defense stays roughly stable with its long-term average performance, or even declines marginally, the company appears more reasonably valued in the low $30s (your results might differ based on differences in assumptions).
Lending support for a higher valuation is the idea that the company’s non-Defense segments have the potential to offset declines in Defense revenues. Since 2008, sales in the company’s other three divisions (which usually make up ~40% of sales) have fallen by 33%. As the economy recovers, these cyclical segments should regain their footing. In a recent filing the company states that a normalizing economy is an opportunity to add $500 million to EBIT (25% of the current market cap). Though this does not account for a likely decline in the Defense segment, there is clearly some opportunity, even if only to offset declines elsewhere. Also note that some of the company’s segments may face continuing pressure as municipalities (purchasers of fire trucks, snow plows) are facing budgetary crises of their own.
One more important point to note is that the company has been engaged in a public fight with activist investor Carl Icahn. In June, Icahn filed an SC-13D noting 9.51% ownership of OSK. In November, Icahn filed an amended SC-13D nominating six people to the Board. Following this, the two parties waged a proxy battle that has not, at the time of writing, been resolved (though, it may be by the time of publication). Icahn seeks to merge OSK with rival Navistar Corporation (NYSE: NAV) (of which Icahn owns 10.33% according to the recent preliminary proxy statement):
The Icahn Parties believe there may be significant synergies between Oshkosh and Navistar International Corporation and that shareholders of both companies could benefit from these synergies and the Icahn Parties would be supportive of a merger. The Icahn Parties believe that synergy driven consolidation will be a primary method for defense contractors to drive earnings and cost savings in the years ahead.
This view is shared by NAV’s CEO, as detailed here. It appears that the companies’ military businesses are aligned and that by merging, one of the benefits would be to reduce expenses in this division. This would be a good move in the face of potentially declining Defense segment sales. Additionally, OSK currently sources components from third parties which NAV produces, which would lead to further cost savings. This could lead to further upside.
Here we see that an investment in OSH carries risks associated with its Defense segment, with potential counterbalancing opportunities in its other segment and a possible merger with NAV. The involvement of Carl Icahn also provides a possible catalyst in the near term. The investor’s role here is to handicap the likelihood of declines in Defense revenues against the