Drew Industries (NYSE:DW) is a leading manufacturer of recreational vehicle (RV), motorized home and manufactured home (MH) parts and accessories. Last time we valued the company, we came to the conclusion that the stock price at the time has already factored in upcoming growth. At current valuations, we initiate a Sell recommendation with a $38 price target for DW. The catalysts moving forward are constrained by the limitations posed by the industry.
The two sources of revenue are the RV and MH segments that account for 88% and 12% of total revenue, respectively. For the RV segment, almost half of the revenue is generated by sales of RV chassis and chassis parts. The parts are manufactured by Lippert Components, one of several brands owned by Drew Industries. As for the MH segment, around two thirds of revenue comes from sales to original equipment manufacturers. The financial success of DW is correlated to the future trends within the two markets.
The manufactured homes industry does not offer room for growth in the next few years. According to the Manufactured Housing Institute, the number of MH shipments has decreased by 33% in the last 4 years, with the average price remaining virtually unchanged over the same period. Moreover, more than half of the customer base for this industry are either unemployed, disabled, retired or employed part-time and that means the income capabilities of these individuals are limited. Any investments made by DW in research and development for this category will not only decrease operating margins, but would also be unfruitful as industry demand is limited.
One positive aspect regarding the manufactured house revenue segment is that DW is shifting away from it. From 2010 to 2012, sales dropped from 17% to 13% of total revenue. According to the latest quarter report, the proportion decreased even further to 11.9%. The segment experienced a 9% jump in net sales for FY 2012. Wholesale for manufactured homes increased by 4% whereas aftermarket sales decreased by 1% in the same period. The majority of increase in sales in fact is attributed to sales of MH components sold in other industries, which increased by 39%. We believe moving away from manufactured homes will prove beneficial in the long run for the company.
Next, we would like to look at the RV segment. The two most popular types of RVs are motorhomes and towable RV's. More than 80% of RV revenue comes from components for towables, whereas only 5% comes from actual motorhomes. This is a plus as the current demand for RV's is propelled by the towable segment, as this type is more affordable and convenient for customers. Nevertheless, we believe the overall popularity of the RV is dwindling. While it currently appeals to the 55 and over age group, we do not see the trend catching on to the younger generation.
The RV industry is in an upward trend judging by the last 2 years, but the 5 year trend for number of wholesale shipments is downward. Data provided by the Recreational Vehicle Industry Assocation (RVIA) from 2007 to 2012 shows the annual number of shipments dropped from 353K to 286K per year, representing a 19% decline. The same data source projects the industry to grow by 7.5% for the current year. Gross margins for DW have decreased for 4 out of the last 5 years. Operating profit for the RV segment for FY 2012 represents 7% of RV sales. According to the latest earnings report, the company noted plans to increase sales and administrative staff, which would further hurt operating margins. The issue for us remains what happens to the industry 5 years from now, as we believe the industry will see less and less growth.
A catalyst moving forward is the company looking to diversify its revenue stream. Aside from manufacturing components for RV and mobile homes, DW also distributes its products to adjacent industries. The company produces components for buses, modular housing, truck caps, boat, livestock and other equipment trailers. The revenue generated by this segment grew from $28.7 million or 5% of total revenue in 2010 to $96.4 million or 11% of total revenue in 2012. We see an opportunity in this segment and could be the key to future growth, as growth of the RV and mobile home industries slows down.
Drew Industries acquired in June 2013 Midstates Tool and Die Engineering, a small Indiana based company that produces automated equipment. We see this as a positive sign, as improving the manufacturing process of products will help drive the cost of production down and improve profit margins as a result. One added bonus is Midstates Tool provides its products and services to the US government. The company holds Military Classified Document Clearance whereby it produces machines for US Military Facilities. This is another positive step in our opinion towards revenue diversification, depending on what DW decides to do with this aspect of operations.
After looking at the different segments of the company, we are not keen on the potential for organic growth. It may not be the case moving forward. The company has a historical trend of purchasing a number of smaller companies to expand its reach in the components market for RVs and mobile homes. From 2006 to present, DW engaged in the acquisition of 16 different companies that offer DW the ability to provide additional components for RVs and mobile homes to its customers. It seems that DW is transforming itself into a one stop shop for RV manufacturers. Moving forward, this could lock in customers and lock out competitors by creating barriers to entry to the market. This mergers and acquisitions model may be a catalyst for growth in the near future.
Turning to valuations, DW has a pe value of 27.6, which is high compared to the industry average of 21.6. Moreover, the current pe value is the highest in the last 10 years. The PEG value of 1.84 means growth is priced in the stock as we look for value around 1. In terms of financial health, DW has an optimal current ratio of 2.33 which means a good balance of current assets to liabilities. Quick ratio of 1.01 shows an improvement over the last 3 months. Currently, free cash flow to sales is a low 2.2%. Operating cash flow grew considerably in the last 5 years, but free cash flow has decreased in the same period by 46%, due to increased capital expenditures. The company has no long term debt and recent acquisitions were done using cash flow. If DW continues its expansion through acquisitions, then we may see the company take on some debt in the near future, especially since cash flow levels are less than optimal.
For FY 2013 we assume operating income to increase by 8.5%, followed by 4%-5% growth for the next 4 years as market conditions contract. We assume a 4% residual growth rate and a 35% tax rate. In the last years depreciation has increased by 20-30%. We expect this number to decrease around 6%-8% per year for the next 5 years. We expect the pace of acquisitions to decrease in the near future and as a result capital expenditures will decrease in the next years. After factoring the above assumption, we come up with a price target of $38 for the next 12 months.
Summarizing the impediments and catalysts to growth, we see two paths for DW moving forward. If future revenue is dependent on manufactured homes and RV's, then we see little opportunity for long term investment. If DW manages to tap into new revenue streams by expanding the use of its components to different markets, then we may see potential for growth.
Given that 90% of current revenue is due to RV and mobile homes sales we do not see potential when the two main markets of operations are due to grow at a dismal rate. Year to date the stock has rallied by 43%. We don't see how the stock can grow any further and since there are no dividends, we do not see any reason to be long DW.
At current price levels and valuations, we initiate a Sell recommendation with a $38 price target. At current valuations, DW offers little upside to long investors in our opinion. While we do see some potential for future growth, we believe the best scenario for Drew Industries may already be factored in the share price.
Additional disclosure: Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.