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What the government giveth, it can taketh away. While Oshkosh (OSK) reaped some significant growth from its tactical truck business while Department of Defense budgets were flush, tighter budgets have brought down expectations and valuation significantly. While Oshkosh is going to be hard-pressed to fully neutralize tougher defense comps with better sales of commercial trucks, fire/emergency vehicles, and access equipment, the undemanding valuation nevertheless makes this one worth a little due diligence.

Feast And Famine From The Public Purse

More than half of Oshkosh's revenue comes from its defense business, and that's quite clearly not a "private payer" market. But it's not just the federal government that underwrites a lot of Oshkosh's business. While the company has leading share in airport, fire, and rescue vehicles, vehicle sales in these markets depend significantly on state and municipal budgets. All in all, then, something north of 70% of Oshkosh's revenue is derived from some sort of government spending.

Certainly the health of the defense business has been an issue for these shares. Orders dropped 83% year-on-year in the last quarter, backlog dropped 21%, and the DoD has been cutting its procurement plans and looking to make due with older vehicles. Oshkosh has created a very solid defense business and beaten rivals like BAE Systems (OTCPK:BAESY) and Navistar (NAV) in competitions for contracts, but its a cyclical business and it seems unlikely that demand is going to match the 2010 for quite a long time.

Can Access And Commercial Bridge The Gap?

All is not lost for Oshkosh. Several decent ABI readings recently give credible hope that North American construction activity may finally be picking up. Likewise, building activity in Brazil continues apace and although worries about growth in China have hurt sentiment on heavy equipment companies like Caterpillar (CAT), Oshkosh can still build from a small base here. In particular, new facilities like a plan in Tianjin may help the company fill gaps in its lower-price offerings.

Oshkosh isn't the only company looking forward to a recovery in access equipment, but its JLG subsidiary should hold its own with Terex (TEX) and there's ample growth to share in a lot of emerging markets where aerial work platforms are still relatively uncommon.

On the commercial side, there's likewise reason for optimism. Backlog improved 30% in the last quarter, and other commercial vehicle manufacturers like Navistar, Terex, and Miller (MLR) have been reporting generally solid conditions for most of the relevant markets.

Plenty Can Yet Go Wrong

To offer a little balance to the story, it's worth contemplating some of the ways in which this stock could still go wrong. First of all, this is a company whose free cash conversion and return on invested capital has generally been fairly poor in most of the recent years. Even allowing that others like Terex, Manitowoc (MTW), and Caterpillar can be plenty cyclical, there's room to argue that management here has not always delivered the results that market leadership in multiple markets would suggest.

Along those lines, it's not too hard to see why Carl Icahn targeted this company. Although Icahn's prescriptions are not always the best ones for long-term corporate success, he had some points with respect to management performance and its communication with shareholders.

It's also well worth observing that North American construction activity is still far from healthy; it's coming up off of a low base, but the recovery is still vulnerable. Along those lines, it's also worth wondering what impact the United Rentals (URI) and RSC Holdings (RRR) might have on the market. By and large, bigger customers can demand more favorable pricing and neither Terex nor Oshkosh really need a more aggressive customer base right now.

The Bottom Line

Although Icahn's attempt to push Navistar and Oshkosh together in a merger did not work, there is nevertheless cogency to the idea. Oshkosh would fit in well with Navistar's existing commercial truck business (which is more than just long haul trucking rigs), and the JLG business arguably is worth a lot more than the current valuation reflects. By the same token, I could see Oshkosh fitting in with other suitors as well, and there's a long-standing relationship with Caterpillar.

If Oshkosh can grow its free cash flow at half the clip over the next decade as it has over the trailing ten years, it's not at all hard to argue that the shares are cheap. The stock looks undervalued from a free cash flow yield perspective, and a forward FCF growth rate of 5% points to fair value above $30. Even just a 3% forward growth assumption would suggest more than 20% undervaluation.

At the bottom line, then, it seems as though the market expects too little from Oshkosh. The heavy reliance on federal, state, and local budgets is a drawback, as is the company's unspectacular record of economic returns on capital. That said, investors seem too concerned about the fall off in defense, and these shares could be priced to surprise patient longs.

Source: For Oshkosh, Offense Is Better Than Defense