By Adam Fleck, CFA
Over the past several quarters, Terex Corporation (TEX) has enjoyed solidifying end markets, improved internal operations, and an appreciating stock price, but we think the company has a runway for further improvement.
Although the firm holds sizable exposure to Western Europe (more than one fourth of total revenue), some leading signs in the region have proved encouraging in recent months. Moreover, the U.S. nonresidential construction picture has seemingly bottomed, and indicators here also suggest improvement in the coming quarters.
Along with better cost control, continued working capital improvement, and further integration of acquired companies, this environment should help Terex expand its operating margin over the next few years, with potential for additional debt reduction as well. In all, we think the company's prospects remain sound, and the market currently offers a decent margin of safety for investors.
U.S. End Markets Strengthening, Europe Not as Bad as Feared
Year-over-year revenue growth rates for Terex's end-markets turned positive in late 2010 and early 2011, and the company has enjoyed double-digit sales gains in each quarter since. Part of these increases stem from some increased end market activity, but we attribute most of this success in the firm's aerial work platform segment (about 27% of 2011 revenue) to customers' fleet replacement. Several periods of delayed capital expenditures resulted in aging fleets, but increasing rental utilization has led to increased purchasing in recent quarters. The aerial work platform segment sells the vast majority of its products to rental customers; as equipment usage has climbed, so too have orders for new products. Given the aim to reduce fleet ages and continued end market improvement, we anticipate that Terex will see further growth in its aerial work platform business in the near term, though probably at lower growth rates than last year simply because of more difficult comparisons.
United Rental Fleet Capital Expenditure Versus Utilization
Further helping this business, Terex's management said half of orders in the most recent quarter stemmed from independent rental houses, indicating that the replacement demand is broad-based rather than concentrated only at larger, better-capitalized major customers. Although these smaller clients also tend to purchase fewer units per order, they also typically pay higher per-unit prices, buoying Terex's planned early 2012 mid-single-digit price increase.
In Terex's crane segment (about 31% of sales), business is driven more by commercial construction and infrastructure expansion, areas that have actually shown improvement lately. Within this climb of U.S. nonresidential construction spending, power-related projects - critical for Terex's larger crane offerings - have increased markedly year over year in the past few months.
Moreover, the Architecture Billings Index remains above the critical 50 mark, suggesting continued U.S. nonresidential growth for the next several quarters. While this market is certainly not back to pre-recession levels, we're encouraged that it appears to have bottomed.
Importantly, we don't think Terex has lost market share in these two businesses over the past several years. The segments face only a handful of competitors, and these outside companies (Manitowoc (MTW) in cranes and JLG, a division of Oshkosh (OSK), in aerial work platforms) look to have suffered and rebounded in the past several years in a similar fashion to Terex. Going forward, however, we expect there could be some divergence, as Terex's plans to target only higher-margin sales could lead to lower growth.
In Terex's other strong business, material processing (roughly 11% of revenue), high commodity prices and demand for aggregates tend to drive success. The unit has enjoyed solid growth and sustainable positive profitability over the past 18 months, and although we think prices of mined goods could face some pressure in the near term as a result of slowing Chinese economic activity, Terex has recently noted a secular shift toward its mobile - rather than competitors' permanent - machines. As a result, the firm recently announced capacity increases for its facility in Northern Ireland.
Terex's product quality has also improved in recent years, as evidenced by its falling warranty-related expenses. Both as a percentage of sales and raw dollars spent, warranty settlements have fallen since 2008, similarly driving down necessary accruals. As a result, we estimate that the firm has picked up about 60 basis points of operating margin over the same period.
Of course, Europe is still a concern, and at about a third of sales, it constitutes a larger portion of revenue than North America. However, roughly 40% of this total is the United Kingdom and Germany, whose situations actually aren't dire for manufacturing firms. The remaining weakness outside these countries leads us to expect relatively slow growth in the total region for the near term, though.
Working Capital Becoming a Cash Flow Driver
Terex has improved working capital since the Great Recession. As a percentage of sales, net working capital fell to about 28% of annualized revenue in the fourth quarter of 2011, down from 34% in the fourth quarter of 2008 and a high of 41% in late 2009. Management is targeting 25% by the end of 2012, which we believe is achievable.
Primarily, we expect inventory reductions to drive this continued improvement. Although Terex has substantially reduced this line item as a percentage of sales in recent years, it still holds substantially more on its balance sheet than comparable companies. That said, it has actually performed much better in regards to finished goods of late; it is in raw materials and work in progress that Terex has room for improvement.
Finished Goods Inventory as Percentage of Sales
We also expect working capital improvement in accounts receivable, where average days' sales outstanding have climbed over the past two years. We attribute some of this degradation to expanded Terex Financial receivables, but we're encouraged by management's comments that suggest minimal delinquencies in the portfolio. In all, Terex is targeting more than $500 million in free cash flow (defined as adjusted earnings before interest, taxes, depreciation, and amortization less changes in working capital and capital expenditures) for 2012; after interest payments and taxes (at a 38% rate), we estimate free cash flow, as defined by operating cash flow less capital expenditures, of around $200 million, up from negative $60 million in 2011.
Although Terex is likely to enjoy positive free cash flow this year, we caution that all of this liquidity is already tied up for 2012. In the first quarter, the firm faces a $160 million tax bill, thanks to capital gains from last year's sale of Bucyrus shares (after Caterpillar (CAT) acquired the company), and it must also shell out roughly $200 million-$300 million for the remaining minority stake in Demag (about 18% of outstanding shares) in the third quarter. As such, we estimate that Terex will burn through some cash this year, but we take some solace in its relatively strong cash hoard of more than $775 million.
Looking past 2012, we project further positive free cash flow generation, and with no similar existing earmarks on these funds, we expect some balance sheet deleveraging. Terex finished 2011 with about $2.3 billion in debt, up from $1.7 billion in 2010, as it assumed more than $1 billion to finance and consolidate its Demag purchase, which more than offset nearly $450 million in debt reduction.
We don't expect Terex to pursue extremely large acquisitions; management could probably add a bolt-on purchase or two, but given the increased debt level and a desire to maintain its credit rating (we currently rate the firm BB-), we doubt the company would want to significantly leverage back up to support a major purchase or even share buybacks.
Could Terex Sell Its Construction Equipment Segment?
One option we see for Terex is the potential to sell its fourth major legacy segment, construction equipment. The unit has struggled to generate sustainable positive profitability, owing to a bloated cost structure and rapidly declining end markets. Nonetheless, recent efforts to rightsize the business amid a better selling picture have led to break-even operating margins, and we expect the segment to enjoy decent profits over the next few years.
That said, we think the business could offer some incremental product and geographic opportunities for several competing manufacturers. We think Hitachi (HIT), Liebherr, and Sany could benefit the most from Terex's compact equipment lineup. However, we're not sure that Hitachi, with its excavator-focused niche, would be interested in the segment, and the potential acquirer also already holds North American exposure through a venture with Deere (DE). Similarly, Liebherr has historically concentrated on large equipment in the mining and commercial construction arenas. On the other hand, China-based Sany is actively seeking additional U.S. and European exposure and has shown itself as acquisitive in recent months with a $650 million purchase (including assumed debt) of German concrete pump manufacturer Putzmeister. Even after this acquisition, we estimate that Sany holds nearly $600 million in cash on its balance sheet; it is reportedly also planning an initial public offering in Hong Kong for more than $3 billion in the near term.
However, the timing of any potential deal remains highly uncertain. Terex's segment has underperformed in recent quarters, only recently generating positive EBITDA. When we look at the longer-term picture, we can foresee improving profitability given the business' more-focused product lineup and renewed concentration on cost control, but we don't expect the segment will reach the margins of Terex's other units. Still, if the business can climb to mid- to high-single-digit operating margins, even with relatively flat top-line performance, we think $125 million in EBITDA within the next three years is possible. Assuming an 8 times multiple on this income (about in line with comparable firms) and a 10% discount rate, we think Terex's construction equipment business could fetch a price north of $800 million. Putting this into perspective, we estimate that the segment contributes about $7-$8 toward our $33 fair value estimate.
We Expect Improved Profitability, and Terex's Valuation Looks Appealing
In our discounted cash flow model, we assume Terex can achieve 9% operating margins by 2015, well below prior peaks and still less than management's forecast 12% peak profitability goals. We think our metric is sustainable over the long run; the firm will probably continue to see boom and bust periods given the inherent cyclicality in its businesses, but we expect trough periods to lead to margins in the low single digits rather than sharply negative levels, thanks to restructuring actions and better cost discipline.
We currently see the most significant risk as a worsening economic environment in China that subsequently leads to challenges for developed markets. On top of this, we caution that Terex has proved highly acquisitive in the past. Although management seems likely to avoid major purchases in the near future, overleveraging for a transformational acquisition presents another critical risk. In our downside modeling, we peg Terex's fair value below $20 per share, stemming from midcycle margins around 6% amid slower average revenue growth.
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