Short Case Of Navistar: Was Carl Icahn Wrong?

| About: Navistar International (NAV)

As can be seen in our previous article, we were considerably wary of how Navistar (NAV)'s stock would perform in the near future in light of its engine compliance issues, rising warranty costs, declining end markets, and poor liquidity conditions. We therefore suggested shorting the stock, despite the involvement of tycoons like Carl Icahn and Mark Rachesky.

Yesterday's announcements have substantiated our arguments for the stock, as it fell 13%. It carried with it both good and bad news for investors. On a positive note, the company announced that it will temporarily use Cummins' (CMI) exhaust treatment component till it gets its own engine cleared from the Environmental Protection Agency (EPA). Also, the company has been successful in raising $1 billion, which will help it cover its financial deficit in the short term, and get rid of some debt maturing in the near future.

However, the Securities and Exchange Commission (SEC) has launched an inquiry into an accounting disclosure that Navistar failed to identify in its financial statements. This, coupled with the fact that the company has reduced its outlook for the next earnings release, the falling U.S. Truck Industry, a potential rise in penalties from the EPA, and the erosion of its market share because of potential unfavorable pricing, have been received as undesirable news by investors.

However, most of the bad news has already been priced in the stock, as NAV gave a YTD performance of -43%. The company has won a substantial amount to help it survive the current circumstances. Important catalysts for stock movement will be the decision following the SEC probe, the rise in penalties by the EPA, the management's role of pricing the CMI engine fitted Navistar trucks that will eventually decide the margins and the consequent market share.

CMI Engines & Market Shares

NAV CEO Daniel Ustian struggled for two years to get the Exhaust Gas Recirculation engine approved from the EPA, but failed in this regard. Meanwhile, this cost the company millions in the form warranties and fines paid to the EPA.

After finally giving up on this technology, the company recently announced it would be moving to the industry-wide used Selective Catalytic Reduction (SCR) technology. Today, the company has decided to outsource the exhaust engine component to CMI, as its own SCR engine will take time up till March to be approved by the EPA. Our earlier article on NAV suggested this as a turnaround strategy for the company. This decision is considered to be taken favorably by truckers, as well as investors who now have, to some extent, clarity as to the future course of sales of NAV trucks. The CMI 15L engine fitted trucks will roll out in the market in January.

However, CMI SCR engines are expensive as compared to the company's own engines. Therefore, the company will have to increase the prices of its trucks. This unfavorable pricing might lead to an erosion of the current 17% share in the heavy duty truck market that NAV owns.


The company has seen its cash reserves being depleted since it pays a fine of $1919 per every engine sold. This fine is expected to go up as the company continuously uses the outdated and prohibited engine. The penalty can go up as high as $10,000 per engine sold. Latest figures for warranty were $104 million. This can increase manifold in case the EPA raises the penalty imposed.

SEC inquiry

The SEC has recently reopened documents from November 2010 till now, and has requested additional information from NAV regarding the documents. This announcement has set off alarms in the investor lobby, who clearly remember the last time that the SEC probe led to fines, firing of auditors, delisting of the stock for 16 months, and a complete restatement of results from 2002 to 2005. The SEC, NAV's management and NAV's auditors, KPMG, have declined to comment about the severity of the issue. However, the sell-side is confident that the issue is not as serious as the previous case, given that many large banks, including JPMorgan (JPM) and Goldman Sachs (GS) are involved in the offering of a $1 billion debt to the company.

U.S. Truck Demand

The U.S. July truck season remained well below market expectations. The truck sales for the Class 8 were 12,900 units, lowest after sales of August 2010, around 25% lesser than the market estimates of 15,000-20,000 and -31% YoY. These sales were 23% below June's sales. The soft demand is expected to continue in the second half as well.

Future Outlook

Earlier this month, NAV's management refused to comment on the third quarter earnings outlook, stating that they were waiting on the EPA's decision regarding the engine approval. However, today they slashed the earnings from a 5 cents gain per share to a loss of $1.2-$1.7, giving a total loss of $105-140 million, owing to the high penalties and engineering costs related to engine development. The company expects to earn revenues worth $2.8 billion-$3 billion, 17% below the market expectations of $3.5 billion. However, the company hopes that it will turn profitable in the fourth quarter of the year, after showing three consecutive quarters of losses. NAV will reintroduce its outlook for the year in the next press release that will come out on September 3.


The company has managed to win a debt worth $1 billion from a consortium of banks. This will help to curb liquidity issues in the near term. However, this, added with pension liabilities, now total $5 billion. The company is expected to pay 6.5%-to-7% above the LIBOR for the $1 billion loan. These interest payments will force some pressure on the minimal cash reserves of the business.


As already stated, important catalysts to watch out for are:

  • Result of SEC probe.
  • Change in penalties.
  • Impact of CMI engine cost on NAV's current heavy duty truck market share.
  • Finalized cost of debt.

Since two of the main issues i.e. the issues of engine and liquidity have been resolved, we switch our stance from short to neutral. We will not recommend a long position unless we see clear bullish newsflow from the other two.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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