Navistar (NAV) and its investors will always remember this year's August, as a variety of news moved the company's stock to and fro. In the first week of the month, the company announced an ongoing SEC inquiry, its intention to cut jobs, an approval for an engine usage from the EPA (the announcement of the fines associated with the usage is still pending), winning a $1 billion loan from a consortium of banks and most importantly, a change in strategy to use engines manufactured by Cummins in its 8 class trucks, the sales of which will commence next year.
However, this was not enough for the company, as the CEO Dan Ustian unexpectedly resigned on Monday. There are doubts that the CEO has been ousted by the board after his disastrous engine strategy led to two straight quarters of falling sales and negative profits.
The company also received a hit last week when it was not awarded a military engineering and development contract.
On a positive note, recently, the Chinese government has approved the joint venture license for NAV and Chinese truck maker, Anhui Jianghuai Automobile Co. Ltd. (JAC). This will help NAV to grow globally.
Even though the market is positive about the change of CEOs, Wall Street is not confident about NAV's capability to return to profitability in the fourth quarter, something that Dan Ustian had promised some weeks ago. Also, the market has a confused point of view for the newly appointed Executive Chairman and interim CEO, Lewis Campbell, who was previously the CEO at Textron (TXT).
From Dan Ustian to Lewis Campbell
Dan Ustian was no doubt an accomplished leader. Had it not been for the engine disaster, Dan's tenure was an ideal one. Dan remained CEO for nine years and spent 37 years of his life in NAV. In his tenure, the company's market share in the North American heavy duty truck market doubled to almost 20%. Also, the profitability for the truck's business improved due to the lowering of overall expenses. Sales almost doubled from $7.7 billion to $14 billion, as NAV diversified its global operations and ventured in the military business.
However, nobody knows why Dan stuck to the idea of using EGR-only engine technology rather than Selective Catalytic Reduction (SCR) engines - which are simply EGR engines with an added treatment of urea solution. The urea solution is known to reduce the amount of nitrogen oxide emissions that are considered to cause asthma, which is a huge concern for the Environment Protection Agency (EPA). This rigid attitude led to two years of logjam between NAV, the EPA and the California Resource Air Board. Financial costs were also attached, as the company had to pay $1,919 per engine in fines and offer steep discounts to induce truck users to buy the non-compliant product, which resulted in an erosion of margins and the company had to bear over $100 million in warranty claims. The company suffered from two straight quarters of losses and declining revenues. Not only this, some activist buyers also increased their stakes to carry out a hostile takeover of the company, which led NAV to take a poison pill.
Finally, when the company lost half of its market value this year, Dan decided to give up the idea of EGR engines and moved to SCR engines, much like the entire industry did some two years ago.
The trucks, with their new engines, are expected to be rolled out next year. Till then, regulators have allowed the company to use the non-compliant engines. However, the fines may increase after the federal court appealed that the EPA fine was low. The incremental cost of using a CMI-produced SCR engine is $10,000. The increase in fines, which has not yet been announced, can be up to $10,000. Also, the expensive CMI-built engines will reduce NAV trucks' market share, as the company will have to raise prices in order to keep the same margins.
Dan announced on August 2 that the company is well on its way to turn profitable in the fourth quarter of the year, and margins are expected to improve in 2013. However, after his departure, such a progress seems a remote idea.
The interim CEO, and more importantly, the Executive Chairman, former Textron CEO Lewis Campbell, has plenty of experience under his belt. He served for 24 years in the product, design and manufacturing departments at General Motors (GM). Also, he assumed key positions in TXT for 17 years, including the post of CEO and chairman for 10 years. When he became the CEO of TXT, the stock was hovering in the mid-$30s. However, he increased operational efficiency by consolidating manufacturing facilities, outsourcing non-core operations and speeding up the whole product development process. By the end of 2007, the stock had climbed to $70. However, he could not handle the company when the global financial meltdown hit in 2008 and therefore left TXT in 2010 when the stock had plunged to $20. He made his way to Cramer's Wall of Shame six months before he left TXT.
Therefore, the market seems to be confused about how Campbell will steer the company forward. Bears are skeptic that an experience in airplanes and helicopters (in which TXT deals) will be of no use to an engine manufacturer like NAV.
The $4 billion dollar contract to replace the Humvee, a combat vehicle, was one of the very few golden opportunities that the U.S. defense sector had to offer, especially after the state announced deep cuts in the U.S. defense budget. Ustian, in the conference call, was very optimistic that NAV would win the contract and the resulting inflow of money would help curb the earlier losses. However, NAV lost the 27 month engineering and development JLTV (Joint Light Tactical Vehicle) contract that had led to an award of $54-$67 million to the winner:
These amounts are for the contracts of development of prototypes. Therefore, NAV can still join the race for the $4 billion production contract once the development phase is over. The army has announced that the losing bidders [that include NAV, General Dynamics Corp (GD) and BAE Systems (OTCPK:BAESY)] can proceed to build prototypes at their own cost and risk. However, NAV is silent about whether it will appeal against the government's decision or not.
Chinese Joint Venture
On August 22, the Chinese government approved a license for the Joint venture between NAV and JAC, which has opened massive opportunities for the former. The Chinese truck market is a huge one, and the strategic alliance will give NAV an immediate presence in the Chinese market. Construction has already started on 93,000 m(2) area for assembling and manufacturing purposes.
The stock is up 4% since the change in CEO. However, there is lot of confusion as to how the company will proceed under the directions of the new chairman. The sudden resignation of the CEO has led the market to believe that NAV may not be in a position to show profits in the fourth quarter. As far as valuations are concerned, margins are significantly below the industry average due to the discounts offered on products. Revenues are declining while losses are rising. The only positive factor is the $1 billion loan that the company has been offered recently, but bears do not think that it will last much longer, until and unless the company revisits its strategy. Investors are keenly waiting for results of the SEC probe and the magnitude of fines on the non-compliant engines. Important catalysts will be:
- Employment of a permanent CEO.
- Decision regarding the SEC inquiry and fines.
- September 3rd's earnings release
We will recommend investors to short the stock till the earnings release.