Michael Xiao-Yong Xie's  Instablog

SPAR's Q3 profit below the street view. But it is not the end of world as any company's intrinsic value is not based solely on one single year. In fact, from my system, with the most conservative assumptions, it is obviously undervalued. Mr. Soros, you can reload it now.

Three reasons to invest SPAR

 

1.     Its ROIC is high and still growing. Because the high ROIC is embedded with its special business model the ROIC is sustainable.

 

As illustrated in Figure 1, unlike the WACC which is relatively stable, the ROIC is keeping track on a clear upward trend. A higher ROIC means that it earns more on per dollar investment than other companies with lower ROIC. More importantly, the spread between its ROIC and its WACC is widening meaning that it is earning even more on per dollar invested than itself before.   

Figure 1 ROIC vs WACC

Whether the high ROIC is sustainable requires further analysis on the drivers on this high ROIC. The two immediate drivers are NOPLAT/Revenue and Revenue/Invested Capital. Compared with improving NOPLAT/Revenue, the Revenue/Invested Capital has been less volatile (Figure 2). It is the improving NOPLAT/Revenue that contributes the most to the increasing ROIC. A deeper analysis on NOPLAT/Revenue suggests that SPARTAN has been striving to manage costs.                                                         

An obvious decreasing driver is SG&A/REV’s which shows the management’s efforts on managing overhead costs. Among other drivers listed in Figure 3 the deceasing COGS/Revenue implies a strengthening Figure 2 ROIC drivers         

bargaining power as a buyer. 2008 is one of the worst years for the auto industry. However, reached its lowest level of COGS/Revenue (Form 1) it seems that Spartan has been taking advantage of auto part suppliers’ loss.                                                                                                 

In fact, it is the advantageous business model that was designed for the high ROIC. Focusing on niche markets introduces rigid demand which is less elastic on price and economic change. Consequently, as rule of demand and supply suggested, when Spartan stayed in line with the few purchasers in the economic down turn its bargaining power with suppliers       Figure 3 Drivers trend                                        was strengthened. This explained the record low level of cost of goods sold in 2008. Embedded with the advantageous business model, the high ROIC is sustainable.

Decomposition of ROIC further confirms the sustainable ROIC around its current level as all drivers are either stable or improving.

VALUE DRIVERS	2002	2003	2004	2005	2006	2007	2008
COGS/REV'S	82.28%	85.32%	86.75%	85.78%	83.52%	85.85%	82.44%
SG&A/REV'S	5.60%	6.76%	5.36%	6.08%	5.67%	5.31%	5.55%
DEP/REV'S	0.73%	0.85%	0.74%	0.77%	0.64%	0.60%	0.72%
R&D/REV'S	2.76%	2.98%	2.54%	2.75%	2.83%	2.33%	2.30%
NOPLAT/REV		2.42%	3.22%	2.98%	4.46%	3.39%	5.79%
WC/REV'S	13.84%	18.37%	15.88%	17.66%	22.22%	19.25%	14.39%
NET PPE/REV	10.24%	10.85%	9.21%	8.33%	8.84%	9.68%	8.97%
REV/IC	3.86	3.21	3.83	3.72	3.14	3.40	4.01
ROIC		8.14%	12.96%	11.77%	16.96%	13.49%	23.77%

Form1 Decomposition of ROIC

 

 

2.     Its revenue is growing fast. The demand is stable with a potential high growth product line.

 

Empirically, in the past 15 years Spartan’s revenue growth has been following a clear upward trend line regardless the company’s cyclical nature. The log-linear regression analysis on the time series shows that the slope for this trend is around 9.6% for the past 15 years. Translating into revenue growth rate, it will be a10.08% growth rate. There is no other reason to downward adjust this slope than its first two quarters’ performance in 2009.                                            

As this time’s economic crisis is once-in-a-century, the disastrous sales can be considered as a very rare case, a noise in the whole time series.  However, there is a more convincing reason to adjust this slope upward.

                                                                                        Figure 4 Revenue growth log-linear regression                         

President Obama’s healthcare plan will provide Spartan an opportunity to grow revenue faster. According to the U.S. Census Bureau, nearly 47 million Americans, or 20 percent of the population under the age of 65, were without health insurance in 2008, their latest data available.[1] According to Obama’s plan, 20 percent of whole population without a health insurance will be offered one. In another words, there will be 20 percent additional medical services needed.



Figure 5 Segment contribution       These include proportionally 20 percent more emergency vehicles which are under the coverage of Spartan’s product lines. Spartan clearly noticed this growing spot. Unsurprisingly, the management just announced that they added more capital on Road Rescue. Following its core competitive advantage, Spartan apparently is resizing operations to prepare fetching this immediate opportunity. Suppose that the EVTeam will grow 20% per year instead of projected 9.6% from 2013 when the new health plan will take effect, and to be conservative, that the segment contribution will keep as it was in 2008 (Figure 5) disregarding Spartan’s efforts to increase the EVTeam share, the additional revenue from EVTeam would contribute for 1.7%[2] more overall revenue after 2013.                                 

From demand side, the aggressive nature of the United States government will keep its army vehicle orders stable. Besides, the life style of US seniors won’t change too much. The disappointed RV sales in recent years will catch up. Until baby boomers’ 401K account balance returns to a level making them feel safe enough to chase their RV dream, they will not start to consume. The recent V-shaped stock market rebound suggests that the motor home sales will back to normal sooner rather than later.  In fact, in September 23^rd, Spartan just announced that Fleetwood RV, Inc. will begin offering its 2010 Fleetwood RV brand Class on Spartan's custom diesel chassis. Delivery of the custom chassis to Fleetwood RV is scheduled to begin in this October[3]. This suggests an early return of motor home market demand. After analyzing Spartan’s products line by line, there is no apparent demand shortage was found in the mid to long term but a potential fast growing emergency vehicle market in the near term.

With diversified product lines, Spartan further diluted the risks encountering in the economic down turn. When its peers were screaming for the end of world, Spartan booked a record high 2008 revenue. Suppose that the growth is demand driven, the demand analysis suggests that Spartan’s revenue growth is sustainable.

 

  3.     It is trading around its book value with great liquidity and a strong balance sheet.

 

Based on adjusted financial statements, its adjusted tangible book value at the end of 2008 was $5.30. With unadjusted shareholder’s equity as of June 30 which is the latest information available the Book Value per share in June 30^th was $5.49 which is also its market closing price at Oct.12^th 2009. Since the finished financial statements adjustments haven’t make material difference on any single year’s book value, SPAR apparently is trading around its book value. Regardless its potential growth and profitability its book value already worth the market price.  

Spartan has great liquidity as Form 2 illustrated. During the 2004 to 2008 period, the interest coverage ratio ranged from 13.6 to 33.8 which is extremely safe. The current ratio is among the highest in the industry and it is still growing. And the quick ratio is high and stable.  Consequently SPAR will keep obtaining low borrowing rate.

Liquidity ratios	2004	2005	2006	2007	2008
Free Cash Flow/Share $	0.00079	0.08308	1.26675	-1.0396	0.846037
Current Ratio	2.67	2.77	2.82	2.09	2.93
Acid Test (Quick Ratio)	1.45	1.38	1.40	1.22	1.43
Acct. Rec./Acct. Pay.	1.68	1.78	2.04	1.46	3.49
Working Cap./Total Assets %	73.35%	76.89%	80.56%	79.41%	70.46%
Long-term Debt/Common Equity	0.19%	1.55%	23.69%	49.05%	9.51%
Total Debt/Common Equity	0.20%	1.62%	24.18%	49.46%	15.61%
Interest Coverage	24.54	89.73	72.67	22.70	30.51

Form 2 Liquidity ratios

More importantly, SPAR has a conservative capital structure policy. Although it has grown fast its debt to total capital has remained at the lowest level among its competitors. This gives SPAR huge potential to improve its WACC in the future when it feels necessary to increase its leverage. From investors’ perspective this means potential intrinsic value increase in the future.

	2004	2005	2006	2007	2008
Total Debt/Common Equity	0.20%	1.62%	24.18%	49.46%	15.61%

  Risks

 

Among Porter’s five forces the bargaining power of SPAR’s customers is too strong which is also considered the major risk for investing SPAR. As the customers usually buy large volumes and they are concentrated, their bargaining power is strong which in turn limits SPAR’s profit potential i.e. ROIC. As the top three customers accounted for 65.5%[4] of its total revenues in 2008 any negative change on these major customers’ relationship will have huge effect on its revenue.

Another risk is that its revenues depend on the U.S. Government too much. In 2008, more than 66.0% of revenues were derived from U.S. Government contracts and subcontracts for military drive train integration, vehicle final assembly and service parts[5]. This imposes SPAR at uncontrollable U.S. Government policy risk.

  Historical Financial Performance Analysis

 

Financial performance highlights:

·        SPAR has the highest ROIC in the industry. And the ROIC is still growing.

·        SPAR has the highest 5 year revenue growth rate in the industry.

Screens	2004	2005	2006	2007	2008
ROIC	13.0%	11.8%	17.0%	13.5%	23.8%
Earnings per Share $	0.32	0.34	0.67	0.74	1.45
Earnings Growth %	31.6%	9.8%	29.8%	53.1%	23.8%
Tangible Book Value/Sh $	2.52	2.87	3.49	3.90	5.38
Cash Flow/Share $	0.29	0.44	0.44	0.70	0.85

 

·        SPAR has the lowest leverage in the industry.

·        SPAR has the extremely high interest coverage ratio to get low borrowing rate.

Liquidity	2004	2005	2006	2007	2008
Free Cash Flow/Share $	0.09	0.00	-1.04	-1.09	1.20
Cash Flow/Total Debt %	1.20	1.16	0.65	0.38	1.53
Current Ratio	2.62	2.71	2.82	2.09	2.93
Acid Test (Quick Ratio)	13.05	17.07	29.50	43.49	19.56
Acct. Rec./Acct. Pay.	1.68	1.78	2.04	1.46	3.49
Working Cap./Total Assets %	43.7%	46.7%	50.6%	41.0%	46.2%
Long-term Debt/Common Equity	14.8%	13.8%	32.8%	56.2%	14.6%
Total Debt/Common Equity	14.8%	13.9%	33.3%	56.6%	20.7%
Interest Coverage	13.63	19.96	33.84	17.15	28.83
D/D+E	12.9%	12.2%	25.0%	36.2%	17.2%

 

·        SPAR has the highest margin in the industry. And it is still growing.

·        SPAR has the highest ROE in the industry.

Earnings Quality Model	2004	2005	2006	2007	2008
Profit margin	2.90%	2.88%	4.62%	3.58%	5.57%
Asset Turnover	2.75	2.65	2.27	2.13	3.21
Leverage	1.57	1.56	1.84	2.50	1.51
ROE	12.53%	11.95%	19.35%	19.08%	26.95%
retention	58.84%	89.34%	34.43%	54.13%	94.37%
sustainable growth	7.38%	10.68%	6.66%	10.33%	25.44%

 

Profitability & Efficiency %	2004	2005	2006	2007	2008
Operating Margin	4.47%	4.49%	7.24%	5.86%	8.95%
Pre-tax Margin	4.32%	4.52%	7.26%	5.62%	8.72%
Net Profit Margin	2.90%	2.88%	4.62%	3.58%	5.57%
Return on Equity	12.53%	11.95%	19.35%	19.08%	26.95%
Return on Assets	7.97%	7.64%	10.52%	7.63%	17.89%
Return on Inv. Capital (average invested capital)	13.0%	11.8%	17.0%	13.5%	23.8%

  Target

 

Above all, SPAR is profitable, fast growing, and trading at a discount. Investing SPAR is investing profit (ROIC) and sustainable growth (NOPLAT) at a bargain price (P/B).

Despite of the cyclical nature of SPAR, the valuation model used projected revenue by linear regression. As 2009 is an extreme case in which the real FCF will be much lower than projected one, the calculated equity value is less accurate without adjustments on the FCF difference. It is hoped that in 2011 the economy will back to normal level. So the result at the beginning of 2012 is more trustworthy. Adopting Residual Income model, SPAR’s intrinsic value at the end of 2011 (2 years later) can be obtained at $7.95. The catalyst for its upward move however will be the passing of President OBAMA's new Healthcare plan.

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  Sensitivity analysis

 

The sensitivity test result proved that the most influential factor to SPAR’s intrinsic value are operating expense/rev and borrowing and equity cost. PPE’s economic life also plays significant weight. The uncertainty in this figure gives the management space to cook the book. Further due diligence on PPE is needed to get the real figure on its economic life. The results again confirmed the correctness of SPAR’s strategy: increase ROIC by decreasing operating expense/rev’s i.e. managing costs. This strategy will bring additional return to investors. In addition, using more leverage to decrease WACC is another important way for SPAR to increase its intrinsic value. Coincidentally, SPAR announced new COO and CFO this year aiming to further strengthen these two critical areas for SPAR. SPAR is right on the track.

	No. Description of scenario	DCF 2012	difference	RI 2012	difference
Base case		$7.99	0.00%	$7.95	0.00%
10.80%	nominal growth + 1% from 2009	$8.07	1%	$8.18	2.89%
92.10%	− 1% [operating expenses/revenues] from year 2009	$10.24	28.16%	$9.78	23.02%
0.23	Capital intensity factor K 0.18 rather than 0.23	$9.17	14.77%	$8.84	11.19%
18.95	Economic life n of PPE 15 rather than 19 years	$7.36	-7.88%	$7.41	-6.8%
	interest rates (borrowing and equity) -1% from 2009	$9.20	15.14%	$8.97	12.83%

Sophisticated investors in china market were taught how to interpret various warning signs from the government correctly and act accordingly. When they study the historical china market patterns they can always find there are almost no exceptions that the correlation between various warning signs from the government and the following market performance are very strong as Figure 1 and Figure 2 illustrated. The latest and the most famous example is the one between 2006 and 2007 when the Shanghai Composite Index (000001.SS) rose from 998 to its all time high 6124 in two years. Over liquidity was blamed for the surge. The government rose ten times deposit reserve ratio within one year to reduce liquidity. The market reacted by a free fall from 6124 to 1706 in the following year. Then the government imposed four times rises on the same ratio since September 2008. The following market surge proved this correlation again.
No matter how cautious it is, however, the government started to send out warning signs. Yesterday, one week after the assurance of the loose monetary policy, not surprisingly, the central bank changed its tone. The first time since recession, it emphasized a future minor adjustment on its loose policy. Neglecting the adjective “minor”, we can now safely say if the history repeats the bull markets is near its end.