As Top Ideas go, Miller Industries (NYSE:MLR) hasn't really worked out so far. Up about 13% since my original late September piece, the shares have done alright compared to Spartan Motors (NASDAQ:SPAR) and Oshkosh (NYSE:OSK), but they've lagged the S&P 500 and Supreme Industries (NYSEMKT:STS). While none of these are particularly good comps (Supreme is more focused on truck bodies, Spartan on emergency response and delivery vehicles, Oshkosh on aerial work platforms, defense, and fire/rescue/refuse), I think the problem is that access to capital for small businesses (and most towing companies are smaller businesses) is still limited and Miller is an illiquid stock with no sell-side support.
I still believe this is a stock that can generate market-beating returns over the long term. Double-digit revenue growth is not the "new normal", but catch-up/replacement spending should generate above-market growth for a few years and the company's offshore growth efforts offer meaningful upside. I'm not looking for particularly ambitious margin improvements, but I think the shares are about 20% undervalued today.
Catch-Up Growth Driving The Story
Since my March 6 article, Miller has delivered a couple of good quarters. Revenue in the first quarter rose almost 23% and the company followed it up 16% yoy growth (and 17% qoq) in the second quarter. While the prior year comp wasn't challenging for the first quarter (down more than 10%), the second quarter comp (up 21%) was more challenging and more in line with normalized performance. The growing European business is helping, but the 14.6% yoy growth in North America sales (almost 85% of total sales) is quite solid in its own right.
As is always the case with Miller, comps are problematic. Oshkosh's Jerr-Dan towing business is blended into "Other" within Commercial and the company rarely talks about the business. Extrapolating from past numbers, I believe the towing business is about 75% of this category, a category which grew external revenue by 39% in the June quarter and about 20% over the past nine months (versus approximately 23% growth at Miller over the same three quarters).
Management at Miller doesn't track (or at least doesn't report) sales by customer type, so it is hard to say whether larger customers or smaller "mom and pop" operators are driving this recovery. Miller's business has historically skewed more toward professional towing operators and towing industry magazines suggest that larger players are doing pretty well. As I said before, though, one of the limiting factors has been access to capital - interest rates remain low and there's supposedly a lot of competition for commercial lending on the part of banks, but smaller operators continue to report some challenges in getting access to capital to grow their business.
All of that said, there's still a replacement cycle to drive the story. As companies like Oshkosh, Spartan, and Dover (NYSE:DOV) have seen, weaker economic conditions during the recession led many operators in the refuse, fire, and emergency vehicle markets to delay fleet replacements and upgrades. In the case of towing, business failures may have supplied the market with secondhand alternatives, but it now looks like replace/refresh demand is showing up - Miller referred in its second quarter to ramping up production to deal with incoming orders.
Where Can The Margins Go?
Miller has yet to see a solid gross margin recovery to go along with its revenue recovery. While gross margins were in the 11% to 12% range in 2012 and 10% to 11% in 2013, the 10.5% and 10.2% gross margins in the first and second quarter of this year aren't exciting. Management previously referred to a product mix shift that has skewed to lower-margin chassis and that hasn't reversed. It was also a little disappointing to hear management comment on its second quarter earnings call that gross margin could "expand somewhat". Obviously there could be different interpretations of magnitude and timing, but to me that does not sound like a return to 14%-plus gross margin is imminent (and it is not in my model).
Miller has been doing well with controlling SG&A expenses, though, and that is supporting some positive momentum in operating margin - while second quarter gross margin was down 86bp, the operating margin improved 24bp. I expect the company to continue to run a tight ship, but I don't expect operating expenses to decline much further as a percentage of sales, as the company will need to spend to support the revenue growth I expect.
What it all boils down to is my expectation that Miller should be able to add about two to two and a half points to operating margin over time, but I think 6% to 7% is about as far as the company will go. That, in turn, doesn't support stellar free cash flow margins (in the 4%'s), but those margins aren't that bad by the standards of the comp group (including Oshkosh and Spartan).
A Tough Wait For Value
There are realities to owning Miller shares that go beyond the financials that readers need to consider. No sell-side analysts follow Miller (or at least the analyst estimate aggregators show "zero") and the relatively low trading volume doesn't make it an attractive candidate to follow. Likewise, with low volume and no sell-side coverage, Miller is going to be effectively off-limits for many buy-side investors.
There is another potential sources of upside that goes beyond just waiting for the market to realize the value here (from/for those institutions willing and able to buy the shares). I think Miller would be a solid acquisition candidate for a company like Dover, particularly if a buyer believes they can generate better gross margins.
The Bottom Line
The changes in my model relative to my last update haven't changed the underlying value all that much - revenue has come in a little stronger than I expected, while gross margin has been a little weaker. I've increased my per-share DCF-based value by about $0.25, but instead of slightly rounding up to a $23 target, I now slightly round down to $23.
A fair value of $23 still makes Miller worth exploring in my opinion. This is a name that will take patience, though, so readers who want or expect a lot of market-moving news from their holdings may want to pass this one by. For patient investors, though, this still looks like a good play on an improving market with upside from overseas expansion and margin leverage.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.