Shares of Paccar (PCAR) have seen some pressure this past week despite an upgrade from analysts at Global Hunter who believe that shares deserve a premium valuation thanks to very strong execution through the cycle, the strict cost control and solid balance sheet.
I like the shares for the long run as well, as I don't think that this is a great time to initiate a position given the fact that shares trade near their highs, having seen a great momentum ride from October's lows. I am awaiting a further correction before initiating a position.
Hunter Believes A Premium Valuation Is Warranted
Michael Shlisky, analyst at Global Hunter initiated his rating on Paccar, immediately placing a buy rating and $78 price target to the stock, calling it a top pick.
Shlisky is quick to admit that shares trade at their highs, and actually at multi-year highs while favorable industry conditions are not likely to last forever.
He sees Paccar as a mature operator, being able to execute well in both downturns and upturns. Shlisky refers to the solid performance under the extreme conditions seen in 2009, and expects that the company can maintain its payout ratio of roughly 50% in terms of dividends. On top of that, the company has the ability to generate free cash flows to fund both investments to grow as well as make share repurchases.
As a result of this robust performance through the cycles, anticipated growth and higher engine penetration, Paccar deserves a premium valuation versus its peer group in Shlisky's eyes. As a result he applies a 18 times expected earnings multiples on 2015s earnings which translates in the $78 price target, while applying a 16 times multiple to the peer group.
Paccar's Improving Position
Paccar has focused heavily on the quality, technology and innovation of its products. The company has some very strong brands including Kenworth, Peterbilt as well as DAF. This makes the company the 6th largest truck producer of the globe in 2013, according to the company's most recent presentation. The market is still dominated by some large European players including Daimler, Volvo, Volkswagen as well as some Chinese players.
The consistent focus on quality and innovation has resulted in stable results as well as growth, with the company having been profitable for 75 straight years in a row, as the company has hiked its dividend every year since 1941. In 2009 sales fell by 46% to just $8.1 billion. Despite this dramatic fall in sales, the company managed to squeeze out a tiny profit of $112 million that year.
While building trucks is the core business of Paccar, the company focuses strongly on IT, aftermarket support and financial services as well. The company relies heavily on the operations in Europe and the US in which sales have been volatile over the past decades, not having approached the highs before the crisis yet. South America has been a real growth engine, with the company steadily increasing production to some 150,000 units per year.
This strong performance is reflected in a compounded annual growth rate in terms of sales of 5% over the past decade as operating margins of roughly 11% are very solid as well. Volvo (OTCPK:VOLVY), reported a CAGR of just 3% while its margins come in at just 3-4%. Daimler (OTCPK:DDAIY), known from its Mercedes trucks, managed to grow sales at a similar pace as Paccar, while its margins trail those of Paccar, coming in at just 8% of sales. Volkswagen (OTCQX:VLKPY), which is the producer of Scania and MAN, managed to more than double its sales over the past decade, translating into annual growth of 8-9% per year. Consolidation and rapid growth of its automotive operations in China have been driving these results. Operating margins of the largest car company come in around 6% of sales currently.
It should be stressed that these three major European-based competitors have suffered from relative weak economic growth at home, as they have large regular automotive operations as well, which contrasts to Paccar, essentially being a pure player on trucks. Despite these headwinds for the European manufacturers, growth and notably margins of Paccar are very strong, as its trucks are in greater demand resulting from a relentless focus on quality and innovation. On page 22 of the 2013 annual report, Paccar claims that its market share in Europe has risen from less than 13% in 2004 to 16.2% in 2013. In Northern America, Paccar's market share has improved from little over 24% to 28% within the same time frame. The focused strategy has paid off in recent years, something expected to continue going forwards.
Operational Momentum Continues
In October, Paccar released its third quarter results which showed that revenues reached a quarterly record. Truck, parts and related sales were up 15.4% to $4.62 billion. Gross margins came in at 13.3% of sales which marked a 40 basis point improvement thanks to the increase in sales.
While these margins appear small versus gross margins reported in other industries, Paccar has a very lean cost structure. R&D expenses actually fell to $50.5 million, making up nearly 1.1% of sales as selling, general and other administrative costs of $112.4 million are the equivalent of just 2.4% of sales. As a result, the manufacturing side of the business generates earnings of close to $450 million per quarter.
Actual truck sales totaled $3.81 billion for the quarter on which Paccar posted operating earnings of $330 million, for margins of 8.7% of sales. Parts make up just $784 million in revenues, but this business is very profitable. Paccar earned $128 million on the sale of parts, resulting in impressive margins of 16.3% of sales.
The financing unit reported a 4.2% increase in sales to $305.9 million. Financing costs make up the vast majority of the unit's costs. The operating costs of the unit are quite low as well, as have been the loan loss provisions of less than $5 million for the quarter, resulting in earnings of nearly $97 million for the business unit.
Strong Balance Sheet, Fair Valuation
Paccar is relatively conservatively financed. The company holds $2.9 billion in cash and equivalents as the manufacturing side of the business has no debt outstanding. That said, the financial service business has liabilities of $9.5 billion which is large, although the company stresses the low default rates on those debts.
At the moment, Paccar has 356 million shares outstanding which at $68 per share translates into a market valuation of roughly $24 billion. After backing out the near $3 billion net cash position of the manufacturing business, this translated in operating assets being valued at $21 billion, assuming the financing liabilities are covered.
On a trailing basis, Paccar has now posted sales of $18.5 billion on which it has reported EBITDA of nearly $3 billion and net earnings of $1.3 billion. This implies that the business is valued at 1.2 times sales, just 7 times EBITDA and roughly 16 times earnings. It is difficult to make direct comparisons to some of its major competitors in terms of the valuation multiples, given that these players often have very large auto manufacturing operations as well.
Paccar is a cyclical player, with a long term underlying trend for revenue growth resulting from the focus on innovation and quality, as a great focus on operational excellence allows for earnings even in the most difficult years. Over the past few years, shares have recovered from the lows of $25 during the crisis to recent highs at $70 per share in the past week. The recent momentum followed the lows of $56 set in October's sell-off.
What is noteworthy is that Paccar has bought back roughly 10% of its shares over the past decade, yet it has cut back the pace of share repurchases recently with the share base being flat over the past three years.
For now the company is enjoying excellent momentum as quarterly sales approach the $5 billion mark, or close to $20 billion per yea when annualized. The strong economic conditions in the US are a real driver behind the results. That said, shares still trade some 15% above the lows of October, with investors wondering if the anticipated turmoil in the energy sector can spill over to the transportation and the industrial complex, thereby directly impacting Paccar's business.
As such I don't feel that now is the right time to initiate position given the potential impact of further worries about the state of the global economy on the share price, as I fully agree that the long term valuation creation, lean cost structure and strong balance sheet offer appeal.
As such I like shares for the long run, yet I am not willing to pick up shares at current levels, hoping for a re-test of October's lows.
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.