There's a marked contrast between the passenger and commercial vehicle sectors now, with ample worries that the former is peaking and growing hopes that the later is bottoming out. As a commercial components player, the prospect of improving market conditions is bullish for Meritor (NYSE:MTOR), although 2017 is likely to still be a challenging year.
What's more interesting about Meritor is the bold targets that management has laid out for growth over the next few years, including 20% outperformance relative to the underlying markets. Although I don't believe Meritor will get there without M&A (which I don't model), it has been building a much better track record for itself in recent years, and I don't dismiss the possibility that the company will do better than expected. That said, today's price already seems to assume meaningful improvement at the company, and it may make more sense on a risk/reward basis to wait in the hopes of temporary disruptions or disappointments creating a more opportune entry price.
Basic Components For Commercial Vehicles
Relative to many other companies in the vehicle components space, Meritor's business is pretty straightforward. The company is principally a supplier of axles and brakes for commercial vehicles, with other products (drivelines, undercarriages, suspensions) and markets (aftermarket, trailers) also factoring into the mix.
Within axles, Meritor is the leading supply of heavy-duty truck drive axles in North America, Europe, South America, and some of Asia-Pacific (India and Australia), and the company is also a strong player in commercial vehicle brakes (#1 in North America and South America, #2 in Europe). The large majority of this business comes from the heavy-duty truck market, as the company presently only has a modest presence in medium-duty trucks (around 15% share in North America) and an even smaller presence in off-highway vehicles like construction, ag, and mining equipment (less than 5% worldwide, and very little in North America).
Dana (NYSE:DAN) and American Axle (NYSE:AXL) are both competitors to Meritor in its core axle business, but neither is as committed to the commercial vehicle market as Meritor (though Dana's off-highway business is larger). While I would argue that Dana does a better job of communicating to the Street regarding product innovation, I wouldn't say that Meritor is just standing pat - like Dana, Meritor has been rolling out axle products that are lighter and more fuel efficient, and the company has also been devoting resources to developing electric drivetrains for electric and hybrid commercial vehicles. All of that said, competing with internal sourcing (like Daimler's (OTCPK:DDAIF) Detroit Axle) remains a significant competitive factor for Meritor, but it is something that vehicle component suppliers (particularly commercial and off-road suppliers) just have to deal with.
On the brake side of the business, Meritor competes largely with Brembo (OTC:BRBOF), Knorr-Bremse, and WABCO (NYSE:WBC), although the company also has a joint venture with WABCO for advanced safety equipment like ABS and automated crash avoidance systems.
Bold Growth Targets Will Be Hard To Reach
Having successfully completed the company's "M2016 Initiative" strategic plan, Meritor is now working on a new set of targets ("M2019") aimed at driving meaningfully higher earnings for shareholders. In addition to looking for ongoing margin improvement and financial deleveraging, management is looking to generate 20% revenue outperformance versus its underlying markets. In addition to new products and new markets, Meritor is looking to achieve this through expanded relationships with key customers, an expanded components business, and improving aftermarket share.
I have my doubts about whether management can achieve these targets, particularly without turning to M&A. New products include axles for the medium-duty market, a target market that should be worth more than $1 billion (in addressable dollars) to the company and where its current share is modest (around 15%), and new products for the off-highway market (an addressable opportunity worth close to $5 billion). I'm actually somewhat bullish on the off-highway opportunity, although Meritor will have to convince OEMs to turn away from internal sourcing in many cases, the company's know-how in heavy trucks is transferable. Building up its single-digit share in the air disc brake market would also offer Meritor tens of millions of dollars in incremental revenue opportunities. As for expanding the components business, the market opportunity is there, but I'm not sure how much the company can do internally in a relatively short period of time.
New market opportunities include developing a bigger presence in China. While the axle business has done well in markets like India, the company hasn't established itself so well in the Chinese truck market. There are existing competitors (like Weichai (OTCPK:WEICY)) to deal with, but I do think this is a market where Meritor can reasonably expect to have some success. The company's policy of manufacturing close to its markets should help mitigate some of the price/cost issues in competing with domestic Chinese suppliers.
Expanding business with existing customers is a more interesting debate to me. Even though Daimler has its own in-house capabilities, Meritor does still generate meaningful revenue from Daimler, and the company has shown that it can be opportunistic, taking business from Dana at PACCAR (NASDAQ:PCAR) when Dana's supply chain reorganization efforts compromised its ability to meet PACCAR's needs. My concern here, though, is that I'm not sure Meritor is positioned to offer technology and capabilities that its potential customers can't match in-house; I don't want to say that "an axle is an axle is an axle," but I think it may be a challenge for management to convince more heavily in-sourced potential customers to bring Meritor into the mix.
These are challenging times in the commercial vehicle market (at least in North America, Europe, and South America), but I have found that Meritor's management is usually pretty realistic about market conditions and near-term prospects. More to the point, while 2017 is not going to be a great year, I think the markets will start to improve and offer growth potential again in 2018. That could make Meritor an interesting play relative to those component suppliers targeting passenger vehicles. While Meritor's key markets may be bottoming out, it seems unlikely that the passenger market is going to continuing growing in the near term. I'd also note that Meritor could be looking at a "two birds with one stone" opportunity in the off-highway space if it can win business as markets like construction, mining, and ag start to recover.
As I said, I'm not assuming that Meritor can reach its revenue growth goals, but I do believe it can keep adjusted EBITDA margins in the double digits. My modeling assumptions work out to long-term revenue growth of 3% to 4%, and I believe the company's efforts to improve its margins and operating efficiency in recent years will start to translate into better free cash flow production. While Meritor's track record with free cash flow generation is poor (as is pretty common in this space over the past decade), I think improvement into the 3-5% range on a sustained basis is possible, and that can drive mid- to high-single-digit FCF growth.
Discounting those cash flows back, Meritor looks pretty fairly valued to me today. The shares have done extremely well over the past year and are up almost 60% from the time of the election. While I understand that many investors may think the new administration will push policies that drive better economic growth, I don't think the real outlook for the commercial vehicle market has improved as much as that stock move would suggest. Consequently, I think expectations may be excessive now, and I would note that other valuation approaches like EV/EBITDA and margin-driven EV/revenue suggest quite a bit of optimism.
The Bottom Line
I am bullish on the prospects for Meritor to take advantage of opportunities in markets like medium-duty trucks and off-highway vehicles, and I think management can do more to improve margins and the company's financial leverage (it has too much debt today). That said, it's hard for me to reconcile the recent move in the shares with the fundamental picture, so I'd be inclined to wait on this one in the hope that the enthusiasm fades and leads to a better risk/reward balance on the shares.
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