Is Generac Holdings a growth trap? (Part 1 of 2)

Value Investing Case Study 18-1: I first analyzed Generac for Seeking Alpha in Jul 2021. At that juncture only the Q1 2021 results were available. Since then, the company has released its Q2 2021 results. This post incorporates the latest quarterly results. 
 
Is GNRC a growth trap?

As of 11 Aug 2021, Generac Holdings Inc (GNRC or the Group) was trading at USD 423.32 per share compared to its Book value of USD 26.64 per share (as of 30 Jun 2021). 

This is equal to a Price to Book of 15.9. This is about 2.5 times the electrical equipment industry Price Book multiple of 6.3 (Source: Damodaran Jan 2021).

The price of GNRC at the end of Dec 2020 was USD 227.41. The price had grown by about 86 % over the past 7 months.

A high Price Book multiple is commonly associated with a growth stock. From 2010 to 2020, GNRC revenue had grown at a CAGR of 15.4 %. 

Is the price growth over the past 7 months justified or is GNRC a growth trap? A growth trap is a stock that appears to have strong growth potential. But the strong growth is illusory.

To determine whether a company is a growth stock you need to dig deeper. Looking at metrics superficially can be misleading.

Join me in a 2-part series as I argue why GNRC is a growth trap. Part 1 is presented here while Part 2 will be published a week later.

Should you go and short the stock? Well, read my Disclaimer.


Contents

  • Is there Anything Special about the Group’s Expertise?
  • Is there Concern about how it Uses its Funds?
  • Is the Current Performance Outstanding?
  • Tracing the Group’s Rich and Unique History
  • Is there a Great Future?
  • Pulling it all together
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Is there Anything Special about the Group’s Expertise?

Power generation and storage are the key focus of the Group. Its success is built on its engineering expertise, manufacturing excellence, and innovative approaches.

Founded by Robert Kern in 1959, GNRC soon began producing portable generators for Sears, Roebuck, and Co. Over the next few decades, the Group expanded its product offerings. It also went through some corporate exercises to shape it into what it is today.
  • During the 1970s, the Group expanded its offerings in the portable and recreational vehicle markets. 
  • In the 1980s the Group expanded beyond portable generators. It entered the commercial and industrial markets with its backup power generation systems.
  • In 1992, GNRC began private labeling generator sets for Caterpillar, Inc. This was terminated in 1996 although the Group challenged this in court for several years. 
  • In 1998, GNRC sold its portable products division. Upon expiration of a non-compete agreement related to the sale, the Group re-entered the portable generator market in 2008.
  • In late 2006, GNRC was purchased by CCMP Capital of New York. CCMP partnered with management to invest in R&D, product line extensions and expanded distribution. This resulted in significant revenue and EBITDA growth, followed by a successful initial public offering in 2010.

The Group is today a leading global designer and manufacturer of a wide range of energy technology solutions. The Group provides power generation equipment, energy storage systems, and grid solutions. It also supplied other power products for the residential, light commercial, and industrial markets.

The Group segments its business by its products as well as by regions:
  • Products - Residential, Industrial & Commercial, and Others.
  • Regions - Domestic (the US and Canada) and International.

In 2020 the US and Canada accounted for about 84 % of the Group’s revenue. According to the Group, it has:
  • A significant market share in the residential and light commercial markets for automatic standby generators. GNRC had stated that it had 75 % of the home standby market.
  • A leading market position for portable generators used in residential, light construction, and recreational applications. 

Is there Concern about how it Uses its Funds?

As of the end of Jun 2021, the Group had a Total Capital Employed (TCE) of USD 2.7 billion. Shareholder’s fund accounted for 61 % of the TCE with the balance from debt (including leases).

This is equal to a book debt to TCE ratio of 39 % compared to the US electrical equipment industry average of 49 % (Industry source: Damodaran Jan 2021).

GNRC Sources and Uses of Funds
Table 1: Sources and Uses of Funds June 2021

About 86 % of the TCE has been deployed for the operations with the balance tied up mainly in cash.

GNRC Capital Structure and Uses of Funds
Chart 1: Sources and Uses of Funds

GNRC is unusual for a brick-and-mortar company.  As of the end of Jun 2021, about 42 % of the Total Assets are in the form of intangibles - customer lists, patents, tradenames, and goodwill.

The Group did not provide a breakdown of the TCE by its products or regions.  However, it did provide a breakdown of the Total Assets by region. In 2020, about 82 % of the Group Total Assets are in the Domestic segment.

Its debt to TCE is currently below the industry level.  But the Group’s cash position is a bit high.  Its current cash to firm value is 14 % compared to the electrical equipment industry average of 5 % (Source: Damodaran Jan 2021).

GNRC Debt Equity
Chart 2: Debt to Equity & MI

In terms of borrowings, the Group has managed to bring down the Debt-Equity ratio from its peak in 2013 to 0.7 in 2020. 
  • In 2012 the Group amended and restated its existing credit agreement. Part of the loan was used to repay the previous credit agreement as well as to fund a USD 6 per share dividend.
  • In 2013, the Group undertook another amendment to the credit arrangement.  It increased the total amount to USD 1.2 billion term loan and USD 300 incremental million loan facility. Part of the money was used to repay the amount outstanding under the previous credit arrangements as well as to fund a USD 5 per share dividend.

Is the Current Performance Outstanding?

For the 6 months ended June 2021, the Group achieved USD 1.73 billion of revenue with USD 278 million PAT. For the same period last year, the Group achieved revenue of USD 1.02 billion with USD 107 million PAT. 

Revenue grew by 70 % while PAT grew by 160 %.

Domestic sales grew at 77 % for the first half of 2021 compared to the same period last year. This was driven by the growth of residential products highlighted by home standby and portable generators. 

The increased sales volume and related favorable sales mix resulted in the increase in the PAT for the first half of 2021.

The growth in the half-year revenue and net income is in line with the long-term trends as can be seen from the Performance Index chart below.

GNRC Performance Index
Chart 3: Performance Index
  • Over the period from 2010 to 2020, the Group revenue grew at a CAGR of 15.4 % while net income grew at a CAGR of 19.8 %.
  • The jump in profit in 2011 is due to a USD 237.7 million tax benefit. This was for a reversal of valuation allowances recorded on the net deferred tax assets.
  • The drop in PAT in 2015 was partly due to the decline in revenue, higher tax rate, and a one-off impairment charge of USD 40.7 million. There was also a USD 16.1 gain in the prior year due to a reduction in borrowing costs. 
  • Since 2012, gross profitability had ranged from 1.32 to 1.61 of the 2010 level. 

GNRC monitored segment performance based on EBITDA.  But the Group only provided segment performance by regions and not product categories. Based on the regional data, we can see that the Domestic market contributed the majority of the profits and return.

GNRC EBITDA/Total Assets
Table 2: Segment Performance
Note
(a) Average EBITDA / Total Assets

The Group has been able to improve its ROE from 13 % in 2010 to 24 % in 2020. This has come from improvements in the operating efficiency and use of assets despite a reduction in leverage. Refer to the DuPont analysis chart shows.  
  • The Group achieved about 50% improvement in the profit margin and asset turnover.
  • At the same time, there was about a 20% reduction in leverage.
GNRC DuPont Analysis
Chart 4: DuPont Analysis

Case Notes

According to Investopedia, the DuPont analysis is a framework for analyzing fundamental performance. This was popularized by the DuPont Corporation.  

DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE). The decomposition of ROE allows investors to focus on the key metrics of financial performance. You can then identify the individual component's strengths and weaknesses.

The Dupont analysis is an expanded return on equity formula, calculated as follows

ROE = PAT / Equity

         = (PAT / Revenue) X (Revenue / Total Assets) X (Total Assets / Equity)

         = Profit Margin X Asset Turnover X Leverage

The analysis showed that are three major financial metrics that drive ROE. These are operating efficiency, asset use efficiency, and financial leverage. 
  • Operating efficiency is represented by net profit margin. It indicates the amount of net income generated per dollar of sales.
  • Asset use efficiency is measured by the asset turnover ratio and represents the sales amount generated per dollar of assets.
  • Leverage is measured by the equity multiplier.

The first two components assess the operations of the business. The larger these components, the more productive the business is. However, depending on the industry, Profit Margin and Asset Turnover tend to trade off with each other.

The last component, Leverage, captures the company’s financial activities. The more leverage the company takes, the higher the risk of default.

As you can see, fundamental analysis is more than just using some formula. There are choices to be made in terms of which approach to use.

So, if you are just starting out to analyze and value companies, it may be helpful to supplement it with third-party analyses and valuation.  

There are several financial advisers who provide such analyses. 

Those who do this well include people like Seeking Alpha.* Click the link for some free stock advice. If you subscribe to their services, you can tap into their business analysis and valuation.




Tracing the Group’s Rich and Unique History

Over the past 11 years, the revenue of the Group has grown from USD 593 million in 2010 to 2,485 million in 2020 equivalent to a CAGR of 15.4 %. 

This was driven by a combination of organic growth and acquisitions. During this period, the Group spent USD 375 million on CAPEX and USD 701 million on acquisitions. This is equal to a 0.54 ratio between CAPEX and acquisitions.

There have been acquisitions every year.  So it is difficult to separate the revenue growth into those due to organic growth and those due to acquisitions.

As can be seen from the chart below, part of the revenue growth was due to the increase in the Total Assets.  From 2010 to 2020, there is a 0.96 correlation between revenue and total assets.

GNRC Drivers of revenue growth
Chart 5: Drivers of revenue growth

Assuming that all the CAPEX is for organic growth, I apportioned the revenue growth between those due to organic growth as follows

= (15.4 % X 0.54) / 1.54

= 5.4 %

This is of course a back-of-envelop calculation. But it does give a sense of organic growth. There are limitations to such an analysis as the first few years of the period, there was also an increase in the Asset Turnover. This meant a more productive use of the assets.

In dollar terms, the bigger contribution was by the Domestic segment. But this was because the Domestic segment had a much bigger dollar value at the start.  When you consider the percentage growth, the Domestic segment achieved a CAGR of 14 % from 2010 to 2020. But the International segment achieved a CAGR of 30 %. 

GNRC revenue by regions
Chart 6: Revenue by regions

In terms of products, both the Residential and Industrial & Commercial categories had almost similar CAGR with 15 % and 14 %. 

Growth in the Industrial & Commercial categories and the International segment was due to acquisitions.

GNRC revenue by products
Chart 7: Revenue by its products

Before 2010, the main products of the Group were generators. It began to venture into the non-generator business in 2010.  It acquired Magnum Products, a supplier of light towers, mobile generators, and power units.  It further expanded its light tower business when it acquired Tower Light in 2013.

There was another major product diversification in 2019.  The Group acquired Neurio Technology and Pika Energy. The former was a leading energy data company and the latter is a designer and manufacturer of battery storage.

It further expanded into the energy service sector in 2020.  This was with the acquisition of Enbala Power Networks, one of the leading providers for power grid services.

Despite these diversifications, the bulk of the Group business is still tied to generators. This conclusion was based on the residential and industrial & commercial product sales.  

Is there a Great Future?

In its 2020 Form 10k, the Group identified the following mega-trends.  These will drive significant secular growth opportunities. These are 
  • Grid 2.0.
  • Climate change and abundance of natural gas.
  • Aging infrastructure in the US.
  • 5 G telecommunication.
  • Home-as-a-sanctuary or the work-from-home.

In looking at the prospects of GNRC, I would focus on the generator sector as this still accounted for the bulk of the Group revenue. Generators can be segmented into the following:
  • Types eg diesel, gas.
  • Application eg standby, continuous.
  • Power rating eg < 100 KVA, 100 to 350 KVA, 

The generator industry is still a growth sector.  Various market research companies projecting global growth over the next 5 to 10 years at greater than 5 % CAGR.
  • Statista estimated the US generator set industry to be USD 4 billion in 2017 with the global market as USD 20 billion. Diesel generators accounted for half of the market. 
  • Over the next ten years, the global generator market size is slated to continue its steady growth pace at a CAGR of over 5%.  Source: FactMR
  • The global generator sales market size was USD 20.31 billion in 2019. It is anticipated to reach USD 27.16 billion by 2027, exhibiting a CAGR of 5.7% during the forecast period. Fortune Source: Business Insights
  • The global generator sales market is projected to reach USD 26.5 billion by 2026 from an estimated USD 19.9 billion in 2021. This is equal to a CAGR of 5.9% during the forecast period. Source: Markets and Markets

It would appear that the growth outside the US would be faster than those in the US as illustrated in the chart below.

GNRC global generator growth
Chart 8: Global generator growth

To illustrate the different growth rates, I have compared global demand with those of the US for various generator segments.  These were based on data from the various market research reports. 
  • The global standby generator market reached a value of USD 17.4 billion in the year 2019. It is expected to garner a value of USD 19.3 billion by the end of 2025 by registering a CAGR of 4.9% across the globe over the forecast period 2021-2025. Source: Research Nester.
  • The North American standby generator market reached a value of USD 5.9 billion in the year 2019.  It is anticipated to reach a CAGR of 3.7% during the forecast period of 2021-2025. Source: Research Nester
  • The global diesel Genset market will grow from $13,8 billion in 2019 to $22.0 billion in 2030, at a 6.0% CAGR between 2020 and 2030.  This is due to the rapid digitization around the world. Source: Research and Markets
  • The North American diesel generator market is expected to grow at a CAGR of more than 2.5% during the forecast period.  Source: Mordor Intelligence
  • According to Precedence Research, the global portable generator market size is estimated at US$ 4.2 billion in 2020. It is poised to garner growth at a CAGR of 5.34 % throughout the forecast period and to reach a value of around US$ 7.0 billion by 2030.
  • The United States portable generator market reached a value of US$ 1.3 billion in 2020. Looking forward, IMARC Group expects the market to grow at a CAGR of 3.3% during 2021-2026.

As you can see, the US accounted for about 1/4 to 1/3 of the global market with growth rates less than the global ones. And the US generator growth rates seemed to be less than the long-term US GDP growth rate of 4.0 %

For the Group, it meant that revenue growth from 2010 to 2020 is due to its acquisition. It gained market share.

While it had a significant share of the US market, the Group still believed that there are growth opportunities in the US. This is because there is only about 5 % penetration of the addressable market of homes.

Pulling it all together

GNRC revenue grew at 15.4 % from 2010 to 2020. This was driven by both organic growth as well as acquisitions. I estimate that about 1/3 of this growth was due to organic growth while the balance was due to acquisitions.

The Group has been able to fund its growth from internally generated funds and the Debt-Equity ratio had come down from a peak of 3.8 in 2013 to 0.7 in 2020.

At the same time, the Group had been able to increase its ROE from 13 % in 2010 to 24 % in 2020. 

The Group is fundamentally strong. This is due to its low debt to firm-level compared to that for the electrical equipment industry as well as strong growth in the ROE.  

The generator sector is not a sunset industry and there is potential for the Group to grow both the domestic and international market.

These are not the signs of a growth trap. However, a definitive answer will depend on its valuation.  

Join me in Part 2 as I further explore further whether GNRC is a growth trap.



End of Part 1 of 2

Part 2 of 2 will be published on 22 Aug 2021



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I am not an investment adviser, security analyst, or stockbroker.  The contents are meant for educational purposes and should not be taken as any recommendation to purchase or dispose of shares in the featured companies.   Investments or strategies mentioned on this website may not be suitable for you and you should have your own independent decision regarding them. 

The opinions expressed here are based on information I consider reliable but I do not warrant its completeness or accuracy and should not be relied on as such. 

I may have equity interests in some of the companies featured.

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