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

Value Investing Case Study 18-2: 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. In Part 1, I focused on the company analysis. Part 2 here focuses on management performance and valuation.

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).

The stock price of GNRC had grown by 86 % over the past 7 months. What drove the price growth?

Over the period from 2010 to 2020, the Group revenue had grown at a 15.4 % CAGR. For the 6 months ended June 2021, the revenue had grown by 70% compared to the same period last year. PAT for the period had grown by 160 %.

Is the market looking at these and concluding that GNRC is a growth stock?

Join me as I showed that this growth is not sustainable. GNRC is a growth trap at the current price. A growth trap is a stock that appears to have strong growth potential. But the strong growth is illusory.

I had in Part 1 shown that there are bases for the growth. But when investing, growth should be not seen as independent of the valuation. Whether a growth stock can be a good investment should be based on comparing its price with its intrinsic value.

I will pursue such an analysis here under Part 2 of this series.

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

Did Top Management Seize Opportunities?

Is there an Awesome Buying Opportunity?

Will there be Spectacular Growth in Shareholders’ Value?

How to Secure Your Investment by Minimizing Risk

Pulling it all together

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Did Top Management Seize Opportunities?

The Board comprises 10 members. The Executive Chairman is the only Non-Independent Director. The age of the Board members ranged from 49 to 70 with an average of 60. They have an average tenure of 13 years.

Including the Executive Chairman, there were 7 executives profiled in the 2020 Form 10k. They are on average 52 years old and have been with the Group for an average of 10 years. Two of them - the Executive Chairman and the CFO - were with the Group before its IPO.

As of April 2021, the Board and executives held a 2.8 % share of GNRC. Three institutions (Blackrock, Vanguard, and FMR) held another 25.5 % share.

Given the above, I would not classify GNRC as an owner-managed Group.

The Group has an Executive Compensation Programme with a clawback component. This is to ensure alignment between shareholders and executives while maintaining corporate governance. The clawback kicks in if there is an accounting restatement due to non-compliance with any financial reporting requirement under the federal securities law.

Over the past 3 years, the incentive part of the executive compensation averaged about 3.7 % of the net income. This is about the lowest so far compared to the various US companies that I have analyzed. The comparative percentages for the other companies were:

Worthington Industries - 7.9 %

Steel Dynamics - 11.8 %

Boise Cascade - 33.2 %. This high percentage was because there was a low net income for one of the years. However, the incentive programme is not pegged to just the net income for the year.

Leggett & Platt - 5.9 %

Tempur-Sealy - 11.3 %

Of course, the incentive plan would also be affected by industry practices as well as the history of the company. But I was surprised by the GNRC percentage.

Case Notes

According to Investopedia, the management of a publicly-traded company is in charge of creating value for shareholders. Thus, management should have the business smarts to run a company in the interest of the owners.

Of course, it is unrealistic to believe that management only thinks about the shareholders. Managers are people too and are, like anybody else, looking for personal gain.

That is why it is important to assess whether management interests are aligned with those of the shareholders.

I have found this to be very challenging. I took the easy way out by assuming that management or Board with a controlling shareholding automatically meets this criterion.

In those cases where the management does not have substantial share ownerships, I looked for whether there are incentive plans to ensure that management acts in the best interest of shareholders.

While the incentives should be substantial to motivate management, they should not be excessive relative to the earning power of the company. One measure is to check that the incentives and value of stock options are comparable to those of its peers.

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.

Operations

To assess management, I compared GNRC performance with those of a number of US-listed companies in the power generation sector.

The peers compared are:

Briggs & Stratton Corporation (BGG). Note that BGG filed for bankruptcy in Jul 2020.

Caterpillar Inc (CAT).

Cummins Inc (CMI).

Enphase Energy Inc (ENPH).

In terms of scale, Caterpillar and Cummins's revenue are much larger than those of GNRC. These companies do not operate exclusively in the power generation market like GNRC. Furthermore, Enphase is a relatively smaller player and focuses on the solar voltaic industry.

Table 1: Peer comparison

Note (a) Based on 2019

Based on revenue growth and return on assets, I would rate the Group as the top performer.

Chart 1: Peer revenue

Chart 2: Peer ROA

Capital allocation

From 2010 to 2020, the Group generated USD 2.76 billion cash from operations. Of these:

USD 0.75 billion was spent on dividends. Given the USD 2.0 billion net income during the same period, this is equal to a payout ratio of 38 %.

USD 0.31 billion was spent on share repurchases. If you considered dividends and share repurchases together, this is equal to returning 53 % of the net profits to shareholders.

USD 0.37 billion was spent on CAPEX while USD 0.70 billion was incurred for net acquisitions. This is equal to a 54 % reinvestment rate based on the net income.

If you consider CAPEX and net acquisitions together, the Group generated USD 1.70 billion in free cash flow. Compare this with the USD 1.1 billion returned to shareholders.

There was an increase in cash of USD 0.57 billion.

To fund these cash expenditures, the Group increased its borrowings by USD 0.29 billion. I would rate the capital allocation performance as good.

Chart 3: Deployment of Cash from Ops + Loan

I would point out that a significant portion of the acquisitions was for intangibles. Based on a simple Balance Sheet comparison over the period from 2010 to 2010:

USD 0.70 billion was spent on acquisitions.

The intangibles in the form of customer lists, patents, tradenames, and goodwill increased by USD 0.29 billion.

This meant that at least 41 % of the acquisitions were in the form of intangibles. Did the acquisitions add value? From 2010 to 2020.

Net income increased by USD 0.29 billion.

The Group spent USD 0.38 billion on CAPEX and USD 0.70 billion on acquisitions.

I assumed the same contribution from CAPEX and acquisitions. Based on this, there is about USD 0.19 billion of the net income attributable to the acquisitions. This is equal to about 3.7 years of payback for the acquisitions.

This is a back-of-envelope analysis. But it does suggest that the Group did not overpay for the acquisitions, despite the high level of intangibles.

Is there an Awesome Buying Opportunity?

I generally use two approaches in assessing the intrinsic value.

Asset Value (AV). This is broken down into NTA and Book Value.

Earning Value. This is broken down into the Non-Operating Asset component, Earning Power Value (EPV), and the Earning Value with growth.

For the Earning Value with growth, I have a Conservative one and an Optimistic one.

To derive the EPV and the Conservative Earning Value with growth, I used the single-stage Discounted Free Cash Flow to the firm model. I assumed that the growth rate was 4 % based on the long-term US GDP growth rate for the Conservative Earning Value with growth.

For the Optimistic Earning Value with growth, I used a 2-stage Discounted Free Cash Flow model. I assumed that the high growth period was 10 years at 10.3 % per annum based on the historical CAGR in Total Assets. The terminal growth was assumed to be 4 %.

The other key assumptions used in the valuation were:

Given its growth record, I used the 2020 revenue as the base. The gross profits and SGA were based on the past 11 years' average percentage of revenue.

The tax rate was based on the average 2019 and 2020 tax rates.

The cost of equity and cost of debt was based on Damodaran Jan 2021 datasets. This incorporated the 2020 pandemic impacts and has resulted in low values for the cost of funds. In other words, using these costs of funds meant that the derived intrinsic values would be on the high side.

Chart 4: Valuation

As can be seen from the chart:

The Earning value is greater than the Asset Value.

Over the past 5 years, the highest market price has gone above the Optimistic Earning value with growth.

Any assessment on the margin of safety would hinge on the Optimistic Earning Value with growth being realistic.

Table 2: Valuation

For the Optimistic Earning Value with growth to be realistic, we should have the following scenario.

The current revenue of USD 2.5 billion suggests that GNRC has about 45 % of the US market for generators.

Under the Optimistic Earnings Value with growth, the model projected that GNRC would have 81 % of the US market in 10 years’ time. Note that based on the analysis in Part 1, I assumed that the US market would grow at 4 % per annum.

This is of course an aggressive gain in market share. If the Group is not able to increase its US market share, then growth has to be from the International segment.

Take the scenario where GNRC maintained its existing US market share. This would mean that the International segment revenue has to increase by USD 2.9 billion over the high growth period. This is equal to a 22 % CAGR or USD 290 million per year.

Over the past 11 years, the International segment revenue only grew by about less than USD 40 million per year. Thus the growth assumptions are not realistic.

You can of course have a combination of domestic and international growths. But the difference between what is required and the Group track record is too great for any combination to be realistic.

Another back-of-envelope way to look at the growth is to relate it to acquisitions. Consider the scenario with an average 0.74 asset turnover. The Group would have to spend about USD 215 million per year in acquisitions to achieve USD 290 million additional annual revenue per year.

Over the past 11 years, the Group had only spent about USD 70 million per year for both domestic and international acquisitions. Based on this, the growth again does not look realistic.

Since the Optimistic Earnings Value with growth does not look realistic, there is no margin of safety at the current price. The market seemed to be pricing as if GNRC can grow at a higher rate than the 10.3% that I have assumed.

Will there be Spectacular Growth in Shareholders’ Value?

If you have been following my blog, you will know that a high-quality company is one that has a good chance of increasing shareholders’ value.

I looked at the following metrics to assess shareholders' value creation.

Over the period from 2010 to 2020, assuming that no dividend had been distributed, the shareholders’ funds would have increased by a CAGR of 18.4 %. This is more than double the cost of equity of 7.3 %.

Over the past 11 years, the Group achieved an average 13.9 % return. This return was computed as EBIT(1-t)/TCE assuming a 22 % tax rate. The return is almost double the Group’s cost of funds of 7.1 %.

If a shareholder had bought a share at the start of 2011 and held onto it till the end of 2020, he would have achieved a CAGR of 30.8 %. Compare this with the 7.3 % cost of equity

Table 3: Shareholders' gain

Based on these 3 metrics, the conclusion is that GNRC had been able to create shareholders' value.

There is another perspective of the excess returns especially for the growth in shareholders’ funds and the EBIT(1-t)/TCE. It suggested that the Group must have some sustainable competitive advantages for this to be sustained over the past 11 years.

This competitive edge picture is consistent with the EPV > AV valuation scenario.

Finally, the share repurchases undertaken from 2015 to 2018 seemed to be at prices less than intrinsic values.

As per the table below, the share repurchases were carried out at prices that were less than 6 times the book value.

In my analysis, I have assumed that the intrinsic value for the respective years is 11 times the respective Book Value. This was the ratio based on the Conservative Earning Value with growth and I assumed that this ratio held during the past 11 years

Table 4: Share buyback

How to Secure Your Investment by Minimizing Risk

The main business risk for the Group relates to growth. There are two related issues here:

Can the Group sustain its organic growth? This requires the Group to not only grow the existing business but also to grow the ones it has acquired recently.

Over the past 11 years, the bigger portion of the growth was due to acquisitions. Will the Group be able to find new acquisition targets every year?

With regards to the former, the Group has a good track record and there is no reason to suggest that it cannot continue to do so. If there was any concern, it would be driving organic growth in the international market as I see this as the main growth area.

With regards to acquisitions. I would group GNRC business into 2 categories:

The power generation business. This is its legacy business and accounted for the bulk of the current earnings. GNRC has a significant market share in the US and it would be a challenge to find new acquisition targets.

The new ventures. I would include the clean energy and grid services here. This is represented by the “Others” products segment and I estimated that it currently accounted for about 10 % of the Group 2020 revenue.

While GNRC may have a significant market share in the power generation business, it is a “start-up” stage in the new ventures. On one hand, there are the business risks associated with start-ups. But, there are opportunities for further acquisitions.

GNRC acquisition opportunities and risks can be broken down into 4 groups based on the following segment mix. The matrix focuses on acquisition risk. I defined this as not being able to find an attractive business - in terms of acquisition price as well as products or markets it served.

Chart 5: Risk matrix

The domestic power generation business has been the biggest source of earning for the Group. Over the past 11 years, the residential sector accounted for 55 % of the Group's revenue.

GNRC has stated that its business prospects are tied to the Housing Starts. There was a 0.92 correlation between GNRC revenue and the US Housing Starts for the period 2010 to 2020. The positive thing here is that the US Housing Starts has an 8.9 % CAGR during this period and indications are that there will be continued growth.

What does this all mean for GNRC?

There is a low risk for the current main revenue and earning driver - the domestic power generation segment.

This would give the Group breathing space to pursue the riskier international expansion as well as the new ventures. Given that these are a small part of the Group's revenue and earnings, there is a manageable impact in case of any failure.

Pulling it all together

The analysis showed that GNRC is fundamentally strong.

It is financially healthy with a 0.6 Debt Equity ratio as of Jun 2021.

It has been able to achieve a 15.4 % CAGR in revenue from 2010 to 2020. About 1/3 of this has been from organic growth.

The industry is not a sunset one. There are still prospects for growth. But the bigger growth will be from the international market where GNRC has a small presence.

Management has a good track record for operations and capital allocation.

It has been able to create shareholders’ value.

The main risk - new acquisitions - seemed manageable.

Unfortunately, the current market price does not provide any margin of safety. The market is pricing GNRC at a growth rate that is not realistic. I would conclude that GNRC is a growth trap.

End of Part 2 of 2

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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.

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