Value Investors Club / GENERAC HOLDINGS INC (GNRC)

Description

Generac

Generac is the global leader in natural gas and propane powered standby generators. The company has

about 75% share of the residential standby market (largely U.S.) and about 22% share of the

commercial/ industrial standby market. We believe that Generac is misunderstood as the market seems

to believe that current business activity, three years post the revenue bolus from Hurricane Sandy, is the

new normal for the business and the company is unlikely to grow again. This belief is based in the fact

that Generac is currently valued (share price of $30) at about 12x 2015 calendar free cash flow. To us it

doesn’t make much sense to put a low multiple on what is likely trough, or close to trough, free cash

flow.

The misunderstanding comes from the fact that Generac’s business cycle is driven largely by significant

power outages caused by weather events rather than typical economic activity. Generac’s revenue and

earnings typically peak 12-18 months after a major weather event and decline after this until the next

weather event arises. We are now three years post Hurricane Sandy and it has been 10 years since a

major hurricane has struck Florida, something that has never happened. Operating income this year will

likely be close to 30% below the 2013 peak and is very unlikely to get significantly worse.

You can make an investment in Generac complicated by ignoring statistics related to long-term weather

activity or make it simple by investing with a very good management team, in an asset light business, at

a low multiple and at what is likely trough free cash flow. The kicker is that there is a secular story as

well given that natural gas standby only became a competitive product in the late 1990s and has steadily

grown to 3.5% market share of homes greater than $100,000 since then. I would add that market share

penetration is accelerating as recognition grows with market share growing from 1.25% in 2009 at the

IPO to the current 3.5%. With portable gensets (primarily diesel) in 13.5% of homes with a value greater

than $100,000 we believe there is lots of room for growth. Also, with 15-20 year average lives, and a late

1990s product introduction, replacement demand will become additive to growth in the next five years

especially looking back at the impact of Katrina in 2006. There are other secular growth drivers that I will

outline below.

Residential – Primarily Standby

Residential represents 52% of Generac’s (3Q 2015 $185 million) revenue and is primarily driven by sales

of natural gas generators in the 7kW to 20 kW (air cooled)/ 60kW (liquid cooled) range. A 7 kW

generator is about $2,800 installed while a more powerful model would approach $7,000 installed.

Given that the generators have a 15-20 year life the cost is not very prohibitive given low service and

maintenance requirements. Because of this about 25% of Generac’s business comes from homes valued

at $150,000 or less and is fairly evenly split in quartiles at $100-150,000 increments above this price. The

residential segment also includes revenue from portable diesel generators, power washers and inverters

for household tools. Revenue is down in the residential standby segment as Generac is in the second

year post the peak revenue benefit from Hurricane Sandy. We believe that revenue is either at a trough

or close to a trough with the number of outage events in the last two years 58% below normal. We don’t

claim to have any ability to predict the weather but we do believe that weather activity will mean revert

and Generac will benefit as severe weather is a primary driver of business activity.

This is only the cyclical element and ignores the secular story. Nat gas standby is a relatively new

product having been introduced in the late 1990s, it has grown to household penetration (homes of

greater than $100,000 in value) of 3.5% with market share gains versus diesel recently accelerating as

standby had 1.25% share in 2009. We believe that nat gas will continue to grow and take share as nat

gas generators are generally less expensive upfront than diesel with the ability to power more of your

home for longer, have always on reliability during an outage (you have to refuel diesel) and lower

maintenance (for example diesel sitting in a generator causes algae and has to be switched out or it will

cause problems). The catalyst for growth will not only be increased weather activity but greater

recognition of nat gas as a diesel alternative from Generac’s promotional activity and its growing base of

5,600 distributors. While we don’t expect nat gas to achieve portable generators 13.5% penetration in

the next five years even a couple more percentage points of market share will make for significant

growth. With a 15-20 year replacement cycle, replacement revenue will also start to contribute to

growth over the next five years as we are just entering that period relative to the product’s introduction

in the late 1990s with revenue growing to $680 million in 2006 creating a nice tailwind over our five year

investment time horizon.

Some more context to the secular growth story is that residential standby has

grown by 12% compound over the last 12 months (to 09/30/2015) compared to the prior baseline

period in 2010 (between Katrina and Sandy). For context trailing 12 months residential standby is down

greater than 15% from the recent peak so the 12% CAGR’s endpoint is closer to a trough than a peak.

If you are concerned about competition I would note that Generac sold its portable generator business

to PE in 2008 who then sold it to Briggs and Stratton. For a time Generac was excluded from the market

due to non-competes but now has more market share than Briggs in portable generators after starting

from zero. Briggs and Kohler are the primary competitors in standby with about 10% share each.

There has been some noise about Tesla but their solution is not close to economic versus Generac and is

really a solution for off the grid solar storage.

Commercial/ Industrial

Commercial and industrial represents 41% of Generac’s sales (Q3 2015 $148 million). The revenue split

within commercial and industrial is about 58% from nat gas and diesel standby/ backup generators and

42% from mobile industrial products like generators, pumps, light towers and heaters.

The company expects their commercial standby/ backup mix to grow faster than their mobile products

over the next three years. The primary growth driver is expected to be greater penetration of nat gas in

the less than 60 kW and 60-300 kW segments of the market with benefits from growth in CRE which is

still well below 2007 peak levels. Again, market share gains is largely to do with the significantly better

upfront price for nat gas versus diesel and lower maintenance and service over the lifetime ownership.

Generac also provides greater product flexibility with a modular product option that can allow a

customer to expand its backup as it grows, while diesel is one size fits all. Finally, through the acquisition

of Ottomotores and Baldor, Generac expanded into high kW diesel generators (above 400 kW). The

reason for this was that nat gas is not economic at powers above 400 kW. While Generac does not have

huge expectations for market share growth in the greater than 400 kW market given the strength of

competitors Cummins and Cat, this is a market with a TAM of about $1.3 billion so even small share

gains will be meaningful when their annual revenue in this segments is about $60 million. Ottomotores

also gave them access to Mexico and South America and they expect good growth beyond a cyclical

recovery in these geographies as Ottomotores was a sleepy, family run company.

Another example of a significant niche TAM within commercial/ industrial is backup for mobile towers.

Of the 300,000 mobile towers about 100,000 have backup. With the average generator cost of $12,000

per tower the opportunity here is $2.4 billion (4x current CI revenue) with Generac having 60% share of

the 100,000 installed base. Service providers have laid off backup spending in 2015 (contrary to the new

commercials with Luke McCown) so this should provide a cyclical tailwind in 2016. The potential for

regulated backup of mobile towers would be a nice tailwind.

For mobile products (42% of CI revenue), the business should benefit from cyclical tailwinds in energy,

mining and industrial related to these segments. While people may think this is nonsense given the

current “industrial recession” meme, we would note that Parker Hannifan expects its materials and

mining business to return to growth in Q4 and energy in Q2 next year. While PH typically leads by a

quarter the market also tends to look ahead by six months so we should be close to a point where

equity investors look through a cyclical trough. For longer term investors, whether the recovery is six or

twelve months away is irrelevant as the cyclical benefits from energy, mining and CRE are tailwinds for

years to come. I would expect the mobile segment of CI to also be an area that will benefit from

acquisitions as Generac has stated they expect a 3% CAGR in revenue from acquisitions through 2018

with a focus on products that can be sold through the rental channel which includes mobile products.

Financial

At it’s analyst day in May of this year, Generac outlined a plan to grow the topline by 10% through 2018

with 7% organic growth and 3% external growth. I would note that the plan includes a modest $65

million, or 4% in aggregate over the period, from power outages which seems unrealistic given the

current lull in activity. 10% growth would get the company to $2.2 billion in revenue but given this year’s

decline in revenue I will assume $2 billion is more realistic. The company expects to achieve low-to-mid

20s EBITDA margins (about the long-term average) so splitting the difference gets us to $450 million in

EBTDA. Based on this year’s guidance the company expects to generate $160 million in free cash flow

and had guided to $1 billion in free cash flow for 2015-2018. I am going to haircut annual free cash flow

by $40 million for 2016-2018 and assume the $100 million in Q4 2015 goes to share repurchases that

are subsequently diluted away through forward option/ RSU grants thus having no impact to enterprise

value. With the FCF haircut and deducting this year’s free cash generation you are left with $720 million

in free cash generation in 2016-2018. I will assume $180 million of this goes to acquisitions from 2016-

18. With a current market cap of $2.1 billion and $1 billion in debt and assuming the $540 million in free

cash flow net of acquisition payments goes to debt reduction Generac would have an enterprise value of

$2.55 billion at the end of 2018 This would leave the company with only $450 million in debt or 1x

EBITDA versus long-term guidance of 2.5x allowing for some capital allocation flexibility through the

period.

Generac is largely an assembly business and thus is very capital light requiring only about 2% of revenue

in annual capex. Generac also has a large tax shield from the capital gains transfer from the founder to

private equity to public company. It is a fixed amount flowing through amortization and expires in 2021.

For those of you who worry about how the market will discount the loss of the tax shield (as we do) later

this decade, I would note that replacement revenue should really start to kick in later in the decade

providing for some nice growth in revenue and earnings as an offset (revenue in 2006 was $680 million

and almost all standby). I believe a fair value for an asset light business like this is 10x EBITDA giving you

a high probability double in the equity through the forecast period.

Given the nature of Generac’s business cycle I won’t provide a model as I believe that would make as much sense as modelling annual

weather patterns.

I would add that I find Aaron Jagfeld a competent and focused CEO. He was CFO of Generac at age 30

and President at 32 when the company was still owned by its founder and subsequently by CCMP

private equity. He has strong Midwestern industrial DNA and f you tour their faculties you will find them

immaculate. I would note that he did not repurchase shares at the peak and instead waited to the lull in

activity and the share price to start a repurchase, purchasing $64 million of a $200 million authorization

in Q3. The arguable offset for this smart capital allocation may be the timing of energy exposed/ related

acquisitions. I would also note that director Timothy Walsh of CCMP purchased $1.2 million in stock at

$42.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

- Cyclical growth from recovery in energy

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			2015	2016
Price:	32.00	EPS	2.50	$0.00
Shares Out. (in M):	36M	P/E	12.5	0.0x
Market Cap (in $M):	2,200	P/FCF	12.5	0.0x
Net Debt (in $M):	1,000	EBIT	250,000	0
TEV (in $M):	3,200	TEV/EBIT	13	0.0x