Trucking sector stocks have surely left many investors perplexed in the last year. Most of them suffered heavy declines in 2018 even as they were upgrading their estimates for heavy-truck production in 2018 and 2019. Things have become even more curious in 2019 as stocks in the sector have risen sharply, but without a lot of fundamental change in their outlooks. What's going on and how should investors think about this sector and stocks in it like PACCAR (NASDAQ:PCAR)?
Investing in highly cyclical stocks
Truck sales and production are highly cyclical and they always have been. This means that revenue, margin, and profit tend to oscillate wildly with the business cycle. Of course, this is where it gets tricky for investors. After all, who would want to buy a stock on a seemingly cheap earnings valuation if those earnings are going to collapse in a year or two?
That's exactly the quandary facing investors in stocks like truck makers PACCAR and Navistar (NYSE:NAV) and axle and other drivetrain component manufacturers like Dana Corp. (NYSE:DAN) and Meritor (NYSE:MTOR). They all had good years from an operational perspective in 2018, and PACCAR, Meritor, and Navistar are all expected to generate mid-single-digit revenue growth in 2019 alongside moderate growth in North American heavy-duty truck production.
However, the problem is that sales are expected to drop in 2020 as the truck market starts to fall after a few years of strong growth. For example, analysts expect fiscal 2020 sales to dip 6% for Meritor, 6.2% for Navistar, and 10% for PACCAR.
A market set to decline after 2019
The shape of things to come was described by Meritor's management during the company's analyst day in December. As you can see below, the key North American and Western Europe markets are expected to decline from 2020 to 2022 and reach levels equivalent to those in 2016.
In other words, revenue is expected to fall after 2020 -- this usually means earnings will as well.
So even as all these stocks appear cheap on, say, the basis of trailing enterprise value (market cap plus net debt) to earnings before interest and taxes (EBIT), in the years ahead, their EBIT is likely to decline and this could make their future EV/EBIT valuations seem expensive. In a nutshell, it's a classic investment conundrum for cyclical stocks.
Valuing cyclical stocks
A closer look at PACCAR helps to clarify matters. The company's revenue tends to track the cycle of U.S. heavy-truck sales (which in turn guides production), so the task is to try to find a way to calculate PACCAR's current valuation if it were on the trend line through the cycle rather than at the peak or the trough.
Let's start by estimating the long-term growth in the industry. As you can see below, 2013 and 2017 can be used as a rough proxy for the midpoints of the cycle. Calculating the annualized growth rate for PACCAR's revenue between these periods gives a growth rate of 3.3% -- this is a useful estimate for long-term growth.
Meanwhile, the average operating income (or EBIT) margin during the period was 11%, and this can be used to obtain a rough EBIT trend line.
Going back to PACCAR's 2013 revenue figure of $17.1 billion and applying a growth rate of 3.3% per year gives an estimated revenue of $20.1 billion for 2018 -- this is compared to PACCAR's actual revenue of $23.5 billion. Now, applying the 11% EBIT margin estimate to estimated revenue of $20.1 billion gives EBIT of $2.21 billion.
Applying the current EV of $19.07 billion and the EBIT trend line estimate of $2.21 billion produces a trend line EV/EBIT multiple of 8.6 times -- note this is above the 6.6 times multiple that PACCAR actually trades at.
Is PACCAR stock a good value?
Using that trend line EV/EBIT multiple of 8.6 times as a baseline suggests that PACCAR is a good value -- for example, the multiples of "safe" noncyclical but low-single-digit growth companies like Johnson & Johnson, PepsiCo, or Colgate-Palmolive are all in the teens.
For sure, highly cyclical stocks should trade at a discount to reflect the extra uncertainty inherent in their revenue streams. After all, who truly knows the length and severity of the likely downturn in the trucking industry?
That said, PACCAR's current EV/EBIT multiple is similar to where it was trading before the economy entered a recession, and as we've seen, its trend line EV/EBIT multiple looks attractive. All told, provided the global economy avoids a recession in the next few years, then PACCAR looks like a good buy for investors with a tolerance for risk.