During the past 10 years, Paccar (PCAR 2.42%) has increased its market share in the heavy-duty truck segment in each of the geographical regions in which it operates. For example, Paccar grew its U.S. market share from approximately 23% in 2003 to 27% in 2013, while its share of the European market expanded from 12% to 16% during the same period.
In addition, it has been profitable in every year for the past three-quarters of a century, while its track record of consecutive dividends goes all the way back to 1941. In a competitive market, how has Paccar fended off threats from competitors such as Navistar International (NAV)? Will it continue to maintain its status as one of the leading (and more profitable) players in the segment?
Me-too competitors in a difficult market
In contrast to Paccar's stellar track record of profitability for 75 years running, Navistar has suffered losses in three of the past 10 years. With respect to gross margin, a strong indicator of pricing power, Navistar's 10-year average gross margin is 15.7%, compared with 19.3% for Paccar. If the most recent financial year is used as a basis for comparison, the differences between Paccar and Navistar are even starker. Paccar is profitable in fiscal 2013 sporting a 19% ROE, while Navistar is still in the red.
Industry dynamics have a big role in the lackluster profitability of Navistar. First, customers -- the operators of truck fleets -- are extremely price sensitive, because trucks make up a large proportion of their costs. Second, most trucks are similar, and have few differentiating factors to justify a price premium. Third, truck manufacturers are under pressure to cut prices and maintain high-capacity utilization because of the high fixed-cost structure of the business.
Navistar realized its past profitability (or lack thereof) has been hampered by the lack of pricing power and inefficient operations. In response, it has implemented a "Drive-to-Deliver" turnaround plan. As part of plans to improve its ability to charge higher prices, Navistar has sought to enhance the quality of its trucks with respect to fuel economy and uptime.
One example is Navistar offering customers the choice of either its own MaxxForce engine, or third-party engine with its trucks. It also divested non-core businesses, such as the Indian truck and engine joint venture with Mahindra, to focus on its core North American heavy-duty truck segment.
With respect to cutting costs, Navistar has decided to buy certain engine models from a third-party vendor, and not manufacture them on its own. The reason is that these engines have too little sales volumes to benefit from economies of scale in manufacturing. Navistar is also looking at its current supplier base to determine opportunities for savings in material costs.
It remains to be seen if Navistar will be successful with its turnaround plans. But the crux of the issue is that of positioning, something Paccar has done very well.
Focusing on end users and economic buyers
Paccar is much more profitable than its peer Navistar because it has satisfied the needs of both end users (truckers), and economic buyers (truck fleet operators who pay for the trucks), with its focus on quality.
Truck drivers spend almost all of their time on their trucks, and demand a high level of comfort. Unlike standard trucks made by competitors like Navistar, Paccar's trucks are built-to-order, and customized to the individual needs of the truck drivers. Truckers can choose how the interiors of their "home away from home" looks like, with leather seats and sleeper cabins among the features offered.
In addition, truck drivers are just like any other vehicle owner, taking great pride in the trucks they drive around in. Paccar's leading truck brands, Kenworth and Peterbilt, give drivers the bragging rights with their peers. As a result, truckers are more likely to recommend Paccar's trucks to truck-fleet operators.
From the perspective of truck-fleet operators, maintaining low costs are equally important, if not more so, than keeping truckers happy. Paccar is the winner of more than 30 J.D. Power and Associates quality awards, the Oscar-equivalent of product quality in various industries. This gives further credence to the view that Paccar's trucks are of the highest quality among competing products.
Notwithstanding Paccar's premium prices, truck-fleet operators understand that they will derive greater cost savings with Paccar's products in the long run because of shorter downtime. As only time will tell whether trucks truly last the mile literally, Paccar's reputation for quality, built over the years, will deter any potential new entrants.
Another major cost driver for truck-fleet operators is fuel costs, and Paccar places a strong emphasis on fuel economy. Paccar spent approximately $251 million on R&D in 2013, and has introduced new fuel-efficient trucks. Its new Kenworth T680 is powered by the PACCAR MX-13 engine, which promises cost savings of $4,000 per vehicle, with an 8% fuel-efficiency improvement. For another of its trucks, the T880, Paccar's real-time diagnostic data, and driver feedback system called Driver Performance Center, provides annual fuel savings of up to 5%.
When it comes to costs, Paccar has traditionally been very focused on operational efficiency, having pioneered the adoption of Six Sigma in 1997. The results speak for themselves, with Paccar holding selling, general and administrative expenses below 4% of sales during the past decade.
Paccar has outperformed its peer Navistar because of its strong pricing power granted by strong customer satisfaction -- both from truckers and truck-fleet operators -- and its lean cost structure.
Foolish final thoughts
Paccar currently trades at a forward P/E of 15.5 and a trailing 12-month price-to-sales ratio of 1.3. In contrast, loss-making Navistar sports a price-to-sales ratio of 0.3. In my opinion, Paccar's valuation premium is justified by its ability to dominate the heavy-duty truck market in the present and the foreseeable future.