I wanted to believe. But belief doesn't come cheap. Now, I've paid the price.

Three months ago, in a column entitled "Let's Pop the Hood at Oshkosh," I set about examining Oshkosh's (NYSE:OSK) Q2 earnings report. I had two objectives in doing so: Determine how well the company was performing. Decide whether to buy more shares. And what did I find?

  • $18 million in cash-burn
  • Inventories growing faster than sales, and "finished goods" inventories growing faster still (up more than 30%)

Said I: "Cheap as Oshkosh's stock looks, the inventory picture worries me mightily ... if I don't see inventories drop back to reasonable growth rates PDQ, I'm going to have to postpone buying ... " But a few weeks ago, I jumped the gun and bought anyway.

Exactly. And not of the "capital F" variety, either. I saw the danger. I recognized the danger. I ignored the danger. And now I've paid the price.

In June, Oshkosh, a truck- and construction equipment-maker, warned us that a $2.32-per-share "non-cash charge for the impairment of goodwill [at European subsidiary] Geesink Norba Group" would result in a $1.22 to $1.32 per-share loss for Oshkosh in fiscal Q3. Quite a change from the $1.40 to $1.50 profit management had previously told us to expect. Reading the release, I thought with hope that this was just an accounting adjustment, latching on to management's assurance that "the charge is not expected to affect ... cash flows from operating activities."

But that was only half of what Oshkosh had to tell us in June. In recent weeks, Terex (NYSE:TEX), Caterpillar (NYSE:CAT), and CNH (NYSE:CNH) have all suggested they see storm clouds gathering in Europe. Oshkosh rival Terex is still growing, but another competitor, Federal Signal (NYSE:FSS), followed Oshkosh's lead in reporting a net loss for the quarter. For its part, Oshkosh warned of "Lower than expected sales in both North America and Europe driven by softness in non-residential construction ... and rising raw material and fuel costs."

Sales weakness? Higher input costs? These two factors go right to the heart of Oshkosh's ability to generate cash.

Past was prelude
Now fast-forward to last week's earnings report. Sales were up about 7% -- just like the previous quarter. Oshkosh lost "only" $1.14 for the quarter -- less than it had warned of. And yet, the stock enjoyed no bump on this (relatively) good news. Rather, it sank more than 11%. Why? Because as bad as Q3 was, Q4 looks to be worse.

Management predicts "significantly lower results in the access equipment segment in the fourth quarter of fiscal 2008 as a result of lower sales expectations in North America and certain areas of Western Europe and increases in the costs of raw materials." We're told to expect full-year profits to dwindle to $0.84 to $0.99. And while Oshkosh's management tossed out the possibility of a win on the military's JLTV program, I see that one as a red herring. Everyone who's anyone in defense contracting is bidding on the JLTV program. Oshkosh may be good, but I'm not sure it's playing in the same league as General Dynamics (NYSE:GD) or Lockheed Martin (NYSE:LMT).

Where to from here?
Long story short (or if you prefer, short thesis writ shorter), here's how I see things playing out for Oshkosh by year-end: Free cash flow (FCF) so far this year is down around 80% to $49 million. Run-rate that out through the end of the year, and I see the company generating about $65 million in cash. That makes for an FCF multiple of around 18 times at today's price -- not too far off from the 16 P/E that Oshkosh will bear if it hits the top of its earnings projections for the year.

Sound good? Not so fast. Once you factor in Oshkosh's massive debt load, the enterprise value-to-free cash flow becomes more than 60 times. Nor do I expect the valuation picture to improve any time soon. Remember last quarter, when I spotlighted Oshkosh's working capital problems -- the 7% sales growth, 12% inventory growth, and 32% rise in finished goods inventory in particular?

Well, as bad as Q2 looked, Q3 was worse. Sales are still stuck at 7% growth, but inventories spiked 22%, and finished goods inventories super-spiked 39%. That, combined with projections of continued (or even worsening) sales weakness next quarter tells me we will see further erosion of free cash flow and earnings.

"I want to believe"
And now we come to the moral of this story. Like federal super-agent Fox Mulder of the X-Files, I "wanted to believe" in Oshkosh. Ignoring the warning signs, I decided I had found the exception to the rule: Don't invest in debt-laden heavy industrial companies on the cusp of a recession. So what do you think? Was that a good idea?

Apparently not. Mulder got canceled.

Hi. I'm Fool contributor Rich Smith and I'm ... an Oshkosh addict.

[Hi, Rich!]

It's been more than a week since my last purchase (The Motley Fool has a disclosure policy), and I want to get clean. The Fool owns shares in Terex.