Navistar's Turnaround Is Ugly And Bumpy, But Making Progress

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At the risk of working a little too hard for the metaphor, as a foodie I know that there are certain foods that don't look all that appetizing (celeriac and morels come to mind), but have a lot to offer if you go past the looks. I'm starting to feel that way about Navistar (NYSE:NAV). Although this company's fall from the top was just as ugly as it looked, the turnaround efforts seem to be gaining some traction. The Street has taken a time-out with this name, as it traded down about 5% over the past three months after a big run, but patient investors may yet be able to reap better results as Navistar regains its footing in the medium-duty and heavy-duty truck markets.

Ugly Results, But How Much Does It Matter?

This year is still largely about fixing the problems of the past and getting the company on firm ground for the next upswing in the truck cycle. With that, I don't think investors should care too much about the details of the quarter.

Revenue fell 14% from last year, but did improve 13% sequentially. Truck sales drove all of that sequential improvement, as sales here did fall 18% from last year, but improved 26% from the prior quarter. Engines and parts were down both annually and sequentially – (1%)/(4%) and (8%)/(8%), respectively.

Gross margin did nearly double on a sequential basis, but was down two and a half points from last year and well below forecast, as the company once again had to spend more on warranty-related costs tied to its disastrous foray into self-built engines. With that, EBITDA missed expectations, as did the company's operating and segment losses. Although I would think the Street would probably overlook the warranty-related loss in the engine segment, the worse-than-expected performance in the truck business is a bigger concern.

Class 8 Share Recovering, And Management Looking to Improve Medium-Duty Results

From a high-water mark that saw Navistar hold roughly 30% of the Class 8 North American truck market, the company's share has plunged to a recent retail share of under 14% (as reported by ACT Research and confirmed by management).

That's the bad news. The good news is that order share continues to recover – from 12% in the second quarter to 20% this quarter. Working with Cummins (NYSE:CMI) to offer its engines in Navistar trucks has played a big part in this recovery, but it does remain to be seen how much share the company can ultimately retake from Freightliner (a subsidiary of Daimler), PACCAR (Nasdaq:PCAR), and Volvo (Nasdaq:VOLVY).

With Class 8 orders improving, Navistar is now looking to reverse some declines in medium-duty trucks as well. While Navistar still has about one-quarter of the MD market (down from over 40% two years ago), order share trends (16% in the third quarter) are going the wrong way. The company recently announced a deal with Cummins to offer their 6.7-liter engine in Navistar medium-duty trucks, and I'm optimistic that this can help stem the share declines.

Managing the Boardroom

In attention to shoring up the business, Navistar has also been looking to pacify its large shareholders. The company has put forth a new system whereby a shareholder owning 12% (or more) of the shares can nominate two board members, while a shareholder owning 7% to 12% can nominate one – a compromise that should give a voice to activist investors, but also compel them to maintain their stakes on a long-term basis.

The Bottom Line

I believe management has made a lot of important steps in reversing the bad decisions of the prior Navistar management team. While restoring Navistar to its former glories may be too much to ask, I do believe better results are possible. To that end, I believe Navistar can regain share and outgrow the market over the next five to six years, while also building toward a long-term free cash flow margin in the mid-single digits (on par with PACCAR).

With that (but excluding pension/retirement obligations from the net debt total), on a fully diluted basis these shares appear to be worth close to $39 – or about 20% more than today's price. As I don't currently believe that Navistar will go back above 25% share in Class 8 trucks, outperformance there would certainly lead to a higher fair value down the road.

Disclosure: As of this writing, the author has no financial positions in any companies mentioned.