Navistar‘s (NAV) story over the last two decades has been a difficult one, with the company losing significant share in its core medium-duty and heavy-duty truck markets and suffering repeated hits to its reputation from product quality issues (including, but not exclusively, the well-known EGR fiasco). Adjusted annual revenue growth over the past 10-15 years has been slightly negative, with very little in the way of meaningful free cash flow generation, and the shares have done almost nothing over that time.

The five-year returns haven’t been so bad, though, and now-former CEO Tony Clarke has done some good things with the company. Even so, I believe Traton‘s improved offer for the company is a good starting point, and I am encouraged by the board’s willingness to pursue negotiations. While a fully turned-around Navistar would indeed be worth more than Traton’s offer, perhaps substantially more, I believe shareholders have to weigh the upside potential against the risk of the company coming up well short of the performance metrics that would drive that upside.

Familiar Themes In The Quarter

Relative to what we’ve all seen from other heavy machinery companies in recent months, I’d say that Navistar’s fiscal third quarter was pretty consistent with those trends. Sales of medium-duty (or MD) and heavy-duty (or HD) trucks have been pummeled by COVD-19, but the industry was already heading into a cyclical downturn. Like many of its peers/comps, Navistar did manage to do better on costs, with the company beating sell-side EBITDA expectations by about 15%.

Manufacturing revenue declined 45% in the quarter, better than PACCAR‘s (PCAR) 57% decline and the high 40%s to high 50%s declines in Cummins‘ (CMI) MD and HD engines business. While Navistar did appear to recover some share sequentially, the company’s overall Class 8 share still fell more than a point, to under 13%, relative to the year-ago period. North American Truck revenue declined 50%, while parts revenue declined 27%, and Global operations revenue declined 48%.

Gross margin fell more than a point, leading to a 61% decline in adjusted EBITDA and an 85% decline in operating income. The NA Truck business fell into the red (from 6.3% margin a year ago), while the parts business stayed comfortably profitable with a margin of over 23%.

Although Navistar does have a meaningful net debt position, management reported that the company ended the quarter with $1.6 billion of cash in the manufacturing operations and there are no meaningful debt maturities until 2025.

Traton Goes Public With A Higher Offer

The day after earnings, Traton announced that it had increased its buyout offer for Navistar from $35 at the start of the year to $43 per share in cash. The only real reason to be public about this is to drive shareholders to pressure the board of Navistar to engage in active negotiations with Traton on a deal. And as of Monday morning, Navistar’s board has expressed a willingness to view this upgraded bid as a starting point for discussions. There have been plenty of rumors around this entire process, with Navistar’s board, led in particular by Carl Icahn and Mark Rachesky, supposedly deeming Traton’s initial offers too low to even merit giving Traton a look at the books for financial due diligence. One rumor, reported in the New York Post, says that the board has been insisting on a $50 bid, with Rachesky supposedly holding out for $70 a share.

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I believe Navistar’s board has an obligation to act in the best interests of Navistar shareholders, and I believe that means actively engaging in discussions with Traton on this bid. To start with, Traton’s revised bid does represent a fair price for the best-ever EBITDA margin Navistar has ever posted – a level that the company is unlikely to regain for several years.

It is plausible that with negotiation and cooperation, an even better bid (closer to $50) could be possible on the basis of what Navistar could worth with ongoing improvements in the business. With Navistar in hand, Traton would have a global footprint allowing it to compete more effectively with Daimler (OTCPK:DMLRY) and Volvo (OTCPK:VLVLY), and I would expect significant cost synergies in sourcing, manufacturing, product development and so on. Traton would likely also help repair Navistar’s damaged product quality reputation, though that would likely still take time.

Moreover, on its own, there’s substantial room for argument about the real fair value of Navistar on a standalone basis. The company has made some progress with its turnaround efforts, and I like what the company is doing with respect to its R&D priorities, but given that it could be a multiyear process just to get back to double-digit adjusted EBITDA margins, there’s a good argument for a standalone fair value in the low-to-mid $30s.

While Traton’s deal is fair relative to the best Navistar has done in recent times, it doesn’t necessarily reflect what Navistar could be worth in the market if the turnaround goes exceptionally well. If Navistar could improve itself to the point where it generates EBITDA margins on par with PACCAR and Cummins, a fair value of $70 could be theoretically in play given what the market has historically been willing to pay for heavy machinery companies (on a forward EV/revenue basis) relative to their EBITDA margins.

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Of course, investors have to assess how likely that is – over the last two decades, Navistar really hasn’t been in the same league as PACCAR or Volvo, and I have to consider margin parity with PACCAR to be a “best case” scenario – something I wouldn’t expect Traton to pay for, particularly with no competing bidders in play.

Going Alone Is Risky

I believe it’s difficult to be viable in this business with less than 20% to 25% market share, and it’s been a long time since Navistar has enjoyed that sort of market position, even though it has managed to regain a few points of share in recent years. At the same time, the reinvestment demands for truck companies has never been higher, with fleet operators increasingly interested in alternative fuels, alternative powertrains (including electric), and new technologies like autonomous driving.

I actually like the direction Navistar seems to be going with its R&D. It looks to me like Navistar is content to let Cummins do the heavy lifting on diesel engine development, recently agreeing to an extended supply agreement for 7, 9, and 15-liter engines across the next two emissions cycles. At the same time, the company is allocating more resources to alternative powertrain technologies and making greater use of development partnerships.

Navistar is working with TuSimple on Level 4 self-driving trucks with a production startup target of 2024, and the company is also working with Samsara and GeoTab on telematics. Navistar is also working with Traton in electrification, and the company’s annual R&D spending is on par with PACCAR’s. All told, then, it seems like Navistar content to let Cummins be its diesel engine supplier for the foreseeable future while directing its resources to new technologies where the company could, perhaps, be more competitive down the road.

Still, the risks here are substantial. Although Navistar has had some meaningful product development successes in its past (including electric vans and diesel-electric hybrids), it’s also had some well-publicized failures. There’s going to be no shortage of competition in next-gen trucks either, with Tesla (TSLA), Nikola (NKLA), and Xos (formerly Thor) on the newer entrant side as well as established players like Daimler and Volvo. At a minimum, I think Navistar and Traton would be stronger together, and I believe going it alone would be a high-risk (though potentially high-reward) move for Navistar with little to cushion the blow if Navistar finds itself in similar sub-20% market share position after the transition to new fuels/powertrains.

The Outlook

I believe that there is a path forward where Navistar could regain share in the North American market and produce better margins, but it’s hardly guaranteed. Navistar has long lagged PACCAR when it comes to margins, and I don’t see an easy path to double-digit EBITDA over the next three to five years, even with a recovery in HD and MD trucks and better company performance. As I said before, achieving EBITDA margins similar to PACCAR or Volvo could support a far higher share price, but I believe the likelihood of that sort of margin improvement is not very high for Navistar on a standalone basis.

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On its own, I think around 12% EBITDA margin is probably the best that Navistar can do, and that would support a fair value around $50 a share on a margin-driven EV/revenue basis. As I said before, there have been rumors that Navistar’s board wants a $50 bid from Traton, and I think that would probably be a decent price for both parties, though it’s not unreasonable to think Traton may want some discount there just to compensate for the risk. And yes, the upside to a very successful turnaround is well above that price, but Traton deserves to share that benefit given that I don’t really think Navistar can get there alone.

The Bottom Line

Traton needs a stronger North American position and Navistar really would benefit from the synergies and risk reduction offered by merging with a stronger company in the commercial truck space. As such, the deal really does make sense for both parties and I’d like to think that logic will drive the process from here. I also think Navistar is a $30-something stock without Traton’s interest, and I would hope that Navistar’s board is reasonable about the sort of self-improvement it can reasonably expect to achieve on its own.

Still, negotiations aren’t always solely rational and logical, and there is a risk that either party ultimately walks away. I don’t think there’s a high risk of that, but investors have to weigh the risk of securing a bid closer to $50 against the risk of seeing the shares drop back to the $30s in the near term. Likewise, while a strong turnaround could eventually drive a much higher value, that value is very much “at risk” and uncertain. I think there’s decent upside here, but the valuation is now tied to negotiation more than operational performance.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.