Oshkosh Truck Corp (OSK)

For much of its early history, Oshkosh Truck was an undiversified manufacturer of heavy tactical vehicles for the military. Beginning in 1996, the company embarked upon an aggressive series of acquisitions enabling diversification into the commercial and fire/emergency truck manufacturing business. In its current incarnation, Oshkosh Truck produces aircraft rescue, firefighting, and municipal snow removal vehicles, ambulances, wreckers, concrete mixer systems, refuse and waste transfer haulers, truck-mounted cranes, and heavy and medium-payload tactical military trucks. These vehicle brands are well regarded within each individual industry. Acquired businesses such as Pierce, McNeilus, Medtec, and JerrDan are viewed as embodying a certain degree of quality and reliability. The most recent acquisition of JLG Industries in 2006 added aerial work platforms and telehandler vehicles to the evolving product portfolio.

Perhaps rather wisely, Oshkosh has found it necessary to diversify its earnings base.
Clearly, the loss of a critical military contract, which can be imposed by the government without notice, would be quite injurious to the company’s earnings. In the hypothetical sense, the military could actually find it necessary to greatly reduce the number of ground-based vehicles in combat or training in favor of other modes of transportation such as those through the air or water. The strategies of combat, based on knowledge of historical warfare, certainly manifest change. The fear of suffering a great diminution of earnings compelled Oshkosh to acquire non-military businesses. The company was clearly successful in this regard. Defense-related income is no longer the dominant feature of its earnings. However, the acquired companies of the last decade are clearly cyclical. The majority of the Oshkosh earnings then will depend on the state of the commercial and residential construction industries as well as the health of state municipalities. Rather than achieving linear earnings consistency, which generally is the objective of diversification, Oshkosh will most likely suffer great earnings volatility.

Financials
The expansion of the Oshkosh earnings has been more subtle simply because it has been increasing its earnings base through non-defense/military acquisitions. There has, however, been a marked improvement in the profit margin and return on equity. It is not entirely clear, due to the velocity of acquisitions over the past decade, to what degree margin expansion has been achieved through either astute acquisitions or increased military order backlog. In any event, the profit margin has expanded from the 3.4% level in 2002 to 6% in 2006. The ROE has also increased by nearly 500 basis points, or by
33%. It is important to note that the most recent acquisition of JLG created a highly leveraged balance sheet such that a higher ROE might be expected.

It is observed that Oshkosh has greatly improved its earnings profile from modest profitability one decade prior. It does not appear that this accomplishment can be entirely attributed to the level of defense backlog. In 1998, defense income represented roughly one third of total company operating income. A gradual improvement appeared during the years of 2003-2005, in which orders for its military vehicles increased dramatically.
However, at the moment, defense income contributes 37% of income.
Since Oshkosh did not acquire any defense related businesses during 2003-2007, it is reasonable then to assume that certain operating efficiencies have been achieved within the commercial and industrial aspects of its business. However, it also might be presumed that these cyclical businesses are experiencing or, have experienced, a period of peak earnings. The cyclicality of commercial vehicle and equipment production can be observed in the JLG financial statements. Prior to the recessionary conditions of 2001,
JLG realized a ROE of 28% in 1999. During the years 2001, 2002, and 2003, the respective ROE was 11%, 4%, and 5%. In 2006, or the year in which Oshkosh consummated this acquisition, the ROE once again had expanded to 26%.

In the absence of any substantial debt reduction, a loss of defense earnings will disproportionately cause a decline in net income. Rather importantly, defense income has expanded from $41 million to $231 million, or by 460%, since the beginning of the Iraq war

Valuation
Defense income, which is the earnings feature with questionable sustainability, represents one third of the company’s income. The balance of the earnings base is represented by pure cyclical businesses. Either of these sources of income, either individually or combined, if in decline mode could, cause the Oshkosh earnings to become problematic.
However, the earnings impact would actually be enhanced by the company’s obligation to service its debt. Any loss of revenues would result in a disproportionate loss of after-tax earnings. Based on the earnings estimates for the company in the 2008 fiscal year, Oshkosh trades at a P/E ratio of 12x. If this forecast is achievable, Oshkosh will generate $347 million of net income. On a pre-interest and tax basis, based on $236 million of run-rate interest expense, operating income might be $770 million. In 2002, Oshkosh reported $41 million of defense-related income. Let us assume, since no acquisitions were made so as to interfere with this calculation, that this level of earnings is normal for the company when the U.S. is not engaged in war.

Annualized defense income might be $230 million in 2007 and, assuming a 10% growth rate as expected by the company, the figure might be closer to $253 million by 2008. If
2002 is an accurate reflection of a normalized earnings environment, and then the potential loss of income would be $212 million ($253m - $41m). In relation to $770 million of anticipated EBIT in 2008, the adjusted figure would be $558 million. Less $236 million of interest expense, pre-tax profit would be $322 million or $209 million after taxes. At the per share level, Oshkosh might then generate $2.82 of earnings. Assuming there is no change in valuation, one might conclude that a $34 share price is reasonable. Oshkosh presently trades at $56 such that the loss of equity value could be 41%.

Of course, the diminution of earnings could be more severe if Oshkosh experienced some cyclicality of its earnings concurrent with a reduction of U.S. government income. If the appearance of cyclicality is rather fierce, Oshkosh could suffer a dramatic decline in earnings perhaps even greater than 40%.