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An Oshkosh-Navistar Combo Could Create a Defensible Armory

Oshkosh's enticing valuation also offers a potentially lucrative merger kicker.

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We've concluded that  Oshkosh (OSK) could be worth between $43 and $46 per share if activist investor Carl Icahn--who owns nearly 10% of both companies' outstanding shares--succeeds in persuading  Navistar (NAV) to acquire the specialty vehicle manufacturer. We think Navistar could offer an acquisition premium of between $8 and $11 per share (or between 35% and 45%) above Oshkosh's current market price for the incremental synergies. We see three major categories where Navistar could extract value: manufacturing synergies, truck chassis synergies, and engine synergies.

Manufacturing Synergies
Corporate savings are the most palpable and could generate 50% (or $80 million) of the annual pretax savings. We believe manufacturing synergies are the mostly likely to occur, as they represent concrete savings opportunities. For instance, the merged entity would remove one executive management team, an accounting department, and other back-office staff. While there will be some manufacturing rationalization, we anticipate that most operating facilities will remain intact. Additionally, Oshkosh is already undertaking an internal manufacturing rationalization, but these savings aren't incremental to a merger.

Purchasing power synergies are harder to quantify. The 2006 JLG acquisition doubled Oshkosh's annual direct materials spending to $4 billion. Management estimated that purchasing efficiencies and stronger supplier bargaining power generated most of the $75 million annual pretax synergies captured in that combination. At $12 billion of annual spending, Navistar already receives a large discount, in our view. Also, the Oshkosh-JLG purchase synergies didn't materialize as projected. JLG's end markets collapsed nearly 70% during the most recent recession, forcing Oshkosh to record a $1 billion goodwill impairment charge in 2009. Thus, we believe that a 1.5% savings was the best-case materials cost-saving potential. Accordingly, we project a modest 50-basis-point savings on direct materials purchases in this case.

Truck Chassis Synergies
Truck chassis synergies are likely, but "dis-synergies" reduce almost all the benefits. Oshkosh uses multiple chassis manufacturers, including Navistar, for its nondefense business. Within this nondefense business, Oshkosh is a big buyer of Navistar chassis. We assume that Navistar supplies chassis for about 15%, or 500, of Oshkosh's nondefense vehicles. Thus, Navistar could convert the remaining 85% of Oshkosh's nondefense production, or about 3,000 chassis per year currently supplied by other manufacturers, to Navistar chassis. However, it's not assured that all customers will convert to a Navistar chassis. In some cases, customer preferences will be so strong that discounts fail to compel conversion. We arrive at our 34% potential conversion rate using the assumptions below.

We created our conversion schedule based on Oshkosh's annual production for each chassis, which we estimated using industry data and Oshkosh's approximate market share. Applying our expected 34% conversion rate to our estimate of 3,000 potential chassis conversions, we project that Navistar could convert about 1,000 current Oshkosh units to a Navistar chassis. However, we think the merger could cause customer defections for two reasons.

First, as the merging companies focus on integration, competitors can woo away customers. Second, customers may view the vertically integrated company not as a supplier, but as a competitor. While we don't expect massive defections, we estimate 15% (roughly 435 units) may leave.

Last, Navistar will supply chassis it already supplies Oshkosh (about 500 units annually) at cost. We estimate this amounts to $60 million in annual revenue per year based on current selling prices. Historically, Navistar has generated 18% gross margins. Therefore, 18% of the $60 million, or $11 million, is the lost profitability due to chassis being supplied at Navistar's cost. Collectively, Navistar could generate a trivial $2 million per year in chassis synergies.

Engine Synergies
We think engine conversions offer potential, but our reservations about EGR technology reduce the probable savings. We didn't think Navistar's exhaust gas recirculation technology was worth pursuing for the 2010 emission standards, given its fuel diseconomies. Because of our engine skepticism, we employ scenario analyses to adjust the gross margin on internally generated engines and the profitability from newly serviced engines.

To value our potential engine synergies, we apply the same methodology as for gross margin profit; however, we didn't eliminate any amount for internally supplied engines because Navistar supplies Oshkosh with an immaterial number of engines. We also incorporate the parts and service business related to these new engines by estimating that the profitability of the parts and service business is equal to about 20% of the cost of each engine--our margin estimate for the parts and service business.

Merger Premium Looks Promising for Oshkosh Shareholders

Based on our incremental analysis, we believe Navistar would pay between $8 and $11 per share to acquire synergies at Oshkosh, on top of our $35 fair value estimate for the Oshkosh enterprise.

In the end, Oshkosh is still underappreciated by the stock market, which doesn't see the firm's full potential, in our opinion. Shareholders should consider our $8-$11 per share range as the incremental synergy amount that Navistar could achieve if it acquired Oshkosh. We think current Oshkosh shareholders are likely to benefit from Icahn's advances.

Basili Alukos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.