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This Stock Will Keep On Truckin'

We think the market is too focused on near-term farm equipment headwinds and not enough on a cyclical European trucking upturn.

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We believe  CNH Industrial (CNHI) currently offers investors a decent margin of safety for long-term returns, but we don't think it has built an economic moat. However, we believe the market is overlooking opportunity for internal profitability improvement at Iveco, the firm's Europe-focused trucking segment. On top of this potential for better margins, we think Iveco will enjoy end market recovery in 2014 and beyond following several challenging years.

CNHI is the late-2013 merger of farm and construction equipment manufacturer CNH Global and its parent company, Fiat Industrial (which owned Iveco and Fiat Powertrain engines). The firm has enjoyed strong farm equipment markets recently (roughly 50% of total sales) but challenged construction (10%) and trucking (34%) businesses. Over the next several quarters, we expect these prospects to reverse; lower global farm income and difficult comparisons are likely to threaten CNH's ag machinery sales, but an improved construction picture and trucking market should help the company still increase earnings.

Iveco Has Suffered, but Should Recover
Revenue at CNH's Iveco commercial vehicle division declined a total 20% from 2007 through 2012, as higher per-truck pricing didn't offset a 39% decline in delivered units. During this time, the firm faced a difficult end market and lost share--a combination that drove down operating margins to 5.3% from 7.3%. And although revenue was relatively flat in 2013, operating margins fell to just 1.2%.

Iveco sells into four primary geographies: Western Europe (roughly 55% of total consolidated volume in 2013), Latin America (19%), Eastern Europe (13%), and rest of world (12%). The company also sells into China through two unconsolidated joint ventures. Of these end markets, Iveco's sales in Western Europe have seen the largest decline since 2007--down nearly 50% in total, versus a 42% decline in Eastern Europe and a substantial increase for Latin America.

European Truck Sales Should (Finally) Rebound
Western European commercial medium and heavy-duty truck registrations fell a cumulative 32% from a peak of 358,000 units in 2007 to 245,000 in 2012, according to the European Automobile Manufacturers' Association, before rebounding slightly (up 5%) in 2013. In the broader EU-27, the results were similar: a 31% decline to 285,000 trucks in 2012 from roughly 430,000 in 2011, with only a 6% bump last year.

We believe the market should improve further over the medium term. Already, volume has shown several straight months of year-over-year improvements , with the second half of 2013 enjoying 26% growth year over year; however, we caution that part of these gains stems from pulled-forward demand ahead of new engine emission standards that went into effect Jan. 1 (known as Euro VI). Still, improved leading economic indicators and pent-up demand following several difficult years (as evidenced by a lofty average fleet age) should provide ongoing tailwinds past the next several quarters.

We find a very strong historical correlation between medium and heavy commercial vehicles and Europe's manufacturing production; we don't think this is terribly surprising, given such trucks' primary use for deliveries of manufactured goods and construction materials. The recent declines in truck volume have mirrored an eroding manufacturing economy in the region. Although both have shown upticks in recent months, Europe's industrial production suffers as a potential leading indicator because of its reporting time lag. Instead, we also examined the relationship between truck sales and the Markit Eurozone Purchasing Managers' Index, which tends to lead industrial production on a multiquarter basis. Here, we find a strong correlation on a nine-month lag between the monthly year-over-year growth rates in the PMI and European truck sales since early 2007. With the PMI remaining above 50 in recent months, we expect the underlying economic environment to be favorable for truck demand in 2014.

As previously mentioned, we caution that the recent spike in commercial vehicle registrations stems largely from the prebuy ahead of new engine emission requirements for OEMs beginning this year. Although the underlying demand picture appears to be improving, it may take several quarters for this growth to materialize at the company level.

Still, we believe there is potential for truck sales to benefit at a stronger rate than the underlying economy in late 2014 and beyond, as a result of pent-up demand following the recent tough years. CNH Industrial estimates that the average age of a commercial truck in Europe is about 9.5 years currently, versus historical averages (in the late 1990s) close to 6-7 years. There are pitfalls to looking solely at average age--for instance, trucks are typically driven less during periods of lower economic activity--but the industry has a history of overshooting to both the downside and upside on changes in economic activity.

We also look at unit sales in another fashion, which again suggests potential pent-up demand. Total medium and heavy commercial vehicles sold per unit of manufacturing industrial production took a step downward in 2009 and has not yet recovered to prerecession levels. Although manufacturing industrial production remains more than 7% below 2008 levels, truck registrations are still 28% below sales from that year. If we assume that manufacturing industrial production returns to 2007 levels (which suggests a 2.5% compound annual growth rate--not overly aggressive, in our opinion) and that trucks registered per unit of manufacturing industrial production climbs back to the 1997-2007 average, we foresee a roughly 10% annual growth opportunity in European truck sales from 2013--albeit probably beginning in earnest in 2015 because of hangover effects from late 2013's prebuy.

Iveco's Strongest Markets Hit Hardest in Western Europe
We expect the entire eurozone to enjoy rising medium and heavy commercial vehicle sales as the region's manufacturing economy recovers, but trends in particular geographies and vehicle classes will affect Iveco more than others. In all, we think the company has room to regain lost share, as its strongest geographic markets (Italy and Spain) have seen some of the largest drop-offs of any country in the EU-15, but now appear to be facing potential manufacturing expansion.

Across Europe, Iveco reports its market share at about 11% (including light commercial vehicles), trailing Daimler (DDAIF), MAN, Paccar's (PCAR) DAF brand, and Volvo. This figure has fallen from about more than 13% in 2009, but we believe this decline primarily stems from a mix shift issue. The firm enjoys 34% share in Italy and 21% of the Spanish market. Per CNHI, Italy alone has seen commercial vehicle demand fall 42% since 2009, well below Western Europe's overall 16% increase, and we estimate Spain is not far behind in its declines. In fact, countries in which Iveco holds lower share have performed the best; the United Kingdom is up 15% (Iveco has just 6.1% of the market), Germany has rebounded 29% (8.2% Iveco share), and France has climbed 15% (13.5% Iveco share).

Based on the PMIs of each of these countries, we expect Iveco to stem its market share losses as the manufacturing sectors in Italy and Spain recover. Both regions currently enjoy readings above 50, indicating positive growth expectations for manufacturing and therefore an opportunity for Iveco to see rebounding volume in its strongest markets.

Beyond geographic-specific opportunities, we also think Iveco will enjoy solid performance in its strongest vehicle category. The commercial truck market is broken into several classes: light duty is the smallest, with gross vehicle weight of 3.5-6 metric tons; medium duty covers vehicles of 6 metric tons up to 16 metric tons; and heavy-duty (known as Class 8 in the U.S.) comprises trucks 16 metric tons or greater.

While Iveco builds products for each of these markets, its strongest position is in medium applications. These trucks tend to be used in more specialty applications than their larger counterparts and hold the smallest overall share of the European truck market (roughly 9%, compared with 32% for heavy and 59% for light). Nonetheless, Iveco's Eurocargo product controls the number-two position in the market, trailing only Daimler. Similar to the firm's overall position, Iveco is strongest in Italy and Spain, where it holds 67% and 44% of the respective markets.

Conversely, Iveco has shed share in recent years in the light-duty market, as car-based models from competitors such as Ford (F) and Volkswagen (VLKAY) have proved popular. In addition, Iveco's primary driver in this market is construction spending, which remains 23% below early 2008 levels. Similar to total manufacturing production, we expect construction spending to rebound alongside better economic conditions. However, this latter metric has trailed manufacturing to date, suggesting some additional pent-up demand is possible.

Buses and South America Are Also Important Pieces of Iveco's Portfolio
In 2013, Iveco sold nearly 94,000 vehicles in Europe, the Middle East, and Africa, or 64% of total volume. The next-largest geography was Latin America, at about 19% of volume. Here, the company faces many of the same competitors as in Europe; Ford leads the light commercial vehicle market, Volkswagen the medium, and Daimler is the number-one heavy-truck manufacturer. That said, CNHI estimates that Iveco has doubled its market share in the region's light and medium truck market since 2007, while the company's total volume has increased substantially over that period.

Although Latin America is still a smaller portion of revenue than Europe for Iveco, we believe the company probably enjoys decent profitability there. It is a local manufacturer and enjoys solid brand recognition for its Daily light commercial vehicle (it holds more than one fourth of the Brazilian light market, for instance). A PMI just barely above 50 in this region (50.4 in February, following a 50.8 reading in January) provides some concern, as does a greater potential for competitors based in China and other emerging economies, but we're encouraged by Iveco's rapid growth in the geography.

Iveco also holds a decent market position in coaches and buses throughout Europe; it estimates an 18.5% share in 2013. These products made up just 6.9% of the firm's unit volume in 2013, but they carry much higher price tags than most of the firm's trucks, so we estimate the business is 10%-15% of Iveco's revenue. Total units sold remain below 2007 levels, though competitor Volvo has noted a recent uptick in new orders. Similar to trucks, some of this recent strength probably stems from prebuy activity ahead of Euro VI, but the market should benefit from improved economic activity.

Specialty vehicles round out Iveco's product offering. The company manufactures military, mining, and emergency trucks in this segment, and its firefighting vehicles in particular enjoy strong pricing, thanks to all custom bid work and minimal competition. But reduced government spending and challenged economic conditions have driven down volume 24% since 2007, to roughly 3% of overall units. As with buses, the revenue impact is greater because of higher average pricing, and increases here would help to lift the segment's profitability. However, we don't believe this segment will be a key driver going forward.

Iveco Has Struggled to Generate Positive Profits, but Margins Should Improve
Before the global recession, Iveco posted operating margins north of 7%, but challenged volume, pricing, and execution drove down this metric to 1.5% in 2009. Profitability improved to 5.3% in 2012, but fell to just 1.2% in 2013 because of the downturn in market volume, renewed pricing difficulties, and supplier- and production-related headwinds.

We think pricing will remain challenging, though not to the degree seen in recent quarters. Many companies, including profit leader Scania, have used price as a method to gain market share, but management commentary at this company and others suggests more discipline going forward, especially since new Euro VI engine requirements are likely to push per-truck costs up 8%-10% for OEMs in 2014. Similarly, Paccar and Daimler have pointed out recently that they would like to pass these costs on to consumers, and CNHI's management has gone as far as calling the pricing environment "unnecessarily difficult."

We're also encouraged that Iveco's margins climbed sequentially each quarter in 2013, suggesting the company has worked through higher-than-expected costs associated with the launch of its new heavy truck in the first quarter of 2013. In addition, we think the firm is poised to benefit from restructuring its heavy-truck production facilities in Europe in 2012 as volume recovers; management said recently that it believes its manufacturing base is set to capture any upturn from this point, limiting the need for immediate capital spending.

In all, we believe Iveco can drive operating margin expansion over the long run from 2013 levels, through facility rationalization and operating leverage from greater volume. Given the uncertainty in continued economic expansion in places such as Brazil and Eastern Europe, however, and concerns regarding renewed pricing competition, we constrain our forecast to just 6% by 2017, still well below the levels before 2009 and only slightly above 2011 and 2012.

Although Iveco Should Enjoy a Cyclical Upturn, We Don't Think It Has a Moat
We believe Iveco's revenue and earnings should improve as a result of end market recovery and recent restructuring actions, but we don't think the firm enjoys an economic moat. Returns on invested capital are difficult to estimate, given a lack of information, but we estimate they probably weren't north of cost of capital while Iveco was a part of Fiat Industrial. Operating margins were roughly in line with many peers over the past several years, and the group's dealer network seems to be on par with major competitors--Iveco has more than 2,000 sales and service locations throughout Europe, compared with 1,750 for Daimler, for instance--but profitability remains below that of margin leader Scania.

Moreover, Iveco is not a price leader for heavy trucks in its core European region, and although the business has taken substantial share in several key Latin American categories, this latter region also remains hotly contested. Although we're encouraged by Iveco's manufacturing facility rationalization, we think any cost advantage will prove fleeting; for instance, Volvo has outlined its own plans for production consolidation in Europe. We also don't see any meaningful switching costs; although some larger customers may prefer to work only with a single truck supplier, we believe most truck offerings are relatively commodified, with price and fuel economy (which both change upon new model releases every year) differentiating factors.

Although we don't think Iveco enjoys any long-term sustainable competitive advantages, we think the market is pricing CNHI's stock as if it won't enjoy any earnings growth over the next three years. Though we agree with that sentiment when solely examining the farm equipment side, we believe the market isn't giving Iveco full credit for a rebounding end market and the potential to improve profitability.

Farm Equipment Will Face Difficulty, but That's Probably Not News
Unlike our positive take for Iveco, we don't expect CNHI's farm and construction equipment segment to enjoy any growth in operating income through 2017. This business--more than 60% of consolidated revenue in 2013--mostly consists of agricultural machinery (about 84% of segment revenue), where falling farm income, difficult comparisons following several strong years, and additional headwinds such as reduced U.S. tax incentives and higher Brazilian borrowing rates will probably pressure sales over the next several quarters. We've lowered our top-line projections for this business to account for commentary from competitors AGCO (AGCO) and Deere (DE) that suggests a mid-single-digit drop in global volume for 2014.

We still believe the remaining construction business in this segment will enjoy near-term growth, as leading indicators such as the U.S. Architecture Billings Index still suggest tailwinds for nonresidential construction spending. Although it is a small piece of CNHI's overall business (about 10% of revenue), we expect double-digit revenue gains and rebounding profitability here to help mitigate but not fully offset declines in farming.

We forecast declining operating margins for the combined farm and construction machinery segment over the next five years as a result of a negative mix shift away from large farm equipment (which enjoyed a cyclical upswing in recent years). While the resulting slow growth of operating earnings (just 2% annually) is concerning for CNHI's entire enterprise, we believe this negativity is well known by the market, given several quarters of falling global crop prices and discussion surrounding near-term headwinds.

CNHI's Valuation Compelling
Although CNH Industrial faces challenges in its core farm equipment segment, we think it will still enjoy growing earnings, given a more positive outlook for truck sales. Including the financial services arm, we forecast net income growing at an 8% compound annual rate from 2014 through 2018, far higher than the flat earnings we project for farm and construction equipment peer AGCO and declines we see at Deere. While we'd be happy to buy Deere at the right price because of its narrow economic moat and positive moat trend, its milder discount to our fair value estimate gives us pause.

In addition, CNHI Chairman Sergio Marchionne has proved to be a shrewd rebuilder of companies, most recently at Fiat SpA. Although he doesn't hold day-to-day management responsibility at CNH Industrial, his guidance and experience at Fiat Industrial (where he was also chairman) and Fiat automotive over the past several years should help to manage improvement at Iveco.

Also, CNHI's free cash flow should improve following several years of increased capital spending needs. Cash from operation less capital expenditure was a paltry 17% of net income in 2012, by our calculation, but improved to 58% in 2013. With production capacity needs and engine emission-related investment requirements now mostly behind the company, we expect capital expenditures to fall to below 4%of sales, similar to the level of spending we foresee for AGCO and Deere.

Overall, we think there's currently more upside to CNHI's valuation than downside. Our scenario analysis suggests a bear-case valuation of roughly $8 per share, about 27% lower than the current market price. Here, we incorporate a revenue decline in 2014 followed by several years of low-single-digit gains and operating margins falling to about 5.5% over the long run from 6.4% in 2013. Conversely, we think a more optimistic scenario could lead to a fair value estimate of $20 per share, as the European economy rebounds at a stronger rate than we project and margins reach double-digit levels. We believe this outsize reward versus risk provides a suitable margin of safety for investors looking for increased European exposure, with potential upside from improved internal profitability.

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