• Product Activation Key

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Elevator Pitch

Generac Holdings (NYSE:GNRC), the market leader in the home standby power generators, is a great business that trades at reasonable valuations. In the past 52 weeks, Generac's share price declined from its peak of $61.17 in March 2014 to trade as low as $38.93 in October 2014. This is largely due to the fact that Generac's organic revenue growth has been almost flat in 2014, compared with a 19% CAGR between 2003 and 2013. In management's exact words, 2014 was a year where the 'power outage environment that remained well below normal levels nationally.' While Generac's share price has since rallied by 27% in the last six months to close at $49.70 on March 5, 2015, I still find Generac's valuations attractive at 12.1 times adjusted EV/EBITDA and at a 19% discount to its previous peak. However, Generac is not necessarily a suitable investment for every single investor. In Warren Buffett's 1996 Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) letter, he wrote that 'Charlie and I would much rather earn a lumpy 15% over time than a smooth 12%.' I share his views. Having 75% market share of the home standby power generation market that boasts a mere 3% penetration rate, Generac has a very substantial growth runway, albeit a lumpy one due to the unpredictability of outage activity.

Company Description

Started in 1959, Generac is a manufacturer of power generation equipment and other engine powered products, which derived approximately 49% and 44% of its 2014 revenues from the residential and the industrial & commercial end-markets respectively. I will be focusing the majority of my analysis on Generac's residential standby power generator business, as this segment has the strongest competitive advantages, the greatest growth opportunities and the longest growth runway to reinvest its free cash flow at high rates of returns.

Sustainable Competitive Advantages

Generac's home standby power generator business boasts strong competitive advantages and high barriers to entry.

There is a virtuous cycle at play here, as Generac's market leadership in the domestic home standby generator market (75% market share as at end-2014) enhances its brand image in the eyes of prospective customers, which in turn further enhances its market share. A seller's reputation for reliability is the key consideration for home owners seeking to purchase home standby generators to guard against the possibility of power outages and blackouts. Therefore, home owners will naturally choose the market leader Generac, as its dominance of the home standby generator market serves as the best proxy for the quality of its products.

Scale is a key critical success factor for most manufacturing companies and Generac is no exception here. Generac boasts significant economies of scale in manufacturing, due to its ability to spread its fixed production costs over a larger revenue base vis-à-vis smaller sub-scale competitors. Generac has manufacturing plants and distribution facilities in the U.S., Mexico, Italy, the U.K. and Brazil totaling approximately 2.1 million square feet to support its business operations. Sub-scale competitors without the revenue base to support such significant capital investments and the resulting fixed costs will find it difficult to compete with Generac. In its 2013 10-K, Generac wrote that 'we are the only significant market participant with a primary focus on power generation with a core emphasis on standby, portable and mobile generators with broad capabilities across the residential, light commercial, industrial, oil & gas and construction generator markets.' In addition, Generac has considerable bargaining power over its suppliers of machined and manufactured components. Its scale implies that it is a significant customer for its suppliers, which gives it greater leeway to negotiate for more favorable prices for its supplies.

The results speak for themselves. Generac is the outright leader in the domestic home standby generator market with 75% market share. This also represents a 500 basis points gain in market share in the past year, as Generac's domestic home standby generator sales only accounted for 70% of the market in 2013. In addition, Generac has historically delivered consistent gross margins and EBITDA margins in the high-30% range and the low-to-mid-20% range respectively.

Long Growth Runway

While there are other high-return companies on the market, not every one of them has a long growth runaway to compound its high returns like Generac. Although Generac grew its revenue by an impressive 2003-2013 CAGR of 19%, the North American home standby power generator market is still in its first innings.

Firstly, the penetration rate of home standby generators in the U.S. is very low at 3%, compared with other home 'essentials' such as home security alarms (found in 20% of U.S. households) and central air conditioning (found in close to 80% of domestic households). Every 1% increase in the domestic home standby generator market penetration implies an additional $2 billion revenue opportunity for Generac.

Product Activation Key

Secondly, the lack of significant outages in 2014 should be perceived as an anomaly rather than the norm. The U.S. power grid is more than 50 years old and it comes as no surprise that an aging grid is the cause of increased outages. The number of power interruptions affecting more than 50,000 customers has increased by a 17% CAGR between 2003 and 2013. According to a International Business Times article titled 'Aging US Power Grid Blacks Out More Than Any Other Developed Nation', the U.S. electric grid currently loses power almost four times as often than in 1984, and the U.S. also has the dubious honor of being the developed nation with the highest number of blackouts globally. The increased frequency outages help to raise awareness of the benefits of owning a home standby generator.

Thirdly, Generac is the beneficiary of an aging population. According to its internal warranty registration data, three out of four of its customers are aged 50 and older. This is hardly surprising since people become more risk-averse as they grow older. In addition, older people have also experienced more blackouts to understand the need for mitigating such risks. A new Census report released in May 2014 suggested that the population aged 65 and over is expected to double between 2012 and 2050. This should be a key driver of increased penetration rates for the domestic home standby generators market.

Creating Demand In An Unfavorable Environment

2014 has been an exceptional year for Generac in a negative way. 'Regular' power outages and blackouts are positive for Generac, as these events help to boost public awareness of the need for home standby generators and increase product adoption rates as a result. In 2014, the U.S. experienced below average normalized baseline level of outages at the national level in every quarter; the level of outages in Q4 2014 was estimated to be more than 70% below average. Despite the absence of significant outages nationally in the past two years, Generac has performed admirably well. At the recent Q4 2014 earnings conference call, management commented that there was 'organic year-over-year growth in orders for home standby generators,' and 'home standby generator sales exceeded our expectations during the fourth quarter with product activation rates proving to be resilient.'

While bears might choose to focus on the unfavorable environment that Generac is currently operating in, I am encouraged by the fact that Generac has managed to drive positive demand for its products via effective marketing strategies and new products. This is especially the case since Generac has managed to grow the sales of its home standby generators, in the absence of significant outages to simulate such demand.

Generac has been optimizing its sales and marketing efforts in the past few years and one such example is its PowerPlay, an in-home selling solution. PowerPlay is a tablet-based software program that provides its dealers with pre-qualified leads (by Generac's lead team) and an in-built scheduling application for in-home consultations to assist them in closing more deals. Currently, approximately a quarter of Generac's dealers are on the PowerPlay system and they are experiencing double-digit increases in sales. As more of the remaining 75% of Generac's dealers use the Powerplay system, I expect Generac to experience stronger revenue growth resulting from a higher rate of conversion of in-home consultations to sales. PowerPlay complements Generac's strategies in the other parts of the sales cycle such as a targeted process to find the best sales prospects and relevant media advertising campaigns.

Generac also continues to expand its product portfolio of home standby power generators to meet the varying needs of its customers. In 2014, Generac introduced the PowerPact line of standby generators, where the entry-level 7-kilowatt unit in the PowerPact product line is priced at $1,899, providing budget-conscious buyers an affordable option. For customers willingly to pay up for a product of higher quality, Generac's Guardian Synergy line of standby generators, also launched last year, promises higher fuel efficiency, significantly reduced noise and exceptionally clean power output.

Growth Prospects For Commercial & Industrial Markets Equally Compelling

Generac generated approximately 44% of its 2014 revenues from the industrial & commercial end-markets, so it is sufficiently significant for me to elaborate on the growth drivers for these markets. Apart from the tremendous growth opportunities embedded within the under-penetrated North American residential standby generator market, Generac's commercial & industrial end-markets also benefit from certain secular trends.

One key driver is the increased popularity of natural gas fueled generators, which is driving the adoption of power generators in the commercial & industrial markets. Natural gas fueled generators are estimated to be 35% cheaper than their diesel fueled counterparts. According to research by Frost & Sullivan, natural gas fueled generators are expected to account for 52% of the U.S. market by 2018, compared with 37% market share in 2013. Generac has capitalized on the potential market share shift from natural gas fueled generators to diesel fueled generators, with the launch of a new 400-kilowatt natural gas fueled generator in 2014 to broaden its product line-up.

Another key driver is the fact that certain segments of the commercial & industrial markets for power generators remain under-penetrated. For example, management estimates that the power generator penetration rate for cell tower sites in the U.S. is only 30%-35%. As regulatory scrutiny over the networks increases, more of the 300,000 cell tower sites should be equipped with power generators. Similarly, an increasing number of commercial building owners and operators are realizing the need to have a 'optional' standby generator to provide backup power in the event of outages. The opportunity set for this is significant, which management estimates at 14 million commercial buildings in the country.

Decent Capital Allocation Track Record

A company's capital allocation practices and track record is equally if not more important than its competitive advantages and growth prospects. This is particularly true for a high-return, cash flow generative company like Generac.

Generac has historically maintained a good balance between investing for future growth and returning excess capital to shareholders. Generac completed the acquisition of seven companies in the past three years to increase cross-selling opportunities by expanding its product portfolio and drive operating leverage with increased scale. It also increased its R&D spending by 24.6% and 7.6% year-on-year in 2013 and 2014 respectively. Generac's focus on R&D has allowed it to build up a portfolio of more than 170 patents and patent applications, and broaden its product offerings.

On the other hand, Generac issued special dividends in the second quarter of 2012 and the second quarter of 2013. This reflects Generac's emphasis on allocating capital to the highest yielding projects. In the absence of such compelling opportunities, Generac does not hoard cash and is in fact willingly to return excess capital to shareholders. At the Baird Industrial Conference, management highlighted that 'as future cash flow permits, may consider further return of capital to shareholders.'

Valuation

Generac is currently trading at a headline trailing twelve months EV/EBITDA multiple of 12.7 times, based on its 2014 EBITDA of $337 million. It has a substantial tax asset created from the $1.9 billion combined asset basis step-up created through past acquisitions. Assuming that Generac stays profitable and a 38.5% federal and state tax rate, management estimates annual tax savings of approximately $49 million between 2015 and 2020. If I deduct the $234 million present value (assuming 10% discount rate) of such tax savings from Generac's enterprise value of approximately $4.33 billion, Generac's adjusted EV/EBITDA ratio is 12.1 times. This compares favorably with the 12.4-13.8 EV/EBITDA trading range for Generac's peers, Ametek (NYSE:AME), IDEX Corporation (NYSE:IEX) and Nordson Corporation (NASDAQ:NDSN). I have chosen these three industrial technology companies as Generac's peers, because they sport similar EBITDA margins in the 23%-26% range.

GNRC EV to EBITDA (TTM) data by YCharts

GNRC EBITDA Margin (TTM) data by YCharts

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I find Generac's valuations reasonable, as it trades at a slight discount to its peers based on EV/EBITDA, despite delivering similar EBITDA margins. Furthermore, 2014 has been a difficult year for Generac as mentioned above. Generac's sales were flat and its EBITDA declined 16% year-on-year in 2014. I expect Generac to get back on the growth path, as outage levels normalize. Looking ahead, Generac should grow its EBITDA and witness a positive re-rating of its EV/EBITDA multiple in the next three to five years, as it continues to benefit from the increased penetration rate of domestic home standby generators.

Variant View

Power outage activity is inherently uncertain and unpredictable which could lead to substantial revenue and earnings volatility. The potentially lumpy growth of Generac on a year-on-year basis will put off most investors seeking predictability in the stocks they own.

Disclosure:The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.