Generac: A Fantastic Long-Term Opportunity

seekingalpha04-23

Generac's shares have fallen over 80% from their all-time high, creating an attractive valuation for investors.The company is well-positioned to benefit from long-term "megatrends" such as the ...

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Michael Jones Thesis For a seemingly simple business, shareholders of Generac (NYSE:GNRC) have been through quite the emotional roller coaster over the years. Since hitting all-time highs in 2021 of $505.80, shares have fallen over 80% from peak to trough, translating to a loss of over $25B in shareholder value. This pessimism can largely be attributed to concerns over the high-interest rate environment, excessive inventories, and the overall cyclical nature of the business. However, with several long-term \"megatrends\" in place and a return to robust growth, the current valuation is beginning to look highly attractive. Let's take a deep dive into Generac's business model and these \"megatrends\" to determine how attractive this valuation really is. Company Overview Generac is an industry-leading energy technology company offering backup power generation for residential, commercial, and industrial markets. Through several notable acquisitions, Generac has the broadest product portfolio in the industry, including solar + battery solutions, energy monitoring devices, and battery-powered tools. Generac Public Filings With a market share greater than 70%, GNRC has leveraged its strength in power generation products to expand its product portfolio even further. GNRC is now focused on building vertically integrated \"ecosystems\" of energy technology products with significant investments in residential and C&I energy storage, solar, energy monitoring, and electric vehicle charging. Generac is led by longtime CEO Aaron Jagdfeld, who has been with the company for nearly 30 years. Jagdfeld has significant skin in the game, owning roughly 592k shares worth $78m, something I always look for when researching new investment opportunities. Interest Rates And Inflation GNRC is a highly cyclical business, heavily dependent on consumer sentiment and confidence. Considering the big-ticket discretionary nature of most product lines, GNRC sales can be highly vulnerable to a weakened consumer. This sort of sentiment deterioration is exactly what occurred from late 2021 to the beginning of 2023. In the chart below, I overlaid the US Index of Consumer Sentiment with GNRC share price. Data by YCharts As you can see, the correlation between GNRC share price and consumer sentiment is a near mirror image. One of the biggest drivers behind this rapid deterioration in sentiment was the near-overnight spike in US inflation. Over two years, US CPI surged from 1% to 9.1%, levels that we have not witnessed since the 1980s. Data by YCharts In a high inflationary environment where everyday essentials become a challenge, the last thing most consumers are looking to purchase is a big-ticket discretionary item. Not only did GNRC have to combat this weakened demand, raw material inflation weighed heavily on profitability. Component parts and raw materials comprised approximately 72% of the cost of goods sold in FY2022. These primary raw materials, such as steel, copper, and aluminum, experienced significant price fluctuations throughout 2021-2022. With little to no long-term supply contracts with fixed prices in place, GNRC margins began to erode. Gross profit margins fell by over 500 basis points from FY2020 to FY2022, declining from 38.53% to 33.34%. GNRC underwent multiple rounds of price increases in 2021 and 2022 to counter these rising input costs. To combat the rise in US inflation, we witnessed the Federal Reserve undergo the fastest rate hiking cycle in history. The surge in the cost of borrowing has forced corporations to delay capital expenditure projects and consumers to hold off on home renovations and remodels. Generac's light commercial and industrial generator sales rely highly on these non-residential construction and capital investment projects. Residential products also take a hit as they correlate to home remodeling expenditures. In the Q4 earnings call, management highlighted that their 3rd party financing program, Synchrony, has grown by almost 50% over the last year. Clearly, consumers weigh interest rates and financing options when evaluating home standby generator purchases. Management is highly constructive about the anticipated tailwinds brought on by the return to a lower interest rate environment. Specifically, they have pointed to the lifting of pressure on commercial project timelines and the resumption of projects that had been previously delayed. Inventory Buildup Home standby field inventory levels have been one of the most significant headwinds for GNRC over recent quarters. After experiencing a surge in demand from late 2021-2022, GNRC began to overproduce ahead of market demand to keep up. Data by YCharts When consumer sentiment deteriorated as the Federal Reserve engaged in the fastest rate hiking cycle in history, GNRC was left with highly excessive inventory levels and weakened demand. From Q1 2021 to Q2 2022, inventory levels surged over 85% from $772.9M to $1,424M. These elevated field inventory levels continued to have lingering effects, one of the largest being four consecutive quarters of negative free cash flow in FY 2022. The good news is that management has made tremendous strides in bringing field inventory levels back to historically in-line levels. By severely undershipping the market, management has been able to reduce inventory levels by over $144M this past quarter alone. Generac Public Filings As highlighted in the Q4 earnings call, management estimates that current inventory levels are still 1.2x higher than normal, but by the end of Q1 2024, the issues will be largely gone. This news of progress gives shareholders a sigh of relief, as these elevated inventory levels have been a distraction for the past six quarters. We are already seeing immediate positive effects as GNRC generated a record high of $266M in free cash flow this past quarter. Mega Trends Generac Public Filings Grid 2.0 The evolution of the traditional electrical utility model as supply/demand imbalances are created due to the accelerating adoption of renewable energy generation and the \"electrification of everything\" in society's energy consumption. It includes the grid's decarbonization, digitization, decentralization, and migration toward distributed energy resources, which is expected to drive demand for various clean energy and grid service solutions going forward. This trend examines the pivot from traditional coal plants to the rapid growth of renewable power sources such as solar and wind. These sources are intermittent, meaning they do not have the ability to supply reliable power 24 hours a day, 365 days a year. According to the recent PJM Interconnection report, fossil fuel plants are being retired significantly faster than renewable sources are being developed. As a result, we now have fewer power sources that are more intermittent in nature, a combination that will never bode well. According to Generac's recent form 10-K, \"The North American Electric Reliability Corporation has labeled significant portions of the continent at high risk of resource adequacy shortfalls during normal seasonal peak conditions in 2023–2027.\" This disastrous trend becomes even more magnified when considering the broadening \"electrification\" theme we are undergoing. Nearly everything around us is becoming electric, from vehicles to household appliances. This theme has been further fueled by significant government incentives and regulations, pushing consumers to transition to electric vehicles and heating sources. When this enormous increase in demand meets the weakened supply, the outcome will be disastrous. Climate Change The expectation of more volatile and severe weather driving increased power outage activity and more global regulation accelerating renewable investments Just this past week, the CSU Tropical Weather & Climate Research forecasted 2024 hurricane activity. CSU Tropical Weather and Climate Research The 2024 forecast marks the highest hurricane prediction CSU has ever guided for, predicting 11 hurricanes compared to the 7.2 annual average from 1991-2020. This extremely active hurricane season is predicated upon the record warm sea surface temperatures and transition to La Niña conditions. Whether it be hurricanes in the south, wildfires in the west, or the Great Texas Freeze, there is no denying that volatile weather events are here to stay. The increased likelihood of severe weather events serves as an incredible opportunity for GNRC. As highlighted in the Q4 earnings call, an event such as a category three or higher landed hurricane or major winter storm can potentially add between $50-$100M in sales. Emergence of cleaner alternative fuels Natural gas will remain in demand as a source of cleaner, reliable power generation for backup power and beyond standby applications, compared to diesel fuel. As the world continues to shift towards lower-emission power generation sources, natural gas should continue to experience robust demand as opposed to traditional diesel-fueled generators. GNRC is well positioned for this continued growth, specifically in the C&I business, where natural gas generators represent an increasing portion of product offerings. Global Infrastructure Legacy infrastructure, including transportation, water, and power, needs a major investment cycle to rebuild and upgrade aging networks and systems. In addition, telecommunications infrastructure is shifting to the \"5G\" architecture. Generac is the leading global supplier of backup power to the telecommunications market in the US. In addition, over half of all existing tower sites are not yet built with backup power solutions. The rollout of new \"5G\" infrastructure to meet the rapidly growing demand for wireless networks creates the runway for robust C&I demand. In addition to this, there is a highly apparent need for upgrades to legacy infrastructure and capital investments. Generac services many industrial markets, including retail, office, data centers, and healthcare facilities. The US. The Department of Energy found that \"the average age of large power transformers in the US, which handle over 90% of electricity flow, is 40 years.\" Moreover, we are also witnessing policies such as the Bipartisan Infrastructure Law that directly allocates $550B to new federal investment in US infrastructure. Home As A Sanctuary In recent years, there has been a trend of more people working, shopping, entertaining, aging in place, and generally spending more time at home. This growing trend leads to increased sensitivity for homeowners to long-lasting power outages. According to Forbes, roughly 12.7% of full-time employees worked from home in 2023. While we are beginning to see a shift back into in-person settings, hybrid models have continued to gain traction. These remote and hybrid work models require reliable power sources, creating significant residential opportunities for Generac. Residential Business Generac's residential business represents 51% of total sales, and historically, it has been the company's most important segment. As previously mentioned, GNRC is the product category leader with over 70% of the total market share. While residential product sales only increased 1% this past quarter, multiple tailwinds and opportunities for organic growth remain intact. In my opinion, the most promising of these tailwinds is the remaining growth opportunity within the residential segment. As of 2023, the total home standby generator penetration rate is 6.25%. Generac Public Filings While some of the highest penetrated markets are between 15%-20% and growing, the largest markets (CA, TX, & FL) remain significantly underpenetrated at ~3.5%. For context, every 1% penetration equals a $3B end-market revenue opportunity. Management forecasts US penetration rates to be 7.8% by FY2026. With a near stranglehold of 70% market share, this forecasted penetration represents a $3.36B opportunity. Generac Public Filings Management is aware of this incredible growth engine and is taking meaningful steps to unlock it. This past quarter, Generac introduced a new advertising campaign, \"It's a Power Move,\" to help drive consumer awareness of the home standby generator market. Although the advertising campaign is still in the first couple of innings, signs are already pointing in the right direction. Not only did close rates improve during Q4, but home consultations in January were also at an all-time high for the month. In addition to this, activations, which are a proxy for installations, were at an all-time quarterly record. For FY 2024, management expects product sales growth in the mid-teens range, led by home standby generators and residential energy technology products. This robust increase in residential growth also serves as a tailwind for gross margin expansion, as home standby products offer significantly higher margins than their commercial peers. Commercial & Industrial Business Representing 37% of overall sales is the Commercial & Industrial (C&I) segment. This business caters to large and growing markets, providing solutions such as natural gas & diesel generators, mobile products, telecom, and mobile storage. This broad portfolio includes products like light towers and mobile generators, which are typically used for road and commercial construction sites. Generac Public Filings As highlighted in the Q4 earnings call, global C&I product sales reached an all-time record in 2023 of approximately $1.5B. This past year marked the segment's third consecutive year of robust double-digit growth. Generac forecasts significant growth opportunities within the segment, estimating a 10-12% compounded annual growth rate through 2026. As a result of this optimism, management continues to make substantial investments within the segment, breaking ground on a new manufacturing facility in Wisconsin to increase capacity for C&I products. One of the biggest drivers of this robust organic growth opportunity is the increased construction of infrastructure within the US, specifically cell sites and data centers. Generac Public Filings Starting with telecom, GNRC is a tier 1 supplier of some of the world's largest telecommunications companies. With goals of 99.5% network reliability and \"5G\" infrastructure rollout, wireless networks have become increasingly reliant on Generac's support network. Between 2022 and 2030, data center power consumption is expected to double. This is primarily driven by the push for US semiconductor facilities and artificial intelligence requirements. As a result of this demand, data center backup power TAM is expected to reach roughly $7B in 2026. As the global leader in natural gas-fueled generators, GNRC has now been created with a multiyear runway of organic growth. As for FY2024 C&I guidance, management expects product sales to decrease by approximately 10%. This softened outlook is primarily the result of weakness in the telecom category and delayed capital investment projects due to a higher interest rate environment. Other Products And Services As highlighted previously, Generac has expanded from its core home standby generator business to creating a \"residential energy ecosystem.\" While this segment currently only accounts for 12% of sales, management forecasts this to grow to roughly 21% by FY2026. Management has relied on acquisitions to fuel this growth, acquiring 28 companies since 2001. Generac has leveraged these technologies to expand its served addressable market. As a result, management forecasts the projected SAM to be $66B, roughly 5x expansion since 2018. Generac Public Filings One of the most successful acquisitions throughout this period was the 2021 Ecobee acquisition. Ecobee is a leader in sustainable home technology solutions, offering smart home thermostats and monitoring products. GNRC has leveraged Ecobee's technologies to create a \"single pane of glass,\" an all-in-one user interface platform that monitors and controls Generac's entire suite of products. For example, if a homeowner has an Ecobee thermostat, customers can view the status of their home standby generator and even fuel levels. Ecobee finished 2023 with over 3.5 million homes, giving GNRC a massive customer base to cross-sell products and continue to create the energy ecosystem. Ecobee is just one piece of Generac's strategy to create the residential energy ecosystem. Other notable acquisitions include the 2019 Pika Energy deal, which offers clean energy solutions such as PWRcell, and the recent minority investment in Wallbox, a global leader in EV charging solutions. For FY2024, management expects gross sales of this segment to be between $325 and $350M, with a year-over-year growth rate of roughly 25%. Competitive Position Generac, known as the \"Kleenex of generators,\" has grown as the industry leader with over 70% market share. This enormous competitive \"moat\" has been created in various ways, including Generac's scale. With over 8,700 dealers and a target of reaching 10,000, Generac has created the largest distribution network in the industry. Generac continues to invest and strengthen this network with the 2021 implementation of \"Power Play,\" a guided sales process for residential dealers. The goal of Power Play is to significantly improve close rates by redeveloping the selling process, improving financing, and improving training. With the largest distribution network and broadest product portfolio, I see this moat going nowhere. Margins After gross profit margins fell by over 500 basis points from FY2020 to FY2022, we have seen three straight quarters of sequential gross margin expansion, with Q4 2023 margins of 36.55%. Data by YCharts Management is confident we have seen the inflection point and has guided for approximately 300 basis points of expansion in FY 2024. Generac is significantly above the sector median gross margins of 30.59% and still has plenty of room to expand. As higher-margin residential products make up a more significant portion of the overall sales mix and technology products improve profitability, shareholders can expect continued gross margin expansion in the foreseeable future. Debt Breakdown With $1.65B in total debt and $201M in cash and short-term investments, GNRC holds significant leverage. Management has a heightened focus on maintaining a healthy balance sheet, targeting a gross debt leverage ratio between 1-2x. I listed Generac's schedule of debt maturities below as of the 2022 annual report. Generac Public Filings Most debt matures between FY2026 and FY2027, giving management plenty of time to continue accumulating positive free cash flow. This past year, GNRC generated $396M in free cash flow and has guided for positive free cash flow in FY2024 with an approximate 100% conversion rate from adjusted net income. Free cash flow generation should remain strong as we continue to see reductions in inventories and operational efficiencies. Over management's three-year forecast period, they expect to generate over $1B in cumulative free cash flow. In my opinion, Generac's leverage should not pose a significant risk. Share Repurchases One of the most important factors when analyzing a potential investment opportunity is that the company is run by shareholder-friendly management that respects capital. Over the years, management has expressed this through substantial share repurchases. Data by YCharts Since the inception of stock repurchase programs, GNRC has repurchased 11,748,713 shares of common stock for $777.4M (Average cost per share of $66.17). This boils down to a nearly 13% reduction in shares outstanding since 2014. This past year, management completed over $252M of share repurchases and approved a new stock repurchase program that allows for repurchases of up to $500M over the following two years. I expect management to continue opportunistically buying back shares in periods of weakness to unlock shareholder value. Valuation During 2021, GNRC traded between $450-$500, hitting an all-time high of $505.80. Here is a financial summary of GNRC in 2021: Data by YCharts  Total Revenue: $3.74B Gross Profit: $1.36B (36.39% Gross margin) Net income: $550.50M (14.73% Net profit margin) Shares Outstanding: 63.70M Earnings Per share: $8.51  Here is my conservative forecast valuation for what I believe GNRC can achieve through 2027: Author's Calculations Using management's guidance as a benchmark, I forecasted 2024 revenue growth of 7%, the high end of initial guidance. This was followed by revenue growth of 12% through 2027, still well below Generac's five-year average growth rate of 18.31%. Although management has guided 2026 revenue targets of $5.85B (12%-14% CAGR), I opted for conservative growth rates significantly below these estimates. Next, I used management's guidance of 300 basis point gross margin expansion for FY2024, followed by sequential 50 basis point expansion through 2027. Management has guided for gross margin targets of 37.5%-38.5% by FY2026, making my estimates in line with the midpoint of this range. I forecasted FY2024 net income margins of 8%, followed by sequential expansions to 11.50% by FY2027. This forecast aligns with Generac's 5-year average net income margin of 11.31%. With a new two-year $500M share repurchase program and a long history of opportunistically buying back shares, I forecasted a reduction of roughly 2M shares, down to 58M total shares outstanding. This is deliberately highly conservative, and forecasts management is not fully utilizing the repurchase program. If management were to use the full $500M and buy back shares at an average price of $140, this would lead to a reduction of roughly 3.6M shares. With that said, this leads us to a FY 2027 EPS of $11.45. By assigning a 20x P/E ratio to these earnings, significantly below Generac's five-year average P/E ratio of 26, we land at a share price of $229. This price target implies a 43% upside to GNRC from today's share price. Over three years, this boils down to a roughly 20% compounded annual growth rate. Risks While shares of GNRC appear to be trading at a significant discount to intrinsic value, there are always risks to any investment. Some of these risks include the following: Restrictive interest rate environment: GNRC has already expressed a downturn in the C&I business as many corporations have delayed capital investment projects due to the current higher borrowing costs. Any prolonged restrictive environment could impact Generac's top-line sales. Consumer Sentiment: A negative shift in consumer sentiment would significantly impact Generac's residential sales. With most product lines being \"big ticket\" discretionary purchases, GNRC is highly vulnerable to consumer health/confidence. Conclusion  I rate GNRC as a buy at these levels. A deteriorating grid, the impact of climate change, the global infrastructure boom, and the transition to cleaner alternative fuels serve as incredible tailwinds for GNRC to capitalize on. Management relentlessly focuses on inventory reduction and operational efficiencies while making strategic, innovative investments for the next wave of organic growth. Generac is one of the largest positions in my portfolio, and I view any short-term weakness as a prime buying opportunity.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2429159208"}