In the nine months since I wrote my relatively bullish piece on Navistar International Corporation (NAV), the shares are down about 9% against a basically flat performance for the S&P 500. The shares have risen a great deal and dropped a great deal since then, so I thought I’d look in on the name again to see if now is a good time to buy. In addition, I suggested selling some put options on these shares and that trade also deserves comment. I think my readers can be put into two groups: the people who want me to “just get to the point, already”, and that guy who likes to read every word. For the benefit of the former group, (sorry, odd guy who reads these for their entertainment value), I’ll come right to the point. I think history demonstrates that this is not a “buy and forget” kind of stock, as demonstrated by the fact that share price has hardly moved in 20 years. That said it’s been a potentially very profitable investment for those who were willing to buy when it was inexpensive and sell when it traded for a dearer price. I think the shares are near the high end of their historical valuation, and for that reason I think investors should avoid the name and wait for a better entry point. I think the short puts I recommend below help in that effort by generating premia now while trying to lock in a much better buy price.
I think the financial history here is mixed, with some good news and bad news. On the bright side, the company has managed to grow net income fairly dramatically over the past several years, in spite of sluggish sales growth. Specifically, investors saw revenue grow at a CAGR of about .7%, and in just 6 years, net income has swung $840 million from a $619 million loss in FY 2014 to profit of $221 million during the most recent full year. Further, I think investors can take heart in the fact that the firm is an essential business that is working in support of the world’s increasingly stressed supply chain. This hasn’t prevented truck and bus assembly plants in the U.S. and Mexico, and engine assembly plants in the U.S. and Brazil from being shut down for a time during the height of the Covid-19 pandemic, though. Another bright spot is the fact that the firm seems capable of reacting relatively dynamically to changing market conditions, as demonstrated by how the company reacted to a 30% drop in sales in the first six months of this year compared to last. Specifically, the company managed to drop SG&A expenses by 37% from $559 million to $352 million. Interestingly, interest expense dropped by 23% in spite of a ~6% uptick in the size of long term debt.
The bad news relates to that debt in my view, given that it has grown to the point where the company now has negative equity. The primary problem with this debt in my view is that it may need to be rolled over at a particularly inopportune time. The more the debt grows, the greater this risk becomes in my estimation. I’ve tried to take the first steps toward quantifying this risk below by comparing the size and timing of future obligations with the company’s current and expected resources.
As is frequently the case, I need to offer further commentary about Capital expenditures. On page 39 of its latest 10-K (LINK BELOW) the company forecast approximately $225 million of capital expenditures for 2020. This compares to the average of $116 million spent on CAPEX over the past three years. I’ve estimated future capital expenditure requirements after 2020 by averaging these two figures. Please note that this is obviously a guess, but hopefully an informed one. I’d make two further points before unveiling the master piece that is the following table. First, I think it’s possible to delay CAPEX investment in the short term, but over the long term, these investments must be made if the firm is to remain viable. Second, the only figure listed below that is relatively uncertain is the capital expenditure. Thankfully this represents a small percentage of the total, so my forecast is relatively robust.
Source: Latest 10-K
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Against the upcoming obligations, the company has cash and equivalents of $1.5 billion. In addition, the firm has generated an average cash from operations of about $275 million over the past three years. In addition, the company has enhanced its liquidity by selling another $600 million in senior secured notes. Finally, the company has taken actions that are designed to conserve $300 million of cash. So, approximately $2.675 billion will be available to the firm in 2020, and based on that I think the firm will need to come back to the well by 2023 at the latest. It’s also somewhat alarming that the firm generates about $275 million annually and has annual obligations about five times that figure.
Source: Company filings
In conclusion, I think the financial history here is relatively troubling. That doesn’t disqualify the company from consideration, because I’m willing to buy challenged companies at the right price. Thus, I need to spend some time looking into whether investors are compensated for the risks here with a lower stock price.
As my long time victims of my writing know by now, “right” price is a more polite way of saying “cheap” price. I judge the relative cheapness of a stock in a few ways, ranging from the simple to the more complex. On the simple side, I like to look at the ratio of price to some measure of economic value, like earnings, free cash flow and the like. In particular, I want to see a stock trading at a discount relative to both the overall market and its own history. When I first wrote about Navistar, I was surprised that these shares have risen and fallen a great deal, but the price in 2019 price was quite close to the 1999 price. This suggests that the “buy and forget” idea in investing isn’t appropriate in this case.
Per the following, the shares are inexpensive relative to many other stocks, but they are expensive relative to their own past. This is particularly troubling in the case of a cyclical business like this one.
In addition to looking at what investors are being asked to pay for $1 of future value, I like to look at the assumptions currently embedded in price. In order to do that, I turn to the methodology described by Professor Stephen Penman in his book “Accounting for Value.” in this book, Penman walks investors through how they can isolate the “g” (growth) variable in a standard finance formula to work out what the market must be assuming about long term (i.e. perpetual) growth. Applying this methodology to Navistar at the moment suggests the market is forecasting a growth rate of about 6% for this company. I consider that to be a fairly optimistic forecast, and for that reason, I can’t recommend buying the shares at current levels.
In my previous article on Navistar, I made the point that successful investing in a company like this required that the investor not overpay. I made the point that the options market allows investors to simultaneously pocket some premium while obliging themselves to buy this company at a price that has historically lead to great future returns. With that in mind, I recommended investors sell the April 2020 put with a strike of $22. These were bid-asked at the time at $1-$1.20. I was exercised on these earlier this year, when the price dropped far below $22 and when there was only 1 month of time value left on the puts. I locked in a net price of ~$21, and I was content because I think that price has lead to great future returns on this business. The shares are 27% higher today, which offers further positive evidence of the risk lowering and profit enhancing potential of put options.
Because I want to try to replicate success whenever possible, I’ll be recommending another short put trade. In particular, I’m suggesting that investors sell the January 2021 put with a strike of $22. There is currently bid-ask spread, with buyers willing to pay $.90 and sellers demanding $4.90. I think the sellers are wrong in this case, and I would be happy to sell at the bid here. If I’m exercised again, I’ll own this business at a net price that has historically offered great returns. If the shares remain above $22, the options obviously expire worthless, and that’s never a bad thing. Thus, I consider this trade to be a win-win proposition.
I sincerely hope that stories of my own success with this trade and the win-win nature of short put options has gotten you excited about the profit potential here, because I take some pleasure in deflating hope. I never claimed to be a nice person. Anyway, I take great pleasure in obliterating the optimistic mood by talking about risk. Investing, like life in general, involves making choices among a host of imperfect trade-offs. There is no ‘risk-free’ option. We try to navigate the world by exchanging one pair of risk-reward trade-offs for another. For example, holding cash presents the risk of erosion of purchasing power via inflation and the reward of preserving capital at times of extreme volatility. If you don’t know the risk-reward trade-off of buying shares, you must be new here.
I think the risks of put options are very similar to those associated with a long stock position. If the shares drop in price, the stockholder loses money and the short put writer may be obliged to buy the stock. Thus, both long stock and short put investors typically want to see higher stock prices.
Puts are distinct from stocks in that some put writers don’t want to actually buy the stock; they simply want to collect premia. Such investors care more about maximizing their income and will, therefore, be less discriminating about which stock they sell puts on, or at what strike prices. These people don’t want to own the underlying security. For my part, I really value sleep, and really value not stressing too much about anything, so I’ll never sell puts on anything other than companies I’m willing to buy at prices I’m willing to pay. For that reason, being exercised isn’t the hardship for me that it might be for many other put writers. My advice, dear reader, is that if you are considering this strategy yourself, you would be wise to only ever write puts on companies you’d be happy to own and at prices you’d be happy to pay.
In my view, put writers take on risk, but they take on less risk than stock buyers in a critical way. Short put writers generate income simply for taking on the obligation to buy a business that they like at a price that they find attractive. This circumstance is objectively better than simply taking the prevailing market price. This is why I consider the risks of selling puts on a given day to be far lower than the risks associated with simply buying the stock on that day.
Not only do I want to splash cold water all over your hope, dear reader, but I want to be somewhat repetitive while doing it. I’ll pad this article even more by indulging this tendency. I’ll use the trade I’m currently recommending as an example. An investor can choose to buy Navistar shares today at a price of ~$26.70. Alternatively, they can generate a credit for their accounts immediately by selling put options that oblige them – under the worst possible circumstance – to buy the shares at a net price more than 27% below today’s level. In my view, that is the definition of lower risk. This is especially the case for a company like Navistar, where the price paid determines future returns.
I think there are certainly some positives here financially, but I think there are some problems too. For that reason, I’m not willing to pay an enormous premium to own this business. This is especially the case in light of the fact that over the very long term, these shares are basically flat. I think the only way to “play” this investment is by buying at the correct time and price. I think the shares have crept up in price to a point where the only direction is down, and for that reason I’ll be taking profits on this name. That said, I’m comfortable owning the shares again at $21.10, so I’ll be selling the puts described above. I think this is an example of a company that investors need to pay a great deal of attention to, and that they must be willing to trade. The past two decades have demonstrated what happens to investors who “buy and forget” companies like this, and I want to learn from their mistakes. I recommend other investors do the same and eschew these shares until they come down in price.
Disclosure: I am/we are long NAV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I’ll be selling my shares and selling 10 of the puts described in this article.