GNRC - Generac: Generating Backup Power And Potentially Strong Gains For Investors

Summary

• Generac provides power backup generators that protect homes, businesses, and mission critical infrastructure & healthcare facilities from electrical outages. It has also made investments for the smart grid future.
• The industry enjoys the tailwind of powerful trends and high returns on capital, and its US residential business has grown strongly over the past decade.
• Revenue has decelerated over the last quarters, which management attributes to a shortage of electricians needed to do the installations, and margins compressed due to increased logistics costs, but both factor appear to be moderating.
• Valuations have pulled back and the stock now trades at an earnings yield of over 6% and an EBITDA multiple of ~10x.
• It may be worth initiating a position in Generac but I would watch the days of inventory to sales closely.

Overview

Generac Holdings Inc. ( GNRC ) manufactures and markets power backup generators that protect homes from blackouts, businesses from loss of revenue, mission critical infrastructure (data centers, cell towers) from disruption, and healthcare facilities from the risk of loss of life due to electrical outages. More recently, it has made investments to position itself for the smart grid future.

I have admired Generac for its growth, execution, and high returns on capital but stayed on the sidelines as the valuation and stock price soared (Figure 1, orange line). After the stock price tumbled by 80% over the last year as interest rates rose, housing starts tumbled, and recessionary fears loomed, the market capitalization has collapsed from over $30 billion to about $6 billion.

I decided to dig into the company and its fundamentals to ascertain whether the bad news had been factored in and if current levels offer an attractive point.

Figure 1 : Generac stock price has tumbled

The Business

Generac provides power backup generators for both residential and commercial & industrial (C&I) applications.

In the residential segment, Generac makes home standby generators and portable generators (it does not break down the relative share, but I believe it has a stronger market leadership in the former). While most of the generators as powered by diesel, natural gas, and liquid propane, the company is driving towards cleaner energy with newer products such as solar with battery storage as well as smart thermostats (with its ecoBee acquisition). In addition, the company markets home chore equipment such as power washing equipment and grass cutters.

In the commercial and industrial segment, the company provides natural gas, liquid propane, and bi-fuel backup generators for small and medium businesses such as grocery, convenience stores, restaurants, retailers, as well as larger and industrial generators for healthcare, telecom, data center, manufacturing businesses. It also provides temporary lighting and power for construction, mining, special events, and to the military.

Generac moved into smart grid products with the 2020 acquisition of Enbala. It is creating a new platform to sell smart-grid ready hardware and software solutions that enable the connection of distributed energy resources (DERs), such as Generac's Smart Grid Ready residential and C&I natural gas generators, PWRcell energy storage systems, to provide electricity to utility transmission power grids. The platform gives utilities and energy retailers the flexibility to operate virtual power plants in real-time and Generac the potential opportunity to convert and manage a fleet of customer power generation assets previously utilized only in emergency power outage situations into a source of recurring revenue for the owners.

The company has generated (no pun intended) strong revenue growth in recent years (Figure 2, red line) as demand soared, particularly in its residential market (green line). As a result, the share of residential products has increased to over 60%, even after the recent pullback (Figure 3).

Figure 2 : Generac revenues by segment

Figure 3 : Generac segment revenues, by percent

Competition:

Generac competes against large equipment and auto manufacturers such as Caterpillar ( CAT ), Honda ( HMC ), Cummins ( CMI ), Honeywell ( HON ), Kohler (private), Briggs & Stratton (private), Westinghouse (private), as well as specialized players such as Bloom Energy ( BE ), Tesla ( TSLA ) and regional providers.

Customer Ratings:

Generac's portable and home standby generators and other mainstream brands are generally rated highly (4.5 stars) on Amazon and Home Depot (Figure 4 and Figure 5), indicating a high level of customer satisfaction (personally, I have a standby generator installed in my backyard-I don't give it much thought, but it kicks in when my local utility fails, which is exactly the way it should be). However, its home chore equipment is not as highly rated.

Figure 4 : Home standby generator ratings

Figure 5 : Portable generators ratings

Key industry trends

1. Persistent power problems in the US and around the world:

Power outages in the US have not diminished, largely due to the increased incidences of storms, heatwaves, and natural disasters (Figure 6). The recent outages due to wildfires and earthquakes in California, apparent terrorist attacks on substations in North Carolina and Washington, hurricanes and floods in Florida, and snowstorms in the Northeast (which led to 1.6 million homes losing power in December 2022) add to the awareness of this issue. Citing these factors, investment bank Northland Capital named Generac its "top pick for 2023".

Figure 6 : Power outages in the US

United States Power Outage Statistics by State (2000 - 2021)

Global power outages have also persisted around the world. An IHS Markit report titled "Are we entering an age of increasing power supply disruptions?" noted that at least 350 million people, or more than 4% of the global population, were impacted by major power outages over the past year. Power supply challenges ranged from a massive nationwide blackout in Pakistan due to a technical fault at a power plant, to rolling blackouts in northeast China caused primarily by coal shortages amid robust demand growth, and soaring energy prices in Europe (Figure 7).

Figure 7 : Major global power challenges (2020-2021)

Even though these events are attention grabbing, I wouldn't get overly excited or base my investment decision on this factor - these are longer-term demand drivers as it takes time for people to make a decision to install a backup generator, and the purchases if often done in conjunction with building a new home. Furthermore, people in countries with poor infrastructure are unlikely to be able to afford power backups for their home.

2. Home as workplace and sanctuary:

With the work from home trend picking up following the COVID-19 pandemic, it becomes of even greater importance that for remote workers (even those working from home just part of the time) that power be available at all times.

3. Telecom rollout of 5G:

Generac states in its 2021 10-K filing that it is the leading supplier of backup power to the telecommunications market in the United States, and that approximately half of all existing tower sites have yet to be hardened with backup power. Over the last two years, the telecom mobile providers have paid the FCC (Federal Communications Commission) eye-popping amounts for their 5G spectrum and are under pressure to roll out their 5G network.

As I noted in my previous SA article on the mobile industry , 5G networks are able to carry more data because of the higher frequencies, but require more closely spaced towers as the electromagnetic waves do not travel as far or penetrate thick concrete structures as well. As a result, the cell tower companies will have to install many new towers in the next year, which creates more demand for power storage and backup systems.

4. Healthcare facilities:

I assume most modern hospitals already have power backup systems to prevent critical equipment from failing to operate during power outages that could result in potential loss of life. This requirement is shifting into nursing homes as well. FL enacted laws in 2018 to require backup generators in nursing homes; Louisiana has followed suit following the disastrous storm from Hurricane Ida that resulted in 7 nursing home deaths, passing a law in June 2022 requiring all nursing homes install emergency backup power.

5. Grid 2.0 and the aggregation of Distributed Energy Resources ((DER)) into virtual power plants:

There is a trend towards electrical generation and storage by a variety of smaller (10 MW or less) decentralized, and modular sources utilizing more flexible technologies that are connected to a " smart " power grid located closer to the load they serve. This mitigates problems of transmitting power over long distances over the grid and can supplement utility power or function as backups to utility power, particularly during peak periods of power usage or power plant outages. Companies like Generac, Bloom Energy, Tesla and others have developed smart-grid ready, power generation equipment that use sustainable fuel sources to supply energy to the grid.

Generac's installation dealer network

Generac relies exclusively on independent third-party dealers to install its generators and has no plans to create a company-owned force of dealers and installers. According to Generac, it has "the industry's largest network" of over 8,500 independent generator dealers of electrical and HVAC contractors who can install and service their equipment.

Segment analysis

Segments and geographical breakdown

As noted in Figure 2 above, over 60% of Generac's sales are residential. Geographically, over 80% of sales are domestic (Figure 8), but it domestic and international sales have been growing at similar rates since 2020 (Figure 9).

Figure 8 : Revenues by region

Figure 9 : Growth of revenues by region, indexed

The domestic market is the main driver of revenue and shareholder value

Generac's revenue drivers in the US are very different than in the international markets. Its US domestic market is 70% residential, in which homes standby generators has driven the bulk of the revenue gains (Figure 10, green line). However, the residential segment has pulled back sharply over the last quarter.

Figure 10 : Generac US domestic revenue

As I sought to understand the causes of the decline, I realized that housing starts was not as significant a factor as I had initially thought. Instead, management explains that the lack of electricians is the constraint.

Housing starts: Even though US housing starts was up about 40% from 2018 levels (Figure 11, orange line), domestic residential revenue was up by almost than 5 times at its peak (blue line). This indicates that Generac's revenue per housing start has quadrupled (green dashed line), suggesting that the company has increased its penetration into new homes built or made more sales that were not part of a new home. The import price index of end-use electric generating, and electric equipment and parts did not inflate significantly (I note that much of the company's home standby units are manufactured in Trenton, South Carolina, but believe it is a decent assumption that a significant amount of the parts are imported), indicating that, unlike some other more commoditized industries, inflation was not a major driver of revenue growth for Generac.

Figure 11 : Generac revenue sensitivity to housing starts

Shortage of dealer installation capacity as the cause of the deceleration in revenue: Chief Executive Aaron Jagdfeld said in a November 2022 interview with the Wall Street Journal that the booming residential and commercial construction market earlier this year has diverted some electricians from installing backup generators towards more lucrative projects. He noted that the company's dealers are struggling to install the generators they have on hand and are reluctant to order more from the company until they shrink backlogs of customer orders.

Mr. Jagdfeld said the inventory of generators in the field is twice the normal size. Indeed, the amount of finished goods inventory as of Q3 2022 of $587 million (Figure 12) was almost double that of the year ago period of $302 million (Figure 13), but sales for Q3 2022 was only up by less than 10% (to $1.083 billion, up from $942 million for Q3 2021).

Figure 12 : Inventory for Q3 2022

Figure 13 : Inventory for Q3 2021

As a result of the shortage of electricians, many customers who have placed orders are waiting for months to get their generators installed. Mr. Jagdfeld noted in the Q3 earnings call that even though "underlying demand and market fundamentals are strong" and in-home consultations are grew, he warned that Generac's sales during the first half of next year will be lower as dealers hold off on ordering more generators while they work through their install­ation backlogs.

"We've never had installers be a constraint before… We have to find more dealer installers."

As the company does not disclose the value of signed purchase orders with customers, it is difficult to determine how much of the finished good inventory is contractually sold but remains uninstalled (as opposed to it being excess unsold inventory). I note that the days of inventory to sales metric has soared in Q3 2022 (Figure 14, Q3, pink bar) and will keep a close watch on the level of this metric over the coming months to ensure the inventory is being recognized as revenue and steadily moving its way over cost of goods sold. There is evidence that the US construction boom is moderating, which theoretically should free up electricians to perform standby generator installations.

Figure 14 : Generac inventory to sales days

Domestic commercial & industrial revenue has doubled (Figure 10, blue line). I believe the growth momentum will continue over the long term and may accelerate as additional data-centers are built to accommodate the increase in demand for digital transactions, more nursing homes install back-up power as required by law, and the three US mobile providers race to build out their 5G network. As mentioned above, 5G require more closely spaced towers as the electromagnetic waves do not travel as far or through thick concrete structures as well.

As an example, Crown Castle International ( CCI ) - the leading cellular tower provider in dense urban areas, has experienced strong growth - its small cell node count has increased to over 115,000 , and the company reported a 60,000 contracted small cell backlog in Q2 2020, setting the stage for continued growth in demand for power backup and storage equipment.

International market: unlikely to drive the needle in the near term

Commercial & industrial sales is the largest segment in Generac's international markets, representing 90% of revenues. At a Q3 2022 TTM (trailing twelve-month) revenue of $513 million (Figure 15 blue line), international C&I is roughly 75% the size of the company's US C&I revenue of $670 million and has grown at about the same rate as US domestic C&I revenue (Figure 16, red vs blue line). International residential revenue is even smaller-representing just one-quarter of international C&I revenue. Unless sales accelerates significantly, international is unlikely to be a major needle mover in the near term.

Figure 15 : International segments

Figure 16 : Comparison of domestic vs international growth

"Other" segment: potential long-term game changers

This segment consists of long-term investments and recent acquisitions in Grid 2.0, sustainable energy, storage, and IoT (internet of things) technologies. Even though most of these technologies do not currently generate meaningful cash flow, they have the potential to be very valuable game-changers for Generac over the long term.

Financial analysis

Revenue

Generac's TTM sales growth is decelerating due to the weakness in Q3 2022, which the company attributes to a shortage of third-party installers as discussed above. However, it has still outgrown both Bloom Energy (a distributed electricity generation platform) and EMCOR (an electrical and mechanical contractor) on a per-share revenue basis over the last four years (Figure 17, solid green line).

Figure 17 : Generac per-share vs actual revenue growth

Adjusted EBITDA margins

According to the firm's 10-K filing, "we have maintained business continuity by utilizing safety stock inventory levels and executing air freight strategies. We have experienced inbound and outbound logistics delays and increased costs, resulting in longer lead times and higher prices to our customers." This has largely manifested itself in an increased cost of revenue margin (Figure 18, orange dashed line), which was the main driver of lower EBITDA margins (blue line) as the company's selling, general, & administrative and research & development margins were flat to down (green and red dotted lines).

Figure 18 : EBITDA margin compression

While domestic EBITDA margin was down due to the higher supply chain and logistics costs (Figure 19, blue line), international EBITDA margin has tripled from 5% to 15% since the onset of the COVID-19 outbreak due to the strong margins from two acquisitions (Deep Sea and Off Grid Energy) as well as operating leverage from higher sales. However, the international margin expansion was insufficient to offset the domestic margin compression.

Figure 19 : Domestic vs international adjusted EBITDA margin

Ocean freight container shipping costs are moderating (Figure 20). However, domestic trucking costs remain elevated (Figure 21). Given the high percentage of US domestic sales, the margin pressure from shipping could persist for the near term.

Figure 20 : China to West Coast ocean freight container costs

Figure 21 : General freight trucking price index

Free cash flow

Free cash flow has dipped into negative territory in 2022 (Figure 20, green line), largely because of increased inventory which management attributes to longer logistics transit, ongoing supply chain constraints, and the shortage of electricians to install generators. While I have no basis to question management's explanation, this is a metric I will be watching closely.

Figure 22 : Free cash flow comparison

Return on tangible capital

Even though Generac performs its manufacturing in-house, its return on tangible has been over 20% for almost the last half a decade (Figure 21, green line).

Figure 23 : Return on tangible capital

Valuation

As noted at the start of this article, Generac's stock price is down ~ 80% (Figure 1). The earnings yield has ticked above 6%, which are levels last seen eight years ago (Figure 24, green line). The EV to EBITDA multiple has also pulled back sharply from its highs in 2020 to the longer-term range of ~10x (Figure 25, green line). (I note that free cash flow yield, my preferred measure, has been declining and is less relevant here due to the lumpy inventory fluctuations (Figure 26, green line)).

Figure 24 : Earnings yield

Figure 25 : EV to EBITDA multiple

Figure 26 : Free cash flow yield

Concerns

(1) Revenue and free cash flow generation are down:

This is my biggest concern. As discussed above, I will be watching future earnings reports for confirmation that the slowdown in revenue due to constraints on installation capacity due to shortages of electricians is moderating and the company's finished goods inventory is receding.

(2) Residential housing starts decelerating:

While my analysis in Figure 11 above seems to suggest otherwise, a severe recession will still inevitably crimp spending on home improvement products like standby generators.

(3) Rising interest rates drive up interest expenses:

The company has $2.2 billion in outstanding debt tied to LIBOR but entered into $1.5 billion notional value in interest rate hedges, which mitigates (but does not fully eliminate) interest rate risk.

(4) The company has few sources of recurring revenues at this time:

This may be typical of industrial equipment manufacturers but unnatural for software investors (like me) who are used to and spoilt by the recurring nature of software as a service (SaaS) revenues.

In summary…

Generac provides power backup generators that protect homes, businesses, and mission critical infrastructure & healthcare facilities from electrical outages. It has also made investments for the smart grid future.

The industry enjoys the tailwind of powerful trends and high returns on capital, and its US residential business has grown strongly over the past decade.

Revenue has begun to decelerate over the last quarters, which management attributes to a shortage of electricians needed to do the installations; and margins compressed due to increased logistics costs, but there are signs they both are beginning to moderate.

Valuations have pulled back and the stock now trades at an earnings yield of over 6% and an EBITDA multiple of ~10x.

It may be worth initiating a position in Generac, but I would watch the days of inventory to sales closely.

For further details see:

Generac: Generating Backup Power And Potentially Strong Gains For Investors