Summary
- Generac's frantic growth phase may be over.
- The company's long-term growth prospects look good.
- Valuation metrics show the stock as overvalued.
- A discounted cash flow model may be showing the company's long-term potential.
- It may be an excellent long-term holding if bought below $100.
Generac Holdings (GNRC) has been one of the worst-performing stocks over the past year, declining by 73% from its high of $329 to its low of $86. But, the company's long-term growth thesis looks intact, driven by the massive changes in the energy, utility, and automotive sectors, which cause changes to the grid. The climate-related uncertainty and damage have spotlighted unreliable power supply for homes and businesses.
The company's sky-high valuation has vanished, and any sell-off in the market may present a buying opportunity if the stock dips below $100. The stock looks fully valued based on the valuation metrics such as the GAAP PE ratios. But, a discounted cash flow model estimates a per-share value of $149, a 22% upside potential.
A slowdown in revenue growth was inevitable, but long-term prospects are still bright
Generac started seeing a slowdown in growth rate in the middle of 2022, during its Q2 2022 quarter . The company saw its residential product sales growth decelerate considerably in Q3 2022. Residential product sales grew by 9% y/y in Q3 2022 compared to a growth rate of 49% in Q2 2022 and 43% in Q1 2022. The company's CEO, Aaron Jagdfeld, mentioned that the total power outages in the US remained above average in Q3 2022. The company was also seeing year-over-year growth in consultations at home and lead generation, both favorable for the company. It is difficult for any company to grow at over 40% for a prolonged period. This slowdown in growth and the re-rating of its valuation allows investors to buy Generac at a reasonable valuation.
Inflation has taken a toll on the company's gross margins. The company has averaged a gross margin of 36% over the past decade, but since the quarter ending September 2021, gross margins have dropped below 36% (Exhibit 1) .
Exhibit 1:
Generac Holdings Quarterly Revenue, Y/Y Growth Rate, Gross, and Operating Margin (Seeking Alpha, Author Compilation)
The proliferation of wind, solar, and other energy sources has increased the importance of using software to manage these distributed energy resources [DER]. The use of the company's power generation equipment as DER presents exciting long-term opportunities for the company. Generators could go from seeing sporadic use during an outage to regular use and help generate income for the customers who deploy the equipment-using a generator as DER could lower the cost of ownership. The company is also looking at ways to connect its generators to the grid, and software will play a significant role in effectively managing these resources. In short, the company's software could be a good and growing revenue source in the future.
High Inventory Costs
The company's inventory carrying costs increased by 80% at the end of 2021 compared to 2020. As of Q3 2022, the company reported another 30% increase compared to the end of 2021in its inventory carrying costs to $1.4 billion. The company may have 171 days' worth of sales in its inventory, compared to an average of 136 over the past decade (Exhibit 2) .
Exhibit 2:
Generac Holdings Inventory and Days' Sales in Inventory (Seeking Alpha, Author calculations)
The company's residential customers facing headwinds from inflation and dwindling savings may resist higher costs and big-ticket purchases such as a generator. Investors should pay close attention to the strength of the company's residential business when the company releases earnings on February 15, 2023 . The high inventory costs took a bite out of operating cash flow, with its operating cash flow margin dipping into negative territory in the March and September quarter of 2022 (Exhibit 3) .
Exhibit 3:
Generac Holding Quarterly Operating Cash Flow (Seeking Alpha, Author Compilation)
High Price Volatility and Low Correlation with the Vanguard S&P 500 Index ETF
A linear regression of the monthly returns of General Holdings and the Vanguard S&P 500 Index ETF ( VOO ) between June 2019 and January 2023 yielded a beta of 1.19 . Yahoo Finance shows a beta of 1.16 . This high beta of the stock signifies that the stock amplifies the monthly change in the market's returns. The expectation is that, on average, for every 1% change in the S&P 500 index, the stock can be expected to change by 1.19%.
The monthly returns of the Vanguard S&P 500 Index ETF and Generac Holdings have a positive correlation of 0.44, a good but not a high correlation. A correlation of 0.7 can be considered a strong positive correlation between the two equities. The correlation between October 2021 and September 2022 was 0.72, but as Generac's growth faded, the stock lost more than the market, thus reducing the correlation. The stock has lost 55.55% in the past twelve months, while the Vanguard S&P 500 Index ETF has lost just 7.73%. The market rally since the beginning of the year has helped the S&P 500 and Generac pare some losses. The valuation premium on the stock has all but disappeared over the past year as the company's growth has slowed.
The company had excellent price momentum, with the stock returning 23.8%, over the past three months . But, the momentum may fade with the lower RSI and MFI technical indicators. The company has seen its earnings estimates lowered for the Q4 2022 quarter and was downgraded to neutral from a buy rating by Guggenheim Securities.
Debt and Return on Invested Capital
The company carries a low and manageable amount of debt. At the end of its September 2022 quarter, the company had total debt of $1.3 billion and net debt, after accounting for cash on its balance sheet, of $1.09 billion. The Debt to EBITDA ratio is 1.1x, and its current ratio is 1.5x suggesting good short-term liquidity (source: Seeking Alpha/YCharts) . Based on the last available quarterly report, the company's after-tax return on invested capital is 15.1% (Exhibit 4) , compared to its estimated weighted average cost of capital of 10%.
Exhibit 4:
Generac Return on Invested Capital (Seeking Alpha, Author Calculations)
The company trades at a forward GAAP PE of 19x, which aligns with its sector median. A discounted cash flow model assuming a 5% revenue growth rate and a 13.7% free cash flow margin yields a per-share value of $149 (Exhibit 5) . The company's average free cash flow margin (operating cash flow - CapEx) was 13.7% over the past decade.
Exhibit 5:
Generac Holdings Discounted Cash Flow Model (Seeking Alpha, Author Assumptions and Calculations)
Generac Holdings has long-term growth opportunities as the addition of renewable energy sources and power outages transforms the power grid. Last year, the stock fell from its lofty valuation due to lower growth expectations. Since then, it has rebounded but is currently fully valued at its price of $122.44 . It may be an excellent long-term stock if it drops below $100. Investors should watch for the Q4 2022 earnings release on February 15.
For further details see:
Generac Holdings: Change Creates Opportunity