Oshkosh Offers A Complicated Puzzle As Non-Residential Activity Decelerates (NYSE:OSK)

These are “interesting” days for manufacturers of construction equipment and heavy machinery, as companies try to navigate a more complicated mix of positive and negative drivers. Investors don’t typically like those “interesting” times, and Oshkosh (NYSE:OSK) shares have pulled back about 15% from their April high on growing worries about the impact of slowing non-residential construction activity and upcoming margin compression from product investments and the ramp of the Next Generation Delivery Vehicle (or NGDV).

Oshkosh hasn’t done badly since my last update, as the company has seen improved production and delivery efficiency and healthy demand in its core markets. That said, it has still modestly lagged the broader industrial group, and it’s tough to get really excited about making a case for operating results to be materially better than currently expected.

Non-Residential May Be Near A Peak, But The Details Get Complicated

With more than a third of Oshkosh’s revenue coming from non-residential construction (not to mention roughly 50% of the company’s higher-margin Access Equipment business), the health of that end-market is no minor consideration. Unfortunately, the best answer I can come up with for the outlook over the next couple of years is “it’s complicated”.

On the negative side, there’s definite weakness in office and warehouse construction activity, and both were significant segments of commercial construction in the last upturn. Industrial construction activity has likewise fallen off significantly, and overall non-residential construction starts were down more than 4% year-over-year in April and down more than 5% year-to-date.

I don’t see much reason to expect a near-term upswing in office or warehouse. Investors are still waiting for the other shoe to drop with respect to bank loans to the office segment, and it’s tough to argue for a strong new-build market when so many buildings sit underutilized. I’m more confident about a recovery in industrial construction after the election, as I do think reshoring still has legs, and I think at least some warehouse recovery will be needed to support that down the line.

Where things get complicated, though, is when you add in drivers like infrastructure spending (roads and bridges), utility spending (transmission as well as renewable generation), and discrete niches like data centers. All of these are likely to be quite healthy for a while longer, and indeed, spending on “heavy engineering” and water/wastewater projects is up this year.

Both Oshkosh and Terex (TEX) had good reports from their access equipment businesses in Q1’24, with Oshkosh up 4% and Terex up 13%, but it sounds as though a lot of this growth is being driven more by improving supply chain dynamics and executing on the backlog rather than stronger than expected demand. To that end, neither company extrapolated their outperformance here in Q1 through the remainder of 2024 and Oshkosh’s order entry was about 20% lower year over year.

Management sounds relatively confident that orders will pick up as the year goes on. I’m less confident. Dealers seem more cautious now, and United Rentals (URI) has been standing pat with its capex guidance. While it’s true that access equipment fleets are somewhat overaged now (58 to 60 months versus a target of 50), I see a risk that higher rates and more economic uncertainty will lead to weaker orders and a possible “air pocket” for 2025 and 2026.

NGDV Ramping Up, At A Cost, While Vocational Demand Looks Healthy

As the company starts winding down its JLTV production for the military (having lost a recompete award in early 2023), the company now turns to the NGDV contract from the U.S. Postal Service.

Oshkosh will be providing as many as 165,000 electric vehicles worth a combined $6B (at maximum potential value), but in the short term there will be margin pressures as the company starts to ramp production. I expect the business to scale up relatively quickly and for these pressures to abate in 2025, opening the door to double-digit revenue growth in the Defense segment and mid-single-digit operating margins (versus a little over 2% in the first quarter of this year).

I’m more excited about the opportunities in Oshkosh’s vocational businesses. With property tax receipts heading higher, local governments have the budgets to refurbish their overaged fire and emergency vehicle fleets, and Oshkosh has been booking much higher prices into its backlog (a 40% price increase since 2021) that haven’t fully played out yet into revenue. While there isn’t the same pricing dynamic working for categories like refuse trucks or cement trucks, underlying demand is still relatively healthy, and I think cement demand should remain elevated given the infrastructure projects underway and in the planning stages.

The Outlook

Management has been active in trying to diversify its business through add-on M&A, acquiring the AeroTech business from John Bean (JBT) in 2023 and more recently acquiring AUSA, a small Spanish manufacturer of telehandlers, wheeled dumpers, and rough terrain forklifts. I don’t think Oshkosh overpaid in either transaction (particularly if it can execute on cost synergies with AeroTech), and adding more capabilities in vehicle electrification, connectivity, and autonomy (again, through AeroTech) makes sense given where trends are heading across most of Oshkosh’s end-markets.

My revenue expectations for FY’24 are a little below the Street (about 4%) and I do see some risk to sentiment from weaker access equipment orders and sales as the year goes on, not to mention a tougher/weaker macro environment. I also think the company has something left to prove when it comes to scaling its business profitably, and a lot of eyes will be on the NGDV ramp and how quickly that becomes a positive contributor.

Not to beat a dead horse, but margin and free cash flow leverage remain important issues here. Oshkosh’s long-term free cash flow margins have basically been range-bound for two decades, with a long-term average in the 4% to 4.5% range (4.2% from 2004 to 2013 and 4.4% from 2014 to 2023), and while the potential to get into the 5% to 6% range should be there, “potential” only takes you so far.

I’m looking for long-term revenue growth of a little under 4% from Oshkosh, which is again pretty consistent with the company’s past performance. I do expect some margin uplift, with EBITDA margin improving over 12% over the next three years and free cash flow margins moving toward 5% and above, supporting double-digit FCF growth (closer to 8% adjusting for the below-trend result in FY’23).

The Bottom Line

Both discounted cash flow and margin/return-driven EV/EBITDA suggest that Oshkosh is undervalued, but only up to around the $120’s and not by so much that I’m eager to buy into the risk of increased pressure on the Access Equipment business. I may be underrating the underlying health of the U.S. economy and pent-up demand for access equipment and vocational trucks, not to mention management’s ability to drive better margins, but I’d prefer to be cautious at this point.