Just like the broader economy, various industries go through phases of retrenchment, growth and then a peak. If you hold off on investing in these cyclical industries until growth is robust, then you've missed the boat. Various studies indicate that stock prices peak about 24 months before earnings do. So to make money in these kinds of stocks, you have to envision what the business will look like in 2014 and 2015.
Yet, few investors are thinking about cycles right now. The U.S. economy slumped badly in 2008 as the country entered a recession and has performed anemically ever since. Investors have come to assume that we'll be in a funk as far as the eye can see.
Though, that’s often the case when the economy is at a low point. Only investors that focus on the cycles -- and can wade in at a time of maximum pessimism -- can score big gains with cyclical stocks. If you're one of those investors, then now is the time to buy. Start looking for stocks that are deeply out of favor, but have a history of robust profit and sales growth when the cycle turns.
My favorite cyclical stock right now: Wabash National (NYSE: WNC), one of the leading providers of truck trailers that ply the nation's highways. Orders have been subpar for quite some time, and the fleet of trailers is now aging fast. Notably, trailers wear out, thanks to heavy pounding, and 10 years is considered to be a realistic lifespan for these big boxes. Whether it's an improving economy or simply the need for major trucking firms to lower the age of their fleets, Wabash should see decent results in 2013 and should improve upon them going into the middle of the decade.
You have to go back to the middle of the past decade to see how shares trade in relation to earnings growth. As noted earlier, this stock often builds a head of steam prior to peak cycle earnings.
Wabash was deeply affected by the economic slowdown early in the decade, and only managed to generate quarterly profits again in the first-quarter of 2004. Wabash went on to earn $1.80 a share that year, and $3.06 a share in 2005. Yet, the time to buy this stock was in 2003. If you waited until 2004, then you already missed most of the gains.
One way to look at where we are in the cycle is to look at industry bottoms. In 1995 and again in 2002, demand for semi-trailers slumped for roughly two years. This time around, that slump has lasted four years.
Another measure: the average trailer on the road has historically been around 6.5 years old. Now, that figure exceeds eight years. Again, that's an average figure, and many trailers actually exceed 10 years, which as noted, is typically time to replace them. "Carriers view the age of the trailer in terms of years, not in miles, (as tractors and autos are evaluated) because trailers wear out any time they are exposed to the elements," note analysts at Craig-Hallum. In fact, a number of trucking companies have a firm 10-year limit on trailers, which even in the absence of a growing economy. should begin this industry's upward cyclical move.
Shares steady throughout the cycle
In good times or bad, Wabash typically controls roughly 20% of the market, thanks to long-term supply contracts with the nation's leading freight carriers. (Privately-held Great Dane and Utility each have similar market share). The company is best known for its "DuraPlate" technology, which is a composite plate dry van trailer with increased durability and strength, compared to traditional aluminum plate trailers sold by other vendors. DuraPlate trailers last nearly 10 years, which partially explains the extended age of the fleet. Still, even these units are getting close to the end of their usable life.
Management has leveraged into other categories, such as portable storage units (PODS). DuraPlate is also used for truck skirts to boost aerodynamics and fuel savings.
Better margins in the next upcycle?
In 2009, management realized that the economic slump might last a while, so they removed roughly $35-40 million in annual expenses. Part of the savings came from an increased use of automation on the factory floor. When the cycle turns up, roughly half of that amount will need to be put back into the business, but Wabash still has a chance to post profit margins above levels seen in past peaks, thanks to the cost cuts that will remain intact.
The move to cut costs has turned out to be a life-saver. Wabash nearly went broke in 2009. The company quickly issued $35 million in preferred stock that year and then raised another $75 million in a May 2010 traditional equity offering. As a result, the balance sheet is now more stable, though at a cost of a rising share count.
Shares outstanding swelled from 30 million at the end of 2008 to a recent 68 million. All other things being equal, the share price peak in this cycle would naturally be diminished by the same percentage that the share count has risen. As I'll soon note, this cycle could be even better than past cycles.
reduces cycle risk
Management knows that a down leg of the cycle will emerge again after the next upswing, so they are making tuck-in acquisitions should smooth out operating results. For example, Wabash acquired Walker Group Holdings in May 2012 to build market share in the refrigerated trailer and energy transport markets. Those markets are a lot less cyclical than the traditional tractor-trailer market.
Wabash is also developing other container-like products outside of the core trailer market to help smooth out results. Broadly speaking, Wabash's generic trailers generate 8% gross margins, while customized products (including the business lines picked up in the Walker deal) average in the low 20s. Analysts at Sterne Agee predict that "with a greater focus on customized solutions, sustainable pricing, and better supply buying practices, we believe that Wabash will become significantly more profitable during this cycle than past ones."
Second-quarter results establish a different approach to sales and margins
Wabash reported second-quarter results in early August that highlight a new strategy for management: Focus on profit margins and don't wait for the economy to improve. Indeed, Second-quarter sales of $362 million were more than 15% below forecasts -- in part because management focused on higher-margin products in its backlog that take longer to build. Yet operating margins were solidly ahead of forecasts, which explains why Wabash was able to meet consensus earnings forecasts (prior to Walker-related charges), despite the revenue miss. Another key metric: backlog stood at $713 million at the end of June, which greatly reduces the chances of a revenue miss in coming quarters.
Looking ahead to mid-decade
So what kind of results can Wabash generate as the economy starts to rebound? Consider that in the last really solid upgrade cycle, which occurred from 1998 until 2000, more than 500,000 trailers were sold. That figure fell to just 162,000 in the period between 2008 and 2010. Since then, demand has begun to rebound as the aging-fleet cycle kicks in, but a firmer economy could push volume sharply higher, perhaps toward that rate we saw in the late 1990s.
Analysts expect Wabash to earn close to $1 a share this year on roughly $1.5 billion in sales. Looking into 2013, sales growth of 25% (to around $1.8 billion) should help earnings north of $1.25 per share. Assuming constant market share and typical trailer volumes when the cycle has moved up before, Wabash appears capable of $2.5 billion in sales by 2015 and earnings exceeding $2 per share. If history is any guide, shares will start to move up in advance of that trend. Assuming shares are valued at six times that figure, then you're looking at a $12 stock price, or more than 80% above the current level.
Frankly, both that forecast for peak earnings per share and the target multiple could prove to be far too conservative, and there's no reason this stock can't trade up toward the $20 mark. But it's prudent to keep expectations in check -- until we really see the cycle kick in. As noted earlier, shares could rise up well in advance of the peak of the cycle as investors look ahead.
The Downside Protection --> Demand for trailers has yet to materially rise, and a much deeper slump in the U.S. economy would force Wabash to eat into backlog, putting 2013 and 2014 forecasts at risks. You'll get a sense of any deepening crisis if shares fall below $6, which will be a reflection that industry-wide sales are falling to new lows. That still seems unlikely in light of the aged industry fleet, but bears close scrutiny.
Upside Triggers --> The clearest catalyst for this stock is a pickup in trailer orders. That hasn't happened yet, in part because freight companies have noted a slowdown in the U.S. economy thus far in 2012. At some point -- soon -- the weak economy will no longer be the driving factor and instead it will be the badly-needed replacement cycle. Wabash intends to pursue firm pricing and margins when that cycle kicks in, moving away from its historical role of a company in search of market share at any cost. That might cost the company a few percentage points in terms of market share, but should help prove that the recent trend of firming margins is here to stay.
Action to Take --> I will buy 800 shares of Wabash (or roughly $5,000 worth) 48 hours after you read this. I also suggest investors put in a stop loss at $5.75, though I will not be deploying the stop-loss limits myself. Shares can be bought under $9.