The Navistar Mess Gets Messier

It hasn't been easy to follow, or own, heavy-duty truck builder Navistar (NYSE:NAV) over the last four years. Not only has the company had to deal with the normal deep cyclicality of the heavy truck market and the big changes in the defense market, but also self-inflicted challenges brought about by breaking with Cummins (NYSE:CMI) and developing its own engine technology.

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With the fiscal second quarter results in hand, it's pretty clear that we are not even close to a "steady state" with Navistar. Significant erosion in overseas markets has made investors nervous about the sector as a whole, but the company's ongoing warranty and Environmental Protection Agency (EPA) compliance issues continue to occupy management's time and unnerve customers.

Fiscal Second Quarter - Everything but the Locusts
If something could go wrong this quarter at Navistar, it probably did. Consolidated company revenue fell roughly 2%, with product revenue down about 1% as the company's 4% growth in truck revenue was offset by double-digit declines in external engine and parts sales. This result was well below (10% below) analyst expectations, even though analysts have steadily and significantly cut estimates for the last 12 weeks.

Profits were a complete mess. Gross margin was nearly cut in half from last year, and the adjusted segment profit cratered from last year. Although the North American business was decent, the overseas business was weak, as was the defense business. Navistar also recognized significant warranty expenses ($138 million) tied to the company's ongoing problems with its proprietary engine technology.

Can Navistar Get the EPA Sign-Off?
A while back Navistar decided that it wanted to capture the revenue and profits that were going to Cummins for supplying the company with engines. It's not exactly an uncommon decision, as other major OEMs like Daimler (OTCBB:DDAIF), Volvo (OTCBB:VOLVY) and Paccar (Nasdaq:PCAR) have looked to alternatives (including internally-developed engines) to Cummins to some extent.

It hasn't been an easy road for Navistar, though. While Navistar has sold some customers on the convenience of its technology, there have been significant issues regarding reliability and performance almost from the launch. Making matters worse, the company has not been able to get certification from the EPA.

While the EPA has a variety of tools at its disposal to enforce compliance with regulations, Navistar's competitors don't believe the agency has played fair in this case. Cummins, Volvo and Daimler have filed suit against the EPA, arguing that the agency violated its own policies and gave special treatment to Navistar. The agency countered that its actions (including allowing Navistar to pay fines on engines sold that were non-compliant) were necessary to keep Navistar competitive.

Whether you believe that the EPA is unfairly playing favorites or showing sound long-term judgment in supporting an alternative technology, the reality is that this matter is getting expensive. Not only is Navistar racking up fines and warranty costs, but customers appear to be getting nervous and choosing other trucks. It has also put management in a very difficult position - backing down and going back to Cummins (and surrendering the hoped-for competitive advantages and profits) or continuing to throw money at an increasingly hungry white elephant.

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The Bottom Line
Daimler, Cummins, Paccar, Caterpillar (NYSE:CAT) and Eaton (NYSE:ETN) have all talked about increasingly difficult conditions in Europe, China and South America in both on-road and off-road heavy vehicles. So while the North American heavy truck market is looking alright, which is good news for companies like BorgWarner (NYSE:BWA) and Honeywell (NYSE:HON), the overall market is challenging right now and the engine issues aren't helping.

Navistar has a lot of debt and a market share that is meaningful, but not bulletproof. If the company can iron out its engine troubles and avoid the maximum potential fines, these shares are probably undervalued and could be a decent turnaround candidate. Still, buying risky stocks in a soft market is a challenging proposition and investors may find that there are a lot of easier ways to make a buck in heavy vehicles.

At the time of writing, Stephen D. Simpson did not own shares in any of the companies mentioned in this article.