Description

Summary

I believe Blue Bird Corporation (BLBD) (Blue Bird or the “Company”) is an attractive long investment, with catalysts in the coming year that should propel the stock 30%+ higher from today’s levels.  This is mostly a simple investment in a sleepy industry, which is partially what I believe contributes to the valuation disconnect and investor’s poor understanding of the story. We live in a world where companies that have made no money, and may never make money, routinely trade at 10x+ revenue.  Unfortunately for BLBD, the Company generates meaningful free cash flow, and has a stable and dominant market position. The Company is a leading player in the domestic school bus market, with a meaningful advantage in alternative fuels which are gaining material share in the industry and help keep BLBD volumes and growth steady even in flat or slightly negative demand scenarios.  The Company is not operationally leveraged, as they are largely an assembler of purchased components so free cash flow generation is high and cyclicality is low. The industry has three players with sticky end demand, an aging fleet supporting continued replacement demand, and a large settlement with Volkswagen driving upgrades to alternative fuel technologies. Additionally, the Company has spent a meaningful amount of capital relative to historical standards in the past few years upgrading its operations as volumes have grown, which should drive continued margin improvement towards the 10+% EBITDA margin target within nine months.  As the capex normalizes the robust free cash flow generation of the business should become more apparent. Additionally, as substantial free cash flow is added to the balance sheet in the remainder of the current year, Blue Bird should re-rate from its current 6.4x TEV/EBITDA valuation (FY2020E, working capital adjusted) to a more reasonable valuation in-line with historical standards. The Company trades today at levels that are absolutely cheap in my opinion - at even 7.5x EBITDA on BLBD’s FY 2020 (beginning 10/1/19), the stock would be 22% higher – this would equate to an approximately 9.8% free cash flow yield assuming steady-state capex.  In the next 18 months, I believe BLBD is also likely to be an attractive acquisition target to strategic acquirors in similar industries and has a motivated seller in its private equity owner that controls 42% of the company.

Source of Mispricing

• Seasonally, BLBD seems to trade at its lowest valuation of the year in calendar Q1, as this is a seasonally slow quarter for bus sales and the company typically builds inventory ahead of the busy period in the summer when the Company typically delivers to school districts.  To put this in context, the Company has guided to approximately $26mm of free cash flow for the full year (burdened by $25mm of “growth” capex), but had ($-56.6mm) through the end of reported Q1 because of seasonal inventory build. This delta of $82.6mm represents over 16% of current equity value.  I have adjusted the TEV by $50m for my analysis to account for average working capital balances throughout the year.

• Though I do not know for sure, based on a review of 13F filings, I believe the stock may be artificially depressed because of a forced seller.  This is not the most liquid stock because of a large private equity owner, so one seller can have a dramatic short-term impact on price. I do believe the PE ownership will ultimately result in a sale at some point, and it is worth noting the sponsor was selling shares at $28 last September when the Company tendered for ~10% of its market cap.

• There seems to be skepticism around management’s ability to hit its 10%+ margin target for FY 2020.  As I depict later, I believe this is misguided and if not for the sharp rise in commodity costs in the summer of 2018, I believe the Company would have achieved its target already and would be on its way to a 12% margin in the next few years.  Given the industry structure, I do believe it is possible for margins to be meaningfully higher than 10% over time if the manufacturers “keep” lower commodity cost savings and are rational on prices. At today’s valuation, my opinion is that the stock is cheap regardless.

• The stock seems correlated to broader moves in transportation stocks, and there is some fear of cyclicality.  Blue Bird’s underlying demand is far less cyclical because it is driven by property tax proceeds and an underlying replacement cycle given the large portion of the existing fleet that 15+ years old.  Additionally, because BLBD is more of a capital-light assembler, the EBITDA cyclicality is far lower than a traditional industrial company.

Capitalization

Company Description

Blue Bird is on of three players in the domestic school bus market, producing primarily type C and type D (flat front) buses and having a significant advantage in alternative fuels.  The other players in the industry are IC Buses, owned by Navistar and Thomas Built Buses, owned by Daimler. For both of the latter two organizations, I think buses are largely the afterthought in the corporate umbrella.  BLBD has approximately 35% of the market share by units and is the clear leader in alternative fuels, as they were largely first to market several years ago as Navistar dealt with its own corporate challenges. Importantly, because buses are typically sold to school districts looking to simply future procurement on parts and maintenance and generally do not switch fleets, being the first mover in alternative fuels allowed BLBD to get a dominant share of that fast-growing segment of the market.  Over the past several years, though traditional diesel buses have started to decline, alternative fuels continue to grow significantly leading to overall growth in the school bus market. Alternative fuel buses have gone from 4% of the market by units in FY 2012 to 17% in 2018, so BLBD is well-positioned to take advantage of this continued trend. For BLBD alternative fuels, the bread and butter products right now are the gasoline powered type C bus, and the propane bus. Below shows the units growth of BLBD as well as the alternative fuel mix.

Although gasoline buses are lower in price point, BLBD makes a higher profit margin percentage and the same gross profit dollars on gasoline buses, so looking at ASPs alone is a bit deceiving.  In terms of relative profitability, the industry workhorse is the Type C Diesel bus. A gasoline type C is roughly $5k cheaper with similar dollar profit margin, and a type C propane bus is $4k-$8k of a price premium, and they keep a lot of the incremental price in terms of margin.  Type D buses tend to be significantly more expensive, and electric buses would be great because price points are 3-4x as high, so I’d expect a lot lower penetration over time. For a school district, gasoline and propane are cheaper long-term because of the reduced maintenance costs and savings on parts (diesel is more expensive.)  The corporate presentation is actually pretty thorough and I’d suggest looking at it for good data points on the company and industry generally.

Finally, although you might think of this as a cyclical manufacturing business, BLBD is largely an assembler of third-party parts.  They buy engines and pre-fabricated products from suppliers and put them together in small batches that are generally customized for school districts.  Long-term, the company’s maintenance capex will be something like $15-$20mm and they can do sales of well over $1bn with that footprint. If volumes ever weaken, I would not expect margins to fall of a cliff, though I’d also not expect significant operating leverage if sales increased significantly as is clear from recent history.  I do think this stable operating profile and high free cash flow conversion should lead to a more reasonable multiple over time, or at least higher than a cyclical manufacturer might get.

Income Statement Summary

Industry Structure

A long investment in Blue Bird is essentially about picking a strong horse in a very stable industry.  To that end, I believe the industry structure is attractive for the following reasons:

• Oligopoly dynamic as market share is controlled by BLBD, IC and Thomas.  As a sign of rational players, when commodity costs rose in the middle of 2018, BLBD was able to increase pricing to offset costs, though largely on a lagged basis as outstanding quotes to customers are typically valid for six months.  This catch up in pricing has already started to show up in the past few quarters and should become more apparent as they report the rest of fiscal year 2019 (ending 9/30).

• The market is not huge with approximately 35k buses produced in the US, limiting the potential for new entrants.  Additionally, as school districts tend to be sticky and try to keep fleets uniform for maintenance and efficiency reasons, market share gains for a new entrant could be difficult. Additionally, orders tend to be highly specialized on a district by district basis.

• Key demand drivers are very stable.  School buses are funded primarily with property tax receipts, which is why the large decline in the industry actually occurred a few years after the housing crisis when property taxes adjusted.  Housing trends today are relatively stable and prices continue to increase. Absent another housing catastrophe, demand trends should not be materially affected by trending. In addition, the K-12 population continues to increase, which should drive continued demand for buses.  Finally, after the housing crisis, many school districts simply deferred purchases of replacement buses. Over 180k of the ~590k buses in the domestic fleet are now over 15 years of age, which is usually when school buses get replaced. Although replacement can be deferred, it generally isn’t a good look to have America’s children riding around on buses that are falling apart.  Longer term, I’d expect the industry to grow 2% a year for the foreseeable future, with more rapid growth in alternative fuels offset by declines/slower growth in legacy diesel demand.

• The Volkswagen Diesel settlement with the Federal Government provides incremental funding that is earmarked for NOx output reductions across ten categories, of which buses are one.  Thus far, in the 30 state plans already finalized, the company has identified $167mm of potential opportunity, with $68mm already specifically earmarked for buses. This is not likely to drive volume, but should significantly help with incremental funding for alternative fuels such as propane, where BLBD has a strong market position.  Though it is hard to quantify exactly how much this could help “trade-up” demand, it isn’t likely to hurt.

Add it all up and what do you get?  An industry with a history of private equity ownership.  BLBD has a large private equity owner in American Securities, and was previously owned by Cerberus.  Berkshire partners used to own Thomas Built before selling to Daimler years ago. Though there is certainly a chance industry volumes have slight declines, over the long-term I’d expect bus demand to grow and BLBD to continue to take incremental market share.

The 10+% Margin Target

Although BLBD continues to affirm its 10%+ EBITDA margin target for FY 2020 (starts 10/1/19), the Street has largely given up on achieving the goal.  However, I believe the Company would have already achieved the target if not for rising commodity costs last year. The company uses cold-rolled steel, which is typically $150-$200/ton premium over hot-rolled steel which can be tracked. Prices have come down from the highs of 2018, and there is certainly a chance the lower prices help the company given the favorable industry structure.  Going forward, sources of margin improvement should come from:

• First, to drive improvement in 2019 vs. 2018, the Company was able to offset $18mm of commodity cost increases in FY 2018, and they only got a ½ year benefit from cost actions they took.  The annualized benefit should be closer to $36mm from pricing and cost savings, and this should flow through the numbers in the back half of this year and into 2020.

• I have been to the Company’s facility in Georgia.  It is hard to imagine, but there were giant holes in the ceiling, broken windows, and a generally neglected structure that led to major issues with the paint line (when it rains…that’ll mess up your paint job).  Blue Bird is currently investing capital in an upgraded manufacturing facility including an all new paint line that should yield considerable savings. The first buses should go through the paint facility this April, with a stronger ramp throughout the year.  Though they won’t give specifics, they have said that the entire EBITDA margin decline from 2016 to 2017 was related to re-painting and overtime hours that should be eliminated from new facilities. That should yield an incremental 1% to EBITDA margins in 2020.

• Finally, some growth capex on reconfiguring manufacturing lines should begin to improve efficiency in 2020 and beyond.  As the new paint facility has come online, the company has had a chance, with external consultants, to review production flows and optimize output going forward.

It is important to note that the 10%+ target does not assume any benefit from lower commodity costs, though it also assumes a relatively stable demand environment.  The company believes they can maintain the 10% margin even at 5-10% lower volume, which is good to hear and makes sense given the low operating leverage. With a stable demand environment, I believe margins over time could approach 12% and that is what the Company originally seemed to have penciled in prior to commodity cost increases.

Valuation

Assuming a 10% EBITDA margin on approximately $1,010mm of sales in FY 2020 (flat with FY 2019 despite positive mix), BLBD should do approximately $101m in Adjusted EBITDA in FY 2020.  Steady state capex should be approximately $15mm long-term, but with some of the operational spend in 2020 I expect $20mm. I struggle with the valuation here – or at least my perception of how the market will value this.  To me, this is good business with a good industry structure and low cyclicality, albeit in a slower growth industry, but with very high free cash flow conversion, a good balance sheet, and takeout potential when the PE sponsor seeks to exit.  I typically like to value things on FCF multiples or EBITDA – CapEx to account for the low capital spending required, but I also think the market could be dumb and will just look at EBITDA multiples (like E&P…). I’ve shown my reasonable ranges below on the metrics I think are important, as of 9/30/19.  I think under even conservative scenarios, BLBD has significant upside in the next several months, and there is a reasonable chance it is ultimately acquired in the $30 range in the next 12-18 months. From a downside perspective, it is hard to see how one loses money in an investment in BLBD over the next 12 months.  Even if the Company falls slightly short of 10%, today’s valuation is so cheap that I believe an investor still makes money from here.  To the extent margins continue to go higher and volumes show strength from alternative fuels, it would not be hard to see the higher end of the valuation range coming to fruition.

Risks

• Short-term, another surge in input costs can cause havoc as they cannot push pricing for another six months because of how long quotes remain active.  Given the industry structure, the Company’s portfolio of products in alternative fuels, and recent history taking price, I would view this as a short-term risk and not something that changes the long-term story much.

• A total housing collapse, similar to 2007/2008, would be bad for the Company because it would likely hurt property tax receipts.  Volumes would probably take a hit on a two-year lag, but over time, the age of the existing fleet and increasing population should create catch-up demand in the future.

• Poor execution is always possible, though that hasn’t been common for Blue Bird.  Transitioning to a new process and paint facility to handle volumes could come with some kinks, but they have executed well when volumes ramped previously and this isn’t much more a risk than any other Company launching a new facility or increasing/modifying production.

Catalyst

• Sale of the company when PE wants out.  PE bought the stake from Cerberus a few years ago in the low teens and sold shares in the tender in September 2018 at $28.  This company might make sense to a strategic such as New Flyer or Rev Group that are also in the bus industry and where synergies might be high from procurement of parts and commodities as well as corporate synergies.  Once the Company has successfully executed on its 10%+ margin plan, I’d expect them to consider a sale. I view it as a good sign that they would be sellers in the high $20s.

• Guidance in December 2019 with a 10%+ EBITDA margin and continued cash flow generation