Generac May be a Little Short on Power Here

January 2 -- I love modestly-sized niche industrial companies, but I tend to like them a lot better when they're not especially popular or well known yet. That's the problem with Generac (GNRC) - although I really like Generac's power generator business (and the prospects for taking it global), there is ample analyst coverage today and the valuation is not all that compelling.

Generac has built itself into a billion dollar-plus business by manufacturing a broad range of standby and portable electric power generators. Generac's systems range from 0.8kW to 9MW and cover the waterfront from small portable generators to fixed residential standby units to larger industrial generators.

Unlike competitors like Briggs & Stratton (BGG), Kohler, Cummins (CMI), and Caterpillar (CAT), Generac is solely focused on generators, and that focus shows. The company has the broadest array of products available to the market, many of which offer meaningful performance/cost advantages (like lower cost of ownership and higher reliability). Generac also uses a lean manufacturing process that includes outsourcing, and the company has reaped good margins and returns as a result.

Generac has also differentiated itself with the fuel sources - while it's commonplace for residential standby generators to run on natural gas or LP, industrial generators have historically used diesel. By offering natural gas and LP options (as well as diesel and bi-fuel), Generac has created genset options with lower cost of ownership and operation, but without sacrificing performance.

While Generac is certainly working on building its commercial and industrial (C&I) business (more on this later), the residential business generates more than 60% of revenue at present. The real question is just how big Generac's addressable market could get.

Generac believes it has about 70% of the residential standby market, with Briggs & Stratton and Kohler claiming about 10% each and Cummins holding 5%. Unfortunately, the residential standby market is only about 2.5% penetrated today (with another 12% or so of homeowners owning a portable system). With each 1% of residential standby market penetration worth about $2 billion in addressable market size, it's well worth asking if this market can grow.

The biggest obstacle to growth is that the purchase of a standby system is at the very least a highly discretionary purchase, if not a luxury item. Generac (and others in the market) have made great strides in lowering the cost (down about 50% over the last 14 years), and the company has worked with builders to increasingly design standby units into the basic design of new homes. Accordingly, it's not unreasonable to think that the growth of this market is tied at least in part to the growth in residential housing (particularly on the higher end where an incremental $2,000 to $5,000 may not be problematic).

Perception of need is another issue, but the U.S. utility infrastructure is taking care of that one for Generac. While major weather events like Hurricane Sandy and 2012's "super derecho" certainly bring more attention to the need for and advantages of standby power supplies, the ongoing erosion of the power system is arguably a bigger factor. There were over 60 power outages affecting more than 50,000 people in 2010, versus just five such outages in 1993. Given that it seems unlikely that the U.S. government is going to find enough spare change in the couch cushions to fund a major transmission/distribution system improvement initiative, more and more homeowners may turn to fixed standby systems as a means of guaranteeing that their power stays on all the time.

When it comes time to buy, Generac is usually well-positioned. Not only does Generac have over 4,000 dealers across the country, but its products figure prominently at Home Depot (HD) and Lowe's (LOW), even with Briggs & Stratton selling systems under the General Electric (GE) brand name.

Though clearly smaller than the residential business, I wouldn't sleep on Generac's C&I business, as the company has ramped up its investments into these operations. Right now, Generac has about 15% share in the C&I market, with much of that concentrated in the standby market. That leaves them well behind the likes of Caterpillar (which has about 30%) share, Cummins (25%), Kohler (20%), and Germany's Tognum.

Generac has done relatively well in places where you'd expect solid interest in standby power - healthcare facilities, educational facilities, telecom installations and so on. Part of the question now is how successfully the company can expand its addressable market. Given the cost of spoilage, businesses like supermarkets, convenience stores, and restaurants are all likely candidates, but I suspect there's a larger market in customer service-sensitive applications. Consider that in the recent Hurricane Sandy it would seem that more Verizon (VZ) towers stayed operational compared with AT&T (T), as Verizon made greater use of mobile gensets.

Generac is also looking to compete more directly in markets like construction, where rivals like Caterpillar and Cummins have been pretty successful. In acquiring Magnum, Generac bought a business that has about 10% share in mobile trailer-mounted generators, as well as 35% share in the light towers that construction crews use to light up work areas at night.

Perhaps just as important are the overseas growth opportunities. Caterpillar, Cummins, and Tognum are global genset businesses, but Generac really hasn't been up until recently. The company is moving to change that, though, with a recent distribution arrangement for Australia and the acquisition of Ottomotores from TT Electronics. Ottomotores has solid C&I market positions in Mexico and Brazil, and I believe entry into Australia could be a launching pad into markets like Indonesia and India - markets where power reliability is a major issue even in large cities.

Will Risks Zap Investors?

Like any company, Generac has multiple operating risks for investors to consider. While Generac has benefited from its focused approach to the generator market, the company has begun to spread its wings a bit, re-entering markets like pressure washers. At the same time, there's always the risk that competitors will check any moves the company makes to gain share in the C&I market and/or look to grab some of that sizable share in the residential standby market.

Investors should also note that private equity group CCMP Capital Advisors owns more than half of the shares and three of the seven board seats. While the company recently announced (and then canceled) a secondary offering that would have seen about one-third of that stake go into the float, investors need to realize the potential for conflicts of interest here.

Likewise, I can't say I'm ecstatic about the company's decision earlier in 2012 to recapitalize and pay a $6 per share special dividend. The recapitalization added about $400 million in net debt, and I believe the capital could have been better used to grow the business.

Last and maybe least, there's a small matter with Briggs & Stratton that means little today, but could become an issue in the future. Generac exited the portable generator business years ago, and in so doing Briggs & Stratton came to own the trademark to "Generac Portable Products." Generac reentered the business in 2007 and while Briggs & Stratton doesn't presently use that trademark, I suppose it could and create some market confusion in the process.

The Bottom Line

I like the Generac business quite a lot, and I think there are good prospects for both domestic market penetration and overseas growth. What I don't like so much, though, are the expectations already built into the stock.

Generac has recently been delivering free cash flow margins in the high teens, but I think the company is likely to see those fall into the mid-teens as the company invests in growth. Even still, investors should note that the company spends quite little on Capex (relative to sales) compared with most industrial companies. Consequently, while I can see this company growing revenue at a nearly 10% compound rate out past 2000, the free cash flow growth rate is more likely to be in the high single digits.

If Generac grows at an 8%-9% clip, fair value (net of the debt) would seem to be in the high $20s. That said, I would note that the company earns very good returns on capital, enjoys healthy market shares, and has a manufacturing system that should scale well with relatively modest incremental investments. That would lead me to give it some benefit of the doubt in terms of its future growth prospects (and/or the appropriate discount rate), but even an "enhanced" fair value analysis suggests a fair value in the mid-$30s today. To me, then, that makes it a great watch list candidate, but a riskier idea for new money.

Stephen Simpson         www.seekingalpha.com