Losing The JLTV Recompete Intensifies Oshkosh’s Operational Challenges (NYSE:OSK)

Oshkosh (NYSE:OSK) was already having a difficult go of it. Despite healthy demand for access equipment, refuse and cement trucks, and fire and rescue equipment, operational execution challenges were limiting the company’s ability to leverage that demand, leading to multiple miss-and-lower quarters. To underline the issues, Oshkosh had already been a noticeable laggard compared to Caterpillar (CAT), CNH (CNHI), Deere (DE), and Terex (TEX) over the past year.

Now the company has to deal with the loss of the next leg of the U.S. Army JLTV contract, with the announcement on February 9 that the Army had chosen AM General in a recompete bid that will likely be worth around $8.7B over 10 years (excluding potential foreign sales).

Assuming that the pre-market indications for Oshkosh represent how the shares will end the day, the valuation and investment argument for Oshkosh are complicated. On one hand, the shares are not all that expensive even factoring in the lost JLTV business. On the other hand, operational execution issues are real, the company’s trailing record with margins and free cash flow generation is not great, and there is a lot to prove here.

An Unexpected Contract Loss Will Create A Lot Of Uncertainty

Oshkosh was awarded the original JLTV contract in 2015 and ramped to full production in 2019, helping drive meaningful revenue and operating scale for a business that was struggling prior to the contract award. While there was always a theoretical risk that Oshkosh could lose the recompete, the general view was that as the incumbent Oshkosh was very likely to win the next phase of the business.

The Army went in a different direction, awarding the business to AM General. It’s unclear to me at this point if Oshkosh has the right to protest the award (I would expect that they do, but I haven’t been able to confirm it), but even if they do, not enough of those protests succeed to support giving Oshkosh more than a token chance of retaining this business. If that ends up being the case, Oshkosh will be able to accept orders through the third quarter of this year for delivery in 2024 and then will see the business scale down massively in 2025, leaving the Defense segment largely dependent upon its Next Generation Delivery Vehicle (or NGDV) contract with the U.S. Postal Service.

This is a meaningful loss. I was expecting around $1B in revenue contributions in 2025 with a margin around 8%, or around 40% of segment revenue. The ongoing contributions of the JLTV program were explicitly included in management’s guidance for 2025 from its most recent investor day, and management has referred to it as a “foundational product” for the company.

There’s really no bright side to this development. Given that the company added capacity to fulfill orders, underutilized capacity will likely become a headwind, and the company was already having enough issues with its margins. While there are other projects out there, like the OMFV, this is a meaningful setback.

Operational Issues Have Continued To Dog The Company

It wasn’t as if business was going great for Oshkosh anyway. The company has posted multiple miss-and-lower quarters, including the fourth quarter, with the company struggling with supply chain issues that have impacted the company’s ability to deliver on demand and do so profitably.

To that end, demand for access equipment is healthy, with the North American fleet about 20% overaged and non-residential construction spending holding up relatively well so far (and increased infrastructure-related spending on the way), but the December on-time delivery rate of 70% was the highest figure for Oshkosh in some time. Likewise, there have been challenges meeting demand in the Fire & Emergency and Commercial segments (which are being combined into a single “Vocational” segment), despite healthy demand for fire/rescue equipment, cement mixers, and waste handling equipment.

The last couple of quarters have seen 8% adjusted operating margin misses and management guided down for 2023 on ongoing supply chain challenges. Why Oshkosh is struggling so much more than many of its peers is a good question, but operational execution has been an issue at this company for some time – while Oshkosh generates decent returns on invested capital (a 13.7% five-year average), there’s been no sustained operating margin leverage, nor any meaningful improvement in a pretty mediocre free cash flow margin.

The Demand Is There, If They Can Meet It

It’s not all doom and gloom for Oshkosh. Operational challenges can be surmounted, and underlying demand is healthy.

Access Equipment sales rose 29% in the fourth quarter (a 4% miss), and segment margin improved 460bp to 10.8%. While orders fell 6%, the backlog rose 22% to a new record of $4.4B (more than a year at the fourth quarter run-rate). As I said above and in reference to Terex, the North American access equipment fleet is overaged and needs to be refreshed ahead of strong non-residential and infrastructure activity in 2024, and up-cycles in this segment usually last three years or more.

In Vocational, Oshkosh has an opportunity to benefit from a multiyear refresh of fire equipment fleets, as more than half of the installed base is more than 15 years old, and IDEX (IEX) has confirmed healthy underlying demand trends. With the cement truck business, I expect multiple years of strong volume demand driven by infrastructure projects, and I like Oshkosh’s decision to exit the low-margin rear discharge cement truck business. Waste handling equipment is also strong, with Dover (DOV) calling out strong demand that seems to have legs into 2023.

In the Defense business, even with the loss of the JLTV revenue in a couple of years, there is a significant runway left with the NGDV contract, and I expect margins to improve into the double-digits over the next two to three years.

The Outlook

Adjusting for the JLTV news, I expect around 3% long-term growth from Oshkosh, with strong near-term demand supporting virtually all of the company’s major lines. I do expect the company to get past these operational challenges, and I’m looking for operating margin to move from around 6.5% in FY’23 to around 8% in FY’24, with EBITDA margins improving from around 7.75% to 9.5%.

I’m not as bullish on the free cash flow side. Oshkosh has struggled to meaningfully improve free cash flow conversion and has consistently missed my expectations. To that end, without evidence of sustained improvement, I think management’s projection of 7.5% FCF margin for 2025 (from the May 2022 investor day) is way too optimistic and I’m expecting a ceiling of around 5% until I see compelling evidence to model otherwise.

Oshkosh isn’t tremendously cheap on a discounted cash flow basis, but if management can figure out how to drive high single-digit FCF margins on a sustained basis, that changes meaningfully. Looking at margin-driven EV/EBITDA, and making estimates for the impact of the JLTV contract loss, I believe a 10x multiple on adjusted 2025 EBITDA is reasonable, and discounted back two years that supports a fair value close to $100 now (again, including the impact of the JLTV loss).

The Bottom Line

Oshkosh has an opportunity to ride a strong tide of demand, but there are legitimate questions about whether they can ride that wave or get knocked off their board by ongoing operational shortfalls. I don’t think the valuation now is demanding, but it’s hard for me to like a company with these challenges. The opportunity to do better is definitely there, and that can support meaningful upside, but I’m not willing to give that much benefit of the doubt at this point even though I’m bullish on virtually all of the markets that Oshkosh serves.