Light up your returns with Generac

Enter Generac (US:GNRC), a leading supplier of back-up power solutions. The group designs and manufactures both portable and fixed power generators, supplying residential, commercial and industrial customers. It does so through numerous distribution channels, including retailers, equipment rental companies, direct-to-consumer sales and 6,700 independent dealers. A little over 50 per cent of its total net sales typically come from the residential market and JPMorgan estimates that around 90 per cent of that is derived from ‘home standby generators’ (HSBs) – permanent units that are installed outside a building, run on natural gas, diesel or propane and automatically kick in when the electricity goes out. Generac has amassed an installed base of more than 2m HSBs to date.

The group is a popular pick among fund managers and one of its top shareholders is asset management company Ninety One. “Generac has been held in our funds for a number of years and over this time we have seen the company transition from a play on freak weather events… to a very interesting structural growth story,” says Christine Baalham, manager of the Ninety One Global Equity Fund (GB00B01VDL32). “When we consider some of the key short and long-term themes that need tackling, whether this be clean energy, worsening weather patterns, stay-at-home, 5G or distributed generation, Generac plays into all of these.”

It is also the number three holding of Impax Environmental Markets (IEM), one of the IC’s top 100 fund picks for 2020. IEM has pointed to Generac’s “circa 75 per cent market share of the US residential market, with a strong brand and well-established distribution network that is difficult for competitors to replicate”. That leading position doesn’t mean there isn’t still growth to be found. Out of an estimated total addressable market of 53m US households, Generac reckons that less than 5 per cent currently have an HSB – a far lower penetration rate than for home security systems and the 15 per cent uptake for portable generators. Analysts at investment bank William Blair project that over the long term, market penetration of HSBs will trend towards that of portable generators – a significant opportunity given that Generac estimates every additional 1 per cent of market penetration equates to $2.5bn of revenue.

California has emerged as the key US growth market. Indeed, although Generac listed in 2010, its shares have largely flown under investors’ radars and only really started to take off last October amid the Californian wildfire season. The catalyst was one of the US’s largest utility companies, Pacific Gas & Electric Company (PG&E) (US:PCG), enacting a series of large-scale power cuts across the state to prevent damage to its power lines from windstorms starting further fires. The power outages turbocharged demand for home generators, with Generac’s HSB installations in California increasing almost fourfold in 2019 versus a year earlier. Forking out on average $4,000-$10,000 for a back-up power source may seem like overkill for infrequent blackouts. But PG&E’s chief executive, Bill Johnson, has said that such power outages are likely to continue over the next 10 years as it works to improve its infrastructure.

The HSB penetration rate in California is even less that for the wider market – just 1 per cent. William Blair believes this could reach up to 10 per cent in the long term, translating to a $3bn revenue opportunity. But California is not the only state seeing extreme weather patterns – there are also hurricanes and winter storms to contend with on the east coast. Hurricane season usually runs from June through November and the National Oceanic and Atmospheric Administration (NOAA) is predicting “above-normal” activity this year. Exacerbated by climate change, these events are not only becoming more frequent, but more intense, too. Coupled with ageing grid infrastructure suffering from decades of underinvestment, this means that there are likely to be more power interruptions. The US already saw over 500m hours of power outages in 2019, a compound annual growth rate (CAGR) of almost 30 per cent from 2014. These trends underpin Generac's stand-out growth record and climbing profitability (see table).

As residential sales grow, margins are set to improve:

Going green

There are opportunities outside of standby power, too. Amid the shift to renewables, we are likely to see more decentralised power generation and the need for energy storage to help balance the grid and address intermittency issues. Generac entered the energy storage market last year with the acquisition of Pika Energy, a manufacturer of smart storage solutions and batteries. It has since introduced the ‘PWRcell’ energy storage system, which captures and stores electricity produced from solar panels. Generac claims the PWRcell is more efficient than rival models from Tesla (US:TSLA) and LG (KR:066570). According to energy consultancy Wood Mackenzie, the second quarter of 2020 saw a record number of megawatt hours (MWh) of storage deployed in the US and this is set to grow over the next five years. While currently in a very early stage, Generac believes its energy storage business could be as large as its HSB business in five to 10 years. It could also enable the group to diversify beyond equipment provision to higher-margin services. The acquisition of Neurio in 2019 means Generac now offers customers the ability to monitor and optimise their home energy usage, and it is exploring a subscription model that would generate recurring revenues.

Analysts have recently turned bullish on the group’s prospects and it’s worth noting that Generac has a track record of beating expectations. The three months to 30 June saw residential sales climb by 27 per cent year on year to $341m – far ahead of analysts’ projections of $282m. Generac says this reflects people treating their homes as a sanctuary during the pandemic, and it more than offset industrial and commercial (I&C) sales dropping by a third. The I&C segment has more cyclical vulnerability and has been hit by the Covid-19 squeeze on the equipment rental market, non-residential construction and telecommunications companies. Around two-fifths of I&C sales also come from international markets – compared with just 5 per cent for residential – which were already weighed down by trade war tensions pre-pandemic. Still, because residential sales are higher-margin, adjusted cash profits (Ebitda) increased by 10 per cent in the second quarter to $123m – again, exceeding analyst forecasts of $88m.  

Generac has also surprised the market by increasing its guidance for 2020. The group had been signalling that revenue for the full year would fall by 5-10 per cent amid ongoing I&C weakness. But it is now projecting a 5-8 per cent increase, driven by “significant” residential growth. A further 2-3 percentage point bump could also be on the cards if there are more hurricanes and outages in California than anticipated – a scenario that could well transpire. In August – after the group’s second quarter results came out – Tropical Storm Isaias lashed the east coast and Hurricane Laura hit Louisiana and Texas. Storm Sally is also now approaching. Generac estimates that the boost to demand from a major power outage can last for six to 12 months after the event.

Turning to the balance sheet, Generac was sitting on $500m of net debt at the end of June, equivalent to 1.1 times cash profits. Despite a good track record of free cash flow generation, the group does not pay dividends. It does, however, invest in acquisitions, having purchased 15 businesses since 2011. If it were to hold off on the M&A front this year, analysts at Bank of America (BoA) estimate that the ratio of net debt to cash profits would fall to an all-time low of 0.5. However, BoA expects M&A activity to ramp up and believes acquisitions can help lift cash profits to almost $1bn in 2025.

The group does use third-party lenders to fund orders. Total inventory financed under this scheme amounted to just over a tenth of net sales in 2019, with $50m of payments outstanding. If dealers don’t pay the lender on time, Generac may be required to purchase the unpaid inventory they hold.

Net debt and leverage have been coming down