Generac: A Significantly Undervalued Mid-Cap Stock For 2024 (NYSE:GNRC)

Introduction

Mid-cap stocks have not been the best place to be.

Over the past ten years, the iShares Russell 2000 ETF (IWM) has returned roughly 100%, including dividends. During this period, the S&P 500 has returned more than twice as much.

Even worse, in the current environment of elevated rates, Apollo Global Management (APO) finds that 40% of Russell 2000 companies have negative earnings.

That’s as much as during the peak of the Great Financial Crisis. Even worse, we aren’t even in an official recession!

However, declaring the demise of small-cap stocks has been a recurring mistake in financial history, according to a recent Bloomberg article.

Wall Street recently witnessed a sharp rally in small caps after hitting two-decade lows compared to the S&P 500, fueled by the Federal Reserve’s unexpected dovish policy.

According to the article, despite short-term market fluctuations, deep-seated concerns persist regarding the long-term viability of small-cap investing.

Economic shifts have made smaller firms less profitable, less exciting, and more indebted.

Skeptics argue that these disadvantages pose significant challenges for small caps in the evolving market landscape. They are not wrong, I think.

As the Apollo chart just showed, the median profitability of American small caps has significantly declined over the years, raising concerns about a permanent shift in market dynamics.

Meanwhile, large corporations have doubled their earnings relative to interest payments, providing them with resilience against rising interest rates.

Even worse, the dominance of mega-cap companies, particularly in the tech sector, has transformed American markets fundamentally.

The winner-take-all nature of scalable software and networks favors incumbents, while new innovators opt to remain private for longer periods due to the private equity boom.

Nonetheless, despite the prevailing challenges, there remains optimism among money managers who see potential gems among small caps at attractive prices.

According to Bloomberg, the S&P SmallCap 600 Index, trading at historically low valuations, presents an opportunity for discerning stock pickers.

As we can see below, even after the recent rally, small-cap stocks are attractively valued compared to historic numbers.

That’s where Generac Holdings (NYSE:GNRC) comes in, the star of this article.

I started covering this $8 billion market cap stock on September 11 of this year. Since then, the stock is up 11%, beating the S&P 500 by more than 500 basis points.

Going forward, I believe that GNRC remains in a great spot to generate elevated returns.

Why I Remain So Bullish On Generac Holdings

Generac, which produces generators and related products, benefits from a number of megatrends.

Among these, my favorites are the ones below (from my prior article):

Grid 2.0: This trend reflects the evolution of the traditional electrical utility model towards decentralized, digitized, and decarbonized grids. It results from the increasing adoption of renewable energy and the electrification of various aspects of society’s energy consumption, driving demand for clean energy and grid services solutions.

Legacy Infrastructure Investment: Aging and underinvested infrastructure networks require substantial rebuilding and upgrading, spanning transportation, water, and power systems.

Home as a Sanctuary: Growing trends of working, shopping, and spending more time at home, combined with the electrification of daily life, have increased awareness of the need for backup power due to power outages’ impact on productivity and functionality.

The declining reliability of the U.S. electricity network is a reason for people to look for alternatives (de-risking energy supply).

The less dependable the grid is and the more dependent people are on securing their own power, the more potent the divide becomes, said Jackson Voss, climate policy coordinator at the Alliance for Affordable Energy, a consumer advocacy nonprofit. – Axios

However, as much as I believe that these secular trends benefit General, it is still a company with a very cyclical component.

During its 3Q23 earnings call, the company reported that its net sales saw a 2% decrease to $1.07 billion compared to the prior year.

This decline was attributed to lower residential product sales, offset in part by contributions from recent acquisitions and favorable foreign currency impacts.

Residential product sales saw a significant decline of 15% to $565 million, primarily driven by lower shipments of home standby and portable generators.

However, as we can see above, commercial and industrial product sales showed a robust increase of 24% to $385 million. This growth was fueled by contributions from recent acquisitions and favorable foreign currency impacts.

The core sales growth was driven by increased domestic shipments for industrial applications, with international shipments also contributing, though telecom customer shipments were down sharply.

Based on that context, Generac is strategically building a comprehensive solution set to enable the deployment of its products in multi-asset applications.

This includes pairing smart grid-ready generators with emerging C&I storage, connectivity, advanced controls, and grid services platforms.

According to the company, the focus on providing a complete energy technology solution presents a significant business opportunity as the market demands more integrated and versatile offerings.

The company also sees business opportunities in important long-term growth markets such as India, Latin America, Australia, and the Middle East.

Geographic expansion and a diverse product portfolio position Generac to capitalize on global energy transition trends and power resiliency concerns beyond North America.

Moreover, despite near-term softness in the telecom channel, Generac sees a long-term growth opportunity in backup power for telecom infrastructure. The critical need for backup power in wireless communications to ensure resiliency aligns with global trends of expanding tower and network hub counts.

This presents a substantial business opportunity as wireless communications continue to play a crucial role in various industries.

With regard to the aforementioned megatrends, the strongest markets in the U.S. have a market penetration of 15% to 20%. The total rate in the U.S. is roughly 6%.

Every 1% penetration rate increase would result in a market expansion of $3 billion. That’s the main reason why buying a company in a highly fragmented market can pay off handsomely, as long as the company is making smart choices, allowing it to grow.

Related to this, the recognition of changing demographics and the need for an extended education process for newer customer groups presents an opportunity for the company to tailor marketing and sales strategies.

By understanding and addressing the specific needs of different demographics, the company can expand its customer base and increase sales.

It also helps that despite poor economic growth conditions, the valuation remains attractive.

Valuation

Using the data in the overview below:

• GNRC shares are trading at a blended P/E ratio of 23.5x, which is not cheap and caused by two consecutive years of negative EPS growth. After a 14% EPS contraction in 2022, 2023 is expected to see a 35% contraction. 2022 was a normalization year after skyrocketing sales during the pandemic. 2023 is impacted by a weakening economy.
• Next year, EPS is expected to grow by 35%, followed by 21% growth in 2025.
• Also, note that expectations have come down a lot. The lower part of the overview shows that 2024 EPS expectations have fallen from $8.48 to $7.44 over the past six months.
• The company’s normalized valuation over the past five years was 20.4x sales, which I believe is very fair for its growth profile – it may even be a bit low.
• However, using its fair valuation and EPS growth expectations, the stock has a fair price of roughly $180, which is 40% above the current price.

On a prolonged basis, I expect the company to move well beyond $180 per share.

It also has a healthy balance sheet. It is expected to end this year with $1.0 billion in net debt, which is roughly 1.6x EBITDA. Next year, the net leverage ratio is expected to drop below 0.8x EBITDA.

With all of this in mind, please be aware that these smaller stocks bear elevated risks. GNRC is highly cyclical and much more volatile than most dividend stocks that I discuss on Seeking Alpha.

Although I have GNRC on my watchlist to potentially buy next year, I need to warn people that GNRC may not be right for them.

I think GNRC is a fantastic wild-card play for long-term investors. If I’m right, GNRC is in a great spot to grow rapidly for many years to come.

Takeaway

While the Russell 2000 faces challenges, with 40% of its companies reporting negative earnings, there’s a persistent optimism among money managers eyeing opportunities in small/mid-cap stocks.

Generac emerges as a standout in this landscape, capitalizing on megatrends like Grid 2.0, legacy infrastructure investment, and the growing reliance on homes.

Despite recent declines in residential product sales, Generac strategically expands into commercial and industrial markets, offering a comprehensive energy technology solution.

As the company positions itself for global expansion and resilience, its cyclical nature and volatility warrant caution, but for seasoned investors, Generac could be a compelling long-term wild-card play with the potential for substantial growth beyond its current valuation.