Patience is normally a virtue, but when it comes to investing in deep cyclical stocks, it's an absolute necessity. Because of the boom-and-bust nature of their end markets, bottom-line results can swing from big profits to steep losses.



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, for instance, which I covered

in June. The stock of this maker of commercial trucks, school buses and midrange diesel engines gained significant ground last year. Shares more than doubled from their low of late 2002, reaching a high of nearly $52 in early 2004. But since then, Navistar has lost more than 30% of its value. Seven percent of that decline occurred just last Thursday, when the company released fiscal third-quarter results and held a conference call.

As earnings conference calls go, Navistar's certainly could have been better. During the call, it became apparent that not only was the quality of third-quarter earnings low, the company's new full-year guidance was higher only because of a number of nonoperating items.

Hope Shines

Although the pace of Navistar's earnings improvement may lag what many analysts had expected by this point, it's clear that the company is moving in the right direction. Even excluding some nonoperating benefits to earnings, such as those accruing to the company from the new Medicare Act, Navistar is still expected to earn well over $2 per share. That's a big swing from the loss of 50 cents it posted last year.

And assuming that demand for medium- and heavy-duty trucks continues to be strong in 2005, as is widely expected to be the case, Navistar's earnings could approach $4 next year. Now trading at a forward price-to-earnings ratio of just 8.8 times, Navistar's shares look cheap. Its long-term historical average P/E is more like 11. Once the market gains more confidence in the sustainability of the truck cycle and the upside in Navistar's earnings, the shares should move higher.

Making Progress

Despite rising oil prices and interest rates, the recovery in the truck cycle still looks very much intact. North American heavy-duty truck production plunged by roughly one-half from its peak of 330,000 units in 1999 to its trough of about 150,000 units in 2001. Now it could reach 240,000 units this year, which would be up 36% from 2003 levels. An economic recovery is producing strong gains in truck tonnage. According to the American Trucking Association, truck tonnage rose 7.7% in June and is up more than 6% year to date.

A strong recovery in demand for new trucks is shaping up. The current fleet on the road is aging, and upcoming EPA regulations could spur pre-buying of trucks in advance of the new standards. There's also an increasingly limited supply of used trucks. Monthly heavy-duty truck orders have moderated recently from a torrid 30,000-unit monthly pace earlier this year. But many analysts expect a seasonal pickup to occur later this year. For 2004, heavy-duty truck production is estimated to be up 36% to 240,000 units. Medium-duty truck production is expected to rise 21% to 235,000 units.

Navistar's third-quarter unit growth was solid across the board, with heavy-duty shipments up 65.4% year over year. That's a clear sign the company has gained share in the segment. CEO Dave Ustian noted that the company is on track to achieve a 20% market share, up from 15% just a few years ago. "Every month in the last five months, our share has been greater than 19%," Ustian said. Medium-duty shipments, which typically lag heavy-duty by at least one-quarter, rose 33.4% year over year -- a faster rate of growth than the second-quarter increase of 23%.

Navistar's profit margins still lag those of some of its peers like


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, but the company is making steady progress. Navistar's gross margin rose to 14.3% in the third quarter, up from 12.9% in the second quarter and 13.5% in the third quarter of 2003. The company's incremental margin jumped sequentially to 17.1%, from 13.4% in the second quarter of this year. Ustian maintains that the company is still on track to achieve a $1,600-per-unit cost improvement this year. In fact, he said on the call that the company has the lowest man-hours per unit ever. Eighteen months ago it took 75 man-hours to build a truck or engine, and in the third quarter it took just 50.

Bumps in the Road

Unfortunately, Navistar has been afflicted with some offsetting factors this year. For one thing, the company's new I-6 engine costs significantly more to produce in order to meet new emissions regulations. Ustian claims the company will bring those costs down in the fourth quarter.

Rising steel costs are hitting Navistar hard as well. Initially, the company had expected higher steel costs to hurt profits by $40 million this year, or about 40 cents per share. Instead, that number could be more like $50 million, Ustian said. Both of these issues could be hot topics on the company's fourth-quarter conference call.

Higher oil prices and interest rates may have increased the risk of investing in deep cyclical stocks like Navistar. But in coming months, the market will start focusing on earnings in 2005. More growth in truck demand, reflecting solid GDP growth and continued gains in industrial production, and Navistar's strong earnings leverage to it, could give the stock a second wind.

Odette Galli is a freelance columnist for She has been a writer at SmartMoney Magazine and a senior manager at Ark Asset Management, where she co-managed $3 billion in institutional assets. In addition, Galli was a senior vice president at J & W Seligman. At the time of publication, she had no positions in any of the securities mentioned in this column, although holdings can change at any time. Under no circumstances does the information in this commentary represent a recommendation to buy or sell stocks. She welcomes your feedback and invites you to send your comments to