Last year's serious drought was certainly bad news for uninsured farmers, unhedged buyers of grain, and those who were on the other side of the hedging transactions. On the flip side, the resulting high grain prices have been good news for equipment makers like Deere (NYSE:DE) and Lindsay (NYSE:LNN). The biggest questions for the world's second-largest maker of irrigation equipment now are how much longer the good times will last and whether investors have already let their expectations get ahead of reality.
Strong Results In Fiscal Q2
Results at Lindsay and chief rival Valmont (NYSE:VMI) have historically tracked the price of corn, and that relationship has led to strong results in recent quarters for the company.
Revenue in the fiscal second quarter jumped 33% and beat the average of sell-side estimates by about 7%. Irrigation revenue led the way with 39% growth, with domestic sales (more than 70% of the total) up 41%. Strong international irrigation sales (up 34%) were also helped by the U.S. drought, as it effectively set the international prices higher. Infrastructure sales were down 15%, as companies connected to road construction/maintenance continue to founder.
Lindsay is taking advantage of this upswing in volume and revenue and realizing better margins. Gross margin improved more than a full point, while operating income increased 56% as the company continues to see excellent operating leverage and strong incremental margins.
How Long Can The Good Times Last?
In my view, the biggest risk to the Lindsay story is the extent to which investors have run with the idea that the good times in irrigation equipment are going to last quite a bit longer. As I mentioned before, there's a pretty strong historical correlation between corn prices and the level of demand seen at Valmont and Lindsay. Given that futures, the USDA, and Deere are all pointing to lower corn prices for the 2013-2014 season, that suggests that the rally could be long in the tooth. Even Lindsay management has echoed this viewpoint that corn prices are likely to fall, and with it irrigation equipment demand.
On the other hand, correlation is not causation. Perhaps the drought has led more farmers to adopt irrigation systems. Likewise, the rising price of water makes pivot irrigation and its significantly higher efficiency (about 50% higher than competing approaches) even more valuable. Between higher grain prices and higher water prices, it's not hard to argue that the payback period for irrigation equipment looks better today than in years past. What's more, the relatively primitive state of mechanization in many overseas markets (particularly Russia, but also China and India) argues for many years of solid growth potential.
The Risk Of Cyclical Businesses
Suffice it to say, I tend to believe that Lindsay's sales momentum is going to slow. Although irrigation revenue increased more than 30% this quarter and the backlog jumped 82%, I believe growth is likely to slow to a more normalized level in the high single digits. In that respect, the action in Lindsay is disturbingly familiar – when cyclical companies/stocks are near the highs, investors often forget that they're still cyclical businesses and they start making bold growth forecasts with the cyclical peaks as the starting points.
To that end, I believe that Lindsay will grow its revenue at a long-term rate of about 7% even from these elevated levels, but that isn't enough to generate an attractive fair value. While I may be underestimating the company's ability to convert even more revenue into cash flow in the coming years, I just don't see enough leverage in the model at this point to make me excited about the stock. That said, the company has ample cash flow on the balance sheet and a special dividend could offer incremental upside.
The Bottom Line
At the risk of talking my book here, I'd prefer to continue owning Monsanto (NYSE:MON) shares rather than buy into capital equipment stories like Lindsay (or Deere) or fertilizer plays. I realize the entire agricultural sector is still a hot play, but at least the seed companies have the advantage of generating repeat business year after year.
As it concerns Lindsay, I'm certainly not going to be buying these shares myself, but I wouldn't rush to sell. While I think the market has gotten ahead of itself here, I've seen enough cyclical stories play out to know that these shares could go even higher. I would, however, consider protecting at least part of my position with stops or option strategies – there's nothing wrong with wanting to ride these shares to the end, but just make sure you don't lose all of your gains in the process.
Stephen D. Simpson, at the time of writing, owned shares of Monsanto.