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.

Related Articles
  1. Options & Futures

    Hedging Basics: What Is A Hedge?

    This strategy is widely misunderstood, but it's not as complicated as you may think.
  2. Options & Futures

    Practical And Affordable Hedging Strategies

    Learn how to find and use the most cost-effective ways to transfer risk.
  3. Investing Basics

    A Primer For Investing In Agriculture

    In this article, we'll look at the agriculture sector and the different ways investors can approach it.
  4. Mutual Funds & ETFs

    Water: The Ultimate Commodity

    Opportunities to invest in this scarce resource are flowing freely - dive in!
  5. Options & Futures

    A Beginner's Guide To Hedging

    Learn how investors use strategies to reduce the impact of negative events on investments.
  6. Charts & Patterns

    Understand How Square Works before the IPO

    Square is reported to have filed for an IPO. For interested investors wondering how the company makes money, Investopedia takes a look at its business.
  7. Investing News

    Is Quinoa Unhealthy for Bolivia's Economy?

    Is one of the world’s healthiest superfoods terribly unhealthy for its country's economy?
  8. Technical Indicators

    4 Ways to Find a Penny Stock Worth Millions

    Thinking of trading in risky penny stocks? Use this checklist to find bargains, not scams.
  9. Professionals

    Chinese Slowdown Affects Iron Ore Market

    The Chinese economy's ongoing slowdown is having a major impact on iron ore demand.
  10. Investing Basics

    Why do Debt to Equity Ratios Vary From Industry to Industry?

    Obtain a better understanding of the debt/equity ratio, and learn why this fundamental financial metric varies significantly between industries.
RELATED TERMS
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  4. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  5. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
  6. Net Present Value - NPV

    The difference between the present values of cash inflows and ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  3. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  4. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  5. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>
  6. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>

You May Also Like

COMPANIES IN THIS ARTICLE
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!