Although I have mentioned it before in previous articles on Titan Machinery (Nasdaq:TITN), it bears repeating – Titan Machinery is pursuing a risky, debt-fueled roll-up model that puts a premium on driving solid long-term operating leverage. This makes the company's fourth quarter miss all the more concerning. While I'm the last person to advocate freaking out (or abandoning a position) over one bad quarter, the long-term impact to fair value of even a half-point adjustment to margin estimates can be significant.
Ending The Year On A Sour Note
Although there has been a lot of nervousness in the agriculture sector lately, companies like Deere (NYSE:DE) have generally managed to come through. And to be fair, sales growth isn't looking like a major problem for Titan – at least not in the agriculture business.
Revenue rose 29% this quarter, with organic same-store revenue growth of 19.6%. As has been the case for quite some time, agricultural equipment was the driver as same-store sales increased almost 23% (with total sales up 33%). Construction remains weak, with same-store sales growth of just under 3% and overall sales growth of 11%.
However, margins were quite problematic. While revenue exceeded the average sell-side estimate by over 10%, weak gross margin is the real talking point now. Gross margin declined two full points from last year, with same-store gross profit growth of 4%. Poor margins and utilization in the construction business is the big negative driver here, as same-store agriculture gross profits were up more than 7%, while construction dropped almost 9%. It's also worth noting that equipment sales continue to outpace overall sales (up 31% this quarter), which puts even more pressure on margins.
With such weak gross profits, Titan's operational efficiency was moot in some respects. While the decline in operating margin (down 130bp) wasn't as bad, operating income was nevertheless down 1% for the quarter – a sizable miss relative to sell-side expectations.
Margins A Worry For The Next Year, But What About Market Share?
Management didn't help matters with lower guidance for the next fiscal year. While Titan management is now looking for a higher revenue total (about 7% above the prior average), the midpoint of the EPS guidance range was 17% below the prior average estimate. That's a highly significant diversion to me, and raises some serious questions about management's strategy in growing the construction business and/or their ability to hit long-term targets.
These operational issues are serious, particularly when equipment rental companies like United Rentals (NYSE:URI) seem to be performing incrementally better. While a recovery in non-residential construction would probably help Titan's performance, recent commentary from the likes of Caterpillar (NYSE:CAT) and Terex (NYSE:TEX) has not been what I'd call encouraging.
I do wonder, too, if a longer-term issue is emerging for Titan. Titan Machinery sells CNH Global (NYSE:CNH) agriculture equipment, and it looks as though Deere has been gaining share in North America in markets like tractors and combines. In March, for instance, it sounds like Deere's sales growth in both categories was well above the industry growth rates.
Moreover, it's worth noting that Deere's management team is seen as one of the best in the heavy equipment sector. If Case and New Holland (the “C” and “NH” of CNH) brands are losing share in North American agriculture, particularly on product design/performance attributes, that's a real threat to Titan's model.
The Bottom Line
I don't want to harp on this, but when roll-up stories have failed in the past, the failure has often started in the margins before spreading into the organic growth figures. That doesn't guarantee that the same will happen to Titan Machinery, but it's something to watch out for in the coming quarters. After all, the fundamental reality of equipment dealerships/rental is that it's a very low-margin business with high working capital demands. If Titan can't deliver on meaningful operating leverage, there's no reason to pay any sort of premium for the stock.
If you believe that Titan will continue to find good acquisition candidates, drive low-to-mid single-digit long-term organic revenue growth, and deliver meaningful margin leverage, these shares may still be quite cheap. By the same token, given the risk of the model these shares need to be cheap and this is not a stock for nervous investors.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.