At the risk of drifting into broken record territory, it's very difficult to generate real long-term economic profits from distribution and dealership businesses. By and large, these are business with razor-thin margins, low returns on assets and capital, and significant cyclicality. Maybe Titan Machinery (Nasdaq:TITN) will be the exception, and maybe the company's aggressive dealership roll-up strategy will lead to strong synergies, margin leverage, and cash flow generation. This is a risky play, though, and investors who really want to play trends like agriculture or a construction recovery would likely be better off with the original equipment manufacturers.
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Meeting The Lowered Bar
Titan Machinery shares dropped another 10% (they're down over 20% for the trailing 12 months) a few weeks back when management warned that first quarter results were going to come in low due to weather-related issues in the agriculture business and ongoing issues in the construction business. Relative to the reset expectations, Titan did alright.
Revenue rose 5% as reported, with 4% equipment growth, 10% parts growth, and 10% service growth. By sector, agriculture revenue rose 2%, with construction sales up a nearly identical percentage. Gross margin stayed flat with last year, while operating income dropped more than two-thirds on a 25% increase in operating expenses.
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The Horse In The Race Doesn't Seem To Be The Problem
If the ag equipment makers had seen a bad first quarter, that would explain a lot of Titan's struggles. Likewise, if it were the case that Titan is tied to the wrong OEM (Titan's dealerships sell CNH Global (NYSE:CNH) equipment), that too could explain the weak results.
That's not the case. CNH farm equipment sales were up 9% for the first quarter, which was broadly in line with both Deere (NYSE:DE) and AGCO (Nasdaq:AGCO). Of course, there's a big difference between what the OEMs experience selling to the dealers and what those dealers experience selling to the farmers, and multiple companies did mention concerns of building channel inventories during spring due to weather-related spending delays.
On a somewhat encouraging note, Titan Machinery management believes that the sales lost in this quarter will be be made up for as the year goes on. While I believe that Wall Street typically makes too much of quarter-to-quarter performance, this will nevertheless be a serious test of management credibility – if sales don't show significant sequential improvement, that's going to be a problem.
Are The Bulls Expecting Too Much?
As I have expressed before, I have a number of concerns about the company's business model. While I think the idea of building a dealer network in Eastern Europe is a great idea (Eastern European agriculture is under-mechanized and CNH is strong in the region), I'm not sold on the U.S. dealership roll-up model.
I don't want to belabor that point, and I think there are other issues to consider as well. The sell-side coverage of Titan seems to be making some pretty aggressive long-term assumptions. Estimates for long-term same-store sales growth in the high single-digits seems pretty aggressive relative to what OEMs like Deere and Caterpillar (NYSE:CAT) have said about their ag and construction dealer networks in the past. Likewise, these estimates don't seem to factor in the demonstrated cyclicality of equipment demand. Last and not least, while I do think there will be a rebound in construction equipment demand, I think these analysts are overestimating CNH's likely share and the impact of factors like Bakken oil development (which has been going on for a little while now already).
The Bottom Line
With the shares down more than 20% over the past year, my concerns about the model are running into an increasingly interesting valuation. If sales rebound strongly in the next quarter and the company restores its operating leverage, the market will likely be quick to forgive.
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Titan looks very cheap on the basis of its structural free cash flow. EBITDA analysis likewise suggests potential value, as the approximately 10x EV/EBITDA ratio is a little below most three to five year growth estimates. Last and not least, Titan is currently trading at about 25% above its tangible book value, and I would think that should be a floor for the stock. I expect these shares to be very sensitive to further incremental data about planting activity, farmer surveys, and so on, but these shares offer a reasonable short-term trade back into the mid-$20s over the next couple of quarters.
At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.