Keep An Eye On This Titan

By Stephen D. Simpson, CFA | April 20, 2011 AAA

No one knows when the next run in agriculture is going to start, or if the last one is truly over yet. After all, some of the high crop prices last year were certainly due to a spate of bad harvests, and favorable weather could deliver a bumper crop this year. Then again, a large amount of the U.S. corn crop is going to ethanol, food demand is ever-growing and natural disasters are a "where" not "if" question.

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When agriculture runs, investors turn to fertilizer stocks like Potash (NYSE:POT), equipment companies like Deere (NYSE:DE), seed companies like Syngenta (NYSE:SYT), and ETFs like PowerShares Agriculture (NYSE:DBA) and MarketVectors Agribusiness (NYSE:MOO).

Perhaps investors should add Titan Machinery (Nasdaq:TITN), the leading dealer of CNH Global's (NYSE:CNH) Case and New Holland agriculture and construction equipment, to their watch lists. Not only is this a viable play on agriculture equipment demand, but it gives investors exposure to a recovery in construction equipment demand (whenever that may happen).

Machinery Flying Out the Door
Titan reported sales growth of 46% to $368 million. That was more than 10% ahead of the highest published revenue estimate, and growth was strongest in the company's largest revenue segment (equipment) - up 53% to almost $311 million. Unfortunately, the company does not provide information on the breakdown of price and volume growth, nor the make-up of sales for new or used equipment. Based on management commentary, as well as recent commentary from Deere, Caterpillar (NYSE:CAT) and independent dealer surveys, it does seem like the new equipment market is pretty healthy. (For more, see 5 Agriculture Stocks To Grow With.)

Titan not only sold more equipment, they sold it more profitability. Gross margin ticked up about 50 basis points, while operating income more than doubled. Titan does not break out operating expenses to a fine degree, but sales commissions are often significant parts of the operating expense structure of these kinds of businesses, so the growth in operating expenses does not seem all that troubling (particularly as sales growth clearly outstripped it).

Playing One Horse in the Race
The good and bad news for Titan Machinery investors is that the dealership sells almost exclusively CNH products. CNH is not the strongest ag equipment company in the U.S., but an optimist could say that is just more room for the company to grow. And while it is true that Titan's fortunes are tied to the popularity of CNH equipment, it is also true that the ag and construction equipment dealership market is extremely fragmented and there is ample room to grow through consolidation.

Along those lines, it will be interesting to see if any players step up and try to become a multi-state rival to Titan. Could a private equity investor look to consolidate dealers focused on Caterpillar, Deere or
AGCO (Nasdaq:AGCO) equipment? Or would an established construction equipment rental operation like Hertz (NYSE:HTZ), United Rental (NYSE:URI) or RSC Holdings (NYSE:RRR) want to get into the ag equipment market?

Titan does not have the most impressive margins right now, but if the company can boost margin performance and earn a strong premium from investors, it's a fair bet that others will want to get a piece of that action.

The Bottom Line
Titan is tough to value. The expansion of the company's business, as well as increased customer demand, is leading to inventory build that makes free cash flow useless. On the basis of structural free cash flow (that is, free cash flow analysis that ignores net working capital) the stock's price looks more reasonable, but there is very little operating history to go on with this name. When it comes to simpler valuation methodologies, the stock looks expensive on profit-based metrics, but relatively cheap on revenue-based ratios, due in large part to the company's low margins.

There is clearly growth potential here, not only from share gains of CNH Global in the U.S. ag and construction markets and the recovery of the construction market, but from dealership expansion and consolidation as well. With the stock up more than 130% in the last year, a lot of value-oriented investors probably won't even consider it, but more aggressive investors should at least give this name a look and perhaps a slot on their watch list. (For more, see The Value Investor's Handbook.)

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