Machinery Markets Catch Cold; Titan Gets The Flu

By Stephen D. Simpson, CFA | September 28, 2012 AAA

There are plenty of examples of small companies growing through tough times in their sectors, often by grabbing share with new and innovative approaches to old problems. Nevertheless, it is still generally the case that when the big boys catch a sniffle, the smaller companies suffer even more.

With major construction and agriculture equipment original equipment manufacturers (OEMs) such as Caterpillar (NYSE:CAT) and Deere (NYSE:DE) looking a little weaker (and their managements sounding more cautious), it's not so surprising that the shares of Titan International (NYSE:TWI), a maker of wheels and tires for off-road commercial vehicles, have weakened. Titan remains an ambitious and aggressive company, however, and these shares look quite interesting as a more aggressive play on long-term growth in sectors such as mining, construction and agriculture.

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Drought, Doubt and Debt
As 2012 has moved along, investors have gotten significantly less optimistic about the outlook in 2013 for construction, mining and agriculture equipment. In only one quarter, 2013 analysts' numbers for Caterpillar (one of the world's largest manufacturers of mining and construction equipment) have fallen nearly 10%, and while the revisions for farm and construction equipment makers Deere and CNH Global N.V. (NYSE:CNH) haven't been as severe, there are substantial worries about the impact of Europe's debt crisis, the North American drought and ongoing economic turbulence in major emerging markets such as China and Brazil.

It's not hard to understand the concern. Off-road commercial vehicle OEMs have seen major revenue rebounds since 2009, but now dealer inventories in China are clogged, U.S. economic activity has slowed and bears are rushing to point out that these have always been businesses in cyclical industries. While it may be true that machinery operators will continue to need consumables like tires, Titan is nevertheless vulnerable if these end markets are due for a serious correction.

SEE: How The Severe Drought Will Affect Americans

Ambitious Growth Plans
Titan's management is certainly not positioning the business on the assumption of a prolonged malaise in these end markets. The company has launched a bid for sister company Titan Europe, which, if successful, will expand the company's exposure not only to Europe, but also to markets like mining and product categories like undercarriages.

But if management's prior comments to analysts and investors are still valid, a lot more could be on the way. Management has talked about some bold plans/targets for 2014 revenue, and those are likely to include additional acquisitions - whether that means buying more businesses from Goodyear (NYSE:GT), distributors and small manufacturers in mining or agriculture, or perhaps even wheel/tire businesses of rivals like Trelleborg (if they'd be interested in selling, of course).

Titan's goals don't lie solely on deals, however. The company has already begun building its mining wheel/tire business on its own, and there should be opportunities to win more business from the likes of Caterpillar, Komatsu (OTC:KMTUY) and other global OEMs.

SEE: Mergers and Acquisitions: Understanding Takeovers

How Good Can It Get?
Titan's ambitious growth potential has to be considered in the context of the risks and realities of its business and industry. Titan has already posted some good operating margins for an OEM components supplier; improved manufacturing efficiencies and overhead utilization could drive them higher, but how much higher can they go?

Likewise, can Titan convert revenue to free cash flow at a rate above the mid single digits? The company hasn't done so thus far, and aggressive revenue growth will require capital spending to support it, but this is arguably the biggest variable when it comes to projecting Titan's future value.

Companies such as Cummins (NYSE:CMI), Allison Transmission (NYSE:ALSN) and Commercial Vehicle Group (Nasdaq:CVGI) offer only very limited comparability to Titan, but they do support the broader point - that pushing operating margins beyond 20% and free cash flow margin into the high single digits is not easy as a commercial vehicle component supplier, but can be possible in some cases.

SEE: Free Cash Flow: Free, But Not Always Easy

The Bottom Line
I admit that the range of possible outcomes on revenue, margins and free cash flow are large with Titan, but I do believe these shares are undervalued today. If the company can produce revenue of around $2.5 billion and a free cash flow margin of 6.5% in 2017, these shares can support a fair value in the high $20s.

Don't underestimate the importance of that free cash flow conversion, however. Drop the 2017 estimated free cash flow margin to 5% and revenue has to be $3.3 billion to achieve the same free cash flow production. What's more, while further M&A may build the revenue base faster, additional debt and/or share dilution reduces the implied fair value.

All of that said, I still like Titan. This is not a safe stock, and investors shouldn't underestimate the risks of small-cap cyclicals, but I like management's growth ambitions and the opportunity Titan offers to play multiple markets (construction, mining, agriculture) all at once.

Stephen Simpson has owned shares of Commercial Vehicle Group for over 5 years.

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