The markets have seen plenty of stories like Titan Machinery (Nasdaq:TITN) - stories where a company uses debt to consolidate a highly-fragmented, low-margin industry where the hope is that scale can ultimately improve those margins. Many of these stories hit the rocks when acquisition-fueled growth peters out and/or operational missteps make the debt load unmanageable. There's no guarantee that Titan Machinery will meet this same fate, but investors would do well to realize the risks that come with the apparent undervaluation here.

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Solid Growth in Fiscal Third Quarter, but with Some Mixed Challenges
Titan Machinery continues to outgrow agriculture OEMs such as Deere (NYSE:DE), AGCO (NYSE:AGCO) and CNH (NYSE:CNH) (the company whose equipment Titan Machinery sells) in North America. Impressively, this growth doesn't seem to be just a byproduct of acquisitions. For the fiscal third quarter, Titan reported that revenue rose 38% , beating the average sell-side guess by a low teens margin. Equipment sales rose 46%, with parts and service both up 12% and rental revenue up 25%. Overall agriculture-related revenue rose 39% and made up more than 80% of sales. Most impressive to me, however, was the fact that organic revenue growth came in at 24% (though the company doesn't break it down by segment).

Margins came in a little mixed, though not necessarily for bad reasons. The company's gross margin declined by 130bp and missed the average estimate by about half a point. Interestingly, segment gross margin was steady or up pretty much across the board - equipment margins were flat, parts margins improved 60bp, service margins declined 30bp and rental margins rose 50bp. What happened here, then, was a mixed issue - Titan Machinery sold quite a bit more of that lower-margin equipment this quarter.

Titan management deserves credit, however, for making up some of that through more efficient operations. Operating income rose 26% and the operating margin only shrank half a point, missing estimates by about 20bp. Segment profits saw agriculture up strongly (30%), while construction declined significantly (down 84%).

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Survey Says ... Be Cautious
Various dealer and farmer surveys conducted by analysts following Titan, Deere, AGCO and CNH have indicated some reasons for cautious optimism. Those surveys suggested a solid fall (which showed up in Titan's strong equipment sales), as the harvest came in early and farmers looked ahead to the next planting season. On the other hand, there's more caution in the market now than before, as inventory levels of used equipment are still relatively high and the North American ag cycle is getting a little long in the tooth.

That doesn't mean huge declines are ahead, though. There is certainly a risk that depreciation incentives that expire at year-end pulled demand forward, but crop prices are still quite high and interest rates are very low. Generally speaking, those are pretty good conditions for ag equipment.

A Logical Plan, but a Risky One
As I wrote in the intro, investors have seen the Titan Machinery business model before, and many times the companies end up struggling to produce organic revenue growth and manage the debt they take on in their acquisition binges.

It's not a given that Titan has to follow the same path, though. For starters, there's a high-margin parts and service business here to compliment the OEM/used equipment sales, and a large percentage of Titan's buyers return to their dealerships for service. Titan is also moving into Eastern Europe (with stores in Romania and Bulgaria and expansion into the Ukraine on the way), an area where the agricultural equipment infrastructure is old and inefficient and where CNH has good share. It would likely help Titan if CNH were to improve its small tractor line-up (an area where AGCO is stronger), but that's more of a long-term development.

The Bottom Line
Examples such as Penske Automotive (NYSE:PAG) and United Rentals (NYSE:URI) do suggest that acquisition/roll-up plans can work in the equipment and vehicle dealership/rental markets, though they admittedly serve very different customers and end-markets. The key, in my view, is to not gorge on debt in the pursuit of growth and scale.

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Businesses such as Titan are hard to evaluate with a traditional cash flow analysis because of the huge short-term financing needs and large year-to-year shifts in inventory. Consequently, I suggest investors consider the company's "structural free cash flow," that is, free cash flow excluding the working capital changes. If Titan can grow this cash flow by a mid-to-high single digit clip, fair value looks to be in the low $30s and Titan looks like a promising, albeit risky, prospect.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

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