Toro Q1: Answers Short Questions, But It’s Still Not Cheap (NYSE:TTC)

A short thesis is not as dire as it seemed

Toro Company (New York Stock Exchange: TTC) The stock has seen a huge swing over the past two weeks. It closed at $90 on May 20, roughly in the middle of its range Trading since suffering an earnings loss and lower FY2023 guidance September 2023. On May 21, a short report was released Jehoshaphat’s research Warning of more problems to come. While many topics were covered, there were two points that were most compelling. First, the receivables owed to Red Iron, Toro’s distributor floor plan, to finance a joint venture with Huntington Bank (Two loves), has increased significantly. This was seen as an indication that the dealer channel was overwhelmed with inventory, and future sales had to be reduced to help clear this inventory. Secondly, while Toro has recently begun selling its products in Louie (a little), they appear to be in the process of being phased out at Home Depot (High resolution). Toro stock traded below $79 by the end of May as investors waited Release of earnings for the second quarter of the fiscal year.

I personally was affected by the short report and sold my position in Toro, as indicated in the pinned comment to my last article. Right now, that seems like a bad move. The stock rose after the earnings announcement, and is back above $91, higher than it was before the short report and above where I rated it a buyback in March.

While short seller claims have had some merit, second-quarter results show that inventory is actually declining in the dealer channel. As of last quarter, the graph of outstanding receivables measured in days of sales showed a frightening upward trend of more than 200 days from a seasonal pattern averaging about 100 days prior to 2020. This suggests that dealers are carrying much larger inventory financed by red iron floor plan loans .

If we look at the latest data from Red Iron in Note 13 of their 10-K, DSO accruals are already starting to improve. Calculate DSO with the following formula:

(Receivables outstanding under the red iron arrangement at the end of the period / receivables financed under this arrangement during the period) * Number of days in the period

We get these results comparing the first half of 2024 with the first half of 2023:

While the average sales days of 159 for the first half of 2024 are still higher than the 135 days the previous year, it shows an improvement from the 204 days that existed at the end of the first quarter. Note that this result is consistent with management’s comment on the earnings call that it was “about 40%” through inventory disposal in the dealer channel (i.e. about 40% of the way from the more typical 200 to 100 days). The company expects this to return to normal around the end of this fiscal year, but demand during the snow season is a wild card at this point, which could speed up or slow down the process.

Neither the elimination of dealer inventories nor the phase-out at Home Depot appear to have caused a significant impact on sales, as overall sales were up slightly compared to the second quarter of 2023. However, it’s not all green shoots for Toro. Sales growth remains below the 7.5% level that characterized the period 2014-2020. Margins are lower this year as well, thanks to higher materials and manufacturing costs. Although the worst concerns in the short report have been addressed, the fair value of the stock is lower than I expected in March and is now in line with the current price. This makes Toro a contract.

Second quarter results and expectations

Although a smaller portion of the company as a whole, the residential segment was a winner for Toro in the second quarter. Sales rose 26% and margins also increased. This is true despite concerns about the Home Depot phaseout. When searching for Toro products on the Home Depot website, I came up with one riding mower model and one snow blower model, neither of which are available at my local store. In contrast, Lowe’s website offered a full line of Toro products, including lawn mowers, snow throwers and other outdoor power equipment. The Home Depot loss doesn’t appear to be a drag on Toro’s sales suggested in the short report. Management noted on the earnings call that Lowe’s has the highest share of consumer riding mowers, even larger than Home Depot. There is still some question in my mind as to whether second quarter sales helped the initial stocking of products at Lowe’s, resulting in difficult comparisons for future quarters. Even if this is the case, it is part of future directions.

The professional segment continues to be a drag on overall results, with sales and margins declining. This is where the company sees the brunt of the impact of destroying the dealer channel. This is especially the case for zero turn mowers. Partially offsetting this, sales of underground and specialty equipment as well as golf and course maintenance equipment remain strong. Golf continues to enjoy the increased popularity it gained over the summer of 2020, freeing up course owners with money to spend on upgrading their equipment. More recently, upscale golf courses that cater to tourists have also seen an uptick in business. In the construction equipment market, Toro continues to point to growth in investment in infrastructure, such as utilities and broadband, creating demand for products such as trenching and underground excavation machines. Toro is still experiencing a significant backlog of orders in these markets, and it looks like it will take a year or so to reach more normal levels.

Looking ahead, Toro sees higher sales and margins in both segments during its fiscal third quarter, which is the quarter we’re in now. As a result, the company expects a “significant uptick” in earnings per share, even surpassing the Q3 record of $1.19 per share set in Q3 2022. That’s just enough to offset a slower first half of the year, as Toro left guidance unchanged, With full year EPS of $4.25-$4.35 and 100% free cash flow conversion. I think there are some positives in this guidance if we see a more normal snow season at the end of the year, as opposed to the low snow seasons we’ve seen recently.

In the long term, residential and landscaping will continue to be cyclical. The shift of these products to battery power in the coming years could increase demand, with Toro being a top 5 market share leader globally. Toro should also continue to see strong demand in the construction equipment market due to infrastructure spending, although future moderation in government spending poses a risk. Toro is also participating in a 3-year productivity enhancement initiative to help mitigate the rising material and manufacturing costs seen in recent years. However, overall, it may be difficult for Toro to return to the 7.5% sales growth and high returns on invested capital that it had in 2014-2019. Toro was a great agribusiness through mergers and acquisitions during this period, but as the company grew, it became more difficult to grow efficiently in this way. We saw this with the acquisition of riding mower maker Intimidator Group in 2022 and subsequent impairment charges in 2023. So, while Toro appears to be working to resolve the issues highlighted in the recent short report, it will still It is difficult to grow globally. Rate what it did in the late 2010s.

Capital management

Toro’s free cash flow is seasonal, and is heavily leveraged in the second half of the year. However, free cash flow for the first half was nearly $100 million, compared to about zero in the first half of 2023. Toro is still on track to convert 100% FCF this year, which would deliver projected net income of $4.30. per share or 450 million US dollars.

Toro has no debt due this year and will pay a dividend of $148 million. That’s $0.36 per share quarterly, for a yield of 1.6%. Mathematically, that leaves about $302 million available for buybacks in 2024. Toro did $10 million in buybacks in the second quarter, roughly equivalent to after-dividend FCF. Management has not committed to the full $292 million buyback in the second half, suggesting only that it will be “above” the fiscal 2023 total of $64 million. They’re clearly hedging a bit after badly missing FCF forecasts in 2022 and 2023. A shortfall in FCF forecasts remains a risk this year, but achieving it would go a long way toward taking the stock out of its current trading range.

evaluation

Earnings expectations of $4.30 per share at the midpoint have not changed since the last quarter. The stock price of $91 is slightly higher. This leaves the forward P/E at 21.2. This level is in line with the average during the first half of 2010 and is at the bottom of the range in which it has traded since then.

Compared to its peers, Toro trades at a very large premium to AGCO (AGCO) and Kubota (OTCPK:KUBTY). It is also trading at a slight premium to Husqvarna (OTCPK:HSQVY).

Looking at Seeking Alpha’s peer comparison tool, Toro is not exceptional compared to its peers in growth metrics. In terms of profitability metrics, it is still better than two foreign peers and in line with AGCO. As noted above, Toro’s return on invested capital has deteriorated from the high 20s before 2019 to the mid 20s currently.

Based on the lower ROIC and growth compared to the first half of 2010, I now believe a fair P/E ratio of 21 is appropriate. As noted above, this is about the historical average P/E up to 2016 and the bottom of the range since then. This would put the fair value of Toro stock at around $90, just below its trading price at the time of writing.

Conclusion

Toro responded to the major concerns of short sellers with its second-quarter earnings. The company is shedding its high dealer inventories and managing the move from Home Depot to Lowe’s without a significant negative impact on sales. However, the company needs to prove itself in the second half of 2024, where it will need to outperform the actual first half performance to deliver EPS and free cash flow guidance.

While Toro has shown it’s not in any near-term trouble that would make it a good short candidate, it will still suffer from slowing growth and cost headwinds. This will create an environment that is more challenging than that of the 2000s, when Toro achieved exceptional returns on invested capital. As a result, a lower P/E ratio than I was using previously is appropriate for valuing Toro. At 21 times forward earnings, the fair value of Toro stock is $90, making it outstanding.