ALG - Alamo: The Diamond In The Rough That's Worth Closely Following

2023-07-06 06:12:05 ET

Summary

• The economic climate remains uncertain, marked by weakness in manufacturing on the one hand and strong job numbers on the other hand.
• Despite challenges, Alamo's earnings continue to soar, as evident from the company's latest results.
• ALG's future looks bright and it looks poised to not only grow earnings but also expand margins in the future.

It's been a rough year for US manufacturers. Between supply chain hiccups, skyrocketing raw materials and borrowing costs, and a lack of skilled labor, it's been a bit of a roller coaster. And that's not even touching on the shaky economic climate at home and the global slowdown overseas. But amidst all this chaos, there are still some high-quality, lesser-known companies out there that are not just surviving, but thriving. One company that's caught my eye is Alamo Group ( ALG ).

You might not have come across Alamo before, but let me tell you, it's a hidden diamond in the rough. It's carved out a niche for itself, and despite the economic uncertainties, it's been doing an admirable job. In fact, I'm willing to bet that Alamo is geared up to not only grow its earnings, but also to enhance its profit margins. So, if you're on the hunt for a promising company to keep tabs on, Alamo Group should definitely be on your radar.

Economic Environment

Early this week, the ISM Manufacturing Business Survey disclosed a continual slack in US manufacturing activity. The manufacturing PMI nosedived to 46.0 in June, marking its lowest point since May 2020. The critical indicator has lingered below the neutral 50-mark for the previous eight months, signifying a lengthy period of contraction in manufacturing activity comparable to the Great Recession duration. The stumbling manufacturing sector, constituting 11.1% of the economy, might amplify recession anxieties. Concurrently, the Federal Reserve might be bracing to escalate interest rates in the forthcoming period to curb inflation, potentially slowing down economic growth.

Conversely, the robustness of the labor market might hint at a less grim picture than anticipated. New jobless claims plunged to a one-month low of 239,000 in the week ending June 24, following three weeks of figures above 260,000. A hike in unemployment claims breaching the psychological 300,000 threshold might have triggered alarm, signaling an imminent recession and economic downturn. However, the reverse situation unfolded.

In this fluctuating landscape marred by the manufacturing downturn, Alamo Group has sustained its earnings growth trajectory. Alamo Group, a producer of maintenance equipment for managing public and private infrastructure, natural vegetation, and industrial facilities, offers an array of products such as mowers, street sweepers, hydro-excavation equipment, snow removers, agricultural implements, and other machinery. The company operates from 28 manufacturing sites across North and South Americas, Australia, and Europe and functions through two segments - Vegetation Management ((VM)) and Industrial Equipment ((IE)). Approximately 60% of its revenue stems from VM, while the remaining 40% is from IE. Alamo Group caters to both public and private sector customers, drawing around 70% of its annual sales from the United States, with the remainder predominantly from Canada, France, United Kingdom, Brazil, and Australia.

Like numerous manufacturers, Alamo's operations have taken a hit from supply chain disruptions, elevated raw material costs, and skilled labor shortages, impairing its business units' performance. The IE segment has borne the brunt of supply chain complications, especially delays in chassis deliveries, significantly hampering its performance. However, I believe Alamo's admirable trait is its persistent earnings growth despite these hurdles.

This was prominently displayed in its first quarter results , wherein it registered a 13.7% increase in net sales, reaching an all-time high of $411.8 million. Both segments witnessed double-digit sales growth, with VM advancing by 16% to $256.4 million and IE by 10.2% to $155.3 million. Its operating income skyrocketed by 68.4% to $49 million, and net income soared by 80.6% to $33.3 million. In essence, Alamo delivered an exceptional performance. Yet, I think the most exciting part is the likelihood of an even brighter future.

Promising Future

Alamo has the advantage of a strong brand, deeply rooted in its rich history and extensive product portfolio, enabling it to secure a vital slice of this niche market. Born out of rotary cutting technology-based products in 1969, the company now boasts a significant array of offerings. Through organic growth and strategic acquisitions, it has seen substantial expansion over the years. Its customer base spans governmental bodies and private-sector entities, earning it a solid reputation, especially in the US where it's a leading supplier to the government markets and a significant player in the agricultural sector.

Furthermore, its customer base is incredibly diverse, with no single client contributing more than 10% of its revenues. Notably, many of its IE product lines serve a plethora of government customers who tend to be more economically resilient and financially stable than independent contractors or commercial clients. These key benefits enabled the company to weather the storm of the pandemic. It also grew its earnings significantly not only in the last quarter but over the past couple of years. This puts Alamo in a stronger position to navigate future economic uncertainties.

Data Source: Seeking Alpha

Currently, I believe there's no sign that Alamo is facing a harsh environment that could hamper its growth and earnings. The company continues to see robust demand, evident from its backlog worth $994.8 million. This order book marks an 8% increase from the same quarter last year, providing the company with revenue visibility and laying the groundwork for future growth.

Of course, the business environment is far from perfect, and several challenges persist. For instance, the VM segment continues grappling with labor shortages and supply chain issues, while the IE segment faces challenges in procuring parts like truck chassis, hydraulics, and oil coolers on time.

However, it appears that the tide is turning in the right direction. Alamo has seen significant improvements in its supply chain situation, including the issues with chassis delivery. Additionally, the price realization is on an upward trend, following the actions taken last year, positively impacting both profits and margins.

Data Source: ALG Earnings Release (link provided earlier)

In my view, a standout aspect of Alamo is its ability to leverage robust demand, improved prices, and enhanced supply chain to solidify its ambition to push operating margins to 12%. In fact, this target seems just within arm's reach. I believe the company looks poised to hit this milestone either in the current quarter or the next.

Alamo is experiencing healthy demand for forestry, tree care, mowing products, sweepers, and debris collectors both domestically and internationally. The positive implications of pricing decisions made in 2022 are now starting to reflect in margins, which could remain robust. While the IE segment has been held back by equipment delivery issues, as supply chain problems begin to recede and production volumes normalize, sales will likely accelerate in the forthcoming quarters. Improved utilization is likely to enhance margins, pushing earnings higher and operating margins to the 12% mark. While the second and third quarters might experience a positive seasonal effect on margins, even without this, Alamo is well-poised to register higher earnings and better margins in the future.

Takeaway & Risks

Navigating the economic uncertainties of our time is no small feat, particularly for those in manufacturing sectors. However, Alamo stands out as a high-quality operator that has demonstrated the ability to grow both revenues and profits. The future looks promising too, with a solid positioning to bolster its earnings further. I'm optimistic about this stock, anticipating its continued rise backed by growth in earnings and margin expansion.

However, from a valuation standpoint, the stock doesn't look attractive. According to data from Seeking Alpha, Alamo's shares are trading at around 17x forward earnings estimates, aligning quite closely with the sector's median of 17.5x as well as its five-year average of 18.5x. However, when examining industry valuations more closely, the shares appear rather expensive. Leading heavy equipment manufacturers Caterpillar ( CAT ) and Deere & Co ( DE ) are trading at more modest forward earnings estimates of 12.8x and 13.9x respectively. Similarly, the shares of agricultural and construction machinery manufacturers, CNH Industrial ( CNHI ) and AGCO Corporation ( AGCO ), are trading at even lower forward earnings estimates of 8.3x and 9.1x respectively.

Given these comparisons, Alamo Group's shares appear noticeably pricier. Consequently, for investors on the hunt for value opportunities, I'd advise waiting for a drop in the share price before making a move.

Investors considering Alamo Group should take into account certain associated risks. One of these risks is the potential for a prolonged economic recession, which could negatively affect the demand for Alamo's products in North America. If this happens, the company's current backlog, a crucial indicator of future business, might suffer, casting a shadow over its prospective outlook.

Another concern revolves around the current environment of rising interest rates. This could inflate the company's borrowing costs. It could also influence the behavior of Alamo's dealers, a critical link in its distribution and sales network. Higher interest rates could constrain the dealers' capacity to maintain inventory levels, which could subsequently affect Alamo's sales and cash flows. These factors pose potential issues for Alamo and are risks that investors should consider.

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