2023-07-04 06:38:16 ET
Summary
- The Toro Company reported a record second quarter but lowered guidance for the year due to rapidly declining Residential segment sales.
- With Residential now only 1/4 of the company's sales and headed lower, the company should consider selling it to focus on the higher margin Professional segment.
- A sale is not an easy call as it is initially dilutive to earnings, although it results in higher future growth.
- I wouldn't buy the stock to speculate on a sale of Residential, but it is around fairly valued and worth holding.
Record Second Quarter, No Thanks To Residential
The Toro Company ( TTC ) reported fiscal 2Q 2023 results on 6/8/2023. The company set a second quarter sales record of $1.34 billion, up 7% from last year, and a 2Q EPS record of $1.59, up 28%. Toro continued to improve gross margin and operating margin as well. Gross margin was up 3.4% to 35.8% and operating margin was up 2.7% to 16.3%. Due to high demand in the Professional segment, the company was able to pass along material inflation and more fully utilize production facilities. An improvement in the supply chain also led to more efficient production. Finally, freight costs have started to come down as well.
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It was a tale of two segments as the Professional segment increased sales by more than twice the company average. Construction, golf, and grounds keeping equipment were all strong end markets. As discussed by CEO Rick Olson on the earnings call , order backlog is still near the $2.7 billion level where it ended 2022 (about 6-7 months of sales) even though supply chain bottlenecks have eased.
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In contrast, the Residential segment suffered mid-teens sales declines and shrinking margins as well. Consumer demand has weakened after the "stay-at-home" spike of the last couple of years.
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The outlook for the year is just as grim for Residential. This led to Toro revising its sales guidance for the year to the low end of the prior range. The company now expects 7%-8% sales growth for the year, down from 7%-10% growth released last quarter. Here are my sales estimates by segment, based on company guidance:
Author Spreadsheet
EPS guidance is also lower, at $4.70 - $4.80, down from $4.70 - $4.90. The bright side of the decline in the Residential segment is that this terrible outlook reduces the EPS forecast for the company by only around 1%.
Toro's share price has come down over 13% since my analysis last quarter . This decline puts the stock closer to the bottom of its historical valuation range, but the tough outlook for Residential remains a challenge. While the segment is a well-recognized brand and a long-standing part of Toro's heritage, it is now a small enough part of the business that selling it is worth consideration. As I will show below, selling Residential would create a faster-growing Professional-focused company that is more deserving of Toro's high valuation.
Earnings Model Updates
I updated the earnings model from prior articles with the company's latest guidance. I now expect Toro to earn $4.76/share this year, down $0.05 from the estimate of $4.81 last quarter. This agrees with the company EPS guidance, which is also down $0.05 at the midpoint.
Author Spreadsheet
This guidance implies a severe slowdown in sales growth and a decline in operating income when looking at the second half of the year alone.
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Evaluating A Residential Segment Sale
We, fortunately, have a recent comparable deal to help value the Residential segment. In December 2021, Stanley Black & Decker ( SWK ) bought privately held companies MTD and Excel . Based on the 2021 Form 10-K , we see that Stanley paid about $2.28 billion for these companies. They owned MTD for one month and Excel for about 7 weeks of the fiscal year. Using the actual and pro forma sales numbers for the acquired companies in the 10-K, I calculate that full year 2021 sales of the acquisitions were $2.85 billion. This values the acquisitions at 0.80 times sales. Using Toro's Residential segment forecasted sales of $908 million, the segment is worth $727 million on a comparable basis.
Author Spreadsheet
Toro could use the cash from this purchase to pay off debt and buy back stock. Toro's current debt/EBITDA leverage of 1.3 is in the lower half of their 1-2 target range. In this example, I show the company buying back just 10% of outstanding debt. After paying the tax on the gains from the asset sale, the remaining cash is used to buy back stock.
Author Spreadsheet
Taking into account the lower sales and operating income, offset by the lower interest expense and share count, we can generate a pro forma earnings model for Toro without Residential.
Author Spreadsheet
The sale is dilutive to EPS, taking the P/E from 21 to 22.5, but the expected growth rate increases, leaving the stock similarly valued based on the PEG ratio.
Industry analysts estimate the size of the global outdoor power equipment market at around $30 billion in 2022. That gives Toro's residential segment about 3.5% market share, a digestible piece for a large company and smaller than the MTD deal. Leaving Stanley Black & Decker out of the mix, possible acquirers include Deere ( DE ) and several European and Japanese companies.
The segment could even be a good fit for Berkshire Hathaway's ( BRK.A ) ( BRK.B ) Scott Fetzer subsidiary.
Toro may also wish to reduce exposure to the growing electrification trend in consumer outdoor power equipment. California is set to ban gasoline-powered mowers and other outdoor equipment as early as next year . Professional segment products will also be under pressure to electrify, but this trend should be slower, especially in the underground and specialty construction market, which is now about 1/3 of the segment's sales.
Other Considerations
Late 2021 when the MTD deal occurred was probably a better time for a sale, coming at the end of the pandemic-influenced consumer demand for outdoor maintenance equipment. Price/Sales multiples may be lower than they were then, or Toro may want to wait until Residential segment sales recover from this current slump.
One-time costs for separation have not been included in this analysis. Given the long history of the business, they may be substantial. For example, the landscaping portion of the Professional segment likely uses common suppliers and parts with Residential and may even manufacture products at the same locations.
Toro might identify additional takeover candidates in the Professional segment where it could apply the proceeds of a residential sale. In that case, investors would not see the immediate debt reduction or share buyback and would instead have to wait to see the earnings benefits from integrating the new business.
Conclusion
Toro has successfully expanded its Professional segment over the past decade to the point where it now makes up 75% of sales, an even larger share of the profits. The Residential segment had a brief resurgence from pandemic-influenced consumer demand but is once again a drag on the company's growth. With a P/E over 20, the company is still on the expensive side given its growth expectations.
Selling the Residential segment would be slightly dilutive to earnings but would increase the expected growth rate of the company, making the high P/E more justified. Still, it's not an easy call because the multiples achieved in the 2021 Stanley - MTD deal may no longer be available. The long history of Toro as an integrated company may also result in high separation costs.
The drop in share price since last quarter makes Toro closer to fairly valued as opposed to overvalued. If I did not already own it, I would not buy it just to speculate on a Residential segment sale. I will continue to hold, however, as the company has a long history of managing through economic cycles and growing over the long term.
For further details see:
Should Toro Trim Its Residential Business?