2023-11-03 07:27:36 ET
Summary
- Tennant Company has decent fundamentals and has managed an annualized EPS growth of almost 8.5% for the past 20 years.
- The company has a gross margin in the 85th+ percentile and a net margin above average, indicating good profitability.
- Tennant Company generates over $1.1B in revenues, has a diverse customer base, and a three-prong business model focused on equipment sales, global direct service, and parts/consumables.
Dear readers/followers,
One of my readers works in cleaning and hygiene products/industrial products and asked me to take a look at the Tennant Company (TNC). I'm happy to take subscriber requests insofar as these businesses go. Tennant isn't a massively high yielder - but that's not always what I look for. I'm open to investing in businesses from a perspective of capital appreciation, as long as the 15% annualized RoR that I'm looking for is possible.
Tennant has very decent fundamentals - but it does have some drawbacks. The company's yield and some of the fundamentals are some of these. But in this article, I'm going to take a look at and see what we can expect from the business on a forward basis.
Let's see what the company does, offers, and what the advantages are.
Tennant Company - Cleaning is timeless
I generally like investing in cleaning and industrial machinery businesses like these. The products they make are generally timeless and provided they have a good business model and have been around a while, competition in this segment, while it exists, is generally smaller than in other machinery businesses. We can confirm this by looking at Tennant, which has managed an annualized EPS growth of almost 10% for the past 20 years. This is better than the market.
In addition, investors in the company have managed an annualized RoR close to this - 9,1% today, even after the relatively significant declines over the past few months. This is generally above the market average, even if it's not the sort of outperformer that typically gets my interest.
However, Tennant Company is objectively speaking a good business.
What do I mean by "objectively speaking a good business"? How can I make that qualification?
By looking at sector averages and comparing profitability and margins.
Let's look here.
Tennant is a business that manages an impressive 40%+ gross margin and over 8% net margin. While that net margin is so-so, it's above average, and that gross margin, is in the 85th+ percentile, meaning it's better than over 80% of the companies in the Industrial products industry. That's a good profitability.
The company has drawbacks and fairly clear ones. It only has a 1.3% yield, which is very much sub-par. It also has only a BB rating, and the combination of these two things may mean that this company is disqualified from some of your overall investment profiles - which I would say is understandable.
This is a company that generates upwards of $1.1B in revenues, as you can see a double-digit EBITDA and a $4+ EPS. It has a backlog of over $300M. As typical businesses in this segment, it works from an appeal of sales as well as services for its machines. Surprisingly, it's not just a NA company. Tennant has geographical diversification, managing a 27% EMEA split, and an 8% APAC, aside from a 65% Americas diversification.
It's verticals are well-diversified. Tennant machines run as well as clean in Retail, Healthcare, Education, Contracting, Logistics and Warehousing, and Manufacturing. Basically, anywhere a surface needs cleaning, you can find Tennant machines.
This is technically a very appealing, three-prong business. 61% of the company's overall revenue comes from the selling of pre-owned and new equipment, while 15% comes from global direct service, employing 900 people worldwide, and 24% from parts and consumables for the machines.
This is also how the company organizes its businesses and sales, rather than going the "geographical" approach. You can see the business model and its specifics, and exactly where money goes here.
Tennant business model (GuruFocus)
As I said - not an unattractive business model in the least. Where I see the weakest point of the model is the SG&A - the company spends perhaps a bit much on this compared to other businesses - implying that competition here has always been hard, or is increasing. That's why the net margins are as low as they are.
The company has an attractive portfolio of what I would call industry-leading machines and products.
This is backed up by a 9-year average tenure of service rep, all of them Tennant employees (not a third party), with over 60+ hours of training each. This is a capable organization not only on the sales, but the service side, and I can understand why the reader in question was curious about the company and where it's going.
The company's recipe for continued sales increases includes organic sales growth through better efficiencies, enabling competitiveness, which should result in a 50-100 bps EBITDA margin increase, and 6-10% adjusted EBITDA growth.
The company has some proof of this already. Despite an environment where we can obviously see not only cost increases for raw materials but labor and other factors, the company is outperforming across the board. By that, I mean that not only is sales revenue increasing, but bottom-line indicators are improving as well. EBITDA and EBITDA margins are both up as well.
3Q23 results for Tennant are positive as well. The quarter saw a continuation of sales increases, with a 13.9% sales increase, both from price growth and volume in sales. The company's backlog, is as of this latest quarter down to close to $200M however, implying a lack of current pent-up demand - but is weighed up by over 100% FCF conversion from net income.
The company also increased its full-year estimates, now expecting upwards of $1.25B of net sales, and over $190M of adjusted EBITDA. The company is one year early with its enterprise strategy, managing both revenue growth, EBITDA growth, and EBITDA margin in accordance with its 5-year strategy target within the 4th year, this fiscal.
It's also launching a new target strategy.
Capital deployment remains interesting here, as the company is focusing on paying down debt, with net leverage of 0.64x and total debt of $222M, close to an EBITDA number they could pay off in a single year if they chose to do so. This is a very conservatively leveraged business, and it's surprising to me that we're still seeing a BB rating for this company, especially with the increased guidance for the year and the overall improved fundamentals.
The problem perhaps, if looking for some, is at this point relegated to the company's valuation and how it's being forecasted. You see, Tennant unfortunately cannot really be called "cheap". While the company's annual results were very solid, the problem here is that the company really, unless you believe in estimates that are negatively missed over 30% of the time, cannot be called "cheap".
Let me show you what I mean.
Tennant - The company's valuation is so-so, and good only if you believe in significant growth.
So, the company is growing here. Two things give me pause. First off, the price - second, the backlog. In less than a year we're down 33% in backlog and the "refilling" really isn't happening. So while some of the current estimates may turn out to be right and we see a 7-10% EBITDA growth and good sales growth, the question is how long this can persist.
If you allow the company a premium of over 20-22x P/E, there is a good upside here - over 20% per year even, and that's without the dividend included in the calculation.
However, why would you assign a high premium of all things, to a company with BB credit, with less than 1.5% yield, and with a relatively high historical chance of missing its forecast?
You can get a better, safe yield and return by throwing a dart at a pref stock or a bond today - in order to get that "good good" return, you need the capital appreciation and growth estimates to materialize.
And I am not saying that's impossible - just that I'm not considering it as likely or as certain as others seem to. Tennant isn't exactly an overfollowed or overanalyzed company. S&P Global currently has 3 analysts following the business. These consider the company significantly undervalued. They assign it a target starting at $100 and going to $115, with an average of $105, with 2 analysts at a "BUY" here.
However, those analysts also have the dubious historical honor of considering Tennant 10-60% undervalued for the past several years, and those estimates have very rarely been realized. What I am saying is that the company is perhaps given a bit too much leeway here.
I like what I see when I look at Tennant Company. I see a business with good margins, especially gross margins, working in a very attractive sector, and seeming to have a business model that's working very well, even if the SG&A is perhaps on the high side, giving us sub-9% net margins.
But on the flip side, we also have a BB-rating, we have less than 2% yield in an environment that gives 5% easily, and the company is trading above 14x P/E already, demanding in order to get a market outperformance that we assign a 19-24x P/E in order to get solid returns here.
That, in the end, is not something that I am willing to do.
You might be - you'd have some analysts on your side - but I believe there are better options out there at this time.
If you estimate Tennant at 15x P/E, you're getting annualized returns of just above 10% here - that's not good enough for me for what the company offers.
I would be interested in investing in Tennant at perhaps $60/share, at which point we'd have a very solid conservative upside. Even then, however, I'd still want to look deeper into continued demand for products, to see if the current dip in the backlog is anything that should worry investors.
So, as an answer to my reader - I like Tennant - just not here, and I would currently invest in other things.
Here is my current thesis on the business.
Thesis
- Tennant Company is a solid, fundamentally profitable business with good margins and a good upside at the right environment. I would, at the right sort of valuation, be interested in buying shares of the business.
- However, at the current valuation, that's not something that's possible under my investment criteria. I would be interested in buying the company at a price of around $60/share, giving it a conservative upside to a 15x P/E.
- Because of that, I start out here at a "HOLD", with a PT of $60/share, which is below the market, but where I believe the fair value of the company lies.
Remember, I'm all about : 1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.
2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.
3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.
4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.
Here are my criteria and how the company fulfills them (italicized).
- This company is overall qualitative.
- This company is fundamentally safe/conservative & well-run.
- This company pays a well-covered dividend.
- This company is currently cheap.
- This company has a realistic upside based on earnings growth or multiple expansion/reversion.
For further details see:
Tennant Company: A Potential Upside In Cleaning (At The Right Price)