2023-10-17 13:24:44 ET
Summary
- The Toro Company's stock price has fallen due to temporary difficulties caused by weather and economic conditions.
- The stock is currently fairly valued and offers long-term investors a good opportunity.
- Revenues are protected by high barriers to entry and Toro's competitive position.
Thesis
The Toro Company (TTC), one of the best investments of the past 10 years, is currently in an interesting situation. With an annualized total return of 14.82% since 01/01/2013 versus 12.62% for the S&P 500, management has rewarded shareholders handsomely. Due to temporary difficulties caused by weather and economic conditions, the share price fell from $115 to $87 today. The big question now is whether this is a big opportunity or whether the valuation has returned to a fair level.
In my opinion, the stock is fairly valued at the moment and therefore offers a good opportunity for long-term investors to acquire shares in a wonderful company at a good price. I think a long-term total return of 12%-14% per year could be achievable at this price.
Toro's Business Overview
Toro is one of those boring mid-sized companies that many investors overlook. With two segments, Professional, which accounts for about 3/4 of sales, and Residential, which accounts for 1/4, they serve many different customers. Lawn and landscape maintenance, snow and ice management, underground utilities, irrigation are some of their business areas. In particular, golf course turf maintenance and sports fields & grounds are important parts of their business.
So there is a certain seasonality to their business. For example, if there is less snowfall, the winter season has less revenue, but generally speaking, the residential segment is the more seasonal segment because it is more dependent on weather conditions. Pre-season demand and unusual weather conditions can therefore have both a negative and a positive impact. This year, the impact was more negative as the climate was hotter and drier than normal. In addition, receivables increased from January to April and decreased from May to December as payment terms are extended in the early part of the year.
Net sales outside the U.S. are approximately 20%, and the manufacturing process runs throughout the year, with peak production just before the key season for the products begins. The competition is definitely tougher in the residential segment, but the professional segment is not an easy one either.
Competitive Advantages/Barriers to Entry
Toro operates in a challenging environment. The business is capital intensive and competition is fierce. However, barriers to entry are high because of the points mentioned above and because Toro has a strong network and expertise built up over a long period of time. New competitors are therefore rare.
As a result, investments in R&D, especially in alternative energy, smart, connected and autonomous solutions, are growth drivers for the industry and for Toro, and help to maintain the competitive edge.
Capital Allocation of TTC
Toro's has many ways to use its capital. Sometimes they use it for M&A activities, like the $400 million acquisition of Intimidator in 2022, and sometimes they use it for R&D or organic growth opportunities. Share buybacks and dividends to return cash to shareholders are also two things they do repeatedly.
The share repurchases represent a CAGR of -1.90%, helping shareholders to take a larger stake in the company and its earnings each year. In addition, the dividend growth has a CAGR of 17.12% over the past 10 years and 11.20% over the past 5 years. TTC is truly a shareholder friendly company in my view.
A 1.5% dividend yield that is likely to grow between 5% and 10% annually over the next 10 years, combined with share repurchases that are likely to add another 1% to 2% to shareholder returns, will really help with total shareholder return.
Given that TTC bought back a lot of shares at slightly higher prices in 2022 and 2021, it should buy back a lot of shares in fiscal 2023 as the shares are now more undervalued than they were then in order to use the capital efficiently.
Return on capital is at a 10-year low, but still strong at 15%. However, if it continues to decline, it could destroy the investment thesis for Toro's. Because of the debt position, which I will talk about later, they have a WACC in the range of 7% to 10% and therefore a ROIC-WACC spread of 5% to 8%. This shows that they are creating value today, but rising interest rates and tougher economic times could lead to a narrowing of the spread.
TCC's Balance Sheet
TCC has $147 million in cash and cash equivalents as well as a $600 million credit facility to ensure liquidity and is FCF positive. The LT debt position is $1 billion but the TTM net income is in the amount of $376 million. So debt/net income is <4, which I think is a safe situation.
Looking at the structure of the debt, the 2026 and 2027 maturities should be easily serviced from today's perspective. As a result, I see a strong balance sheet that gives the company the flexibility to respond to future events.
Interest expense is approximately $15 million per quarter or $60 million per year, resulting in 9.2x interest coverage. The average for the S&P 500 is ~10x, so TTC is a bit worse, but still good enough when we consider all the factors.
Valuation of The Toro Company
Over the past 10 years, multiple expansion has driven some of the shareholder returns as it has grown from 14x EBIT to 19x today. But one could also argue that the multiple today is a bit lower on a normalized basis as earnings are impacted by the abnormal weather conditions. But in general, I think we are not going to see significant multiple expansion in the next few years, so shareholder returns will have to come from earnings growth plus dividends and buybacks. But I believe a 19x multiple is a fair value for a company like TTC, given the quality, growth rates and profitability of the business.
Reverse DCF
My favorite tool to see if the stock price is justified is a reverse DCF model. This time the assumptions are:
- EPS: $4.10 (Guidance for 2023)
- Discount Rate: 10% like the long-term S&P TR
- Exit Multiple: 20x
In this case, EPS would have to grow by 12% over the next 10 years to justify the current share price. The 10-year CAGR for diluted EPS is 10.99% , which is slightly lower. However, if we adjust for normalized earnings, EPS would normally be a bit higher, and therefore the growth rate would need to be closer to 11%, and therefore the stock is fairly valued.
Risks for TTC
Toro's risks include a shortage of parts or raw materials needed for its products. Raw materials include steel, aluminum, copper and rubber. In addition, certain engines are imported from China . Plus climate change can also have a big impact on the business, as we saw earlier this year.
Strong competitors with greater financial resources could also outpace Toro in R&D and gain a competitive advantage that would be difficult to regain. It is a tough market they are competing in.
Conclusion
All in all, I think that Toro's total return will be earnings growth plus dividends and buybacks, and that the multiple will probably stay the same or maybe even shrink depending on the market environment going forward. Net income growth over the past 10 years has been between 9% and 10% per year, and growing dividends plus buybacks will likely add 3% to 4%. Thus, total shareholder returns could be in the range of 12% to 14% per year.
Since I like to invest in a company when there is a high probability that returns will reach 15%+ annually, I would personally invest at an entry point of 13x - 14x EBIT multiple. But even now, it is a good opportunity given the quality of the business.
For further details see:
The Toro Company: Excellent Opportunities Often Arise After Disappointing Results