2023-09-08 00:25:19 ET
Summary
- Toro hugely missed expectations and guided FY 2023 results lower due to a rapidly deteriorating Residential segment.
- Professional segment performance and a new deal for consumer product placement at Lowe's are green shoots from this ugly quarter.
- TTC share price is down just in line with the lower earnings guidance, leaving the stock a Hold.
Holy Cow, What A Miss
The Toro Company ( TTC ) shocked investors with its fiscal 3Q 2023 results . Sales of $1.08 billion in the quarter were 11.5% below analyst expectations . Non-GAAP EPS of $0.95 missed by 23.4%. GAAP EPS was actually a loss of -$0.14 due to a $150 pre-tax impairment charge on the Intimidator Group , the maker of Spartan brand zero-turn mowers that Toro purchased for $400 million in early 2022.
That's not the worst of it. Toro revised down the EPS guidance for FY 2023 to $4.05-$4.10 from the prior guidance of $4.70-$4.80, a drop of 14.2% at the midpoint. Keep in mind, there is only one quarter left in the fiscal year. That implies a 4Q EPS guidance of $0.53-$0.58, vs. expectations of $0.99.
Last quarter, I asked the provocative question , "Should Toro Trim Its Residential Business?" as that segment was already seeing a slowdown, but nowhere near what actually happened in the quarter. The sales plunge was attributed to both dry weather and a suddenly reluctant consumer thanks to high interest rates, economic uncertainty, and a rebound from unusually high demand during the pandemic period.
We also learned this quarter that a significant chunk of sales in the Professional segment are actually to homeowners with large amounts of land who want a professional-grade mower. That was the reason for the slowdown in Intimidator Group sales which resulted in the impairment charge. The one piece of good news is that outside of the landscaping market, Professional sales continued to be strong. This includes golf and grounds maintenance as well as specialty construction. The supply chain for raw materials is also improving, allowing Toro to deliver against its large backlog in these areas. As a result, Professional segment sales showed a 1% increase. Segment operating earnings would have been down less than 2% without the Intimidator Group impairment.
A Few Green Shoots
Longer term, there are reasons to believe the company can get back on track. Rainfall in August, the first month of fiscal 4Q, was 14% above normal in the US. The demand issues will take some time to work through, however. High inventories at retailers delayed them from making mid-season replenishment orders to allow for destocking.
Looking forward to spring 2024, Toro has announced a deal to sell its residential products at Lowe's ( LOW ). This gives the company a presence at Lowe's, Home Depot ( HD ), as well as Tractor Supply ( TSCO ).
In the professional landscaping business, the impairment of 37.5% of the purchase price of Intimidator Group does not necessarily imply a similar drop in future sales. Impairment tests are based on a discounted cash flow model. This means that higher interest rates lower the present value of the business. Also, the near-term results are more heavily weighted in the model.
Toro plans to get through this period by rebalancing production away from the residential products and toward the golf and grounds and specialty construction markets where demand is still strong. This causes some inefficiency and will impact margins even though it does help sales and operating income.
Going back to last quarter's question, the rebalancing could just be optimizing a bad situation, but it could also be the start of actually spinning off the residential segment. The shockingly bad performance of Residential in contrast with the strong performance in Professional could lead to calls from investment bankers and activist investors to split up the company. It's not a good idea to speculate on such a deal while the business fundamentals are poor, but a restructuring plan announcement would be a possible upside surprise.
Valuation
Toro stock reacted to the earnings news by dropping over 13%, almost exactly in line with the drop in earnings guidance vs. expectations.
In my last two articles, I rated Toro a hold at 24 times FY 2023 earnings in March and 21 times in June. With the price drop following the earnings announcement, the company's P/E is little changed at $86.46/$4.075 = 21.2.
I expect analyst estimates for 2023 to be quickly revised down to company guidance and will not change much until we get more details on inventory levels at retailers, the level of sales to be expected from the partnership with Lowe's and the long-range weather forecast for the snow season. Until then, the stock is a Hold down to 20 time the new lower EPS guidance, or $81.50. The next earnings call in December will include management's first outlook for FY 2024.
Capital Management
Free cash flow for the fiscal year to date has been just $50 million. Working capital chewed up $345 million of cash in the first nine months of the year, with over half of this being a decline in accounts payable. This suggests lower purchases of raw materials as the company tries to slow manufacturing and work off inventories.
For the full year, management guidance is for free cash flow conversion of 50%-60%. This is down from the 90%-100% level predicted previously. Using company guidance for 4Q earnings, GAAP net income for the year would be $316.7 million, implying free cash flow around $174.2 million. This figure includes $130 million of capital expenditure, down from the previous forecast and FY 2022 actual capex of $150 million.
Toro will pay dividends of $142 million for the full year. Buybacks, net of stock issuance for employee compensation, have been $44.4 million. So, capital return in 2023 already exceeds expected FCF by $12.2 million before acquisitions and other investing cash outflow of $13.5 million.
This net debt increase of $25.7 million is manageable, as Toro's debt/EBITDA is still at a comfortable 1.7 times. The company will need to get back to a more typical FCF conversion around 100% next year before I consider the stock a buy, however.
Conclusion
Toro has had a long history of growth by smart acquisitions which has balanced the company more toward the Professional segment and less tied to housing market issues. Still, the fiscal 3Q 2023 results were shockingly bad for the Residential segment. Shares are now down about 25% from the high reached in January 2023.That's less than the 36% drop the stock endured between May, 2021 and June, 2022 before fully recovering. It's also nowhere near the 65% drop during the 2007-09 housing crisis.
Buying the dips and patiently waiting for the recovery has been a rewarding strategy in the past, but this current decline may not be over until we hear more positive news about the consumer. A strategic review or spinoff of the Residential segment would be a positive catalyst, be we can't count on it. Anyone interested in adding shares or building a new position should consider waiting for P/E levels below 20, or $81.50 based on the recently lowered EPS guidance.
For further details see:
Toro: Investors Get The Horns