Summary
- Toro's Professional segment has strong sales and margin growth. Professional now makes up more than 3/4 of total sales.
- Slowing Residential segment growth after two strong "stay-at-home" years is not a major concern.
- The company raised its EPS guidance, but it is still below the $4.25 I forecasted last quarter and am maintaining currently.
- At 19.7 times earnings, Toro stock is still at the cheap end of the range. It is a good buy on any market weakness like we had in June 2022.
Professional Segment Leads Growth
The Toro Company ( TTC ) recently reported fiscal 3Q 2022 results and raised EPS guidance for the year. The Professional segment grew both sales and margins thanks to strong demand and easing supply chain issues. This segment now makes up over 3/4 of company sales, up from 2/3 ten years ago after profitable acquisitions in the underground and specialty construction market. This has reduced the seasonality of Toro's earnings and the dependence on the cyclical housing market.
The Professional segment grew sales 23.3% in fiscal 3Q compared to the same quarter last year, while segment operating income grew 35.9%. This means that operating margin is also growing. The company has been successful at raising prices due to strong and growing demand in the underground construction and golf markets. Some supply chain issues have been easing, for example in engines and plastics. Other components, like chips and other electronics are still supply constrained so the company continues to have a large backlog of orders.
Residential segment sales grew more slowly at 7.1%, although this was expected following two unusually strong years of demand from the "stay-at-home" trade. Operating income was down 16.5% indicating lower margins in this segment.
Toro 3Q 2022 Earnings Presentation
As we see on the margin chart below, operating margin and net profit margin improved through 2018. Growth slowed but margin performance became less cyclical following the 2019 acquisition of Charles Machine Works. After a couple years of unusual behavior, margins appear to be on the upward trajectory again. In the Fiscal 3Q results just released (not shown on chart) the margins were:
Gross Margin: 34.5% (up 2.1% sequentially and 0.5% year-on-year)
Operating Margin: 14.0% (up 0.4% sequentially and 1.5% y-o-y)
Net Income Margin: 10.8% (up 0.3% sequentially and 0.9% y-o-y)
With this strong margin performance, Toro raised FY 2022 EPS guidance to $4.07 - $4.17, up from the $4.00 - $4.15 range they had guided to previously. This is despite the revised sales guidance of 14%, at the low end of the previous 14%-16% range. Analyst consensus has also moved up a bit since last quarter to stay within management's guidance range. I noted last quarter that management EPS guidance looked conservative compared to the $4.25 I estimated by putting the individual assumptions into my earnings model. Updating the model with this quarter's data, my estimate remains at $4.25, which is still above company guidance but now only by 3% above the midpoint or 2% above the high end. The $4.25 EPS estimate implies a forward P/E of 19.7, a value it has rarely seen since 2016 except for the last general market bottom in June 2022.
Earnings Model Updates
As noted above, the sales growth guidance was reduced to 14% due to performance in the Residential segment. Following the strong margin performance in 3Q, I am revising the full year gross margin to be in-line with 2021 at 33.8%, above the 33.5% I used last quarter.
Toro left the operating margin forecast for the year at "similar compared to fiscal 2021," or 13.1%. This looks reasonable, as it is close to the weighted average of the first nine months actual operating margin of 12.7%, and a 4Q assumption of 14.1% which would be only slightly above the 3Q actual.
Below the operating income line, interest and tax assumptions are unchanged but I increased Other Income from my previous assumption. This category covers mainly profits from vendor financing programs, which should increase along with interest rates.
Rolling all these estimates together and using an updated share count, I get an EPS estimate of $4.25, equal to my estimate from last quarter but 2% above the high end of the company range.
Author Spreadsheet (Data Source: Company guidance and author estimates)
Capital Management
Like many companies with a high level of inventory, Toro's free cash flow ("FCF") is negatively impacted during inflationary periods as more cash is required to maintain the same number of units. In Toro's case, working capital also increased with their acquisition of Intimidator Group. The inflationary environment has lasted longer than originally anticipated, unfortunately causing Toro to revise down its free cash flow forecast for 2022.
For FY 2022, the company is now projecting free cash flow conversion of 60% - 80% of net income, down from 80% - 90% previously. This reduction is despite a decrease in the capex forecast to $140 million from $150 - $175 million previously. Based on the 70% conversion level midpoint, Toro would have about $314 million FCF in FY 2022. This covers the dividend of $127 million and the completed buybacks of $110 million. (YTD buybacks are up from $75 million last quarter.)
Toro spent $402 million on the acquisition of Intimidator Group, which it financed by increasing debt by $365 million and by drawing on cash balances and excess free cash flow after dividends and buybacks. Debt to trailing EBITDA ratio has increased to 1.7 times, which is above normal for Toro but within the company's target range of 1-2 times. Interest coverage, which is operating income divided by interest expense, was a comfortable 17.75 times in fiscal 3Q.
Valuation
At $4.25, Toro has a forward P/E of 19.7. Historically, the trailing P/E has been above this level since early 2016. The forward P/E dropped below this level in June 2022, in line with the most recent bottom in the general market.
A P/E at the low end of the range can be expected when interest rates are higher. The 10-year treasury at 3.25% is close to exceeding levels last seen in 2018 when Toro's P/E was at a cyclical low. However, Toro is a more diversified company since then, having completed acquisitions of Charles Machine Works, Venture Products, and Intimidator Group.
A lower P/E would also be appropriate for a company with declining profitability metrics. Toro's return on invested capital has been declining the past couple years as they work to integrate the new acquisitions and deal with the inflationary working capital build.
For fiscal 2022, I anticipate continued recovery in ROIC:
Adjusted Operating Earnings: $468.2 million ($568.2 * (1-0.21))
Average Capital Employed: $2133 million ($1912 million starting, $2354 million ending)
ROIC = 22.0%
Longer term, the company's "Drive for Five" Initiative targets $5 billion in sales by 2024 at an operating margin of 15% for an operating income target of $750 million. This looks achievable, as it implies sales growth of 5.4% per year compared to the 2022 forecast and operating margin expansion of less than 1% from current levels.
Toro should earn about $5.43 per share in 2024 if it delivers this target, not including any positive impacts from share buybacks. ROIC would get back to around 25%, a typical level during the decade of the 2010's.
Author Spreadsheet
The fair P/E for Toro in 2024 will still depend on interest rates. The unpredictability of interest rates makes it hard to set a price target, but if Toro sees no P/E multiple expansion, the share price should still reach $107 in 2024. If interest rates go back down about 100 basis points and Toro's P/E gets back to 25, the stock would be worth $136.
Conclusion
Toro positioned itself well for the current environment by expanding its Professional segment through acquisitions in the past decade. While the Residential segment provided temporary support during the stay-at-home trade od 2020-21, Professional once again leads the company. Strong demand in this segment allows the company to increase prices and grow margins despite inflation.
The company is still on track to earn $4.25 per share despite a weaker sales forecast from Residential. That values the company at 19.7 times earnings, which is low compared to recent history but explainable given higher interest rates and lower returns on capital. Looking forward, capital employed will improve as inflationary impacts on working capital are lessened. The Drive for Five initiative is expected to grow earnings by 12% - 13% per year over the next two years. Without any help from interest rates or multiple expansion, the stock should be able to deliver returns at that level as well.
For further details see:
Toro: It's All About The Pro