The Toro Company Q1: Answering the Short Sellers, But Still Not Cheap (NYSE:TTC)

Short essays aren’t as dire as you might think

Toro Corporation (New York Stock Exchange:TTC) shares have experienced significant volatility in recent weeks, closing at $90 on May 20, roughly in the middle of the range they’ve had thus far. Trading has declined since it missed profit expectations and lowered its fiscal 2023 guidance. September 2023A short report was released on May 21st. Jehoshapat Research A warning of more trouble to come. Several topics were covered, but two were most telling. First, Huntington Bank, Toro’s dealer floorplan financing joint venture,HBAN) increased significantly. This was seen as an indicator that the dealer channel was overstocked and would need to reduce future sales to clear this inventory. Secondly, Toro recently Lowe’slow), and Home Depot plans to phase them out (High resolutionAs investors waited, Toro’s stock price fell below $79 by the end of May. Second Quarter Earnings Announcement.

Personally, this short report influenced me to sell my Toro position as noted in the pinned comment on my post. Previous ArticleFor now, that looks like a bad move. The stock surged after the earnings release, climbing back up above $91, higher than it was before the short report and above the levels where I recommended buying in March.

While the short sellers’ claims had some merit, the second quarter results show that dealer channel inventory is already shrinking. As of last quarter, charts of outstanding accounts receivable, measured in days on sale, were showing a frightening upward trend from an average of about 100 days through 2020 to over 200 days. This suggests that dealers are sitting on much more inventory that they’ve financed with floorplan loans from Red Iron.

Looking at the latest data for Red Iron, 10-KAccounts receivable DSO is already starting to improve. DSO is calculated as follows:

(Outstanding receivables under the Red Iron contract at the end of the period / Receivables funded under this contract during the period) * Number of days in the period

Comparing the first half of 2024 to the first half of 2023, we get the following results.

The average number of days on sale for the first half of 2024, 159 days, is higher than 135 days a year ago, but is an improvement from 204 days at the end of the first quarter. This result is consistent with management’s comments on the earnings call that the inventory reduction process in the dealer channel is “approximately 40%” complete (i.e., a roughly 40% reduction from 200 days to a more typical 100 days). The company expects this situation to normalize toward the end of the year, although current uncertainty over snow season demand could accelerate or slow this process.

Neither dealer inventory drawdowns nor the Home Depot phase-out appear to have had a significant impact on sales, with overall sales up slightly compared to 2Q2023. However, it’s not all smooth sailing for Toro. Sales growth remains below the roughly 7.5% levels that characterized the 2014-2020 period. Margins have been declining again this year due to rising material and manufacturing costs. While the worst fears have been allayed in the short-term report, the fair value of the stock is lower than I estimated in March and is now in line with current prices. As such, I’d hold on Toro.

Second Quarter Results and Outlook

Though the residential division is a small part of the overall company, it was a winner for Toro in the second quarter. Sales increased 26% and profit margins rose. This was true even as fears of a phase-out at Home Depot became reality. A search for Toro products on Home Depot’s website showed one riding mower model and one snowblower model, neither of which are in stock at my local store. In contrast, Lowe’s website showed the full line of Toro products, including mowers, snowblower and other outdoor power equipment. The loss of Home Depot does not seem to have dragged Toro sales as the short report suggests. Management said during the earnings call that Lowe’s has the highest share of consumer riding mowers, larger than Home Depot. The question remains as to whether second-quarter sales were boosted by early inventory of products at Lowe’s, making comparisons to future quarters tougher. But even if that were the case, it would be built into future projections.

The Professional division continues to drag on overall performance due to declining sales and margins. It is this division where the company is most impacted by inventory adjustments in the dealer channel. This is especially true for zero-turn riding mowers. Partially offsetting this, sales of underground and specialty equipment, as well as golf and grounds maintenance equipment, remain strong. Golf continues to enjoy increased popularity in the summer of 2020, giving course owners funds to spend on equipment upgrades. More recently, luxury golf courses catering to tourists have also seen increased business. In the construction equipment market, Toro continues to point to increased investment in infrastructure such as utilities and broadband as creating demand for products such as trenchers and underground excavators. Toro continues to have a high backlog in these markets, which it believes will take a year or so to bring down to more normal levels.

Going forward, Toro expects sales and margins to increase in both segments in the fiscal third quarter currently underway. As a result, the company expects “significantly elevated” EPS, even surpassing its third-quarter record of $1.19 per share recorded in Q3 2022. This should be enough to make up for a weak first half of the year, as Toro is leaving its guidance unchanged, calling for full-year EPS of $4.25-4.35 and free cash flow conversion of 100%. I believe there is some upside room on this guidance if the end of the year snow season is more normal, unlike the light snow season we recently experienced.

Longer term, the home and landscaping business remains cyclical. As these products transition to battery power over the next few years, demand could increase, which is where Toro could be a strong player. Top 5 Toro is a market share leader globally. And while demand in the construction equipment market should remain strong due to infrastructure spending, future government spending restraints are a risk. Toro is also working on a three-year productivity improvement initiative to mitigate the high raw material and manufacturing costs of recent years. Overall, however, it may be difficult for Toro to regain the 7.5% sales growth and high return on invested capital it achieved in the 2014-2019 period. During this period, Toro grew significantly through M&A, but the larger the company gets, the harder it becomes to grow efficiently this way. This was confirmed by the acquisition of professional riding lawn mower manufacturer Intimidator Group in 2022 and the subsequent impairment charge in 2023. So, while Toro appears to be addressing the issues highlighted in its recent short report, it will still be difficult for the company to grow at the same pace as it did in the late 2010s.

Capital Management

Toro’s free cash flow is seasonal and heavily driven by the second half of the year, but still, free cash flow was nearly $100 million in the first half of the year, compared with nearly zero in the first half of 2023. Toro is still targeting 100% FCF conversion this year, which would result in net income of $4.30 per share, or $450 million.

Toro has no debt coming due this year and is set to pay a dividend of $148 million. That works out to $0.36/share per quarter, yielding 1.6%. Mathematically, that leaves about $302 million available for share buybacks in 2024. Toro repurchased $10 million worth of stock in Q2, roughly the same amount as its FCF after dividends. Management didn’t commit to paying off the full $292 million in buybacks in Q2, only hinting at a “higher” total of $64 million for FY23. Clearly, the company is hedging a bit after missing its FCF projections by a large margin in 2022 and 2023. Missing FCF projections is a risk again this year, but meeting them would go a long way to lifting the stock out of its current trading range.

evaluation

The midpoint earnings forecast of $4.30 per share is unchanged from last quarter. The stock is priced at $91, up slightly. This puts the forward P/E at 21.2, a level that is in line with the average for the early 2010s and at the low end of the trading range since then.

Relative to its peers, Toro is trading at a significant premium to AGCO (AGCO) and Kubota (OTCPK: Kubti). It is also traded at a slightly higher price than the Husqvarna (OTCPK:HSQVY).

View Seeking Alpha Peer Comparison ToolToro’s growth metrics are not superior to its peers. Its profitability metrics are still better than its two international peers and roughly on par with AGCO. As mentioned above, Toro’s return on invested capital has deteriorated from the high 20s prior to 2019 to the mid teens today.

Given the lower ROIC and growth rate compared to the early 2010s, I currently believe a fair P/E is 21. As mentioned above, this is the average of the historical P/E through 2016 and the low end of the range since then. This puts a fair price for Toro stock at around $90, slightly below where it is trading as of this writing.

Conclusion

Toro answered short sellers’ main concerns with its second-quarter results. The company has significantly reduced dealer inventory and managed the transition from Home Depot to Lowe’s without a significant negative impact on sales. Still, it needs to prove itself in the second half of 2024, as it needs to beat first-half results to hit its EPS and free cash flow guidance.

While Toro has not demonstrated any near-term issues that would make it a good short candidate, it will certainly suffer from slowing growth and cost headwinds. This will create a more challenging environment than the 2010s, when Toro generated exceptional investment returns. As a result, a lower P/E ratio is appropriate for valuing Toro than the fair value ratio I have used in the past. At 21 times forward earnings, Toro shares have a fair value of $90, making it a Hold.