Douglas Dynamics, INC. (NYSE: PLOW)

Price: $13.61 (1/29/12)

Market Capitalization: $299.4MM                              Shares Outstanding: 22MM

Advocate: Buy                                               

 

Albert Einstein once noted that there are five ascending levels of intellect:  “smart, intelligent, brilliant, genius, simple.” Amidst pandemic uncertainty and anemic economic growth, it is helpful to heed the spirit of Einstein’s wisdom and utilize a simple framework through which to identify businesses with a greater chance to succeed in the current economic climate.

To that end, I believe that clear answers to the following five questions will help uncover companies better equipped to prosper in the face of a protracted economic malaise:

1) What problem does the company solve?

2) Who are the company’s customers and how badly do they need the

      product or service?

3) Is the company run by an honest, competent management team that treats

      minority shareholders as valued corporate partners?

4) Does the current financial position and share price provide a sufficient

      margin of safety?

5) What could go seriously wrong?

 

Enter Douglas Dynamics, Inc.  With an estimated 50% share of the market, Douglas Dynamics (“DD” or, the “Company”) is the North American leader in the design, manufacture and sale of snowplows, sand and salt spreaders, and related parts and accessories.  DD sells its products through a network of 720 distributors located throughout the Snowbelt region of the United States.  The distributors sell to an end-user base that includes professional snowplowers, businesses, municipalities and individuals.  The Company sells its products under the WESTERN, FISHER and BLIZZARD brands.  

Careful analysis of DD’s business reveals compelling answers to the preceding five questions.  First, the business is designed to solve a dangerous, urgent problem: snow and ice removal.  Second, the Company’s end-users have a non-discretionary need for DD’s products because their livelihood and safety are dependent on high-quality, reliable equipment.  Third, DD’s management has a demonstrated record as thoughtful stewards of shareholder capital.  The Company has avoided value-destroying acquisitions and thoughtfully deployed free cash flow.  Fourth, based on the Company’s mid-point 2011 revenue guidance, the stock currently trades at a 10% free cash flow yield.  Assuming 2% catalog price increases (in-line with historical levels), and 2% annual organic growth over the next ten years, an investor stands to generate an approximately 14% annual rate of return at the Company’s current valuation of $13.61 per share.  Finally, DD’s variable cost structure, minimal capital reinvestment requirements, and replacement-driven business model ensure that the Company can withstand acute shocks to the business and/or the economy. 

 

1) What problem does the company solve?      

In one word: snow.  Winter can be a cruel mistress.  Heavy snowfall and treacherous icy conditions restrict intrastate and interstate travel and stanch economic activity.  When people are snowed in, they cannot go to work, go to the mall or dine out at a restaurant.  The lost productivity and irreplaceable tax revenue cost businesses and governments hundreds of million of dollars: 

 

 

The Costs of Snow

?In 2010, the Washington D.C. Office of Personnel Management reported that each snow day cost taxpayers $100MM in lost productivity of federal workers

?An IHS Global Insight Study found that one major snowstorm can cost a state $300MM-$700MM in both direct and indirect costs

?“Lost wages of hourly workers account for about two-thirds of the direct impact of a major snowstorm.” –James Gulla, Managing Director of Global Insight.

 

In addition to the deleterious economic effects, snowstorms are also a serious threat to public safety:

Weather-Related Car Crash Statistics               Source: fourteen-year averages from 1995-2008 analyzed by Noblis,                based on NHTSA data                                               Crashes               % of Vehicle Crashes       % of Weather- Related Crashes       Snow/Sleet                                  225,000                    4%                                                 15%           Icy Pavement                              190,100                    3%                                                 12%           Snow/Slushy Pavement           168,300                     3%                                                 13%           Total                                             583,400                    13%                                              40%

It is incumbent upon local, state and federal governments to keep the roads safe.  This requirement is not a choice that can be postponed, such as re-paving a highway or building a bridge.  Due to the economic repercussions and safety considerations, snow and ice removal cannot be ignored, moderated or delayed due to exogenous macro-economic factors or political infighting.  It is not a “discretionary” activity like buying an expensive purse or eating a fancy dinner.  Hazardous conditions caused by snow and ice create a very serious problem that needs immediate solving.  A granular look at DD’s design, manufacturing and selling processes will illustrate why DD has been, and should continue to be, so effective at solving the “snow” problem.  

 

Design and Engineering

DD designs, engineers and manufacturers its snowplows and sand and salt spreaders in-house.  A casual winter weather observer probably does not appreciate the level of technological expertise and engineering know-how that is required to design and build high-quality snow and ice control equipment. 

Snowplows are highly engineered products comprised of mechanical, hydraulic and electrical components that must be effectively integrated with vehicles to function properly and conform to government passenger vehicle regulations.  Each snowplow consists of four components: the blade, the hydraulic system, the mount, and the A-Frame, Quadrant and Lift (the “AQL”)-see the picture.  

 

 

 

 

Once more, the plow or spreader must be attached to a light truck, redoubling the importance of expert engineering.                                             

As an interesting aside, the Discovery Channel’s popular television show, “How It’s Made,” recently filmed an episode at DD’s manufacturing facility in Rockland, Maine. Viewers were given a behind-the-scenes look at the assembly of a FISHER Xtreme V Plow.  The fact that an entire “How it’s Made” television show was dedicated to chronicling the manufacturing process of a DD plow speaks to the complexity of the engineering and the sterling reputation of the Company.   

For a professional snowplower, product quality is paramount because snow and ice equipment constitutes a major capital investment in his plowing business.  The retail price of a DD plow ranges from $4000-$8000; the range on salt/sand spreaders varies from approximately $1600-$11,500.  In order to be comfortable investing in the equipment, the snowplower must have confidence in the craftsmanship and quality of the product.  Thus, the engineering expertise and knowledge capital that DD has accumulated over the course of 60 years in the business are integral to the Company’s success.

The quality concerns native to any equipment purchaser erect significant barriers to entry for potential new competitors.  End-users are not apt to spend several thousand dollars on an unfamiliar brand as evidenced by the fact that the competitive landscape of the snow and ice equipment business has stayed relatively consistent for over a decade.  DD’s primary competitors are Meyer Products, Northern Star Industries, Sno-Way, and Curtis, Buyers and Hiniker.  DD estimates that it has maintained its approximately 50% share of the market for at least the last eight years.  The snow and ice control equipment business is not susceptible to rapid rates of change, and for reasons discussed below, it is difficult for a competitor to make a meaningful dent in DD’s market share.      

 The threat of a low-cost foreign manufacturer disrupting the market also appears remote.  It is telling that despite that mass exodus of a large percentage of the U.S. manufacturing base to low cost Asian producers, every one of the major snow and ice control equipment companies still manufactures its equipment in the United States.  An end-user base that covets quality and reliability in the harshest of conditions has simply not evinced an appetite for products brandishing a “made-in-China” sticker.

    Innovation

    An outgrowth of DD’s manufacturing and design expertise is a proven ability to innovate.  The Company claims to have the industry’s largest in-house product and development team.  The development team has consistently brought new products and technologies to market.  Case in point, in Q3 2011, the Company unveiled its new “PNP” pre-packed plow assembly system.  The “PNP” system is designed so that a larger portion of the snowplow arrives at the distributor pre-assembled, reducing installation time and distributor installation error.  The PNP system also contains an enhanced electrical system that allows fleet customers to marry any fleet truck to virtually any of the Company’s plow models.  Previously, plows were not easily interchangeable on fleet trucks, which limited flexibility for fleet customers with multiple trucks.  The Company’s familiarity with the body styles in the U.S. light truck market has been a key reason it has been able to adapt its technology so effectively.  After sixty plus years in the business, DD’s engineers are intimately acquainted with light truck frames. 

Manufacturing

Given the unpredictability of winter, it is critical for snow and ice control equipment companies to optimize manufacturing efficiency and thoughtfully manage expenses.  Operating with too much overhead and high fixed costs will crimp profitability during years of light snowfall.  Conversely, unexpected heavy snowfall can cause a rapid surge in demand for a company’s products, particularly parts and accessories.  DD’s management has done an effective job maximizing operating efficiency and implementing a flexible, variable cost structure.  In 2008, 2009, and 2010, variable costs as a percentage of sales were 84%, 83%, and 81%, respectively.   In addition, approximately 10%-15% of the Company’s workforce is comprised of temporary workers.    

  

As a result of the variable cost structure, the Company has managed to post relatively consistent margins throughout different snow and economic cycles:  

Year	Gross Margin	EBTIDA Margin	Operating Margin
2005	39%	30%	25%
2006	31%	22%	14%
2007	30%	23%	14%
2008	34%	26%	20%
2009	32%	25%	18%
2010	34%	25%	18%
TTM                       (7/11)	36%	26%	18%

 

Importantly, DD has significant amortization expense that weighs on the operating margin, but likely overstates the economic obsolescence of its intangible assets:

 

		Amortization Expense 2008-2010
Year	Total	Per Share	% Total Operating                 Expense
2008	$6.1MM	$0.41	23.4%
2009	$6.1MM	$0.41	23.5%
2010	$6.0MM	$0.31	18.4%

 

Amortization expense is an accounting operation that is often unreflective of economic reality.  For example, in the 2010 10-K, DD’s dealer network was carried at $53MM on the balance sheet, with accumulated amortization expense of $27MM.  For reasons expounded on in detail below, it is unlikely that the dealer network is depreciating in value as the accounting treatment would suggest.  Still, DD is obligated to amortize the network and run expense through its income statement even though the replacement cost of the network is probably increasing every year. 

 As a testament to the Company’s operating efficiency, in 2010, DD closed its Johnson City, Tennessee facility, leaving the Company with two manufacturing facilities.  The Company estimates that closing the Johnson City facility will yield estimated cost savings of $4MM annually ($.18/share) with no anticipated reduction in production capacity.  Understanding how to adapt the manufacturing process and cost structure to the vagaries of winter is one of DD’s hidden assets; although not reflected on the balance sheet, it creates an important competitive advantage for the business.

 

Distribution and Sale

After the equipment is assembled, it is sold to one of DD’s 720 distributors located throughout the Snowbelt region of North America (primarily in the Midwest, East, Northeast and provinces in Canada).  The distributors sell the products to professional snowplowers, businesses, municipalities and individuals.  Over 50% of DD’s end-users are professional snowplowers, many of whom are independent contractors that offer snow and ice removal services during the winter months. 

            DD’s distribution network is the most extensive North American direct distribution network in the industry.  The location and scope of the distribution network helps widen the moat around DD’s business on several levels.  In the snow and ice control equipment business, geographic concentration and proximity to end-users is critical.  If an unexpected snowstorm hits, it is mission critical for end-users to have rapid access to equipment, parts and accessories.  Consequently, the geographic footprint of DD’s distributor network ensures that end-users in snow and ice prone regions are in close proximity to retailers:    

 

                                              Distributor Geography 

With manufacturing facilities in Milwaukee, Wisconsin and Rockland, Maine, the Company can assure rapid and efficient deployment of its products.  Because winter weather is harsh and unpredictable, the supply chain continuity assured by the location of DD’s manufacturing facilities and distributors is an important strategic asset.  

            DD’s long-standing relationships with its distributors is another favorable characteristic of its business.  The average tenure of a DD distributor is 15 years;  some distributors have been selling the Company’s products for over 45 years.  The reservoir of goodwill between the Company and its distributor network takes years to establish and would be untenable without quality products.  The process of buying a snowplow or sand/salt spreader is different than most big-ticket items because of the function that the equipment serves.  Unlike an expensive television or pair of earrings, a piece of snow and ice control equipment is often a capital investment for the purchaser.  As previously stated, the retail price of a plow can range from $4000-$8000; a salt/sand spreader goes from $1600-$11,500.  Many of DD’s end-users’ incomes are directly tied to the performance of their equipment.  If the equipment breaks or does not work properly, the snowplower’s bottom line, and livelihood, will be adversely affected.  This dynamic makes it incumbent upon distributors to stock and sell quality products if they hope to retain customers and earn their trust.  Thus, the fact that DD’s distributors have been loyal sales agents of the Company’s products for so long makes the dealer network a valuable asset.  Of note, in 2010, no single DD distributor accounted for more than 5% of the Company’s net sales. 

One can imagine the resistance that a new market entrant, with unproven products and an unrecognized brand, would face if it attempted to break onto distributors’ shelves.  It is unlikely that distributors are going to be eager to carry, and hawk, products that they do not know or trust, especially given that the product is designed to operate in punishing winter weather.  Strategic geographic positioning, long-standing relationships with distributors, and an enduring reputation for quality make the scale of DD’s distribution network difficult for a competitor to replicate.  Collectively, these attributes highlight the disconnect between the dealer network amortization expense and the real economic value of the asset.           

DD’s business is designed to solve a very serious problem: snow and ice.  The Company has been very effective at solving this problem for a long time.  The business model allows DD to control the design process, innovate with new products, and carefully manage manufacturing costs.  As long as the seasons continue to change, the “snow” problem is here to stay.  DD is well positioned to continue solving it.    

 

2) Who are the company’s customers and how badly do they need the product or service?  

            Many of the world’s mature economies are experiencing muted demand for goods and services.  Consequently, when analyzing a business, it is critical to identify the source of demand for the products and why the demand will persist in a challenged economy.  If a company’s products or services constitute a highly discretionary purchase, the business may be more exposed to a protracted economic downturn.  Put simply, it is important to understand “who” buys the company’s products, and “how badly” the products are needed.

            DD’s 720 distributors sell the Company’s products to professional snowplowers, businesses, municipalities, and individuals.  Thus, the “who,” and the “how-bad,” customer analysis concerns both the distributors and the end-users.    

  

            Distributors  

DD’s distributors are dispersed throughout the snowbelt region of the U.S. and provinces in Canada.  A large percentage of the distributors are independent, owner-operated businesses, often employing multiple generations of the same family.  In addition to snow and ice control equipment, many of the distributors sell auto and truck parts and construction equipment.  Over the last ten years, DD has added approximately 300 distributors to its network; the average tenure of a distributor is 15 years.  DD employs a rigorous screening process to ensure that prospective distributors are reputable and financially sound.  After a distributor joins the network, the Company closely monitors the performance, quality of service and credit profile of each distributor.  The 15-year average tenure of the distributor base is a testament to the efficacy of the Company’s screening process.                        

   At around 500,000 units of equipment, DD boasts the largest installed base of snow and ice equipment in the industry.  For a variety of reasons discussed below, DD’s end-users are a “sticky” constituency who are unlikely to switch brands.  Consequently, the large, entrenched customer base creates a compelling incentive for distributors to carry DD’s products because distributors can be reasonably assured that demand for the Company’s equipment, as well as the attendant parts and accessories, will remain pervasive.  If distributors hope to retain, and augment, their customer base, they “badly need” to carry DD’s products.   

            End-Users

The other important prong of the Company’s customer base is the end-users. DD’s end-users consist of professional snowplowers, businesses, municipalities and individuals.  Over 50% of the end-users are professional snowplowers, many of whom are landscapers in the spring and summer.  During the winter months, they are contracted to remove snow and ice.  The single most important capital investment that a professional snowplower will make is his equipment.  Once a snowplower becomes comfortable with a specific brand of equipment, he is unlikely to switch for a few key reasons.

 First, there is not a huge disparity between the prices of different pieces of equipment.  Different brands of plows and sand/salt spreaders are generally priced within a few hundred dollars of each other.  The benefits of saving a couple hundred bucks are simply outweighed by the costs associated with operating untested, unfamiliar equipment in harsh winter conditions.  In many instances, a professional snowplower can recoup the cost of a piece of equipment within a very short period of time, sometimes as the result of one major snowfall event. 

Second, the Company estimates that the average life cycle of an actively used snowplow runs between 7-8 years.  Some distributors this figure and suggest that an actively used plow can last between 9-12 years.  End-users are less likely to pinch pennies for an item that they will use, and depend-on, for a multi-year period.   

Third, many end-users operate plowing businesses with multiple trucks.  If a piece of equipment starts malfunctioning, it may require a new part or accessory.  Maintaining a fleet of uniform branded equipment ensures that parts and accessories will be interchangeable and the snowplower will have more familiarity with the maintenance process.  This is especially critical during a massive snowstorm because time is of the essence.  The last thing that a snowplower needs in the midst of a brutal storm is broken equipment with no replacement parts.            

As CEO Jim Janik put it, “This is the most important piece of equipment they have in the toolkit.  They don’t want to take a chance once they like the product.”  In many parts of the Snowbelt, brand names have become part of the lexicon.  Snowplowers refer to their plows simply as their “Western” or “Fisher,” the same way people use “Kleenex” in reference to facial tissues.  When venturing out into a hazardous winter storm, a snowplower must trust that his equipment will function properly and keep him safe.  Once he finds a piece of equipment that satisfies these important criteria, he is apt to stick with it.  Hence, DD’s end-users “badly need” the Company’s products because their livelihood and safety are often at stake.   

 

Pricing Power

DD’s brand equity and reputation have afforded the Company a measure of pricing power.  In each of the past five years, DD has passed on an approximate 2%-4% average catalog price increase, including steel surcharges.  For comparison, the average inflation rate since 2005 has been approximately 2.2% per annum.  The Company’s ability to raise prices at, or above, the rate of inflation maintains investor purchasing power and helps insulate gross margins from a rise in input costs, most notably steel. 

In 2008, 2009, and 2010, steel purchases approximated 15%, 18%, and 13% of revenue respectively.  Steel is an important component of DD’s products and is the most significant raw material cost.  The capacity to pass raw steel price increases on to customers in the form of higher unit prices has offset any increase in the cost of steel.  DD’s pricing power gives the Company an important inflation hedge, which will prove to be a particularly valuable asset if current monetary policy leads to a sustained rise in prices down the road.   

 

3) Is the Company run by an honest, competent management team that treats minority shareholders as valued corporate partners?

            As a passive, minority shareholder with no ability to affect corporate change, it is vital to partner with an honest, competent management team that treats shareholders as respected corporate partners.  DD’s top brass has a combined 102 years of weather-related industry experience.

Reviewing a company’s proxy statement can provide keen insight into the true character of management and the board of directors.  For example, the proxy will identify the performance metrics that the compensation committee has chosen as a basis for determining incentive-based compensation.  Certain accounting figures, such as return on assets or net income, are easy to manipulate and are often tweaked to achieve desired targets.  Basing compensation on malleable accounting metrics creates perverse incentives for management to make aggressive accounting choices.  This practice may also underlie a management and/or board with a fundamental misunderstanding of the relationship between GAAP accounting and business performance.  A board that chooses to reward its executives based on metrics that do not correspond to a real increase in intrinsic business value is not a desirable partner. 

            In 2010, DD’s compensation committee based incentive compensation on two meaningful performance metrics: operating income and free cash flow.  Operating income is less susceptible to accounting distortions than net income and should theoretically depict the profitability of the core operating business.  Free cash flow represents the earnings available for the equity holders.  The following sentence from the Company’s proxy statement suggests that DD’s board understands the importance of free cash flow:

                 

Management's decision to use free cash flow for 2010 was based on its use of free cash flow as a primary measure of our profitability and our ability to pay dividends and its view that free cash flow is influenced to a lesser degree by factors below the operating profit level than some other performance measures.   -2011 Proxy Statement

 

Management and the board understand that free cash flow is the true driver of long-term business performance; they have put their money where the mouth is and structured incentive compensation accordingly.     

            Desirable corporate partners must not only grasp the importance of free cash flow, they also must also deploy free cash wisely.  DD’s management is disciplined with respect to capital allocation.  Because the business requires little capital reinvestment to maintain its operations, the Company generates ample free cash flow.[1] Amortization expense also works to depress net income relative to FCF:

           

				Free Cash Flow Figures 2008- 2010
Year	FCF		Sales		FCF Margin		Net Income		FCF as % of Net Income
2008	$24.2MM		$180.1MM		13.4%		$11.4MM		110%
2009	$21.7MM		$174.3MM		12.5%		$9.8MM		120%
2010	$19.4MM		$176.7MM		10.9%		$6.8MM		180%

 

Management is committed to returning discretionary cash to shareholders in the form of a large dividend.  The current yield is 5.6%, an attractive cash return in a negative real interest rate environment.  In 2010, the Company paid out approximately 40% of its free cash flow in dividends (DD did not disclose dividends prior to going public in 2010).  In Q3 2011, the Company increased the dividend 2.5%.

The Company’s commitment to the dividend imposes discipline on management and discourages value-dilutive acquisitions; DD has shown very little interest in empire building.  In an April 2011 interview, CEO Jim Janik remarked, “My philosophy is, the less you can focus on, the better.”[2]  Many executives pay lip service to this approach, but DD’s executives have actually followed it.  DD’s last material acquisition was the purchase of BLIZZARD in 2005, an important addition to its brand portfolio.  On the 2011 Q3 conference call, management stated that they walked away from two potential deals in the third quarter due to valuation and reiterated that they are not interested in increasing the size of the business simply for the sake of growth.  Instead, DD has opted to do what too few businesses have done: put cash directly in the pocket of its owners.

A skeptic may argue that DD’s dividend policy is a tacit admission that the Company has few high-return growth opportunities.  Perhaps there is some truth to this argument; snow and ice equipment is not a “growth” industry.  However, the fact that management is actually in tune with this reality makes DD’s management distinguishable from troves of other corporate executives who are unable to resist misdirecting cash from high return core businesses into new ventures, all in the name of expansion.  Unfortunately for shareholders, the result is often a corporate hydra that is no longer able to defend its high return businesses because its resources have been spread too thin. 

To date, DD’s management has walked the walk and avoided value-destroying acquisitions.  Prudent reinvestment has contributed to the Company’s high rates of return on tangible capital ( 2008-37%; 2009-28%; 2010-40%).  Management’s demonstrated history of returning cash to owners, and reinvesting capital to defend its core business strengths, should provide minority shareholders with some assurance that they are partnering with a good team.               

 

4) Does the current financial position and share price provide a sufficient margin of safety?

            A wise man once said, “Hope for the best, prepare for the worst.” With capital markets on tenuous ground, it is important to own businesses that have the financial strength to survive weak, or negative, economic growth.  A spike in borrowing costs could make debt financing unattractive and new equity may be come at the expense of dilution and a prohibitively costly premium.  With moderate leverage and minimal capital reinvestment needs, DD’s business is positioned to survive in a weak economic environment.    

            DD’s coverage and leverages ratios are conservative for a company with its  cash flow profile and reinvestment requirements:

            

		Coverage and Leverage Ratios
	EBITDA/Interest   Expense	EBITDA-Cap-Ex/Interest Expense	Net Debt/EBTIDA	Total Debt/EBITDA
LTM (Sept 30, 2011)	5.8x	5.5x	2.9x	3x

           

Liabilities (9/30/11) Total Liabilities: 212.1MM   Current Liabilities: $43MM       Long-Term Debt: $169MM  (ex. deferred comp.)                                                                              Retiree Health Obligations: $7.5MM        Pension Obligations: $10.3MM        Deferred Income Taxes: $26.8MM        Revolver and Term Loan: $122.1MM        Other Long-Term           Liabilities: $1MM

  

Based on the Company’s mid point 2011E EBITDA ($53MM), and pro forma interest expense ($7.8MM), the 2011 EBITDA-Cap-Ex coverage ratio is approximately 6.3x.  At the Company’s low EBITDA estimate ($48MM), the coverage ratio is 5.7x.        

            DD’s business requires little capital reinvestment to maintain its competitive position.  This characteristic frees up cash and assures that growth and profitability are not dependent on additional tangible capital investment:

 

		Maintenance Capital Spending
Year	Maintenance Cap-Ex	Maintenance Cap-Ex % Total Sales	Maintenance Cap-Ex  % Free Cash Flow
2008	$3.1MM	1.7%	11.0%
2009	$3.1MM	1.7%	12.4%
2010	$3.0MM	1.7%	13.2%

           

Contrast DD’s “asset-lite” business model with a more capital-intensive business that requires significant tangible capital to stay competitive.  The latter is more exposed to the wrath of inflation and is probably more dependent on the capital markets to finance its growth.  Considering that central bank printing presses are stuck in the “on” position and capital market financiers are subject to violent mood swings, avoiding asset-intensive businesses with substantial reinvestment needs increases the overall margin of safety in this market. 

 

            Valuation

            On the Q3 2011 conference call, management reiterated revenue guidance between $185MM-$215MM.  Accordingly, the following valuation tables assume $185MM as the “bear case,” $200MM as the “base case,” and $215MM as the “bull case” for 2011 revenue figures.  See the valuation models below:

 

	Bear Case
2011E Revenue:	$185MM
EBIT (18%)	$33.3MM
-pro forma interest: $7.8MM
-cash taxes:                $5MM
-cap-ex:                       $3.5MM
+D&A:                         $10MM
Owner Earnings:	$27MM
Share Price: $13.61 (1/29/12)
Shares Outstanding: 22MM
Equity Market Cap: $299.4MM
Owner Earnings Yield:	9%

 

 

 

	Base Case
2011E Revenue:	$200MM
EBIT (20%)	$40MM
-pro forma interest:      $7.8MM
-cash taxes:                     $6.3MM
-cap-ex:                            $3.5MM
+D&A:                              $10MM
Owner Earnings:	$32.4MM
Share Price: $13.61 (1/29/12)
Shares Outstanding: 22MM
Equity Market Cap: $299.4MM
Owner Earnings Yield:	10.8%

 

 

	*Bull Case
2011E Revenue:	$215MM
EBIT (21%)	$45MM
-pro forma interest:        $7.8MM
-cash taxes:                       $7.3MM
-cap-ex:                              $3.5MM
+D&A:                                 $10MM
Owner Earnings:	$36.5MM
Share Price: $13.61 (1/29/12)
Shares Outstanding: 22MM
Equity Market Cap: $299.4MM
Owner Earnings Yield:	12%

           

*Since I began this research, the Snowbelt has experienced a relatively light winter.  Accordingly, the “bull” case is very unlikely to be realized. 

 

The “base case” assumes 18% EBIT margins, the same level as 2009 and 2010.  This may be a conservative assumption given that the low revenue estimate for 2011 ($185MM) is greater than sales in 2010 ($176MM) or 2009 ($174MM). 

            Further, DD has ample opportunity to realize margin improvement given that the Company has reduced fixed operating and interest expenses in the last year.  Specifically, subsequent to the IPO in May of 2010, DD is no longer obligated to pay a $1.2MM annual management fee to its private equity sponsors, resulting in annual savings of $.05/share.  Additionally, management has estimated that closing the Johnson City, TN facility will save approximately $4MM per year, or $.18/share.  And proceeds from the IPO were used to deleverage the balance sheet: pro forma net cash interest expense of $7.8MM is down from net cash interest of $10.9MM in 2010, a 32% decrease. 

Based on these reductions, the “base” case model assumes estimated mid-point 2011 sales of $200MM leveraged over reduced fixed expenses will allow the Company to achieve 20% EBIT Margins (equal to the 2008 EBIT margin).  The “bull case” revenue estimate ($215MM) is modeled to yield 21% EBIT margins.    

Because the timing and location of snowfall is inherently unknowable, multi-year earnings projections are shrouded in false precision.  Given most meteorologist’ general inability to correctly nail the five-day forecast, I will be seriously impressed with any analyst who is able to foretell the level of snowfall that winter will bring in 2012.  Punxsutawney Phil had better watch out!  Even with only one quarter left in the fiscal year, the Company’s 2011 revenue guidance ($185MM-$215MM) and EBITDA guidance ($48MM-$58MM) still exhibited a broad range.   Consequently, the valuation models focus on what seems to be the least “unknowable,” namely 2011 projections.    

Based on the “base case” model, DD is currently trading at a 10.8% owner earnings yield.  Assuming that the Company can continue its history of implementing catalog prices increases in-line with inflation (≈2%), as well as achieve organic growth of 2% per year over the next ten years, an investor at the current share price can generate an annual rate of return of about 15% on “base case” estimates.  The same assumptions on the “bear” case yield a 13% rate of return. With interest rates pinned to the floor for the foreseeable future, these equity coupons offer a nice return for a business of this quality.  These return projections rest on pricing and growth assumptions that I believe are defensible:   

             

Pricing Power

DD has historically been able to track, or exceed, the rate of inflation with consistent catalog price increases and steel surcharges.  Absent hyperinflation or an unforeseen surge in steel prices, DD’s brands and competitive position should afford the Company continued pricing power.    

Organic Growth (2%)

DD’s business model is predominantly replacement-driven; most new equipment purchases result from the need of end-users to replace existing equipment.  Over a long-term time horizon ( > 20 years), growth in the addressable market is fueled by an increase in plowable pavement in the Snowbelt (ex. any potential overseas expansion).  More commercial and residential development results in more roads, which increases the need for snowplow services. 

But year-to-year, unit volume growth is heavily influenced by the replacement cycle and the level of snowfall.  DD estimates that the average actively-used snowplow needs to be replaced every 7-8 years.  Unusually harsh winters will expedite equipment obsolescence because equipment is used with greater frequency in severe conditions: 

 

                                   Equipment Sales vs. Snowfall 

 

			Equipment Unit Sales and Snowfall vs. 2000-2010 Average Snowfall
Year		Equipment Unit Sales vs. 2000-2010 Average Equipment Unit Sales		Snowfall vs. 2000-2010 Average Snowfall
2003		+13%		+14%
2004		+34%		+9%
2005		+26%		+12%
2006		-13%		-12%
2007		-23%		-15%
2008		-8%		+17%
2009		-15%		+17%
2010		-14%		+15%

 

As the visuals illustrate, above average equipment sales have traditionally been correlated with above average snowfall.  This makes sense as more snow results in greater equipment usage, which shortens the lifecycle of the equipment.  However, 2008-2010 bucked recent history as above average snowfall did not result in above average equipment sales.  This despite the fact that during the six month snow season ending March 31, 2008, 2009, and 2010, the US experienced snowfall that was 22%, 20%, and 22% above the 1980-2010 historical snowfall average.    

The Company believes that the economic crisis compelled many end-users to delay equipment purchases as long as possible.  Instead, end-users chose to purchase more parts and accessories to prolong the life of their current stock of equipment:

 

                        Sales of Parts and Accessories 2002-2010

Year	Parts and Accessories Sales	% Net Sales
2002	$9MM	N/A
2003	$14MM	N/A
2004	$16MM	N/A
2005	$19MM	N/A
2006	$14MM	10%
2007	$18MM	13%
2008	$29MM	16%
2009	$27MM	15%
2010	$25MM	14%

 

Corroborating the Company’s theory is the fact that sales of parts and accessories for 2008, 2009, and 2010, were approximately 88.5%, 44.5%, and 34.4% higher than average annual parts and accessories sales over the preceding ten years.  Naturally, parts and accessories sales are going to increase during heavy winters as equipment breaks down and requires replacement parts.  And the winters of 2008, 2009, and 2010, each received lots of snow.  The “Snowpocalypse” in the beginning of 2011 marked another heavy snow season.

            However, the worst economic crisis since the Great Depression invariably weakened end-users appetite for big-ticket equipment purchases.  Instead of shelling out several thousands dollars for a new plow, end-users opted to eke more life out of their current stock.  Also of note is that during the recession, light truck sales suffered a material decline.  Because many end-users time the purchase of a new piece of equipment with a new truck purchase, the decline in light truck-sales was another anchor on performance.  But, end-users cannot delay equipment purchases indefinitely because eventually the equipment will cease to function effectively.

            Importantly, the last year that equipment sales exceeded the 10-year average was 2005 (26% above average equipment sales vs. 12% above average snowfall)  If the Company’s 7-8 year estimate regarding the average useful life of an actively used plow is accurate, it follows that the 2004 and 2005 plow “vintages” should be nearing the tail end of their useful lives: 

The 2011 Q3 10-Q reveals that equipment sales are on the uptick.  During the nine months ended September 30, 2011, the Company sold 35,835 units of equipment, a 9.3% YOY increase.  Data also indicates that light truck sales are on the mend: as of December 2011, sales were up 11.7% year-to-date.  As light truck sales rebound off the Great Recession lows, equipment unit sales should benefit.   

            After four consecutive harsh winters in which the Company experienced below average equipment sales, there is likely a measure of pent-up equipment demand that should gradually unwind over the next several years.  In effect, DD represents a convex bet on overall economic growth.  If the economy recovers more than expected, several tailwinds (i.e. an increase in light truck sales; increased consumer confidence) should compel end-users, who had been delaying new equipment purchases, to expedite their buying in order replace obsolescent equipment.  If the economy performs poorly or continues to merely putter along, DD’s replacement-driven business model, and non-discretionary products, should ensure that the Company’s organic growth is at least in line with projected nominal GDP growth (forecasted by the CBO to be 2.4% in 2011; 2.6% in 2012; and 3.6% 2013-2015).

DD’s Competitive Advantages

Even if the aforementioned pent-up demand takes longer than expected to unwind, investors should take comfort in knowing that they are buying into a solid business with a defensible competitive position at a good price.  Importantly, DD’s intrinsic business value is not reflected in its balance sheet.  Price/book and net asset values are not revealing heuristics of value, or lack thereof, for business models that rely on the marriage of imprecisely quantifiable intangible assets to generate cash flows.  The key to assessing DD’s long-term intrinsic value is to understand the character, and defensibility, of the Company’s competitive advantages borne out of the harmonization of its intangible assets.  DD’s apparent competitive advantages lie in its brand equity, distributor network, engineering and technological expertise, adaptable cost structure and operating efficiency.  To the extent that competition, bad management or unwise capital allocation erodes any of the aforementioned advantages, intrinsic business value will diminish and returns on capital will follow.  However, for many of the reasons discussed above, DD’s enumerated competitive advantages appear defensible for the foreseeable future. 

With around 500,000 installed units of equipment, the Company should continue to benefit from sizable institutionalized demand for its parts, accessories, and equipment.  Strong brand loyalty and high switching costs for distributors and end-users will make it difficult for a competitor to put a significant dent in DD’s market share.  Knowledge capital, in the form of design and engineering expertise, takes years to accumulate and has invariably prevented potential competitors from  entering the market.  DD should continue to retain current customers, and woe prospective ones, with its quality products, brand portfolio, leading technology, and innovation.  And although the past is not necessarily prelude, management’s commitment to the dividend, coupled with its demonstrated unwillingness to gorge on acquisitions, renders a sudden bout of corporate profligacy unlikely. 

5) What could go seriously wrong?

Several of the major potential disruptions to DD’s business, such as increased competition, spiking steel prices, and corporate mismanagement, have been discussed above.  The following analysis posits a few “worst” case scenarios and addresses the Company’s capacity to withstand them:

 

Product Liability

Perhaps the most potent threat to a manufacturing, engineering and design company is a product liability cause of action stemming from a wrongful death suit.  For a company that makes snow and ice control equipment designed to operate in treacherous conditions, product liability is an omnipresent concern.  The pecuniary and reputational damage from a successful lawsuit could be enough to put a company out of business. 

Currently, DD is not involved in any legal proceedings that it expects would have a material effect on its operations.  The Company claims that it maintains the appropriate type and amount of insurance for a company in the snow and ice control equipment business. 

 

Where is the Snow?  

Year-to-year, the single most important determinant of DD’s results is the timing, location and level of snowfall.  Heavy snowfall increases equipment usage, expedites equipment obsolescence and amplifies demand for parts and accessories. The level of snowfall in the prior winter is a particularly important driver of current year demand because a heavy winter leaves an indelible psychological impact on snowplowers; they are more likely to invest in new equipment in order to prepare for next season. 

If DD were to experience anomalously “light” winters, its installed base of  equipment would suffer less obsolescence, thereby extending the replacement cycle.  Parts and accessories sales, an important supplemental source of revenue, would also decline as equipment requires less maintenance in light winters.  And if the economy was to contract concurrent with the light winters, DD’s business would be dealt a serious blow. 

But, even if this negative confluence of events were to occur, the Company should still be able to satisfy its maintenance capital reinvestment requirements and meet its financial obligations to creditors and Uncle Sam:

 

		Historical EBITDA Figures
Year	Sales	EBITDA	Cap-Ex	EBITDA-Cap Ex
2006	$145.5MM	$32.5MM	$3.4MM	$29.1MM
2007	$140MM	$32.7MM	$1MM	$31.7MM
2008	$180.1MM	$47.7MM	$3.1MM	$44.6MM
2009	$174.3MM	$45.1MM	$3.1MM (adjusted)	$42MM
2010	$176.MM	$47.3MM	$3MM	$44.3MM
2011E	$185MM-215MM	$48MM-$58MM	$3.5MM	$44.5MM-$54.5MM

 

The mid-point of 2011E EBITDA-Cap Ex ($49.5MM) covers pro forma interest expense of $7.8MM by 6.3x.  The senior credit facilities do not mandate a specific coverage ratio unless the Company fails to maintain borrowing capacity equal to the greater of $8.75MM, or 12.5%, of the aggregate revolving commitments (totaling $70MM).  As of September 30, 2011, the Company had borrowings of $24MM on the revolving credit facility, with remaining borrowing availability of $45.9MM, equal to approximately 65% of total borrowing availability under the revolver.  DD is comfortably in compliance with its maintenance covenant.  With modest capital reinvestment needs, recent cost-cutting measures and a variable cost structure, DD should be able to comfortably finance its business, and pay creditors, without being forced to seek additional financing in the face of slow-down in business.   

            To press the worst-case scenario further, assume that the combination of light snow and a deteriorating economy cause 2012 sales to fall to $130MM, a 35% retreat from 2011E mid-point revenue of $200MM.  To contextualize the magnitude of this level of sales attenuation, see the historical revenue figures on the following page:     

                                    

Net Sales 2004-2011E

2004 (for the 9 months ended December 31, 2004):                           $159.8MM

2005:                                                                                                                                   $183.6MM

2006:                                                                                                                                   $145.7MM

2007:                                                                                                                                   $140MM

2008:                                                                                                                                   $180.1MM

2009:                                                                                                                                   $174.3MM

2010:                                                                                                                                   $176.7MM

2011E (midpoint):                                                                                                     $205MM     2012E (worst-case scenario):                                                                     $130MM

 

If DD posted $130MM in sales in 2012, it would mark the lowest sales figure in the last eight years (sales figures prior to 2004 are not available).  When one considers that the Company has implemented 2%-4% price increases every year and broadened the distribution network since 2004, realizing such a monumental sales decline becomes all the more impressive.  Applying an 18% EBITDA margin (400 bps below the eight year low of 22% achieved in 2006), yields $23.4MM in EBTIDA.  Given the fixed costs eliminated in 2010, the variable cost structure, and the fact that the Company has achieved EBITDA margins above 20% every year since 2005 (prior data not available), an 18% EBITDA margin seems very conservative (see the following page):

 

Potential Worst Case Scenario

Sales:     $130MM (8-year low)

EBITDA: (18%): $23.4MM

less cap-ex: $3.5MM

less pro forma interest: $7.8MM

=$12.1MM pre-tax

 

            If these abysmal results were realized, DD would still generate enough pre-tax cash flow to internally finance pro forma maintenance capital expenditures, and pay the interest on its debt.  The Company would have to suspend its dividend and the share price would decline.  However, given that the scenario posits what would happen in a potential worst-case scenario, the fundamental issue is survival.  And DD would survive, which is more than can be said for a host of other companies saddled with too much leverage or overly dependent on highly discretionary goods and services.  The large installed customer base and operating flexibility ensure that the business can endure unusually light winters without having to rely on the kindness of strangers.  Light snowfall may hurt the Company’s short-term performance, but it does not threaten its long-term competitive position.       

            Anecdotally, it is worth highlighting that although the level of snowfall can vary considerably from year-to-year, it is relatively consistent over multi-year periods:

                                   

                               Snowfall in Snowbelt States (inches) for Oct. 1-March 31               

 

The chart depicts the aggregate annual, and 8-year rolling average, of the aggregate snowfall levels in 66 cities in 26 Snowbelt states across the Northeast, East, Midwest, and Western United States.  Since 1982, aggregate snowfall levels in any given rolling eight-year period have been relatively consistent.  The eight-year rolling average was chosen to correspond to the estimated average life of an actively used DD snowplow. 

            DD is more than a cyclical gamble on the level of snowfall in a given winter.  The long-term drivers of growth are relatively consistent and visible: a compelling brand portfolio, loyal customers, steady catalog price increases, and mean-reverting levels of snowfall.  Over time, these factors, coupled with continued thoughtful stewardship of the Company, should work in concert to meaningfully increase the overall value of the business.  This is not an investment that is going to sky-rocket tomorrow or next month.  But, the recent economic crisis and relatively mild of 2011 has created the opportunity to pick up a very good business at a fair price.        

 

 

 

 

 

There is probably no imminent catalyst for price appreciation, save for an earnings surprise for fiscal 2011.  Given that most snowplow purchasers time their equipment purchases with the purchase of a new light truck, the recent uptick in light truck sales could deliver some upside surprise.  However, the relatively mild winter of 2011-2012 probably means that earnings projections will be near the low end of guidance. But, I view the combination of a light winter and recent economic contraction as a good opportunity to pick up a high quality business with a dominant market position at a fair price.  The market's short-term bias creates an attractive entry point; eventually snowfall will pick-up and the pent-up demand for equipment will increase.  In the mean time, the almost 6% dividend yield provides an attractive cash return while the investor waits.