Description

Because of a cyclical downturn in certain ag equipment sales, Lindsay Corp will earn less in its fiscal year ending August 31, 2014 than it did in FY13. Hence the opportunity. Though the near-term outlook is unclear, over the medium and long term, revenue and earnings growth should be very robust and that the company’s current valuation does not properly account for this growth, or for Lindsay’s top-notch return on capital and enviable competitive position. We think an investment in Lindsay today will compound at mid-teens rates over the next 3-5 years, with significant potential for multiple expansion given Lindsay’s below-average current multiple compared to its history.

The Business of Irrigation

Lindsay has two business lines - irrigation and infrastructure. The irrigation business made up about 90% of FY2013 revenue and 96% of segment-level EBITDA, so we focus on that business here (we’ll briefly address the infrastructure segment at the end of the writeup).

Lindsay’s irrigation segment primarily manufactures and sells mechanized irrigation systems under the Zimmatic brand, which come in two basic versions - center-pivot and lateral-move. We suggest watching this video to learn about the basics of central-pivot irrigation and this one to see how a lateral-move system works. In addition to irrigation system packages, Lindsay also manufactures and sells repair and replacement parts (R&R), as well as tangential add-ons to mechanized irrigation systems such as pumping stations and filtration solutions. In recent years, Lindsay has also started to offer advanced technological packages - such as GPS positioning and guidance, variable-rate irrigation, and smartphone/wireless irrigation management solutions - as add-ons to the core product.

Before getting to the value proposition of a mechanized irrigation system, it’s important to put irrigation in some sort of general agricultural context. A farmer can choose to have his crops watered in one of two ways:

• The old fashioned way - rain. This works well in regions that get rain. If you grow corn in Western Nebraska, good luck relying on the rain!

• Irrigate - using groundwater extracted from springs, using wells, or channeling some sort of surface water source such as a river nearby, a farmer can set up an irrigation system for his farm. There are 3 basic types of irrigation:

• Flood/surface/gravity irrigation - by far the most dominant irrigation method in use world-wide, flood irrigation does exactly what it sounds like - uses the water source to flood the field with water. A flood irrigation system is pretty labor-intensive to design and execute because it requires people to dig ditches and furrows that will allow the flood water to reach as much of the cropland as possible. It’s also extremely inefficient from a water-usage standpoint because the quantity of water needed to maximize the effectiveness of a flood irrigation system is much more than the quantity of water the crops need in order to grow properly. In other words, this is the shotgun approach to irrigation - use a ton of water, and some of it will reach the crops.

• Drip/micro irrigation - here, a system of hoses and pipes are run through the field and punctured with holes so that the water literally drips out at the crop’s root-level. The water efficiency here is much better the flood-irrigation method, but it’s still labor-intensive to lay out the hoses and pipes, and this method is also the most prone to problems like soil clogging the drip-holes.

• Mechanized/sprinkler irrigation - through center-pivot or lateral-move systems, an entire field can be watered on close to auto-pilot. The water efficiency here is slightly worse than drip irrigation, but there is very little labor involved in the operation of one of these systems. On a mega-farm, in fact, a bunch of these systems can be used simultaneously and controlled from one iPad. In addition to super-low labor intensity, modern mechanized irrigation systems allow a farmer to irrigate uneven land or soil with a sandy composition that flood irrigation systems simply could not logistically handle. Newer mechanized systems also allow micro-control of water timing and quantity, which saves water, and can also be used to pump fertilizer and herbicides with precision across a field.

On a microeconomic level, the decision to irrigate is a relatively simple cost benefit analysis comparing the cost of installing the irrigation system with the benefit of the yield increase that the system will bring the farmer. In terms of which irrigation system to choose, the cost-benefit analysis is similar - comparing the cost of the systems and the yield increases they’re expected to bring. In general, the cost per acre of installing a center pivot system is about half of the cost of a drip system, and the maintenance costs on an annual basis can be even cheaper than that (Lindsay does a very good - and self-serving - job with the comparisons here, though they understate the retail cost of the center pivot system, based on the conversations we’ve had with several dealers). In general, for farms large enough to support a center-pivot system, drip irrigation systems are not even an option. Hence, the market share numbers among the various types of irrigation in the US as of both 1998 and 2008 (the government agricultural survey of irrigation trends only happens every five years, with the 2008 data being the latest on record; the 2013 data will be out later this year):

The vast majority of irrigation is done either via mechanized irrigation or the brute force flooding method. The drip method is left to fields that are too small or oddly shaped for a center pivot system, or where sprinkler irrigation would be too inefficient  (e.g., vineyards). Some other interesting facts to be gleaned from the above chart (presented by Lindsay in its Investor Presentation, but taken from the USDA’s irrigation survey data, which we have corroborated) are that about 40% of irrigated cropland was still irrigated using the water-and-labor-intense flood irrigation method (“Gravity Flow”), and only 14% of total cropland was irrigated at all. We think that both those numbers have probably gone up a bit as of year-end 2013, given the number of systems that Lindsay and Valley have sold over the past few years, as well as the drought of 2012. But we also think - for reasons we’ll elaborate upon in a bit - that there is much more to go in the penetration of irrigation, and particularly its mechanized manifestation.

To Irrigate or Not to Irrigate - Not Even a Question

The ROI on installing an irrigation system is almost always compelling. That’s not only because we’re pitching an irrigation equipment manufacturer. Below is a chart of corn yields in the US in irrigated vs. non-irrigated fields:

Based on the trendlines above, irrigated corn acreage will yield 15-20% more than non-irrigated corn acreage. But that actually understates the advantage of irrigation for two reasons: First, in drought years, the downside to yields from not irrigating is much worse than average, so the “tail risk” in not irrigating is high (see the final data point on that chart, which is the 2012 drought year). Additionally, comparing irrigated to non-irrigated acreage (so-called “Dryland acres” not because they are dry - in fact, they tend to get more rainfall - but because they are not irrigated) is not an apples-to-apples comparison - in general, dryland acreage gets more rainfall (that’s why they don’t irrigate) - so the yield advantage is probably a lot more than 15-20% on land that doesn’t get much rainfall.

In what we consider to be a much more useful yield comparison, Professor Bruce Johnson of the University of Nebraska-Lincoln analyzed mechanized irrigation yields vs. non-irrigated yields under multiple scenarios, including no-drought conditions, corn-belt drought conditions, and “Nebraska-only” drought conditions. The results, from his September 2012 paper, can be seen in the table below:

The conclusions you come to regarding the ROI of a mechanized irrigation system, even on dryland that normally gets rainfall, are very simple. Given the $500-600 per acre investment in installing a center-pivot system, even if a farmer were assured of never suffering through a drought, the ROI is compelling (>12% per annum, and that’s a relatively small 125-acre pivot - the larger the system, the lower the per-acre installation costs). When you throw in one or two drought years every so often, the investment is a no-brainer. As Johnson concludes in his analysis:

The economics of irrigation largely hinges upon the productivity enhancement which irrigation provides from year to year. For example, in the case of corn, Nebraska’s primary crop, yield differentials between irrigated and non-irrigated can range from 60 to 100 bushels per acre in any given year, depending on where one is in the state. However, in addition to this productivity-enhancement pattern, irrigation also serves as a very critical risk management tool for dealing with crop losses due to extreme rainfall-deficit conditions - such as occurred this year. This downside risk of extreme weather events creates a whole new ballgame for the value of irrigation [bold emphasis added, italic emphasis in the original].

Quick note on the Johnson study: he was looking at Eastern Nebraska, where they get a lot more rain than in Western Nebraska (see the map below), so the yield comparison is apples-to-apples.

So why are only 14% of croplands irrigated in the US? There are a few factors, including:

• Most cropland doesn’t need irrigation to be profitable. Take a look at the map of average annual rainfall across the US. Much of the cropland is in areas that get enough rainfall to be quite profitable without ever installing an irrigation system.

• Agri-”Culture” - the culture in each region is different. In California, for example, which accounts for 14% or US irrigated acres as of 2007 (#2 behind Nebraska, at 15%), there is little to no culture of mechanized irrigation. Indeed while Nebraska and California have a similar number of irrigated acres, take a look at the number of Zimmatic and Valley dealers in each of the states: Nebraska has 32 Zimmatic dealers and 32 Valley dealers, while California has 9 Zimmatic dealers and 6 Valley dealers. A lot more flood and drip irrigation happens in California. Given the drought this year, we’d bet that changes over time. The point here is that the culture of each region matters - center-pivot systems were first designed and manufactured in Nebraska 50 years ago, and their penetration there is much higher. Over time, we think that will change.

• Small farms - as of the 2012 agricultural survey, there are about 900M total acres of farmland across the US, and about 200M of those acres belong to farms with fewer than 500 total acres - these are the farms least likely to install mechanized irrigation systems (or any irrigation systems) given the large initial outlay and the fact that the smaller the farm, the tougher it is to get financing. Now, only about 45% of this farmland is actually cultivated cropland, but it’s the proportion that matters here - about 20% of cultivated cropland is less amenable to mechanized irrigation solely due to size. (Side note - Nebraska’s average farm size is about 900 acres, while California’s is about 325. The respective median size disparity is even greater 280 acres to 20 acres - so it’s not just the culture that’s responsible for the lower California penetration of mechanized irrigation, though that certainly does play the major role).

• Varying yield differentials - depending on the crop, the yield differential between irrigating and not irrigating may not be as big. This is a minor factor in the list, as based on our discussions with a few equipment dealers, almost anything a farmer grows would benefit from irrigation, and would have a decent ROI on the initial outlay.

A Note on International Irrigation

We should discuss international irrigation here, because it’s probably the most critical part of our thesis. It’s also the much simpler part of the thesis. The main thing to know about the state of irrigation outside the US is that it is in the comparative stone age. A few facts (all from the UN Food and Agriculture Organization, and note that the database is not easy to work with):

• There are a total of 563 Million (recorded) irrigated acres around the world. Fully 90% of them are irrigated through the flooding method.

• While mechanized irrigation penetration is low (i.e., mechanized acres as a proportion of total irrigated acres), irrigation penetration as a whole leaves a lot to be desired:

• Russia has over 300M cultivated acres (75% of the US) with only 1% total irrigation penetration.

• Brazil has 200M cultivated acres with 7% penetration.

• Australia and NZ, with 120M cultivated acres (and a relative paucity of water available for agriculture) with only 5% penetration.

• Ukraine has 82M cultivated acres with only 3% total irrigation penetration.

These are total irrigation penetration numbers (compare the US at +15%, which itself has room to run). Mechanized irrigation penetration is even lower (it’s about 50% of total irrigation in the US and less than 10% abroad).Thus, there are two major irrigation opportunities outside the US:

• Increasing total irrigation penetration, i.e., take advantage of the conversion of dryland to irrigated land.

• Increasing mechanized irrigation penetration, i.e., exploit the the conversion of flood irrigation systems to mechanized methods.

Lindsay’s Irrigation Business

We lay out nine years of operating data at Lindsay’s irrigation segment below:

A few notes on the above (though it’s really mostly self-explanatory):

• Yes, Lindsay has grown its revenues really fast, even adjusted for the financial crisis. Since 2005, Lindsay has grown total irrigation revenues at a 18.9% CAGR. Domestic irrigation revenues have grown at a 17.8% CAGR, while international has grown at 20.9%.

• EBITDA margins in the graphic are calculated as segment-level EBITDA - so just segment operating income minus segment D&A. This includes any stock-based comp attributed to the segment, but excludes corporate expenses. EBITDA margins have grown by a lot, mostly due to operating leverage, but a big part has also been constant improvement in the manufacturing process and efficiency on the part of Lindsay.

• ROAA - Return on Average Assets - is using segment-level operating income and segment-level operating assets. There’s enough information in there for you to calculate your own preferred metric. Whatever metric you use, Lindsay’s ROIC is impressive.

Now, there are bunch of other facts we think are important to note about Lindsay’s irrigation business:

• About 15% of irrigation sales are repair and replacement of parts (R&R).

• Of the new equipment sales, historically close to around a third have been for retirement and replacement of old systems (a center-pivot system lasts for about 20 years on average), a third have been systems for fields converting from flood to mechanized irrigation, and the final third have been to dryland fields that are being newly irrigated.

• The weather for the past few years (since 2011) has been a bit nuts - droughts have been commonplace (2012 was particularly bad). The 33/33/33 split mentioned in the previous bullet point has been tilted closer to 45/25/30 for dryland/conversion/replacement sales. 2013 was an extraordinary year because it came on the heels of the corn-belt drought of 2012. As human nature is always to fight the last war and buy insurance after disaster strikes, 2013 and 2012 US sales benefitted greatly from the 2012 drought.

• Given the 2013 anomaly, a bit less than a third of 2013 new equipment sales were replacement of old system. Management estimated that R&R sales stayed steady at around 15% of sales, probably as irrigation equipment usage was up dramatically during the year (that’s our assumption, not management’s).

• Historically, sales of irrigation equipment have been correlated with ag prices and farmer incomes - the more money farmers make, the more they spend on ag equipment. We think this is starting to change a bit, and will only matter for cyclical ebbs and flows. We’ll discuss our long term secular views below.

Competitive Dynamics

The global market for mechanized irrigation systems is dominated by two players - Lindsay, selling under the Zimmatic brand, and Valmont, selling under the Valley brand. The global market share picture breaks out as follows:

We believe that Lindsay’s position within the industry is secure (and in fact, they’ve gained market share vs. Valley over the past few years). We’ve done a lot of due diligence on this and here’s how we think about this:

• Irrigation equipment is sold through a dealer network. This is absolutely critical. Each dealer is usually exclusively associated with only one equipment manufacturer. It is extraordinarily difficult to start a competitor from scratch and build out a dealer network, and it;s just as difficult for a small competitor like Reinke to build out the kind of dealer footprint that Valley and Lindsay each have.

• Reputation for quality - we’ve talked to dealers and farmers, and perused lots of agricultural internet forums. The general consensus seems to be that if you want a quality product that will last a long time, the only way to go is to buy a Valley or Zimmatic product. Here and there, you will find a satisfied Reinke owner, but you find many more Reinke owners who wish they would’ve spent the extra couple of thousand dollars on a Valley or Zimmatic. We also heard and read many comments to the effect of “If you want to do this right buy a Valley/Zimmatic.” The reputation for quality matters a lot when spending $300-600 per acre on equipment. The dealer loyalty that we have encountered is also impressive - dealers are passionate about the product, expect to sell more of it over time, and sing the praises of how good a piece of equipment they are selling.

In general, while we wouldn’t call this a duopoly, given the reputation for quality, we believe that Lindsay’s market share position is quite safe, and that the competitive nature of the business is not very aggressive. The +30% gross margins of the irrigation business, which are pretty high for a manufacturer, further bolster the case.

The Bear Case and Valuation

We lay out our model for Lindsay below, counting only the irrigation segment (and incorporating full corporate expenses in there). Note that the lines “EBITDA - Corporate Expenses” and the FCF numbers subtract stock-based comp. We’ll briefly comment on that at the end of the writeup.

The bear case on Lindsay is, essentially, that 2014 is going to be terrible, that US sales of irrigation equipment will level off because penetration is already quite high, and that valuing Lindsay based off 2013 earnings and cash flow is giving the company credit for a performance that will not be repeated anytime soon (10x the cyclical peak in FCF is not really a cheap multiple).

We would counter that while the cyclical driver of revenues will remain crop prices and farm income, there are 3 major secular tailwinds that will carry Lindsay over the next decade:

• Replacement demand - Lindsay estimates that there are approximately 250K center pivot machines in the US “fleet.” about half of these are greater than ten years old, the average machine lasts 20 years, and the increased technology on the new machines is compelling. As a result, about 125K machines will be purchased over the next decade just to replace the portion of the center pivot fleet that will be retired. Lindsay says that the average price of a system that it sells into the dealer network is $55K (we corroborate this by seeing that a small-size bare-bones 125-acre system runs about $60k at retail and the average system is larger and better equipped, and is sold alongside dealer services and warranty). Assuming 2% annual price increases, Lindsay will be selling about $2.3B worth of replacement systems over the next decade, which translates into a 15% annual CAGR on replacement system sales - we plug in that 15% rate as the growth rate on the US Replacement revenue line in the above model.

• Increased dryland penetration - we don’t want to turn this into a discussion on global warming. The reality is that the global ag supply lines are as fragile as ever, the need to feed a growing population is a real long term requirement, and there’s no question that weather has been extreme. From droughts, to floods, to more droughts, better and more efficient access to water, even just as a risk management tool for farmers, is a secular theme here in the US. Based on our conversations with dealers and some of the marketing personnel at Lindsay and Valley, we believe that there is a lot of dryland territory that is ripe for irrigation equipment penetration because a) the economics are compelling even without drought, b) the risk management aspect in case of drought makes the case even more compelling, c) there’s a lot of territory not currently mechanically irrigated just because of cultural reasons that Lindsay and Valley’s marketing personnel are zeroing in on (think about the California droughts and the miniscule penetration rate of mechanized irrigation there), and d) the continuing trend of small farms being sold to bigger ones is unlikely to end anytime soon. To that end, we believe that dryland sales in the US over the next decade will grow high single digits (significantly below the growth rate in recent years). In the model above, we assume that 2014 dryland equipment sales decline to 2011 levels (a 45% decline) and will grow 8% annually from there. This is an arbitrary number, and you can model whatever you want, but we think it’s conservative, if anything.

• International sales - we went through the statistics above. The international opportunity is huge and cannot be overstated for this case. Growth here will be driven by increased irrigation use and increased penetration of mechanized irrigation as a proportion of total irrigated acres. In turn, the drivers of these trends are simple - the need for better yields, the need for more efficient water usage, and the overall trend of corporate agriculture in the developing world. Places like Ukraine, Russia, India, Brazil, and Argentina (all of which are huge agricultural producers) are decades behind the US in farm consolidation, and we believe this will be the dominant driver of revenue growth internationally for Lindsay as large farms are much more likely to make large scale equipment purchases, and to make those purchase decisions based on ROI calculations. We assume 2014 international revenue is flat (2013 included a large project in Iraq that will not be repeated in 2014) and that sales grow 12% annually subsequently - likely conservative given the past 8 years +20% CAGR and the fact that we are nowhere near the end of that growth.

So we mostly agree with the bears that 2014 revenue will be weak - we model a 20% decline in US revenues (driven by a 45% decline in dryland equipment sales) and no growth in international revenues. But these will be short-lived bumps in the road given the secular growth drivers highlighted above.

Some other assumptions we make in our model:

• EBITDA margins come down by >200bp as revenues decline and international revenue increases as a proportion of total revenues (international margins are lower than in the US, but Lindsay is building manufacturing facilities abroad in pursuit of international margin expansion). As revenues start growing again, EBITDA margins should start expanding again, though we don’t assume they’ll come back to 2013 levels for a while.

• Our capex rate is what we believe maintenance capex to be. Actual capex will likley be higher given the international manufacturing initiatives.

• By “net corporate expense” we mean corporate expense minus stock-based comp. We assume 2.25% of sales (2012 levels).

• We assume a tax rate of 33%, although that will likely come down over time given the increased representation of international revenues.

• We assume that US conversion revenue - i.e. revenue from equipment sold in order to convert flood-irrigated fields to mechanically irrigated fields declines 5% annually over time as the mechanized irrigation penetration rate rises to the point where it can’t go much further.

Valuation

Lindsay currently trades at an EV/FCF of about 14x our estimate of FY14 FCF, and about 12x our 2015 estimates. Note that Lindsay’s fiscal year end in August rather than December:

Stock Price:$80.37

Shares Out:12.83M

Market Cap:$1,031M

Non-core assets + cash:$250M

EV:$781M

2014E FCF:$57M

2015E FCF:$64M

12x 2015 FCF for a business of this quality, with many years of strong double digit growth runway ahead of it, high returns on capital, and a strong competitive position is extremely cheap. This is one of our favorite ideas currently. We can’t know for certain what Lindsay will generate in revenue this year or what it will earn - we know we’re in for a cyclical downturn in irrigation equipment sales. But what we’re pretty certain of is that Lindsay will be selling many more irrigation systems 5 years from now and 10 years from now than it is selling today or even than it sold last year. And we think when that happens, both earnings and the multiple will be much higher, especially given that these multiples are at the very low end of the range in Lindsay’s recent history.

Miscellaneous notes:

• A note on our EV calculation: Our enterprise value calculation includes the $150M of cash on Lindsay’s balance sheet, and an assumed $25M in cash build-up for the first half of this year (which we’ll find out about on the earnings call tomorrow morning). We also subtract $75M for the value of Lindsay’s infrastructure business - we consider this a non-core asset that has fallen on hard times in the wake of government austerity. Just two years ago, the business generated $17.5M in EBITDA while last year’s number was closer to $5M. This year’s performance has so far been better than last year and management is optimistic about the business. It’s possible the business is worth double the $75M we attribute to it, but it’s definitely not worth very much less.

• A note on stock-based comp - Lindsay’s stock based comp is actually pretty fair, which is a difficult thing to find these days. They have granted about 0.5-1% of shares outstanding annually in their compensation historically, and in the past 3 years, the number has been even less. Given the strong growth rate here, we consider this a rounding error - your IRR here will be the FCF yield + growth rate - share dilution. If the first two numbers sum to close to 20% and the share dilution is 50bp, we can live with that.

Risks: The biggest risk in our mind is management being acquisitive in a dumb way. Frankly, the way they talk about potential acquisitions on conference calls seems a bit amature - it’s almost as if they’re catering to the bank analysts on the call. It’s possible that Lindsay will blow its cash on a large stupid acquisition, but we think it’s unlikely. Still - that’s the biggest risk in our mind. Realistically, they would make a great acquisition candidate for a John Deere or Agco, which already have strong dealership relationships globally and would be able to exploit significant economies of distribution in an acquisition. But we’re not remotely banking on such an outcome.

Catalyst