Description

Overview

Rocky Mountain Dealerships Inc., (RME) is one of North Americas largest vendors of tractors and combines. RME provides exposure to the agricultural sector without investing directly into the underlying commodities. As farmers have generated more income from wheat and crop sales, they spend more on new equipment. This sector should experience long term growth from increasing demand for food caused by global population growth and improving diets.RME has grown through acquisition and continues to look for opportunities to consolidate the fragmented agricultural equipment dealership space. RME has successfully closed 18 transactions of smaller independent dealers, since their IPO in 2007. The company now has 39 active dealerships representing an approximately 20% market share.

Financial Summary

Investment Thesis

The industry remains highly fragmented with over 100 potential target locations across the Prairies. These dealerships range from single-store family operations to mini-chains of a few outlets. According to the company, most of these are owned by individuals in their 60s and 70s, looking for an exit. All of RMEs acquisitions were done at a valuation lower than their stock price, generally acquiring businesses based on a multiple of 2-3x trailing EV/ EBITDA. 

These acquisitions enable RME to achieve operating leverage by: spreading the cost of administrative functions over a wider revenue base, sharing equipment and parts inventory across an expanded branch network, and reducing overall inventory levels along with their associated carrying costs. Due to these efficiencies, RME has gross profit margins close to 15%, compared to between 8% to 12% for RME’s acquisition targets.

RME’s stock has been trending downwards for the last two years, though up in the last quarter, due to modest sales declines. RME has also not been able to show much growth on a same-store-sales basis. This is most likely due to the caution amongst farmers who previously enjoyed healthy income from high grain prices and aggressively purchased new equipment in that period. This has pushed back the inventory replacement cycle, as evidenced by the decrease in RME’s sales for 2016 coming almost exclusively from the new equipment segment. This is not a structural problem and should result in pent up demand in the future.

The weak Canadian dollar is somewhat of a problem for the company as a high USD, inflates prices in CAD, making equipment costlier for Canadian farmers. The higher price of new equipment seems to have led to substitution, evidenced by a moderate growth in used inventory as well as growth in the service and repair side of RME’s business. This also hurts RME on a relative basis as the company buys inventory in USD, while sales are in CAD. This being said, the need for eventual replacement of machinery has not gone away, it has just been deferred. This could potentially set the company up for stronger year-over-year sales growth in 2017 and onward. The Company has strong exposure to Western Canada and due to the continued weakness in the economy, espeically in Alberta, its business has suffered in the last few years.

Another potential reason for relatively poor performance of Rocky could be the fact that it distributes products of Case through its dealers’ network as opposed to competing products from Deere, which is a much better brand and has done a better job with its dealer by infusing a mission of profitability into its dealer network. When Rocky Mountain acquires the dealers, they are not as profitable as they should be. However this also represents a an opportunity for margin improvement and even a small improvement can lead to a sizable gain in the profitablity for the company.

Another issue is that RME operates on a floor plan financing model instead of a consignment model. This means that RME has to hold inventory. This allows RME to show inventory on their balance sheet but it does expose them to higher risks if sales are slow. 

According to the company, sentiment in the agricultural industry is positive and farmer balance sheets are strong. As farmers become more confident with the macroeconomic picture they should start increasing their purchases of new farm equipment.

RME has an approximately 5% exposure to the construction segment which is week due to the slowing down oil dependent Western Canadian economy. The company has taken steps to consolidate its construction equipment dealerships and reduce overhead from this segment going forward.

Investment Summary

RME is currently trading slightly below its book value and at a 5.8x EV/EBITDA. The company looks relatively attractive when compared to its peers Cervus Equipment Corp (CVL:TSX), Finning International Inc. (FTT:TSX) and Wajax Corp. (WJX:TSX) which trade at 7.2x, 12x and 7.8x respectively. This could be attributed to: lower sales when compared to last year, small market capitalization and limited trading liquidity.

If RME is able to maintain current sales volumes and continue their operational improvements leading to increased margins, RME has the potential to enjoy multiple expansion. Using a reasonable 11x P/E multiple to RME’s 2017E earnings, a $9.24 price can be expected. This represents an 12% increase from the closing price on August 10th 2016. It also helps that the Company pays a healthy dividend of over 6%. The dividend looks to be secure as the company has maintained a payout ratio under 70%. If RME meets expectations for 2016, its payout ratio should be 66%. This would still represent a discount relative to their peers.

Catalyst

RME represents a favorable risk return situation as sales shouldn’t decrease materially from this point and could increase as old machinery needs to be replaced. RME could see multiple expansion from increasing margins as well as from improving macro-economic conditions. In the meantime, investors are getting paid a healthy dividend to wait for potential equity appreciation. Near term catalysts include a potential revial in the economy of prairies region, especailly Alberta, if ther is an uptick in the price of oil, which can result in more discretionary spending on farm equipments.