Description

Titan Machinery is CNH’s largest dealer.  It is a cyclical but decent business that should earn mid-cycle returns in the mid-teens on tangible book value that’s comprised primarily of equipment inventory.  The stock is down about 70% from recent highs to $14 as the farm economy pulls back in reaction to lower crop prices and higher interest rates.  This has resulted in an attractive valuation of 0.6x P/TBV and P/E of 3.5-4.5x estimated normal EPS of $3.00-4.00 per share.  The deeply discounted valuation reflects the long downturn of the prior cycle, which I think significantly misprices the high odds of a short and shallow downturn.  An aged fleet, rolling 10-year equipment sales at 35-year lows, and only one year in the last 10 above mid-cycle are supportive of a solid medium-term outlook. 

Base case target of $30 represents 115% upside in the stock and is supported by a 1.3x P/TBV multiple that’s roughly in-line with the five-year average and justified by a double-digit normalized ROE.  I think the downside is minimal at 0.6x P/TBV given most of the inventory is low-risk new equipment; this downturn is likely to be more benign than the last one in which TBV per share only eroded 18% peak to trough.  If the terrible equipment sales in the last decade gives way to a strong decade ahead, they will have some years where EPS is $5.00-6.00 and a 2x P/TBV would be warranted at the onset, yielding 230% upside to $46.  Perhaps I’m early with CY2025 not likely to be a good year, but last cycle the stock only traded below 0.7x TBV for four months.  Chairman David Meyer owns 8% of the company and bought $1m of stock in May at $18.  The stock trades $3m per day, thus is only suitable for smaller funds.

BUSINESS DESCRIPTION

Titan operates out of 149 locations across North America, Europe and Australia.  The North America Ag business comprises 70% of revenue and includes 76 Ag dealerships located across the Midwestern US farm belt.  Titan retails an estimated 10% of CNH’s North America Ag business and has 2x and 3.5x the locations of the second and third largest North America dealers.  North America Construction, Europe, and Australia each comprise about 10% of revenue.

Retailing new and used equipment accounts for about 45% of gross profit in a normal year but can range from 35-55% due to its cyclical nature.  There isn’t much structural volume growth as acres farmed in the US have been flat for a long time.  However, average selling price has been increasing 5-7% annually over the last decade due to like-for-like pricing of 3% and positive mix shift toward higher technology products.  Equipment margin percentage should be about 11% at mid-cycle. 

Parts, service and a small amount of rental revenue comprise 55% of mid-cycle gross profit.  This is a stable revenue and profit stream with a 40% gross margin (parts ~30% margin, service ~65% margin).  It’s possible to see some modest cyclicality during downturns as farmers defer preventative maintenance, however this pressure would likely be short-lived. 

Titan’s fiscal year ends in January.  For simplicity, I will refer to the calendar year that most closely aligns with the fiscal year.  As an example, fiscal year ended January 2025 (FY25) will be denoted as CY2024.

THESIS

(1) REPLACEMENT DEMAND SUPPORTED BY AGED FLEET

The current aged equipment installed base sharply contrasts with a young fleet heading into the last downturn.  A strong boom from 2008-2014 was followed by an extended deeper than usual trough in equipment demand.  As the industry was beginning to recover, COVID supply chain shortages constrained equipment production well below true demand, preventing the usual upcycle.  Thus, since 2014 there has only been one year (2023) of just modestly (10-15%) above normal equipment production. 

The limited fleet replacement over the last decade has resulted in rolling 10-year industry unit sales are lower than any time in the last 35 years.  The two recent downturns have been preceded by rolling 10-year sales that were at historic highs (i.e. the fleet was young), which is the opposite of the situation today.  Betting on an extended downturn from here would suggest a continual fleet aging far beyond what has ever been experienced and obviously isn’t sustainable.  Thus, there is likely pent-up demand that could support an extended upcycle given how bad the last 10 years have been. 

Note the charts above depict unit sales of combines and 4-wheel drive tractors per the Association of Equipment Manufacturers.  These are definitively large ag row crop equipment.  You can also include 100+ horsepower 2-wheel drive tractors and the charts will essentially tell the same story, though there is (a) horsepower creep up over time from equipment in the <100 hp categories, and (b) some equipment in 2wd tractors is used in non-row crop applications such as dairy and livestock.

(2) LOWER INVENTORY LEVELS AND NO SHORT-TERM LEASES INCREASE ODDS OF SHORTER DOWNTURN

Last cycle, the OEMs were slow to cut production and relied on one-year leases to keep demand going in the face of reduced farm income.  Inventory on the dealer lots built up to record levels, which was further exacerbated by most of the one-year leases getting returned.  This cycle has been much different.

COVID-related supply chain disruptions curtailed production, driving extended backlogs and lead times which gave the equipment OEMs greater than usual time to respond to changing industry conditions, resulting in lower inventory build-up this cycle.  All the OEMs are targeting to underproduce retail demand by about 10% in 2024 to facilitate inventory reductions.  They are also aiding dealers in reducing used equipment inventory such as by increasing pool funds and financing terms.  Pool funds are dollars earned by dealers when they sell new equipment (say 1-3% of dealer cost) which are then allocated as incentives and rebates to facilitate the sale of used trade-ins.  The OEMs have also shunned short-term leases this cycle, which will prevent the build-up of lease returns that need remarketed seen last cycle.

This has resulted in much lower equipment inventory on Titan’s books today than at the last peak.  Current equipment inventory per location of $8.9m is 6% above the prior cycle high.  However, over the last decade a 5-7% annual increase in average selling price translates into a cumulative price increase of 60-100%.  Therefore, Titan’s unit inventory is likely 40-50% lower than the prior cycle peak, implying perhaps a 1.5-year downcycle rather than three years like last time.  

(3) THE STOCK TRADES AT JUST 3.5 - 4.5x ESTIMATED MID-CYCLE EARNINGS

Titan targets earning a pre-tax margin of 2%, 4.5% and 7% at cycle trough, average, and peak, respectively, though actual margins have been 50-100bps lower.  At depressed conditions during CY2018/19 the business earned a 1.5% pre-tax margin.  At peak conditions of CY2022/23, the business earned a 6% pre-tax margin.  Assuming a normalized mid-cycle pre-tax margin of 3.5-4.5% implies $3.00-4.00 of earnings and a return on tangible equity of 13-17%.

During the depressed period of CY2018-19, the business earned about a 4% ROTE excluding intangible impairments from prior acquisitions.  At the recent peak, ROTE was 22%.  Seems supportive of the idea this could be a low-teen return business at mid-cycle. 

As another sanity check, heavy duty truck and mining equipment dealers such as Rush, Toromont, and Fining each have delivered long-term returns on tangible equity of about 20%.  Rocky Mountain Equipment Alberta, CNH’s largest dealer in Canada, averaged a 15% return on tangible equity during its 12 years as a public company.

$95M INCREASE IN PRE-TAX INCOME FROM CY2024e TO MID-CYCLE 

• $50m from higher equipment profits.  $48m is margin percentage improvement to long-term normal as supply/demand comes into balance and $22m is tied to higher revenue with 2025 slightly below mid-cycle, partially offset by $10m of higher commissions. 
• $25m from lower interest expense.  Based on inventory reductions driving a lower floorplan balance, a greater portion of the floorplan balance staying in the interest free period, and 200bps of fed rate cuts from July 2024 levels. 
• $20m from lower operating expense (excluding variable commissions).  Operating expenses haven’t yet been adjusted from spend/staffing levels at peak industry conditions.  Historically a $1.00 change in revenue has driven a $0.045 change in fixed opex.  Last downturn, Titan executed several restructuring plans that removed $45m of opex on a smaller store and revenue base than today.

 “TROUGH” TROUGH VS. “NORMAL” TROUGH

Because Titan generally has about six months of equipment inventory on hand, a downturn in the pricing of used equipment can lead to mark-to-market declines that will be recaptured once they sell through the inventory underwritten at higher prices.  Last cycle saw one year of a very depressed 5.6% equipment margin (CY2015), which then improved to 8.1% in CY2016.  Titan expects a similar 300bp headwind from working through higher cost inventory this cycle.  Margins will mechanically reset higher once the old high-cost inventory has been turned over, even without cycle improvement.  They are sitting on $1.3b of equipment inventory, of which about $400m is used equipment and where the risk lies.  This would take about a year to work through at trough conditions. 

Higher discounts and incentives are often required to reduce inventory in a weak market, which will abate once destocking ends.  CY2016 margin of 8.1% didn’t have the mark-to-market headwinds but still had destocking headwinds.  When inventory stabilized at target levels, equipment margins improved to 9.5% and 10.6% in CY2018 and CY2019, respectively.  Keep in mind that 2017 and 2018 were years where new equipment demand was low-70s percentage of normal, showing their earnings power in a still trough environment but once past the mark-to-market and destocking headwinds.

Note that Titan’s CY2024 is still benefiting from a double-digit margin on equipment sales in 1H.  It’s reasonable to expect a one-year “trough” trough margin in the mid-single digits as they absorb mark-to-market headwinds in CY2025, which could cause a $45-60m annualized pre-tax profit headwind (net of commissions) vs. CY2024.  However, this one-year “trough” trough should give way to returning to the normal pre-tax margin framework (2%, 4.5%, 7% at trough, mid, peak) in CY2026. 

O’CONNORS AND HEARTLAND ACQUISITIONS

Recent acquisitions will be meaningfully additive to Titan’s normalized earnings.  In October of 2023, Titan acquired the largest CNH dealer in Australia, O’Connors.  In August 2022, Titan acquired Heartland, CNH’s largest retailer of sprayers and fertilizer equipment sold to commercial applicators.  Pro forma revenue for CY2022 would have been $2.6b if they had owned both of those businesses for the full year, well above the $2.2b reported on their financial statements.  These pro forma results support about $2.8b in normal revenue given near mid-cycle volumes in 2022 and continued increases in average selling price.  Both businesses have margin profiles in-line with Titan at acquisition.

GROWING PARTS & SERVICE, LOWER OPEX AND INTEREST COSTS = STRUCTURAL MARGIN IMPROVEMENT

As a result of lessons from the deep trough last cycle, Titan has increased its stability and profitability by focusing on growing parts and service while structurally reducing fixed operating expenses.  On a per location basis, recurring parts and service revenue has grown 4.5% annually over the last decade while operating expenses excluding commissions have grown at just a 1.3% CAGR.  Absorption excluding floorplan (gross profit from recurring parts/service/rental divided by operating expense excluding commissions) has risen from 69% ten years ago to mid-70s in CY2024.  Some of the key initiatives are outlined below:

• Consolidation of subscale stores into ones geographically close that had greater scale, parts breadth, equipment selection, and technicians to structurally reduce cost while keeping farmers at worst 20 miles from dealer. 
• To enhance growth and efficiency, they pivoted from managing a location with a “jack of all trades” store manager to one managed by a team of experts, each specializing in equipment sales, parts, service, or back-office functions across two or three locations. 
• Another big focus has been improving labor recruitment and training as sourcing mechanics has been a challenge for the industry.    

Total interest expense consumed 21% of recurring gross profit in CY2014 and is expected to be 17% in CY2024.  Interest costs should decline to less than 10% due to the aforementioned factors related to lower floorplan expense, generally driven by inventory reductions and fed rate cuts.

(4) TARGET PRICE $22 - 46 (+57% - 230%) DEPENDING ON CYCLE DEPTH AND STRENGTH OF RECOVERY

Current TBV per share is $24.  Titan has traded at an average 1.26x and 1.11x TBV over the last five and 10 years – again, a period of below normal market conditions.  For historical perspective, last cycle, once adjusted pre-tax earnings turned breakeven in CY2017 and until CY2024, the stock consistently traded in a range of 1-2x TBV excluding the COVID sell-off in 2020.   

• Low case intrinsic value = $22 (+57%).  Assumes the stock trades at 1.1x TBV and TBV erodes 18% peak-to-trough to $20 as in the prior deep trough. 
• Base case intrinsic value = $30 (+115%).  Based on TBV declining modestly to $23 and the stock trading at 1.3x TBV that’s more reflective of long-term normal earnings potential. 
• Upside case intrinsic value = $46 (+230%).  If the low sales of the past decade foretell a strong decade ahead, a peak 2x TBV could be justified.  Remember, they will have some years where EPS is $5.00-6.00.

(5) NOT TOO EARLY TO BUY.  THERE IS UPSIDE TO WHERE THE STOCK TRADED DURING LAST DOWNTURN.

During the money losing period of CY2014-16, the stock averaged 0.8x TBV and was only below 0.7x TBV for four months.  Using a haircut TBV of $20-23 and apply a 0.8x multiple suggests the stock should be in a range of $16-18 during this fallow period, still 15-30% higher than where the stock is today.  I think the stock is currently below this range because in the span of five months, EPS guidance for CY2024 went from $3.25 to $0.25 and management spoke to CY2025 being a trough year, causing many investors to exit the stock with a broken thesis.

(6) INSIDERS OWN 10% OF THE COMPANY AND HAVE BEEN BUYING

Chairman David Meyer owns 8% of the company and bought $1m in the open market in late May at about $18 per share.  His last significant purchase was during the prior downcycle in 2014.

RISKS

(1) Used equipment inventory mark downs.  Used large ag equipment prices have increased 40-60% since 2019, similar to new equipment pricing.  With demand for used equipment weakening, used pricing has recently been trending down mid-single digits, with the more volatile auction pricing down in the teens.  Moving the higher cost trade-ins off the books will result in equipment margins falling to historical lows, which was about 5% last cycle.  As higher cost equipment is turned over and inventories are worked down through the course of CY2025, margins should return to normal levels in CY2026.

The risk of permanent impairment seems low.  If they took an immediate 30% markdown on their approximately $400m of used inventory, tangible book value would still be $20.50 per share.  This would be a larger markdown than the 10-15% decline in used pricing last cycle.  OEMs continue to project flat to up pricing for new equipment.  It would be unusual for used pricing to deviate significantly from new over the long run since weaker used prices increase the cost of new equipment net of trade-in, which will push more demand to used and away from new.

(2) Crop prices have come down to pre-COVID levels.  Farmers that own their land will make money, those that don’t won’t.  I have no view on what crop prices will do in the short term.  We are generally always one bad weather year from higher crop prices.  Also, machinery doesn’t last forever and eventually needs to be replaced – machinery demand increased in 2018 and 2019 despite lower soybean prices and flat corn.

(3) Dependance on CNH.  CNH supplies about 75% of new equipment sold in the North America Ag business.  CNH also provides floorplan financing (Titan also has a bank syndicate floorplan).  The company’s relationship with CNH appears strong, as evidenced by CNH giving approval to Titan’s numerous acquisitions over the years and ascending to become by far their largest dealer. 

In my opinion, the biggest risk related to CNH is that they fail to make the correct technology investments to keep their equipment competitive with Deere.  While Deere is ahead in the tech game, CNH is playing fast follower, making investments to build out their in-house precision ag tech stack (Raven, Hemisphere, Augmenta, near doubling of R&D/capex from 2022-24 vs. prior three years).  The Agnelli family ownership brings a long-term investor mindset to CNH that likely ensures they will do what it takes to maintain competitiveness.  Also, market share doesn’t shift quickly in this industry due to brand loyalty, efficiencies of running one fleet type, local dealer support and relationships, and capacity constraints at OEMs.

(4) Interest rates and financing.  Higher interest rates decrease equipment affordability and increase floorplan carrying costs.  Fortunately, it appears interest rates are moving lower for now.  Titan has a 3.5x leverage covenant on their two largest floorplan lines, calculated as total liabilities less non-interest-bearing floorplan balances divided by tangible equity.  Current leverage of 1.8x is well below the covenant.  Even if the company were to liquidate $400m of inventory (their standing target in this environment) at a 30% loss and use the cash flow to pay down the floorplan, the leverage ratio would likely stay below 2.0x.  The $127m of corporate debt is comprised primarily of mortgage loans (Titan owns 59% of their locations) and backed by $357m of net PP&E.

(5) Acquisitions.  Historically the company has been an active acquirer of CNH dealerships.  There is a risk they could overpay, though I don’t think it’s particularly high now given the depressed industry conditions. 

Catalyst

Inventory reductions beginning in C3Q24 and through CY2025 sets up for getting back to positive EPS entering CY2026, which likely pushes the stock back to at least 1.0x TBV (stock up 40-65% depending on where TBV settles).

Lower interest rates improve equipment affordability and lowers Titan’s interest expense.

Management takes cost action now that it’s clear the ag economy is in a downturn.

Higher crop prices.  Hard to predict when this might happen.  But crop prices are low right now and weather/macro can change instantly.