Description

This is a simple and straightforward thesis so I will keep the write-up short. I have not seen this idea elsewhere. Toromont has fairly large and liquid market cap. And the borrow rate is low and borrow is available.

Note that this idea is short Toromont in U.S.$. So if you short 1 share for C$29, be sure to exchange the C$29 to US$ at time of short. Do not keep the proceeds of the short in C$.

Toromont sells and leases heavy equipment for mining, construction, and agriculture in Canada. They also have a segment that builds commercial, engineered refrigeration systems, but it is only 7% of EBIT so we will focus on the equipment segment. As well, the refrigeration segment will suffer from the same characteristics as the equipment segment.

The basic valuation:

Shares: 78.7mm * C$29 --> C$2,282mm

Cash: C$97mm

Debt: C$302mm

Pension: C$15mm (after tax)

So TEV = C$2.5bn.

EBIT '15 = C$210mm

NOPAT (27% tax) = C$153mm (16.3x)

NOPAT and Unlevered FCF are about same, and P/E is also about 16x since the company is unlevered.

TBV (almost same as BV) is about C$700mm.

I think a company whose sales are to mining, construction, and agriculture in Canada should trade for a much lower multiple of peak NOPAT given that we are headed for a long down cycle. I would think it should trade for about half.

So why is a company that sells heavy equipment in Canada to three peaking cyclical sectors trading at over 16x? My guess is that the market is not understanding the nature of the financials with respect to C$/US$ exchange rates.

The company grew revenues organically 7% in Q3 y-o-y. How is this possible in these sectors in Canada? Here is the key: About 80% of their revenue is priced in US$ (even if sold in Canada). And the C$ fell 20% versus the U.S.$ y-o-y in Q3.

I have normalized numbers for project lumpiness (Q3'15 was hurt due to lumpiness, but Q1-Q2'15 was aided by lumpiness), and once normalized, FX neutral revenue YTD is down 6-7%. Management will not reveal FX neutral revenue or unit volumes, but they give enough information that you can figure it out fairly closely.

Further, their margins are mis-leading as well because (1) they keep getting the advantage of their inventory appreciation in C$ terms; (2) their expenses are more C$ based than their revenues; and (3) they hedge the FX a bit so that they have made some money being short C$ that comes thru the cost side of their financials.

The easy way to value this company is to simply re-create all the financials in U.S.$. It will still trade at same multiple (actually higher due to mis-leading margin) but now we will see that the business is being hit by the same cycle that is hitting all of Canadian mining, construction, and agriculture.

This is a chance to get short Canada/mining/construction/agriculture at over 16x.

Catalyst

If the C$ stops dropping against the US$, the cyclicality and decline of the business will be revealed.