Description

We believe that Titan International is an interesting risk/reward for 2007, albeit with some potential short term issues. Guidance for 2007 points to a double digit free cash flow yield, with potential for further upside linked to a potential ethanol-fuelled boom in agricultural equipment in the US over the next couple of years, synergies to come from two recent acquisitions, a favorable mix shift from greater penetration of the aftermarket channel and some hidden value on the balance sheet.   The near term downside is that inventory de-stocking by Deere could make Q4 2006 projections tough to achieve.  

 

Background: Titan was written up last year by evan73, whose writeup I highly recommend.  The writeup and thread from last year contains a lot of good information on the company and industry.  Titan manufactures wheels, tires and assemblies for the agricultural (~64% sales) Earthmoving/Construction (~23% sales) and Consumer (~13%) segments.  The company’s website lays out the various end markets so I will pass on that here.  The company has been rolling up wheel and tires businesses (strictly off-highway) in the US for many years.  The long term strategy is to increase penetration of the aftermarket business, develop new products (especially for the construction/mining business), increase operating efficiencies across its existing facilities and continue to pursue opportunistic acquisitions. Titan is run by one of the most colorful CEOs in business, Morry Taylor, known as “the Grizz” (check out the company’s logo). It’s worth reading a few of the most recent conference call transcripts to get a flavor of the man. 

 

In conversations with the company I have been told that the OEM/Aftermarket mix is roughly 85/15 for wheels and 40/60 for tires.  The tire estimate is borne out by data on the agricultural market for 2005 from www.moderntiredealer.com.  The primary competitors are Bridgestone/Firestone in Agriculture and in construction/OTR (OTR = “off-the-road”) Bridgestone/Firestone, Goodyear and Michelin. We believe that recent events (shortage of mining tires, Goodyear strike) have allowed Titan to further penetrate the more lucrative aftermarket channel, which should reduce dependence on cyclical and lower-margin OEM sales.

 

Titan has a superior union deal in its facilities courtesy of a multi-year strike a few years back, which Morry estimates saves him up to $10/hour on labor costs vs his competition due to no pension or OPEB costs (a similar situation to Wilbur Ross in the steel business), and additional workforce rationalization.  This makes him a natural consolidator of assets from other tire and wheel manufacturers.  In many cases, the facilities tend to be orphans within larger organizations that are more focused on producing the equipment or on consumer tire production (Goodyear, Continental et al.).  Given Titan’s pure focus on Agricultural and OTR tires, and its inherently lower labor costs, the company claims to be a more efficient user of assets than its competitors for whom these markets are an afterthought. The company claims to have made most of its acquisitions at a significant discount to replacement cost.  A history of the firm’s acquisitions is available at http://www.titan-intl.com/heritage.html.  The company has five operating manufacturing facilities including the recently acquired Freeport, Illinois (Goodyear agricultural tires $215MM sales, $100MM cost), and Bryan, Ohio (Continental OTR/mining tires, $125MM sales, $50MM cost) facilities.

 

Since last year the stock has bounced between about $17 and $20 but the business itself has moved along nicely, with the integration of the two acquistions.  There have been headwinds too – input cost increases linked to oil and steel, partially offset by price increases, extra costs carried while the Freeport plant was being integrated, and a slower agricultural sales market than expected.

 

New market opportunities. 

Titan’s recent acquisitions of Goodyear and Continental’s facilities has opened up a few new opportunities for the company

–         Significant opportunity in mining tires in the Bryan facility

–         Opportunity to leverage the fixed assets at Freeport by moving unused molds and tooling from Bryan (which is operating flat-out) to Freeport, expanding OTR production, and increasing the range of SKUs.

–         Using leverage from the shortage of mining and OTR tires and the Goodyear strike to sign longer term supply agreements (recently Deere and Grove) and further penetrate the aftermarket

–         Expanded presence through Goodyear dealers

 

Operational upside

Probably the most important initiatives are the expansion of the OTR production, which is expected to occur over the next 4-5 months as molds and tooling are moved, production is qualified at Freeport, and equipment is shipped from the idled Brownsville and Natchez facilities to Freeport and Bryan to optimize and increase production.  While some benefits have already shown, the full results of all of these initiatives won’t be seen for a few quarters yet, based on comments on the last call that equipment installations would take 5 months or so.  Management has said that it takes 18-24 months to realize operating efficiencies at each acquired facility (headcount reductions, operating processes, moving equipment, repricing product lines and so forth).

 

Macro - potential agricultural equipment upcycle. 

The real kicker for Titan is the effect that rising corn, wheat and soy prices driven by increased ethanol production and worldwide protein consumption should have on the sales of agricultural equipment.  Farm income tends to drive sales of farm equipment, and the recent boom in commodity prices could be the start in a multi-year upcycle for farm equipment.  Apart from sales of compact tractors, new equipment sales for most farm equipment is down substantially from what was admittedly a huge peak in 1997. 

 

Equipment                             1997 Units             2005 Units             (Decrease)/Increase

4WD Tractors                       8,295                       4,235                       -49%

Combine Harvester              12,990                     8,225                       -37%

2WD Tractors

                >100HP  28,355                     23,625                     -17%

                <40HP                    55,700                     135,380   143%

Source: Titan/Stark’s Truck & Off Highway Ledger

 

If the current run in farm commodities does push sales of farm equipment, Titan has two ways to win –increased sales of new equipment with their wheels and tires, and the increased utilization/consumption of tires on existing equipment, allied to increased penetration of the aftermarket channel. 

 

Several analysts covering Deere have put out pieces on this issue, including Bear Stearns and Stifel Nicholas.  The Stifel piece is interesting in that it compares equipment sales with crop prices and points out that the equipment sales tend to follow with a two year lag.  That could bode well for late 2007 and onward.  Issambres recent post on CSY speaks to the same thoughts.

 

 

Other Assets

Titan has a certain amount of “other” assets that have to be taken into account in the valuation – Evan73’s writeup covers these in more detail, but there have been some changes over the last year. 

–         15.4% stock ownership interest in Titan Europe Plc. recorded as an available-for-sale security, worth about $50MM.  (Titan has not shown an inclination to sell this yet, though they do receive dividends).

–         Note receivable from Titan Europe of $5.6MM. 

–         Assets held for sale of over $15MM (depreciated book value) which the company states to be worth a premium at market values (but which are still being depreciated).  These assets are being marketed, but there is no indication as to when they will be sold.  $10-$12MM of the assets will be put back into service at the operating facilities in lieu of purchasing new equipment. 

–         There appears to be a high level of working capital – partly due to recent acquisitions, partly due to rising input costs.  Aftermarket sales in the fourth quarter should bring inventories back down in line, but again this is a situation that may not fully normalize until 2007.

 

Cash Flow greater than Earnings. 

Capex has been quite low the last few years – about $5MM so far this year, $6.8 in 2005, $4.3 the year before that.  Management estimates maintenance needs in the $6MM range, but I will use $10MM.  Depreciation has run in the mid $20MM range, but going forward should be closer to $30MM run-rate, adjusted for the new Bryan facility.  This includes depreciation charges from idled facilities (about $3.6MM in 2006, $5.4MM in 2005). Titan expenses as much routine maintenance as possible rather than treating it as capex, and uses equipment from idled facilities where possible.  The result is that capex is significantly less than depreciation, and cashflow is in excess of net income.

 

Finally, Jana (owns ~20%) has been buying, adding about 218k shares to its position when the stock fell below $17.  I don’t mean to infer too much from this point, but at the least you would have to say that it’s not a negative.

 

THE MATH

 

Estimates.

Titan’s issued or goals for 2006 and 2007 revenue and EBITDA in early August, but given Deere’s subsequent comments on working down inventory I think 2006’s may be a reach, so I have used the low end ($720MM revenue, $75MM EBITDA) and knocked them down slightly.  2007 should not be affected (inventory should have normalized) so I used the midpoint of the goals for that.  Could Titan’s guidance for 2007 be aggressive? It seems reasonable based on the $470 2005 run-rate for “legacy” Titan, plus the $340 of acquired sales = $810MM.  The fall in Ag sales from 05 to 06 should correct in 07.  Potential upside from mining tires, new SKUs etc could drive sales further. The August press release stated “Titan currently has excess capacity and has the possibility to increase the output volume of OTR tires by a minimum of 30 percent over the next 12 months”.  That should mean $38MM in extra OTR tire sales, before any price increases. $815MM revenue seems reasonable. 13.5% margins on the improved mix (to higher margin aftermarket and OTR) plus price increases compare to 12% in 2004.

 

For 2008, I have grown revenues from 2007 by $30MM for increased OTR tire production, and used a 15% EBITDA margin.  In conversations with management they have indicated that they feel that this is very achievable (and far below their ultimate goal in the 20s), and given the shift in mix, stabilizing input costs, increased operating leverage and recent cost and staff cuts, and the planned introduction of whole new wheel and tire assemblies (particularly in OTR, where Morry claims the basic design is decades behind other wheel/tire technology) 15% seems very achievable. 

 

I have bumped Capex to about 10mm/yr to allow for increased number of facilities, though this is nearly twice what Morry estimates as maintenance capex.  Titan has guided to about $8MM extra capex in 2007 for new equipment etc, so I use $18MM.

Interest is increased for the Continental debt, though reducing working capital and sale of any of the assets outlined above should allow for aggressive debt paydown.

Interest includes a little under $4.3MM per year for the converts which should go away in 2009, though the share count used is fully diluted for the conversion.  It is appropriate to just gross up the remaining convert interest payments, tax affect and treat them as debt.  I estimate 4.3x3 = $13mm*(1-38%) = $8mm.  I have reduced interest payments accordingly to get to a “run-rate” interest number. I reduce this in 2008 for debt paydown.

I have left out “other income” which is substantially dividends received from Titan Europe

 

                                                2005A     2006E      2007E      2008E

Revenue                                470          725          815          815

EBITDA                 52.6         70            110          124

Capex                                     6.8           10.0         18.0         10.0

EBITDA-Capex     35.4         60            92            114

 

 

Free Cash Flow Calculation

                                                2005A     2006E      2007E      2008E

EBITDA                 52.6         70            110          127

D&A                                      20.7         27.7         30.0         30.0

Interest                                  8.6           16.6         14.0         11.0

Taxes      (38%)                                      9.8           25.1         32.6

Net Income                                            15.9         40.9         53.2

Add D&A                                             27.7         30.0         30.0

Less Capex                                            10.0         18.0         10.0

FCF                                                         33.6         52.9         73.2

 

Valuation

Titan has $81.2 million of 5.25% senior unsecured convertible notes are due 2009. These notes have a conversion price of $13.50 per common share.  I adjust the market cap and debt for this conversion.

 

Shares Outstanding             26.1 (pro forma for the effect of the convertible)

Stock Price                            19.00

Market Cap                           $495 MM

Add Convert interest          8MM     

Adj Market Cap    503MM

 

Assets held for sale             $5MM (book value, ex-reused portion)

Titan Europe                         $49.2

Debt (ex-convert) $180MM

 

EV                                           629MM

 

 

                                                                2006E      2007E      2008E

EV/EBITDA                                          9.0x         5.7x         5.0x

EV/EBITDA-Capex                              10.5x       6.8x         5.4x

 

FCF Yield                                               6.7%       10.5%     14.5%

 

If you subtract the value of the $15MM of assets held for sale at book and the $50MM value of Titan Europe from the market cap, the FCF yield looks even better. 

 

So what could TWI be worth?  If you take my 2008 FCF number, use a 10-12 multiple, add back Titan Europe plus the assets held for sale, you get $29-$35 per FD share.

 

Some notes:

–         Depreciation and amortization is currently greater than maintenance capex as discussed above.  This is clearly going to normalize eventually, but even with D&A = Capex it’s a double digit yield in 2008.

–         I have left working capital at its current level, though I expect it to fall.

–         The above does not account for any further acquisitions by Titan.  Morry has hinted that there will be more to come, and evan73 went over what some of the potential candidates could be in his writeup.

 

Risks:

·         The awaited agricultural boom fails to come to the benefit of the OEMs.  Deere is cautious on 2007, despite analyst bullishness, and Morry Taylor has said that 2006 was softer for agricultural equipment than he expected.  The USDA is raising farm income estimates though, and the 2007 Farm Bill is expected to have incentives for renewable energy.

·         Titan’s business is seasonal (bias to Q1 and Q2) and lumpy. Morry Taylor also runs the business with a view to the long term, which can result in quarterly earnings volatility.

·         We think that Q4 may be a bit rough as a result of Deere working down inventory in the channel, but that should not affect 2007.  It may make sense to wait until 2006 numbers are out, with the risk that the good news for 2007 may be baked in at that point.

·         GAAP earnings trail cashflow, and the company is unlikely to sell its Titan Europe shares so the company will not screen as well on straight P/E

·         Morry Taylor’s rough edges can be too much for some investors (not very complimentary about our foreign friends).

·         Little analyst coverage (Oppenheimer). We don’t expect this to change.

·         Extreme falloff in the construction industry could take away some of the upside (we think that the tight mining market will offset this).

·         My margin estimates for 2007/8 could be aggressive – beaten to death above, and below company’s LT goals.

·         Imports – OEMs could use seek to import more of the high-volume specialized tires and wheels.  Cost of importing such large low-margin items should provide some margin of safety on this issue.

Catalyst

Crop pricing drives equipment purchasing by farmers / Mining tires remain tight
Realizing the cost savings and from the Continental and Goodyear acquisitions
Expansion of OTR manufacturing kicks in
Further penetration of the aftermarket channel
Sales of remaining assets held for sale
Potential future acquisitions