Description

Without a lot of exciting things to do in the U.S. lately, we have been looking in controversial emerging markets.  While the headline The Fragile Five has already turned out to be much more a buying opportunity than anything to be scared of, there are still some high quality companies in these countries trading at interesting valuations.  This is an opportunity to achieve both currency appreciation and stock appreciation at the same time.  Turkey and South Africa are two emerging markets that remain controversial.

Turk Traktor is a high return on capital, growing, company trading at about 12 times trailing earnings.  We believe those earnings will go up substantially, and that the company is at a free cash flow trough.  They have the strongest agricultural dealer network in Turkey, and their relationship with Case New Holland gives them premier export distribution globally.  We believe the Turkish Lira is significantly undervalued, giving them an added advantage in their export business.  A new factory due to start up this year will allow them to capture this cost advantage on even higher scale.

Turkey is the largest agricultural producer in Europe, and the fifth biggest tractor market by units in the world.  I never would have guessed that.  It is not a wheat/corn/soybean market like we are used to –Turkeyis #1 in the world in things like cherries, apricots, lentils – stuff that does not lend itself to big row crop tractors and combines.

Turk Traktor has 48% unit share of the Turkish market, though there are 33 competitors.  They have a long history, being the first to produce a tractor in Turkey.  Long ago they tied up with Fiat, now Case-New Holland.  New Holland is the big brand in Turkey, though they have recently introduced the higher horsepower Case equipment as imports and are starting to produce some red (Case) machines domestically.

That kind of market share means a VERY strong dealer network, which is the critical barrier to entry in this business.  Deere has it in the U.S.  They clearly do not have it in Turkey - New Holland (Turk Traktor) does.  With 200 dealers in Turkey and 400 points of service, they are far and away the distribution leader domestically.

The company is 37.5% owned by Case New Holland (Fiat) and another 37.5% owned by Turkish industrial conglomerate Koc.  Only 25% of the shares are in the public float.  That is far from unusual for Turkey, and the company certainly does not present itself as a mere subsidiary of CNH.  They see CNH as an important strategic relationship which benefits both sides, very much inclusive of minority shareholders.

The relationship with CNH has two big benefits, including another enormous competitive advantage in distribution.

1. First, they can access first class export distribution all over the world.  In many countries including Turkey, CNH is the dominant leader.  Turk Traktor is one of Turkey’s largest exporters, selling 37% of their 2013 production outside of Turkey, up from 30% the year before.  They export to 130 countries, including the USA.

Turk Traktor is the primary manufacturer globally for certain CNH products, mainly smaller tractors.  Theirs is one of CNH’s lowest cost operations, and their low cost position got even more favorable due to the depreciation of Turkey’s currency in the last year.

To underscore the value of Turk Traktor to Case New Holland, here is some language from the 2013 annual.  “This facility is the sole design center for New Holland TDD and Case 1H JX series tractors and several specialty ranges, the only manufacturing center for Utility Light series tractors, and the global engineering and manufacturing center for the 66 series transmission.”  The products they reference are 65-110 hp tractors.

2. TT can leverage not only CNH’s distribution, but also scale their parent’s R&D and fixed investment.  R&D is only 4% of sales for TT, though they continue to develop important new products.  They punch higher than their weight class because they can incorporate R&D in big ticket investments like emissions control from the parent.  Turk Traktor often manufactures as an assembler of major CNH components.  Their gross margin is lower than comps, but they run a very lean operation without a lot of fixed costs, so their operating margin is 16%.  SG&A looks extremely tight.

What really attracted us to the company were the financials, which are simply gorgeous.  This reads like a company that is built to last, very well managed financially.

• Debt  roughly equals Cash.  They have borrowed a little bit more than usual to build their new factory.
• Return on operating assets of 22%, return on capital invested 33%.
• Dividend policy is to pay out at least 60% of net income while funding robust growth.
• They made decent money in 2009, when the Turkish and global market for tractors just collapsed.  That may be the most important statement I can make about the company.
• On SG&A they run very lean, with SG&A/sales of only 6.3%.
• Their financial disclosure is exemplary in their English language annual, far superior to other Turkish companies’ global investor relations effort.
• Free cash flow is not huge, but it was enough to fund a 7% dividend in 2012.  In 2013 they paid the dividend though they were free cash flow breakeven.  Debt went up, but is not at all a problem.  Free cash flow was zero in 2013 for two reasons.  First, the new factory which is an investment we want them making.  Second, though, was an inventory increase in 2013 which certainly bears watching going forward.
• It grows.  Not in a straight line, because they are in a cyclical business, but this company grows.  For the last 10 years they have had a top line CAGR of 17%, virtually all of that organically generated.  They were profitable every one of those      years, including 2008 and 2009.  And they managed to fund this growth while paying out the majority of earnings to shareholders as dividends.  That math only works with a very high return on capital.

Speaking of growth, Turk Traktor is halfway through one of their biggest investments ever. 

Turk Traktor has one big factory with capacity of 35,000 units.  They produced 38,000 last year, so one might conclude that they are working it hard, and quite possibly turning away business.  The company is spending about 170MM TL last year and this year to build a second factory which will take production capacity up to 50,000 units.  They don’t build a big new factory every day – their footprint now is one big factory after 60 years of growth.  Adapazari will be their second.  They are financing this growth while paying out 60-70% of their earnings and maintaining their pristine balance sheet!

The new factory is located on a harbor, so it is clearly built with exports in mind.

If we estimate a price of about 45,000TL per export unit based on what they sold last year, another 15,000 units of capacity equals about 675 million of revenues.  Assuming an 18% contribution margin gets us to 121 million of operating income potentially.  The factory costs 175 million to build.  That sounds like money well spent, with the potential to significantly increase the earnings power of Turk Traktor.  They broke ground in March 2013 and will complete it this year.

The big risk here is that Turkey tractor sales in 2011 were the highest ever, and the next two years, while down from the peak, were still high compared with past years.  Historically the market has been VERY cyclical. 

Despite the turmoil in Turkey in 2013, tractor sales were up low single digit.  In the first quarter of 2014, which was when Turkey really scared people, Turk Traktor had a minor disappointment, but nothing serious. 

Financing is very important to this business and interest rates have gone up.  We recently met with a Turkish bank, and things appear to be getting better.  The country cut rates last week by 50 bp from 10% and the banks expect further action down, and stronger economic activity in the second half.  Credit quality never deteriorated as was feared, and loan growth is picking up again. 

The government has been friendly, coming through with subsidies and programs to support demand.  Is this a peak?  The company argues that half of Turkey’s tractor installed base is 25 years old or more and needs to be replaced to drive productivity in agriculture which employs 25% of Turkish workers and drives much of its exports.  Furthermore, since the last decline in Turkey the company has gotten much more serious about exporting, so a big part of their business is insulated from the Turkish cycle.  Seeing that they produced at full capacity last year, one might infer that they could have sold even more into the export channel if business were not so strong at home.

We do not find it hard to imagine Turk Traktor earning about 400 MM TL two years from now, or 7.50 per share.  At a 14 multiple reflecting this company’s growth, that would equate to a TL 105 stock.

The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.

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