Titan International: Good Time to Bet the Farm

Includes: DE, TWI
by: Dr. Hugh Akston

Titan International (NYSE:TWI) offers a compelling value even based on what are very likely to be trough earnings. Sales have evaporated across all of the business segments, however the agriculture segment (75% of sales) should rebound significantly from current levels given the recurring and nondiscretionary end demand for that industry. The stock has a free cash flow yield of over 10% for 2010 which is based on a revenue level that is still down -26% vs. the level seen in 2008. With a tangible book value of $7.43, the downside is limited here with upside potential of roughly $11.

Company overview

Titan International is a leading manufacturer of wheels and tires for off-highway equipment used in agriculture, earthmoving, construction, and consumer markets. TWI is the primary source of wheels and rims to the majority of the US OEMs. Agricultural sales account for 75% of total revenue, construction/earthmoving 22%, and consumer 3%. Roughly 78% of sales are generated in the US and 12% internationally.

TWI reported Q4 earnings this past week which missed analyst expectations for both revenue ($146.5m vs. $157m Street) and EPS (-$.41 vs. -$.10 Street) however I think TWI is an example of a stock climbing the “wall of worry” as the stock eventually closed up on the day. More important than the Q4 results was TWI reaffirming their previous guidance for FY 2010 and providing some general guidance for a profitable Q1 2010.

Business Fundamentals:

The business environment appears to be improving for TWI as Q4 showed a sequential increase in revenue vs. Q3. This is significant because there is not a meaningful amount of seasonality between Q3 and Q4. The seasonality is sequentially seen between Q4 and Q1 of the following year. This uptick in revenue was the first increase seen in five quarters.

TWI Total Revenue

Anecdotally, the CEO of TWI, who is remarkably candid, called a bottom in Q3 2009 and thus far appears to have called it correctly. Q3 2009 was most likely the bottom for TWI because sales in that Q were based on purchase decisions that were made in early spring of 2009, which was basically the darkest period of the recession with a plummeting stock market and crop prices along with rapidly increasing unemployment. The long lead time for TWI’s products means that orders placed in the spring of 2009 did not hit the income statement until Q3 2009.

Furthermore, John Deere (NYSE:DE), TWI’s largest customer and a good proxy for demand as they also have a similar 75%/25% breakdown between agriculture and construction, reported better than expected results last week (see earnings call transcript here) and also revised their expectations upward for the US agriculture industry for 2010. Deere now expects US sales to be flat in 2010 vs. 2009 versus the prior expectation for US sales to be down -10%.

Finally, the Association of Equipment Manufacturers released data for January showing that North American tractor sales were up yr/yr in January 2010. This is the first yr/yr increase since September 2008.

· Agriculture business should bounce back, food has non-discretionary and recurring demand

The agriculture segment, which is 75% of sales, should bounce back from the tremendous drop in sales that was seen in Q3 2009. The business of farming is unique from a construction point of view because the demand for agricultural products is recurring and the products have a very short life span. It is possible that construction spending does not approach the levels seen before the recession for a very long time because the buildings and infrastructure that were built during the boom will last 50 years or more.

Food, however, has a very short life span and the demand for new food is constantly being regenerated. For this reason I think it is likely the agriculture segment recovers faster and more significantly than the construction segment. Given that agriculture represents 75% of TWI this should be enough to move the stock even if the construction business lags. The average tractor lasts about 5 years (possible to make them last much longer but requires significant maintenance spending and repairs) and the average combine wears out even sooner. While crop prices are well off their peaks set in the summer of 2008, they are still at levels that are profitable for farmers, which should support spending on agricultural equipment.

The below chart shows how revenue for the different segments has fared (keep in mind agriculture is on the left axis as that segment is 3x larger than construction).

· Recent convert deal gives TWI flexibility for acquisition, debt funding rock solid

TWI is sitting on a pile of cash ($229m). Following their convert offering (convert price= $10.75) last year, I expect them to use the cash to acquire Goodyear’s (NYSE:GT) farm tire business. However on the earnings call (see transcript here) they said they also have a few other potential targets and will either make a deal by the end of March or use the cash to pay down earlier maturity debt. The company has very solid funding in place with debt not expiring until 2012 and 2017.

· Huge short interest

TWI has a huge short interest with 32% of the float currently short. Some of this short interest is obviously due to the recent convert offering but in addition the stock was recommended by a short selling service in August 2008 and the call turned out to be timely (short recommendation no longer in effect). So I’m assuming many of these investors have kept the trade on because the idea has continued to work. Any improvement in the business or positive news flow could result in a short squeeze with the short trade that crowded.

· Risks

o Crop prices decline and spending on agricultural equipment does not rebound.

o Economy double dips into another recession, TWI is subject to marco economic forces and sales would not rebound.

o Rubber prices increase significantly, which would pressure margins. It is highly unlikely that rubber prices would rise without crop prices and economic activity also increasing.

o Decreased government farming subsidies would impair the economic well-being of the farming sector. This seems remote given the propensity to prop up the farming constituency.

Disclosure: Long: TWI, No DE position