Titan Machinery (NASDAQ: TITN) is the latest darling of the so-called "Ag Boom". Titan Machinery sells farm and construction equipment via a network of 48 stores located in the upper Midwest – mostly in the Dakotas, Minnesota and Iowa. They exclusively sell Case and New Holland ag and construction equipment, all produced by CNH Global, NV (NYSE: CNH). The company came public in December 2007 with an IPO price of $8.50 and closed the first day of trading at $9.50. In the next 6 months the stock made steady progress towards $20, lingered in the low $20's, and in the last month has broken out to the low $30's. As of this writing, the total return to IPO investors is 256%.
Lately, the company has been on an absolute tear – showing 3 year revenue and net income CAGRs of 39% and 59%, respectively. For their most recent quarter ended 4/30/2008, revenue was up 91% y/y to $152.6M, and net income was up a staggering 327% to a record $3.4M. On the day of the release, the stock opened up 7% before closing up 11%, and climbing to $34 over the next week, a 22% increase on the pre-earnings closing price. That paragraph should have set off a few alarm bells, which I'll return to in a bit.
Titan has achieved this growth 2 ways: 1) By being in the right business at the right time and 2) acquisitions of regional dealers of CNH products, expanding their footprint and leveraging their back office. They have made 15 separate acquisitions over the last 4 years totaling 30 new stores. While precise numbers are somewhat hard to come by, it appears roughly 60% of their growth in each of the last 3 years has come via acquisitions. Now, there is nothing intrinsically wrong with growing via acquisitions. Such "Roll Up" strategies have been employed across a variety of industries, usually retail, with varying degrees of success. The problem with these strategies is that they generally work…until they don't. Titan's particular brand of roll-up is what the industry calls a "multiple arbitrage" play, or less euphemistically, a Ponzi scheme (Ok, Titan's isn't illegal like a Ponzi scheme, but the similarities are striking). I'll explain.
Titan didn't give the sales numbers for their acquisitions prior to the IPO. Therefore, I am only able to obtain sales figures and acquisition prices for Titan's last 5 acquisitions. For these 5 transactions, the Price/Sales ratio has been between .1 and .3. If I assume a generous 6% EBITDA margin for the acquired stores (Titan has never done better than 5%), the transaction multiples are between 2 and 5 times EBITDA. Not surprisingly, Titan's most recent and largest acquisition cost them the most – Midland equipment sold for $14.4M, with sales of $48.3M.
Titan came public at around 4X EBITDA. Their median EBITDA multiple since they've been public has been 9.4X, and they currently sit at an amazing 20X EBITDA. Think about what happens when they do an acquisition: $1 of EBITDA acquired for $5 is suddenly worth $20! Instant value creation! Obviously, there's little value created in these acquisitions. Sure, they can likely wring out a few synergies by being part of a larger organization, but ultimately this is a low margin, low value-add business. Adding a new dealer to the organization does not immediately make that new dealer 4, or even 2 times as valuable.
Things get worse: As the company grows, they have to continue to acquire proportionally more sales and EBITDA dollars to keep the growth up, which in turn keeps the stock up, which in turn allows them to do more acquisitions. Any hiccup along the way, and the whole thing falls apart. It's been relatively easy for them to buy $50-$75M in sales per year, but when they need to buy $150M in sales they'll have 2 options – do twice as many deals and incur twice as much brain damage integrating 1 or 2 stores here and there, or do significantly larger deals. As we've seen with the Midland acquisition, larger deals come with more sophisticated players and higher prices.
Remember when I mentioned some alarm bells earlier? Here's one of them. Titan's last quarter was, by any measure, a blowout quarter. Analysts (that is, analysts of the firms which underwrote Titan's IPO and secondary offering) were looking for $0.13 and got $0.24! Yet the stock increased only 11% that day, and 20% over the next week. This indicates market expectations for this stock are absolutely through the roof. Any stumble, a single slow quarter of "only" 50% income growth, will crater this stock, and the vaunted "Titan Operating Model" will fall apart.
The second alarm bell was the $151.6M in sales producing only $3.4M of net income – a 2.24% profit margin in during the middle of the best market conditions this company will likely ever see. EBITDA margins are razor thin as well, touching almost 5%, which is an all time high. Fundamentally, this company isn't much different from an auto dealership. A composite of the largest auto dealer stocks shows they have EBITDA margins which over the course a business cycle will range between 3%-4%, profit margins which cycle between 0.5% and 1.5% and will trade for between 4 and 6X EBITDA.
There are other reasons not to like the stock as well. Generally speaking, they're selling 2nd tier products into both the Ag and Construction markets, the leaders being Deere and Caterpillar, respectively (I realize this is likely the most controversial item in this column, but I stand behind it). They're not exclusive in their regions – a simple search of the Case IH website will point you to both Titan and other dealers in the same city all across the upper Midwest. By being exclusive in the upper Midwest, they're missing out on the best part of the Ag boom – emerging markets. Look at the other darlings of the Ag Boom – MOS, MON, LNN, DE – all sell 35%+ into foreign countries, and many do 50% or more. American farmers do benefit from high crop prices globally, but I'm not particularly bullish on farm incomes this year as compared to last year. They'll do well by historical standards, but many farmers locked in this year's crop at somewhat lower prices earlier this year, but will face skyrocketing input costs along the way.
Also, several items from the financial statements don't pass the sniff test. 25 of their dealerships are located in buildings leased from the CEO, the CFO, or the CFO's brother (who is also a board member). These may well be all arms' length transactions, but then again, they might not be. As referenced above, the 8 member board consists of the CEO (who is also Chairman), the CFO, the CFO's brother who runs several investment funds invested in Titan, and the CFO's other brother, who is the company's Treasurer. Collectively these individuals control 31% of the company's stock (they used to control more, but they've been selling). It's nice to see managements interests aligned with stockholders, but I generally don't like to see them have an iron grip on the company.
So where should the stock trade? Conservatively, I'll assume they can continue their 40% revenue CAGR for the next 3 years and kept margins roughly constant (remember, we're at the top of a cycle here). They've been getting about half their growth from acquisitions and half from same store sales, so I'll assume that continues. To buy the sales they need at 0.3X sales, doing 50/50 cash/stock acquisitions (again, in line with recent results), will cost them $63M in cash over 3 years, plus about 2.5M shares at current prices. That would absorb all of their free cash flow for that time period, and continue to dilute current shareholders. There are a few other assumptions in the model, but the bottom line is my optimistic case scenario produces a price of about $16.50 per share, with plenty of downside if everything does not go smoothly.
In summary, the business plan, while reasonable, does not even begin to support the current valuation multiples. The optics of the business strategy can appear promising in the short run but long run, this is a very low margin, low value add business which should trade as such. As mentioned, there are a variety of other reasons beyond the business itself which indicate the company, long run, will likely trade at a discount to peers. As you can imagine given the scenario I've lain out, we're short quite a few shares.