Rocky Mountain: Way Too Cheap

(Editor's note: shares offer better liquidity on the Toronto Stock Exchange under ticker RME.TO)

Shares of Rocky Mountain Dealerships (OTCPK:RCKXF) have fallen dramatically over the last few months, for issues that appear to be only short term in nature. As a result, the company can be purchased for not much more than its 2007 IPO price.

But since that IPO six years ago, both sales and operating income have tripled. Consequently, the company now trades at a P/E of less than 10 despite a history of stellar returns on capital, including an ROE* of 19% for 2012.

The Business

Rocky Mountain sells equipment (including tractors, combines, excavators etc.) for the agriculture and construction industries through its 40+ dealerships throughout the Canadian Prairies. It operates as an independent dealer of Case, one of the world's largest agriculture equipment manufacturers. More on Rocky Equipment Dealerships' business can be found in the company's Annual Information Form.

Strategy

The company has managed to grow quickly thanks to its acquisition strategy. Rocky Mountain has picked up a number of smaller dealerships, such that it is now the largest Case equipment dealer in Canada.

An acquisition strategy of this nature has two benefits. First, the company is able to arbitrage the "multiple" difference between private and public companies; Rocky Mountain can purchase a private company at a smaller multiple of sales/earnings than it receives for its own shares.

The second benefit arises through economies of scale. The company can spread marketing, purchasing, technology and other fixed expenses across a higher number of units, providing for better margins versus those of its competition.

The company is currently run by the same management team, which initiated and executed this strategy. The company's returns on capital (depicted below) suggest the strategy has been working and that management has been a prudent allocator of shareholder capital:

Short-Term Pressure

Recently, however, Rocky Mountain's share price has come under pressure due to a reduced demand outlook for new agriculture equipment for the rest of the year. Newly enacted regulations have resulted in price increases for certain types of equipment, which has encouraged farmers to delay purchasing new equipment.

This will hurt Rocky Mountain's results in the short term, as demand will shift from new equipment to used equipment. In response, the company has stated that it plans to reduce inventory, thus simultaneously lowering its carrying costs and increasing free cash flow.

While higher prices can cause buyers to extend the use of their older equipment and increase their willingness to purchase used equipment in the short term, they cannot change the long-term dynamics of the agricultural industry. Increasing global demand for food products (the world's population is expected to increase to $8 billion by 2024) encourages farmers to continue to increase the productivity of their lands, requiring a constant supply of advanced equipment to meet that need. As the productivity of new equipment continues to increase, the benefits of buying these tools will soon outweigh the cost increases of the new regulations.

The 15% drop in the company's shares since this announcement has created a buying opportunity for long-term investors.

Insider Ownership and Purchase

Rocky Mountain's president appears to share the view that the company is a long-term buy. Following the recent price drop, he bought 200,000 shares of the company on the open market at an average price of $11.50/share, which is higher than Tuesday's closing price. This brings his ownership stake in the company to about 10%.

In addition, the company's chief executive officer owns another 13% of the company's shares. Considering the strong insider ownership, management interests appear aligned with those of shareholders.

Valuation

Rocky Mountain's operating margins have been remarkably steady, fluctuating between 4.7% and 5.4% of sales. Because the company owns exclusive licenses for Case equipment within its selling regions, there is a certain inelasticity of demand for its dealerships.

At the same time, sales have grown significantly. Assuming normalized margins of 5% on the company's 2012 sales level of $966 million results in an estimate of normalized operating income of $48 million.

The company currently has an enterprise value** of $250 million, for an EV/EBIT ratio of barely over 5. Such a ratio may be appropriate for a declining business or one with an uncertain future, not one such as Rocky Mountain, which also has a competent, proven management team, which is properly incentivized.

Considering the company's return on its capital, shares of Rocky Mountain probably deserve a P/E closer to 15, which implies upside from the current price of over 80%!

Risks

The company is heavily dependent on Case as a major supplier. Currently, Case is considered a top manufacturer of heavy equipment. Should that change for whatever reason, Rocky Mountain would likely take a significant hit.

The company is also subject to the cyclicality of the agriculture and construction industries. Should commodity-prices and/or real-estate prices fall significantly, demand for Rocky Mountain's products would decline. However, the company has a safe capital structure that should allow it to weather the ups and downs of the industry.

Conclusion

Rocky Mountain Dealerships is run by strong managers with skin in the game. The company has successfully grown by acquiring smaller dealerships, resulting in excellent returns on capital. Because of temporary issues, the company's stock price has taken a hit, offering long-term investors the opportunity to buy into the company at an attractive price.

*ROE calculated as Net Income / Beginning Shareholder Equity

**Enterprise value is calculated as market value plus net debt, ignoring payables related to inventory holdings

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have a long position in RCKXF.PK

Comments

[Martin Keck]

Today -5.98%. Results were good in relation to current valuation of the company. Lower debt, higher equity.
What's not to like? Too low new equipment sales?

[hardcorevalue]

Thanks, another day, great comments. I wasn't looking at the absolute level of debt rather, the interest expense compared to profitability. The interest coverage is a little thin for my liking.

My concern would be a reversion to the mean in crop prices which would slow farm expenditures from these seeming high levels.

[mister-ugly]

the AEM Association of Equipment Manufacturers of Canada released these sales figures on 10//10/2013: 2wd 40hp farm tractors for Sept 2013 down 7%: YTD thru Sept up 13.2% over 2012; 40hp to 100hp down 7.8% YTD thru Sept down 1.9%; 100 plus HP down 9.6% for YTD Thru Sept up 13.8% 4wd tractors only 46 sold versus 97 for YTD 2012. down 52.6% sizeable decrease not much volume. In self prop combines down 35.9% YTD versus 2012 and for year down 1.4% It appears farmers bought early this year. Interesting almost all 2WD Tractors. So what is the correlation of regulation? I have not found out?

[anotherday14]

A few quick comments on the name:

brettmag: Rocky has a few stores in Saskatchewan as well so they too will benefit from the year those farmers have had. Rocky's main footprint is in Alberta and you will find that Alberta farmers have also been seeing record yields this year.

harcorevalue: You have to be careful when looking at the debt of this company because you need to strip out the floorplan payables since that is not actual corporate debt. Bloomberg does not make the distinction which is why dealerships in general do not screen cheap. The company’s corporate debt is around 51 million. You make the same adjustment to the debt figures when looking at Cervus, Titan, auto dealers, or Rush enterprises.

One issue not touched upon in this article that is very important is the strategy of the company. In the process of buying up all the mom and pop Case dealers in Western Canada, the company will not only improve the sales of equipment, but also the parts and service business of the dealerships they acquire. This is important because the parts and service business is very high margin. Not only does growth in that area benefit margins, but it helps decrease the cyclicality of the business. The growth in parts and service takes a few years because first you need to have a pick-up in sales at the dealership level of equipment before you can realize the benefit of people bringing more equipment to you for parts and service. In past presentations the company has included a slide about post acquisition performance improvement. I would urge everyone to look at that slide because it shows how powerful the acquisitions can be. To see how powerful growing the parts and service business can be, I would suggest people look at Rush Enterprises as an example.

Finally, while I own this stock, I think it is a long term play. I do not think Q3 will be anything spectacular as management continues to pare down inventory and focuses less on new sales. I think long term this is the right decision, but it will have an impact on Q3 and likely Q4. That being said, as they exit Q4, they will be in a great position inventory wise, have lots of cash on the balance sheet, and as alluded to above the farmers are having a good year. The price of crops are down, but that is as a result of the record yields and the farmers in that scenario still make good money and they will as always look to spend that money.

[mister-ugly]

would you like to comment on titn versus rckxf? and expand on problems in purchasing new OEM equipment in recently enacted regulations? I cannot imagine farmers preferring to purchase used equipment for such an on demand industry. In this field used usually means either outdated, or used up. Tax write-offs, stable growth crops, warranties, improved new design equipment, fuel advantages, technology, risk factor of using used equipment, all make for peace of mind in purchasing reliable new equipment.

[hardcorevalue]

Any concerns on their debt? less than 4x interest coverage.

[Martin Keck]

I am also long RME.TO. Could you elaborate why CVL.TO is better value?

[brettmag]

I prefer CVL. Farmers in Saskatchewan had an amazing (record, or near record) harvest and have tons of cash to be buying new equipment for next season.

[Netwall]

the ticker on US exchange is : (RCKXF)

Thanks for the article. We will take a deeper look.