Lindsay Corporation: A Free Cash Flow Desert

Summary

• Year to date, Lindsay Corporation has generated negative free cash flow after dividends. Q4, given some management pessimism, likely does not improve that.
• 2020 objective of just 200bps of operating margin expansion shows how impaired agriculture businesses are. International growth opportunities are low and domestic sales have been light.
• US farm income is set to fall by high single digits this year, with another decline likely next year. Farmers have bigger problems than buying $80,000 irrigation systems.
• Even if management hits its targets, Lindsay Corporation still trades expensively at <5% free cash flow yield.
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The market continues to be incredibly fickle in who it rewards and punishes in 2018, and Lindsay Corporation (NYSE:LNN) has remained remarkably resilient. Adjusted operating margins in the company's core irrigation business were the lowest they have been in a decade last quarter, hit hard by poor international project growth (especially in Brazil), freight increases, commodity costs, and a book filled with lower margin projects. Even despite that weakness, management alluded to the fact that there was likely some pull-forward in sales, with customers buying ahead of likely pricing increases. The company has generated no meaningful cash flow this year, and while improvements continue to be made in the infrastructure business, those results are still small and realized profit there can be lumpy depending on contract timing.

Growth expectations are tepid, and shares remain prohibitively expensive: More than 14x 2019 EBITDA expectations. In many ways, I see the company being treated as a technology company given its FieldNET and Growsmart products, both of which Lindsay states are one of the few options for remote monitoring and control of irrigation equipment. Short interest continues to build off an established low, and I believe there are legs to that negative sentiment. In 2016, more than 3.3mm shares were held short, triple the rate of today. While the short side did not make money back then, I suspect that bears will take another run at Lindsay Corporation if results continue to come in weak. Shares have 30% downside in my opinion.

Business Overview, Turnaround Plan

Lindsay Corporation is a global manufacturer and marketer of water management and road infrastructure products and services. With a history stretching back to the 1950s, the company was built off the back of its agricultural irrigation equipment sales, growing from a regional player to an international giant in the space. While the company has some infrastructure assets that diversify the company away from farming (primarily road safety equipment), fundamentally, the company remains an irrigation player: More than 80% of revenue is generated from its irrigation assets.

This isn't the equivalent of your sprinkler in your backyard. The standard center pivot system is a quarter mile long and can irrigate more than one hundred acres of land. The average farmer will spend $80,000 setting up one standard center pivot irrigation system. This equipment is not cheap, a factor which has hurt higher rates of adoption. Demand is driven by a couple of factors: New installs for farmers that previously operated "dry" farmland, replacement of old systems, and the conversion of more labor-intensive or wasteful irrigation methods (e.g., gravity). Throughout the United States, acreage of production farmland has been in a steady decline for decades. So while irrigated acres as a percentage of total farmland has been increasing in recent years (after some declines from 2005 to 2010), the pie continues to shrink.

*Lindsay Corporation, Q3 2018 Investor Presentation, Slide 16

Over the past two decades, overall penetration of irrigated cropland has not changed materially. This is likely not to change, mostly because not all crop types require irrigation, especially in certain states. Soybeans and corn, despite being two of the largest products in terms of overall production, require very little irrigation water per acre. In many states, the majority of production of these products are not irrigated. Just five states (California, Nebraska, Texas, Arkansas, Idaho) account for more than 52% of irrigated acreage despite accounting for only one quarter of overall cropland domestically. Instead, the driver of demand continues to be for farmers moving toward more efficient irrigation equipment on land already being irrigated - away from gravity-fed systems that tend to be wasteful (evaporation, less water at the crop roots) and toward pivots/laterals and drip systems. However, penetration growth rates continue to slow. Net farm income is expected to fall 7% this year, with another negative year likely in 2019 given the recent downdraft in pricing. Management itself admits that irrigation project markets are a little soft given this reality.

In my opinion, future growth hinges on international sales. However, many international farmers simply cannot afford to run these expensive systems. Overseas, especially outside of Latin America, commercial farming is not as big as it is here in the United States. Spending hundreds of thousands of dollars to set up irrigation equipment is just out of reach, even if it would improve crop yields and give a decent return on investment. International irrigation sales have slipped 9% year to date, despite what should be higher average selling prices ("ASPs") because of rising commodity costs.

The Foundation for Growth Initiative set 2020 objectives, with the most relevant being an 11% to 12% operating margin target. This represents only marginal improvement from current levels: 9.9% reported through the first nine months of 2018, 11.2% in 2017. Nonetheless, given the lack of below the line costs, this is a catalyst for why investors continue to buy the stock. Assuming $600mm in 2020 revenue, this would be good enough to generate $69mm in operating income at the midpoint. Continued growth and margin expansion in this way are necessary to justify the current price. Both factors are necessary to get earnings per share back up into the $4.50-5.00/share range and a resulting multiple in line with the rest of the market. Alongside that margin target, announced simplification initiatives include a divestiture plan (Watertronics, Lakos, Irrigation Specialists). I expect these sales to net about $30mm inclusive of selling costs - nothing material. But the cash infusion, alongside the targeted cash balance of $60-75mm, does give management a little bit of money to play around with for organic growth projects and/or possibly some shareholder returns.

Poor Free Cash Flow Problems This Year, Tight Valuation Even Under 2020 Growth Initiative

Thus far this year, Lindsay Corporation has generated just $8mm in operating cash flow - primarily due to a significant build in accounts receivable. This has created a situation of net cash burn: $7mm out the door from capital expenditures and $10mm paid to common stockholders in dividends. They've done a great job elsewhere, including keeping inventory carrying costs down despite significant underlying price increases in commodities. However, even if the company meets its margin targets and continues to grow revenue, implied free cash flow yield is still very light here:

• $48mm in net income ($600mm revenue, 11.5% operating margin, 25% tax rate)
• $24mm in depreciation (in-line with likely maintenance/sustaining capital expenditures)
• Net of 4.9% free cash flow yield on the current market cap

Given the beating that shareholders have bore in other agriculture plays, I'm not sure I understand how and why the common stock here continues to trade at such relatively stretched valuations. Irrigation equipment, like new farm tractors or other assets, is an expensive, capital-intensive decision. While the company does have a strong installed base, laterals and pivots are generally long-lived assets that require very little upkeep. In a world of declining farm income in the United States and lack of capital availability internationally, I continue to hold a skeptical view on the valuation here. I don't see much upside and do see a material downside risk if management does not execute on a near perfect basis over the next 12 months.

Analyst’s Disclosure: I am/we are short LNN. 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.