Stock Toro: It’s all about the pro (NYSE: TTC)

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Professional Segment Leads Growth

The Toro Company (NYSE: tax included) recently released its Q3 2022 results and raised its EPS guidance for the year. The Professional segment increased both sales and margins thanks to strong demand and easing supply chain issues. This segment now represents more than 3/4 of the company’s turnover, compared to 2/3 ten years ago after profitable acquisitions in the underground and specialized construction market. This has reduced the seasonality of Toro’s earnings and reliance on the cyclical real estate market.

Toro Sales by Segment and Market

Toro Investor Presentation

The Professional segment increased its sales by 23.3% in the third quarter of the fiscal year compared to the same quarter last year, while the segment’s operating profit increased by 35.9%. This means that the operating margin is also growing. The company has managed to raise its prices thanks to strong and growing demand in the underground construction and golf markets. Some supply chain issues have eased, for example in engines and plastics. Other components, such as chips and other electronics, are still limited in supply, so the company continues to have a large backlog.

Sales in the residential segment grew more slowly at 7.1%, although this was expected after two exceptionally strong years of demand from the stay-at-home trade. Operating income decreased by 16.5%, indicating lower margins in this segment.

Toro segment performance

Toro Third Quarter 2022 Results Presentation

As we see in the margin chart below, operating margin and net profit margin improved through 2018. Growth slowed, but margin performance became less cyclical following the acquisition from Charles Machine Works in 2019. After a few years of unusual behavior, margins appear to be on the upward trajectory again. In the fiscal Q3 results just released (not shown on the chart), the margins were:

Gross margin: 34.5% (up 2.1% sequentially and 0.5% year-on-year)

Operating margin: 14.0% (up 0.4% sequentially and 1.5% year-on-year)

Net profit margin: 10.8% (up 0.3% sequentially and 0.9% year-on-year)

Chart
Gross Profit Margin Data Including Tax (Quarterly) by YCharts

With this strong margin performance, Toro raised its FY2022 EPS guidance to $4.07-$4.17, up from the $4.00-$4.15 range they had previously guided. This is despite the revised sales forecast of 14%, at the bottom of the previous range of 14% to 16%. Analyst consensus also rose slightly from last quarter to stay within management’s forecast range. I noted last quarter that management’s EPS guidance appeared conservative compared to the $4.25 I had estimated by incorporating the individual assumptions into my earnings model. Updating the model with this quarter’s data, my estimate remains at $4.25, which is still above the company’s forecast, but now only 3% above the midpoint or 2% above the high end. The EPS estimate of $4.25 implies a forward P/E of 19.7, a value it has rarely seen since 2016 except for the last general market low in June 2022.

Revenue model updates

As indicated above, the sales growth forecast has been reduced to 14% due to the performance of the Residential segment. Following strong margin performance in 3Q, I am revising full year gross margin to be in line with 2021 at 33.8%, above the 33.5% I used in last quarter.

Toro left the operating margin forecast for the year at “similar to fiscal 2021” or 13.1%. This seems reasonable, as it is close to the weighted average of the first nine months actual operating margin of 12.7%, and an assumption of 14.1% in the 4th quarter, which would only be slightly higher. to reality in the 3rd trimester.

Below the operating income line, the interest and tax assumptions are unchanged, but I have increased other income from my previous assumption. This category primarily covers profits from vendor financing programs, which are expected to increase with interest rates.

Combining all of these estimates and using an updated share count, I get an EPS estimate of $4.25, equal to my last quarter estimate, but 2% above the high end of the company’s fork.

Toro revenue model

Author’s spreadsheet (data source: company advice and author’s estimates)

capital management

Like many businesses with high inventory levels, Toro’s free cash flow (“FCF”) is negatively impacted during periods of inflation, as more cash is needed to maintain the same number of units. In the case of Toro, working capital also increased with the acquisition of Intimidator Group. The inflationary environment has lasted longer than initially expected, unfortunately forcing Toro to revise its 2022 free cash flow forecast downward.

For fiscal 2022, the company now expects free cash flow conversion of 60% to 80% of net income, down from 80% to 90% previously. This reduction occurs despite a decrease in the investment forecast to $140 million, from $150 to $175 million previously. Based on the midpoint of the 70% conversion level, Toro would have approximately $314 million FCF available for fiscal 2022. This covers the dividend of $127 million and realized buybacks of $110 million. (Year-to-date redemptions are up from $75 million last quarter.)

Toro spent $402 million on the acquisition of Intimidator Group, which it financed by raising debt by $365 million and tapping into cash balances and excess free cash flow after dividends and buybacks. Debt to recurring EBITDA increased to 1.7x, which is above normal for Toro but within the company’s target range of 1 to 2x. Interest coverage, which is operating profit divided by interest expense, increased by a comfortable 17.75x in the third quarter of the year.

Evaluation

At $4.25, Toro has a forward P/E of 19.7. Historically, the trailing P/E has been above this level since early 2016. The forward P/E fell below this level in June 2022, consistent with the most recent broad market low.

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TTC PE Ratio data by YCharts

An AP/E at the bottom of the range can be expected when interest rates are higher. The 10-year Treasury at 3.25% is poised to break above levels last seen in 2018, when Toro’s P/E was at a cyclical low. However, Toro has been a more diversified company since then, having completed the acquisitions of Charles Machine Works, Venture Products and Intimidator Group.

A lower P/E would also be appropriate for a company with declining profitability metrics. Toro’s return on invested capital has declined over the past two years as they struggle to integrate new acquisitions and deal with inflationary working capital builds.

Toro Return on Investment

Toro Investor Presentation

For fiscal year 2022, I expect continued ROIC recovery:

Adjusted operating income: $468.2 million ($568.2 * (1-0.21))

Average capital employed: $2,133 million ($1,912 million at start, $2,354 million at end)

ROI = 22.0%

Longer term, the company’s “Drive for Five” initiative is targeting $5 billion in sales by 2024 with an operating margin of 15% on an operating profit target of $750 million. This seems achievable, as it implies sales growth of 5.4% per year compared to the 2022 forecast and an increase in operating margin of less than 1% compared to current levels.

Toro Drive for Five

Toro Investor Presentation

Toro is expected to earn around $5.43 per share in 2024 if it hits that target, not counting the positive impacts from stock buybacks. The ROIC would return to around 25%, a typical level during the decade of the 2010s.

Toro Drive for the five-gain model

Author’s worksheet

Toro’s fair P/E in 2024 will still depend on interest rates. The unpredictability of interest rates makes it difficult to set a price target, but if Toro does not see an expansion in the P/E multiple, the stock price should still reach $107 in 2024. If the interest rates go down about 100 basis points and Toro’s P/E returns to 25, the stock would be worth $136.

Conclusion

Toro has positioned itself well in the current environment by expanding its professional segment through acquisitions over the past decade. While the Residential segment provided temporary support during the 2020-21 home trade, Professional is once again leading the business. Strong demand in this segment allows the company to raise prices and increase margins despite inflation.

The company is still on track to earn $4.25 a share despite a weaker Residential sales forecast. This values ​​the company at 19.7 times earnings, which is low compared to recent history but explainable given higher interest rates and lower returns on capital. Going forward, capital employed will improve as inflationary effects on working capital are mitigated. The Drive for Five initiative is expected to grow earnings by 12-13% per year over the next two years. Without the help of interest rates or the multiple expansion, the stock should also be able to generate returns at this level.

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