Titan Machinery: Doesn't Anybody Look at Valuation?

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 2^nd 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.

Disclosure: Short

Comments

[A29]

As an investor you must feel very good today as you had disclosed that you were heavily short TITN and the stock certainly has taken a major hit.

I prefer to look at TITN from a PC to earnings growth point of view in seeing if it is fairly valued. To try and not be too wordy I will try and keep my remarks to a minimum.

Last qtr E/sh was .25. I would assume contribution from the Midland acquisition was not much in this number as acquisition did not close until May. Assuming a continuation of the same level I can certainly have faith that a yearly E/sh of $1.00 is very achievable (in line with guidance that the company has provided). In last company web cast I believe it was said that there was further cash available in excess of $100M for further acquisitions. Assuming the 1 to 3 purchase to sales ratio, $100M would likely result in $300M of yearly sales for the company. This should then result in at least an additional $.50 earnings (yearly). Taking these factors together I believe 50% earnings growth could certainly be achieved over the next year or two. With earnings growth of that level, I certainly feel a PE of 30 is not unreasonable. Beyond that a further stock issuance could be needed but another 3M shares added to 16M would not dilute share value significantly (in addition don't forget that profit from existing operations will also provide cash input).

I have several farmer friends that live here in my area and via discuss with them believe that there are several small private equipment sales companys available with older owners that would like to sell their businesses. In addition, the Ag area is a good business sector to be in as farmers are making good money as they should and have more money then normal to buy new equipment. Farmers like to deal with people they feel they can trust and I believe TITN brings the correct experience and attitude to the party.

Obviously I am long on TITN and today has not been a good day (am holding on to what I have and plan to further add to my position).

[Pfloyd234]

Nice call.........For today at least!!!

[phoenixinthesun]

While not as bearish as you, thank you for a well written and factually-driven article. Your analysis was thoughtful and well- articulated. Best.

[maelstrom]

The North Wind was blowing HARD today.

[fatcat]

This was always a momentum play on ag.I looked at it 5 months ago and came to the same conclusion as the author(didn't look as deep as he did)...Titan will be a lot cheaper by fall

[jayson]

If I was short on a stock, I'd write a negative review myself. Why not? Who doesn't like money. How easy was that for you to do. Good job, it worked. Being short on a stock and then knocking it is just a little suspect. Duh!

[Glen Mead]

I think you have applied a Graham/Buffet style value study to an IPO is an hot sector. This sort of valuation method seems to me to be better suited to Dow index components, or at least companies that have been public for at least 10 years. This is a momentum stock. Your Benjamin Graham approach to valuation will be valid in a few years, but not now. Not with the furor over grain prices in both here and abroad.

Norman Vincent Peale made a good point in his book "The Power of Positive Thinking". He said, "attitudes are more important than facts". You method of calculating value for TITN, if applied to GOOG when it first IPOed would have kept everyone out of that stock as well. I seem to recall people doing very well with that one in the first year or two. Others stocks come to mind. HANS, TASR, ERS. Legitimate momentum stocks that would not have stood up to the valuation methods you employed that are better suited to mature, non-growth, dividend type stocks.

I was surprised at your open admission of your short position. I suspected as much, but for you to just blurt it out like that was nothing less than astonishing. With no other news to move the stock except your blog I suspect you are responsible for the tumble in price today. Nice going. I hope the SEC takes a close look at your actions.

I took advantage of the situation to add to my position. I don't question the numbers in your evalutation, but I think you completely missed the point of what kind of critter TITN is. You seem to be applying pig judging rules in a dog show. Did you deliberately try to trip up the share price? Not content to wait for your wisdom to prevail? Let me guess, you've already covered your short position.

[fxtrader07]

@Glen: there is no such thing as 'momentum investing'. People buying stocks based just on momentum are nothing but gamblers and 95% of them lose out long-term. That's a proven fact. graham-style analysis is crucial as it provides you with clues about whether or not you have a margin of safety when buying a stock. If ait is not there and momentum wanes, you could be in for a very nasty loss. if hot air is all that keeps a stock up and rising, than a crash is the most likely outcome when the weather gets cold
'attitudes more important than facts'? when it comes to stocks and investing? give me a break. good luck with that approach, but I think all the luck there is won't help you in the long run

[User 203140]

you can't look at valuation in this stock when trying to trade it, this sector is about trends and momentum, you have to be crazy to short this stock risk/reward is terrible....Titan can be at 40$/share by august......I have no position in this stock but if i had to take one, granted the market conditions I would be long.

[MaxTheDog]

So Glen, you'd prefer the author not disclose his short position? What is it with the knee-jerk reaction that if a short seller lays out his or her thesis on a stock they're somehow being manipulative? Do you apply the same reasoning to all those who hold long positions and present their ideas here? This is a well articulated and intriguing short thesis. You're free to agree or disagree, just like any other investor (though if you want to convince others of the merits of your position, I'd suggest coming up with something more compelling than "it's a momentum stock"). But to suggest that the author should be precluded from sharing this analysis, with full disclosure of the author's position, is nothing short (no pun intended) of absurd.

[23ANTCYSMx3x2]

@Glen: You highlighted a few momentum stocks where the Graham/Buffett framework would have prevented a value investor from entering. Depending on when a value investor looked at the stock, you’re right. I would argue that very few investors apply a strict Graham/Dodd framework – e.g. a classic net-net is effectively impossible to find – but instead try to buy/sell companies where there is a market price / intrinsic value mismatch – hence, the TITN short call above.

On to your examples of profitable momentum names - one of the basic tenets of value investing is a margin of safety. The stocks you mentioned as being profitable momentum stocks are listed below and have performed from peak to current as follows:

- HANS is down 57% since October 2007
- TASR down 87% since December 2004
- ERS is down 94% since May 2006 (traded down 61% in 8 trading days from its top tick)
- In fairness, the markets have been down too - SPX/Nasdaq/Russell all down 21% from peak (ex 2000 for Nasdaq - another ugly outcome of momentum investing)

With the benefit of hindsight, you're correct, all of these would have been fantastically profitable longs and shorts. Sadly, none of us have next year’s stock almanac so we depend heavily on a margin of safety to protect us from massive draw-downs when (not if) our analysis turns out to be incorrect.

Why are you surprised at the author’s “open admission of [his] short position”? It is perfectly legal/ethical to disclose that you have a short position – in fact it’s encouraged…I’d much rather know that someone is short than wonder if s/he is just creating a more attractive entry point ahead of a positive catalyst. Beyond that, the author presented a seemingly factual case with no sensational claims…the closest he got was pointing out that there could be corporate governance issues.

Finally, an ad hominem argument takes away from your point – attack the central theme, not the author of the article and use facts when you do so. It’s easy to get angry when someone takes the other side of a trade but it’s hard to listen and see if they’re right and you’re wrong. Fundamentals always prevail and momentum cuts both ways. Happy investing.

[Glen Mead]

HANS was a spectacular winner for more than a year. Shooting stars come down sometimes faster than they go up. There have been plenty of them. GROW comes to mind.

The idea of buying a stock and holding it to your grave seems to me to be counter productive. I mean, what's the point? When you have made a good profit on a stock and it looks like the main part of the move is over, why not step aside and look for better opportunities?

The few articles I read on Warren Buffet have pointed out that he buys and sells frequently. Sure, he has held on to some well known names, but he has bought and sold more than he bought and held. My point was that an IPO can have tremendous upward momentum in the first year in particular after they go public. Using a Graham/Dodd valuation method on IPOs is rediculous. There is too much volatility as investors and traders jockey for position in the new company.

Sorry if my tone was offensive. Taking a short position in a stock and then publishing a scathing criticism of it in a blog that will be picked up on the Yahoo! Finance web page for that stock seems a little self serving. Of course that is just my opinion.
Since there is no other news that I can discover on TITN that could have moved the share price I am presuming this is what did it.

Best Regards,

Glen

[floorboard]

Glenn, I have to agree with MaxTheDog. Analysis reveals facts both positive and negative. I am familiar with the stock as a top pick by Investors Business Daily and made money on it. I am glad to know the facts presented by this article. It this author had not told us who was. Nobody yet. He can present info. and tell us he is short as well as he is long. Maybe the stock went down because he revealed the weak under belly.

[SeenItBefore]

This was an extremely well written and comprehensive analysis of Titan Machinery (NASDAQ: TITN). After checking up on the facts presented it’s clear that the author has done his homework well. Luckily I was able to get a pretty decent short position today on the bounce… dead cat?.. we’ll see.

There are several things that make this look like a situation that was designed to make a few people (insiders) very wealthy (or wealthier) and leave the people investing long “holding the bag” in the end.

The insiders started selling at $20 a share. As was mentioned they have large positions and cannot get out of them easily but will likely keep selling to insure profiting from this “multiple arbitrage” play.

This was an IPO valued at $8.50 seven months ago. What makes it worth 3 times that much now 7 months later? Were all of the prior owners of these farm equipment dealerships stupid and therefore sold their businesses really cheap? Usually people in this type of business worked long and hard and know what their business is worth. 30 of Titan’s 40 stores were purchased relatively recently so it difficult to imagine that somehow they’re worth a lot more now.

There are a number of ways for the insiders to make money besides ongoing stock sales. 25 of the 40 stores are paying rent each month to the insiders. I wonder how often the rents have gone up lately? Then there is also the salaries and additional compensation to the principals and Board members. There is no doubt that there are also other ways that are not mentioned here.

A few years back some people I know invested in a hot IPO they thought had more "momentum" left in it. It was DriveTime, the used car dealership with stores in 9 states. A very small group of owners took it public and over a couple of years liquidated their positions. Then the company released a series of disappointing financial reports and the stock tanked. Big time. Then the insiders bought back all of the stock with money they had taken out of the market and still had PLENTY left over. Today DriveTime is privately held by the original principals and is doing relatively well. Their plan worked out perfectly.

I want to be clear on a few points. I am not saying the stock has no value and I am not saying that the insiders are lacking in integrity. I do not know them so I am not qualified to comment on their motives. What I am saying is that given what is known, and also taking into account what is unknown, the stock is seriously overpriced and the enormous exposure will likely lead to people investing "long" losing money when hype is over. It’s not if, it’s WHEN the hype is over. This is, after all, farm equipment. Possibly, 2nd tier farm equipment at that.

[Opps Didn'tget theOrder]

Njord what is your email?

[NjordWind]

You can reach me at NjordWind at Yahoo dot com. I welcome informed discourse on any of my picks, especially if you disagree with me.