Still All About The Pro
The Toro Company (NYSE:TTC) reported fiscal 4Q 2022 and full year results. For the year, sales were up 9% to $4.5 billion and EPS came in at $4.20, about 1% shy of my prediction last quarter. While Residential was a strong grower during the “stay-at-home” years of 2020-21, the Professional segment has been dominant since then. Professional made up 80% of total company sales in 4Q, pulling the full year average to 76%. In terms of pre-tax profits, Professional is now above 100% of the company total. Profit from Residential plus Other is not enough to offset interest expense. Note also that in terms of year-on-year growth, Professional was the only growth driver for the company while Residential was flat.
Looking forward, the environment still favors Professional. Supply chain issues are improving but backlog continues to grow, indicating demand shows no signs of slowing. Underground and Specialty is one key driver, where Toro increased its exposure through the 2019 purchase of Charles Machine Works. The infrastructure bill passed by the US Congress in 2021 created strong multiyear demand in this area, supporting underground construction uses like water piping and broadband fiber. Golf continues to be a strong end market as many who took up the sport as an escape from social distancing continue to play. The number of players in the US is expected to exceed 40 million in 2022 after approaching that level last year. This has left course finances in great shape, enabling them to spend on irrigation, mowers, and other equipment. The snow season is off to a strong start with a historically high snowfall in areas like Western New York in November and another coming through the Midwest and Northeast ahead of Christmas.
Given this environment, Toro expects 7%-10% sales growth in 2023. All of this growth will come from Professional, with Residential expected to be flat. The company also expects to improve operating margin beyond the 12.8% achieved in 2022. Toro will have higher interest expense due to the added debt for 2022’s acquisition of Intimidator Group and a higher tax rate of 21%, up from 19.8% in 2022. The net result of these changes is a company EPS forecast of $4.70 to $4.90 for 2023. Unlike many previous forecasts, there appears to be little room for error in this first pass at 2023, as I will show below. This being the case, along with the run-up in share price in the last 3 months, makes Toro stock a Hold at current prices around $111.
Earnings Model Updates
To hit the low end of Toro’s 2023 EPS estimate given the higher interest and tax expense requires optimistic sales and operating profit forecasts. For example, with forecasted sales growth of 9% (in the top half of the 7%-10% range), operating margin needs to come in at 13.4%, which is a good size bump from 2022’s 12.8%.
While this is optimistic, it is achievable with supply chain improvements and merger synergies following the Intimidator Group purchase. It is also in line with margins seen in the 2016-2018 period.
Capital Management
Free cash flow was unusually low for Toro in 2022 as cash was consumed to build work in process inventory to keep production running amid supply chain issues. Free Cash Flow Conversion, or FCF/Net Income was only 34.7% in 2022. For 2023, the company expects FCF conversion to return to the 100% level. Capex will still exceed depreciation by about $30 million, but working capital draw down will provide about that level of cash, making FCF equal net income.
Starting from $488 million of FCF for 2023, Toro will use about $124 million on the dividend of $0.30/share per quarter (1.1% yield). The company has typically paid off some debt after big acquisitions, and I think they could pay off $150 million, or half of the $300 incremental debt added in 2022. This leaves about $214 million for buybacks, assuming there are no big acquisitions in 2023.
Debt to trailing EBITDA ratio has decreased to 1.4 times, which is within the company’s target range of 1-2 times. Interest coverage, which is operating income divided by interest expense, has decreased, but remains comfortable at 13 times in fiscal 4Q.
Valuation
At $4.71, Toro has a forward P/E of 23.4. Since last quarter, the run up in the share price has taken the forward P/E back to the middle of its recent range compared to the low end seen in September.
This run up in P/E has occurred even though interest rates continue to increase, which should depress stock prices, other things being equal.
Looking out further, I have updated my estimate of Toro’s “Drive for Five” initiative for 2024. Given inflationary pressures and Toro’s ability to pass along price, I now think the company will exceed the $5 billion sales goal and deliver more like $5.4 billion. I have left operating income at $750 million, however. This implies margins do not increase as much as I assumed last quarter, but still continue to improve from current levels.
If Toro sees no P/E multiple expansion, the share price would reach $130 in 2024. I believe the current valuation already reflects optimism about interest rates decreasing in the near future, so I am not comfortable assuming any multiple expansion from these levels. With an expected return around 8.2% annualized, the stock would perform in line with the market, which makes it a Hold.
Conclusion
Toro has executed well, managing through supply chain constraints and growing both top and bottom lines in 2022. The company is poised to do the same in 2023, although the initial guidance does not leave much room for error. This makes either a deep recession or continued high inflation a risk to the forecast.
Despite these risks, the share price and P/E have increased considerably in the past three months. At 23.4 times earnings, the stock is no longer cheap, especially considering the increase in interest rates. From current levels around $111, my end-2024 valuation of $130 would provide returns in-line with the general market. This moves TTC back into the Hold category.
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