September 2016: The Good, The Bad, The Average, and Unique*

So here’s where we really need to step up the hope that I’m a more gifted stock picker than meteorologist, or at least less motivated by wishful thinking. I wrote back at the beginning of August in a letter I was fortunate enough not to publish here (because there was no here here, yet) that I looked forward to the second half of that month, when the evenings grow cool, and breezes make their way increasingly into the daytime at both ends, despite the Mad Dogs and Englishmen aspect of the midday sun. Well, it’s fortunate that you didn’t read that [oops—Ed.] because at least here in the arid climes of the lower southwest (of Connecticut) we continued to stretch on the sun-baked drying rack for another six weeks, bizarro groundhog if you will, and you will, because we did.

In other words, August was toasty, so was September, all of which 1) you already know and 2) kept me in the office a lot, though I only wrote up one new idea, which will be discussed in some detail below. A couple more are likely to be following in October, but they—and we—will all just have to wait.

*Headline Note. Under the general heading of “keeping this interesting for myself,” we’ll be titling these missives after a snippet of a more-obscure-than-it-should-be pop music lyric. No prizes other than a disproportionate dollop of personal satisfaction for learning something new, or knowing something old, will be awarded for figuring it out. Or if you don’t care to figure it out, the song will be posted somewhere on this site. Or if you don’t care at all, you don’t have to listen to it. Heck, you don’t even have to read this. Isn’t there something on the teevee?

It Must Have Been The Heat

Because, well, what’s not just plain kind of weird right now? OK, except half the Mets being on the DL and the other half forgetting that it’s even better to get hits when there are guys on base (which is perfectly normal, of course, Dammit.), but STILL getting to the wild card, only to have Terry Collins think he owed the Giants a handicap for going out of their way to make the trip to New York. That’s perfectly normal. Dammit.) A summer in frosty New England so hot that you could fry an egg just by thinking about the word “egg,” the UK implementing an unexpected decision to leave the EU by, well, not really leaving the EU, a presidential election campaign in which the Democratic candidate’s net negative favorability is so high you’d expect a McGovern-like result except that the Republican’s dwarfs it, an electorate driven by inchoate anger on all sides motivated by an absolute, indeed ontological conviction that we are now in a manifestly post-factual world.

What is an analytically-inclined guy (or gal, or dog) to do? Well, for want of any better idea, because there probably isn’t one, this: more or less what one has always done. Take a step or twelve back, get a panoramic view, take a deep breath (or twelve), and figure out how things would make sense if things made sense, because if they’re never going to make sense again we’ve all got much bigger problems. screen-shot-2016-10-12-at-10-26-39-amDo look up Enneagram Type Five at this point, you’ll find me there—and I’ve come far enough along from my “all information is on a need to know basis” default that I’m prepared to tell you which type I am. (And write a letter mentioning it. And when you realize that 25 years ago someone I dated used to call me “Secret Squirrel,” you’ll get it. But then again, what did she know—I prefer to consider myself discreet.) In any event, likely a good type for doing this kind of work, assuming one’s head’s on straight, and you should probably come to your own conclusions regarding that part, because if it’s not, I’m going to be the last to know. So, to quote that great poet Warner Wolf, let’s go to the videotape.

Shameless Plug Dept.

My wife Becky is, among her other manifold and great talents, gifts, and responsibilities (no, seriously, and not just because saying it is mandatory), the program director of a speaker series. On September 24, the series hosted Bryan Stevenson, founder of the Equal Justice Initiative and author of the best-selling book Just Mercy, and who Archbishop Desmond Tutu has called “America’s Nelson Mandela.”

Nearly 500 people packed in to Christ Church in Greenwich to hear Stevenson talk, and I don’t think I’ve ever seen a group of people so riveted by what someone had to say; I didn’t see or hear a single person cough, talk, play with their smartphone, or so much as shift volubly in their seats over the course of the entire hour-long talk. Including, remarkably, myself. Stevenson, in my paraphrase, framed the debate in a manner accessible to everyone, regardless of partisan affiliation, making it clear that reversing inequality in the justice system was not an issue of right and left, but of right and wrong. It was a deeply powerful and enjoyable evening. Sorry if you weren’t there!

Last Month’s News Today

September was a typically quiet month in terms of news flow, though a couple names that have been on my list were particularly of note, mostly positively, I’m mostly relieved to note.

Imvescor Restaurant Group (IRG.TO-$C3.19), an asset-light franchisor (only owning four stores) of four chains—three casual dining (Scores, Trattoria di Mike’s and Pizza Delight) and one white tablecloth, Baton Rouge–in Eastern Canada, reported a solid quarter at the beginning of the month. IRG has been a turnaround for a couple years, and the combination of a relatively new CEO, refocused and streamlined menus and particularly a store remodel program in which the company provides some financial assistance to franchises for renovation have helped drive a return to positive same-store sales growth. The July quarter was in its way particularly promising in that, while same-restaurant growth was only 1.2%, the company managed to acieve that number while losing 3% of its sales weeks to restaurants closed for remodeling. IRG’s geographic concentration in Quebec and Atlantic Canada is another significant selling point, as Quebec is an especially difficult market to crack, and the company’s presence in the provinces further east is large and should provide a solid base for future growth. Management has stated its desire to grow by acquisition, using its balance sheet and operational expertise to acquire another smaller operation, presumably a franchisor as well, though an activist investor has demanded that the company look to put itself up for sale. Despite being up approximately 40% since I first recommended purchase back in January, I believe the prospects for the turnaround merit continued accumulation of the shares.

Polaris Infrastructure (PIF.TO-$C17.37), a provider of geothermal energy in Nicaragua, had another strong month in September, up 20% following a 68% increase in August, on the heels of extremely positive drilling news at the end of that month. On Aug 25, Polaris announced that well 9-4, which the company had thought was going to generate “at least 5mW” is not only now tied in but producing 10mW, and the company was already at 63mW total generation, ahead of our full year estimate. The stock has moved up sharply on the news, but the increased generation suggests that the shares would be fairly valued in at least the mid-$20s and possibly as much as $30, compared with my original valuation target of $17, assuming complete execution of its plans. Looking beyond the existing San Jacinto field, Further plans include exploration of another site within Nicaragua, for which there is a strong possibility that the company would be putting only $5-10 million of the $45 million initial exploration and buildout cost, and possible acquisitions or joint ventures with similar companies in other countries in the region, most likely starting in Costa Rica.

The kicker to this story has always been the opportunity for incremental energy generation under its existing contract with the Nicaraguan government through expansion drilling. Investors had been waiting for word on the new well projects; I had assumed that two of the three would ultimately be successful adding roughly 8mW of power, with each mW being worth approximately $1 million to EBITDA; it appears that my estimate could be exceeded handily by the results announced at the end of August, though steady-state production from 9-4 could easily be lower than the initial 8-10Mw. The next step, in 2017, would likely be the addition of a binary unit to convert heat from pumped water into power; this could add another 8-10mW by the end of 2018. At present, PIF pays a dividend of US$0.10 quarterly, or $0.40 annually, equating to $0.53 Canadian, at a 50% payout ratio after contributions to a sinking fund (making the payout ratio closer to a very conservative 35% today and below 30% factoring in the additional production if that contribution is added back).

Each additional mW at the current payout ratio would add $0.03 to dividends, which could bring the total up to $0.80 by the end of next year, and $1.00 or higher the year after, assuming completion of the binary unit. The shares are selling at approximately 8x current-year EBITDA, compared with a peer group average of approximately 12x. While haircuts off the group multiple are understandable for 1) the poor understanding of Nicaragua and 2) the company’s former troubled status, I would hope that in addition to increased payouts the Street might revisit both those issues as the company continues to generate both incremental geothermal and earnings power.

LSB Industries (LXU-$6.56), a troubled producer of ammonia and , I appear to have recommended just a shade too early for my own good. While the company’s turnaround, particularly of its El Dorado, Arkansas facility, continues to proceed, unplanned downtime at all three of its large plants will have a significantly negative impact on second-half earnings. The stock, which had begun to climb out of the hole former management had dug for it through underinvestment and disastrous cost overruns at El Dorado, has responded disproportionately to the news. My fear is that the street’s honeymoon with the new management has come to an abrupt halt, as two announcements of unexpected shutdowns were dropped on an unsuspecting investor base in the space of about a month. Additionally, both came a non-trivial length of time after the actual events occurred, while the stocks themselves moved down in advance of public disclosure. If folk are miffed, it’s not desperately hard to see how and why. I’m sticking with LSB for the meanwhile despite the red flags because I do believe in management, even if they’re behind the eight-ball both from investors and operationally because the shutdowns appear to be directly related to prior underinvestment ,implying there could be more to come, even if all three plants are now back at or above nameplate capacity. However, at $6.75 the value would be extraordinary if the turnaround really is just having a few hiccups, and in a consolidating industry LSB is probably too small to be a standalone entity for the long haul, but the stock’s on the shortest of leashes.

What’s New? Tractor Tires, That’s What’s New!

On September 6 before the open, I recommended purchase of Titan International (TWI-$10.37), a leading manufacturer of wheels and tires for agriculture, construction, and mining, at $9.24. Titan had been in a downturn both of its own making and driven by a huge decline in agricultural profitability. Looking for the potential of a return to at least stabilization, if not a significant increase, in farmer income, Titan looks like an opportunity to generate strong returns both from internal and macro factors.

And some pretend Q&A. Well, pretend Q, actual A.

What Does Titan Make And Who Do They Sell To? Titan is a worldwide leader in manufacturing and distribution of tires, wheels, assemblies and undercarriage products, with revenue estimated to come in just under $1.3 billion in 2016, down from the cyclical peak of $2.1 billion two years earlier. Titan’s customers, under the Titan, Goodyear, and Italworks brands, are a Who’s Who of global heavy equipment manufacturers, including John Deere, Caterpillar, Hitachi, Komatsu, Kubota, Terex, Volvo, ThyssenKurpp, and many more. Additionally, there is a significant aftermarket business to farmers for replacement wheels and tires. The company also has significant businesses in construction and earthmoving/mining, and a consumer tire and wheel business. I focus on the opportunity in agriculture because even if those other two areas remain flat, an ag recovery alone could drive the earnings to over $2 per share, and potentially higher.

Isn’t Agriculture A Mess Now? The three-years’ long decline in farmer income appears likely to flatten, if not improve in the near-to-medium term. A month or two ago, it appeared that the corn crop this year might be affected by hot, dry weather; across the grain belt, the heat broke and it rained sufficiently for a large crop, driving corn prices down from a speculative spike of $4.45 to a seven-year low at $3.19. Pricing has firmed recently, and the current CME strip shows $3.45 for the 2016-17 growing year. Even at this depressed level, the size of the harvest would imply greater farm revenue in 16-7 compared with 15-16., close to $53 billion, up from the $49 billion in 15-16. I believe that investors are not taking this potential increase in farm revenue into account when looking at depressed ag-related stocks. There appears to have been a massive amount of deferred purchasing for items like tires, and indeed the equipment itself, which leads me to believe that there should be significant pent-up demand for necessary products such as the tires and wheels Titan produces.

What’s Going On With Management? Isn’t The CEO A Little, Well, You Know? Well, there is that. The company is still led by Maurice (Morry) Taylor, the 72-year-old founder of the company as we know it today. Taylor is beloved by farmers but viewed by the Street as something of a loose cannon and promotional voice. The entrance on to the scene (and the company’s board) of an activist investor, Mark Rachesky, whose firm MHR has a 15% position, has hastened a management transition at Titan. Paul Reitz, who had been CFO since 2010, was appointed President in 2014, shortly after Rachesky announced his firm’s position in the shares. It is clear that Reitz has been groomed to be the next CEO, and the company appears to have become more professionally managed over the last two years, as TWI has posted significant margin gains even in a declining sales environment. The issue of a full-time replacement CFO continues to hang over TWI, and I would hope that the search will be completed in the near term. I would not be surprised to see Taylor, who is invaluable to Titan in the role of evangelist to the farming community for the low sidewall tire business, perhaps step aside for Reitz, while retaining the chairman title. People who know him well suggest that he may want to remain CEO until the turnaround is clearly in place.

All Well and Good, But Is There A Big Kicker Aside From The Macro Concept? The huge opportunity as I see it is in the Low Side Wall (LSW) tire business. There are huge advantages to the farmer in adopting LSW tires: lower soil compaction as the tire tread (and hence the weight load) is spread more evenly over a broader area, better fuel consumption compared with equipment running on tracks, and significantly reduced power hopa bouncing effect a tractor sometimes experiences when pulling a load—and road lope, the bouncing and swaying of a tractor or combine during road transport. Reducing power hop leads directly to more even compaction, while eliminating road lope allows for faster road speeds which let the user spend less time on the roads and more in the fields. I have also heard that LSW can ultimately also allow farmers to get into the fields 2-3 weeks earlier, leading to a longer growing season.

However, the LSW tires also require new wheels, and Titan is the only manufacturer both of the tires (sold under the Goodyear brand) and the wheels themselves. This is both good and bad. The positive is obvious: if a farmer wants to make the move to LSW, he’s going to Titan. On the down side, there may have been some OEM reluctance to offer a product for which there’s only one supplier. Cost is also an issue: a set of LSW tires and wheels (necessary for the first-time buyer) can run in the $25,000 range, several times the cost of a set of tires, though still only about a third of the cost of a track set-up. It is much more likely that uptake will come first from big farmers, and when equipment with LSW reaches the used market, the technology will trickle down to smaller farmers as well.

Latin America is also an LSW opportunity for the company. TWI’s consumer business (approximately 12% of sales) is mostly Latin America-focused, largely tires for pick-up trucks and ATVs under the Titan and Goodyear brands, and will probably chug along but not be terribly exciting. It’s another LSW adoption story, principally in Brazil, which is dominated by megafarms that are somewhat behind the curve technologically. One analyst I spoke to that attended Farm Progress said there was significant interest from several large Brazilian farms for LSW tires, and one owner talked about placing an order for several hundred tractors equipped with the technology.

And what about this Goodyear deal in Europe? Goodyear had actually pretty much exited the European ag market, which had been a roughly $250 million annual business for the company. Titan’s agreement to manufacture and sell Goodyear-branded tires, which it will produce in Russia and possibly other low-cost (presumably eastern) European countries, adds a geographic kicker to the story. Strategically, I would imagine that the OEMs, particularly Case and Deere, which made up $100 million of the $250M, are happy to have a second supplier re-enter the geography, as after Goodyear’s exit, only Bridgestone was supplying those two companies on the continent. It will take many years to rebuild these revenues, but it should not be discounted as a long-term source of growth for Titan.

Could There Be A Big Iron Replacement Cycle? Big farmers have historically replaced their heavy farm equipment on a 3-5 year replacement cycle, typically not wanting to deal with repairs for out-of-warranty machinery. At the last peak, 2011-12, some were even replacing annually, leading to an increase of used inventory on the market. As corn prices in particular tumbled, equipment sales followed. We are now, however, at a point where the equipment bought during the last peak is approaching five years old—smaller farmers may rely on used tractors, but big farms buy new. I would not be surprised, even if corn remains in the mid-3s, to see a replacement cycle pick back up in 2017. This would be a positive for the core ag business, but may spill over to LSW as well.

Isn’t there kind of a lot of debt for a company this size? Well, heck, I never said it was perfect. But it’s actually better than it looks. Of the $507 million in debt as of June 30, the only impending maturity is roughly $60 million outstanding on a convert in January 2017; the rest is all 2020. That convert has a strike price of $10.75; it’s not entirely out of the question that it could be in the money in five months. Additionally, TWI is sitting on $200 million in cash, and has some non-core business lines that could be sold. The Italworks tracks business is already in a sale process, TWI having hired Goldman Sachs to manage the sale after the company received what it characterized as a “nine-figure offer” for the division. Even if that is just $100 million, net debt would be reduced to a much easier-to-manage $200 million.

IS it just $100 million? No. Italworks had a bidder at the end of 2015, which triggered the sale process, which has apparently generated significant interest. There’s a bidding process going on for ITW, and the company appears to have narrowed the process down to three potential buyers. While all that has been announced was that the original bid was “nine figures,” people I’ve spoken with seem to think that $125-150 million would not be unreasonable. Additionally, the TTRC tire recycling business is likely for sale, as is a plant the company owns in Brownsville, Texas, which would likely bring in at least as much again or perhaps significantly more.

They Do Tons of Stuff Other Than Ag, Right? Yeah, but to be brutally honest, I don’t much care right now. Ag’s actually only about half of the company’s business, but nearly all of the most exciting upside. The mining business chugs along, but if there’s no recovery in coal, that’s not going to get appreciably better, and there’s no recovery in coal. The construction business may actually have some legs to it, but I’m going to hold that back for another time, because 1) you don’t need it if farmers start buying tires, and 2) if farmers don’t start buying tires, a pickup in construction tires won’t much matter.

Looking at the company sales going back a few years, at the peak in 2012 agricultural was nearly 60% of TWI’s total sales, which has dropped below 50%, showing that the decline in ag sales more than outstrips the company’s overall decline. Consensus estimates are for a return to sales growth starting in 2017, with agricultural sales being the most significant driver of that growth. A return of farmer income could quite easily move that back to historic levels, though it is worth noting that the LSW opportunity also exists in the mining and construction segments.

Sounds Perfect. Is It? Oh gosh, of course not. There are typical issues of turnaround risk—the company’s improvement in margins is dependent in a declining market on superior execution. While TWI got to my front burner through its ability to improve the quality of its operations even as sales remained soft, there’s no guarantee that this improvement will persist. Although it’s never been much more than a three year thing historically, it’s certainly not impossible that the markets for corn and soybeans could have unprecedentedly long downturns, which could further extend the sales cycle for equipment and replacement tires, particularly holding back the transition to the more expensive LSW product. Finally, it’s also possible that we could see increases in imported corn, though at current prices the economics of shipping would argue against, and we’re keeping an eye on China’s policy towards subsidizing their own corn farmers—if the country genuinely stops stockpiling corn at elevated prices, as it did for soybeans a decade and a half ago, farmers could well change to more profitable crops, reducing rather than increasing imports into the US.

Note: All share prices as of close of day 11 Oct 2016. Recommendations are mine and mine alone, and I may own, trade around, or close out positions in any of them. But if I don’t like something any more, I’ll tell you. Promise.


I've got a dog. Used to have a fish.

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