Scotiabank equity research analysts Michael Doumet and Jonathan Goldman compare the pace of recovery between Caterpillar dealers Finning and Toromont.
We recently hosted industrial stocks Finning International Inc. (TSX—FTT) and Toromont Industries Ltd. (TSX—TIH) at our Transportation & Industrial Conference. Following the sharp downturn, activity levels have taken a big step forward towards getting back to ‘normal’.
Between the two dealers, the pace of the recovery has differed, as production in the oilsands has lagged and pandemic-disruptions peaked in Chile in the third quarter. The more diversified, resilient economies of central and eastern Canada have provided the better backdrop.
Toromont’s tactical cost management and pace of recovery suggest earnings growth (from prior-peak levels) is not many quarters away.
While the two companies are both Caterpillar Inc. (NYSE—CAT) dealers, the two are viewed very differently in the eyes of the market: One is ‘growth’, the other is ‘value’; one is ‘defensive’, the other ‘cyclical’; etc. In terms of opportunities, we see more upside risk to Finning’s earnings (versus consensus).
Meanwhile, Toromont’s earnings appear to be pacing well versus consensus; we think capital deployment could drive a sizable catalyst.
Could Finning’s 2021 EPS exceed 2019?
At the conference, we hosted Finning International’s president and CEO, Scott Thomson, and the president of Finning South America, Juan Pablo Amar. Based on the commentary, we believe 2021 EPS could exceed that of 2019 (not yet reflected in consensus).
Further, driving earnings growth beyond 2019 levels (i.e. breaking out of the ‘cyclical earnings range’) could drive a positive re-rate in the shares, in our view. While there are several macro risks to consider (as usual), we came away increasingly confident in the company’s earnings power, particularly in what can be achieved in 2021.
The third quarter was a big positive surprise. In our view, what made the quarter ‘great’ rather than just ‘good’ was the slope of the margin recovery, which we think puts the company (firmly) on pace to approach or exceed 2019 EPS in 2021. Structural margin enhancements in Canada and a favourable revenue-to-cost outlook in South America put the EPS of $2 a share (back) on the radar screen.
Further, the company’s target (mid-cycle) sales, general and administrative cost (SG&A) rate of 17 per cent supports potential EPS of $2.50, in the outer years.
Finning reported adjusted earnings before interest and taxes (EBIT) and EPS of $101 million and $0.37, respectively, compared with the consensus forecasts of $77 million and $0.25. The company received $37 million from the Canada Emergency Wage Subsidy (CEWS), which was excluded from the adjusted EBIT and EPS figures.
On a consolidated basis, net revenue grew eight per cent quarter-over-quarter, driven by a recovery in the UK & Ireland (with regional trends mirroring COVID-19 developments). Improved execution and a lower cost base across all regions drove improved profitability in a recovery. Lower finance costs (down 16 per cent year-over-year) also contributed to the EPS beat.
Earnings outlook for Chile and UK is strong
Following a challenged 2019, the profit potential in Chile appears to have inflected. Product support growth and Quebrada Blanca Phase 2 or QB2 (deliveries started in the fourth quarter) underpin our favourable view of South America; we expect the region to provide the largest earnings tailwinds in 2021. Teck Resources Ltd. (TSX—TECK.B; NYSE—TECK) awarded a contract to Finning in September 2019 to deliver new equipment and provide product support at QB2, an open-pit copper mining project in northern Chile.
The UK has recovered relatively quickly in the third quarter. High Speed 2, a planned high speed railway linking London with other major UK cities such as Manchester and Birmingham known as HS2 for short, supports continued growth in 2021-22.
Canada is the more complex piece of the equation. The cost reductions were larger (and more structural), but the revenue recovery is tempered. Oilsands mining has improved through the third quarter (which bodes well for the fourth-quarter sequential comparables), but growth thereafter appears more reliant on construction (primarily product support).
Our bullish call on the pace of the overall earnings recovery is based on the view that sales, general and administrative costs can be held relatively constant through the recovery, driving larger operating leverage than assumed by the Street.
Cash flow, profits growing
Cash conversion has been robust as inventory turns were maintained through the downturn (excess parts inventory in South America was sold down). Finning generated about $2.5 billion in free cash flow (FCF) since 2013 and FCF conversion is expected to be around 50 per cent through the cycle. Finning trades at a 10 times price-to-earnings (P/E) discount to Toromont (versus the historical average of three times).
We’re early in the recovery, but Finning is moving fast. In a single quarter, Finning generated the same profit growth that took seven quarters in the last cycle (i.e. from the first three months of 2016 to the last three months of 2017).
In addition, management appeared incrementally bullish on the margin opportunity beyond the third quarter in Canada and South America.
With China leading the global recovery and the copper price holding firm, South America, we believe, will demonstrate the sharpest earnings recovery.
Management expects to convert nearly 100 per cent of EBITDA into FCF in 2020—meaning 2020 will be a record FCF year for the company (at about $3.90 a share). Given its strong capital position (its net debt-to-EBITDA ratio sits at 2.1 times at present), we believe the company may initiate a share buyback.
Toromont Industries earnings recovering
From industrial stock Toromont Industries, we hosted Michael McMillan, executive vice-president and CFO, at our conference fireside chat. We came away increasingly confident in the earnings recovery based on market (and cost) trends.
Through the recovery, product support has lagged activity (as customers were focused on the ‘job’). Given the gradual improvement through the third quarter, we believe a positive comparable in product support can be achieved in the near-term.
We believe rental is poised for a steeper sequential recovery in the fourth quarter as activity improved progressively through the third (from a lower starting point, no less).
Tightly managed costs drove the bulk of the third-quarter beat. Following pandemic lockdowns, economic activity in Toromont’s territories recovered reasonably quickly, at least compared to other geographies.
While management maintained their cautious tone, as is often their style, we expect cost controls and continued business improvements to accelerate earnings recovery. In fact, we expect the company to reach pre-COVID EPS in the fourth quarter, ahead of a full revenue recovery.
Sales, EBIT and EPS beat estimates
Toromont reported third-quarter sales of $922 million, EBIT of $113 million, and EPS of $0.94, comparing well, respectively, to the consensus forecasts of $902 million, $96 million, and $0.83. Excluding CEWS, EBIT came in at $106 million versus consensus of $96 million, reflecting a 10 per cent beat. EBIT decreased seven per cent compared with last year, faring better than peers, reflecting solid cost execution and healthier end-markets.
Equipment group product support and rental declined three per cent and 11 per cent respectively, reflecting a significant step up from the declines of 16 per cent and 31 per cent in the second quarter, suggesting favourable run-rates exiting the third quarter.
Meanwhile, management continues to phase in costs as volumes recover, maintaining a solid margin profile. The recently implemented ERP (enterprise resource planning) system should also help to drive improved execution.
On a regional basis, Quebec shut down sooner and reopened more gradually, whereas Ontario did so later and reopened sooner (and more broadly), suggesting a steeper fourth-quarter ramp-up in quality management.
Integration efforts continue
As it relates to the continued integration efforts, management highlighted margin expansion opportunities in rental (i.e. halfway through its upload/disposition model) and product support.
The company’s ERP rollout in Quebec is complete (following the Maritimes in April) and management spoke of the benefits of leveraging a common platform to drive efficiencies, enabling the company to better assess inventory levels, optimize working capital, and manage risks and exposures.
As it relates to capital deployment, management commented that its primary focus is integration and organic initiatives, but that its goal has always been to have financial capacity to support opportunistic acquisitions.
Since June, Toromont’s P/E multiple expanded five times. The multiple expansion is similar to that seen leading to the Hewitt acquisition. We view mergers and acquisitions as a positive catalyst, given management’s highly effective capital stewardship.
As of the third quarter, the company had more than $700 million of cash and credit availability on hand; net debt-to-EBITDA stood at 0.4 times.
Given the state of the balance sheet, and factoring in working capital requirements in an upturn, we believe the company could comfortably deploy in excess of $1 billion for mergers and acquisitions.
Michael Doumet and Jonathan Goldman are members of Scotiabank’s equity research team and cover industrial stocks. They are based in Montreal.
This is an edited version of an article that was originally published for subscribers in the December 4, 2020, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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