Toro Q1: Don’t Forget It’s A Seasonal Business

Mr. Market Overreacts To Earnings

The market frequently seems to overreact to earnings releases from The Toro Company (NYSE:TTC). When I covered earnings last quarter, the market seemed relieved that a big miss in 3Q was not repeated. The stock rallied hard despite 2024 guidance showing only modest sales and earnings growth. The biggest positive was a forecasted improvement to free cash flow delivery, getting back near 100% of net income thanks to better flowing supply chains and the expectation of working down high finished product inventories. The stock closed at $89.23 ahead of that earnings release but traded up 10% before my article was published. That made my upgrade to Buy look like a bad call, as it’s been downhill for the stock since then. Another overreaction to earnings was the biggest part of that drop, with a 7% decline after releasing 1Q 2024 results on March 7th. The stock is now trading below where it was before the 4Q results that produced the big spike.

What was so bad about 1Q results that invalidated the optimism from the prior quarter? Nothing at all. The company left 2024 guidance completely unchanged. Sales and EPS are both expected to be up a couple percent from 2023 actuals, and free cash flow is still planned to get back to normal at around 100% of net income.

The biggest negative from 1Q was that snow removal equipment sales were slow due to a warmer than normal winter. Additionally, sales of zero-turn mowers, to both landscapers and homeowners, were slower as the sales channels were working off inventory that built in 3Q last year. On the bright side, sales of walk-behind mowers and hand tools in the Residential segment have improved. The 60V battery-powered Flex Force product line has helped these results. Residential is starting to lead sales growth again in 2024, helped by introduction of products at Lowe’s (LOW). On the Professional side, golf courses and municipal groundskeeping markets are also showing demand for electric-powered equipment.

Also within Professional, the Underground and Specialty Construction market continues to be strong, driven by greater infrastructure investment, as I have been reporting for the last several quarters. The problem for Toro is that they are manufacturing for this market as fast as they can, even incurring some extra costs to shift additional capacity to this effort. They are starting to make a dent in the larger than normal backlog of orders here, but demand is still strong. Toro effectively addressed a couple of analyst concerns on the earnings call. Management stated there has not been any increase in order cancellations. They were also asked about a slowdown in the rental equipment market but responded that demand was still strong there, with rental suppliers replacing their aging equipment. This agrees with the American Rental Association, who revised up their growth forecast for 2024 after initial more modest expectations.

Overall, there was nothing about 1Q results or the outlook for 2024 that I would describe as a negative surprise. It’s true EPS came in $0.02 below consensus, but the in-line guidance for the full year, including restating plans for 100% free cash flow conversion, makes the market reaction seem overdone. The stock is still a Buy, and now it’s cheaper than it was before it gave similar guidance one quarter ago. It may be that even though the company’s seasonality of results is well understood, the market still gets spooked by the down swings, especially since the pattern was disrupted somewhat during the 2020-2023 period. Now that the cycle is settling into more normal seasonality, let’s review the typical pattern.

Typical Seasonality

Toro’s fiscal year runs from November to October. As we see on the chart below, there is a clear seasonal pattern of income and cash flows each year. This was even more pronounced before 2010 when the company had less exposure to the snow removal and construction equipment markets. Operating income is typically lowest in 4Q (Aug./Sep./Oct.) as the landscaping season is winding down, and snow season has not started yet. It picks up a little in 1Q with sales of snow removal equipment but starts to take off in 2Q and peaks in 3Q with sales of landscaping and irrigation equipment.

Note that cash flow is about one quarter behind sales and income. 1Q has the lowest operating cash flow (usually negative) as the company is buying raw materials and manufacturing products for the landscaping season. Cash flow peaks in 3Q, but is still decent in 4Q as the company collects its receivables from the past selling season.

This steady seasonal pattern was disrupted somewhat during the pandemic and post-pandemic years. In 2020, the company saw record cash flow in the summer as production slowed at the start of the pandemic, but demand started to increase from people staying at home. In 2021, production had improved, but the stay-at-home demand was even stronger. About this time, supply chain issues started to hit, resulting in higher work-in-process inventories impacting cash flow in 2022 and 2023. (1Q 2024, not shown on the chart, was similarly negative.) Finally, after a record operating income result in 2Q 2023, 3Q was down an unusual amount, resulting in the inventory build of zero-turn mowers still being worked off.

Looking forward, management was optimistic on the earnings call about selling down the excess mower inventory in the spring. Work-in-process inventory is also coming down with better supply chain performance. Cash flow will improve, leading to the forecasted 100% FCF conversion this year, a big improvement from the last two years. 2Q will have a challenging comp on operating income vs. record results last year, but the second half of the year will be up against easy comps from 2023, producing the modest growth forecast for the full year.

Valuation

I don’t have to show the updated earnings model, because it is the same as last quarter. I am forecasting $4.37/share in 2024, just above the high end of management guidance, as I am assuming more buybacks in the second half. Trading around $88.50 after the earnings release, Toro is valued at 20.25 times FY 2024 earnings. This is not expensive relative to history.

I am leaving my price target at $105, which is 24 times this year’s earnings forecast, a multiple that is closer to the 10-year average. That leaves 18.6% upside to fair value, an improvement from the last article, where there was just 7% upside.

Capital Management

Toro’s free cash flow looks low in 1Q at -$111.3 million for the seasonal reasons I outlined above. For the full year, Toro is predicting capex to equal depreciation, each at $125 million. With the improvement in working capital performance, free cash flow will be about equal to net income, which would be $450.8 million for the year. The company has no debt due this year and will be paying dividends of $148.5 million. That is $0.36/share quarterly, for a yield of 1.6%.

In the absence of any M&A, Toro will have $302.4 million available for buybacks in 2024. No buybacks were done in 1Q due to the seasonal negative cash flow, so they will be weighted heavily toward the second half. At the lower price than last quarter of $88.50/share, I now estimate Toro will be able to buy back 3.4 million shares, or 3.26% of current market cap.

Conclusion

Not much changed this quarter with Toro’s outlook, but the market just reversed all the gains that were made in the stock following the initial release of 2024 guidance in December. This appears to be overreaction to normal seasonality in the company’s earnings and cash flow. At 20.25 times my estimate of this year’s earnings, Toro is valued on the low end of its past 10-year historical valuation. The stock is now 18.6% below my price target, which is based on a P/E of 24, more in the middle of the historical range.

Toro will benefit from improved demand for battery powered mowers and landscaping tools, as well as strong demand in golf and underground and specialty construction markets. With an improved supply chain and the opportunity to sell down excess inventory, free cash flow should get back to normal levels around net income. While 2Q may have some tough comparisons to last year, the second half of 2024 should return to normal seasonal patterns, creating a better chance for an upside surprise.