Rocky Mountain Dealerships (RME)

Summary 

After reviewing my holding in Rocky Mountain Dealerships (RME) I continue to hold my position but am no longer accumulating shares. I am willing to swap-out the position if I find a better value opportunity, but I am not at this point liquidating shares to move to cash.

Background 
I originally purchased RME 2 ½ years ago and since then it has been a good (but not great) holding for me. However, after Titan Machinery’s (TITN) bloodbath recently, and after seeing a number of analysts upgrading RME in recent months (which frankly scares me), I thought now would be a good time to step back and review my thesis on the stock, its valuation, and what could go wrong.

Company History 
RME is an agricultural and construction equipment dealer. It primarily sells Case IH, Case Construction, and New Holland brands (as well as a number of “short” lines) through its 39 locations across Alberta, Saskatchewan and Manitoba.

Back in 2006, Matt Campbell (CEO) and Derek Stimson (President) merged their respective Hammer Equipment (primarily construction) and Hi-Way Service (primarily ag equipment) into one company and IPO’ed the firm in late 2007. Since then, the company has been on an acquisition spree, purchasing 15 independent dealerships since 2008. In 2012, sales broke down as (from 2012 annual report):

The strategy behind RME is beautifully simple. A larger dealer network can command better operating efficiencies and cost management than smaller, independent (“Mom & Pop”) dealerships. Management has noted that their target performance is a 15% (maybe up to 17%) gross margin with ~10% SG&A expense netting a 5% operating margin. This compares to small dealerships which typically have ~11% gross margins and an 8-9% SG&A overhead for a 2.5% operating margin. 

Now I’m usually very skeptical of economies of scale arguments, and this alone wouldn’t have gotten me to invest in RME. However, the economy of scale argument with a clear path to market share growth was more compelling. With its ability to dramatically improve margins, RME has been able to aggressively acquire its competitors, while still keeping acquisitions accretive to earnings.

Most importantly (in my mind), RME’s primary supplier (Case New Holland) supports a roll-up of small dealerships. Comments from equipment executives show that the big manufacturers (Case, Deere, Cat, etc.) want larger dealer networks for their own efficiency and operational reasons. When you have a better operational structure than the competition (higher margins), a deep pool for market share growth (acquisitions), and a franchisor (who effectively controls market share) in favor of a dealership roll-up, that’s a powerful business model.

All of this led to 2012 being a banner year for RME. Same-store sales were up 16.3% on the year. The company posted record EPS of $1.28, up 24% year-over-year. On top of this, there was a fair sized debt conversion expense in the year. If I try to adjust for this, I get “normalized” EPS of $1.45 (up 41% yoy).  Suffice to say, the ag economy on the Canadian prairies is booming ($8.00 wheat creates a nice cash flow). But are these types of EPS numbers sustainable?

Risks/Concerns 
The problem for RME is that acquisitions have fueled their growth, and those acquisitions are getting harder to come by. A quick search of the Case IH website reveals 27 ag dealerships listed in Alberta, and 18 of them belong to RME (67%). Saskatchewan may be an opportunity with 25 dealers listed and RME accounting for only 5 (20%), but there are other fairly entrenched dealerships in the province to compete with. Manitoba is similar to Albert, with 12 dealerships listed and RME accounting for 7 (58%). The company could jump south of the border into the U.S. for growth, but there is intense competition there from companies like TITN. There may also be room for RME to grow its New Holland presence, but that remains to be seen. 

Beyond growth, there is the always present worry that a downturn in the ag economy will hurt the company. We can argue about long-term ag environment and Malthusian trends, but that’s not the road I want to take today. What concerns me about a slowdown in ag spending is the following slide that RME management has often used regarding combine sales and the lifecycle of a combine: 

Combines are at the top end of the agricultural equipment food chain. New machines are running at or near $500,000 depending on options – in other words a major capital outlay. 

As the industry shifted away from leasing machines a few years ago (because that put the risk back on the equipment manufacturers [i.e. Deere, Case, Cat] balance sheet), dealers devised this ingenious lifecycle pyramid. The problem with pyramids, if my memory of stacking blocks in pre-school serves me right, is that it’s not the top of the pyramid that is important, but rather the base. 

I pulled some of the data from the above slide to generate the following table. Some of the estimates are my own / backed into to make the math work. 

What we see is that there are ~3,000 ~2.1 yr old machines sold annually (in Canada). There is demand for ~3,500 of those machines (from midsized farms). Basically, the slide is saying that there is a market imbalance. As an aside - I see this demand discrepancy as responsible for allowing the corporate farms to buy new machines annually, run them for a year (on warranty), and then sell them 12-24 months later without seeing much depreciation in value (strong demand from midsized farms). Basically the corporate farms are profiting on the backs of the small farmers (wow . . . doesn’t that sentence sound very Marxist). But . . . if this is happening, why aren’t midsized farms jumping up and buying new machines? Is this what happened in 2012 – boosting RME’s EPS? 

How real the top-end demand discrepancy is (the market clears doesn’t it) isn’t what concerns me the most – what concerns me is the bottom end of the pyramid. Play with the numbers even slightly (change the avg. years in use of machines for small farms from 7.6 to 8, 9, or 10) and the demand drop for combines reverberates up the pyramid (i.e. at 10 years, the “small” farms only demand 2,675 machines per year). As this manifests up the pyramid it would be ugly for farmers and devastating for RME. I have a tough time quantifying how likely this risk is, but common sense would argue that a decline in the ag economy (whether macro, price driven, or even short-term weather driven) would bring on a lengthening in the life cycle of a machine (yes, I know, the lifecycle for a combine is not 13.4 years – you can buy a 2000 model machine for ~$80,000 right now – not $0, but the theory/math holds no matter how you slice the lifecycle). 

Also, rival TITN machinery (based just across the U.S. border in Fargo, ND, and with 106 U.S. based dealerships) showed us recently what happens when the roll-up strategy stalls and margins contract (Midwest drought). The risk of margin contraction is inherent in the tight working capital situation of dealerships. Financing inventory on a floor plan is great when the business is booming, but floor plans add insult to injury when inventory turns slow and the bankers start demanding payments or additional collateral to maintain the line of credit. 

All of this leaves me asking what will drive growth in the future? As acquisitions dry up, market share will be hard to grow, and without market share growth, overall sales shouldn’t grow at much more than GDP type rates. 

Valuation 
The rub with RME is that it is cheap. Whereas TITN whiffed its earnings and investors are punishing it by rerating its P/E down from 14-15x to the current 11x, RME only trades at 9.3x my normalized $1.45 2012 EPS (adjusted for debt conversion expense, new long-term debt, 28% tax rate, etc.). If we look in terms of EV/EBITDA (adjusted for the debt conversion in 2012), RME trades at just over 3.0x. Of course, this assumes that the company’s floor plan is a payable (not included in EV) and not debt (included in EV). If I include the floor plan in EV, the ratio jumps to 9.5x. 

Free-cash-flow is also strong. If we assume depreciation/amortization and capex offset one another, than FCF is equal to net income. Last year an adjusted $1.45 in EPS would equate to a FCF yield of 10.7% - not too shabby. 

Catalyst 
I have a tough time coming up with readily achievable catalysts for RME: 

• Further acquisitions are an opportunity, but the low hanging fruit has already been harvested. Growth into the New Holland line or geographic expansion might surprise me, but these come with new risks and the possibility of cannibalization. 
• Margin expansion may be an opportunity. Management argues that 5-6 years after an acquisition the company’s gross margin should increase from ~15% to ~17% on a “larger installed equipment base” driving an “increase in high-margin product support revenue.” However, like acquisitions, the low hanging fruit is already gone and a 15% gross margin is consistent with what peers earn.
• Long-term growth in the ag sector is an arguable catalyst, but with 16.3% same-store sales growth last year and my own worries about things like the combine lifecycle identified above, the industry may have pre-run this catalyst.
• Free-cash-flow is the most obvious catalyst, with management conservatively being able to throw off $1.00 - $1.50 a year in FCF (7.5% - 11% yield), but this is somewhat offset by the risk of a low margin business in a cyclical industry using a floorplan payable for a large part of its financing. 
• Value is often ridiculed as its own catalyst (cheap can get cheaper), but it’s hard not to argue that RME is a better value than peers. 

Updated Thesis 
My thought process is all over the place in this post – you can see me blindly stumbling around looking for an answer on this one. It just goes to show you that the sell decision is often much harder than the initial buy decision.

Although I’m no longer an accumulator of RME shares, I am not at the point of liquidation either. For my portfolio, I will replace RME shares with better opportunities as they present themselves, but I won’t sell RME to move to cash (yet). Maybe that’s just a cop out (a “hold” recommendation . . . really . . . I’m disappointed in myself), but I continue to view management’s ownership (~22%) and the value as weighted against the risks of slowing or declining sales, weakness in the ag economy, and the overall tight margins of the business.

Disclosure:  Long RME

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