INTRODUCTION
I believe that Wall Street is currently offering Douglas Dynamics (PLOW) at a 30% discount to intrinsic value.
As North America’s premier manufacturer of snow plows, de-icing equipment, and vehicle attachments, Douglas Dynamics possesses two formidable moats stemming from their ability to produce high-quality products more cheaply than their competitors, and then selling those products through an extensive network of dealers.
Further, the company has significant advantages in the shareholder-oriented management team, a high free cash flow conversion rate, low capital spending requirements, and a largely variable cost structure. These considerations make Douglas Dynamics a company that can weather most any storm (pun intended).
An unseasonably warm winter in Douglas Dynamics’s core markets has driven the stock down to $18.50--offering investors the opportunity to buy a great company at only 10X earnings, a 12.5% FCF yield, and a 19% operating earnings yield! Additionally, management is dedicated to paying a significant dividend (5% current yield) under all weather conditions, without sacrificing near- or long-term liquidity.
WHY IS IT CHEAP?
The primary factor weighing on Douglas Dynamics’s stock is the psychological tendency to overweight near-term salient factors (what Munger calls the “availability-misweighing tendency"), which in this case is the impact the warm winter will have on the company's core markets. With temperatures pushing 70 degrees on Christmas in much of the Northeast and little indication of snow, it is easy to discount a business whose prosperity presupposes wintry conditions.
Looking at a small sample size, snowfall amounts indeed appear to be highly varied and unpredictable. But by widening the sample to Douglas's 66 core cities, we get a consistent rolling ten-year average annual snowfall of 3,100 inches. The market appears to be over-focusing on the short-term catalyst of heavy snow fall (or lack thereof), and overlooking longer-term factors, such as the high quality of the business and management's record of prudent capital allocation.
With an estimated 600K units in use, and an average 7 - 8 year replacement cycle (at $5K - $9K each for light-duty mounted plow), Douglas Dynamics can count on a continual demand for products---even if that demand may be uneven. Because snow poses a grave and immediate threat to public safety and productivity, there will always exist a critical need to quickly remove it from roads. In short, it is not a matter of if customers will buy Douglas Dynamics products, but when.
Despite the ill effects that a mild winter will no doubt have on Douglas Dynamics, the market has likely overreacted in the short term---presenting patient investors an attractive opportunity to buy a high-quality business trading at a 30% discount to intrinsic value.
WHAT DOES DOUGLAS DYNAMICS DO?
Douglas Dynamics designs, manufactures, and sells snowplows, sand and salt spreaders, and complementary accessories, which they sell through an extensive network of 2,200 dealers throughout the US/Canada and an additional 40 dealers internationally.
The main costs for the company are raw materials (e.g. steel), employees, amortization oftheir dealer network, interest expense, and from time to time, acquisitions. The operations are astonishingly light, with the current operating earnings yield at 19%! As the company is funded by both debt and equity (1.13 debt to equity ratio), interest expense weighs on margins, but the ability to quickly turn income into cash provides Douglas Dynamics with enviable capital flexibility and hard cash at the end of the year.
Through organic growth of core products and the timely acquisitions of Blizzard, SnowEx, and Henderson, revenue has grown at a 7.7% CAGR since 2008, while profit has increased 248% over the same period.
While Douglas Dynamics has been slowly growing their marketshare of light-duty truck mounted plows (currently 50 - 60%), their $95m acquisition of Henderson Products in 2014 will add $83m in annual sales, and provide entry into the heavy-duty truck mounted equipment market. Gross and operating margins have stayed impressively stable at 34% and 17%, which are a product of Douglas Dynamics’s aggressive employment of lean manufacturing principles, though these will come down for FY 2015 due to the Henderson acquisition.
The straightforward nature of the company’s operations are reflected in the simplicity and candor with which their financial statements are presented. It is here we can see a few key characteristics of the business essentially jump off the page, requiring further analysis and exploration.
ADVANTAGES
For any business to be worthy of investment, it must be able to maintain certain competitive advantages over competitors for long periods of time. These advantages, regularly referred to as “moats”, are often the difference between a failed or mediocre business, and a sensational one. Therefore, an investor’s aim should be to identify businesses fortified by a significant moat, and attempt to acquire it at a reasonable price. If that business happens to require little reinvestment and/or is tended to by capable and honest management—even better—but these cases are tremendously rare.
“I don’t want a business that’s easy for competitors. I want a business with a moat around it. I want a very valuable castle in the middle. And then I want…the Duke who’s in charge of that castle to be honest and hard working and able. And then I want a big moat around the castle, and that moat can be various things.”
- Warren Buffett
If Douglas Dynamics’s strong management team is able to continue their focus on operational efficiency while strengthening the dealer network, all with very little capital, their moats will widen and the intrinsic value of the company will continue to grow.
1. Operations are lean and nimble
For a vertically integrate manufacturing firm, Douglas Dynamics has a surprisingly variable cost structure (15% fixed vs. 85% variable) and low capital spending requirements. Their manufacturing operations are lean and exceptionally nimble, contributing to a consistent 34% average gross margin since 2008. And with 10% - 15% of their workforce being seasonal and demand-driven, they have the added benefit of further flexibility should the weather not play out in their favor.
The company continually optimizes their manufacturing operations, resulting in the fastest lead times in the industry (3-5days, down from 2-4 weeks in 2004), and a 61% reduction in the total number of suppliers since 2007. This ability to operate efficiently and flexibly with little overhead and low fixed costs enables the company to maintain gross (and net) margins across all environments. Impressively, the lowest that gross margins have ever dropped (during 2012, which saw the lowest snowfall in company history) was to a still-healthy 31%. It appears unlikely that a few consecutive years of light snow will put the company at operational risk or make paying the dividend a challenge.
By vertically integrating the selling, designing, manufacturing, and sourcing of raw materials into finished goods, the company is able to deliver high-quality products to their customers cheaper than any of their competitors.
“To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.”
-Warren Buffett
2) Extensive and entrenched dealer network
Perhaps the company’s greatest advantage is its extensive and entrenched dealer network, which has grown from 720 distributors in 2010 to over 1,100 today (plus an additional 570 and 125 for SnowEx and Henderson, respectively). For end-users, a major factor influencing purchase decisions is not only how easy it is to buy and install the snowplows, but how easy it is to service them. This makes the end-user’s relationship with the dealership critically important.
The ubiquity of Douglas Dynamics’s brands, coupled with the reinforcing nature of the dealership’s network effects, has historically driven stable pricing power of 2% above the inflation rate, and the reason is simple. With over 600K products in use---which are in constant need of upgrade, repair, and maintenance---dealers are incentivized to support this massive existing install base to avoid losing out on substantial revenue, providing Douglas Dynamics with compelling pricing power. If we assume a 7-year replacement cycle of Douglas Dynamics's existing install base at an average price of $6K per plow, each dealership stands to sell an additional $250,000+/yr---a substantial sum for the majority of small independent dealers!
And to end-users, dealers are more than just point of sale locations; they also offer immediate access to post-sale service and support during mission-critical periods of snowfall. If a plow operator were to miss a storm due to a product needing service or waiting for a part, it would directly result in lost revenue for him. This results in dealers needing to keep Douglas Dynamics products in stock, strengthening the network effects, and further widening the company’s second substantial moat.
3) Low reinvestment requirements
Another advantage the company enjoys: for a design and manufacturing firm, their reinvestment requirement is surprisingly low (only 1.38% of net sales, and 26% of FCF). This enables their sustained profitability, and even more importantly, generates significant cash---to reinvest in the business, to make strategic acquisitions, and to compensate shareholders via a generous dividend.
It is not uncommon to find a business, especially ones requiring the manufacture of heavy equipment (e.g., auto, airplane, machinery, etc.), that shows an accounting profit at the end of the year, while having very little leftover cash due to the reinvestment requirements of the business, just to maintain its current operating level.
“We prefer businesses that drown in cash. An example of a different business is construction equipment. You work hard all year and there is your profit sitting in the yard. We avoid businesses like that. We prefer those that can write us a check at the end of the year.”
- Charlie Munger
Douglas Dynamics faces no such dilemma. Since 2008, the company has generated $99.68MM in profit, and a remarkable $98.72MM in free cash flow---even accounting for acquisitions.
4) Management
With this surplus cash, management has elected to provide generous dividend payments to shareholders, reduce outstanding debt, and make strategic acquisitions. By remaining disciplined and forgoing expensive or distracting acquisitions made solely for the sake of growth, they’ve focused on maximizing shareholder return and only reinvesting in the business when value can be added. If a wise option doesn't exist, management is happy to cut a fatter dividend check to shareholders.
Management, led by CEO Jim Janik, has a history of acquiring good businesses, which fall within their circle of competence, at fair prices (e.g., Blizzard, SnowEx, & Henderson). Avoiding the common trappings of empire-building that often ensnare executives flush with cash, management has remained laser-focused on their stated goal to consistently produce high-quality products while driving shareholder value.
Shareholders may be tempted to interpret Douglas Dynamics's high dividend payment as a sign of a lack of growth options, rather than a sign of prudent leadership that chooses only smart growth options. But taking a closer look at their record of acquisitions, it's clear that the latter is true.
OPPORTUNITIES
At first glance, the company’s growth opportunities seem limited. While an investor may expect to earn a mid-to-high-teens ROE while collecting a large dividend, there doesn’t appear to be much more the company can do other than to keep selling to their existing (and stagnant) customer base and return any excess earnings to shareholders. After all, total snowfall amounts haven't changed much in 50 years, large swaths of the population aren’t exactly rushing out to become professional snowplow operators, and despite the very real threats of global warming, snowfall patterns likely won’t change in the foreseeable future.
The likeliest source of growth will not come from selling more plows to their existing users or praying for more than average snowfall, but from the 2014 acquisition of Henderson. The acquisition not only adds $83MM in annual sales, but will also open up new markets for the company, with growth potentially exceeding Henderson’s 11.7% 10year-CAGR due to Douglas Dynamics’s existing distribution network and continual grab for marketshare. While the demand for snowplows has a very fixed upper limit (pending drastic weather changes), Henderson’s position in the heavy-duty segment gives Douglas Dynamics access to significant new customers such as municipalities and the Department of Transportation. Though the market leader, the market is somewhat fragmented, and Henderson only has 25% marketshare, giving considerable room for expansion.
Because government contracts are less dependent upon the total amount of snowfall than professional plow operators, the addition of Henderson will make Douglas Dynamics less reliant on snowfall amounts for overall profitability. From 2010-2014, Douglas Dynamics shipped 10% of their unit volume in Q1, 34% in Q2, 26% in Q3, and 30% in Q4. Henderson’s shipments on the other hand, are much more evenly distributed at 22%, 23%, 27%, and 29%, respectively. Even in 2012, which saw the lightest snowfall in 50 years, still saw Henderson’s revenues increase 13.5% from $59MM to $67MM (whereas revenue dropped 33% for Douglas Dynamics).
The only thing not to like about the acquisition is that Henderson’s margins are below those of Douglas Dynamics. As a result, gross and net margins dropped from 36.9% to 33.9% and 13.2% to 10.3%, respectively, for the nine months ended September 30, 2014, compared to the nine months ended September 30, 2015.
As Douglas Dynamics further integrates and refines Henderson’s operations, margins should improve, although it is likely they’ll remain slightly below their historical averages in the future.
RISKS
As with any business, there are risks that prospective investors must be mindful of. A major factor in Douglas Dynamics’s cost of goods is the price of steel. Recently, steel has been very inexpensive, and accounted for around 13% of revenue each of the past two years. However, steel prices have begun to rise, and in the most recent 9 months have accounted for 18% of revenue. Further increases in steel prices will undoubtedly weigh on gross margins, and while the company has historically been able to pass along the increase in component costs to customers, there is no guarantee they will be able to do so in the future, especially if costs increase drastically.
Additional risks are obviously weather related, even though the company has been able to effectively manage these for the past 50 years. However, if snowfall is significantly below average for longer periods of time than the company is used to (i.e. many consecutive years), both profitability and solvency could very well be tested. An acceleration of global warming could threaten the total level of snowfall across the globe—significantly impairing Douglas Dynamics’s business—however, the probability of a short or mid-term impact on results is remote.
Notwithstanding these risks, investors should feel comfortable investing in such a high-quality business given the comfortable margin of safety, which our valuation shows us we have.
VALUATION
Discount rate: 10%
Constant growth rate: 4%, (2% annual price increase + 2% annual organic growth)
Slight decrease in gross, operating, and net margins due to acquisition of Henderson
Pays out 75% of earnings as dividends (based on Douglas Dyanmics's “normalized dividends estimate” as stated in their Spring 2015 investor presentation)
The nearly identical net income and free cash flows makes valuing Douglas Dynamics a relatively straightforward exercise. There aren’t any strange accounting treatments or red flags to get tripped up on, and the fundamental principle that “the value of any business is determined by the cash inflows and outflows–discounted at an appropriate interest rate–that can be expected to occur during the remaining life of the asset” easily applies when using DCF, Dividend Discount Model, or Residual Income Models.
Using a Residual Income Model to account for the cost of equity with the above-mentioned assumptions, we get a value per share of $26.94—31% above the current price!
This margin of safety, estimated using conservative assumptions about the future, provides investors significant protection should any seen or unforeseen risks appear.
CONCLUSION
Historically, demand has been driven by the level of the prior year’s snow (which result in wear and tear from heavy use), rather than the snowfall of the current year. Even if this winter does wind up resembling the winter of 2012 (lightest snowfall in 50 years), resulting in a worst-case 30% drop in revenue, Douglas Dynamics’s long-term intrinsic value will not be significantly impaired.
Obviously snow will be the ultimate catalyst, but it’s anybody’s guess as to when it will fall and how much. All we can be certain of is that when it does fall, Douglas Dynamics, and their shareholders, will be rewarded handsomely.