Investors looking for another way to play the economic recovery may want to look at Canada's heavy equipment dealers.
Those firms are poised to scoop up big gains as mining, construction and forestry companies begin to replace their worn fleets of hulking machines.
Shares of Finning and Toromont , two of the country's biggest dealers, touched 52-week highs in the last few days as numerous signals point to better days ahead for an industry hit hard by the recession.
Both stocks received a boost this week from Caterpillar Inc. , the world's largest maker of construction and mining equipment. Caterpillar made a $7.6-billion (U.S.) bet that global demand for coal and minerals will accelerate by agreeing to acquire U.S.-based mining-equipment maker Bucyrus International Co.
"We view this acquisition as a positive development for Canadian heavy equipment distributors - especially for Finning, given that it has the highest exposure to mining among the stocks that we cover," noted Benoit Poirier, an analyst with Desjardins Securities Ltd.. "We would expect Finning's stock price to increase … [and]we note that the product offerings of Bucyrus and Finning highly complement each other."
Finning and Toromont are the largest dealers for Caterpillar gear in Canada. Vancouver-based Finning generates most of its revenue from the mining sector and the oil sands. It also sells machinery to the construction and forestry industries. Toromont, of Concord, Ont., focuses on construction and mining.
Car dealers on steroids
"We like to think of equipment dealers as car dealers on steroids," says Ben Cherniavsky, an analyst with Raymond James Ltd. "This is not only because many of their products represent a beastly version of the automobile, but also because the former business is arguably a 'souped up' version of the latter."
The heavy equipment distribution business boasts high margins from selling parts and providing specialized mechanical services. It sells to a diversified base of customers, requires limited fixed capital investment and offers the potential of high cash flow, Mr. Cherniavsky noted in a detailed report on the sector published last month.
Although the dealership market remains highly fragmented, he believes that it has begun a slow process of consolidation. He adds that Canada's major public firms in the sector are well positioned to grow after being hit hard by the economic downturn. Finning, for example, spent almost 18 months restructuring and clearing inventory after getting surprised by the speed and severity of the recession.
"The riskiest time to invest in the dealer business is following several years of market growth and - in particular - expanding inventories. As simplistic and obvious as this statement may seem, it lays the groundwork for an important corollary: namely, that the least risky time to invest in the sector is in the years following a big cleanse. We feel that time is now," Mr. Cherniavsky said.
He rates Finning shares "outperform" and has a $29 (Canadian) price target on them over the next six to 12 months. He expects significantly improved cash flow to fund future dividend increases, possible share buybacks and acquisitions. He rates Toromont shares "outperform" with a price target of $36.
Very significant earnings growth forecast
Finning president and chief executive officer Mike Waites recently gave a bullish outlook to analysts, saying that the second half of the year will be stronger than the first. "We expect very significant earnings growth going into 2011," he said on a conference call. "Mining continues to feature strongly and that includes the oil sands in Canada and we are seeing increasing activity in heavy construction, forestry and even some pick up in conventional oil and gas activity in Western Canada."
Several analysts raised their price targets on Finning last week following better-than-expected third-quarter revenue and profit from the company. Sara O'Brien, of RBC Dominion Securities Ltd., increased her target on the stock to $30, from $27. She values the shares at 17.5 times average earnings for fiscal 2011 and 2012 and rates them "outperform."
Toromont's third-quarter results were more mixed. The company said revenue rose 44 per cent from a year earlier, topping expectations, but profit declined, falling short of forecasts.
"Although [third-quarter]results were modestly below our expectations, we are encouraged by the improving operational performance and strengthening backlog. As order flow continues to improve and facility utilization increases, we expect a concurrent improvement in financial performance," CIBC World Markets Inc.'s Jeff Fetterly wrote in a research note. He increased his price target on the stock to $34 from $32 and rates it "sector performer."
Canadian heavy equipment dealers and their market caps:
Cervus Equipment $190-million
Finning International $4.4-billion
Ritchie Brothers $2.1-billion
Rocky Mountain Dealerships $156-million
Toromont Industries $2.2-billion
Wajax Income Fund $597-million
Source: Globe Investor