Dividends From Snowstorms

Snow removal is not a business I think of often, especially not this year in New York with temperatures well above what we expect in December, not to mention all the chatter about global warming. But with shares Douglas Dynamics ($PLOW) – take a hint from the ticker – with a nearly 4% yield, show up in my Smart Alpha Equity Income model, perhaps it’s time for me to take a closer look.

Yes, it’s hard to predict – but not impossible

For those who haven’t solved the riddle of the ticker, the company is a major producer of snow- and ice-control equipment.

The main reason why I reflexively tend to cringe when I see businesses like this is that I hate being involved in stocks whose fortunes seem to depend on things that are completely unpredictable. The level of annual snowfall seems to qualify in that regard. But on closer examination, it’s really not that intimidating.

It is true that annual snowfall varies a lot from year to year. But Figure 1, from $PLOW’s 2014 10-K, shows that when viewed on a longer-term basis, ten-year rolling averages in this instance, it’s actually been quite steady.

Figure 1

 The stability of the 10-year rolling snowfall average would be no consolation if the company is covering its dividend by the skin of its teeth. Table 1 shows, however, that it generates more than enough cash to cover both its dividend needs and its capital spending.

Table 1

There is a relationship between the amount of snowfall and what the company earns with higher levels leading to higher purchases and increasing wear and tear (which boosts demand for the company’s smaller but higher-margin spare parts business), but it’s not so tight as to suggest that an unusually warm winter would put the current payout in jeopardy.

The Big Picture

To the surprise, probably, of nobody, the lion’s share of $PLOW’s revenue comes from replacement sales. And also consistent with what a naïve observer might expect, replacement demand is influenced by usage, which is in turn influenced by the amount of snowfall. So for the most part, the bigness is what you expect it to be.

Less obvious, though, is that there are growth opportunities here.

First, There are the basics, potential boosts to replacement demand inspired by newer and more efficient kinds of equipment. After having launched three to five products a year between 2008 and 2012, the company came out with 20 new offerings in 2015, most of which didn’t start shipping until the second half. Another basic is the prospect of market-share gains, a reasonable assumption considering $PLOW’s size and stature within this small industry.

Next up, there are prospects for a bit of secular growth. As new areas are built up in northern regions, there are new places that need snow- and ice-control equipment.

The next layer up in terms of growth opportunities comes from the company having acquired its way into new areas of the industry. The 12/31/14 acquisition of Henderson gave $PLOW access to a broader range of equipment, an additional distribution network, and the ability to sell turnkey systems to municipal transportation departments. Before that, in 2013, $PLOW acquired SnowEx, a liquid solutions approach that is being integrated into the overall business.

When it comes down to acquisitions, the company uses the phrase “dedicated attachments” rather than snow and ice control. The latter are included among dedicated attachments (example: a big thing that looks like a shovel attached to the front of a truck). A company presentation from last spring made it clear, however, that “dedicated attachments” can mean more than use that. The company specifically expressed interest in “adjacent markets;” i.e. attachments that serve other functions, such as lawn and garden work.

Dividend Growth

Dividend growth is important in the equity income market: But for the prospect of a growing payout, there would be little reason to consider many income stocks which even at today’s measly interest-rate levels, yield less than bonds. But with a yield of nearly 4% (3.85% as of this writing), the need for growth is less pressing than is the case for many other non-speculative situations in the income world, for which the median yield is 2.38%. That’s exactly what the model that called $PLOW to my attention set out to find, as discussed back on 10/24/15.

Still, consider some dividend-related remarks by the CEO on the last conference call:

“I’d also like to reiterate our approach to capital allocation. Our dividend remains a critical component of our capital allocation strategy. We continue to generate significant cash flows and view our commitment to the dividend policy and focus on cash generation as distinguishing characteristics to compare to other companies of our size. At the end of last quarter, we paid a quarterly cash dividend of $22.25 per share on the company’s common stock on September 30. As a reminder, we will review our current dividend and decide upon any changes at the next scheduled Board meeting in March.

“At that point we have data from the end of the year, most of the snow season under our belt, and therefore a clear view of our financial standing which is the best time of the year to make capital allocation decisions. Aside from the dividend, we’re committing to using our excess cash to reduce the company’s debt levels and pursue strategic acquisitions. We remain focused on exploring opportunities with companies that produce work dedicated attachments and offer us the highest risk adjusted return on invested capital.

“It is worth noting that the current M&A landscape is the most active we’ve seen in the past five years in our logical core markets and adjacencies that we monitor. However, I want to point out that we will maintain our disciplined approach regardless of the marketplace and we are keenly aware of valuations and will only pursue deals when and where it matches our strict internal criteria.”

Obviously, nothing is assured regarding future continuation or growth of the dividend. It’s clear that the company has other things in mind for the cash it generates, namely acquisitions and debt reduction. One always has to sweat a bit when corporate executives talk about acquisition goals; many such deals turn out to destroy, rather than enhance, value. But in 2013, 2014, and over the trailing 12 months, $PLOW’s returns on equity were 7.53%, 24.32%, and 23.44% (the first acquisition was completed in May 2013), compared to an average of 7.61% in the five years that preceded the aforementioned purchases. That provides some indication that management wasn’t kidding when it spoke of a disciplined approach, awareness of valuations, and adherence to strict internal criteria.

But as we saw in Table 1, funds are more than amply available to accommodate management’s goals. And Let’s face it: this language seems consistent with what one might expect from a management that does have genuine dividend-growth inclinations.

A Prototypical Smart Alpha Income Selection

The motivating principle behind the model I used was a belief that dividend-security metrics used by many tended to overestimate risk and that we could find better opportunities (higher yields without corresponding upticks in risk) by combining indicators of market sentiment and general fundamental analysis (the sort that would be used to assess any company, not specifically a yield play). And that particular model is open to smaller capitalization issues, which might have higher yields due to their being more readily neglected by income investors, who often tend to think blue chip.

$PLOW (along with $MC and $TIS, which were profiled on 11/20/15) is a representative example of the kinds of opportunities that can be uncovered by this sort of approach.