Seeking Small-Cap Moats: Douglas Dynamics

This article is part of Todd's monthly series "Seeking Small Caps With Moats." The introductory article can be found here. New articles in the series are published on the fourth Wednesday of every month.

If you've ever hunted for seashells at the beach, you know that you won't find the best specimens during peak summer hours in the middle of tourist season, when the beaches are thoroughly combed over.

Instead, the ideal searches are done away from popular beaches, after storms, or early in the morning. While these tips greatly increase your odds of finding good shells, they are hardly well-kept secrets. Other motivated collectors and locals with superior knowledge of the landscape are formidable competitors even if they are fewer in number.

It's much the same in the stock market. The odds of finding true hidden gems in the popular areas of the market--glamour stocks, large caps, and so on--are quite low. As such, our research time can be better spent in more "secluded" areas of the market where fewer hunters are out--specifically, among smaller companies and companies in decidedly unglamorous lines of business.

Though these areas of the market are less picked over by analysts and institutional investors, we should never assume that the person on the other side of a trade is naive or ignorant of the company's prospects. Indeed, you might be buying from an insider looking to unload shares or a local, long-term shareholder who is very familiar with the business.

Mispricing in the small-cap market works both ways, so always remember to do your due diligence and make sure you can identify the source of your advantage before buying. 

Winter Is Coming
Even by Chicago’s standards, this winter was particularly brutal, with 82 inches of snow falling between December and March. Chicago wasn't alone in dealing with a lot of snow this winter, of course, as North America experienced its highest level of snowfall over the past 18 years. 

On the other hand, it was a particularly good winter for snowplow operators and a great one for companies that sell the plows to contractors and municipalities. One such company is Milwaukee-based Douglas Dynamics (PLOW), which manufactures snowplows as well as salt and sand spreaders. 

Below are some quick facts about Douglas Dynamics (as of July 18):

• IPO date: May 5, 2010
• Market cap: $390 million
• Dividend yield: 5%

Winters as harsh as the one we just experienced are rare. As such, demand for snow removal equipment tends to be lumpy, particularly if low snowfall occurs during economic downturns when contractors' pockets aren't flush. (The company finds a positive correlation between light truck sales and plow sales.) The following chart illustrates how important the contractor market is to Douglas Dynamics' plow business.

About 85% of Douglas Dynamics' revenue is generated by equipment sales, with the balance coming from parts and accessories. Despite the lumpiness in orders due to weather and consumer sentiment, it is encouraging to see that price per unit has held steady and kept up with general inflation. 

In other words, Douglas Dynamics doesn't appear to slash prices in bad years to generate demand. They know that the buyers will be back eventually. Such pricing power is a good indication that there is an economic moat present.

How do they derive this potential moat? One answer is that plows are mission critical products, so there's inelastic demand at work. When it comes to clearing large amounts of snow off a highway or city road, there is no alternative to a plow mounted on the front of a truck. Douglas Dynamics has a robust 50%-60% share of the North American snowplow and hopper/spreader markets, so when there is a snowy season in North America, the company is a primary beneficiary.

Second, the stability of Douglas Dynamics' average equipment prices suggests that it's in a "slow-cycle" industry in which the pace of technology disruption is more measured than that of, say, semiconductors or smartphones. Additionally, the company's price realizations indicate that the competition within the space is less intense than in other industries. These favorable industry dynamics allow Douglas Dynamics to focus on creating slow but steady shareholder value.

A third contributor to Douglas Dynamics' moatiness is its extensive network of over 700 dealers, which is the largest in North America. The company also has 15 distributors outside of North America. This extensive network provides customers with valuable in-field support as well as aftermarket parts and servicing. Its core markets are the Upper Midwest, the Mid-Atlantic, and New England, so there remains some room for dealer expansion in the western United States and in Canada that could further strengthen the moat.

Finally, Douglas Dynamics possesses a number of patents on snowplow mounts, assemblies, and hydraulics that help keep would-be competitors at bay.

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Even though Morningstar doesn't currently cover Douglas Dynamics and the company hasn't been vetted by our moat committee to produce an official Morningstar Economic Moat Rating, I’d assert that it has established a narrow economic moat.

Stewardship
Douglas Dynamics is led by Chairman and CEO James Janik, who has been with the company and its previous parent companies since 1992 and has served as its CEO since the company was acquired from AK Steel by a private equity firm in 2004. With smaller companies, I'd like to see insiders own a larger portion of shares outstanding than the 2.6% ownership level reflected by Douglas Dynamics’ management team. Even so, 2.6% is still a considerable sum that should help align shareholder and management interests.

Though Douglas Dynamics has a relatively short track record as a public company, I've been extremely impressed by its ability to generate free cash flow despite a volatile top line. The company has been able to achieve such impressive results due to its highly efficient operations and low reinvestment needs.

Management has also maintained a strong balance sheet with little debt, which is prudent given the cyclicality of the underlying businesses. With low reinvestment requirements and a modest growth runway, Douglas Dynamics returns most of its free cash flow to shareholders each year in the form of dividends. Management has been keen on increasing the dividend, having done so five times since the 2010 IPO at an annualized rate of 5.2%.

Risks and Valuation
Orders for Douglas Dynamics' equipment are naturally lumpy, and investors should be prepared for the possibility of a few winters with below-average snowfall. Enough bad winters strung together could put pressure on the generous dividend. Longer-term, it's difficult to gauge the effects of global warming on snowfall, though some research suggests that increasing global temperatures could actually lead to increased snowfall, as the melting of sea ice produces more moisture in the atmosphere. If you're of the opinion that global warming will lead to less snowfall (and you're certainly entitled to that opinion), then Douglas Dynamics probably isn't the right stock for you to own.

From a valuation perspective, the stock doesn't seem terribly overvalued today--at $17.45 per share (as of July 18), it trades for about 15 times my estimate of normalized free cash flow. Not bad, but not great considering the limited earnings growth potential. A back-of-the-envelope three-stage dividend discount model, which seems appropriate since the company pays out most of its free cash flow in dividends, spits out a fair value around $16 per share assuming an 11% cost of equity, 6% initial dividend growth rate, and 3% terminal dividend growth rate.

Investor expectations seem to be quite high right now following the bad winter we just had, along with improving plow dealer sentiment. I'm putting this one on my watchlist and hoping that a warmer winter will cool investor expectations. I'd look to buy closer to $14 per share.

Other stocks highlighted in this series:

• WD-40 Company
• Raven Industries
• Sun Hydraulics
• John Bean Technologies
• Exponent
• Culp Inc.
• Badger Meter
• US Ecology

Todd owns shares of Sun Hydraulics. You can follow him on Twitter at @toddwenning.