Kendrick Melrose of Toro Co.: Rain or shine

Toro has been a top-performing stock since 2000. But can CEO Ken Melrose prevent more weather-related woes for the lawn mower and snow thrower maker?

Toro Co. seems to do best when the stock market is at its worst.

Twenty-five years ago the lawn mower maker was a hot growth stock in a moribund equity market. Bloomington, Minnesotabased Toro had become a household name, second only to Hershey Foods Corp. among U.S. firms in a 1974 brand-recognition poll. Toro’s 80 percent annual earnings growth during the 1975'78 bear market, combined with its countercyclical strategy of selling lawn mowers in the summer and snow throwers in the winter, won over investors.

But by the early 1980s, the dawn of the longest bull market ever, Toro had begun an equally long stretch of hard times. Unexpected turns in the weather -- from long spells without rain to mild winters -- hurt sales. Wall Street discounted Toro shares in anticipation of these periodic troughs.

Most recently, an unusually benign U.S. winter in 1998 decimated snow thrower sales, resulting in an 88 percent decline in earnings for that year. The company recovered quickly, posting 172 percent earnings growth in 1999, when snow was plentiful. Yet investors all but ignored Toro during the mania for technology and telecommunications stocks.

In October, Toro completed a three-year cost-cutting plan, dubbed “five-by-five” for its goal of doubling after-tax profits to 5.5 percent of sales by pursuing efficiencies in five areas of Toro’s business. The company consolidated purchasing -- for example, going from 12 to three suppliers of cardboard boxes -- and saved more than $2 million annually by better managing cash flow.

Now Toro is again a haven for bruised investors. It posted nearly 10 percent annual earnings growth throughout the 2000'02 bear market. Toro shares have soared, from the high teens three years ago to nearly 50 in late November.

Still, the company isn’t attracting lots of attention. Only two Wall Street analysts follow it, and many investors worry that Toro remains prey to unpredictable weather cycles.

Kendrick Melrose, a 33-year Toro veteran and CEO for 20 years, is fighting to counter that impression. Melrose has reoriented the company, largely through acquisitions, so that two thirds of its sales are to commercial customers, such as landscape contractors and golf courses, whose purchasing decisions are less dependent on weather conditions; in 2000 two thirds of Toro’s sales were to homeowners. And after three years of austerity, he’s begun focusing on growing revenue. Toro has brought out a line of “zero-turn-radius” riding mowers that it is marketing with Home Depot, and the company is making a bigger push to penetrate Europe and Asia.

Melrose is also looking for a successor -- he abandoned a plan to retire three years ago when Toro’s board couldn’t find an external replacement. Now 63, he’s hoping to bow out within three years to teach business or write books about management and community responsibility, a favorite topic of his. Melrose discussed Toro recently with Institutional Investor Senior Writer Justin Schack.

Institutional Investor: How difficult was it to get employees to support the five-by-five plan?

Melrose: Fairly difficult. We were a company that resisted change. We had to get people to start working differently and smarter. We broke everyone into teams and gave them goals. We trained everyone on how to manage these projects. And we met every month or two to talk about our progress. We also provided incentives. Whenever we saw a team accomplishing something, the supervisor would immediately give a $50 voucher to each team member, and we’d recognize those people publicly. Additionally, if we meet our five-by-five goal at the end, everyone except for management will get two weeks extra vacation. [The plan ended with Toro’s latest fiscal year, on October 31, but results are not yet clear.]

Now that five-by-five is over, what’s next?

We need to raise the bar again. We need to do something more than just cost-cutting. We are in the process of rolling out the next initiative, which will take another three years. It will have an element of improving profitability -- it’s not going to be doubling but a more modest improvement. At the same time, we will make some greater investment in growth initiatives both for the long run and short run.

What will you do to boost growth?

We need more investment in new-product development, branding, customer care and building relationships. And they’re all [selling, general and administrative] costs, which is the one area of five-by-five that we haven’t done as well as we would have liked in. We’ve got to either extract savings or make people more productive so they can do more. We may spend the same amount of money in SG&A, but we’ll spend it differently -- more for growth, less for administration, if you will.

Do you expect your zero-turn-radius mowers to be a driver of growth?

Yes. Historically, that has been a landscape contractor product, because it allows them to do more yards with less people. But we thought the consumer would buy into this too, so we have to have a more reasonably priced “Z” mower, as we call them. We had a very good introductory year with Home Depot, and that will expand. The dealers are selling more of these to homeowners and fewer of the garden tractor variety. More and more people that try them actually say, Oh, this is kind of fun to drive.

Is this an area where you can gain on competitors like Deere & Co.?

Yes. In the garden tractor line, we’re not terribly competitive against Cub Cadet, Deere and the other major players. But we are the leader in Zs. So as we get homeowners to migrate from the more traditional riding mower to the newer concept, we will gain share.

Will you make more acquisitions?

We’d like to make large, strategic acquisitions. But the larger candidates are not terribly interested in being acquired. The more likely candidates are the small, bolt-on acquisitions that help us become more important to our core customers or fill gaps in our product line. We would look at acquisitions that would help us better manage weather fluctuations. We also are very interested in developing smart irrigation systems that are operated by Mother Nature instead of a human being. Most people overwater. And as water becomes a scarc- er resource, you’ll see customers saying they want smart irrigation systems that only water when the plant says, I’m thirsty. So we’re looking at technologies that allow us to design a system that is controlled by things like temperature, moisture in the ground, the amount of humidity in the air, wind.

How big is your non-U.S. business?

About 20 percent of our revenue comes from outside the U.S. The biggest market is Europe. Canada is also a big market. And the Pacific Rim countries, from Japan and South Korea all the way down into southeast Asia and Australia, are nice markets. The Pacific Rim is more opportunistic. It’s pretty much all professional, all golf. Japan in the ‘80s and early ‘90s built a lot of golf courses. China is now building them. The Philippines and Malaysia and other countries in southern Asia have been more recently pretty robust. We have similar market shares in equipment and irrigation in the other areas of the world as we have in the U.S., and our competitors are the same. But in consumer we have much lower shares, because the major competitors are local manufacturers that are making lawn mowers at a more competitive cost -- and there are a lot more of them, maybe 20 or 25 for lawn mowers and riding mowers in Europe.

What’s going on with your succession planning?

In the late ‘90s the plan was for me to retire when I turned 60 and the board would bring in somebody from the outside. I turned 60 in 2000. We tried hard to bring in somebody from outside to be COO. But we had a hard time finding somebody that had our cultural values. The board was adamant that it didn’t want someone to come in and change wholesale our philosophy of how we manage people and our cultural values. So we changed direction and said we need to build succession from within. For the past four years, we’ve been identifying strong candidates in the ranks and bringing them to a level where they can be a candidate to take my job. It’s taking longer, obviously.

So when will you retire, and who are the candidates to succeed you?

Probably two or three years from now. There’s no set date. We’re very happy with the candidates that we have, but we haven’t talked about it publicly, other than that we’re developing from within. There are two or three that the board likes very much. They know who they are, and they’re engaged in the process.

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