Monday, November 5, 2012

Northgate Plc -- Vehicle Rentals

Northgate buys vehicles (vans, overwhelmingly) and rents them out, on a monthly and yearly basis, to small and mid-sized businesses in the UK and Spain. 

Fleet management is done centrally, and sales are generated through a network of local offices.  

The advantage of this kind of operational structure is that (1) rental pricing, based as it is on intimate, local knowledge of the customer base, tends to be sensitive to demand, ensuring a high fleet utilization rate (90%) with very little variation.; and (2) fleet size and distribution across locations can be optimized with very little trouble – it is not hard to reduce the size of the fleet (the market for used white vans is liquid and robust) and it is not hard to move  vehicles from one rental location to another .

Add to this (3) the purchasing power derived from buying tens of thousands of identical vehicles from the same manufacturer (Ford, in this case), and (4) the benefit to credit risk management from local knowledge of the customer base, and one can anticipate that Northgate earns returns on its operating capital that are some 3 or 4 percentage points above its cost of capital – perhaps 13% as against a cost of capital of 9%.

In fact, the profit spread is a little higher, an almost 8 and a 1/2 point spread – 17.5% against a cost of capital of 9%.

The extra, unanticipated value is derived from the tax benefits of the excess depreciation that Northgate is able to record.   Northgate reports depreciation of its vehicles that is some 37% higher than its actual maintenance capex requirement. The tax benefit of this over depreciation amounts to an extra 1.8% return on invested capital.

So, Northgate can be expected to earn 17.5% returns on operating assets of 780 million. Discounting at a cost of capital of 9%, this places the value of the business at 1,514 million, and subtracting the non-operating items leaves us with equity that has an intrinsic value of 892p per share. Which means that Northgate is trading at almost a 1/3 of its value.

One would think that Northgate is an attractive acquisition candidate – it could be bought by either a private equity firm or by one of the large vehicle rental companies at a price halfway between price and value (say 575p) and satisfy both parties. The Times reports on rumors of just such a possible purchase, but at a price of 400p. It seems to me that this is the worst case scenario.

The Northgate writeup at Expecting Value and at Share Sleuth  are well worth your time.

Disclosure: No Position 


I calculate maintenance capex as follows (follow along in the 2nd graphic, above):
The average dollar cost of fixed assets required to support a dollar of sales is $1.68

Sales have risen from 338 to 646 million over the last 10 years, which therefore implies that growth capex is approx (1.86 * (646 - 338)) = 687 million

Since total actual capex in that time period is 1,735, it follows that maintenance capex is total capex less growth capex = 1,735 - 687 = 1,048 million.

Now this 1,048 million in maintenance capex is substantially less -- almost half -- than the 1,985 million reported as depreciation over the same time period. 

I therefore adjust annual depreciation expenses downward by 52.7% in order to arrive at a more accurate maintenance capex and annual profit figures.

These adjustments get us much closer to the true economics of the business. I credit the company for tax shield from the excess depreciation that it is able to record because it is a permanent feature of its strategy.


  1. Not a member of my portfolio quite yet - sadly! Didn't rejig enough to get Northgate in. I plan to when I sell one of the 3 companies that are going to be leaving the portfolio soon.

    Thanks for the write up, particularly the bit on depreciation, which isn't a way I'd considered of looking at it and should help in similar situations where depreciation is a key factor in returns. A question on it, though.

    "The average dollar cost of fixed assets required to support a dollar of sales is $1.68

    Sales have risen from 420 to 965 million over the last 10 years, which therefore implies that growth capex is approx (1.68 * (965 - 420)) = 749 million"

    Doesn't this mean that your following analysis on depreciation hinges on the fact that the assets required to support sales is stable? If the company's utilisation rates are weaker over the last few years, as might be expected given the wider picture, that 1.68 might rise.. which would, having just done the maths, actually strengthen your point by further increasing the gap between maintenance capex and depreciation..

    Scratch that, then. Perhaps the company is getting more efficient with its assets. Though, given that you've plotted that over time, that doesn't seem to be the case either. It seems to be staying roughly flat.

    Thinking out loud. Good stuff!


  2. One can see from the total capex figure that, in the absence of overdepreciation, we're being asked to believe that a net increase of 55,200 vehicles was achieved for an outlay of 220 million pounds, or 3,985 pounds per new vehicle. That's obviously not right. More reasonable is to suppose that growth capex is 55,200 vehicles x average of 13,600 per vehicle = 749 million. The rest of capex is maintenance.

    In plainer terms, what's happening, I think is two things:

    1) that they're depreciating the vehicles straight-line over 3 to 6 years of "useful economic life" but are selling them on after 20 to 30 months of actual use. On the one hand, straight-line depreciation understates economic depreciation. On the other hand, the time frame of the book depreciation is twice as long, so the next effect is an overstatement of the loss of value on the vehicles, esp. since used white vans are seemingly always in demand.

    2) as Northgate has grown in size, its purchasing (or bargaining) power has strengthened, meaning that it is buying vehicles at a more favorable price now than it was then, meaning that the cost of replacing its vehicles is less than anticipated.

    What I like about Northgate is that one can figure out where the value is coming from -- a couple of points from clients, a couple of points from suppliers, a point and a half from HM Treasury. It's understandable, defensible and predictable.

    What's variable is the fleet size, which will depend on (and lag only slightly) the business conditions facing its client base. I don't think we'll see 130,000 vehicles again, esp since a substantial share of those vehicles were dedicated to cliens engaged in the Spanish construction market, but 100,000 or so seems quite sustainable to me.

  3. The first paragraph is an excellent way of putting it. Even I can understand that one first time!

    "What I like about Northgate is that one can figure out where the value is coming from -- a couple of points from clients, a couple of points from suppliers, a point and a half from HM Treasury. It's understandable, defensible and predictable. "

    Also rather a neat summary.

  4. You run a worthwhile blog and recently I noted your interest in Northgate. I am interested in Northgate as well, and one question bothers me since I cant answer it.

    1 - Where from did appear 28.4 million more shares in 2011?

    Diluted Shares thou

    2012 - 136,307
    2011 - 135,336
    2010 - 106,981

    Change thou 971 28,355

    Any ideas?

    Best regards, Gusto

  5. Gusto,

    Northgate issued 28.4 million shares and received GBP 108.245 million from the sale of those shares. It is reported in the Statement of Changes in Equity in the Annual Report for the period ending April 2011.

  6. Hi Red and thanks for your answer.
    Sorry but still puzzled.
    Let me explain why.

    They raised the GBP 108.245 million in July and Aug 2009 (fiscal 2010).
    That is reported in Cash Flow, BS and Statement of Changes in Equity 2010.
    At the date they had the following no of shares:
    old shares 5p- 32.43mln
    new shares 5p - July 2009 - 50 million (for GBP 30 million equity)
    New shares 5p - Aug 2009 - 1205.48 (for GBP84.38 mln)

    Total shares 5p = 32.43+50+1205.48 = 1287.9 million shares
    Conversion 10:1 (5p to 50p) = 129,210,944 shares
    So all this happens in 2010. But somehow:
    - Ordinary shares April 2010 = 105.4 mln (?)
    - Ordinary shares April 2011 = 133.03 ... although no new shares have been issued in the meanwhile?

    Hope we can sort it out. I could not. DO British companies submit 10-K type of documents to FSA so I can look there for more info?

  7. Correction:
    After conversion they should have had:
    Conversion 10:1 (5p to 50p) = 128.7 shares
    Then if you add 347,000 shares issued in connection to All Employee Share scheme it gives 129.21 million. The conversion is explained by note 26 AR 2010.

    Now I noted that in note 26 they say they had 132.95 allotted and fully paid. WHre from? There should have been 129.21 only...

    (although when calculating EPS they use that inexplicable 105.4 mln shares number...(!)

  8. I see what you're saying.

    My initial reaction is that the reported ordinary share count is a weighted average for the year. Since the new shares were issues in Aug & Sept & January, the weighted average share count is likely to be somewhat less than the number of shares actually outstanding at the end of the year. The gap between shares outstanding and weighted average shares outstanding would then be made up in the following year. I haven't done the arithmetic myself, but I would venture that that's why we see some the apparent anomalies that you have pointed out.

    I'll look into it some more but if you get there before I do, let me know.

    The regulatory authority is the FSA. The regulatory filing database (the unfortunately named the "national Storage Mechanism")is outsourced to Morningstar.

  9. Apologies for an elementary question but I'm just getting into investing and am wondering how you know the cost of capital is 9% in this instance?

  10. Hi,

    Good question. Cost of capital is not a science but more a judgment about risk. Cost of debt is given, in this case, by Northgate's (interest expense)/(debt) was ~8% at the time of writing and I figured that a a company with a nice cash flow profile but also quite cyclical deserved a cost of equity of ~11%. The weighted average is probably in the 9% range.

    The 11% is basically a judgment call. To simplify a bit, if the FTSE trades at a P/E multiple of 15x, then the implied cost of equity is something like 8%. Why? Because stocks in the major index are generally valued according risk and LT growth. If long term growth is ~2, then E/(P-2%) becomes 1/(15-2) = ~8. So, that's a signpost. Northgate is riskier than an index of blue chip stocks but not so risky that somone who buys it should enjoy 5% advantage over the market for life: that 5% compounds into an incredible big number over time.

    For a more rigorous (or mechanical) treatment, Aswath Damodaran has materials you can read and play around with, including a spreadsheet called WACC

  11. Oh OK, that makes a lot of sense. A company being able to generate returns on capital above its cost of capital is (naturally) very important, so having an idea of what the cost of capital is, is obviously a good starting point! Thanks

    I had one other thing, how did you know the average dollar cost of fixed assets required to support a dollar of sales was $1.68? I'm guessing I missed something in the maths...

    1. Probably easiest to link to the scratch paper:

    2. Cheers red, makes perfect sense now. Have you ever considered teaching?!Ha

      Also, should have said this earlier, very nice writeup.

    3. Since you're starting out, can I recommend that you make the following the core of your education?
      Richard Beddard's blog:
      Lewis' blog:
      Geoff Gannon's blog:
      and Warren Buffett's Berkshire Hathaway letters.

    4. Sure, I'll check them out (though I already follow expecting value).