Northgate's 2013 Results

Northgate  reported its FY 2013 results todays The company incurred a £54 million charge in order to reduce its interest expense from 7.1% to 2.8% . The lower interest charge translates into $20 million in additional annual after-tax cash flows to equity.

Here’s its free cash flow history:

Here’s what its valuation looks like:

Corrected:  July 9th

This is how I arrive at 700p:

Disclosure: I am long Northgate

Portfolio Update

I've reduced my position in Northgate by 40%.

Northgate plc -- Part 2

This is an investment idea that requires very little imagination. It is premised on four factors:

Northgate’s business is sound. Stepping back from the accounting presentation of the business helps to reveal the underlying mechanics of the business. The table below illustrates what happens on a cash basis in rolling 20 to 21 month periods. The key to performance is the utilization rate: 90% is good; 83% is what happens when a quarter of your vehicles are targeted to the Spanish construction industry when the bubble bursts. 

The company's maintenance capex requirement is less than its depreciation rate. Subtracting growth capex (i.e. expenditure for fleet size growth and expenditure on goodwill & acquired intangibles) from total capex reveals that maintenance capex is about 62% of depreciation.

True earnings are therefore higher than may be perceived from a quick glance at the financial statements. In fact, at the current price, Northgate’s equity is yielding 34% on trailing earnings and 35% on average earnings over the past ten years.

As growth is interrupted - momentarily, at least - free cash begins to flow.  In two years, Northgate’s debt has been reduced by 300 million. In another year it will be down to 200 million, an optimal level. The year after that, if the economic environment is as it is now, it can buy back 40% of its shares. Et cetera. 

Nothgate's value exceeds 700p

Disclosure: I am long Northgate

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 

Postscript: 

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.