Wednesday, December 5, 2012

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


  1. Hi

    Am looking at Northgate - I dont get the same FCF as the chart above. Just looking at the FY 2012 presentation. Appendix 6 of the FY 2012 presentation shows FCF of £138.2m for FY 2012 and £99.4m for FY 2011

  2. Fixed. Thanks for bringing it to my attention.

  3. Interesting company, still appears attractively priced even with its big gains in the last year.

    When you calculated the FCF above, did you take into account that the FCF is currently inflated due to them reducing their fleet?

    1. In the last table you can see that FCF includes negative growth capex.

      Run-rate earnings = run-rate FCF is, in my estimation, something like 85p per share meaning that the shares are yielding 85/350 = 25%

      If you click on the "Northgate" tag at the bottom of the post, you'll be able to see all my posts on NTG in chronological order.

      Finding 25% yield is not too hard even today but what I like about Northgate is that its vehicles are working capital, and the business -- as Richard has pointed out - is therefore easily scaled according to demand. As it is shrunk, FCF goes up and leverage goes down increasing the value of book equity; as it is scaled up, earnings go up, increasing the value of the business. Easy idea and quite a boring one, too.

    2. What I meant was that its current cash flow is high because it isn't replacing a large number of its fleet. It does make them very flexible but it makes me weary of valuing them based on current cash flow.

      I had a look at 2012 for example, and it reduced vehicles by 13,600. If it had to buy 13,600 extra to keep the fleet size stable then that's an extra £100m cost by my estimates, reducing free cash flow to £40m or so.

      Given its a capital intensive business you would expect its depreciation to understate capital requirements in the long run on a cross cycle basis which is why I'm a bit cautious about this one.

    3. 1. Keeping the fleet size stable does NOT mean buying 13,600 extra vehicles -- that would be growing the fleet size. Keeping the fleet size stable implies maintenance capex, not growth capex.

      2. Maintenance capex = depreciation unless you have a particular reason to think otherwise. Therefore RUN RATE FCF (i.e. FCF at the current vehicle fleet size) = CFO minus Depreciation. Therefore run-rate FCF = Owner earnings, by definition.

      2.As it happens, I think that D overstates maintenance capex. I have laid out the relationship between D and maintenance capex in my first post on Northgate. D is overstated because there are gains from sale of its hire vehicles. If there were gains from sale in 2008-9, it is reasonable to suppose that there will be gains from sale in 2013 and beyond: the demand for its vehicles is not likely to be softer in a positive aggregate demand environment than it was in a recession. Therefore RUN-RATE FCF = owner earnings = CFO - D + gains from sale = 85p per share.

      3. Again, its hire vehicles are basically inventory; they they live on NTG's balance sheet for a matter of just over 2 years before they are sold. I don't know what cross cycle effects are but, if it is what it sounds like, it may apply to factories and railroad tracks but it doesn't apply to NTG's hire vehicles.

      As I said earlier, the investment case for NTG is a very dull and very simple one: it relies on some light number-crunching rather than on any insights. If I were in your shoes, I'd build my own simple spreadsheet with vehicle units, CFO, & D and see what happens to the value of equity under different fleet size assumptions. Having done so, if you don't see equity value at 2x the current market cap this is perhaps not for you.

      Thanks for the opportunity to clarify.

    4. This does seem a rather compelling investment thesis, but the question I always ask before pulling the trigger is, why does this opportunity exist?

      As you say, it's quite a straightforward business, so I can't quite comprehend why the institutional money is seemingly mispricing NTG to badly...

    5. I ask that question sometimes but the answer never satisfies. "I'm right, they're wrong: they have better access to info than I do so I'm cleverer than them" gets you back to where you started: looking in the mirror and coming to a consensus.

      The best thing is to just figure it out for oneself and let other people do what they will.

      If pressed, though, I'd say that the institutionals are focused on fleet size: where's the bottom? And Spain.

    6. ps. Now that the full year 2013 numbers are in, it seems to me that the run-rate discretionary cash flow to equity (aka "earnings") is in the neighborhood of 80 million, give or take a couple of million. So the yield at the current market cap is ~16%. So, I see a ~75% upside from here.

    7. But what's to stop someone like Hertz from aggressively targeting NTG's market?
      They already do van hire and are pretty sizable so their purchasing power must at the very least be comparable to NTG's no?

    8. Everywhere that Northgate is present -- Huntingdon, Darlington, Plymouth, Scunthorpe and 60 other places -- so are Hertz, Avis, Enterprise, and any number of family businesses.

      Buying vans is easy. Selling them is harder but not difficult. What's hard is keeping so many vans employed 90% of the time that your local costs (the depot, the manager, the sales staff, the cleaning crew, etc) are covered.

      That may be easy in virgin territory or at an airport, but it's not so easy in a small town with limited, seasonal demand and a market already saturated with supply. Add another 850 vans in Scunthorpe and everyone will lose money in that market. I guarantee it. And the overall UK market for white vans basically consists of 65+ such local markets.

      If you are Hertz or Enterprise you don't want to be engaging in irrational competition; if you like Northgate's business, you buy Northgate and earn 16% on your money. You can tell your shareholders that its a nice "tuck in" acquisition, that there will be "synergies", and that it will be "earnings accretive". The sell side will back you up and your share price rises even as your cos of capital goes down.

      Not surprisingly, therefore, Northgate has twice been approached by suitors wanting to buy it outright. For example:

      And it's also worth bearing in mind that Northgate itself was largely assembled via acquisitions, most likely for the reasons sated above.

    9. Fair point, you clearly understand the industry dynamics far better than I do.

      Returning to your point about institutional eyes being focussed on fleet size, is that not a genuine concern, surely a shrinking fleet is indicative of a diminution in future cash flows? More importantly, what if the market for white vans weakens and NTG stop profiting/breaking even on sales?

      Apologies if my questions seem a little obtuse but I'm just trying to develop a better understanding of the sector, annual reports only reveal so much!
      I really appreciate your responses.

    10. These are questions that I asked myself when I was first looking at Northgate so there's nothing obtuse about them.

      Here's what I think: the demand for hire vehicles is cyclical. When the economy's ticking along nicely, then businesses (small businesses, esp) hire more vans and NTG can employ a larger fleet at 90% utilization. When the economy is in recession, then demand goes down and the fleet size shrinks.

      So, the question is, what's the bottom? I'd start with Spain: a very large share of NTG's vans in Spain were leased out to the construction industry. That level of construction activity is never going to recur. But we still have a country in a deep recession employing 35,000 of NTG's vans. Will Spain's situation improve some day? Probably. But we assume that it doesn't and we stay at 35,000 vans.

      The UK currently employs 49,000 of NTG's vans which, all things considered, is the lowest number in 10 years. If the UK economy is now recovering and if small businesses still need to hire vans for the same reasons as they did before, then we can count on 49,000 as the bottom.

      So, anyway. Total fleet size is 85k. At 85K, I reckon it's earning 70 million. At the current share price, earning 50 million represents a 10% yield. In order to shed 20 million in profit, NTG's UK operations would have to shed another 16,000 vehicles (even excepting the 48 million pounds that NTG would receive from those disposals). In the end, it comes down to judgment and I just don't think that's a reasonable expectation under any macroeconomic scenario.

    11. p.s. Put it another way: will the number of vans on hire in the UK ever fall below the comparable number in Spain today? If the answer is "no", then it seems to me that NTG is probably good value.

    12. Hmmm, I guess after one's looked at all the available information it does just come down to judgement. I'm going to try and work through some of the numbers and see what I come out with.

      Thanks for your responses, they've been very useful (that being said I'm sure I'll have more questions!ha)

    13. In the end, it always comes down to judgment. The trick, i think, is to isolate the assumptions underlying the market's pricing of the shares and to judge whether they are reasonable or unreasonable. One will often disagree with them but they may still be reasonable. In such cases, it's not worth the punt. If they are unreasonable, however, that's a real opportunity.

      Keep 'em coming.

  4. Who did you look at when you were doing competitor research outside of Hertz and Avis?
    It seems there aren't many listed pure play van rental vehicles over here in the UK...

    1. Right, NTG is it in the UK. Apart from the hybrids -- Hertz, Avis, etc -- there are hundreds of small, private, LCV rental companies that compete in local markets. NTG's market share is ~40%.

    2. May I ask where you obtained your market share information?

    3. Somwhere in here:

      I don't remember which article, unfortunately. The company, in its, April 2013 investor presentation says it's "20% of a fragmented market". I think a lot tuens on the definition of "the market" and, in any case, I dn't think anything important turns on whether it's 20% or 40%.


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