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.

Silver Chef -- Equipment Leasing

Silver Chef is an Australian company with a straightforward business model. 

Hospitality start-ups – new restaurants – are often starved for cash. They need to invest in professional cooking equipment but purchasing it outright is risky and ties up more working capital than they can spare. The typical piece of equipment costs $10,000. Silver Chef offers them a lease-try-buy option. They commit to leasing, for example, a Middleby convection oven and Silver Chef then buys it and rents it to them. The minimum lease term is one year, and they pay rent monthly, in advance. Banks require Director guarantees, Silver Chef doesn’t. If they can’t pay, the oven is repossessed.   

If their business succeeds, they have the option to buy that piece of equipment and are credited for some of the rental fees they’ve paid. Some do buy but most don’t – they continue to lease because the rent is off-balance sheet.

One can see how it’s a win-win for both parties. Besides, banks concentrate on large businesses, Silver Chef concentrates on small enterprises.

Silver Chef succeeds in making this model work. No one customer constitutes more than 1% of revenue, thereby limiting risk. It grows fast and grows profitably. 

It has the bright idea that the best customers may be franchisees of well-known, fast-growing brands, and it now targets the franchisees of Dominos Pizza, Subway, The Coffee Club, Nandos, Outback Jack’s Bar & Grill,   Gloria Jean’s, and Wendys (an ice cream franchise, not the hamburger chain). These customers subsequently make up a substantial share of its business, are lower risk, and present excellent growth opportunities.

Better, once embedded in these brands, word of mouth makes it likely that there would be some protection from  price competition waged by potential entrants into the equipment leasing space.

The next bight idea: since this model works well in hospitality, why not extend it to other sectors? Silver Chef establishes GoGetta in 2008 and does very well indeed. Earth movers, gym equipment, cash registers, hydraulic pipe benders, trailers, you name it. Same value proposition, same sized businesses, different sectors.

Anyway, here are the financials:

 (NB: Silver Chef's been in business since 1986, went public in 2005, and I don't have access to 2004 balance sheet information).

The above somewhat understates the profitability of Silver Chef's business. The cash recovery rate captures it better:

As an aside, I am convinced that, when Buffett looks at a stock, its CRR is what he calculates first, because it is so quick and so reliable. Consider, for example, this discussion of his investment in Mid-Contental Tab Card Co.

In any case, Silver Chef is in the business of turning purchased assets into cash and one can see from the table above is that it does that quite well and it's getting better at it as it grows.

So, that's where we are: Silver Chef is a simple easy-to-understand business, with a CAGR of 45% over the last eight years, earning its cost of capital, with an as yet 3% penetration of its potential market. It is selling in the market at a yield of 11.65%.

It's no growth value, at an 8.5% cost of capital, is close to AUD$5.15.  If you ask a Buffett-like question -- "Will I earn 15% on $170m of sales?" -- the answer is much more likely to be "yes" than it is to be "no". 

I'd venture that Silver Chef's minimum true value is in the neighborhood of AUD$12.

Disclosure: No position.

Precia SA -- Measuring instruments

Precia Molen ("Precia") is a supplier of instruments that measure, weigh, count, and dose in contexts where exactitude matters a great deal – pharmaceuticals, chemicals, agro-industry, mining, construction, railroads, and many others. Its instruments “weigh anything from a grain of wheat to a sea-going vessel”.  

In support of the design, manufacture, and marketing of these instruments, Precia provides a number of pre- and post-sales services: instrument selection advice, application engineering, pre-installation visits, calibration and commissioning, on-site training, repairs, spare parts, and so on.

Industrial weighing is important, and in some circumstances mission critical: imperfect weighing of pig iron will cost someone a lot of money; imperfect measurement in flavors and fragrances will lead to the manufacture of unusable batches; imperfect measurement of pharma dosages may cost lives. 

What matters most, therefore, is not going to be price, but service and reputational quality. 

This means that measurement instrumentation is a business suited to specialists – in established markets, one can’t easily buy in to the business: one has to wait a long while before a reputation is built, distributor relationships forged, service personnel reach appropriate levels of excellence and reliability. 

For incumbents, therefore, gross margins should be very high, and corporate financial health – operating margins, return on capital, cash conversion -- should follow from that. As the incumbent's business grows, overhead should constitute a smaller share of costs, replacement parts and services should constitute a larger share of revenues, and the return on incremental investment should therefore outstrip ROIC.

Like so:

Precia is currently yielding 18% and is worth approximately €135 – without growth, just doing maintenance business and servicing its current client base.

In recent years, however, Precia has sought to expand internationally, i.e. beyond the European Union. International sales now account for 34% of sales and 31% of profit.

While the company has identified Brazil, Australia, Indonesia, and Eastern Europe as promising markets for its products, its activities in these markets is still embryonic. 

Those international markets in which it has already established a presence, however – India and Morocco, in particular – are growing at 14%, helping to drive overall revenue growth by 4.5%. The client list of Precia's India subsidiary is illustrative of the potential:

It's not out of the question that international sales (and profits) will constitute 50% of both revenue and profit within three years. In fact, it seems unlikely that it won't: India alone contributed 2.8 million to revenue in 2010, 3.65 million in 2011, and is on track for something like 4.55 million in 2012. Brazil is a similar opportunity to India, in terms of both size and market characteristics. 

Barring exceptional events, therefore, one can peer into Precia's future:

If one assumes that an ex-cash P/E ratio of 1.77x is unreasonable for a quality business, one can envisage two paths to share price appreciation by 2015 -- via multiple expansion and via growth in earnings power:

Precia, then, has all the characteristics of the kind of investment that I have had success with: a solid competitive position, a clear pathway to growth, increasing economies of scale, a clean balance sheet,  free cash flow generation, significant insider ownership, and a history of increasing payouts. It is the safest way that I can think of to earn annual returns of 25% or more.

I am in debt to Nate at Oddball Stocks for the lead. His recent post on every stock he's ever written about is a treasure chest.

Disclosure: I have a partial position in Precia and intend to accumulate more shares in the near future.