Equity Research Model
AutoCanada Inc. (Q3/19) (Update)
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Initiating Coverage, A Distressed Company in Waiting… - Target Price: C$7.58; Recommendation: Sell; Risk: High
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(all currencies are in CAD$ unless otherwise noted)
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Event: AutoCanada Inc. (“ACI” or “ACQ” or “Company”) reported Q3/19 results on Nov 07, 2019. The following is an initiating report by Modelyze Investments on ACI.
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Highlight: AutoCanada is the only publicly traded auto-retailer in Canada. The Company has been reporting declining negative earnings for the last six quarters. The long term local and foreign currency bonds have been downgraded to B/CCC with a negative outlook as of 2019Q2 due to ACI’s significant borrowing over the last decade and inefficient management of working capital. 2018 expansions into the US market are yet to become viable and dealerships in Illinois have been reporting negative operating income since their acquisitions. ACI has been growing through dealership acquisitions and despite the continuous decline, in May 2019 ACI’s management team announced the primary focus on Go Forward Plan is growth through accretive acquisitions and seeking investments. The Company is significantly restricted on its capacity for growth through OEM contract terms with OEM’s holding a vertical power throughout the process. In June 2018, in an open letter to the management team, Clearwater Capital Management raised concerns about poor margins and how ACI had been performing historically, suggesting the Company to be an attractive acquisition target. In 2018, President and four members of the board including the executive chairman were replaced. In 2019Q1 ACI’s CFO and US division CEO after only one year on the job stepped down. ACI has been experiencing declining share prices since its peak on June 6th, 2014 with stocks currently trading at IPO price levels in 2006 and company’s beta increasing as ACI has become riskier.
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Financial Analysis: Modelyze Investments considered numerous financial and operating metrics to determine the earning quality, cash flow quality, operating efficiency and balance sheet strength of the company. Operating cash flow (“CFO”) to net income over the last three years has been quite volatile and negative at times with a -908% ratio in 2019Q3; hence, earning quality is weak. To determine the cash flow quality of ACI, total debt to last twelve months earnings before interest, tax and depreciation (“Debt/LTM EBITDA”), interest coverage ratio (“ICR”) and cash flow return on invested capital (“CFROI”) are used. Debt/LTM EBITDA has been quite high and specially during the second half of 2018 when AutoCanada expanded in the US market. ICR’s have been quite low and below 1.00 x in 2019. As a result, cash flow quality is weak. Net margins are weak and negative while return on capital (“ROC”), ranging from -4% to 5%, is way below cost of capital of 10.51% in 2019Q3 given the current capital structure of the company. Consequently, operating efficiency is quite weak. With 6.1 x net debt to capitalization ratio and 68% debt to asset (book value) as of 2019Q3 given industry average rates of 0.74 x and 35% respectively, balance sheet strength is low due to the highly leveraged status of this company. Current ratios, however, have been stable and at 1.1 x.
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Management and Governance: Management, board and their committee memberships were seperately investigated. Overall, 6 out of 7 board members are independent, executive chairman of the board, Paul Antony, is independent holding the highest share ownership among insiders, and all members of Audit, Governance and Compensation Committee are independent. Management and insiders hold 753,956 common shares (excluding RSU and restricted stock awards) or 2.75% of common shares outstanding. The company has only class A common shares and no preferred shares issued. The company has a capacity for unlimited preferred shares issuance. ACI management team and board reshuffling in mid-2018 points to company’s focus on further acquisitions as the newly appointed CSO has significant expertise in M&A activities and CEO’s Go Forward Plan is growth through accretive acquisitions. Looking at the list of investors in the company, 46.41% of common shares are public float, 40% are owned by institutional investors, and 12.57% are owned by hedge funds. With 2.24% share ownership, Paul Antony, executive chairman of the board, is the only individual investor among ACI’s top ten investors list with the rest being institutional investors. As institutional investors often sell out their ownership during bad times, there are no strong minded active investors on the list to push for change during times of crisis in the company and current management team can continue to rule without any resistance from the board or stockholders. This is not necessarily a good indicator given ACI has sparked on an acquisition spree that has led prices to drop significantly over the last 5 years. Modelyze Investments believes the current management and board is not strong enough to turn ACI around from its distressed status. Further acquisitions and expansion plans are not a pathway to succession for a declining or distressed company and a change of direction is required.
Valuation: With 13.8 x Debt/LTM EBITDA, 0.72 x Interest Coverage Ratio (defined as LTM operating income/LTM interest expense), a recent local and foreign currency bond rating downgrade to B with a negative outlook, consecutive negative net earnings for six quarters and volatile and at times negative operating cash flows as of 2019Q3, ACI is a declining and distressed company. Intrinsic valuation of the company as a going concern under the assumption that ACI can repay its debt during the high growth period up until 2025, improve operational efficiency and upgrade its credit rating gradually on a quarterly basis to an investment grade bond rating of BBB does not result in positive equity valuations. The is due to the fact that ACI has a large debt burden, beta is relatively high due to the high debt to equity ratio of 3.4 x and the nature of the products sold are discretionary and cyclical. Consequently, Modelyze Investments applied a contingent claim valuation approach (option valuation of AutoCanada equity) to determine ACQ’s value. Assigning ACI intrinsic valuation of $1,116.03 million as the value of the underlying asset, underlying debt face value of $1,353.88 million as the exercise price, weighted average term to maturity of debt outstanding as the option life, and a 43% standard deviation of ACQ shares over the last five years as a measure of volatility, Modelyze Investments arrived at a share price of C$7.58. Given this analysis, the probability of turnaround for ACI’s distressed equity is 29%. Modelyze Investments also considered US auto-retailer sector pricing given their last twelve months price to sales and enterprise value to revenue (EV/Revenue) multiples. The statistical analysis of a sample of 28 publicly traded US and Canadian automotive retailers’ EV/Revenue multiples and controlling for differences with respect to operating profit margins across the sector, led to a 37% overvaluation of AutoCanada market prices with respect to the sector. Consequently, Modelyze Investments assigns a SELL recommendation with a HIGH risk rating at a target price of C$7.58 per share as of the date of the analysis.
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Risk to Target Price: Investments in ACI equity are exposed to business risks, market and sector risks as well as acquisition risks given AutoCanada go to market and expansion strategy. North American automotive industry is exposed to many uncertainties including capital markets and interest rate risks, macroeconomic risks, foreign exchange risks and USDCAD fluctuations, commodity price risks, import and foreign trade risks, high levels of consumer debt, potential shift in buyers’ behavior patterns and demand risk, uncertainty in relationships with OEM’s and their restrictive covenants, contractual risks, cyclicality of sales, and technological advancements leadings to disruptions in the industry through introduction of Uber, ride sharing or electric vehicles. AutoCanada business, on the other hand, is exposed to risks associated with the degree of ACI leverage, credit agreements and their restrictive covenants, negative earnings, cash flows and liquidity risks, failed acquisitions or integrations and the potential ripple effect on the company’s operations given AutoCanada’s aggressive acquisition strategy as well as the highly fragmented and competitive retail market. Historically, AutoCanada has borrowed too much to grow quite aggressively in very competitive markets such as United States while the business model has been strictly controlled by OEM’s and their proxies.:
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Conclusion: Modelyze Investments believes ACI is a distressed company with significant debt burden; the Company has been growing through acquisitions despite significant restrictions from OEM’s with respect to the change of control, fund raising and growth. Management have not been able to manage operating assets efficiently and maximize shareholder value. Modelyze Investments assigns a SELL recommendation with a HIGH risk rating at a target price of C$7.58 and return to target of -81.25% as of the date of the analysis.
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Contact Modelyze Investments for full initiating coverage.