Equity Research Model

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AutoCanada Inc. (Q4/19) (Update)

Small Improvements with a Long Road to Ultimate Survival - Target Price: C$8.86; Recommendation: Sell; Risk: High

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(all currencies are in CAD$ unless otherwise noted)

EventAutoCanada Inc. (“ACI” or “ACQ” or “Company”) reported Q4/19 results on March 12, 2020.

Highlight: Operating loss of $(6.6) million and net loss of $(16.8) million ($(0.63) per share) were below Modelyze Investments forecasts of $15.9 million and $(4.8) million ($(0.17) per share) in Q4/19. This represents an operating income decrease of 139% relative to Q3/19 and net loss decrease of 162% relative to Q4/18. 2019 annual operating income was $40.3 million relative to $(32.6) in 2018 and net loss was $(30.5) million relative to $(78.1) million in 2018. These losses are the result of annual impairment charges of $(24.0) million as compared to $(23.8) million in 2018 as well as additional expenses due to the adoption of IFRS 16. Company’s long term local and foreign currency bonds are still rated at B with a stable outlook and senior unsecured notes are rated at B- (S&P Global Rating). Working capital is yet to improve with inventory days increasing to 111 days in Q4/19 relative to 85 days in Q3/19 and relative to a sector average of 70 days. Cash conversion cycle increased from 88 days in Q3/19 to 108 days in Q4/19. With a 4.2x debt to capitalization (6.2x as of Q3/19) and 72% debt to asset (book value) (68% as of Q3/19) given industry average rates of 0.78x and 42% respectively, ACI is highly levered. Further debt financing and private placement initiatives including a tender offer to purchase all of its outstanding 5.625% senior notes due May 25, 2021 for cash in Q1/20, led to the increase of the average tenor as of Dec 31, 2019 of long-term debt from approximately 16 months to approximately 4 years. AutoCanada maintained its $0.1 per share dividend, payable in Q1/20.

Details: Q4/19 was a relatively weak quarter from operating efficiency and balance sheet perspective and moderate from earning quality and cash flow perspective. With a volatile and at times negative operating cash flow (“CFO”) to net income over the last three years, earning quality has been low though CFO to net income ratio increased from (908)% in Q3/19 to (632)% in Q4/19. AutoCanada was able to decrease the debt burden on balance sheet by divesting assets, selling redundant Canadian properties and ceasing operations of two underperforming US franchises. This improved the debt to last twelve month EBITDA ratio to 12.17x in fourth quarter from 13.8x in the previous quarter and consequently, annual interest coverage ratio improved to 0.59x from (0.69)x in 2018. In Q4 cash flow return on invested capital increased to 12% from 4% in Q3; hence, cash flow quality has improved ever so slightly. Despite this, with a 72% debt to asset ratio and 4.0x net debt to capital which are significantly above sector averages, balance sheet is highly levered and strength is low. Operating efficiency has also been quite weak due to $24 million impairment charges in the quarter which is a potential consequence of overpayment for acquisition targets with premiums above and beyond the best case synergy values as well as losses relating to the adoption of IFRS 16. In Q4, operating margin on an unadjusted basis was (0.8)% and net margin was (2.1)%  which were a slight improvement to 2018 numbers ((0.1)% and (3.5)%). On an annual basis, 2019 operating margin and net margin improved to 1.2% and (0.88)% from 2018 numbers ((1.0)% and (2.48)%). As part of the Go Forward Plan, ACI continues to emphasize the strategy to grow EBITDA and create a more reliable business model to sustain all economic cycles through increased sale of used vehicles and core initiatives such as Project 50, Finance & Insurance training programs, Service Bay Occupancy and Business Development Centre, Special Finance for more credit challenged customers, Collision Centres, and Cross-Border Wholesale. On the M&A front, which has been the core focus of ACI over the last decade, management continues to look for acquisition targets and growth at a reasonable price while maintaining a net debt to adjusted EBITDA ratio target range of between 2.5x and 3.0x post acquisition. Nevertheless, with significant leverage, Modelyze Investments believes further acquisitions and expansion plans are not a pathway to succession for this declining or distressed company. Further enhancements to strengthen the balance sheet and increase cash flows from existing assets lead to the long road of ultimate survival.

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Valuation: 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. Consequently, Modelyze Investments applied a contingent claim valuation approach (option valuation of AutoCanada equity) to determine ACQ’s value. Assigning ACI intrinsic valuation of $1,003.45 million as the value of the underlying asset, underlying net debt face value of $1,348.99 million as the exercise price, weighted average term to maturity of debt outstanding of 4 years as the option life, a 44% standard deviation of ACQ shares over the last five years as a measure of volatility and 0.27% dividend yield, Modelyze Investments arrived at a share price of C$8.86. Given this analysis, the probability of turnaround for ACI’s distressed equity is 22%. 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 as of the date of the analysis. The statistical analysis of a sample of 21 publicly traded US and Canadian automotive retailers’ EV/Revenue multiples while controlling for differences with respect to operating profit margins across the sector, led to a 21% undervaluation of AutoCanada market price with respect to the sector. However, given AutoCanada’s significant debt burden, B credit rating and an 18% cost of equity, Modelyze Investments assigns a SELL recommendation with a HIGH risk rating at a target price of C$8.86 per share as of the date of the analysis.: 

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.

In January 2020, COVID-19 spread across the world, impacting financial markets and the world economy. On March 8, 2020, Saudi Arabia initiated a price war with Russia which triggered a 34% fall in US oil prices, 26% fall in crude prices and 24% fall in brent oil prices. On March 9, 2020, risk free rates in Canada as well as the US dropped to their 10-year lowest levels and fear led to significant volatility in the market. These macroeconomic events can significantly impact the supply and demand chain across all industries including the auto industry, one which AutoCanada would fail to escape and with significant debt burden, these crises could make it difficult for both the Company to continue operating and service its debt.

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 and with minimal focus on improving cash flows from existing assets. Management have not been able to manage operating assets and working capital efficiently despite recent efforts to improve balance sheet and to maximize shareholder value. Modelyze Investments assigns a SELL recommendation with a HIGH risk rating at a target price of C$8.86 and return to target of 11.8% as of the date of the analysis.

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