|Shares Out. (in M):||28||P/E||0||0|
|Market Cap (in $M):||280||P/FCF||6.2||0|
|Net Debt (in $M):||356||EBIT||57||0|
Buy QLTY at a ~16% 2014E FCF yield.
We think an investment in the shares of Quality Distribution (“QLTY”) is an opportunity to invest in an admittedly ‘so-so’ business BUT at a highly compelling valuation.
OPTICS: On its face, QLTY is a levered, small cap trucking company with oil price exposure (17% of revenue is in their “Energy” Segment, a cursed word to have in your SEC filings in recent months), trading at a mid-teens PE multiple.
REALITY: In reality, the Company’s business model is:
More stable than that of a traditional trucking company due to a highly variable cost structure given QLTY’s Affiliate model
Much more asset light with lower capital requirements than other Trucking peers.
QLTY’s exposure to volatility in the energy markets is quite minimal as oil price fluctuations, more specifically lower oil and lower demand for drilling, only impacts 25% of the Energy Logistics segment which in turn is only 17% of QLTY revenue. Effectively, 4% of QLTY top line is exposed to the negative headlines yet the share price has reacted as if 25%+ is exposed,
Steady free cash flow dynamics will facilitate management’s oft-repeated commitment to debt repayment confirmed by recent actions including a 12/16/14 redemption notice for $10mm of expensive debt (9.875% coupon). Although the turnaround in the Company’s Energy Logistics segment continues to get pushed out, we believe management has no intention of spending incremental capital to grow this segment and that any positive results would provide QLTY investors a free ‘Call’ option on the upside with the ‘Option’ premium having already been paid by prior shareholders (management has made it clear to us in discussions that they will not allow the business to enter a FCF negative stage, hence the ‘Premium’ has been fully paid by past investors).
On a FCF basis (2014E: $45mm), at a 10% FCF yield QLTY is a $16.01 stock, 61.6% upside to its current price.
Over time we expect debt to decrease materially as management has publicly stated (and correspondingly acted to boot), its intention of utilizing all available free cash flow to pay down debt until the company attaints its desired leverage of 2.5-3.0x Debt/EBITDA.
At 11x-15x 2014E EV/EBIT of ~$57mm, QLTY is a $9.65-$17.77 Stock which is -2.6% downside and 79.3% upside to 12/22/14 share price of $9.91. This range compares to an average multiple for comps of 16x which, as described below, we believe have more capital intensive and hence inferior business models. At the same 16.0x multiple of comps, QLTY is a $19.80 stock, offering 100% upside to its current price.
Quality Distribution is engaged in the transportation of bulk chemicals primarily in North America. It operates in three segments; Chemical Logistics, Intermodal, and Energy Logistics.
Representing 67% of total revenue and 55% of Adjusted EBIT, the Chemical Logistics segment is involved in the transportation of a broad range of liquid and dry bulk chemicals as well as food grade products. Quality is one of the primary carriers for many of the major companies engaged in chemical processing (i.e. end users of major Chemical companies produced chemicals); including Dow, Proctor & Gamble, Bayer, Shell, DuPont, Unilever and Honeywell. Management estimates that it has 14% North American market share in this segment.
Representing 15% of total revenue and 49% of Adjusted EBIT, the Intermodal segment provides intermodal ISO tank container transportation through its subsidiary Boasso. This segment provides services that facilitate the global movement of liquid and dry bulk chemicals, pharmaceuticals and food grade products. Company terminals are positioned near major shipping ports along the Gulf and East Coast, as well as inland ports in Chicago and Detroit. Boasso also provides tank cleaning, heating, testing, maintenance and storage services to customers (40% of segment revenue). Key customers of this business include BASF, Lubrizol, Syngenta, DuPont and Honeywell. Management estimates that it has 50% North American market share in this segment.
Representing 17% of total revenue and -1% of Adjusted EBIT, the Energy Logistics segment is responsible for the transportation of water and crude oil for the unconventional oil and gas market. The company has operations in the Bakken, Eagle Ford, Marcellus, Mississippian Limestone, Mowry, Niobrara, Permian, Tuscaloosa Marine, Utica and Woodford shale regions. QLTY manages approximately 1,400 units (tractors, trailers and service equipment) of energy equipment in this market and serves national and regional exploration and production companies, as well as marketers of oil. Management estimates that it has 10-12% North American market share in this segment.
Key Company Attributes
Asset Light Model & Variable Cost Structure: the Affiliate Business Model
Quality operates the majority of its business in an asset light fashion whereby capital expenditures are primarily limited to trailers that the Company leases to its 26 independent affiliates.
By outsourcing the acquisition of the Tractor to its affiliates, QLTY eliminates ~2/3rd of capex associated with Tractor-Trailers as a typical trailer costs $60,000 compared to a Tractor at $110,000. Critically, the useful life on the Trailer is 20-30 years compared to useful life of 5-7 years on a Tractor. In short, QLTY is outsourcing the less compelling (and more frequently recurring due to dramatically shorter useful life) component of the capex required to operate its business.
So what does QLTY do if it outsources a material component of capex to its Affiliates? Why do Affiliates sign up? What is QLTY’s value add?
Due to its size and extensive customer relationships, QLTY is responsible for the initial sales transaction with a customer looking to transport product from its facility to a particular location. Quality then coordinates the arrangement between the customer and one of its regional affiliates who will pick up and deliver the shipment. QLTY’s value-add then is as a scale driven ‘matchmaker’ between customer and transportation provider, akin in many ways to a freight forwarder (virtuous reinforced cycle as it adds affiliates and increases its customer touch point)
Further, in a similar fashion to a franchisor/franchisee relationship, Quality provides the sales force, insurance, technology/back office, regulatory oversight, and weekly cash settlements for the transaction.
Affiliates are responsible for most of the operating expenses related to the business they service, including costs related to the acquisition and maintenance of tractors, driver compensation and fuel costs. Occasionally affiliates will also lease trailers from QLTY.
The typical contractual arrangement with an affiliate yields a 12-15% share of the sale to QLTY.
With affiliates responsible for capital investments and most of the operating expenses related to the business they service, QLTY is left with minimal capital requirements, a highly variable cost structure and correspondingly, decent free cash flow visibility. This business model also results in a low tangible assets/revenue ratio (or conversely higher dollar per tangible asset), and high ROIC relative to traditional trucking companies.
Key Takeaway: QLTY earns more for each dollar it spends on PP&E than conventional trucking peers; conceptually this is what you would expect given its revenue structure outsources a major component of capex.
The petrochemical industry is one of the most direct beneficiaries of low cost natural gas feedstock in the U.S. According to the American Chemistry Council (ACC), the current expectation is for the petrochemical industry to invest approximately $100 billion from 2010-2023, with plans to build 200+ chemical projects over that time period. This should propel further need for transport of chemicals providing growth opportunities for QLTY. We admittedly do not have a firm view as to how the compression of the global natural gas arb (cheap US, expensive foreign gas tied to oil prices which have come down) will impact domestic chemical capex and this is a risk to note.
Why Does the Opportunity Exist?
Overreaction to: Short term EPS
On November 5th QLTY reported Q314 results which beat analyst estimates, driven by solid topline performance in its Chemical (+11% YoY) and Intermodal (+15% YoY) divisions and slight total adjusted EBIT margin improvement.
On the earnings call, management reiterated its expectation of full year net capex of $10-$15m, free cash flow in the range of $45-50m, and its long term Debt/EBITDA target of <3.0x. In Q3 alone, the Company generated $21m in Free Cash Flow and redeemed $22.5m of its high cost senior secured notes.
Despite the strength in the quarter, management revised full year EPS guidance down by 2 cents due to the delayed refinancing of its 9.875% Senior Secured Notes and continued softness in the Energy Logistics segment. Analysts responded by decreasing their 2015 EPS estimates as a result of the higher-than-expected interest expense and a slower ramp towards Energy Logistics profitability.
Over the next two days QLTY’s stock price responded by dropping 14%.
Overreaction to: Headline Oil Turbulence
As the price of oil continued its steady decline over the following weeks, investors dumped anything and everything energy-related, including the admittedly illiquid and small cap QLTY.
QLTY continued falling despite what in reality is its de minimis exposure to oil prices (as noted, effective exposure to oil price sensitive business is only 4% of QLTY top line). More on that below.
At a current traded price of $9.91/share, QLTY has dropped 23% since reporting quite impressive third quarter results.
Overreaction to Refinancing Delay
On the call, CFO Joe Troy noted that the Company was unable to secure new rates and terms that would justify the $9.5m early termination fee and therefore decided to delay the refinancing. He very clearly restated however management’s intention to use virtually all of its free cash flow to pay down debt until the Company reaches its target of <3x Debt/EBITDA
“Now that the bonds have passed the early call date… we can, with free cash flow of approximately $50m a year, call the bonds in $10m chunks at any point in time… and generate substantial savings that way as well.”
One month later the company issued a redemption notice for another $10m of the senior notes, with Troy commenting “This redemption is a further step in achieving our previously discussed goal of reducing our cost of debt while maintaining strong liquidity.” Through 9/30/2014, principal payments on long term debt have been $40m, including $22.5m of its high coupon 9.875% 2018 notes. With $40-$50m of annual free cash flow generation, management seems on its way to reaching its target leverage goal.
Energy Segment: Free upside, Exposure to NEW drilling minimal, Management keen on keeping at or above FCF positive levels = Headline scare at best without justified fundamental impact on valuation
QLTY began its energy-related operations in 2012 after making a series of transportation asset acquisitions near major shale plays in the US.
The company now operates its Energy Logistics segment in the Bakken, Eagle Ford, Marcellus, Mississippian Limestone, Mowry, Niobrara, Permian, Tuscaloosa Marine, Utica and Woodford shale regions where it is responsible for the transportation of water and crude oil for the unconventional oil and gas market
As opposed to the Chemical Logistics and Intermodal segments, QLTY’s Energy Logistics division is not entirely outsourced through Affiliates: operations at the Eagle Ford and Bakken still company-operated (~45% of Energy Logistics revenue).
Transition within Energy – Slow Grind Toward Affiliate Model
In 2013 management entered into new independent affiliate relationships, beginning a long-term plan to restructure this group towards a more variable cost structure akin to the Chemical Logistics and Intermodal divisions.
Continuing to struggle with these non-affiliated operations, management pushed back its expectations for improvement in this segment to mid-2015, noting that the Energy Logistics business will continue to experience some volatility until the entire segment is affiliated.
Management’s stated goal is to bring this division to a >10% EBITDA margin (from 5% currently) once fully transitioned to an affiliate based model. Currently, the market appears to ascribe zero value to this segment. With all of the capital expenditures required for this division already spent and virtually no operating profit currently being generated from the business, any improvement in Energy Logistics would just be upside for investors.
Oil Prices: Limited Impact due to Focus on Existing Wells not New Drilling
The steep drop in oil prices over the past 2 months has most certainly contributed to investor disinterest in QLTY. Yet although declining oil prices may cause companies to idle the drilling of new rigs, and slow down the need for fracking related hauling activities, Quality only has limited exposure to new oil and shale plays.
The Company had prudently moved away from its riskier drilling water business which is tied to up-front development work and has instead focused on hauling oil and discharge water from existing wells. After the well is tapped, the hauling of crude oil, gas etc. is a fairly steady and predictable business unaffected by fluctuating commodity prices. Though the Energy segment only accounts for 15% of company revenue and virtually no profit contribution to the company, the new drilling related portion of that revenue is even smaller, representing only 25% of the total Energy Logistics revenue, or 4% of companywide sales.
Use of Cash: As noted, run-rate free cash flow in the near term is in the $45-50mm+ range and the company is adamantly committed to deploying all of its FCF to pay down debt until it reaches target leverage levels of 2.5-3.0x Debt/EBITDA. The company does have an NOL which naturally lifts FCF over the next few years (through 2016 per our discussions with Management). On a tax adjusted basis, but same current numbers, we get roughly $34-41mm (~$9mm of taxes assuming 30% tax per Q413 CC and ~$27mm of EBT: 30%+ upside assuming 10% Free Cash Flow Yield).
QLTY is cheap on EV/EBIT basis.
Debt Paydown: Management claims they are committed to using all free cash to pay down debt until leverage multiples approach the 2.5x-3.0x Debt/EBITDA range. As the balance sheet de-levers value should ultimately accrue to the equity.
Energy Logistics: The Energy Logistics segment currently contributes virtually no operating income to the overall Company. Uncertainty surrounding this segment’s planned turnaround and the headline risk associated with its exposure to oil price volatility has created an overhang on the stock price. While management has not given any indication that a sale of the Energy Logistics is on the horizon, we believe that any announced disposition plans would undoubtedly be a boon for the stock price. In the meantime, if management is somehow able to fully affiliate this business, continue decreasing its dependence on fracking related sources of revenue, and ultimately manage to approach its 10% EBITDA margin target, it would certainly provide an additional catalyst for QLTY’s valuation re-rating.
Driver shortage in trucking space
Mitigant: Shorter length of haul and more specialized driving (Hazmat) enables Quality to attract enough drivers to sustain and grow its business
Poor use of FCF (ie. Energy was clearly a bad acquisition)
Mitigant: Management admits as such and is committed to using all free cash flow to repay debt. Actions to-date verify this commitment.
Energy segment turnaround
Appreciation that energy/oil exposure 'not there' in meaningful way