Value Investors Club / Ritchie Bros. Auctioneers (RBA)

Description

I recommend a short position in Ritchie Bros. Auctioneers (RBA). The stock is down ~5% since the Q4 2014 earnings call, but still has ~40% downside to intrinsic value. A prior write up by ‘runner’ does an excellent job of laying out the fundamentals of the business and industry. This write up focuses on balance sheet risks, management performance, and Ritchie’s current growth prospects.

Company Description

Ritchie Bros. Auctioneers (“Ritchie”) is the largest auctioneer of industrial and agricultural equipment worldwide. Revenues are tied to gross auction proceeds (GAP), and include seller commissions of ~10% and buyer fees of ~2%. 70% of GAP comes from straight auction proceeds, and the remaining 30% of “at risk” proceeds includes price guarantee contracts and inventory purchases.

Guarantee sales arrangements are commonly used to entice first-time and risk-averse equipment sellers by having the auctioneer assume financial risk for lower-than-expected proceeds. IronPlanet noted in its S-1 that in response to increasing competition, it had increased its guarantee arrangements from 9% of gross merchandise volume (GMV) in 2008 to 20% in 2011. A third incentive that Ritchie uses to attract customers is offering sellers partial cash advances against expected auction proceeds. Since these are netted against auction sales, they don’t carry the same level of profit risk as the first two, but are obviously a drain on cash flows.

RBA has been making a large push to promote its online marketplace, EquipmentOne, which was built from the AssetNation acquisition in 2012. EquipmentOne now accounts for almost 3% of revenues, but continues to operate at a loss. RBA acquired AssetNation for $64M in cash, and seems to have overpaid for the business, considering that it only

generated $13M of revenues even after two years of development effort.

Despite reporting only 3% top line growth and negative margin trends, Ritchie trades at 27x forward P/E and 5x forward revenues. The business is currently showing several areas of weakness:

1. The auction industry is increasingly competitive

2. Ritchie’s revenue quality has been deteriorating

3. Balance sheet under-states business risk

4. Management is running out of levers to drive growth.

5. Management has demonstrated a poor grasp of the business

6. Insiders have inadequate performance incentives

7. Margin trends are negative

Detailed Thesis

Auction industry is becoming more competitive.

RBA’s moat has historically come from the scale of its physical auctions and associated network effects, but this moat is eroding as customers become increasingly comfortable with buying online. Ritchie’s management argues that a key advantage of its model is that live auctions give buyers an opportunity to inspect large quantities of equipment in one place, conducting a level of diligence that cannot be replicated online. But their own data shows that online bidders are growing significantly faster than live auctions; online bidders accounted for 41% of successful bids in 2014 (from 29% in 2008), and 62% of all bidder registrations.

Buyers increasingly prefer the convenience of bidding online to the alternative of physically traveling to auction sites.

This is a problem because online-only players like IronPlanet and OnlineAuction.com provide the same basic services -- secure transactions and equipment appraisals -- while offering reduced fees. IronPlanet has charged commissions as low as 5% by using a sliding fee structure that decreases with lot size. Other auction websites charge only for a la carte value-

added services.

At the same time, some of the largest equipment OEMs, including Caterpillar and United Rentals, have created their own online auction sites to circumvent Ritchie’s heavy commissions. Ritchie charges sellers 10% of proceeds, and buyers 2% for value-added services such as inspections, paint touch-ups, and financing (often “required” by Ritchie). In order for Caterpillar to sell equipment economically through RBA, it needs to secure a price that is at least 12% higher.

Revenue Quality is deteriorating

Ritchie’s former-CEO Pete Blake and current CEO Ravi Saligram have both experienced immense pressure to report growing auction proceeds. Prior to Blake’s resignation in 2014, GAP had been flat for several years, and as noted in runner’s write-up, the last major increase in revenue growth occurred when Ritchie introduced a buyer’s fee in 2010.

Even though Ritchie announced record GAP of $4.2Bn in 2014, this was largely offset by a decline in commission rate, which was down in Q4 2014 to 8.7% from 9.4% a year ago. This decline reflect underperformance on Ritchie’s at-risk business; in 2014, Ritchie accepted guarantee risk on a larger number of small auction lots, and was unable to sell them at profitable prices. At the same time, advances to customers doubled as a percent of seller commissions to 7%.

One indicator of revenue quality is amount of at-risk deals that Ritchie takes on. These have historically been 20-30% of total GAP, and reached 35% of GAP in Q4 2014. Management tries to downplay the risk by presenting at-risk commissions as an opportunity and arguing that Ritchie’s “information advantage” allows the company to manage underwriting risk more successfully than peers. But Ironplanet’s management confirms what Ritchie has tried to gloss over – that growing inventory sales and guaranteed commission deals are a direct response to increasing competition, the moral equivalent of reducing insurance premiums to attract business in a soft cycle:

“We entered into greater volumes of such arrangements than in prior periods as a result of the increased competition for supplies of used heavy equipment for sale…We assume more risk with these types of contracts than in our straight commission arrangements [as…] if the selling prices are less than the amount that we guarantee or the purchase price we paid for equipment, or if we are unable to recover amounts advanced to sellers, we will incur a loss” (IronPlanet S-1)

Both the fact that Ritchie’s at-risk proceeds are at the very high end of the historical range in what is supposed to be a recovering auction environment, and Ritchie’s own acknowledgement that 2014’s at-risk commissions were disappointing further confirm that Ritchie has traded off revenue quality to achieve GAP growth.

Deteriorating Balance Sheet

- Ritchie’s financial statements do not break out “guarantees under contract”, which arise when Ritchie guarantees sellers a minimum level of auction proceeds in connection with an impending sale. In its footnotes, Ritchie states that as of December 2014, the company had guarantees for $86M of industrial assets and $16M of agricultural assets. While this is still small relative to total GAP, it’s several times higher than $7.5M of industrial equipment and $28M of agricultural equipment in 2013.

- Underspending CapEx: Management has been cutting back dramatically on capex over the last two years. This helps Ritchie with their goal of increasing its ratio of FCFO to Net Earnings, but could point to pent up capex requirements in future periods. This is even more the case now as Ritchie is supposed to be investing toward its

goals of achieving low double digit GAP growth and growing US market share. Asset depreciation is $40M per

annum, while net capex was only $21M in 2013 and $16M in 2014, so it seems that Ritchie is investing at below

replacement levels. Capex is also low relative to historical trends. Between 2008 and 2012, Ritchie averaged

$88M of net capex spend per year, while operating at lower GAP and revenue levels than today’s.

- Goodwill balance is at risk. Half of Ritchie’s $82M goodwill balance can be attributed to AssetNation, the auction site they acquired in 2012. EquipmentOne’s CGU assumptions include: a 14% discount rate (note that Ritchie characterizes EquipmentOne as a “start-up), 20% compounded annual FCF growth over the next 5 years, and long-term FCF growth of at least 4%. A decline in short-term FCF growth of >2% or a >1.7% increase in discount rate would cause EquipmentOne’s recoverable value to fall below balance sheet carrying value. Either of these

seems entirely possible, given that EquipmentOne revenues actually declined from 2013 to 2014, and the increase in average monthly users in 2014 was only 13%.

- Other warnings signs. Ritchie has begun to record small inventory write downs, $1M in 2013 and $2M in 2014. While these amounts are small, they also represent the first inventory write-downs in Ritchie’s history, and are inconsistent with Ritchie’s claims that acquired equipment is held for only 30 days, and carries higher average margins than straight-commission sales.

Ritchie is running out of levers to pull for growth

Ritchie characterizes its shareholder base as growth-oriented and consistent with this, lists growth as its #1 strategic priority. The problem is that Ritchie has very few levers for growth, and even fewer for organic growth.

Organic revenue:

Ritchie seems to be struggling to increase its base of bidding customers. Its 2014 targets included growing active bidder registrations by >15%, but actual growth fell short at only 2%. More troubling is that management’s current plans include “utilizing underwritten contracts aggressively”, given that there are clear balance sheet and profitability risks associated

with these.

Inorganic revenue:

Ritchie’s main growth strategy is to use geographic expansion. This obviously requires substantial sales force and capex investments for months / years in advance of any potential pay-off. For some markets, growth will involve forging partnerships with local and government-run companies, adapting to new regulatory requirements, or dealing with trade tariffs. These hurdles may explain why Ritchie has historically struggled with growth outside of Canada. Although “growing US and Europe sales” has been a strategic imperative since at least 2008, Ritchie’s 6-year revenue CAGR has been only 3% for the US and 1% for Europe. M&A is the other obvious growth chanel, but here, management is actually more conservative – describing Ritchie’s M&A outlook at “opportunistic” and focused on “tuck-ins”. In short, neither seems promising.

Adding to this, a strong US dollar is a growth headwind. Management noted on the Q4 2014 earnings call that while European and Canadian participation in US auctions is relatively common, the reverse is much less true. This means that the current FX environment is likely to have a negative effect on US territory sales (as US equipment becomes expensive in real terms to outside bidders) while Ritchie won’t have much of an offset from other geographic markets.

Management has a poor grasp on the business

Based on reported numbers, management either has a very weak grasp on the business or is rapidly ceding market share. In its 2008 annual report, Ritchie estimated its addressable market at $100Bn and forecasted brightly, “Right now we are looking towards gross auction proceeds of $10Bn and beyond”.

Fast forward to 2014, and gross auction proceeds have just barely broken $4Bn. Ritchie’s TAM estimate for the used equipment market doubled to $200Bn in 2013, and without explanation, grew again to $360Bn in 2014 (annual reports). While Ritchie’s TAM apparently doubled twice, its total revenue growth was only ~36% between 2008 and 2014, with nearly all of this increase coming from the addition of fees charged to buyers.

Ritchie’s current CEO Ravi Saligram was appointed in July 2014, and comes from OfficeMax. Optimistic sellside analysts point to Saligram’s cost-cutting record and international background. That is TBD, but Ritchie’s corporate statement from the recently published 2014 AR shows a troubling lack of focus. “Our vision for Ritchie Bros. is not only to be the best in auctions but also to evolve beyond auctions and be the premier equipment asset management and disposition company. This will be achieved by becoming a trusted customer-centric advocate connecting global buyers and sellers through multiple channels. The beginning of this transformation has manifested itself through the purchase of AssetNation, now EquipmentOne and the launch of RB Financial Services.”

The company’s current goals include achieving 5-7 year compounded GAP growth in the high single digits (which seems difficult, absent a sudden industry-wide up-swing) and contained SG&A (inconsistent with the company’s plans for a multi-year sales force investment).

Inadequate performance incentives

While the current management is new (a new CFO and US Group President have not yet been appointed), Ritchie hasn’t had a great track record of aligning management incentives with company performance. In 2013 when net income was $94M, Ritchie incurred $8M of executive compensation expense and separately, paid $5M of benefits for CEO Separation. Even though Blake failed to achieve performance targets, he received a 25% salary increase in 2013 (ex-separation agreement) and received $24,000 for professional career counseling. In 2014, net income declined to $92M, but compensation for directors / officers actually increased to $11M (excluding termination benefits).

Part of the problem may be a lack of financial alignment with Ritchie’s Board. Prior to 2012, directors were actually required to use a portion of their annual retainer to purchase common shares. Since 2012, this plan has been substituted with DSUs (deferred share units), which are simply distributed as a lump sum cash payment after a director leaves the company. On the whole, directors have very little equity exposure outside of their DSUs.

Currently, CEO Ravi Saligram owns just under $500K worth of RBA stock, and stock ownership guidelines indicate that he will eventually need to increase his equity holdings to 3x base salary. Using Blake’s historical base salary as a proxy, this will be around $2M.

Negative Margin Trends

Core operating margins have come down from 33% in 2008 to 27% due to SG&A growing faster than revenues. Margin trends have been steadily negative, even though in most years, reported profits are helped by gains on asset sales and other income. As Ritchie embarks on a multi-year initiative to expand its regional sales team, SG&A seems unlikely to trend back down.

FCFOs also declined 16% in 2014 despite reductions in capex and a more favorable tax rate. This was largely because of an increase in Advances against auction contracts, as well as negative trends in Ritchie’s auction proceeds payable. Ritchie’s own FCF calculation excludes changes in working capital, which management repeatedly dismisses as irrelevant “seasonal fluctuations”, and urges investors to ignore these.

Assessment of Valuation

Ritchie trades like a high-growth company, even though revenue growth is flat, and even 2014’s 3% growth looked like a stretch. The company trades at 4.9x tangible book, and has forward revenue and earnings multiples of 5x and 27x, respectively. On the latter two, RBA trades at a premium to a consortium of high growth auctioneer peers (Copart, eBay,

KAR Auction Services, Sotheby’s) despite producing the lowest growth rates over 1 and 3 years. A more reasonable outlook would be for Ritchie to trade at 20x forward earnings, in line with its growth peers.

Valuation Method 1: P/E and Normalized Earnings

Calculating normalized earnings requires some work, as Ritchie’s earnings have been repeatedly obscured by gains and losses (usually gains) from property sales. For example, 2013 earnings included $11M of gains from asset disposals and $3M of other income. 2014 earnings include $8M in property impairment loss, $2M of inventory write-downs, and $6M of income from FX / other. In both years, Ritchie excluded ~$15M of software development by capitalizing costs and financing expense on the balance sheet.

To get to a reasonable 2015 net income estimate, we can assume for our base case that RBA hits the Street’s revenue target of 5%, and maintains flat SG&A and COGS ratios. Excluding nonrecurring items (write-downs and other income), subtracting $14M of software development, and applying a normalized 30% tax rate gets us to an adjusted 2015E net income of ~$84M.

- At the current 27x forward P/E, Ritchie’s implied per share value is $20 (20% below current price).

- Using a more reasonable (but still generous) 20x P/E gets us to an implied value of $15 / share, 40% below

current price.

- Downside case: As we’ve noted above, Ritchie’s management has had to take some more aggressive measures to achieve even 3% revenue growth in 2014. If the company is unable to hit the Street’s expectations for 5%+ revenue growth, there would be further downside.

Method 2: Simple DCF

Starting with the $84M of 2015E net income above, we can assume flat add-backs for noncash expenses (D&A and SBC). Because cash flows from working capital were higher than the historical average in both 2013 and 2014, our model assumes more normalized Cash from WC of 4% of revenue based on the 10-year average. Similarly, Ritchie’s capex spend in 2013 and 2014 was below replacement; we assume this reverts to replacement capex levels of $40M, and this gets us to 2015E FCFO of $87M.

Assuming a 10% discount rate, 6% FCF growth over the next 5 years, and 3% perpetual growth, we get to a fair equity value per share of $12-13.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Catalysts

Earnings miss. Consensus is projecting 5-7% top line growth through 2017 and a 5% improvement in EBIT margins between 2015 and 2017, which seem like stretch targets for the company. Specifically, an EPS miss could be triggered by:
- Higher than projected SG&A expense as Ritchie invests in recruiting and re-training its sales team, and expanding into new geographies
- Negative operating leverage from slow revenue growth, as Ritchie has high fixed costs
Negative cash flow impact from the business taking on higher under-writing risks to grow GAP
Balance sheet write downs (goodwill, inventory, or advances against auction contracts)
Ongoing management transitions may introduces further business uncertainty

Risks (for short-sellers)

Increasing sales of newer equipment (manufactured post-2010) could drive growth across the industry
Ritchie may have successful M&A-driven growth
Ritchie owns much of its auction real estate, and could dispose of properties to create quarterly gains

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			2015	2016
Price:	25.24	EPS	0	0
Shares Out. (in M):	112	P/E	0	0
Market Cap (in $M):	2,832	P/FCF	0	0
Net Debt (in $M):	-116	EBIT	0	0
TEV (in $M):	2,717	TEV/EBIT	0	0
Borrow Cost:	General Collateral