Description

(Note: Fwd #'s above reflect Bloomberg Consensus. Net debt is offset against vehicles for hire) 

Thesis: Redde Northgate plc (REDD) is a slightly complicated fact pattern for a small cap, but the basic strokes of the thesis are pretty simple in that it's a juicy corporate governance fact pattern attached to a business that is far too cheap even without that angle.

In brief:

1. The underlying business is very cheap on a proforma basis after the merger. It's even cheaper with the stated synergies

2. The real core of the thesis: Management are accomplished value creators in this vertical. The incentives put in place suggest they want to tear the cover off the ball. We believe the evidence points to management being highly optimistic, seeing significant incremental opportunity, and are correspondingly highly likely to be sandbagging

3. The vision of an integrated fleet management business is actually quite attractive and could prompt a rerate if executed well.

Business Overview: REDD is the combination of Redde plc and Northgate plc, completed February 24th, 2020. Both were publicly listed in the UK prior to the combination so plenty of details are available for each as a standalone entity. Northgate is a commercial vehicle rental business in the UK, Ireland and Spain while Redde is the strong 2nd player in the UK's credit hire industry, a particular kind of specialty finance business that basically only exists in the UK and Australia. Northgate was a perennially disappointing value trap and Redde was a strongly performing business (mid-teens or better ROEs and 20%+ revenue growth) after a near-death experience during the GFC. The stated goal behind the merger was to extract synergies and build a full service fleet management business although management didn’t make their case very forcefully - which we.believe was intentional.

In the interest of brevity, a deep dive on each business isn’t that useful so I’ll just call out some relevant bullet points on each if you decide to do more work:

Northgate

• This is a pretty bog standard B2B commercial vehicle renting business. 

• It subdivides into two segments. Spain has been the crown jewel from a performance perspective despite being viewed as non-core and actual subject to some spin-off/divestiture whispers in the past. The UK & Ireland (80% larger than Spain by revenue) has been a perennial operational disappointment but this appears to be the result of mismanagement moreso than commercial vehicle leasing being unable to earn its cost of capital in the UK for some reason. 

• They are the largest rental business in their markets

• As with any vehicle rental business, disposals are a very important part of understanding the cash and IFRS accounting. This has led to an accounting change in the past but we don’t think it was in bad faith - basically the used vehicle market has stayed much stronger than expected so they changed their depreciation schedule accordingly. Conversations with knowledgeable formers reinforce the idea that there was nothing super misleading going on.

• For those plugged into the UK market, Crystal Amber among others were trying to make this one work

• Simply believing that the UK&I segment can start earning an acceptable ROCE gets you a meaningful boost in combined earnings power Interestingly, per the most recent annual: “75% of FY2020 executive Director annual bonus was awarded subject to a minimum ROCE target being achieved. 33% of legacy executive Director long term incentive targets are based on ROCE targets.“

Redde

Credit hire is a counterintuitive business to people used to US auto insurance, but it is a good business all the same. Here’s how it works:

Under UK law, when an accident occurs the not-at-fault party should not be materially inconvenienced and is entitled to a temporary vehicle of comparable quality to their damaged vehicle. To that end, credit hire firms provide a suite of services to the not-at-fault party. For Redde, this includes providing a like-for-like replacement for the damaged vehicle (credit hire), arranging the necessary repairs through their network of repair shops (credit repair), and offering legal consultation as necessary through subsidiaries (legal services). Insurers and insurance brokers generally prefer to refer the business to credit hire firms because this is not a core competency for any of them and it’s economically more attractive to simply take the upfront payment from the credit hire firm given the necessarily regionalized operations as well as the attendant risks and vagaries of the transaction. 

The like-for-like principle has been repeatedly upheld in the courts and insurers have repeatedly failed to in-house these competencies. Instead, the industry has been gradually consolidated down to Redde and Enterprise beating the rest of the small fry. 

Covid: Covid has not been awful for Northgate so far. Its business is down, mostly in Spain, but not radically so and vehicle utilization is hovering near pre-covid levels. It has remained profitable and cash generative. The UK actually showed modest ROCE improvement

While Covid has not been kind to Redde (fewer people driving means fewer accidents to address), the early evidence seems to suggest that people tend to drive as much or more after a city rebounds from Covid. This should provide nice opportunities for Redde in the post-Covid environment. 

The cashflow dynamics of Redde (new accidents make cash go out the door before it comes back in) and a strong used vehicle market has actually meant that REDD generated significant net cash during Covid and did not run into meaningful balance sheet issues. We do not see any meaningful damage to REDD’s business created by Covid. In fact, between weakened competition and the opportunity for tuck-ins, we think it has likely improved their position.

Thesis 1 - The underlying business is very cheap on a proforma basis after the merger. It's even cheaper with the stated synergies

Pretty simple here. Pre-Covid PF Net Income for the combined entity was ~90mn meaning the stock trades at 7.3x that figure. Given that Northgate grew topline MSD and Redde grew nicely into the double-digits, 7.2x seems way too low. 

What about synergies? Management appeared to be sandbagging wildly with their original figure of 10mn (on a 1.3bn revenue base!) and have subsequently found their way to ~20mn. We think that number still goes higher but, on a 15% tax rate, that’s another 17mn of NI or 6x EPS. 

Between operational improvements at UK&I and further synergies. We think another 20mn to 40mn of synergies are quite feasible, but the above are already realized.

The pre-Covid weighted average 5yr multiple for the combined business was 12.5x NTM - and that was during Northgate’s difficult years! We think that’s also too low, especially if management can achieve the improvements they envision at UK&I, but it’s a sanity check.

Thesis 2 - Management are accomplished value creators in this vertical. The incentives put in place suggest they want to tear the cover off the ball. We believe the evidence points to management being highly optimistic, seeing significant incremental opportunity, and are correspondingly highly likely to be sandbagging.

As stated at the beginning, this is why we are so excited.

Avril Palmer-Baunack has spent her career in the UK automotive industry and has had a number of notable successes, especially with BCA - the dominant used car auctioneer in the country

Early in her professional career (mid-90’s), she actually worked at Northgate but started serving on the board of Redde in 2011, serving as Chairman for many years.That ended in May of 2019 after a fabulous run alongside Redde’s CEO since a 2011 battlefield promotion, Martin Ward.

Only three months later, she became the Chairman of Northgate and immediately initiated a strategic review. Three months after that, an all-equity merger of Redde and Northgate was proposed! Even more remarkably, the CEO of Redde (Ward) would run the combined entity despite Northgate being the larger company in basically every relevant way.

Most tellingly, compensation for Palmer Baunack, Ward, CFO Philip Vincent and senior independent director John Pattullo is dictated by a ‘value creation plan’ approved alongside the merger. This plan is exclusively driven by the absolute performance of shares in the combined entity. Management attempted to set the benchmark as the post-announcement price (a ~17% haircut to pre-announcement) but, after pushback from investors, the plan was amended to the pre-announcement price (350 GBp). This deal has the potential to give this small cadre of executives up to 2% ownership of the firm over the observation of ‘at least three and a half years’.

This is a version of the relevant text (before starting price amendment):

We’ve never seen a compensation structure quite like this among UK small-caps and to push this through along with the merger appears to be them telling on themselves. The punchline is that the stock needs to appreciate by 60% over the next few years for the VCP to even be in the money and, for management to collect ~15mn, the stock needs to be up ~120%. If they hit the upper bound, we are talking about almost GBP 45mn, very substantial sums by the standards of UK smallcaps. Of course, if that were to happen, the stock will have been a 4-bagger from here.

When you compare this to the CEO’s cash compensation of 688k base plus a bonus of 290k in an ‘on-target’ year, it’s easy to see how meaningful the VCP could be to his economic outcomes.

We think this explains the undersold merger synergies and generally quiet approach to pushing the benefits of the combined company - management benefitted from as low of a starting point as they could get and felt they had clear visibility on substantially higher earnings power. 

To be tangible about sandbagging, of the 10mn of originally mooted deal synergies, ~3mn simply came from redundant pubco costs! Our work showed that the two companies overlapped branches in nine cities and even very conservative assumptions could get to 17.5mn of synergies instead of 10mn. The company has now announced ~20mn and there still could be further incremental upside.

We think the fact pattern of a sophisticated, industry-savvy management team setting themselves up for a big cash payday if they can generate strong outright performance is compelling, especially at share price levels below where the VCP was struck.

Thesis 3 - The vision of an integrated fleet management business is actually quite attractive and could prompt a rerate if executed well.

Fleet management business can be quite attractive at scale and there aren’t a lot of serious competitors in the UK. Management has begun this process by acquiring Nationwide repair services out of administration and we’d like to ultimately see extensions into fuel management, ticketing/registration and telematics. 

It’s difficult to tie this to fundamental outcomes yet but the Nationwide transaction makes sense as a first step and appears to have been done at an attractive valuation. Success here could change the market’s perception of the company and its forward prospects. 

Valuation: We think the core fundamental outcome here is pre-Covid NI plus synergies plus some growth, operational improvement and/or new business leading to net income growth. Call it 130mn of NI by 3yrs out plus ~30GBp of cume dividends. If that returns to its weighted 5yr avg multiple, that's ~660 GBp or a ~150% total return (~34% CAGR). In the event that the narrative improves or multiple management initiatives work out, it's not fanciful to think this really could be a 1000 GBp stock!

Risks:

Significant Redde share loss to Enterprise

Aggressive pushback from insurance companies

Sustained collapse of used vehicle pricing (combined with inability to raise rental prices to offset)

Ill-advised M&A to build fleet management business

Catalyst

- Reinstatement of prior dividend level (we'd rather see M&A but the market will probably like the higher div yield)

- Visibility on the post-Covid combined entity's earnings power, esp around Redde

- Evidence of operational improvement with respect to UK&I or synergies