Automodular – A Liquidation Play

Ticker: AM.TO / Stock Price: $1.61 CAD / Market Capitalization: $32.4MM / TEV: $4.71MM  / Idea Style: Special Situation / Liquidation

Note: This is a simple idea that can be easily valued on a piece of napkin. Since the business is being wound down I’m not going to post complex spreadsheets of operating performance.

Overview

Automodular (TSE: AM) is an auto sub-assembly contractor in Ontario, Canada. On May 14th, Ford, the company’s only customer, informed AM that it intends to insource the sub-assembly service and not renew the contract, which is scheduled to expire in the second half of 2014. The stock fell over 50% on the news, creating an opportunity to invest at a price substantially less than liquidation value.

For $1.50, you are getting $1.38 in cash ($1.02 cash net of all liabilities), $0.62 in accounts receivables from Ford, at least $0.90 in free cash flow generation in the next six quarters, tons of NOLs and capital loss carry-forwards (which by the way can still be monetized in Canada), no debt, a shareholder friendly management and two free options that have the potential to re-rate the stock to upwards of $3.00 a share.

 

Business Model

AM’s business model is built upon its ability to leverage lower labor costs than original OEMs. AM’s labor cost is about $19 – $21/hour; add $7 – $8 for transportation and AM’s gross margin, the effective cost is a few dollars lower than OEMs would otherwise incur had the sub-assembly been in-sourced. The spread in labor costs has fallen substantially in recent years, due to a combination of OEM restructuring and changes in state labor laws (right-to-work legislation in Michigan, etc), so it would not have come as a surprise that the company would lose its business to in-sourcing.

The contract gave AM very advantageous terms on the Capex side, with the majority of Capex spending subsidized by Ford. Earnings and free cash flow generation has been surprisingly strong in the last three years and return on invested capital reached as much as 45% so it’s not hard to see why in-sourcing this business at a slightly higher labor cost could be highly accretive to Ford.

Exit Scenarios

I think there are basically three exit strategies now that the company’s only business is scheduled to wind down in 2014.

1) Liquidation of the company’s assets to shareholders.

2) New business contract: AM performed a ten-month sub-assembly contract for a wind turbine project for Vestas, who was apparently quite pleased with the service. The contract ended in Q4 2012 and resulted in a double digit IRR for AM. In a May 14th press release, management indicated that “the company is starting to see some additional traction in its business development efforts in the wind energy space”. Management has also hired an external consultant at Deloitte to look for new business opportunities, potentially outside the component sub-assembly space. The main skill-set of the management is in contract management so their options are not entirely limited to the sub-assembly space; in an investor presentation we received last year, management highlighted over 15 potential areas for new opportunities, including warehousing, vehicle inspection & repairs, security services, facility maintenance.

I think this is currently the most likely scenario.

3) M&A: the company currently has more than $27 million in cash and I estimate that it will generate another $18 million before the Ford contract expires. The CEO told me that the board will consider making an acquisition to leverage their skillset in the event that no organic growth opportunities can be found.

Management has made it clear that diversification is currently the top priority of the board, and that they prefer new business (2) to an acquisition (3). Liquidation (1) is also an option should AM be unsuccessful with the diversification effort but is not the management’s focus.

Management has had a decent value creation track record, particularly with the two most recent contracts (Ford, expected to expire in Q4 2014 and Vestas, expired in Q4 2012), both generating a double digit IRR throughout their respective contract periods. Note that outsourcing contracts that AM engages in are normally non-capital intensive in nature (OEMs tend to subsidize a substantial portion of the Capex spending) and high return on capital. New contracts typically consume some cash in the form of initial investments but as long as projected IRR is higher than the cost of capital, a dollar of investment can create more than a dollar in value. The thesis here is that if management is able to secure a similar contract, it is reasonable to conclude that the stock is worth more than its liquidation value. A potential new business is best viewed as a free option on top of the asset (liquidation value) backing.

I view the acquisition scenario as the only real risk to this idea. Management is reasonably well compensated for a company of this size (CEO got paid 400k – 600k a year for the last two years). Even though they own some shares (~5% market cap), they are still quite incentivized to keep the business running. Many dying businesses make dilutive acquisitions to keep managements employed and I certainly can see that as a possible outcome, but I find it quite unlikely considering the impressive capital allocation track record of the management. Coincidentally the CEO had M&A experience while working as an accounting partner before he joined AM so he probably has a decent idea what to look for in case they can’t find a new business contract.

 

Management

Chris Nutt became the CEO of the company in early 2012. He was previously the CFO from 2003 to 2011. I had a meeting with him last year and found him to be quite candid about the challenges the company was facing. Nutt is an accountant and has a strong financial background, which gives us some comfort with regard to new project acquisitions.

Management has demonstrated itself to be very shareholder friendly in the last few years, having paid out $0.96 a share in regular and special dividends since 2010 (compares with today’s stock price of $1.50) and has been consistently buying back shares. The current repurchase program amounts to 6.5% of shares outstanding. I did not model this into our valuation but given that the stock trades severely below liquidation value the buyback will likely be very accretive.

Management/board owns a little less than 5% of the company and there has been some heavy insider buying of the stock since the Ford contract announcement.

 

Valuation

My analysis suggests roughly $2.64 a share in liquidation value, using fairly conservative assumptions. This does not include the potential value of the two free options I outlined earlier.

Critical assumptions:

1) The Ford contract is extended until Q4 2014, at which point the operation will be liquidated

2) Accounts receivable: since Ford is the only customer, A/R is essentially equivalent to a short-term Ford senior note. Unless you think Ford will default on its senior obligations in the next year and half, the A/R is worth 100 cents on the dollar.

3) PP&E: the net carrying value of the equipment is $8.8 million, which is only a fraction of the gross carrying value of $37.7 million. This is due to very aggressive depreciation using the diminishing balance method so the real disposal value is likely materially higher than the net carrying value. Ford will most likely buy back the equipment in its in-sourcing process so it’s not crazy to assume that at least 20% of the net carrying value can be realized under a liquidation scenario. Realistically I would not be surprised if AM got more than $8.8 million for the equipment but here we will just be ultra-conservative.

4) I estimate that the company can generate $3 million per quarter in free cash in the next six quarters, net of changes in working capital. FCF generation has been very steady in the last three years at roughly $15 – $22 million a year so I’m basically projecting that the company will earn less in the next six quarters than the average of last three years. Also note that AM did not disclose when it will close down the plant in Q4 2014, so it is possible that the company will perform the contract for more than six quarters. It is likely that AM will generate more cash than my projections given the recovery in U.S. auto sales and the relative strength of the Ford brand. This estimate is net of changes in working capital as I listed the working capital assets as separate items being converted into cash.

5) The company mentioned in its May 14 contract update that the total charge related to the closure of the Oakville plant will amount to $6 million. Roughly $600k of this is already sitting on the balance sheet as an exit provision. The company will have $4.4 million of operating lease outstanding by Q4 2014 and most likely has a cheap exit option with the landlord. The rest of the exit costs will probably consist of employee severance and facility clean-up costs.

6) AM is currently suing GM for $25 million for early termination of a contract in 2010. AM worked on a GM sub-assembly contract for a number of years as its main business, producing overhead panels for three vehicles. GM cancelled the contract and awarded it to a competitor for AM’s claimed lack of price competitiveness (CEO told us that the competitor, who undercut AM on pricing, could not lower costs enough to make a profit so the deal ended up costing GM just as much as AM would otherwise).

As a result, AM incurred roughly $8 million in closure costs and tens of millions in lost profits. I’m treating this as a free option and did not model out the expected value, though I expect that AM will at least get something given that they do have a fairly credible case. A $10 million settlement, for example, will be worth $0.50 on a per share basis.

7) AM has $8.2 million in NOL assets that it carries till late 2020s. Note that AM is a Canadian company and NOLs can still be used in change-of-control situations in Canada (I believe this is no longer the case in the U.S.). Some of this will be used in the next six quarters so it is appropriate to take a large discount on the NOL value.

8) AM also has $17.2 mil in capital losses that can be used to offset future capital gains.

AM valuation

Note that even if not a penny of FCF is generated in the next six months, you are still getting $1.75 a share in just asset value so the downside here is very limited. If AM gets a decent settlement from the GM litigation or finds a new business, I can easily see the stock at $3.

Catalysts

1) Announcement of a new business contract

2) Announcement of a special dividend

3) Favorable GM litigation result; should be concluded this year

4) Ford buying back AM equipment and hiring employees from the Oakville plant (will decrease exit costs for AM and enhance liquidation value)

Disclosure

The author of this write-up owns shares in the company mentioned (TSE: AM) and may purchase or sell shares without notice. This write-up represents only the author’s personal opinions and is not a recommendation to buy or sell a security. No information presented in the write-up is designed to be timely and accurate and should be used only for informational purposes. Readers of the write-up should perform their own due diligence before making investment decisions.

4 Comments

  1. Curious – What’s your current estimate of liquidation value? Much closer to the end of the year (= higher IRRs) but stock price has drifted back down to 2.14…

    Reply

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