Description

ATS offers an extremely rare combination: a business with very good economics; an outstanding history of profitable growth (revenues have grown every year and the underlying business has been profitable every quarter since it was founded); attractive growth prospects; a high cash distribution yield (9.2%) which is likely to be increased significantly in coming months; a reasonable valuation, offering potential for capital appreciation through multiple expansion; and little downside risk.

(All amounts are in Canadian dollars including stock price and market cap.)

ATS Andlauer Income Fund (“ATS” or “the Fund”), a Canadian income trust traded on the Toronto Stock Exchange, should provide an investor today with a total return of perhaps 40% over six to twelve months, and at least 80-90% over the next two years, through capital appreciation and cash distributions. The units currently pay $0.0941/month ($1.1292/yr). I believe that this distribution rate will increase by 10-15% later this year, and by perhaps 40% over the next 24 months. At that time I expect the stock price to be about $20-21, and this capital appreciation, along with distributions, should result in a total return of 80-90%.

Additionally, if investors over time award Canadian income trusts valuations based on both the cash yield and the quality and prospects of the business (rather than primarily on the cash yield, as is the case today), it is not hard to imagine a total return of 120-160% over two years.

WHY THE OPPORTUNITY?
The main reason for the low valuation today is that investors have not recognized ATS’s true earning power, due to certain quirks associated with the IPO. The Fund was created and went public in September 2005, simultaneously acquired the underlying business (which was founded in 1991), and adopted a calendar fiscal year, whereas the underlying business previously had a fiscal year-end of 10/31. Because of the IPO’s timing, and the fact that the Fund was a new entity, it did not publish 2005 full year earnings when it announced fourth quarter results. In the prospectus the historical income statements of the business are provided, but the last full year of numbers was fiscal year 2004. To get a clear picture of current earning power, one has to piece together 2005 and trailing twelve-month numbers, a somewhat messy process. Once this is done, however, it becomes very clear that the current earnings and distributable cash far exceed today’s distribution rate. (My conversations with the CFO, Brian Mascarenhas, have confirmed the accuracy of my calculations.)

KEY INVESTMENT HIGHLIGHTS
* ATS has carved out a very attractive niche in the Canadian business-to-business transportation industry, with customers willing to pay premium prices for its specialized logistics services and top-notch customer service.
* Profitable every quarter since inception, with 12%+ EBITA margins in recent years.
* A non-capital-intensive business model requiring little PP&E and working capital, so that the company can grow despite distributing most of its profits.
* A very reasonable stock price resulting in today’s 9.2% cash yield.
* Top-line CAGR of 17.4% over the last five years, including 34% and 22% growth in the last two years.
* Good growth prospects, particularly in pharmaceuticals due to recent regulatory changes affecting transportation of drugs.
* Strong likelihood of a big increase in the distribution rate later this year, because of the requirement that the company pay out 80-90% of its “distributable cash”, a number far higher than the current distribution rate.

THE BUSINESS AND ITS HISTORY
The security recommended here is units of ATS Andlauer Income Fund, which went public in September 2005, with proceeds used to acquire ATS Andlauer Transportation Services Inc. This company was founded in 1991 by Michael Andlauer, and has grown steadily since, to revenues of $26 million in 1996, $77 million in 2000, $128 million in 2004, and $174 million in the twelve months ended March 2006. Remarkably, the company has been profitable every quarter since it was founded.

ATS describes itself as a leading single source, full-service transportation solutions provider, focusing on business-to-business distribution of higher value consumer products in Canada. The company provides a broad range of transportation services, including: courier (39% of revenues), airfreight forwarding (12%), and less-than-truckload (LTL) and truckload (TL) transportation (49%). The company started with four distribution centers, supplemented by transportation agents in other areas of Canada. Since then the company has expanded to 23 distribution centers across Canada, giving it a national footprint, reducing its use of other transportation agents, and giving the company greater control and consistency. There are no plans to add more centers.

The strategy is to serve markets that are less price-sensitive due to the nature of the products being shipped, and where the customer is willing to pay a premium for ATS’s value added specialized services and logistics capabilities. The products shipped tend to be high value and time sensitive. Examples are pharmaceuticals (a product whose value is high relative to weight, and where temperature management is now very important due to new regulations in Canada), DVDs/CDs (where the timing of the release is important, and the timing of delivery to the retailer has to be carefully planned), and cellphones. ATS aims to be a “one-stop” transportation solutions provider for large companies, and management believes that its national reach, comprehensive services (courier, air freight, and truck), and ability to provide a broad range of value added services give it a competitive advantage over other players, who tend to be regional or do not provide the full range of services.

At first glance I was inclined to think of ATS as just another trucking company. Upon closer analysis, a better description would be the one provided above, i.e. a “transportations solutions provider”, or a “logistics specialist”, based on the company’s business model and customer focus. Importantly, the business model is non-asset-intensive, with a majority of the trucks run by independent owner-operators. The company leases some trucks and all its distribution centers. At 3/31/06, ATS had net PP&E of just $2.4 million, and TTM sales of about $174 million. So the company requires very little PP&E to support growth. The biggest asset on the balance sheet is receivables, as I discuss in the “Financials” section below (excluding the intangibles created as part of the IPO process and the Fund’s acquisition of the business, since these are just accounting items for our purposes.)

Additional information on the company and regulatory filings can be found at www.atsincomefund.com and www.sedar.com.

CASH DISTRIBUTIONS
ATS has targeted a payout ratio of 80-90% of each year’s “distributable cash flow” to unitholders. Distributable cash flow is EBITDA less capex and interest. An important element of my thesis is that based on this targeted payout, ATS will increase its distribution rate significantly in coming months. Conversations with the CFO confirm this, though he is understandably coy about discussing the timing or amount of future increases.

The IPO was priced at $10, and the initial distribution was $0.081/month ($0.972/yr). Seven months later, in April this year, the rate was increased by 15%. The company just announced a further 1% increase, to $0.0941/month ($1.1292/yr) for the third quarter of this year. Because ATS’s profits have grown dramatically recently, it has the enviable problem of having “distributable cash” which far exceeds the current distribution rate. I estimate below that the distributable cash is $1.70/unit based on the trailing twelve months. The targeted payout ratio of 80-90% implies that the annual distribution should now be between $1.36 and $1.53/unit. The current distribution rate of $1.1292 thus needs to be increased by 20-35% to bring the Fund into the payout ratio range. And this assumes no growth in profits in coming quarters.

“Distributable cash” calculation: 12 months ended 3/31/06

EBITDA $21.5MM
Less:
Maint cap ex (0.4)
Growth cap ex* (0.4)
Add’l G&A ** (0.4)
Interest expense (0.5)

Distributable cash $19.8MM

Dist cash/unit $1.70
Targeted payout $1.36-1.53/unit
(80%-90%)

* The company does not deduct growth capex in its own calculation, but it seems to make more sense to do so.
** Incremental pro forma public company G&A expenses for 6 months before IPO.

Right from the IPO, in part because of its timing, ATS’s distributable cash has far exceeded its regular distribution rate. The fourth quarter is seasonally the strongest quarter. Because the Fund is required to distribute all of its taxable income in any year, management declared a “one-time” special distribution at the end of 2005, of $0.3343/unit. Since going public, ATS has paid a total of $1.01/unit in distributions over the eight months through May. Assuming that the rate is not changed again through September, it will have paid out $1.38 in its first twelve months of being public. This is consistent with the calculations above in demonstrating ATS’s earning power and distributable cash.

Management announces each quarter’s distributions (three monthly payments) quarterly. The modest 1% increase for the third quarter gives management the flexibility to evaluate business conditions before increasing the rate further. My guess (and it is just a guess) is that in September/October they will announce an increase for the fourth quarter of 10-15%, which would result in an annual rate of $1.24-$1.30, translating into a yield of over 10% at today’s price.

Public companies obviously prefer to never cut their dividend. This tendency is exacerbated in the case of trusts such as ATS that are perceived by many investors as being closer to fixed income securities than equities. For this reason, management could choose to continue providing “one-time” distributions at the end of each year, rather than raise the monthly distribution enough to fully match the business’s current earnings. To the extent that the market valuation is influenced by the regular distribution rate, this could result in a lower stock price than a situation where the regular rate is higher and no “one-time” distributions are paid. I view this as a short-term issue: if the company has “one-time” distributions annually, the market will factor this into the price over a couple of years.

CURRENT VALUATION AND REASONABLE PRICE TARGET
If these Canadian income trusts are valued primarily on their distributions, and an “appropriate” yield is 8%, the stock should be trading at $14.11 based on today’s distribution rate, and $17-$19 based on current distribution power. Note that these prices give us an 8% cash yield today, growing at perhaps 10% conservatively (revenues and EBITDA have grown at 17%+ and 18%+ respectively over the last five years). So, using the low end of today’s distribution power ($1.36), and a 10% CAGR in distributions, in two years we would have an annual distribution of $1.65, and a stock price of over $20. This appreciation, along with distributions, will give us a total return of 80-90% over two years.

A BRIEF DIGRESSION: GOOD BUSINESSES, CANADIAN INCOME FUNDS AND FANTASIES ABOUT VALUATIONS
Having looked at a fair number of these Canadian income funds (including many written up on VIC), I have concluded that some may turn out to be very attractive investments to investors like myself, who look for high quality growing companies trading at very reasonable prices. This structure seems ideal for two kinds of businesses: (1) Mature businesses with limited growth prospects, where distributing most of the profits (and avoiding taxes in the process) makes sense; and (2) Businesses that are not capital-intensive, and can grow without equity dilution, despite being required to distribute most of their profits. And the investor gets a large dividend yield. ATS falls into the latter category, as does Sleep Country Canada (Z.UN), written up in the past by dylex849 and zeke375.

These Canadian income trusts seem to be treated as being closer to fixed income securities than to equity. In reality a reasonable number are growing businesses of a non-capital intensive nature with good economics and business prospects. Unlike REITs which are capital-intensive but are required to pay out their profits, and thus continually resort to dilution and/or borrowing to grow, some Canadian trusts are ideal for this partnership-type structure: avoid taxes, distribute the bulk of profits, and continue to grow because the business is not capital-intensive.

What longer-term return could one hope for here? With a cash yield of 9.2%, distributions likely to grow, and the business growing at perhaps 10-15% annually, a 20%+ annualized total return does not seem unreasonable. In fact I would argue that, given the attractive economics and the history of growth and profitability, a much higher stock price is warranted. It strikes me as being ironic that a business with good growth prospects and distributing most of its profits, is valued much lower than many other vastly inferior businesses, growing at slower rates, paying modest or no dividends, and often highly leveraged.

TTM EPS (excluding amortization) is about $1.63 (pre-tax and after-tax). It is very plausible to me that this number could grow at 10% annually, which would make it $1.97 in twenty-four months. If, as I prophesy, the distribution at that time is $1.65, is it possible that the stock trade at $25-30? That translates into a cash yield of 5.5%-6.6%, and a P/E of 13-15 (on trailing earnings) for a business growing at 10-15%. Seems very possible. This price range would translate into a total return of 120-160% over two years.

So we have potential here for a triple dip: (1) the distribution alone provides a decent return; (2) as revenues and profits grow, higher distributions over time should result in price appreciation; and (3) if the quality of the business is are recognized by investors over time, the stock should be awarded a higher multiple.

Sleep Country Canada (Z.UN) is an example of a company that has been awarded a higher multiple over time as earnings and distributions have grown, and investors have recognized the quality of the business.

Dynamex (DDMX), also written up twice on VIC, has a similar low-asset business model, making it in some respects a good comparable for ATS. It trades at 18x trailing EPS and 15x forward EPS, and pays no dividend. DDMX arguable has a stronger competitive position, being the largest player in the same-day delivery business. But at current prices ATS is much better value, given the high distribution and the likelihood of faster growth.

CUSTOMERS/TARGET MARKETS
ATS, from inception, has focused on the transportation and distribution of higher value consumer products that are time sensitive or require specialized supply chain service, efficiency or security. Its philosophy has always been to provide its customers with premium delivery services, and exceptional customer service. ATS targets customers who are relatively price-insensitive and willingly pay a premium for its logistics capabilities and customer service.

The company has approximately 1,400 customers; the largest accounted for 7.0% of revenues in 2005; the top five 26.8%; top ten 40.2%; and top 30 for 66.6% of revenues. In 3005, the top 30 had been customers for an average of eight years, with some having been customers since inception, impressive given that the company had only been in business 15 years.

Key industries served include healthcare/pharmaceuticals (26% of 2004 revenue), entertainment (23%), other consumer products (33%), marketing services (4%), and grocery (3%). Among larger customers are Pfizer Canada, L’Oreal, Buena Vista Home Video (Disney), Sony Music, Warner Video, 20th Century Fox Home Entertainment, Bell Distribution, Ingram, Children’s Place, Blockbuster, and Rogers Video.

ATS’s strength is in transporting high value products that require specialized logistics and supply chain capabilities. One example is the transportation of time sensitive items such as newly released DVDs, which require delivery to stores at a particular time, e.g. midnight on a particular day (think Harry Potter). Another capability is temperature management for pharmaceuticals. Health Canada introduced new regulations last November requiring that all drugs be transported at temperatures printed on their boxes, and that records be kept throughout the transportation process. Many drug companies are not complying with the new regulations yet, but management expects that the government will eventually enforce the rules. ATS considers itself to be the leading player here, based on the number of trucks and warehouses it has with temperature management capabilities, and the automated shipment tracking systems it has set up for customers. Management thinks that there could be a large amount of growth in this business in coming years.

We have spoken on the phone with several of ATS’s large customers, and were impressed at the universal and enthusiastic praise for the company. Customers appear to love the service provided, the flexibility to provide new services to fit customer needs, and the access to senior management. Some typical comments:

“I can’t say enough good things about ATS.”

“We love ATS’s service, but occasionally price other companies to see what they charge. ATS has always been lower or similar in price.”

“They go to great lengths to provide customized services to fit our needs, for example, midnight delivery. They charge extra for these services, but don’t gouge on price.”

“I can talk to senior management, including Michael Andlauer, if I have a problem.”

Several companies we spoke with use ATS as their exclusive shipper for packages, though some also used FedEx or other companies for envelopes. ATS has done a good job getting more and more business from existing customers, and management sees this as continuing to be an important component of future growth.

One concern is the expected decline of the DVD industry. The entertainment industry, including DVDs and CDs, accounted for 23% of 2004 revenue. A rapid decline in the sale of DVDs (and CDs) would certainly have some impact on ATS. If business from that industry declines 5-10% annually, ATS would be losing upto 2% of its revenues. While this would clearly hurt, it is unlikely to have a huge impact on the overall business.

FINANCIALS
ATS is extremely well managed, and the economics of its business model are extraordinarily good. Revenues have grown rapidly and consistently since inception in 1991, to $174 million in the last 12 months, with positive operating income in every quarter of its existence.

Additionally, because of the strategy of using primarily independent owner-operator drivers/trucks, and leasing most of its other capital assets (warehouses and trucks), the business requires little capital: the biggest item on the balance sheet is receivables, which accounted for $23 million of the $27 million in total assets immediately prior to the IPO. Net PP&E was just $2 million.

ROE is very high despite the absence of debt prior to going public. Pre-tax operating profit in fiscal 2002, 2003, and 2004 exceeded $11 million each year, on less than $14 million and $18 million of equity at the end of fiscal 2004 and 2003 respectively, for pre-tax ROE of 60%-80% in the last three years. (The IPO has muddied the balance sheet because of the intangibles created when the Fund acquired the business from the prior owners. The income statement now has amortization of $1.53MM/quarter or $6.12MM/year. But this accounting item does not change the fundamental attractiveness of the business.)

For 2006 the company expects maintenance capex of $0.4 million and growth capex of the same amount. From 2000-2004, total capex each year (maintenance and growth) ranged between $0.6 million and $1.2 million, a reflection of the low capital-intensiveness of the business.

Prior to the IPO the company had no need for debt because of its prodigious cash flow and low capital needs. To finance part of the cost of the acquisition at the time of the IPO, and because of the requirement to distribute the bulk of profits after going public, management arranged for a credit line to ensure adequate liquidity. Debt used is modest: less than $4 million at end-2005, $7.4 million at the end of Q1, and about $5 million now (according to the CFO).

Incidentally, any increases in fuel costs are passed on to customers as surcharges, with weekly adjustments for fuel price changes.

Quantifying the low capital needs of the business:

As of 3/31/06 ($millions)

Net PP&E $2.4
Current assets 27.0
(excluding cash)

Total 29.4

Less:
A/P & acc liabilities (11.0)

W/C & PP&E reqd 18.4

This $18.4 million is 10.6% of the $175 million of revenues of the last 12 months. If revenues grow at 15%/year for the next five years, revenues would double, and an additional $18.4 million of W/C & PP&E would be needed. Assuming that EBITA margins over this period are 11%, net profits would aggregate about $142 million over the five-year period. If the business needs $18.4 million for incremental W/C & PP&E, that would only absorb 13% of the total profits generated (18.4/142), leaving 87% available for distribution to shareholders. This is consistent with the 80-90% payout ratio target.

The Fund has 11.64MM units outstanding. 9.3MM were sold in the IPO. The remaining 2.3MM (19.9%) are controlled by founder/CEO Michael Andlauer.

GROWTH PROSPECTS
ATS’s historical growth has been predominantly organic, but it has also made two small acquisitions, in 1997 and 2003. The CFO said that they hope to make additional acquisitions; the goal is to acquire companies with customers that would fill up trucks serving existing customers, i.e. customers shipping to the same businesses as existing customers. An example would be the acquisition of a pharmaceutical customer who delivered to the same drugstores currently serviced by ATS. They refer to this as “coincidence of delivery”, resulting in additional revenues with little additional cost. The industry is highly fragmented (the courier segment, representing 10% of the Canadian trucking industry, has about 2,400 players), and ATS believes that it will have opportunities for acquisitions that fit well into its existing business and are immediately accretive to earnings.

ATS has been very successful in the past in growing the business by cross-selling existing and new services to its customers, and it expects to continue to earn a larger part of existing customers’ business. Also, as discussed in the “CUSTOMERS/TARGET MARKETS” section above, it expects significant top-line growth from pharmaceutical customers in coming years from its temperature management services, because of drug transportation regulations introduced late last year by Health Canada.

LIMITED DOWNSIDE
It is hard to imagine significant downside at the current price. The current yield of 9.2% should provide a floor for the stock. If, as I expect, the distribution rate is significantly increased later this year, we will have an even greater margin of safety. While we wait for the stock price to appreciate due to growth in the business, increases in distributions, and increased recognition by investors, we are collecting monthly distributions at a very attractive rate. The business would have to become significantly less profitable for the distribution to be cut to a level below the current rate.

RISKS
* Loss of one or more major customers (largest customer accounted for 7% of revenues in 2005; top 30 for 66.6%). On the positive side, ATS appears to inspire tremendous customer loyalty: its top 30 customers have been doing business with the company for over eight years on average.
* A rapid decline in the DVD and CD industries; entertainment accounted for 23% of ATS’s 2004 revenue.
* Significant economic downturn.
* Key person risk – dependence on “visionary” founder Michael Andlauer.

Catalyst

* Increased distribution rate in coming months.
* When the company has a full calendar year of numbers behind it, investors will clearly see the current earning power.
* ATS will become better known to investors over time: it has only been public since September 2005.
* Ongoing growth in the business, profits, and distributions.