Description

ECN – compelling risk/reward

• Canadian-listed ECN Capital Corp is a business undergoing transformation from a balance sheet lender for rail/aviation assets to a fee-based, asset manager of specialty finance consumer loans. Over time the valuation will change from a multiple of book value to a multiple of g.
• The Company currently repurchasing over 15% of the total market cap. In the first two months of this year the Company repurchased $58 million of stock. And then on February 28, the company announced a tender offer ending April 10th between C$3.49 and C$3.90 in the amount of $115 million (a further 9% of the market cap). Additionally, the company still has another ~$35mn (10.3mn shares) outstanding on its NCIB buyback plan which expires in July 2018.
• If the tender is not fully subscribed, we believe the company will raise the tender price range.
• The CEO and most of the management team have also been actively buying stock in the gopen market.
• The company is run by Steven Hudson (CEO), who joined ECN at inception after its spin from Element Fleet Management, where he was also CEO. At the time of the spin, Hudson sold the vast majority of his Element stock and equivalently bought ECN stock in the open market.
• We believe the stock is worth approximately 40% higher based on a SOTP analysis.
• All-in-all, this is a positively-skewed situation when considering the underlying fee-businesses seem to be growing much faster than guidance indicated, the company is very actively buying back a large amount of stock and the insiders clearly believe the stock is worth meaningfully more than where it trades today and show that with their own wallets.

Why is ECN mispriced?

• Canadian listed small-cap
• Complex transformation story scares away many investors
• Sell-side is stuck in the book value mindset from the legacy business
• The company’s former parent-co (Element Fleet) has blown up post-spin leading investors to question the CEO
• Limited visibility into the acquired businesses or into the legacy asset valuation

Background

• ECN spun-off from Element Financial Corporation (now Element Fleet Management Corp.) in late 2016 because ECN was the “bad co” – the asset-intensive railcar, aviation and commercial lessor dragging down the multiple on the market-leading Fleet Management business that was organically growing at 8-10%, with solid margins and very low churn among its customer base.
• Once ECN spun, ECN Management immediately began transforming the company from a railcar & aviation lessor to an asset manager focused on the specialty finance space.
• Post-spin Dispositions
  • Sale of the U.S. C&V Finance Business – In 1Q17, the company sold its Commercial and Vendor finance business to PNC Financial Services Group for $1.5bn in cash, representing a $344mn gain on sale.
  • Sale of Commercial Aviation Advisory Business – In May 2017, the company sold the business to Stellwagon Group, a subsidiary of Acasta Enterprises, for 3.04 million shares of Acasta with a 12-month holding period contingency. The company booked a C$10.3mn gain on sale, but since then Acasta has sold off 66% so I need to dig into that a bit further.
  • Sale of Rail Finance Assets – In 3Q17, in two separate transactions the company sold 65% of their railcar assets for $935 million, which represents a $50mn loss on sale (sold at 0.9x book).
  • Sale of Canadian C&V Assets – In January 2018, the company sold their entire Canadian Commercial and Vendor finance assets to Canadian Western bank for C$902mn in cash, a $2mn premium to book value.
  • Cumulative effect is to reduce the total assets on the balance sheet down from $6.2bn to $2.6bn (pro-forma for completion of Canadian C&V sale).

Service Finance Company (SFC)

• In September, the company completed the acquisition of Service Finance for C$409 million cash plus an earn-out estimated at C$40mn. This was a very solid acquisition.
• Founded in 2004, Service Finance Company, LLC utilizes a technology driven platform to originate prime & super-prime retail installment contracts (“RICs”) to finance home improvement projects.
• 75% of originations are sourced through exclusive national vendor programs with Lennox Industries, Service Experts, Owens Corning, EGIA, Rinnai.
• SFC doesn’t fund originations on its balance sheet but instead sells production through to FDIC insured institutions (13 institutions currently participating) without recourse and acts as the servicer for a management fee. Financings are originated at a discount to par and sold for a gain.
• The US home improvement market is now $350 billion, with approximately half home improvement projects being financed and 7% growth in credit purchases. The installment contract is the fastest growing segment of the financing market with 12-14% market share, which is expected to grow to over 20% in the next 5 years.
• As an example, given the cost of a new furnace may be $10,000, even most customers with great credit would likely not want to put that on their credit card – especially in a rising rate environment. This is what makes SFC’s offering more attractive to the end consumer – charging low rates in an installment based plan.
• Origination volume has been growing massively (+118% in 2015, +52% in 2016, +47% in 2017). Management is projecting 40% core origination growth in 2018 as the company continues to add 170 new dealers per month, coupled with continued success from their exclusive national vendors. To note: YTD 2018, core origination is growing closer to 80%.
• The Company has added Abbey Carpet as a new national vendor for 2018 – Abbey Carpet has $4bn in sales in 800 showrooms across the country – which represents a move into the retail channel, which is a significant opportunity for Service Finance.
• Management is guiding to C$56mn in net income for the business in 2018 (we believe this is too low) and to grow that to C$75+ million in 2019. No synergies are included in this number.

Triad Financial Services (TFS)

• In January 2018, the company completed the acquisition of Triad Financial, a manufactured housing loan originator, for C$125 million.
• Manufactured housing is pre-fabricated homes that are constructed at a factory and assembled at the building site. Currently, there are 8.6 million manufactured homes in the US (10% of the housing stock). At the moment, there are backlogs as there isn’t enough manufacturing capacity to meet demand for these homes.
• The number of manufactured home shipments declined from the late 1990s through 2009 as the housing bubble boomed, but Triad managed to stay profitable in that time period while their competitors flamed out. Since then, shipments have been recovered steadily and are starting to accelerate (15%+ growth in last 2 years).
• The basic thesis for continued growth is that housing affordability continues to decline, interest rates don’t have room to drop and so the relative attractiveness of manufactured housing continues to grow.
• Triad is focused on originating and servicing prime and super-prime manufactured housing loans with high FICOs, an average of approximately 740, and low annualized net charge-offs, approximately 0.6% for the last 5 years.
• Originations are sourced through a long-established national network of manufacturers and dealers. Like Service Finance, the loan production of Triad is sold through to a multitude of U.S. financial institutions for an upfront fee and ongoing management fees.
• They were smart enough to avoid the competition for subprime consumers, which is the reason they’ve been around for 58 years while other lenders collapsed in the late 1990s and 2000s.
• Approximately 75% of originations come from traditional loans to high-quality and high-credit customers. A typical loan: $69,000 loan at 7% with a 226-month term and 18% down payment.
• In addition to this, Triad also assists third parties in underwriting, originating and servicing manufactured homes loan transactions. These transactions are funded at 100% by the third party, for example, a community REIT, with no recourse to Triad. Triad completes the underwriting and origination for a flat origination fee and services the loans for an ongoing service fee.
• On average, Triad earns a fee of approximately 1.5% of the cumulative yield over the life of a loan, not present valued, with a 5.5% yield going to the purchasing bank. 100% of Triad's fee is collected upfront, with 35% of that fee recognized immediately and 65% of that fee deposited into a reserve account in Triad's name in the purchasing bank (recourse for the bank that gets released to Triad if all things go well).
• Triad currently services floor plan credit lines for manufacturers on a state-of-the-art floor plan finance software platform. Services that they provide include marketing credit, documentation, billing, auditing, collections and legal support for portfolios.
• In addition to the servicing business, Triad sees a substantial opportunity to directly offer floor plan financing. This option provides for great returns, on average over 7% interest rate, in addition to further strengthening manufacturer and dealer relationships and driving additional core origination growth. This may be on-balance sheet usage, so it’s worth it to clarify that.
• All-in-all, management is guiding to C$20mn in net income for the business in 2018 and to grow that to C$24 million in 2019. No synergies are included in this number.

Synergies

• There is an opportunity to cross-pollinate the funding partners between Service Finance and Triad, specifically through credit union service organizations that work with Triad that may want to work with Service Finance given they are low-cost funders.
• Introducing existing bank partners to expand capacity for both Triad and Service Finance.
• And finally, but not least, a number of the banks in ECN’s senior credit line, who have U.S. subsidiaries, have expressed a strong interest in joining the funding group.
• On the operational side, sharing operational best practices, leveraging technology, etc. For example, Service Finance is now completely paperless for the first time, which is a meaningful cost savings.

Legacy Businesses

• Rail Finance
  • All ECN owned railcars are managed by Trinity following the disposition in Q2 2017, which allows ECN to leverage one of the largest railcar and marketing networks in the US and minimize operating expenses.
  • Modest amount of originations and syndications expected next year.
  • Cyclical in nature – expect lease rates to pick-up as oversupply of railcars is reduced.
• Aviation Finance - No originations, orderly wind-down
• Management says there will be a step-function reduction in balance sheet assets. Once they make another acquisition and build their management fee base, they’ll feel more comfortable selling-down the remaining legacy balance sheet because otherwise, they’d lose their investment grade rating – which effects their vendor contracts in the Service Finance and Triad businesses.
• While we don’t have visibility into the underlying assets, they have sold other assets at or above book value and they have explicitly indicated they think they can sell the remainder at or near book and as noted above, they could sell more rail assets right now if they wished to, but they are concerned with fewer assets about their IG rating.

Valuation

We value the business using a SOTP as per below:

Management

• The management team collectively owns 6% of the company, of which more than half is the CEO Steven Hudson.
• Steven Hudson is the CEO of the company. He was previously CEO of EFN, but decided to join ECN after the spin-off, sold the vast majority of his stake in EFN and bought ECN stock with the proceeds.
• Since the spin, there have been over 30 separate open market acquisitions or retained stock from derivate exercise by insiders with only 2 small sells.
• For the new fee-based businesses, ECN leaves the existing management teams in place to run the businesses they know how to run and provides support either via network or balance sheet to these companies.
• To note, after Steve Hudson left EFN, it declined for two reasons
  • First, shortly after he left, the company entered into a JV with Celadon Group called 19th Century, which immediately crashed and burned causing impairments.
  • Second, in late 2015, EFN acquired the fleet management business of GE – which continues to have “integration” charges today (in addition to the spin-off separation charges). In February 2018, EFN announced they had lost a handful of larger customers, guided to negative growth in 2018 and the CEO (Brad Nullmeyer) “retired”, likely as a result of a botched integration.

Buybacks

• Canadian buyback rules are different than the US in that they use a Normal Course Issuer Bid (NCIB), which is essentially a government regulated buyback plan that resets annually.
• Under the NCIB, the Company authorized to repurchase up to 37M shares. So far, the company has purchased 26.7m share Common Shares (through February 28) under the NCIB and plans to exhaust the buyback by the July 2018 when the plan resets.
• On February 28, the company announced that it would participate in a $115 million SIB – a modified Dutch auction ranging from $3.49 to $3.90 which will commence in early March and complete in mid-to-late April. This would result in another 8-10% of shares repurchased.

Risks

• Housing cycle bet on the services businesses
• Have to hope the cycle in the legacy businesses don’t turn before they sell the remaining assets
• Lack of transparency of the acquired businesses given no historical financials and also lack of detail on the value of the legacy assets.

Disclaimer:  The author of this idea currently has a long position in securities of this issuer and may trade in and out of these positions at any time without notice.  The data and information contained herein are prepared by the author from publicly available sources and the author's independent research and estimates.  No representation or warranty is made as to the accuracy of the data or opinions contained herein. This report is intended for informational purposes only and the reader should not make any financial, investment, or trading decisions based upon this report.

Catalyst

• Company completes tender (even after raising tender price) and continues buying even more stock following tender
• 2018 results considerably higher than guidance
• Another solid acquisition and Company gets closer to completion of transformation to a fee-based, capital light business model