Description

ECN Capital Corp. [ECN.CN, C$3.60]

Note:  ECN Capital was previously posted by zbeex in March 2018.  We believe an re-posting is warranted because of significant developments over the past three months – principally 1) completion of the company’s dutch tender (Substantial Issuer Bid) in April; 2) announcement and closing of an acquisition of Kessler Group in May; 3) higher projected earnings for acquired businesses; and 4) further commitments of management toward successful completion of the business transformation.

Executive Summary. ECN Capital is a financial company created in October 2016 through a spin-off from Element Financial Corp. (now Element Fleet Management [EFN.CN]).  Since the spin-off, ECN has been substantially transformed by three acquisitions, five dispositions, and significant stock buybacks. Its legacy business, as an on-balance-sheet lessor of aircraft, railcars, and commercial equipment in the U.S. and Canada, has been materially liquidated since the spinoff at prices close to tangible book value.  Management has stated that the remaining legacy assets (having tangible book value of C$2.08) will be liquidated by the end of 2019.

The three newly-acquired ECN businesses are fee-based origination and servicing businesses focused on consumer loans and credit card receivables. As a result, ECN has been substantially transformed into a capital-light, scalable, business services company servicing 90+ US financial institutions, which should henceforth be valued according to its growing earnings streams.  In 2019, we expect these businesses to produce C$0.31 in earnings, including parent-level corporate costs of approximately C$0.08, but not including potential accretion from any value-added deployment of the C$2+ assets in liquidation.  A 12x earnings multiple on these growing businesses informs our C$5.62 Base Case price target (+56% upside).  As discussed below, our Mid Case and High Case targets are substantially higher (C$6.32-C$7.06, upside of +75%-96%) as we consider giving ECN some credit for either 1) higher earnings multiples, 2) accretive capital return or deployment, or 3) further elimination of corporate costs as the business is simplified or in a sale case.  

The catalysts that we expect to drive price appreciation are 1) continuation of the balance sheet monetization, 2) performance and growth of the earnings-based businesses, 3) eventual re-listing of the stock in the US matching ECN with an appropriate comparable set, 4) continued return of excess capital through accretive stock repurchases or otherwise, and 5) progress with corporate cost rationalization.  Positive actions this year toward these ends have been consistent and substantial; however, this special-situation equity has yet to respond.

Why is ECN so cheap?  The under-followed and complex nature of ECN’s business transformation, along with large disappointments at ECN’s former parent company EFN, have conspired to create this pronounced mispricing.  To ECN’s credit, they are capitalizing on the mispricing, having repurchased over 15% of the company since the spin-off at average prices of C$3.69. Perhaps the Company’s largest issue is its management, led by CEO Steve Hudson, and their past affiliation with Element Financial, which spurned investors numerous times over the years.  We examine this dynamic further below.

Since the spin-off, ECN has been methodically executing on a strategy to sell off large portfolios of assets and deploy excess capital in buybacks and acquisitions of fee-based, capital-light businesses.  At the time of the spin-off, ECN had C$6.1bn of total assets, supported by C$1.7bn of book value. Since then, ECN has announced five separate divestiture transactions, including a complete exit from the commercial equipment business and a substantial reduction of its rail and aircraft assets.  At present, ECN holds certain remaining assets supported by minimal leverage; a dramatic reduction in credit risk since the spin-off.

ECN has been repurchasing shares since its spin-off through a Normal Course Issuer Bid (“NCIB”) under which it has repurchased 26.7mm shares, or 6.9% of its shares outstanding for C$3.80 per share (C$102mm).  This was recently supplemented through the successful completion of a Substantial Issuer Bid (“SIB”) in which ECN repurchased 31.9mm shares at a price of C$3.60, representing a further 8.3% of the spin-date shares outstanding.  In total, ECN has spent C$217mm to repurchase 58.6mm shares, or 15.2% of the company.

But the most value-creating use of freed-up capital has been ECN’s purchase of three distinct but synergistic U.S.-based financial services businesses, each as described below.

The Acquired Businesses.  

Service Finance Company (“SFC”).   ECN acquired SFC for C$410mm in June 2017, and we expect 2018 and 2019 segment EBITDA of C$55 and C$77mm, respectively.  SFC is an originator and servicer of prime and super-prime consumer home improvement Retail Installment Contracts (“RICs”) that partners with manufacturers to allow their dealer networks to offer in-showroom financing solutions.  SFC has also partnered with 15 financial institutions, which purchase the RICs that are originated by SFC and for whom SFC performs an ongoing servicing function. SFC never takes ownership of the loans, allowing for the model to remain “capital light.”  SFC has been enjoying high rates of growth post-acquisition, driven by both the penetration of its existing customers’ networks and by adding additional partners. We expect SFC’s originations to grow by 67% in 2018 and by 28% in 2019 and for total assets being serviced by SFC to grow by 135% between year-end 2017 and year-end 2019. A comparable growing loan origination platform company, Greensky Inc., recently IPO’d at fantastic multiples over 20x EBITDA.  For what it’s worth, such multiples applied to SFC would yield implied values of C$5.50-C$6.00 per ECN share, for the SFC segment alone!

Triad Financial Services (“TFS”). ECN acquired TFS in October 2017 for C$125mm and we expect 2018 and 2019 segment EBITDA of C$26 and C$31mm , respectively. TFS is an originator and servicer of super-prime manufactured housing loans in the U.S. with a capital-light, partnership model similar to SFC’s.  While TFS does not grow as quickly as SFC, we expect TFS will continue to enjoy low double-digit origination and revenue growth, driven by aging baby boomers who are entering retirement and a continuation of this demographic’s increasing preference for manufactured housing over site-built homes.  We expect TFS’s originations to grow by 14% in 2018 and 11% in 2019 and for total assets being serviced by TFS to grow by 35% between year-end 2017 and year-end 2019.

The Kessler Group (“KG”).  In May 2018, ECN acquired an 80% interest in KG for US$221mm and we expect attributable 2018 and 2019 EBITDA of US$31 and US$39mm, respectively.  KG is a leading provider of advisory and marketing services to credit card issuers in the US. KG’s founder and Chairman Howard Kessler will continue to lead KG and retain a 20% interest.  Kessler was a pioneer of co-branded credit cards with MBNA and has built KG into a valued advisory partner of credit card issuers with high margins and significant recurring revenues. We expect earnings contribution of C$0.07 per share in 2019 with low to mid-teens growth potential.  

These businesses give ECN a platform to provide an array of value-added business services to over 90 major financial institutions.  Although revenue synergies are not counted in our forecasts, the complementary nature of client bases and product offerings suggest considerable cross-selling opportunities.  Furthermore, given ECN’s predominant US revenue concentrations, management considers a US stock listing to be an inevitable conclusion of this business transformation.

We think about valuation here as a sum-of-the-parts, with the parts being the legacy portfolio/excess capital and the newly acquired business portfolio.  After accounting for the capital used in the SIB and KG acquisition, the legacy part of the company has total tangible book value per share of C$2.08. We have done extensive work on the credit quality of this remaining portfolio, and we are comfortable with a valuation of 1x tangible book value for this portfolio, but for conservative purposes we employ 0.9x realization multiple in our Base Case.  Our Base Case also employs a conservative earnings multiple (12x) relative to the projected growth profile and no diminution in parent-level corporate overhead versus current guidance. We would expect this target value of C$5.62 to be realized by mid-2019, based on 2019 earnings levels.

The Mid Case and High Case demonstrate the fuller potential of new ECN if corporate cost is right-sized and more generous earnings multiples are awarded.  One could further refine a sum-of-the-parts, applying different multiples to the different operating businesses (e.g., we believe 2019 earnings contribution breaks down as follows: SFC C$0.25, TFS C$0.08, KG C$0.07, less corporate –C$0.076).  Plus, even higher price target cases could be conceived, for example, by 1) looking out longer than 2019; 2) considering the effect of accretive buybacks with excess capital; and/or 3) considering the near total elimination of corporate cost in a sale-of-business context.

We see ample opportunity ahead for a positive narrative shift and change in investor perception as ECN becomes further seasoned as a public company.  We applaud the company for following through on its vision to pursue a future in fee-based services businesses and for substantially and opportunistically buying back stock with excess capital.  

Management concerns.  But we note that many investors do not share our optimism for ECN.  There remains considerable antipathy among investors toward this management team because of the poor acquisition track record at prior ventures led by Steve Hudson, including Element Financial and Newcourt Capital.  While we cannot dismiss these episodes, we have analyzed these situations and find their circumstances and risks very different and their timing often unfortunate. As a result, we have taken extraordinary care in underwriting an ECN investment and spent considerable time with management.  

First, we cannot help but admire the logic and timeliness of ECN’s very conscious shift toward a capital-light business services model focused on servicing and origination. It is a lower-risk and more scalable model that capitalizes on management’s apparently strong relationships in the financial service industry.  It also coincides with looser regulation and greater capital freedom at banks allowing them to ramp up lending activity at long last. This creates new headwinds for alternative lenders and significant tailwinds for service providers.

Second, we note that follow through and execution on this strategy has been proceeding quite rapidly and effectively. Three quality businesses have chosen ECN as a partner, and the early results are most encouraging.  Material asset dispositions have transpired without issues and created accretive opportunities for capital re-deployment. ECN’s future as a manager, advisor, and structuring partner to 90+ US financial institutions has come into sharp focus.  

Third, we find nothing in management’s actions since the spinoff that has been anything but shareholder friendly.  With respect to capital allocation, not only have the aforementioned share repurchase levels been larger than anyone could have reasonably expected to this point, but all divestiture and acquisition decisions have been thoughtful.  Most importantly, Hudson has purchased substantial amounts of stock personally, which creates significant alignment of interests. He presently owns ~10.6mm shares, or slightly more than 3% of the company. Management has been relatively accessible and responsive to shareholders. On issues of management compensation and parent-level corporate overhead, we are obviously less well-aligned.  However, they have shown a willingness to have an open dialog on the issues and have given us reason to believe that significant headcount and expense rationalization will occur with the closing of future asset dispositions. We expect management to continue making value maximizing decisions and to be a source of potential upside, rather than downside, to our Base Case valuation.

Catalyst

1) continuation of the balance sheet monetization, 2) performance and growth of the earnings-based businesses, 3) eventual re-listing of the stock in the US matching ECN with an appropriate comparable set, 4) continued return of excess capital through accretive stock repurchases or otherwise, and 5) progress with corporate cost rationalization.