Description

Overview

Eqstra Holdings Limited (EQS - JSE), a diversified equipment and logistics company based in South Africa, has sold off ~75% from its 24 month highs and is currently trading at extraordinarily cheap levels of 2.7x TTM core earnings and 2.4x our estimated forward earnings. The stock currently trades at R2.30 per share and we believe earnings can grow from R0.61 reported in FY15 to R1.50-R2.00/share in 2-3 years, equating to 400%-600% upside using very conservative PE multiples.

Generally these valuations only exist for companies that are near bankruptcy, which Eqstra is nowhere near.  In fact, Eqstra’s comps trade at very high earnings multiples because these businesses possess high quality, annuity-like recurring revenue. This obviously makes businesses like Eqstra (and its peers) more predictable and higher quality.  Eqstra is dramatically mispriced for two reasons. First, though Eqstra has only 15% of its pre-tax profit composed of contract mining, investors have inappropriately classified Eqstra as a mining business. Note, if the contract mining division  is accorded no value, we still come up with a stock price of more than double where Eqstra trades today. Second, Eqstra appears to be highly levered, but it actually has a very manageable debt load. Eqstra’s debt to equity is 2:1 while its peer group average is 4.5:1. Therefore, Eqstra is actually less levered than most of its peers, yet trades at ~1/4 their valuation.  We explain further below on why we believe Eqstra is significantly mispriced.

Why is it Mispriced?

Misunderstanding; Throwing The Baby Out With The Bathwater

The most significant reason for the mispricing is that EQS is covered by mining analysts and thus is lumped in as being a mining company, and as such, is valued inappropriately. Note, if the contract mining division is accorded no value, we still come up with a stock price of more than double where Eqstra trades today. The sell side ignores 85% of Eqstra’s business, which is a services-focused, diversified equipment and logistics company with annuity-like earnings and comps such as Avis and Hertz. Essentially, the sell side is comping all of Eqstra to very low quality contract mining businesses when they should be comping the majority of the company’s earnings streams to high quality leasing, distribution, and services businesses.

Mining is hated in South Africa.  If you read the South African business newspaper or watch South African business TV, you will see nothing but abhorrence for mining stocks.  This hatred has caused unreasonably low valuations, irrational selling and a substantial mispricing of Eqstra. This is a major reason why over the last 24 months, the shares have declined ~75% from their highs and appears to be a situation where investors are throwing the baby out with the bathwater.

To combat this severe misunderstanding, EQS’s management is likely to hire a PR firm and will begin a domestic and international roadshow to introduce the company to a different set of investors (including traveling to New York in December). We believe more investor attention could be a catalyst for the stock to rerate. We think Eqstra is simply too cheap to remain at these levels for long. 

Knowledge Gap

What investors are focused on, versus what is actually occurring at Eqstra are extremely different. Sell-side coverage following the recent September 1^st FY15 earnings announcement missed several key points:

• Even though they are already less levered then their peers, Eqstra is transitioning to an asset-light model, which will significantly benefit profitability, interest/debt, cash flow, and growth capital;
• R120m after tax benefit in low hanging fruit redeploying idle equipment (~R.31 after tax per share)
• Neither management nor the sell side normalized Eqstra’s results for a one-time impairment charge in the second half, and thus did not show that the company generated R0.47/share in EPS in the second half of the year, or a run rate of R0.94/share in annualized EPS (putting the shares at 2.4x normalized earnings).

Misinformation by Financial Media

Based on reviewing local media reports, we believe investors do not have a clear picture of what is happening at Eqstra. For example, the financial media recently reported that Eqstra was looking to do a rights offering (they are not) and that Eqstra was recapitalizing its contract mining business (they are shrinking their contract mining business). Both of these reports are false: EQS has no plans for a rights offering and they are actually shrinking their contract mining business (redeploying idle assets is not recapitalizing). Additionally, we suspect the Eqstra “expert” who reported this information works for a fund that might be short the stock and is thus spreading false rumors.

Background & Business Overview

EQS is composed of three decentralized divisions: Industrial Equipment (IE), Fleet Management & Logistics (FM&L) and Contract Mining & Plant Rental (CM&PR). 

The two most significant divisional profit contributors, IE and FM&L, each hold a leadership position in its industry in terms of its asset base and each have a commanding market share in most of their product areas. Also, both divisions are recurring revenue annuity-like businesses which create revenue and earnings visibility that allow EQS’s higher leverage levels. The following tables highlight the fiscal 2015 contribution from each division to EQS overall and illustrate the historical operating model of the company.

EQS is in the midst of partnering off its loan books to South African banks to de-lever its balance sheet over the next 12-18 months, further de-risking the business and providing a huge opportunity for growth. Eqstra’s balance sheet optically appears to be levered, but this is simply a business model consistent with leasing companies. As highlighted in the following table, Eqstra is less levered than peers.

Industrial Equipment (IE)

Since 1984, the IE division has been leasing and renting mobile capital equipment (e.g., forklifts, heavy trucks, aerial platforms) as well as offering value added services for the materials-handling, industrial, construction, and mining sectors. The IE division operates primarily in South Africa with additional operations in some surrounding countries and the UK. Forklifts are the division’s leading product, with South African forklift products accounting for 55% of IE’s divisional revenues, and UK forklift products providing an additional 19%. Within South Africa’s forklift market, EQS is the leading vendor with 35% share of the market.

Over the last few years, the IE division has grown market share in South Africa and expanded organically and via acquisition in the UK. EBITDA has been growing due to a focus on efficiency improvements, an increased mix of services, a restructuring of contracts, and the elimination of less profitable product lines. The division aims to more than double its profitability by 2020.

Fleet Management and Logistics (FM&L)

The FM&L division has over 30 years of experience offering leases, rentals, and value-added services in South Africa. EQS is the leading vendor of fleet management services in South Africa with a market share of roughly 25%. By leasing assets and providing non-capital intensive services, the division generates a high-margin, annuity-type revenue stream.  FM&L’s services include accident management, fuel management, insurance and vehicle tracking, full maintenance leases, operating leases, long-term rentals, and driver management. In addition to these traditional fleet management products, the division offers customized value added services including service scheduling, downtime management, onsite and remote servicing of vehicles, roadside assistance, tire management, replacement vehicles, accident repairs, and integrated fleet reporting.

Lack of access to additional capital restricted growth in Fleet Management, obscuring a record that historically had healthy, long-term growth prospects. Of Eqstra’s three divisions, FM&L enjoys the highest EBITDA margins. In FY15, EBITDA margins rose to a record high of ~48% due to increasing the level of services in the revenue mix, and implementing new cost reduction measures.

One of these measures is the implementation of “Quest,” a new proprietary ERP-based fleet management system, which a very innovative CTO spent five years and R200m to develop. This system should yield further efficiency gains and position the division as the premier, low-cost provider of integrated fleet management solutions. Management expects a 25% IRR on their Quest investment, or roughly 66m in PBT annually. This should partially kick in during this fiscal year and fully in FY17.

Contract Mining

While we do not need to equate any value to contract mining for Eqstra to be substantially undervalued, we still want do discuss the segment so investors understand the optionality if this business recovers and/or if new management is successful in implementing some of its initiatives. The contract mining division has one of the largest opencast contract-mining equipment fleets in South Africa. As such, this division has the capability to provide all opencast mining requirements to customers, including blasting, drilling, loading, hauling, rehabilitation and rental of heavy earth moving equipment. The division’s value chain is composed of value-added mining services, equipment rental/leasing, and sales of capital equipment at the end of its useful life. Scale gives the contract mining division a huge advantage over peers and therefore the division has contracts with many of the leading worldwide mining companies. Eqstra is well diversified across many different commodities.

Poor management, a lack of focus, and lower commodity prices depressed contract mining’s financial results in the past two years. In January, Justin Colling was brought in as the new contract mining division CEO. He is one of the most well respected contract mining CEO’s in the world, and has made significant financial improvements in the business. We believe he is just getting started.  While we do not have a view on commodity prices, this division’s success is not dependent on rising commodity prices; rather, success will require Colling blocking and tackling some fairly simple issues.

Key Points on a Positive View of EQS’ Shares

Transitioning to an asset-light business model should improve profitability and cash flow, thereby reducing leverage.

In July 2015, Eqstra’s CFO Jan Sefontein took the reins as CEO. The board felt the company was not getting an adequate return on its assets and the prior CEO was hesitant to disrupt the company’s normal operations by shifting to an asset-light model, so we view Sefontein’s promotion as a positive as it will accelerate Eqstra’s shift to an asset light model. 

Perhaps the most important impact of transitioning to an asset-light model will be the significant reduction in overall debt, which should then halve EQS’s interest expense. Instead of taking on the risk and debt of funding the asset book for product leasing/rental in its IE and FM&L divisions as well as the equipment used in its CM&PR division, Eqstra is removing this debt from their books by partnering with their banking/financial partners. Reducing overall debt should provide new opportunities for significant growth, because EQS’s growth in the past was restricted by a lack of access to capital. Management should have the leasing book partially partnered by March 2016 and fully completed by June 2016. Therefore, we will see some of the results in this fiscal year and all of the results in the next fiscal year, leading to a step function in earnings over the next two years. As illustrated below, we estimate potential savings of ~R300m from disposing the IE and FM&L loan books and repaying higher costs South African debt as well as from a re-rating of the remaining debt. Under this scenario, EBITDA/interest coverage will more than double from ~5x to ~10x+.  

Illustrated below is an estimate of the pro-forma impact of disposing a portion of the loan books of the IE & FM&L businesses. From a high level, the reduction in revenues is more then offset by lower interest and D&A charges, yielding about a 48% increase in net income and EPS. We used reported earnings in this table, but keep in mind that normalized earnings are much higher than reported earnings.

Additionally, transitioning to an asset-light model will make the company less capital intensive, so cap-ex requirements will be reduced. When combined with increased profitability, this change will translate into increased cash flow.

Deploying idle assets in CM&PR division should add significant gains to earnings.

When Justin Colling came in as divisional CEO in CM&PR, his biggest initiative was to put idle equipment back to work. In the last FY, this idle equipment cost Eqstra R160M in EBT. We estimate by the next FY there will be no idle equipment and we will see the entire benefit of that R160M in EBT. Colling has already reduced idle equipment from R750M to ~R300M through gaining numerous large new contracts and is well on his way to further lowering that number.

The contract mining division is rebounding significantly from recent improvements. CM&PR reported a R24m EBT loss in the 6 month period (1H) ending June 2014, EBT turned profitable in 1H of FY2015 and increased to R53m in the 2H of the year. Worth noting, this rise in profitability occurred without the benefit of increased commodity prices.

If the CM&PR is successful in deploying all of its idle equipment and producing revenues, EBT profitability in the division should approximate R300m. This would represent a significant improvement over the R59m profit (before a R97m impairment charge) that the division achieved in FY15. Looking out further into the future, Colling believes it is possible that the division can increase EBT profitability to ~R500m even with commodity prices at current levels. If we see a commodity upswing, he thinks EBT will be even higher, approaching the R500m-1b range. While we put no weight in those numbers, we simply view it as a free option we are not paying for.

Selling Benga assets should reduce uncertainty and raise cash.

The contract mining division is in late-stage negotiations to sell one of its largest assets, which is a huge positive because it will further shrink the contract mining business as well as provide a significant injection of capital into the business. We estimate the sale of this asset will bring in about R600m. As the Benga asset has been an open issue of uncertainty, a favorable resolution would bolster investment sentiment.

Tangible Earnings Power Of R1.50-R2.00 Per Share

As discussed above, a number of factors should increase Eqstra’s earnings power over the next 18-24 months. First, transitioning to an asset-light business model will decrease interest expense by 300M. Management estimates that partnering off its loan books should reduce debt levels from R5.6b to about R4.0 to R4.5b, resulting in annual interest savings of ~R300m. Second, management also indicated that successful deployment of idle equipment could reduce CM&PR costs by ~R225m. Additionally, CM&PR’s R97m asset impairment charge booked in FY15 should not recur. Third, selling Benga assets could provide additional interest savings or growth capital.

The table below provides a conservative estimate of EQS’s earnings power. We made the following assumptions to devise this conservative estimate: a no growth sales environment (this is not management’s expectation), no improvement in commodity prices, and a 28% tax rate. Using these assumptions, the three factors delineated above increase Eqstra’s earnings power by R622m in EBT, R448m in net income, and R1.13 per share in incremental earnings compared to the FY15 reported numbers. This puts total earnings power around R1.75 per share, or in the middle of our R1.50-R2.00 per share estimate of earnings power.  

While revenue growth has been constrained recently due to capital conservation measures, this setback should abate as the business model transition continues and cash flows improve. Additionally, the divisional managers in each of Eqstra’s three divisions have articulated tangible growth opportunities. With revenue growth a key component of EQS’s 2020 business plan, there could be upside to the above midpoint estimate of R1.75 per share. Given some improvement in available growth capital, earnings power could extend to the upper end of our estimated range, approaching R2.00 per share.

Management Recently Buying Stock, Shows Its Confidence

One of the qualities we, and many other investors, seek in a potential investment opportunity is management that personally buys into the company’s story and puts their money where their mouth is. Since June, EVERY SINGLE member of Eqstra’s senior management have been aggressively purchasing shares. These purchases were at share prices higher than current levels, with the average at ~R2.80 per share. From our perspective, it seems clear that management has a high level of confidence in the business outlook.

Valuation

The shares are well below comparable peers; attractive on the basis of just its services business, while getting contract mining for free

We believe EQS’s shares are attractive on both an absolute and relative basis. Based upon trailing 12-month results, the shares are currently valued at only about 2.7x EBITDA and a P/E of 2.9x core operating earnings. This valuation is attractive for a company with market leadership and high-quality, high ROIC annuity-like earnings streams. Despite having somewhat comparable margins, EQS’s valuation is significantly below other comparable diversified, industrial equipment and service-oriented companies in South Africa and globally, especially on a P/E basis. Analyzing EQS on a relative basis just using current financial results, one could easily make the case that the shares should sell at a valuation of at least double its current level.

With 85% of Eqstra’s EBT profits  coming  from the IE and FM&L divisions, the value of its shares should be more consistent with other diversified global services companies with annuity-like business models. As illustrated in the table below, the financials from both the IE and FM&L divisions, when combined, show outstanding profitability relative to the above comparables.

Despite the superior margins/profitability that IE and FM&L generate, EQS has a valuation well below its peers if one values the company on just these two businesses (and excluding the contract mining profits). Valuing the annuity-like profitability streams of these two divisions at a P/E of only 8x-9x (still a healthy discount to its peers) ttm earnings of R0.61 (which includes the full corporate overhead and the higher South African corporate tax rate) translates into a valuation of ~R5.00-5.50 per share, which is +120%-140% higher than the current share price. Keep in mind, global peers trade at ~15x earnings and thus our 8-9x is very conservative. To be clear, this ascribes absolutely no value to the profitable CM&PR business. Thus, on ttm results, Eqstra’s shares should be double the current levels and investors would end up with the CM&PR operations for free. We think we have a heavy dose of conservatism in our numbers.

Looking toward the next 18-24 months, we believe Eqstra has earnings power of ~R1.50 to R2.00 per share. It seems very likely that when these earnings materialize, the multiple will expand rapidly as investors re-value the shares. Assuming a P/E of only 6x-7x of the entire earnings stream, EQS could reach a share price of ~R9.00-R14.00. This represents upside of 4-6x the current R2.30 share price.

Catalyst

• EQS’s management is likely to hire a PR firm and will begin a domestic and international roadshow to introduce the company to a different set of investors (including traveling to New York in December).
• The sale of the company's Benga assets, which will likey bring in ~R600m.
• Success in begining to partner off the IE and FM&L loan books, which will reduce the company's leverage.
• A further reduction in putting idle equipment back to work, which will increase CM&PR pofitiability.
• The roll out of the company's "Quest" new proprietary ERP-based fleet management system in the FM&L division, which should imcrease profitability.
• Posting further semi-annual improvement to EBITDA and EPS (we believe management will not be breaking out core earnings, excluding extraordinary items).