Description

Fenix Parts Inc. (FENX)

Thesis

An investment in Fenix Parts is similar to the early day opportunities of investing in United Waste, United Rentals, LKQ, or Copart. It is an opportunity to invest in the consolidation of an attractive industry that has secular growth, is purely domestic, and has high barriers to entry. In addition, FENX is led by a high quality management team that has a history of consolidating, integrating and driving shareholder value at prior firms (Stericycle and Insurance Auto Auctions).

FENX is the second largest recycler and seller of automotive OEM parts used in mechanical and collision repair – that is, they buy large volumes of cars at auctions, dismantle them for their highest value parts, and sell them to body shops to repair cars damaged in collisions or in need of mechanical repair. The secular growth in recycled parts is being driven by insurance companies’ desire to keep the cost of auto repair low, so they can remain competitive in their insurance premiums – alternative/recycled parts are dramatically cheaper than new OEM parts or aftermarket parts. FENX has the liquidity and M&A pipeline necessary to double revenue and EBITDA by the end of 2016. Using LKQ as a template both in terms of its regional hub and spoke model and its ability to make acquisitions in the 4-6x EBITDA range, FENX has the opportunity to consolidate a highly fragmented market over the next 10 years. LKQ, by far the largest player, has >10% market share, FENX is already the second largest player but has less than 0.5% of the market.

FENX shares performed well after IPO and we think the recent pullback to below-IPO levels presents a significant opportunity for investors who are willing to dig deeper into the story. In our base and bull cases, detailed below, we arrive at YE2017 price targets of $22 and $35 respectively.  We see support for our positive outlook in the fact that insiders, who own ~25% of the company, have recently been buying stock at higher than current levels (since September 18, 2015, the CEO, two officers, and three Directors bought shares).

Despite its potential for significant growth within a defensive and growing end market, FENX’s stock is trading at attractive/depressed levels as a result of three factors: 1) FENX’s 10Q for Q2 2015 was filed late; 2) a well-timed, but  in our opinion inaccurate, short report was issued by Streetsweeper questioning, among other things, FENX’s liquidity; and, 3) analysts include almost no upside from acquisitions in their estimates, basing their price targets off organic EBITDA targets, and, thus, vastly underestimating the upside at FENX. Firstly, as a result of its mid-quarter, May 19, 2015, IPO date, FENX’s Q2 was uniquely complex as the founding companies were acquired during the quarter at the IPO.  No such complexity will affect the Q3 results, which should allow for a more timely Q3 filing.  Secondly, the central thrust of Streetsweeper’s short report, which relied on a pre-IPO cash total and was published prior to FENX’s Q2 10Q being filed, that FENX is “almost out of cash,” was entirely undercut by FENX’s 10Q which shows that Q2 FENX has greatly improved its liquidity as a result of the IPO and at the end of Q2 had ~$19mm in cash and cash equivalents, with ~$26mm available on a secured credit facility.  With respect to the third factor, we appreciate, of course, that sell side analysts are hesitant to include acquisitions in their models, but, where FENX has explicitly announced a roll-up strategy (FENX has spoken with confidence of its ability to close 1-3 deals per quarter starting in Q4 2015), we think analysts’ notes fail to capture the upside if FENX is successful with its M&A strategy.

Attractiveness of Industry

Industry Structure

Wholesale markets for collision and mechanical repair parts total approximately $15 billion and $46 billion annually, respectively, and form the addressable market for Fenix (~$61 billion). There are approximately 9,000 vehicle recycling facilities in U.S. & Canada and most of them are small facilities which generate $1M - $10M in annualized revenue. LKQ is the only participant in the market to have more than 1% market share (estimated to have >10%).

Industry Dynamics

A customer has 3 options when repairing a vehicle - a new OEM part, an aftermarket part, or a recycled OEM part. Recycled OEM products are the most cost-effective option of the three and are typically of a better quality and fit than non-OEM products.

Market Share of Recycled OEM Parts Set to Increase

·         Recycled OEM products are typically 40-70% less expensive than new OEM parts.

·         Insurance companies are the driving force in the use of recycled OEM products.  Through the Direct Repair Model, they strongly encourage repair shops to utilize recycled OEM products in the repair of damaged vehicles.

·         As a result of cost advantages and insurance company suasion, the demand for recycled OEM products is marked by consistent long-term low- to mid-single- digit revenue growth.

·         Were part availability better, the customer base, led by insurers, would easily push non-new-OEM parts over 50% of the total repair parts mix (current level is ~35%). It is estimated that major customers - insurance companies and auto repair shops – could use double the amount of recycled OEM parts the industry can currently provide.

·         Unsatisfied demand currently exists, in part, because extreme fragmentation of the industry limits part quality and availability, and the reliability (quick turnaround) of suppliers.

Total Parts Used Set to Grow

·         With more content and parts being put into modern vehicles, more parts are needed per repair.  Thus, on average, model year 2015 vehicles need more parts per repair than model year 2005 vehicles. This explains, in part, industry predictions that average repair costs will show annual increases.

·         Vehicles also require more parts replaced per year as they age. For example, model year 2001 vehicles have had an average of 10.9 parts replaced per year of use over the course of their life, but they had an average of 11.9 parts replaced in 2009, and 13.2 parts in 2014. Over the past five years, the average age of repairable vehicles has increased from 5.5 to 6.2 years.  Increasing fleet age is, then, another factor increasing the demand for parts.

·         The sweet spot for cars to use recycled parts is between 3 and 8 years old.  In this window, cars are off-warranty and still of high enough value to justify repair.  Due to a significant dip in new car sales from approx. 2008-2012 there was a significant drop in cars in the “sweet spot” starting in about 2012 and persisting to the present.  Analysts expect the total numbers of cars in the sweet spot to bottom in 2015/2016 and to grow at a 6% CAGR until at least 2020.

Use of Parts Unaffected by Macro-Economic Factors

·         Because accidents and repairs are unplanned and unavoidable, the industry has strong defensive characteristics and should perform well at all stages of the economic cycle.

In sum: FENX is the #2 player in a highly fragmented, highly defensive, and growing industry.  The total number of parts used in repairs, the cost of repairs, and the percentage of recycled parts used will stack on each other such that FENX’s addressable market is set for several years of healthy growth.

FENX Overview

Description

FENX’s primary business is auto recycling, which is the recovery and resale of OEM parts, components and systems reclaimed from damaged, totaled or low value vehicles. Once the company receives the vehicles, primarily from auto salvage auctions, they dismantle them and sell the recycled components. FENX was founded in January 2014 to combine 8 founding companies and develop a regional network that offers sales, fulfillment and distribution in key regional markets in the United States and Canada. The acquisition and combination of the 8 founding companies closed with FENX’s May 2015 IPO.  7 of the 8 founding companies are located in the Northeast U.S. or Eastern Canada, thus expansion to a national footprint is an obvious growth strategy.  To this end, the eighth founding company is located in Florida, and was chosen for its potential to serve as a regional hub for management and future expansion in the Southeast.

Balance Sheet

        FENX has a strong balance sheet with a net cash position of ~$10mm, and ~$45mm in current liquidity.  With 2.0x net debt/EBITDA an appropriate leverage ratio, FENX has ample capacity to execute on its growth strategy and to make acquisitions at an aggressive rate should the opportunities present themselves.  As of the end of Q2, FENX had ~$19mm in cash and cash equivalents.  Moreover, FENX had approximately $26mm available on a senior secured credit facility with BMO Harris Bank N.A.  In addition, FENX is entitled to request an increase in the revolving credit facility, incorporated in the senior secured credit facility, of $20mm (thus, potentially $65mm liquidity). We also note that with low cap-ex (a maximum of 1% of revenues), FENX should generate strong cash flow that will further bolster its cash available for acquisitions.

Capital Light Model

        Because the hub and spoke infrastructure is already in place, FENX can leverage capital investments.  Total cap-ex should start at a maximum of 1% of revenues and decline as FENX scales with acquisitions and organic growth.  Capital usage is also minimized by FENX’s strategy of not buying, but taking long-term leases on the land of acquired companies. Meanwhile, purchase accounting on acquisitions will drive D&A substantially higher than cap-ex, creating a natural tax shield and free cash flow tailwind.

Capable and Experienced Management

        FENX has a strong management team with the requisite experience and expertise in roll-ups, acquisitions, and, hub and spoke distribution models for them to be well prepared to drive FENX forwards. Kent Robertson (President, Director and CEO since FENX’s inception in January 2014) founded American Medical Disposal, Inc., which was acquired by Stericycle in 2001. Robertson then worked for Stericycle (Mkt Cap. $11.7B) until 2010 during which time he directed a consolidation and integration strategy for Stericycle, managing or facilitating over 70 acquisitions ranging in size from $1m to $200mm. This experience of identifying, executing and integrating acquisitions into a company with a hub and spoke model is directly applicable to FENX. Kent has surrounded himself with a strong team drawn primarily from Stericycle and Insurance Auto Auctions, Inc. (IAAI). FENX’s CFO, Scott Pettit, for example, served as CFO for IAAI during a period in which the company grew from 48 to 150 sites, and from $50mm to $250mm in EBITDA. He was involved in IAAI going private through an LBO, and later in the sale of IAAI to KAR. Thus, he has substantial automotive industry, and acquisition and integration experience. The COO, Arthur Golden, worked in operations for Stericycle from 1993 until his hire by FENX.  Most recently he was responsible for overseeing Stericycle’s operations in the Northeastern region of the U.S. Thus he has experience directing the operations of an acquisitive hub and spoke-based company in the same region as FENX is currently concentrated.  As a start-up consolidator, then, FENX has a highly-qualified leadership team with deep experience of operations, integration and M&A, and we think the strength of the team minimizes the major risks around acquisition sourcing, strategy, and integration, and the development of hub and spoke operations.

FENX’s Opportunity

Fenx has a number of levers it can pull to produce strong revenue and earnings growth for the foreseeable future. These include:

Acquisitions – On its Q2 earnings call, FENX noted that the pipeline of companies meeting its acquisition criteria represents “more than $150mm of annual revenue.”  It had previously discussed a pipeline of $100mm in annual revenue, but as it became more proactive in seeking out opportunities post-IPO the pipeline expanded.  FENX also expressed confidence that it can achieve “an average of one to three acquisitions per quarter,” with most acquisitions in the $5-10mm revenue range.  FENX has spoken of a target range for acquisition prices of 4-6x adjusted EBITDA before synergies; we think that is realistic.  Indeed, since its IPO in May 2015, FENX has made one acquisition – Ocean County Auto Wreckers (Bayville, N.J.) – which had revenues of $8mm over the 12-month period ending June 30, 2015, was acquired for $3.2mm, and fell within the target range.  One important point to note: FENX paid roughly 82% of the purchase price in cash, and the remaining ~18% was paid in stock; we like this structure because it allows FENX to retain a motivated and experienced management team at the facilities it acquires.  As a point of reference, applying a similar strategy to FENX, from inception in 1998 through 1999, LKQ acquired 30 recycler businesses.

Organic Growth – Given the industry dynamics described above, we think many car recyclers have an opportunity to benefit from positive trends of increased number of parts used, increased cost of repairs, and increased percentage of recycled parts used.  FENX has additional drivers of organic growth, for example: 1) State Farm represents ~18% of the vehicle repair market and the founding companies had limited to no participation in State Farm’s procurement system.  State Farm’s system serves as a portal for approved vendors to sell parts to approved State Farm collision repair shops.  This is a substantial additional opportunity on which FENX management is now focused; 2) the founding companies had never used a dedicated sales force to market their services, FENX is developing a sales team and this will help generate revenue from new customers; and, 3) coordinating inventory across the founding and acquired companies should permit each facility to push more parts through its network due to improved fulfillment. Analysts forecast an industry growth rate of approximately 3% given positive secular tailwinds, limited by low fulfillment rates and supply.  We think Fenix will see near and medium-term outperformance due to the above factors and its ability to take advantage of scale, as addressed below.

Importance of Scale for Margin Expansion - Achieving scale, through a combination of acquisitions and organic growth, will open up a number of opportunities for FENX to grow revenues beyond the sum of acquired revenues. Managing inventory across facilities to reduce redundant vehicle purchases will, for example, allow FENX to purchase a wider variety of vehicles and turn them faster, resulting in higher revenues at each facility.  With a more diverse inventory closer to customers, FENX should also be able to reach at least 60% fulfilment rates for recycled products (LKQ is at ~70%), well above the industry average for independents of ~25%. We put FENX at currently above average, but we see room for FENX’s fulfilment rates to improve by 50-100%. In turn, a larger footprint and improved fulfillment should allow FENX to become a preferred source for larger accounts; FENX can become the first or second call or web search by auto shops or insurance companies in the regions it serves. Overhead is a large fixed expense for the acquired companies. Taking into account revenues versus variable expenses (vehicles, towing), we estimate that incremental gross margins are around 50%. If FENX can drive organic growth then significant margin expansion will occur on its base business. Scale will also allow FENX to take costs out by, for example, centralizing back office functions, coordinating a buying strategy across all facilities, towing purchased vehicles shorter distances, and using coordination and software to realize efficiencies around managing inventory levels of specific parts.

Base Case

In a base case scenario we assume FENX acquires $25mm in revenues in 2015, and $80mm per year starting in 2016, with an 8% EBITDA margin, purchased at a 5.5x EBITDA multiple with 85% cash and 15% stock. We also assume 6% organic growth, and we model ending 2018 consolidated EBITDA margins around 12%. We estimate 2018 revenues at $375mm, 2018 EBITDA at $45mm, and an exit run-rate for EBITDA in 2018 of $50mm.  Valuation of early stage growth companies is always challenging – we use LKQ as a benchmark. LKQ has traded consistently at 13-17x forward EV/EBITDA minus cap-ex.  We use 12x forward EV/EBITDA minus cap-ex for FENX.  Applying that multiple we arrive at a YE2017 price target of $22.

Bull Case

In our bull case scenario we assume FENX acquires $35mm in revenues in 2015, and $100mm per year starting in 2016, with an 8% EBITDA margin, purchased at a 5.5x EBITDA multiple with 85% cash and 15% stock.  We assume organic growth of 8%, and we model ending 2018 consolidated EBITDA margins around 13%.  We estimate 2018 revenues at $460mm, 2018 EBITDA at $60mm, and an exit run-rate for EBITDA in 2018 of $65mm.  Applying a 15x forward EV/EBITDA minus cap-ex multiple we arrive at a YE2017 price target of $35.

Bear Case

Given the defensive characteristics of the market, and the appealing arbitrage between target acquisition multiples and the multiples of publicly traded companies, we see limited downside to FENX’s shares at current prices should management execute on even a third of its original pipeline.  Should FENX fail to execute at all, we see shares dropping to $4.  Set against even our base case, the asymmetric risk reward should be apparent.

Disclaimer:

This posting is for informational purposes only, and is not intended to be, and should not be, relied upon as an investment recommendation in connection with any investment decision for any purpose.  It does not constitute an offer to sell, or the solicitation of an offer to buy, any security.  This posting presents the views of an investment firm that currently holds a long position in the company’s common stock and stands to benefit from an increase in the price of the stock.  The information contained herein was obtained from public sources believed to be accurate and reliable as of the date of this posting but is presented “as is” without any warranty as to accuracy or completeness.  It also contains certain forward-looking statements and projections which are inherently speculative and uncertain.  The views expressed herein may change and the author undertakes no obligation to update this posting.   Following this posting, and without further notice, the investment firm, as it deems appropriate, may increase or reduce its long position in the Company’s stock or establish short positions in the company’s stock based on any of a variety of factors, including but not limited to its ongoing evaluation of the company’s financial condition, business, operations and prospects, the market price of the company’s stock, conditions in the securities markets generally, general economic and industry conditions, its business objectives and other relevant factors.  All readers are responsible for conducting their own due diligence and making their own investment decisions with respect to the company’s stock.

Catalyst

Indications that FENX is executing on its strategy will be welcomed by the market and should serve as catalysts for the share price.  We are looking for the following:

·         1-3 deals to close in Q4 2015

·         Timely filing and release of Q3 earnings

·         More detailed guidance from management – expected either on Q3 earnings call or in Q4

Risks

·         Scrap metal pricing.  FENX is exposed to movements in scrap metal and crushed car body prices.  In purchasing vehicles, FENX considers spot pricing for both; its exposure lies in the average one month lag between purchasing a vehicle and disposing of it.  Currently, with scrap metal and crushed car body prices declining in 2015 (down 23% and 48% y/y respectively in Q2), FENX faces a small headwind.  Should prices remain low this will actually be positive for working capital and margins.  Should they rise, FENX will feel a tailwind until they stabilize

·         One-time accounting costs in Q3 associated with first consolidated filing

·         Short term selling pressure due to stock breaking through IPO price

·         Challenge of Q3 filing

·         November 2015 expiry of insider post-IPO lock-up (but reduced odds of material insider selling with recent round of insider buys)