Description

Headline

This is a recommendation to short the common stock of Fleetmatics (FLTX.) While it markets itself as a “cloud-based SaaS business,” FLTX in reality sells commodity telematics services. The company has only spent $40M in cumulative R&D over the last ~10 years and only holds 2 patents. Rampant insider selling, ill-advised international expansion, increasing competition, elevated churn, early signs of pricing pressure, departure of a key executive and a valuation north of 30x next year’s (overly bullish) consensus earnings make FLTX a timely short.

FLTX Business Description:

Fleetmatics is a leading provider of fleet management solutions/telematics services to small and midsize fleets (5 to 100 vehicles.) Fleet owners pay ~$40/month/vehicle and sign a 3 year non-cancelable contract. The offering is primarily a vehicle GPS tracking system used to reduce fuel expense and overtime hours while increasing overall productivity of the fleet. Basically, it allows employers to track their employees and when this happens, employees stop using the vehicles for personal use and stop taking 2 hour lunches. Fleetmatics derives ~90% of its revenues in the U.S. but is actively expanding its offering outside the U.S. Return on investment for fleet owners appear very high with many fleet management companies advertising a 5:1-7:1 return.

Thesis:

Fleetmatics is a short: while FLTX might continue to show strong subscriber growth in the near term as the market remains underpenetrated, over time, the economics of this business should be competed away due to the lack of barriers to entry. Several formidable players have recently entered the space through acquisition, some of which have competitive advantages over FLTX. We believe that because there is no product differentiation and there are minimal variable costs associated with new vehicles, as competition starts heating up, the easiest lever for these companies to differentiate themselves is price. While FLTX’s ability to tap small and medium sized business customers is impressive, we believe it is essentially a sales organization, not a technology company.

Risk / Reward:

We think FLTX is worth $19/share using our base case, or down ~50% applying a lofty 20x multiple to our FY16 estimate. We basically assume it will be very difficult for FLTX to grow earnings in the future given expected ARPU pressure. The risk to the upside is $45/share (+20%) if competition remains irrelevant and FLTX begins to leverage growth investments.

Investment Merits:

• There are very few barriers to entry in fleet management: The product largely consists of off the shelf hardware from companies like CalAmp and a software solution centered around Google Maps, which are available for use to anyone. The sheer number of small mom & pops offering fleet management solutions is very telling of the lack of barriers to entry

• Signs of significant competition from very formidable, highly capitalized players: The industry was historically highly fragmented with many small mom & pops offering services with limited financial resources. The acquisitions of Nextraq by Fleetcor, Teletrac/Navman by Danaher and Hughes Telematics by Verizon bring significant financial resources to the industry. We believe FLTX's capitalization was historically a strong competitive advantage for them.

• TAM is likely overstated: Management suggests that there are 22M commercial vehicles in the North America (FLTX’s core market) with only a 12% penetration rate. Despite this, they are aggressively expanding into new geographies as well as tangential products. This suggests we are further along in the penetration curve than management suggests.

• Current economics are not sustainable: With no barriers to entry, no product differentiation amongst competitors, and minimal variable costs, the easiest way for competitors to gain market share is to cut price. FLTX currently has ~30% EBITDA margins, implying there is significant room for prices to decline. Interestingly, FLTX lost their first large enterprise customer in the history of the entire company in the most recent quarter. They lost 1,500 vehicles to a small regional company who was aggressive on price to win the customer.

• Aggressive insider selling post IPO: Within a year of going public, FLTX’s private equity sponsor, Investcorp, liquidated its remaining ownership via 3 secondary offerings. Investcorp was so eager to sell that one of its follow-on offerings was done within 2 months of a previous secondary, requiring a release from violating customary lock up restrictions. Investcorp potentially exited during peak margins and before management guided to 2014 as an “investment” year. The CEO, who has been with the company since 2006, has also sold ~50% of his holdings post IPO. He most recently sold $2M of stock (~17% of his remaining holdings) after the stock rallied 15% after Q3 earnings. Also concerning is that the SVP of sales, who also started with FLTX in 2006 with the CEO, sold all of his holdings earlier this year and recently left the company.

Variant Perception:

We are further along the penetration curve than the Street expects: FLTX management includes all commercial vehicles in its penetration calculations. However, fleets with less than 5 vehicles are not candidates for telematics, which cuts the TAM in half. We have also conducted calls with ex-sales managers of Fleetmatics and NexTraq. The ex-Fleetmatics sales director estimated the North American market had already reached 25% adoption, while the ex-NexTraq SVP of sales had a more bearish outlook and estimated the market at 50-60% penetrated.

The competitive threats are different this time around: While the fleet management space has always been competitive, the fact that large players have entered the space is game changing. FLTX has had a competitive advantage because it was able to subsidize upfront hardware costs and invest in a web based selling platform. These competitive advantages are now becoming commonplace in the market. Not only are FLTX’s competitive advantages being more commonplace, but Fleetcor (FLTX) is entering this business and already has relationships with many of FLTX’s target customers.

FLTX is over-earning and margins will fall: Street estimates point to growing ARPU in 2015/2016 with further operational leverage after an "investment year" in FY14. We believe that competitive threats will start to pressure ARPU in 2015 and 2016 once competitors have digested their acquisitions and we move further along the penetration curve

Telematics Overview

FleetMatics provides software that helps businesses manage their vehicle fleets more efficiently. The company installs a hardware device in each customer vehicle, which sends positioning data back to FleetMatics’ software platform via cellular networks. This data is analyzed by FleetMatics software to provide actionable intelligence to customers in the form of real-time alerts or customizable reports that helps customers reduce operating costs.

Customers report very strong ROI mainly from 3 key cost savings drivers:

1. Reduced fuel costs by reducing total miles driven and idle time

2. Reduce labor overtime hours through more accurate time sheets (less cheating)

3. Increase worker productivity allowing for more productive utilization of existing fleet

The company advertises up to a 5:1 - 7:1 ROI for its customers. Based on calls we have completed with existing FLTX customers and other telematics customers, it does appear that customers like the product offering and customers have supported that telematics provide a tangible ROI. Given this, we expect continued growth in vehicles for the industry as more and more customers adopt a telematics based solution. However, where we disagree with management is they claim to price their product based on the value to provide to their customers, which means they believe $40/month is cheap given the ROI. We don’t argue that the product provides value, but we believe that given the lack of barriers to entry, $40/month pricing is unsustainable, regardless of the value to the customer.

Total Addressable Market for Telematics

Despite strong ROIs to its customers, we do think that FLTX management is overstating its TAM.

FLTX defines their TAM as 22M commercial vehicles in North Ameirca/UK/Ireland (current target market) with a 12% penetration level and 39M commercial vehicles in Europe and Latin America with a 7% penetration level. This adds up to a total TAM of 61M commercial vehicles and $30B of annual value that is only 12% penetrated.

FLTX's CEO has stated that the economics start making sense for telematics when a fleet has 5 or more vehicles. In the U.S. there are approximately 18.5M commercial vehicles. Per Frost & Sullivan, 9.7M vehicles are in fleets of less than 5 vehicles, making them largely ineligible for telematics solutions. This leaves a real addressable market of 8.8M vehicles.

Assuming a 12% penetration rate of the entire 18.5M vehicles, approximately 2.2M vehicles currently using telematics. Assuming an 8.8M vehicle as the addressable market (fleets >5 vehicles) instead of the full 18.5M assumes we are really at a 25% penetration level. And this assumes that the 12% management is using to assess penetration is accurate.

Our research calls also suggest that penetration is higher than the 12% that FLTX management states. A former Fleetmatics sales director estimates that US penetration is already at 25%+ and a former Nextraq SVP of sales estimates the market to be 50-60% penetrated. While it is difficult to know whether these employees were speaking of the addressable market (over 5 vehicles) or the total market, it nonetheless suggests that FLTX management is overstating the opportunity set.

We also believe that if the N.A. market was still as highly unpenetrated as FLTX management suggests, then FLTX would be focused exclusively on this market where it is a market leader instead of spending significant time and resources developing their international sales force as well as investing in tangential products. When the company disappointed the market earlier this year with their FY14 guidance, they blamed higher expense on sales force expansions outside of their core markets/geographies, mainly Europe. It turns out that all of this incremental spending in FY14 was not really to target Europe, but to target Holland, a country with a whopping 17M people. If FLTX chooses to expand further into Europe, it will take significantly more resources that will weigh on profitability. Selling into the U.S. requires just one sales force through call centers. Selling in Europe requires a different sales force in each country, making Europe materially more difficult to target.

Barriers to Entry / Product Differentiation in Telematics

Our research suggests there are very little barriers to entry and very little product differentiation amongst customers.

Hardware: Fleet management companies do not produce their own hardware and largely purchase through companies like CalAmp. Even TomTom, who is in the GPS business, does not produce their own fleet management hardware. Hardware is completely commoditized.

Satellite: Fleet management companies utilize GPS signals, a program initially developed for the military but opened up for use by anyone.

Data: Fleet management companies utilize wireless data services through AT&T/Verizon/T-Mobile, available for anyone to use.

Software: Software is largely the area that is custom built for each fleet management company. However, all of the custom software is centered around mapping software, which is not unique to individual fleet management companies. Most utilize Google Maps or a similar mapping service.

The CEO of FLTX even suggests that they have no competitive advantage in the technology they utilize:

Question by Analyst at Conference: So what's to prevent someone else from just basically coming out with another piece of hardware that knocks off what you're doing, only cheaper.

Answer by CEO of FLTX: Well, our strategic advantage isn't there [hardware technology]. Our strategic advantage is the ability to get to a very difficult customer to acquire [SMB] and do that efficiently.

Said a little more candidly in an investor meeting, the CEO stated:

“We are a sales organization…if you came into our office and watched our people working the phones, it looks like that movie…The Wolf of Wall Street.”

To assess the product differentiation between FLTX and its competitors, we recently conducted a web based demo with Nextraq (purchased by Fleetcor), who offers service for $35/month including both hardware and software and a 36 month contract. What we found that the features and product set were exactly the same as FLTX and the user interface was very clean and user friendly. Even more telling, they immediately negotiated the price down to $30/month without even asking.

We then compared the Nextraq/FLTX service with a more mom & pop service called Linxup. Linxup offers an unbundled solution of $23/month for the software and $80 for the hardware with no contract, $40 for hardware with a 1 year contract and free hardware for a 2 year contract. From what we can tell, Linxup offers the exact same features as FLTX/Nextraq at a materially discounted price.

Competitive Landscape

Below is a high level summary of the key players in the telematics industry. This is not an extensive list, there are dozens of mom & pops that can be found through a Google search.

As shown above, there is no shortage of players in the space. Despite competition, there has been little impact on FLTX’s topline growth. However, we believe there have been several notable acquisitions by several formidable players that are leading us to believe that these acquisitions will begin to impact FLTX’s business. In fact, in recent investor meetings, the CEO was quite defensive when investors started asking questions surrounding several acquisitions in the space.

FLTX Competitive Advantages

We believe that FLTX has been able to succeed in a highly fragmented market for several reasons. We also believe many of its competitors are catching up and closing the gap on these advantages:

No Upfront Monthly Cost: FLTX’s average fleet size is 18 customers. Management says installation and hardware costs average around $150/vehicle, which would require a $2,700 upfront investment. We believe this is overstated and hardware costs are less than $80 (was as high as $300 5 years ago). Because FLTX had the financial resource of Investcorp as well as IPO proceeds, it has been able to pay the upfront hardware costs and amortize these costs over the life of the contract putting them at a strategic advantage relative to mom & pops who have a limited ability to finance working capital needs. However, many of the more established players are now beginning to offer a bundled monthly fee. Even TomTom, the largest player in Europe, only recently started offering a bundled option in Q1 2014. IR at TomTom expects the majority of their customers as well as the industry as a whole to move to this bundled monthly option. As referenced to the right, many of the recent acquisitions in the space have been acquired by companies with significant financial resources to fund hardware costs. The bundling of hardware and software is becoming commonplace amongst the industry, which was one of FLTX core competitive advantages.

Efficient web based selling model: In 2006, FLTX was largely selling their product through a field sales force, which is extremely inefficient given average fleet size of 18. They spent the next 8 years developing their web based selling platform. Now, 2/3 of all sales are done over the web requiring FLTX to never actually have to meet its customer. However, most of the competitors are catching up to this. I recently completed a sales call with Nextraq, in which case he seamlessly showed me all the features through a web based demo. The vast majority of competitors now have web demos where you never actually have to meet with a sales person to sign up for the service. Installation has historically been completed by third parties, but many hardware offerings can now be easily installed by the customer.

Historically, FLTX has largely competed against mom & pops who were undercapitalized and did not have the resources to develop web based selling platforms or bundle the hardware/software into one monthly payment. As larger, more capitalized players have entered the space, FLTX is losing its only competitive advantage.

Recent Acquisitions

DHR buying Navman / Teletrac: DHR is a $50B+ market cap company that has expanded into the telematics space. In order for it to move the needle, DHR will need to have ambitious plans to ramp this business. Teletrac was often cited in our research calls as the closest competitor to FLTX. We believe that given DHR has made 2 acquisitions in the space in 2013, we should expect to see increasing competition from DHR going forward once it has digested the acquisitions

Verizon buying Hughes Telematics: Verizon used to be a selling channel for FLTX, given Verizon's relationship with many small businesses. The CEO on an earnings call commented on how strong of an opportunity this new selling partnership was. This relationship has largely been downplayed now that Verizon entered the space through its acquisition of Hughes Telematics and the launch of its NetworkFleet solution.

CalAmp buying Wireless Matrix: CalAmp was FLTX's main hardware partner prior to their acquisition of Wireless Matrix in early 2013. Through conversations with CalAmp, they said they saw the opportunity to buy Wireless Matrix at an attractive price and capture substantially more of the margin for the fleet management solution than just providing the hardware. CalAmp has made comments that they think growth will be more significant internationally than domestically given the penetration levels already seen in the U.S.

Fleetcor buying Nextraq: This acquisition is the single most concerning acquisition in the space. Fleetcor already has relationships with many of FLTX's target customers given their leading position in fuel cards. We believe this puts Fleetcor at a distinct advantage over the competition and expect them to gain substantial market share going forward.

Economics of a New Customer to FLTX

FLTX charges ~$40/month/vehicle and customers sign a 3 year non-concealable contract (although management believes average customer life is ~6 years). Its single largest expense is the customer acquisition cost, which is ~$350/vehicle, which it pays out at the signing of the commission but amortizes in the P&L over a 3 year period. Its second largest expense is the upfront hardware and installation cost, which is ~$155/vehicle and they amortize this expense over the expected life of the customer, which is 6 years. Variable COGS, which is mostly wireless data service and mapping software, is only $35/year. Although not variable, we also include other COGS (which are mostly fixed) of ~$50 which is largely server costs.

As shown in the above, FLTX has to pay the upfront customer acquisition cost and vehicle equipment of ~$500 for each new vehicle. For the average fleet size of 18 vehicles, this is an upfront cost of ~$9,000. This upfront cost to sign a new customer was a key hurdle for many mom & pops, that caused them to grow at a measured pace. As larger more established companies enter the telematics market, we believe this upfront cost becomes less of an issue for companies to pay the upfront cost and bundle hardware together in the monthly payment.

We also believe that given the minimal variable costs associated with each new subscriber, there is the potential for substantial pricing pressure. If we cut ARPU to $20/month/vehicle instead of $40/month/vehicle, FLTX will still realize a 20% IRR per new customer.

While we don't necessarily expect pricing to fall to $20/month/vehicle given FLTX would be losing money on the EBIT line once it pays for G&A and R&D, we do expect the current economics to attractive new competition at lower prices. We find it encouraging that there are competitors out there currently charging <$25 for similar services (TomTom's Webfleet Lite and Linxup's product).

Aggressive Accounting Issues

Prior to the IPO, FLTX auditors found several deficiencies on its internal controls, indicating FLTX did not have the accounting systems in place. Management blamed the rapid growth in business as to they were slow to adopt the proper internal controls. Management has since fixed the deficiencies, but nevertheless shows managements lack of regard towards proper accounting policies.

We also believe management is making a series of estimates that might be more aggressive than is necessarily prudent. Despite amortizing commission costs over the life of the non-cancelable contract (i.e. 3 years for a new contract), it chooses to amortize the cost of the hardware over their estimate of the useful life of a customer, which they believe is 6 years. Given the ramp of subscriber growth, FLTX has very little data to support the 6 year life. In fact, prior to 2009, it used 4 years as the average useful life. It’s closest public competitor (Mix Telematics) uses a 4-5 average life. While we don’t view these accounting issues as a near term catalyst for the stock, we do think it speaks somewhat to management’s credibility.

Churn

Management discloses “net churn” in its public filings, which is defined as # of vehicles added through existing customers minus # of vehicles who cancelled their service. Management reported a 8% net churn (positive is good), meaning more existing customers added vehicles than customers who cancelled there service. We think the more conventional gross churn is a more appropriate way of looking at churn, and we believe management’s “spin” on reporting net churn is just one more datapoint that shows management’s aggressiveness in accounting.

While management does not disclose gross churn in its public filings, it does give this number in its quarterly financial press releases and during analyst conference calls. In 2013, gross churn was 8.3%. Management calculates gross churn as the number of vehicles that cancelled their service divided by ending subscribers. However, we believe this is misleading given the ramp in customer vehicles over the last several years as well as the 3 year non-cancelable contracts.

We think a more appropriate way to calculate churn is to take the total gross subscriber churn and divide by the subscriber base from 3 years prior. This leads us to a true churn rate for subscribers eligible to cancel of 16%, 2x the rate that management calculates.

We also think another informative way to look at it is to look at the total subscriber churn divided by the number of new gross subscribers that were added 3 years prior. This would be more indicative a “renewal rate” or those that cancelled their contracts during the period divided by those whose 3 year contract came up for renewal. This leads to a renewal rate of only 50%.

We think ultimately that the true customer renewal rate is somewhere between the 16% we calculated using the first method and the 50% calculated in the second method. We also believe that report churn rates are going to start increases both from just more contracts eligible for cancellation as well as from increasing competition.

Importantly, churn ticked up significantly in Q3 2014 to 2.4% (9.6% annualized) from 1.6% in Q2 2014 citing losing their first enterprise account in the history of the company. We find this particularly concerning as they lost this large enterprise client to a smaller competitor due to price. We think as more and more customers come up for renewal, smaller companies will compete aggressively on price and put pressure both on churn rates and ARPU.

Management / Insider Selling

FLTX went public in Oct 2012 at $17 with 80% primary shares and 20% selling from their private equity backer Investcorp. Within 3 months, on 1/30/2013, they completed their first secondary offering at $25 with Investcorp selling 34% of their remaining stake. 6 months later, on 7/25/2013, they priced another secondary offering at $33 and Investcorp cut their stake by 50%. Less than 2 months later, on 9/17/2013, they broke their lock-up requirements and Investcorp cut their remaining stake at $47. All in, Investcorp was able to sell their entire stake in less than 1 year.

Jim Travers, the current CEO, has been with the company since 2006. He was brought in after the co-founders ran the business for the first two years. Despite having been there since 2006, Jim only owns ~1% of shares outstanding, which seems incredibly low for the CEO of a “tech” company. has also sold over 50% of his holdings since the IPO. Most recently, he sold ~$2M worth of stock, or 16% of his remaining holdings, after the stock rallied ~15% after their Q3 earnings call. Jim Travers retains only ~$10M ownership stake in FLTX, which we do not feel is enough skin in the game for a tech company that he basically started in 2006.

The SVP of sales, who started with the company at the same time as the CEO, has also sold all of his holdings since the IPO and recently resigned (an announcement the company curiously did not feel worthy of an 8-K, despite his being listed in the Proxy as a key employee.) The departure of the SVP of sales is very concerning given this is essentially a sales organization.

Risks

We could be early, competitive threats will take time to play out: We are in the early innings of the FLTX short thesis. This is largely because the growth of the telematics industry has trumped any new entrants into the space. While we think that FLTX management is ultimately overstating the TAM of the market, in the short term, FLTX will continue to benefit from the secular growth in telematics. Once the market growth begins to slow, that is when we will start seeing the material impact competition will have on the space.

Management already gave FY15 revenue guidance: Management has an odd habit of providing next year’s revenue guidance on their Q3 call and providing full guidance on their Q4 call. In 2013, they gave bullish FY14 revenue guide in Q3 but then totally disappointed on EPS guidance on their Q4 call citing investments in growth would lead to flat YoY growth in FY14. Similarly, in 2014 they gave revenue guidance for FY15 on their Q3 earnings call that was slightly above consensus estimates. However, they would only say that EBITDA margins would grow “modestly” and that they were “reasonably comfortable” with certain sellside models. Given insider selling post quarter, we do think there is the possibility they again disappoint with their FY15 guidance. However, given they have already guided to topline revenue growth, this does take away one near term catalyst.

New products such as Connect2Field and new geographies might have initial success: Despite our questioning why management would be aggressively pursuing tangential products given their view that U.S. penetration rates are still so low, there is the potential that the Connect2Field acquisition proves to be a successful cross selling opportunity to its current opportunity base. FLTX just launched the product in April 2014, so it is too early to tell how successful they will be. Management might also be successful in targeting new geographies of growth, although similar competitive dynamics exist outside the US as well.

Takeout Risk: While we think this is highly unlikely, there is the potential for someone to acquire FLTX. We think the company was likely shopped ahead of the IPO with little interest above the $17 IPO price. DHR/FLT were able to acquire telematics platforms at significantly lower prices than FLTX. We think any M&A in the space will be concentrated to smaller players looking to buy a platform, not customers.

Conclusion

Net/Net, FLTX is trading at 30x consensus FY15 numbers for a company that pitches themselves as a cloud based SaaS company, but really just sells commoditized hardware and a completely undifferentiated software solution that has significant competition and no barriers to entry. We think pricing pressure will put significant pressure on earnings growth and it will be very difficult for them to ever growth earnings again, even with subscriber growth continuing. Applying a lofty 20x multiple to our FY16 EPS estimates implies a stock price of $19, or down ~50% from the current stock price.

Catalyst

- Disappointing 2015 guidance.

- Price cuts from competitors.

- More insider sales and/or resignations/reitrements.