Description

Investment Thesis
New Flyer Industries Inc. (“New Flyer” or “NFI”) is a dominant market leader with a strong free cash flow profile – yet few U.S. investors are aware of the company. Over the past two years NFI has strategically consolidated the North American transit bus industry and now commands ~48% market share. However, despite generating ~85% of annual revenue (~$1.5BN) in the United States, New Flyer remains relatively unknown given the company is headquartered in Winnipeg (Manitoba) and is listed on the Toronto Stock Exchange. With NFI trading at 6.6x EBITDA and a 12% FCF yield on conservative 2016E forecasts, the stock offers a +30% target return over a 12-month horizon with an attractive margin of safety.
In 2012 the North American transit bus sector was a competitive five-player industry. However, a sharp decline in new order volumes following the 2008/09 financial crisis put significant pressure on the sector. After a wave of strategic industry consolidation, New Flyer has emerged from the industry downturn as the undisputed leader in a three-player market. NFI now controls ~48% share of new buses and ~33% share of aftermarket parts, sales and service. The aftermarket business is critical to the investment thesis because this division generates margins 3x the core bus manufacturing division.

Business Overview
New Flyer is the North American market leader in the two business segments in which it operates: 1) Engineering and manufacturing of heavy-duty transit buses for municipalities and metropolitan areas (“Bus Manufacturing”), which represented 78% of revenue and 53% of EBITDA based on 2014 financial results; and 2) Provider of aftermarket parts and services (“Aftermarket”), which represented 22% of revenue and 47% of EBITDA based on 2014 financial results.

1) The Bus Manufacturing segment is a low-growth/replenishment industry, however, NFI has shown unit growth via market share increases and acquisitions. Looking forward, NFI expects to show EBITDA growth from higher margins driven by three primary factors: i) lower margin backlog acquired in NFI’s recent acquisitions will roll off during 2015; ii) increased price rationalization on RFP’s within the sector due to the industry’s consolidation from 5 to 3 players; and iii) continued operating synergies from the ongoing integration of two major acquisitions in 2013. For context, adjusted EBITDA margins in the Bus Manufacturing division were under 5% in 2014 (excluding the benefit of Investment Tax Credits) versus over 8% in a more normalized environment in 2010 and 2011.
• In 2012, prior to the recent wave of industry consolidation led by New Flyer, there were 5 competitors in the sector. Bookings activity stagnated in 2012 which led to fierce price competition – ultimately forcing one participant to exit the market (Orion) and another participant into a distressed asset sale to New Flyer (NABI).
• The industry is now a three-player market with NFI as the clear leader. NFI’s market share grew to ~48% in 2014 (up from 43% in 2013) with the next largest players being Gillig at 33% market share and Nova Bus at 15% market share. Gillig and Nova Bus are both privately held companies.
• Municipal transit authorities ("TAs") in the United States receive up to 80% of funding for new bus purchases from the Federal Transit Administration (“FTA”). The FTAs funding is earmarked to replace buses that have operated for 12 years and to support fleet expansion based on ridership trends.
• There are roughly 5,500 buses which need to be replaced every year in the North American market. Although backlog can be lumpy due to the nature of order patterns, NFI manages its pipeline by entering approximately the same number of buses into production every week (~50 units). This has translated into a relatively stable level of rolling-twelve-month deliveries over the past 8 years.
• The average age of the current U.S. bus fleet is ~8 years versus a mid-life of 6 years – implying pent-up replacement demand looking forward. This dynamic is partially offset by ridership falling by ~1% in U.S. in 2014.
• As the #1 player in the market, 24 of the 25 largest TAs in the United States and Canada currently operate NFI buses, and NFI sells products to nearly 400 TAs in total.
• NFI has a good reputation in the market for producing high quality buses and for product innovation. The company has consistently been at the forefront of developing new technologies (propulsion mechanics, customization of features, etc.), something which is becoming increasingly important in today’s RFP processes. NFI provides a full range of products to TAs in terms of propulsion systems (clean diesel, natural gas, hybrid-electric, electric trolley, battery electric). Engineering, product breadth and scale are key advantages for New Flyer.

2) The Aftermarket parts and support business is a fragmented industry serviced by bus manufacturers, component part manufacturers and regional distributors. NFI is the clear market leader in the Aftermarket segment with 33% share in North America. The next closest competitor is Gillig at 15% market share and a dozen other companies with less than 10% share. NFI’s Aftermarket adjusted EBITDA margins were <15% in 2014 (excluding the benefit of Investment Tax Credits), however, the company achieved 20-23% margins in the normalized market environment of 2010 and 2011. The Aftermarket business is well-positioned to grow and expand margins given a number of company-specific and sector-specific factors – including:
• The increased complexity of new technologies being integrated into transit buses is driving increased demand for aftermarket parts and support.
• NFI's Aftermarket business is in a commanding position to be the supplier of choice given the company’s significant footprint of >50% of the ~80,000 active buses on the road in North American. The large install base provides an opportunity for NFI to continue growing its Aftermarket business.
• NFI has grown the Aftermarket division from 25% of total EBITDA in 2010 to 46% of EBITDA in the LTM period. This trend should continue as NFI’s share in Aftermarket improves from ~33% today towards the company’s higher market share for new buses (~48%).
• The Aftermarket business represents a natural hedge for the Bus Manufacturing division because when TAs defer purchases for new buses they need to increase spending on fleet overhaul (parts & service).
• Given New Flyer’s size and scale, the company can bid on large scale fleet overhaul programs. For example, in 2014 NFI generated ~$50MM in sales from the Chicago Transit Authority’s mid-life overhaul program (albeit at modestly lower margins given the size of the order).

Industry Consolidation
• Back in 2012, it was widely rumoured that one of the world’s largest bus manufacturers (Brazil-based Marcopolo) was planning to enter the North American transit bus market via acquisition.
• In early 2013, New Flyer negotiated a strategic investment and Marcopolo acquired a 20% stake in NFI for $161MM. Marcopolo paid a 20% premium to NFI’s share price at the time of the investment and the $161MM was earmarked for strategic acquisitions.
o Concurrent with the strategic investment, NFI and Marcopolo signed an MOU to cooperate on engineering, technical, purchasing and operational matters – focused on reducing NFI’s cost structure while enhancing competitiveness.
o The deal also included a 2-year standstill agreement that expired in January 2015, but Marcopolo has made no indication that it intends to buy (or sell) any shares in New Flyer at this time.
• Following Marcopolo’s strategic investment in early 2013, New Flyer acquired certain assets from Daimler Buses North America (“DBNA”) in March 2013 relating to its Orion aftermarket parts business, the #4 player in North America.
• NFI followed the DBNA transaction with another deal in June 2013 and acquired North American Bus Industries (“NABI”), the #3 player in North America. NABI was acquired from Cerberus Capital for $80MM or an implied 4x EBITDA multiple, reflecting the distressed nature of NABI at the time of the transaction.
• The $161MM strategic investment from Marcopolo has been beneficial for both companies. The influx of capital has enabled New Flyer to consolidate its market position in the North American bus market – and despite paying a 20% premium at time of the transaction, Marcopolo is up ~45% on their investment.

Recent Developments
• In June 2014, NFI announced its decision to fully integrate the NABI business into New Flyer – meaning, the NABI bus platform will be discontinued and the NABI assembly plant in Alabama will be converted to a more cost-efficient NFI assembly plant. This transition/integration will cost NFI $20MM (of combined operating and capital costs), will be completed in H2 2015, and will generate annual EBITDA synergies of $12MM-$14MM (up from NFI’s original synergy estimate of $7MM).
• New Flyer’s recent Q1 2015 report beat consensus EBITDA expectations by ~20% on better than expected revenues and margins in the Aftermarket segment. The Aftermarket segment reported EBITDA margins of 18.5%, despite including lower margin revenue from the large Chicago Transit Authority (CTA) contract which represented $17MM of the $90MM in total Aftermarket revenue.
• In conjunction with the Q1 earnings release in May 2015, NFI also announced its first dividend rate increase since 2011. The dividend represents a yield of 4% at a conservative sub-50% payout ratio on LTM adjusted FCF. Management noted that dividend increases will now be a regular discussion at the board level.

Regulatory Considerations
• “Buy America” regulations require that buses meet fundamental requirements to be eligible for U.S. Federal Transit Administration funding: i) final bus assembly/manufacturing must occur within the United States, and ii) the bus must contain a minimum of 60% United States content by cost.
• The federal regulations create significant barriers to entry for new international players looking to enter the U.S. market and would require significant onshore investment in order to qualify for most RFP bids.
• Changes to the current regulatory structure present both a risk and benefit to NFI:
o Risk: In terms of component costs, if the current 60% threshold is increased further (as has been proposed in the first draft of the Grow America Act – 70% in 2016, 80% in 2017, 90% in 2018), all industry participants will likely experience input cost increases.
o Benefit: As the #1 player in the industry, NFI is the best positioned company to comply with regulatory changes – and presumably a significant percentage of the expected cost increases would be passed on to customers as part of the RFP bidding process.
• The Grow America Act also proposes to materially increase federal funding available for bus purchases, which could accelerate the replenishment cycle of the active fleet. With an average age of 8 years currently, any uptick in federal funding would be a welcome bump to industry volumes.
• For further reading, refer to a recent study published here on the protectionist measures that create barriers to entry for foreign bus manufacturers: http://www.nber.org/papers/w19964
Company Ownership and Management Compensation
• Marcopolo – 19.9% of basic shares outstanding (as described above).
• Coliseum Capital – 11.1% of basic share outstanding. Coliseum Capital is a value-focused fund which purchased its 11.1% position in March 2012. One of the Coliseum’s founders (Adam Grey) sits on NFI’s board.
• Management and directors own 3.9% of the basic shares outstanding. After accounting for options and RSU’s, management and directors own 6.6% of the fully diluted shares outstanding (excluding Coliseum).
• Management’s cash bonuses are based on EBITDA and FCF targets set at the beginning of each year. In 2014, management surpassed targets on both metrics and the same bonus methodology will be applied in 2015.

Balance Sheet
• NFI has a clean balance sheet with capacity to pursue significant growth opportunities. NFI ended Q1 2015 at 1.3x Net Debt to EBITDA, down from 1.6x at Q4 2014. Management is comfortable in a leverage range of 2.0x to 2.5x and the total leverage covenant is <3.25x.
• NFI has $83MM available on its $115MM revolver (with a further $75MM accordion feature) as well as outstanding debt of $142MM on a senior term facility and $65MM in converts (treated as equity given US$10.00 conversion price).

Catalysts and Risks
In addition to the natural roll-off of lower margin backlog associated with the NABI acquisition, over the next several quarters there are two specific catalysts that should result in further EBITDA margin expansion:
• Realization of cost and working capital efficiencies from the change-over of the NABI assembly plant in Alabama to a NFI assembly plant by Q3 2015. Management has guided to $12MM-$14MM in annual cost synergies which equates to >100bps of margin expansion.
• Realization of cost and working capital efficiencies from the combination of the NFI Aftermarket business with the NABI and Orion aftermarket businesses by Q1 2016. Management has not guided to a dollar estimate, but a number of specific cost savings have been identified (e.g. the geographic overlap of certain distribution centers).
• Once the above integrations have been successful completed, management intends to pursue additional growth initiatives, including: i) additional acquisitions in the aftermarket segment; ii) potential platform acquisitions into other bus verticals (i.e. coach buses); iii) the introduction of new products in existing markets; and iv) the export of current products into new international markets.
The key risks facing NFI include:
• Despite the consolidation and rationalization of the market in recent years, competition between the industry’s remaining three players will continue given the RFP nature of the bidding process. This dynamic will be partially offset by having fewer bidders and the industry’s trend towards qualitative factors when selecting RFP process winners – meaning, instances where NFI can present a differentiated product and/or a differentiated long-term service proposal.
• Although the FTA funds 80% of new bus purchases, the U.S. states and municipal budgets fund the remaining 20% of the purchase – so constrained budgets will impact the overall funding available to TAs in North America. As cited earlier, this dynamic is partially offset by the need to spend additional funds on fleet repairs and overhaul in the absence of new bus purchases.
• New Flyer has four collective labor agreements, representing approximately 1,300 of 3,400 employees. The largest, which represents ~22% of the company’s workforce, ratified a new three year collective bargaining agreement in April 2015.
• NFI has some negative economic exposure to a strengthening CAD/USD given approximately half of the SG&A costs are in CAD. Also note the company is listed on the TSX and trades in CAD, but reports in USD.

Valuation and Conclusion
In 2010 and 2011, NFI reported EBITDA margins of 9.9% and 8.5% (respectively) on revenue below $1.0BN. As price competition squeezed the industry in 2011 and 2012, lower margin orders entered the NFI’s backlog, both organically and through the acquisition of NABI. With New Flyer now exiting (and benefiting from) a period of industry consolidation, total Q1 2015 EBITDA margins were 8.2% (or ~8.4% excluding lower margin CTA Aftermarket revenue). If we assume management can extract additional synergies from the Bus Manufacturing segment as per the company’s $12MM-$14MM guidance, NFI should be able to generate at least 8.6% margins in 2016 – without including any benefit from undefined synergies related to the ongoing Aftermarket integration/expansion. With 8.6% EBITDA margins and assuming conservative annual revenue growth of 5.0%, NFI is well positioned to deliver $1.6BN in revenue and $138MM in EBITDA in 2016, implying a current valuation of 6.6x EV/EBITDA.

Catalyst

The sell-side analyst community appears to be partially anchored to the industry’s sub-optimal results in past years and are hesitant to give too much credit for NFI’s strong recent quarters. As such, consensus expectations are for 3.4% annual revenue growth and 8.4% EBITDA margins in 2016. It is not unreasonable to see a scenario where annual revenue growth is greater than 5.0% and EBITDA margins move closer to 2010 and 2011 levels above 9.0%, as the company takes advantage of price rationalization and completes integration activities. NFI currently trades at 8.0x NTM consensus EBITDA and has historically traded in the range of 7.5x to 8.5x. One could argue that recent margin expansion and a reduction in working capital point to an inflection in FCF margin, ROIC and ROE that may translate into a higher trading multiple. If you assume that the NTM multiple remains at 8.0x and apply conservative 5% revenue growth and an 8.6% consolidated EBITDA margin for 2016, NFI shares should trade at >$20.00 per share in one year’s time, representing a >35% total return including the 4% dividend yield. The current multiple appears low relative to the historical average when viewed against a backdrop of improving fundamentals and thus provides a margin of safety that makes shares in NFI a compelling risk-adjusted investment opportunity.