Description

NFI is a Canadian bus manufacturer trading at a wide premium to other commercial vehicle manufacturers facing cyclical / competitive pressures while on peak margins that are potentially inflated form beneficial accounting.

Business – New Flyer Industries (now called NFI Group) is the largest manufacturer of heavy-duty transit buses (buses between 30-60ft in length) in North America, and a leading player in medium-duty buses (21-34ft), low-floor cutaway buses (21-34ft), and motor coaches (35-45ft). They have a 43% market share in North American heavy-duty transit buses, 43% share of Motor coaches, and a 2% share in cutaway buses. The company is listed in Canada but the vast majority of revenue / EBITDA comes from the U.S. It benefited from the consolidation of the heavy duty transit bus market in the 2011-2012 period as the industry struggled in the wake of the financial crisis. The number of major players went from 5 to 3 as New Flyer bought one (NABI) and a second exited the market (Orion). As part of Orion’s exit, NFI acquired their aftermarket parts business, giving them a greater market share of the installed base.  Today the market for buses is split amongst three players: New Flyer (43% share), Gillig (28% share), and Nova (20% share, owned by Volvo). A few players taking share on the margin are El Dorado, owned by REV Group (REVG), BYD (HK 1211), and Proterra (private). The size of the OE market (as of 12/31/17) is 6,300 units / $3.15bn (at avg. $500k ASP).

NFI entered the motor coach market in 2015 with the acquisition of Motor Coach Industries (MCI) for $455m. MCI is the largest player in the industry with a 43% share, versus Prevost (27% share, owned by Volvo), a Belgian company Van Hool (private, 23% share), and the Turkish company Temsa (7% share). The size of the OE market (as of 12/31/17) is 2,500 units / $1.3bn (at avg. $525k ASP).

NFI operates across two segments – manufacturing (84% of sales / 79% of EBITDA) and aftermarket (16% of sales / 21% of EBITDA). Of the manufacturing segment, transit buses make up 71% and motor coaches make up 29% of sales. The transit bus segment sells primarily to municipal transit authorities, where up to 80% of the funding comes from the federal government, funded primarily by gasoline taxes. This segment generally involves large orders from transit authorities which pan out over months and years. Many orders include a number of “firm” units that the transit authority is committed to buy,  with a number of “options”, or additional orders the transit authority can submit. The manufacturing process isn’t linear – buses are generally custom-made with various addons/specs for each transit authority, and are inspected one by one before delivery. On the other hand, the motor coach industry sells primarily into the private sector, where orders can sometimes be volatile based on the ordering habits of inter-state coach operators, tour operators, etc.

Industry at Record Volumes: Starting with the top, both the transit bus industry and motor coach industry are at record numbers of yearly deliveries. Focusing on the heavy-duty transit bus side (where NFI derives the vast bulk of their sales), there are approximately 80,000 transit busses in North America, with an average life of ~15 years. This leads to a replacement cycle of about 5.3k buses per year. Sales for the past two years have exceeded replacement demand, and 2017 set a record for the highest level of deliveries for over 20 years with 6,336 units. However, over the past 10 years bus ridership has been in decline, with the decline accelerating recently. Declines in ridership create a cycle where lower ridership leads to reduced routes/service, further reductions in ridership, and so on. In short, the rate of replacement may need to decrease as service is reduced with lower ridership.

While there is far less available data on motor coach demand / replacement, deliveries in 2017 were 18% above their prior peak in 2006:

Declining Market Share: After gaining substantial share in the 2012-2014 period due to the consolidation of the transit bus market, NFI’s market share has gradually declined over the past three years from 48% to 43%. Most of the share losses have gone to benefit three players on the periphery of the market – El Dorado, Proterra, and BYD.

El Dorado (owned by REV Group, REVG) has historically been focused on the mid duty bus segment (21-34ft buses), but has recently shifted their focus towards the heavy-duty transit segment. To shift to the heavy-duty segment, El Dorado has changed their go-to-market strategy from a dealer-oriented model targeting small and mid-sized transit agencies, to negotiating directly with the largest transit agencies which is generally where NFI makes most of their sales. Notably, El Doardo won a large portion of a recent LA Metro bid. LA Metro put a bid out for 455 buses, of which they put in orders for 60 40-foot electric busses from BYD, 35 60-foot electric buses from NFI (with the vote split to instead award this order to BYD), 65 60-foot CNG buses to NFI, and 295 40-foot buses to El Dorado. Overall, El Dorado won 65% of the units in the bid, while NFI only won 22%

NFI’s other two emerging competitors are BYD and Proterra, both focused exclusively on all-electric buses. BYD, a Chinese firm partially owned by Berkshire, is the largest electric vehicle manufacturer in the world (BYD has built 35,000 EV buses, and has capacity to produce ~15k per year. For perspective, there are probably 1,600 electric buses in the U.S. today). The company also makes electric batteries, and instead of using a Lithium-ion battery, BYD uses a ‘proprietary iron-phosphate battery’. They are supposedly less toxic, more stable in a variety of environments, and have a longer useful life, while at the expense of not having the power/storage capacity of a lithium-ion battery.

BYD has been ramping up their facilities in the U.S., increasing the size of their production facilities from 150k square ft. to 450k in October 2017, and then again to 550k square feet in April 2018. The facility will have capacity for >1,500 buses per year (or ~20% of last year’s industry deliveries). BYD has stated in May 2018 that to date they have sold 772 buses in the U.S., and plan to sell 1,000 by the end of 2018 and 1,500 by the end of 2019. Those incremental sales of 228 and 500 units respectively equate to a 4.2% market and 7.4% market share in 2018/2019 using 2017’s industry volumes. It would also make up 5.2% and 9.4% respectively of replacement cycle volumes of 5,333 per year. In 2017, BYD had an <3% market share.

Proterra is another all EV bus manufacturer with two facilities, one in California and another recently opened in South Carolina. The company made headlines for producing a bus that went 1,000 miles on a single charge. The company is run by a number of former Tesla executives and has discussed going public soon. They have won a number of bids in 2017 and are increasing production while now operating 2 facilities.

Both players have plenty of expertise in the EV world, and in BYD’s case, their scale, substantial funding, and integration may give them an ability to price others out of the market if they want to ramp capacity in their new California facility.  Both BYD and Proterra have been gaining quite a bit of share in the EV bus market, with a number of contract wins over the past 18 months.

The EV category is an attractive one for a transit authority due to the funding structure for bus purchases. 80% of the funding for a new bus comes from the federal government, and is mostly derived from gasoline taxes. The program began in 1964 under LBJ and was expanded in 1982 under Reagan. The total amount of funding for buses/other transit projects was generally determined annually/bi-annually. In 2015, Obama signed the FAST Act, which provided a 5-year runway of funding. The FAST Act also includes ~$55m / year of additional funding for low/no emission competitive grants.

Electric buses cost between $600-750k, which is a substantial premium to the $500-550k for standard transit buses. But with up to 80% of the upfront cost funded by the federal government, the transit authorities don’t need to worry as much about paying bigger prices, as the opex is substantially lower due to fuel costs / lower maintenance expenses. Cutting down on opex by switching to electric buses would be a big benefit for municipal budgets. Electrifying the bus fleet is also an attractive option in improving the quality of life of residents, as electric buses have far less noise and environmental pollution. Diesel buses are massive pollutants, with incredibly high utilizations (running up to 12 hours a day) on very low MPG in constant stop/start traffic. With rough numbers, a bus travels ~40k miles per year at around 4mpg, meaning each individual diesel bus is consuming 10,000 gallons of diesel per year. Any of the top 25 transit agencies (who all have >1,000 buses) are buying millions of gallons of diesel per year for their bus fleets. Electric buses are about ~2% of the install base today, but >10% of the bid universe.

Oncoming Competition in Motor Coaches: Competition extends past the transit side and into the Motor Coach side as well. While data on bids isn’t as robust (~40% of funding is publicly funded dollars, the remainder is transactional to private operators). NFI entered the market in 2016 with the acquisition of Motor Coach Industries, currently the largest player in the market with a 43% market share. However, MCI used to have a monopoly on publicly-funded orders due to the fact they were the only player with American production that qualified for “Buy America” regulations. That changed when the #2 player Prevost (27% market share, owned by Volvo) set up Buy America eligible facilities, and will change again in 2019 when Van Hool (23% market share, privately owned) will be opening Buy America compliant facilities. BYD is also a player on the Motor Coach side, and has launched a line of electric motor coaches.

Impact of Competition: Competitive threats are starting to show up for NFI. NFI called out increasing price competition in the transit bus space from their two largest players, Gillig and Nova in 2016. Shortly thereafter, bus ASP implied in NFI’s backlog has started to decline low single-digits. Management has historically attributed ASPs to be a function of mix during the quarter, and not indicative of much else. However, there has been a protracted shift towards cleaner propulsion systems, where ASPs are significantly higher than standard diesel. A standard diesel bus may cost $300-400k per year, while a diesel-electric hybrid can cost in excess of $500-600k, a CNG bus is typically $400k+, and fully electric buses are north of $600-700k. Yet despite the step-function change in pricing towards cleaner propulsion systems, ASPs have been down, and ASPs implied by NFI’s backlog are also down, implying competitive pressures. On the last call the management highlighted a competitor (NOVA – owned by Volvo) who was undercutting prices by 20-25% in certain bids.

Historical ASPs / Adj. EBITDA per unit: Margins rebounded sharply in 2015 coming out of a trough of the cycle, and 2016 benefited from the acquisition of MCI. The rate of margin expansion / unit has slowed dramatically in 2017 and declined in Q1 2018 (though a large portion of that will be attributable to NFI’s small acquisition of ARBOC, a mid-duty bus manufacturer in Dec 2017).

Margins & Potential Beneficial Accounting: While facing additional competition, NFI’s margins are at all-time highs, possibly aided by favorable accounting practices. NFI had a margin step-up in 2016 from their acquisition of MCI, going from a ~13% gross margin to a 17.5%. However, in 2017 GMs stepped up yet again from 17.6% to 18.8%, despite minor growth and a decline in the higher-margin aftermarket business. Mirroring this ~120bp increase in Gross Margins and 70bp yoy increase in EBITDA margins was a decline in Accruals/Payables, and a slight increase in prepaid expenses in Q4’17 and Q1’18. The difference in AP/Accruals - Prepaids is at a level below almost all comparable periods for the past 5 years.

The EPS benefit from movements on the balance sheet allowed NFI to beat EPS estimates by mid-single digits the past two years, whereas they would have been in-line in 2016, and missed in 2017:

Normalized Mid-Cycle Earnings: NFI’s consensus forward EBITDA estimate of CAD $433m. However, this is at the top of the cycle, while facing oncoming competitive pressure with margins potentially inflated by accruals/prepaids. Normalized-Mid Cycle earnings assumes deliveries in-line with the replacement cycle (5.3k for heavy duty transit buses, and 1,825 for motor coaches, which is the average of the past ~15 years), as well as a slight decline in market share of 100bps in both transit buses and motor coaches to 42% each to reflect increased competition. In addition, it assumes a reversion back to normalized margins (manufacturing margins from 17% -> 15% and aftermarket from 29.5% -> 27.5%). This implies EBITDA of CAD $275m and EPS of CAD $2.04. Assigning a 13x P/E multiple and a 9x EBITDA multiple provides estimated downside of ~50%.  

NOTE: stock is down a couple bucks since some of these charts were pulled together.  While not ideal, we believe the short is still very attractive from the current price.    

Valuation: : Not only is NFI on peak earnings, but it is on peak multiples. NFI is substantially more expensive than peers on a sales basis (note that not a single peer trades >1x sales), and moderately more expensive on an EBITDA basis. Using consensus estimates, NFI trades at 9.9x consensus EBITDA of CAD $433m vs. peers at 8x.

Other Ways to Win: While it’s entirely speculative, Trump may choose to amend or eliminate federal funding for transit bus purchases. He has historically been averse to using federal funds for municipal projects (NYC’s Hudson Tunnel), and with Obama’s FAST Act up for renewal ahead of 2020, there is the possibility that Trump may push to change the funding structure for transit buses. This would likely be massively negative for NFI, and municipal governments would either need to find additional sources of funding for transit buses, reallocate funding from other projects, or simply slow down on replacing existing buses.

Risks: Risks to the thesis include financial leverage (1.7x turns on a Net Debt / T12M EBTIDA basis), which will amplify the result here in either direction; a potential take-out of NFI by a strategic buyer (if Navistar/Oshkosh wanted to get involved in buses / if Volvo wanted to cement leadership of the category); or continued strong orders by transit authorities. Notably, NYC recently proposed a massive subway overhaul which also involves 2,800 new buses in the first 5 years of the plan, and an additional 2,100 new buses in the next 5. That equals out to 4,900 buses over 10 years, or 490 buses a year, which at $500k/bus is a $245m opportunity per year. A big win from NFI (who recently built a facility in NY state in order to be more competitive on NYC bids) could provide an incremental growth opportunity. This plan is in the proposal stage and funding has yet to be committed.

Catalyst

Competition results in lower market share / margin pressure

Industry volumes trend lower to replacement levels

Accruals and prepaids normalize, negatively impacting margins

Federal funding picture becomes murky into 2020 expiration of FAST Act