Description

We last wrote up NFI CN as a short in June 2018. Since then there have been multiple changes impacting the demand outlook & customer funding, competitive environment, business mix, and most importantly, the stock price. Our prior write-up provides some context on the business and industry: https://valueinvestorsclub.com/idea/NFI_GROUP_INC/4780685099

As a brief recap, NFI is a Canadian bus manufacturer, and the core of their business involves manufacturing heavy-duty transit buses for North American municipalities. They have some other businesses including motor coaches, shuttle buses, international transit buses (thanks to the 2019 acquisition of Alexander Dennis), and a large aftermarket platform.

In the near-term, the company is facing supply chain challenges which are impacting their ability to deliver buses to customers. In the long-term, the demand backdrop and competitive environment has positively changed as governments in the U.S., Canada, and the U.K. are providing municipalities with record levels of funding to make the diesel to electric transition.

We believe NFI can earn US$325m in EBITDA and C$2.65/share in FCF (pre-convert) on mid-cycle numbers, though given the current demand backdrop there is a real possibility for a multi-year peak cycle that could lead NFI to generate >US$400m of EBITDA and C$4/share of FCF, vs. the current enterprise value of US$1.8bn and share price of C$13.

What Has Changed Since 2018: In 2018, we wrote up NFI as a short based on the premise that industry volumes were at peak levels in what is a replacement market, there was oncoming competition from well capitalized players like BYD, the market was shifting gradually towards electric which had a more competitive backdrop than traditional diesel, and accounting was potentially benefitting margins.

Since then, industry volumes have been at cyclical lows for >2 years due to covid which may lead pent-up demand period in 2023+. In addition the bus market has been flooded with funding dollars for the diesel to electric transition, and as a result EVs have gone from ~5% of the market in 2018 to >40% of the current bid universe. As demand is increasing, competition is decreasing as new entrants to the market have scaled back, diversified, or exited. Congress removed BYD from the market as of December 2021 and Proterra has diversified away from transit to focus on propulsion for other commercial vehicles.

Lastly, NFI has gone from trading at 15x normalized EBITDA in 2018 to just 5.5x our estimate of normalized EBITDA today, and 5x normalized FCF. If NFI achieves their long-term guidance, which we believe they can given the positive funding backdrop, the company would be trading at 4x EBITDA and 3x FCF.

Near-Term Challenges: New Flyer has faced multiple challenges over the past few years. The first was uncertainty around the viability of mass transit early on in the pandemic, and the more recent challenge has been related to the supply chain. The company entered the pandemic relatively levered after buying Alexander Dennis in May 2019, and NFI was forced to raise capital and receive waivers from their lenders multiple times over the past two years.

Pandemic Timeline:

1)  April 2020 (C$14/share): Covenant waiver in connection with a $250m unsecured lending facility. NFI had covenants waived for Q1, Q2, and Q3 2020, with plans to reintroduce covenants in Q4 2020. The banks did not prohibit dividend payments during this time.

 2)  December 2020 (C$25/share): Second covenant waiver, but cancelled the $250m unsecured facility that NFI entered into in April. Covenants were relaxed for 2021 and 2022, with an added $50m minimum liquidity covenant, and a Net Debt to Capitalization covenant of 70%. Part of the waiver was contingent on an equity cure.

 3)  Feb 2021 (C$30/share): NFI completed a C$250m secondary offering, selling 8.5m shares at C$29.6/share. The share count pre-deal was 62.5m, leading to dilution of ~13%.

Supply Chain Challenges:

4)  September 2021 (C$30/share): First indication of supply chain issues. NFI cuts EBITDA guidance from $230m to $180m for 2021.

 5) November 2021 (C$26/share): NFI obtains another covenant waiver through 2q22, reintroducing the net leverage ratio at 6.25x in 3q22, and the fixed charge ratio at 1.5x. In connection with the waiver, NFI raises C$150m in equity at C$24.55/share (6.11m shares, for ~23% cumulative dilution since 2019), and C$300m through a convertible debenture (5% rate, converting at C$33).

 6)  Mar 2022 (C$19/Share): NFI cuts the dividend by 75% (the banks did not ask them to cut the dividend), and discloses they are in discussions with their banks to address covenants.

 7)  April 2022 (C$14/share): NFI cuts 2022 EBITDA guidance from $115m to $30m due to supply chain constraints, saying they need $200m of working capital to build-up inventory (vs. liquidity of $649m). Reaffirmed need for covenant waiver.

a. CEO states on the business update call: “We are not contemplating an additional equity raise at this time. We are committed to work through the conversation with the leads of the [banking] syndicate.”

8)  May 2022 (C$12/share): NFI announces 1q22 results and discloses the CEO stepped down temporarily for medical reasons (aortic aneurysm).

1. CFO reiterates: “We anticipate that we will be able to achieve a suitable credit amendment program within the second quarter of 2022, and will inform the market when it is complete. We are confident that we have sufficient capital to navigate through these immediate supply challenges and do not currently contemplate the need to issue additional equity.”

b. Following the call, the CFO bought 17k shares of stock in the open market at C$12.3/share (C$210k). In addition, NFI’s largest shareholder (who has board representation), Coliseum Capital, bought 730k shares (C$9m) worth of stock in the week following the call.

Challenges Going Forward: On the April business update call when the company cut guidance, NFI said the issue centered around procuring chips/modules for their buses. They had been told by their supplier they would not receive any shipments until August, at which point they would be guaranteed delivery. NFI plans to continue producing buses despite this issue, completing 99% of each bus, and then waiting for the chips to finish them, building up to $200m of work-in-progress inventory. NFI is also looking to dual-source / re-engineer these components in order to avoid dependence on this chip supplier.

While there is no guarantee that the supply chain challenges don’t get worse, the company is confident in receiving the supply of chips, and is also confident of having a re-engineered module by July.

The Need For Additional Capital: The biggest question currently is whether or not NFI needs to raise capital in order to receive their covenant amendment. There are a few points indicating that NFI may not need to raise capital:

1)      The company has more than enough liquidity (>$600m) to fund their working capital needs in the interim.

2)      The CFO is buying stock in the open market, in addition to NFI’s largest shareholder (who has board representation).

3)      So far the company has stated multiples times on their business update call on April 29th and 1q22 call on May 5th that they do not need additional equity.

a.  Ahead of raising capital in November 2021 and after announcing their supply chain issues, the company admitted on their 3q21 call: “We are currently in ongoing discussions regarding additional financial and covenant flexibility for 2022 as we work through these most recent supply chain disruptions.”, providing a precedent of admitting they need capital ahead of raising.

b.  It is worth noting that when NFI discussed they didn’t need additional capital in April/May 2022, they were specific to say they don’t need to raise equity, implying they may raise capital through some alternative method.

The company has contemplated multiple options for accessing additional liquidity, including AR factoring, customer deposits, supplier financing, sale/leasebacks, etc. In the most recent investor presentation on 5/5, the company has already indicated they have “executed on several opportunities including receivables financing”.

The customer deposits / milestone payments are unlikely to be material. Customers generally do not receive funding to pay for the bus until after delivery, making it impossible for milestone payments to occur.

Long-term Opportunities – Funding: While the near term is uncertain, the setup for next few years is shaping up to have the most positive demand backdrop the industry has seen in 30+ years. Transit buses are mostly federally funded, the Federal Transit Association (FTA) contributes 80% of the funds necessary, states may also contribute, and the municipality covers the remainder. Buses are eligible to be replaced after either 12 years or running a certain number of miles (generally the age comes first). Looking forward, funding has exploded thanks to the Infrastructure Bill and increased grants for Low-No emission vehicles.

A sales rep of one of NFI’s competitors recently said the biggest challenge in the industry is actually finding a way to spend all of the money, a sharp contrast to the prior environment when municipalities were capital constrained for years. He did not believe the industry had enough capacity to satisfy the demand that will come from the influx of spending / orders.

This sentiment was echoed by a transit procurement officer who said there was “so much money out there”, and the government was “hitting us over the head to buy electric”. He was unsure if they will ever make another diesel purchase again. 

The full impact of the funding environment is not yet visible in NFI’s backlog given the Infrastructure Bill was not passed until November 15th 2021. In addition, Low-No Grants required municipalities to have a full EV transition plan in place (a process that takes at least 6 months). As a result, most of the Low-No Grant funding is expected to be awarded in 4q22/1q23.  NFI’s backlog has just started to increase in the past two quarters, reversing two years of declines, while the overall transit bus bid market bottomed in early 2021. Currently EVs make up 17% of NFI’s total backlog, and 43% of the current bid universe, reflecting the increase in Low-No Emission Grant funding.

The EV transition is beneficial for New Flyer as EVs have more attractive unit economics when compared to legacy diesel buses. ASPs for electric buses are up to double that of diesel buses, though margins are lower. Even with lower margins, we estimate the transition to electric will lead to at least a low teens percentage increase in Gross Profit per unit.

We believe the funding environment will get NFI back to at least mid-cycle demand (5,333 buses/year for North America) but has the real potential to lead to a multi-year cycle of peak deliveries, which would be equal to about 6,700 in North America, and ~5,300 in the U.S.  

Looking at the U.S. alone and excluding Canada which is 20%+ of the North American market, there is a large backlog of buses >12 years old that are eligible to be replaced using federal funding based on the current age distribution of the U.S. bus fleet (data last provided by the FTA as of 2020). Assuming the national fleet declines at a rate of 1.5% per year (in-line with history), the U.S. industry could sustain 7 years of peak deliveries before exhausting the current backlog If the fleet were to stay the same size (which is possible given the funding backdrop), the industry could have a decade or more of peak before running out of eligible replacement buses.  

Outside of the U.S., Canada (20%+ of the North American Market) has dedicated C$34bn to new transit / low-emission funding, and the U.K. (relevant for NFI’s Alexander Dennis subsidiary) is subsidizing the purchase of 4,000 electric buses.

Favorable Competitive Changes: While the demand environment is only becoming more favorable, the competitive environment is also changing to benefit New Flyer. The market includes 6 players, New Flyer (43% market share), Nova Bus & Gillig (each 20%+ share), with the remainder of the market rounded out by El Dorado, BYD, and Proterra. New Flyer is relatively insulated from new competitive threats due to Buy America standards, which require >70% of the total cost of the bus to be produced in America. Proterra is NFI’s main competition on the electric side.

BYD: A Chinese manufacturer of electric buses, BYD was an emerging competitive threat in 2018. After using price to win a number of orders in 2018, BYD was effectively banned from the market in December 2021 when Congress passed the National Defense Reauthorization Act of 2019 which prohibited the use of federal funds to purchase Chinese rolling stock.

Proterra: An all-electric bus producer based in the U.S., went public via SPAC in 2021. Proterra has diversified their focus away from transit buses to battery systems for school buses and other commercial vehicles. They have done a very good job at winning initial / pilot orders, but notably repeat orders have been less consistent (Louisville / Rhode Island are two examples of this). Municipal customers have complained about their reliability and performance vs. what Proterra has advertised. In Philadelphia, their entire fleet of 25 Proterra buses has been sidelined since February 2020 due to various defects. Some headlines on Proterra over the past few years include:

 Reliability Problems Stall Duluth’s Transition to Electric Buses: https://energynews.us/2021/08/31/reliability-problems-stall-duluths-transition-to-electric-buses/

SEPTA’s Cracking Battery Buses Raise Questions About the Future of Electric Transit:

https://whyy.org/articles/septas-cracking-battery-buses-raise-questions-about-the-future-of-electric-transit/

Mechanical Problems with Early Electric Buses Plague Multiple Transit Agencies: https://www.dailybulletin.com/2021/09/08/mechanical-problems-with-early-electric-buses-plague-multiple-transit-agencies/

With 50 of its Buses Inoperable, Foothill Transit Searches For a Way to Fix its Fleet: https://www.dailybulletin.com/2021/07/22/with-50-of-its-buses-inoperable-foothill-transit-searches-for-a-way-to-fix-its-fleet/

Plugging Along: Electric Bus Faces Mechanical Issues: https://www.juneauempire.com/news/plugging-along-electric-bus-faces-mechanical-issues/

Nova: Late to the EV transition, won their first RFP for an EV order in March 2021 with Milwaukee, while NFI and others have been making and delivering buses for years. Nova also only makes a 40ft and 60ft bus, while NFI has a far wider range (30 & 35ft low floor, 35ft heavy duty, 40ft, 60ft, etc).

Gillig: Another legacy transit bus manufacturer, they have had an EV product for some time (though it is unclear if they have delivered a single unit yet) with some notable bid wins in Oregon, Florida, and Washington.

As a result, based on announced bid wins, NFI seems to be a clear share winner, though peers are less consistent in disclosing EV bid wins and option awards. However this data seems to directionally support the company’s statement that their EV bid wins have exceeded their historical market share of 43%.

One distinguishing factor between NFI and the rest of the industry that was pointed out to us by one of NFI’s competitors as an advantage for NFI is that NFI is the only company that can produce a fuel cell bus. Battery-electric buses generally don’t have the range to work on long routes, so some fleets are looking to operate with a mix of battery electric and fuel cell. 

Other Businesses: NFI has a number of other businesses in addition to Heavy-Duty Transit buses, including Motor Coaches, UK / International Transit Buses, shuttle buses, and an aftermarket business.

Motor Coaches: NFI’s only competitor in the public sector (40% of the motor coach market), Prevost, exited the market in 2022. This leaves NFI as the sole provider qualified for public sector procurement (which needs to comply with Buy America). This could translate to an additional 12-16% market share vs. pre-covid, which based on mid-cycle numbers would equate to 210-280 additional units/year, or $105-140m in revenue and $15-20m in Gross Profit / EBITDA. 

International Transit: The key international market for NFI is the U.K., where NFI commands  over 70% market share. The market is heading towards an upcycle due to new government funding and 5-6 years of below-average orders. Market share will likely decline as a new player, Arrival, has entered the market, but this will not probably move the needle for NFI as a whole.

Aftermarket: NFI is likely over-earning here slightly, given that bus replacements have been delayed due to covid. Normalized aftermarket EBITDA is in the range of $85-90m, vs. T12M levels of $100m.

Valuation and Normalized Earnings: We estimate NFI can generate mid-cycle EBITDA of $325m. This assumes replacement demand of 5,300 units for the North American Transit market, 1,750 for the Motor Coach Market, 2,000 for the U.K. transit market, as well as long-term average revenue for cutaway/shuttle buses and other international markets. We estimate that NFI’'s aftermarket business declines marginally as the fleet begins to be refreshed.

At 10-12x mid-cycle FCF of C$2.65/share, NFI would be worth C$26-32, or 100-140% above current levels of C$13. Assuming NFI reaches peak EBITDA and the convert kicks in, NFI would be doing C$3.80/share of FCF, which at 10-12x would be C$38-C$46/share, or 190-250% upside from current prices.

Peak numbers would assume the industry is delivering ~6,700 buses/year in North America, and NFI maintains their 43% market share, implying 2,900 deliveries. Peak capacity for NFI is probably around 3,000 units/year, but adding capacity is very capital light (it’s more assembly than it is manufacturing), and the main constraint is labor availability.

Catalyst

Supply Chain Resolution

Covenant Amendment