Description

(All figures in $AUD)

National Tyre and Wheel is an Australian micro-cap with a decent business trading at a ridiculously low valuation. The company IPO’d in December 2017 at $AUD 1 per share and quickly rose 20% before losing two-thirds of its value in the following months. This is not a great business, and there are risks related to the firm’s distribution agreement with Cooper Tire. However, the stock is pricing in much of this risk at a 4x EBITA multiple. Further, NTD has a solid balance sheet and is trading below tangible book value. 

The company is a wholesale tire distributor focused primarily on importing Cooper brand tires via an exclusive agreement. It was founded by Terry and Susanne Smith in 1989 when the first Cooper deal was struck. In the last several years the company has acquired other tire and wheel wholesale businesses, including Dynamic Wheel Co (2013), NSW/ACT (2014), MPC, Cotton Tyre Service, and Top Draw in 2017. With the exception of Top Draw, all of these businesses operate in either Australia or New Zealand. The company operates 11 distribution centers and 7 warehouses. The distribution centers are operated by NTAW whereas the warehouses are operated by 3rd parties.  

NTAW sells over 850 different tire sizes and types for use on cars, SUVs, 4WDs, and RVs. The business is almost entirely aftermarket, and has historically been focused on 4WD and SUV tyres, a market which has grown faster than the industry as a whole. The company has agreements with suppliers that give it the exclusive right to store, market and sell products. Customers are granted exclusive rights to sell the products in their local area.  NTAW controls the marketing of the product. The company supplies over 2,300 customers, although many of these are part of larger chains.

Industry and Competition

The distribution market is made up of brand manufacturer wholesalers (e.g. Bridgestone, Goodyear, Michelin) that also distribute, national wholesalers (NTAW, Tyres 4U, TyreMax, YHI, and Tyre & Tube), as well as other regional & specialty wholesalers.  None of the other national wholesalers that compete with NTAW are public except for YHI. Brands other than Cooper that are distributed by national wholesalers (not vertically integrated) include Continental, Yokohama, Kumho, Toyo, Pirelli and Hankook.  The vertically integrated wholesalers make up half of the distribution market, with national wholesalers making up 33% and other wholesalers making up 17%.

Brand manufacturer and aligned retailers (e.g. Bridgestone store) account for 28% of industry-revenue, while retailers belonging to a chain or retailer group account for 41%, and other retailers (independent tire specialists, mechanics and car dealers) account for the remaining 31%.  The major independent retail chains are Tyrepower, Bob Jane, and Kmart. While independent retailers are NTAW’s largest customer base (~30-40%), Tyrepower members make up between 20 and 25% of revenue. Tyrepower was formed in 1977 by ten independent tyre retailers. The business model is not a franchise; the company is “owned entirely by the members as all 260 of them are equal shareholders in the company.”  

Approximately 19 million tires are sold annually in Australia, with less than 1 million of those coming from NTAW (~5% market share of volume).  The average age of the vehicle fleet in Australia is 10.2 years; almost two years less than the US’s 11.8 years. In the United States, this average age has increased by about 4% annually.  Australia increased their average age from 10.1 to 10.2 years in 2019. Additionally, the number of cars on the road increased 1.7% in 2019 from 2018.

Cooper Tire License

Cooper Tire is the 13th largest tire manufacturer in the world.  The company is known for premium off-road tires, with many consumers in the 4WD community demanding the highest quality.  When NTAW IPO’d in 2017, Cooper and Mickey Thompson (another Cooper brand) accounted for 77.1% of revenue. This has declined due to recent acquisitions, but sales of Cooper tires account for over half of NTAW’s revenue. The distribution agreement with Cooper expires on September 14, 2022. The agreement will automatically renew for an additional five years unless, at least 30 days prior to expiration, the parties mutually agree to its termination. If NTAW can’t hit minimums for two consecutive years, Cooper can terminate their exclusive right to distribute. 

A Cooper defection would certainly not be a preferable outcome, but I believe it is very unlikely, and the risk is mitigated by the following.

• The size of the Australian market makes an ATD situation remote. I estimate Cooper generated less than 25bps of its total sales in 2018 from sales to NTAW. 

• If the agreement is terminated by Cooper, it must repurchase all unsold products and advertising materials. This lends support to tangible book value. 

• The above points make it more likely that Cooper would buy NTAW at the current valuation than to go to the trouble of taking wholesaling in-house.

• With ~3 years remaining on the current agreement and the low valuation being assigned by investors, NTAW has a runway for substantial free cash flow generation relative to the current EV. I estimate the forward dividend yield at 7.5%.

Board and Management

The Board is run by five directors, three of which are independent (including the Chairman).  The CEO, (John) Peter Ludemann, has been at the helm since July of 2013. He has previously worked as a private equity investment manager at AMP Capital.  He owns 2.7% of the company, worth about USD $767k. Terry Smith is on the board and owns 26.7% of the company.  As a director he makes $70k as well as a car allowance of $22,300.  The CFO, Jason Lamb, has been with the firm since 2007.

As the company has acquired other distributors, they have kept management of the acquired firms employed.  Roshan Chelvanaratnam, founder of acquired MPC, has a 3-year contract with NTAW from April 1, 2017. He also owns 4.65m shares of NTAW.

Capital Allocation

The company’s aims for a payout ratio of 40-60%.  After the IPO, the company had some cash that they expected to use for acquisitions, along with their stock as currency.  However, management has reconsidered it capital allocation in the wake of the share price decline. “While the Company continues to engage with potential acquisition targets, given current market conditions and the Company’s share price, potential acquisitions would have to pass a very rigorous assessment and be capable of execution without distracting management’s attention from completing essential organic growth projects.”  NTAW’s most recent investor presentation stated: “The Board continues to consider alternative capital management options.” This was followed by a discussion of recent dividends. The presentation also stated that the “board is reluctant to issue shares as part of an acquisition while shares are trading at a PE ratio well below the ratio considered reasonable when the company listed.”  

The company has a clean balance sheet and is unlikely to deteriorate due to capital allocation policies. Fund company Forager Funds owns 7% of the company and had pushed for a special dividend of 1.5 cents per share, which they got.  Forager stated in their March 2019 quarterly report that they purchased 5% of the company after the stock fell from its IPO heights: “With expectations low and a valuation reminiscent of global financial crisis levels, the Fund bought 5% of the company.”  On October 14th it was reported that Forager bought an additional 2m shares to put their ownership at 7%, the largest owner behind the Smith’s. In November, an Australian small- and micro-cap fund complex named Spheria reported ownership of a 5.5% stake in NTAW.

Financials

Financials have only been made public back to 2015. According to management, gross margins have been 28 - 32%.  Investigation of private competitors suggests that they have gross margins in the low- to mid-20’s but are importing lower-quality products from China; thus, the higher margin of Cooper’s premium products could be justified.  Discussions with management suggest historical EBIT margins even in 2009 were not significantly below current levels, although the cost structure could have been much different.

NTAW has significant amortization of intangibles that do not require reinvestment (almost entirely customer relationships and importation rights).  EBITA is the number to focus on, which topped out over $16 million in 2018, before falling 26% $12 million in 2019.  

2019 was weak due to several factors. First, the AUD fell 10% while the cost of some raw materials rose (e.g. carbon black).  Rubber and oil are the essential raw materials in a tire. Additionally, the US sourced products were relatively more expensive than the Asian sourced products – where competitors get their products.  For Asian sourced competitors, the producers ate the increase in raw material costs. Also, there was inventory built throughout the industry in 2018 that maintained pressure on wholesale prices. To top off the perfect storm of external pressures, the Australian consumer was shifting from premium mud tires to all terrain and rugged terrain tires.  Outside of self-inflicted wounds form the discontinuation of a key product in South Africa due to a factory closure, the external issues should normalize over time. NTAW has historically been successful maintaining gross margins in competitive environments. Industry price competition in 2016 was mitigated by negotiating lower import prices in 2017. 

The balance sheet is solid.  The company had net cash of $6 million as of the end of the fiscal year and had gross leverage  of only 1.0x. The bank loan matures May 21, 2021. The estimated interest rate is 4.5 -5.0%. Fixed capital is light with only $3.6 million of PP&E.  Non-cash working capital is significant at $42 million as of the end of the fiscal year. Due to the low capital requirements, return on tangible capital has been high in the over 20% range in 2019.  

Cash flow has been adequate but working capital has consumed a significant portion as the company has grown.  The FCF yield in 2019 on the current market cap is decent at 7.7%, but when excluding the large use of working capital, the yield jumps to 22%. Payables were brought down meaningfully in 2019 to what is likely a more normalized level, so this should not be a significant cash use at the current level of operations.

Valuation

NTAW has made multiple acquisitions in the last few years.  In total, they paid $31 million for acquisitions since the end of 2017.  Some of this was for purchasing the remaining shares of companies they didn’t already own; if we use what they paid to value all of the businesses that are now fully owned, it values them at $44 million, compared to the current enterprise value of the entire firm of $41 million.

National Tyre and Wheel IPO’d in 2017 to great expectations but management is now in a position where they must prove themselves before taking any further growth initiatives.  Earnings growth isn't expected in the next year, but even so this is a cheap company that is paying out its earnings. The company instituted price increases in Q319 (3-5% in March/April 2019) that should maintain margins in the near term, but management’s outlook is not particularly positive. Management stated: “The difficult trading environment encountered in the 2019 financial year is likely to continue...The company expects the 2020 financial year to deliver profits similar to the 2019 financial year with the strategic initiatives forecast to provide a foundation for a return to growth in the 2021 financial year.”  These initiatives include reconfiguring product mix, as well as focusing on near sourced manufacturing, with supplies coming from the same countries as competitors (i.e. Asian countries).  The two sellside analysts forecast EBITDA of $10.7 million next year (EBITA of roughly $10 million).

I assume revenue falls another $8 million to $160 million (-5%) in FY20.   Management claims the current 7.6% EBITDA margins are close to the lows they experienced in 2009.  This seems like an appropriate normalized margin, but for conservatism let’s assume 7.0%. This results in a normalized EBITA of $10.4 million, compared to the $12 million earned in 2019.  Amortization of customer relationship intangibles provides no tax benefit in Australia, so I’m assuming the full EBITA is taxable at 31%. Invested capital turnover is assumed to be 4x, with 2% perpetual growth. This results in normalized FCFF is $6.4.  Note that this does not give them credit for cash from working capital that should be generated as revenue falls $8 million (~$2 million). 

This is not a great business, and there is risk the Cooper contract is not renewed, so I’m using a relatively high discount rate of 12%.  The resultant EV is $63 million.  After removing debt, cash recently paid for dividends, the book value of the noncontrolling interest of $3.4 million (~12x earnings, which seems conservative), the equity valuation is $63 million. With 103mm shares, this puts the valuation at 61 cents per share, indicating the shares are 30% undervalued compared to the current price of 43 cents.

Catalyst

- Resumption of low-single-digit growth and margin stability

- Working capital normalization boosts FCF

- Cooper contract extension