I am recommending an investment in QLTY, which I estimate will be worth over $20 per share by the end of 2016.  The company should generate 15-20% of its current market cap in free cash flow in 2013 alone and will benefit from a cyclical and secular rebound in the North American chemical industry, driven by a recovery in housing and construction along with low natural gas prices.  The discount to intrinsic value should close over time due to the following:

• Paying down debt with its substantial free cash flow – QLTY has verbally committed to paying down debt and is targeting normal leverage of 2-2.5x down from current pro forma leverage of about 4.3x.  Due to significant NOLs, the company expects to pay essentially no cash taxes until sometime in 2016 during which time it will generate about 70% of the current market cap in FCF.  I believe that significant pay down will happen as the latest proxy states that management will not be eligible to receive significant bonuses unless a specific leverage ratio target is met in 2013.  Unfortunately, the specific number is not provided in the proxy.  
• Improvement of the energy business – A drop in drilling activity recently has hurt asset utilization and earnings.  QLTY has the opportunity to reposition assets to more oil rich plays.  The company has also commented that they can drive $3 million of incremental quarterly EBITDA in this business, which should ramp up starting in 3Q13.  If management can hit the target, this is worth an additional $2 per share at 5x EBITDA. 

Importantly, the thesis and price target do not rely on a big rebound in the US economy as I am assuming 2016 EBITDA only about 11% higher than the company’s 2013 estimated EBITDA pro-forma of all 2012 acquisitions.  It is also a good sign that the CEO, Gary Enzor, owns about 396,000 shares for a total value of $3.7 million.  I believe that this is a significant holding for him as his total compensation from 2010-2012, as disclosed in the proxy, amounted to about $2.8 million.

Finally, while not critical to the thesis, I will also point out that asset light trucking businesses trade at 10-11x EBITDA.  I estimate that a re-rating of the chemical logistics business to an asset light multiple would add close to $3 per share to the stock price.

Why this may be mispriced:

• Screens poorly – The stock trades at about 13x consensus 2013 EPS.  However, this does not account for the fact that the company will pay minimal cash taxes until 2016 and that normalized cash EPS is higher than GAAP EPS because trailer assets are depreciated over 15-20 years but last for 30 years.  The evidence of this is that D&A has run significantly higher than net capital expenditures for a long time excluding more recent years as the company was building the energy business.
• Analyst Apathy – While there are a decent number of analysts covering the stock, I believe that the quality of some of the coverage is severely lacking.  For example, JP Morgan has QLTY generating over $4 per share of FCF over the next 2 years but shows no debt pay down and basically no growth in cash on the balance sheet.  Instead, they seem to assume that the cash is invested in assets that apparently generate basically no incremental revenue or EBITDA.
• Apollo Overhang – Apollo entered this investment all the way back in 1998 with the merger of Montgomery Tank Lines and Chemical Leaman Corporation and still holds about 17% of the shares.  They have sold shares in two secondary offerings in the past 3 years or so.
• Low Liquidity – Average volume is around 145,000 shares daily, which represents only about $1.5 million of stock traded.

Business Description:

Quality distribution is the leading North American bulk chemical distribution network with about 15% market share and the leading North American intermodal container and depot services network.   QLTY also operates an energy business serving various oil and natural gas shale plays through hauling water and oil.  2013 EBITDA is estimated to be about 58% chemical, 24% intermodal, and 18% energy.
 
QLTY operates its businesses primarily through a network of 25 affiliates with QLTY owning the customer relationships while affiliates are responsible for capital investments and handling cargos.  This allows the company to be “asset light”, which limits capital expenditures to 1-2% of revenue, and to drive a good ROIC.  QLTY keeps a percentage of transportation revenue earned by its independent affiliates and owner operators.  These amounts are approximately 15% and 35% respectively for the two groups.  This results in a largely variable cost structure, which helps to mitigate against the large cyclicality typically seen in trucking.  Finally, it is common practice in this industry for customers to pay fuel surcharges, so neither QLTY nor its affiliates have much direct exposure to commodity prices.

Chemical Logistics:

Quality transports a broad range of liquid and dry bulk products and has the leading share in the highly fragmented for-hire bulk transport segment at 15% while operating the largest chemical tank truck network.  As the industry generally competes on rates and service, scale is important because larger players are able to have higher lane density, which lowers overall cost.  It also allows better service as many customers are global players that require significant scale.  QLTY’s key customers include Arkema, BASF, Dow, PPG Industries and Procter & Gamble.

Unfortunately for the company, the recession following the financial crisis was devastating on volumes.  The decline was especially pronounced as there was an inventory destocking of chemicals during the 2008-2009 time frame.  Volumes have still not recovered, and according to the American Chemistry Council, 2012 volumes were still about 18% below the 2007 peak.  Also, QLTY struggled with volumes during 2011-2012 as the company experienced increased driver turnover due to the implementation of electronic on-board recorders to comply with regulation limiting driver hours.  Drivers did not like the change and an increased number moved to other companies that had not yet implemented this change.  As a result, revenue in this segment excluding fuel surcharges declined from a high of about $630 million in 2006-2007 to about $490 million as of 2012.  Driver count is growing again, however, and the issue is now behind the company as the segment has shown two straight quarters of volume growth (+3% revenue, est. +1% volume in 1Q13).  Pricing, in contrast to volumes, has held up pretty well throughout the entire period.
 
Near term demand looks good as Gary Enzor, the CEO, noted during the 1Q13 earnings call:  "… on the Chemical side, yeah I mean we have more freight than we can move. Our biggest constraint on the Chemical side is the drivers, adding drivers."

I believe that as chemical end markets such as construction (which I estimate to be 25% below normalized levels) rebound and US chemicals continue to become more competitive with the benefit of low cost energy inputs, QLTY's chemical segment should benefit and grow about mid-single digits. I am assuming that this segment contributes $58 million of EBITDA in 2016.  This represents about 4% revenue growth annually with some margin expansion as segment margins are currently around 9% excluding the impact of fuel and incremental margins should be 15%+ due to the revenue share agreements mentioned earlier.  At a 9x multiple, this segment would be worth $522 million in 2016. 

Intermodal:

QLTY entered the intermodal business in 2007 when it purchased Boasso, a provider of intermodal ISO tank container transportation and depot services, along with other services including tank cleaning, heating, testing, maintenance and storage.  This is a high service oriented business with 40% of non-fuel revenues coming from services.  The company operates in the eastern half of the US and expanded the business with the acquisition of Greensville Transport Company in 2011, which operates in Norfolk, VA.  The company estimates that it has over 50% market share in the North American intermodal container market.

The main driver of this segment is chemical import and export volumes, which have been increasing at a 10% CAGR for the last decade as manufacturing becomes more and more globalized.  QLTY's intermodal business has seen revenue increase at a 13% CAGR from 2007-2012.

Intermodal ISO tank containers should continue to gain share versus other modes as the ease of handling intermodal containers that can be moved from rail to truck to ship without changing containers reduces cost.  Also, it allows shippers to more easily use rail for longer hauls, which is cheaper, though it generally takes longer than using trucks alone.  A good explanation of the benefits of intermodal transportation can be found at the following link:  http://www.icis.com/Articles/2012/05/07/9556576/intermodal+transport+solves+chemical+shipping+contraints.html

While speaking on the benefits of intermodal, I will note that I believe that QLTY’s chemical logistics business is reasonably well insulated from the shift to intermodal traffic.  The article linked above claims that a shipper can save 10-15% of the cost for hauls ranging from 1,000-1,500 miles.  However, the majority of QLTY’s hauls are much shorter with an average haul distance of only 300 miles.  Having to transfer a container from truck to rail and back again for such short distances seems unlikely to be worth the cost and effort.

I believe that intermodal can grow mid to high single digits over the next few years while maintaining margins.  At 7.5x 2016 EBITDA of $27 million, this segment would be worth $203 million.

Energy:

QLTY’s energy business hauling fresh water, disposal water, and crude oil at various shale sites started in the Marcellus shale when natural gas drilling activity there was high, primarily to find places for assets that were underutilized after the recession.  During mid-2012, the company acquired various assets and now operates in the Bakken, Eagle Ford, Marcellus, Woodford and Utica.  The Bakken shale, which QLTY entered through the acquisition of Bice in June 2012, represents about two thirds of this segment in terms of both revenue and EBITDA.

Without counting any organic investments into the Marcellus operation, QLTY spent about $140 million acquiring companies to build this business and originally expected a run rate of about $25 million in EBITDA.  However, only a few months after closing on these acquisitions, the company reported big misses in energy on the 3Q12 earnings call while citing an unexpected decrease in rig activity in the Marcellus.  Results in this segment have continued to disappoint through the first quarter of 2013, but the outlook is starting to brighten.

The company expects $37 million of annualized revenue in new business won to ramp later this year.  Also, they have identified $5-$8 million of cost reductions that are currently being implemented during 2Q13.  All in all, this is projected to drive an increase of $12 million in annualized EBITDA.  Importantly, none of this improvement needs to occur for this investment to work as significant de-levering can occur regardless.

Energy is definitely QLTY’s worst business.  While the company is talking about double digit growth, I give it credit for low single digit growth and slight margin expansion.  Assets in the energy business run 24/7, which should give it a margin advantage over the other segments, however, rig counts and drilling activity are notoriously difficult to forecast.  I expect that it will continue to be cyclical and will experience periods of low utilization.  At 6x 2016 EBITDA of about $20.5 million, I estimate that this business will be worth $123 million.  I believe that this valuation is conservative as pro-forma 2013 EBITDA for this segment would be over $20 million if management is able to drive the $12 million of incremental EBITDA that they are talking about.  This valuation is also a discount to where QLTY purchased these assets in 2011-2012.

Valuation:

I value QLTY at year end 2016 because this is primarily a de-levering play on a company that has committed to paying down debt in the near term.  Historical and projected segment results are shown below.

Some readers may think that the chemical logistics margin projections are too high, but QLTY has made important changes to the business.  Back in 2008, company owned operations generated nearly half of the transportation revenue in the chemical logistics business.  By 2011, 93% of transportation revenue in the largest segment was generated by independent affiliates, which allowed the company to take out a lot of overhead costs.  2012 results were dampened due to the company being forced to take over a struggling affiliate to maintain customer service and revenues.  Those operations are soon going to be sold back to another affiliate but will have some impact on 2013 expenses.  Finally, 2012 margin in the chemical logistics segment was also impacted by the energy acquisitions as the company runs all corporate overhead through that segment.

My base case assumes moderate growth in all three businesses with no multiple expansion, nor any margin improvement in the energy business.   My low case, which I believe to be conservative, assumes that 2016 EBITDA is flat versus 2013 projected EBITDA and that there is no multiple expansion.

Risks:

• High Leverage – At close to 5x Debt/EBITDA currently, the balance sheet is quite levered.  However, given that most of the business is asset light with a highly variable cost structure, I believe that this does not present a very high risk.  EBITDA-maintenance capex should be roughly 2.5x interest in 2013.  With capital expenditures at only 1-2% of revenue, the company will generate a lot of free cash.  Also, there are no maturities until 2016.  For perspective, the company generated about $60 million of free cash flow from 2008-2010 and had no negative FCF years when the business was more asset intensive, more heavily tilted toward just chemical transportation, and volumes collapsed by 30%.
• Capital Allocation – Given the destruction of value currently in the Energy business, some investors may be concerned about capital allocation.  I believe that this risk is mitigated by the company publicly committing to pay down debt with FCF.  Further acquisitions in the energy space are very unlikely with the CEO having commented that "…At this time, we are content with our broad multi-shale energy footprint and have no near term plans for further acquisitions until we get the appropriate levels of earnings and cash flow from our existing operations."  Finally, with the benefit of hindsight, QLTY did make a very good investment in the intermodal business by paying about 6x EBITDA for a business that has grown 13% per year.