Description

What the business does: Bulk chemical truckload transportation + chemical import/export terminals via rail.  Most of the business is wet but some is dry.

Why it's a good business: 95% of the business is 'affiliated' that is, franchised.  QLTY owns only the chemical trailers, which last for ~30 years.  They lease the trailers to their affiliates at a very attractive ROI.  The trailers last 30 years, yet they're depreciated over 15-20 years so capx is about 50% of depreciation and FCF is materially higher than reported EPS.  ROIC ranges from 20-25%.

Why the stock is mispriced:

• 1. There is an active S1 currently on file that has created an overhang as the market has been anticipating a share offering intended to A) de-lever the balance sheet, B) increase liquidity for the stock and C) reduce Apollo's 50% sponsorship stake. I expect the S1 to be canceled as the recent debt raise eliminates any need for equity capital.
• 2. There has been an information void because brokers on the deal cannot write on the stock until the deal is consummated. There are 8 brokers on the cover of the S1. Only 4 of them cover the stock. Thus, its likely additional coverage is forthcoming.
• 3. The story is not well known. Investors are unaware of how significantly the company has transformed itself over the past 3 years. The company today bears little resemblance to that which Apollo brought public in 2003. The years 2003-2005 were painful ones (one of their now-divested subsidiaries had insurance fraud and there were 2 rounds of management reshuffling) and many investors have not yet revisited the story. Management is just now becoming more visible and explaining how different the company is today.
• 4. The few sell-side analysts that currently cover the name are short term oriented-focusing on charges coming in Q4 related to QLTY's recent debt refinancing (they are also incurring double interest expense for a short period in Q4 while they carry double the debt load) and failing to emphasize the multiple drivers of equity value creation over the next 1-3 years.
• 5. It's still a microcap (but on its way to becoming a small cap).

Difference in the business between 2003 and 2010:

The chief difference in the business between 2003 and 2010 is the % of the assets that are 'affiliated' versus company owned.  At the time of the IPO, the business was a 50/50 split between company-owned assets (tractors) and affiliate-owned assets.  This made for a confusing corporate strategy.  The company went back and forth about what mix to pursue during its first 3 years as a public company with two different management teams coming to two different conclusions.  This lack of clarity about strategy also made it more difficult for investors to classify QLTY as a trucking company or a logistics company.  This matters because logistics companies tend to trade at significantly higher multiples because they have higher potential for profitable growth (higher ROIC).

Public asset-based trucking companies, on average, earn their cost of capital over a cycle while private trucking companies do not.  Logistics (non-asset based) companies, on the other hand, can have ROICs north of 20% and as high as 40%.  Trucking companies often trade at an average EBITDA multiple of ~6x while logistics companies often trade at double-digit EBITDA multiples.

Management: Quality's management team is the most focused and coherent it has ever been.  In 2007, Gary Enzor (then COO of QLTY) became CEO and recruited the former controller from Swift Transportation (Steve Attwood) to become the CFO.  Gary and Steve have worked together for 20 years at 4 different companies and are good friends (Gary was the CFO at SWFT before becoming COO at QLTY in 2005).  Steve came out of retirement to take the role of CFO at QLTY because he loves working with Gary; he doesn't need the money.  In April of this year, Gary brought Randy Struts (former CEO of Morgan Systems and prior to that President of Rail Brokerage at Pacer International) on as SVP of Sales.  Randy has alleviated Gary from wearing multiple hats, which has freed up Gary's resources to focus on M&A opportunities as QLTY begins rolling up the industry.  More recently, Steve Attwood took the role of COO and Gary brought in Joe Troy (former CFO of Walter Industries) to become CFO.  Joe was instrumental in the recent bond placement.  Steve is now devoting his time to emerging growth opportunities with a continued emphasis on maximizing financial returns and improving operational performance. 

How much value is here? 

• My belief is the stock is worth 10x EBITDA - capx at normalized levels. 10x ebitda-capx equates to about 9x EBITDA. Non-asset based comparables trade at EBITDA multiples ranging from 9x (UACL) to 20x (CHRW) with several companies trading at multiples in between. QLTY's current EBITDA multiple is 7.4x.
• 9x EBITDA 2011 EBITDA of ~$67m = $15 stock 1 year from now.
• On 'normal' EBITDA (i.e. regain the revenue lost between 2008 and 2010 due to the recession, allowing them to utilize their excess trailers) of $77m, the stock is worth $20-$21. I think they can get here by 2013.
• Each $50m rev tuck-in acquisition adds ~$2/share of value. They believe they can do 1-2 per year. My analysis does not rely on M&A but I think we'll see it.
• 1. The math here is they buy $5m of EBITDA for $25m. EBITDA becomes $7m after synergies. ABL = <3% interest expense. Maintenance capx is $0.5m. Thus, $7m EBITDA - $0.5m maint capx - $0.75m interest expense = $5.75m pre-tax FCF. Taxed at 40% = $3.45m, or 16c/share. 12x 16c = $1.90/share. 14x 16c = $2.25/share.
• NOL worth at least $1/share. My analysis doesn't rely on this either but it does provide additional cushion.

Balance sheet and cash flow:  Debt/EBITDA = 5x in 2010.  The company has ~$300m of debt with $225m of this not due until 2018 as a result of the recent debt placement.  The $225m bears interest at just under 10%.  There is $35m of remaining 11.75% debt outstanding that will be paid down with FCF going forward.  The rest is on an ABL facility that bears interest at <3%.

Assuming only 3% organic top line growth in 2011 and 2012 while paying no cash taxes brings the leverage ratio down to 3.5x by 2012.  M&A is instantaneously accretive and deleveraging at the same time so leverage will likely be below 3x by 2012. 

While 5x debt/EBITDA may scare some people, the leverage is part of the attraction to the story in my opinion.  QLTY is precisely the kind of business that can make very good use of debt.  It has very low capx needs as their affiliates provide most of the capital.  Fixed costs are low for this same reason.  Since maint capx is only 2/3 of D&A and they don't need any growth capx for another 3 years, debt/EBITDA overstates the actual degree of leverage present.

Liquidity:  It's low currently but will improve over the next 2 years as the thesis plays out.  Liquidity will also improve dramatically as Apollo begins selling shares when the stock gets into double digit territory. 

Where I could be wrong:  Because of the asset-light, variable-cost business model coupled with prodigious FCF generation due to low reinvestment needs, the biggest risk to the thesis is that it takes longer for an upward re-rating to occur.  The debt-to-equity value transfer will continue at a rapid clip even if earnings don't grow at all going forward, which could only occur in a recession.  Under this bearish scenario, the current low-teens FCF yield (untaxed) on 2010 (mid-teens on 2011) would accrete to the equity, which should result in a rising stock price.

QLTY is a business I'm comfortable owning for the long term because they have a long run-way for value enhancing FCF deployment coupled with little/no risk of permanent capital impairment.  De-levering via organic FCF alone should allow EPS to quintuple.  M&A is even more accretive (and de-levering).

Catalyst