Business Description: RBA is the world’s largest auctioneer, of used construction and agricultural equipment. It has operations in more than 25 countries and 44 auction sites worldwide. RBA's core business is live unreserved public auctions with bidding on-site and online. There are 3 types of auction contracts: a) Straight Commission contracts which earn a risk free commission on the Gross Auction Proceeds (GAP) from the seller b) At Risk Contracts (i) Guaranteed commission contracts where RBA guarantees a selling price, which if not met reduces the commission rate (ii) Inventory or outright purchase contracts where RBA takes the assets on its books for a short period before auctioning them. Losses if incurred reduce the commission rate.
Since 2010, in addition to commissions charged to sellers, RBA also charges the buyers a fee. These 2 charges together form the auction revenue (AR) and AR as a % of GAP is termed Auction Revenue Rate (ARR).
In 2013 RBA launched EquipmentOne, a secure online equipment marketplace for private negotiated transactions. RBA also offers a range of value-added services, including equipment financing.
Summary Investment Thesis: RBA is a short for the following reasons: a) Unsustainable business model in the face of increasing competition, likely to lead to lower commission rates b) Poor quality growth in the past few years led by commission rate increases rather than growth in GAP c) Growth is only available at the cost of increased business risk and higher operating expenses d) Impending management change could cause volatility in performance e) Industry outlook remains blurry, despite some early signs of improvement f) RBA's premium valuation is probably supported by a steady dividend yield of ~2.3%. Dividends could decline if the company continues to grow at a tepid rate in the short-medium term g) RBA's currently trades at 26x 2014 consensus EPS and P/B of 3.7x. It is too richly valued for a company with <2% EPS CAGR over the past 5 years, with ROCE that's declined from 18.5% in 2009 to 13.5% in 2012.
Risks to the short thesis a) Sudden revival in the US and/or global construction industry leading to high growth for RBA with no change in pricing power or profitability. There are early signs of pick up in construction activity, particularly in the US, which should benefit the used-equipment market. However, Caterpillar, Volvo, John Deere etc. are guiding for flat revenues at best in 2014, casting a shadow on the prospects of recovery. b) Used equipment prices have begun to stabilize and could attract more sellers to the auction market, helping RBA's GAP growth.
Investment Thesis Although the broader industry could revive in the next few years, RBA is a short in my view because of company specific challenges described in the following sections:
Unsustainable business model Over the past 5 years, RBA has been losing market share in the used equipment sales market. According to RBA's 2012 annual report, the used-equipment market has doubled from $100B to $200B during 2008-2012. But RBA's GAP has barely grown and has fluctuated in the $3.6Bn-$3.9Bn range. The reason for this lack of growth could be the steadily high commission rate charged by RBA.
The used equipment market is primarily comprised of private sales with auctions historically accounting for only ~10% of the transactions. In my view, majority of used-equipment sellers cannot afford the 10-12% commissions charged by RBA. The segment of the market with large players who can afford these commission rates is arguably saturated. Hence RBA has potentially been leaving a huge amount of money on the table in order to sustain its high commission structure. This also implies that auctioneers such as RBA will likely need to find a way to break into the private sales market in the quest for growth.
Poor quality growth Although RBA has grown its auction revenue and earnings in the 2010-2012 period, it has been poor quality growth because it was achieved by charging a 2% fee to buyers which was not charged until 2010. This fee now forms >20% of the auction revenue and has led to commission rates increasing from 9.9% to 11.9% despite no growth in GAP. I believe that earnings growth achieved by increase in gross auction proceeds (GAP) is better quality growth sustainable in the long run. Although the management admits this in its earnings calls, they have been trying to get to $4B GAP for the past 5 years and have been highly ineffective and do not have a good explanation for missing this target.
Higher growth implies higher business risk RBA, in the past 5 years, has grown its auction proceeds only in 2011 and 2012. It achieved this growth by increasing the proportion of its At-Risk contracts at the expense of lower Auction Revenue Rates (commission rate).
If the charge to buyers (described above) was not instituted in 2010, the ARR would have actually declined due to the significantly lower profitability of inventory contracts, as shown in the break-up below:
The increased proportion of at-risk contracts, combined with the fact that during 2008-2012, RBA's GAP has grown by only $300M while global transactions have grown by $100B, suggests that RBA's value proposition could be increasingly turning unattractive to sellers who have to pay this steep commission rate in addition to the lead time and cost of physically transporting the equipment to RBA's auction site. So if and when the used-construction equipment market revives, GAP growth might be available to RBA only at the cost of higher inventory risk and/or lower commission rates. Because RBA does not control the final selling price of equipment, the profitability of its At-Risk contracts and consequently operating margins could be subject to higher volatility.
Intensifying competition from inexpensive, online-only options for sellers Where did the market share go? RBA is a physical exchange as well as a broker-dealer. Much like every other commission/ brokerage based revenue model (Real Estate, stock broking etc.), the used equipment auction business has also been affected by the proliferation of internet based alternatives for erstwhile physical markets. The internet challenges RBA's traditional strength of bringing together sellers and buyers to provide liquidity.
The largest internet based online auctioneer Iron Planet which is backed by Caterpillar, Volvo, Komatsu grew its GAP from ~$340M to $568M during 2008-2011 (From Iron Planet's IPO prospectus). However, Iron Planet is also struggling to increase its market share today, because it charges a commission rate comparable to that of RBA, given its high cost structure and lack of scale. The competition is further intensified by large players such as Caterpillar, United Rentals etc. successfully launching their own internet portals to sell used fleets to avoid commissions.
Another avenue that is truly attractive to small-scale sellers who form >50% of the market is auction portals likewww.equipmentauction.com which does not charge any commission, instead makes money through equipment appraisal services, which actually makes pricing more transparent in the unorganized private market.
RBA is attempting to break into the private sales market through EquipmentOne- its negotiation portal for private transactions. With only $65M of transaction value in 2013 and with a commission structure similar to its auction business, it will be several years before it scales up, assuming it is able to compete with other inexpensive alternatives described above.
This indicates that it is only a matter of time before RBA is forced to bring down commission rates in order to grow. This also warrants the questions a) is a physical marketplace is required/ sustainable in the long term? b) will auctions, with their unfavorable commission structure and high lead times, continue to be the preferred mode of selling used-equipment, given that the internet solves the issue of liquidity and price discovery?
Deteriorating cost structure From 2009 to 2012, RBA's EBITDA margin has contracted from 42% to 37%. Despite heavy investments in its sales force and new auction sites over the past 5 years, auction proceeds have not grown and market share has declined. If RBA retains its current commission structure, there could be a prolonged period of low growth in GAP, bringing margins under pressure in the medium term due to lower SG&A productivity. Another headwind to margins is the recent trend of higher direct costs driven by a large number of small auctions where the company does not realize economies of scale. Management Change likely to introduce near term volatility The stock has not appreciated meaningfully in price for 5 years, which has caused the current CEO to step down. Once the new CEO takes over later in 2014, there will be pressure to increase GAP, which is a much stronger driver of earnings growth than commission and fee increases which RBA has relied on in the past few years. As described above, the growth in GAP is likely to come only after realigning to a higher risk and/or lower commission rate strategy. Hence growth and profitability could be volatile in the near term.
Scenario Analysis & Valuation Following are 3 scenarios and the corresponding earnings and valuation expectations:
Scenario 1: Change in strategy towards higher risk and lower commission and margins, leading to high medium term growth a) implies earnings, ROE and dividend yield decline for 2014-2015 b) 1 yr forward P/E at the high end of historical levels
Scenario 1(Change, growth)
2012
2013E
2014E
2015E
2016E
GAP growth
5%
-2%
10%
10%
10%
Straight Commission contracts as % of GAP
68%
75%
70%
70%
70%
Inventory Contracts as % of GAP
20%
15%
25%
25%
25%
Commission Rate
10%
10%
9.0%
8.5%
8.5%
Profit on Inventory Contracts
6%
10%
7%
7%
7%
SG&A as % of Revenue
52%
53%
52.5%
52.5%
52.5%
Direct Cost as % of GAP
1%
1%
1.3%
1.3%
1.3%
Dividend Payout
63%
65%
65%
65%
65%
(USD Million)
Gross Auction Proceeds (GAP)
3,900
3,808
4,189
4,608
5,068
Auction Revenue Rate (ARR)
11.2%
11.9%
10.8%
10.4%
10.4%
Revenue
438
453
452
480
528
EBITDA
161
166
160
168
185
Net Income
80
76
70
71
81
FCF
41
48
41
67
81
EBITDA Margin
37%
37%
35%
35%
35%
Net Income Margin
18%
17%
16%
15%
15%
EPS
0.77
0.71
0.66
0.67
0.76
DPS
0.47
0.47
0.43
0.44
0.49
ROE
12.1%
11.2%
9.9%
9.8%
10.6%
ROCE
13.6%
13.2%
11.7%
11.7%
12.5%
Dividend Yield
2.1%
2.1%
1.9%
1.9%
2.2%
P/E
29.3
31.7
34.5
33.9
29.9
P/B
3.7
3.6
3.4
3.3
3.2
Scenario 2: Status quo resulting in very low medium term growth, similar to the past few years a) implies earnings, ROE and dividend yield decline for 2014-2015 b) 1 yr forward P/E at the high end of historical levels
Scenario 2 (Status quo, no growth)
2012
2013E
2014E
2015E
2016E
GAP growth
5%
-2%
3%
3%
3%
Straight Commission contracts as % of GAP
68%
75%
75%
75%
75%
Inventory Contracts as % of GAP
20%
15%
15%
15%
15%
Commission Rate
10%
10%
9.8%
9.8%
9.8%
Profit on Inventory Contracts
6%
10%
7%
7%
7%
SG&A as % of Revenue
52%
53%
52.5%
52.5%
52.5%
Direct Cost as % of GAP
1%
1%
1.3%
1.3%
1.3%
Dividend Payout
63%
65%
65%
65%
65%
(USD Million)
Gross Auction Proceeds (GAP)
3,900
3,808
3,922
4,040
4,161
Auction Revenue Rate (ARR)
11.2%
11.9%
11.7%
11.7%
11.7%
Revenue
438
453
459
473
487
EBITDA
161
166
167
172
177
Net Income
80
76
75
75
76
FCF
41
48
84
72
77
EBITDA Margin
37%
37%
36%
36%
36%
Net Income Margin
18%
17%
16%
16%
16%
EPS
0.77
0.71
0.70
0.70
0.71
DPS
0.47
0.47
0.46
0.46
0.46
ROE
12.1%
11.2%
10.6%
10.2%
10.0%
ROCE
13.6%
13.2%
12.4%
12.1%
11.8%
Dividend Yield
2.1%
2.1%
2.0%
2.0%
2.1%
P/E
29.3
31.7
32.1
32.4
31.8
P/B
3.7
3.6
3.4
3.3
3.2
Scenario 3: Status quo, industry revival drives high growth with no deterioration in commissions rates or magins a) implies earnings, ROE and dividend yield growth for 2014-2016 b) 1 yr forward P/E at the lower end of historical levels c) consensus is reflecting this scenario
Scenario 3 (Status quo, growth)
2012
2013E
2014E
2015E
2016E
GAP growth
5%
-2%
15%
10%
10%
Straight Commission contracts as % of GAP
68%
75%
75%
75%
75%
Inventory Contracts as % of GAP
20%
15%
15%
15%
15%
Commission Rate
9.8%
9.8%
9.8%
9.8%
9.8%
Profit on Inventory Contracts
6%
10%
9%
9%
9%
SG&A as % of Revenue
51.9%
52.5%
51.0%
51.0%
51.0%
Direct Cost as % of GAP
1%
1%
1.3%
1.3%
1.3%
Dividend Payout
63%
65%
65%
65%
65%
(USD Million)
Gross Auction Proceeds (GAP)
3,900
3,808
4,379
4,817
5,299
Auction Revenue Rate (ARR)
11.2%
11.9%
11.7%
11.7%
11.7%
Revenue
438
453
513
564
621
EBITDA
161
166
194
214
235
Net Income
80
76
95
104
117
FCF
41
48
107
104
121
EBITDA Margin
37%
37%
38%
38%
38%
Net Income Margin
18%
17%
18%
18%
19%
EPS
0.77
0.71
0.88
0.97
1.09
DPS
0.47
0.47
0.58
0.63
0.71
ROE
12.1%
11.2%
13.2%
13.9%
14.8%
ROCE
13.6%
13.2%
15.1%
15.9%
16.9%
Dividend Yield
2.1%
2.1%
2.5%
2.8%
3.2%
P/E
29.3
31.7
25.6
23.3
20.7
P/B
3.7
3.6
3.4
3.2
3.1
Valuation & Conclusion The current valuation for a stock which has delivered 1.3% earnings growth and 2% dividend yield in the past 5 years, with a poor management and not very convincing strategy and/or growth prospects seems too rich.
Consistent with the reasoning outlined in the investment thesis, the current strategy cannot meet consensus GAP growth or earnings numbers, making scenario 3 highly unlikely. Scenarios 1 and 2 are far more likely, both of which mean stagnating to declining earnings over the next few years. Applying 5-yr average low P/E of 23x to FY14 EPS (based on scenario 1), I would value the stock at $15, 34% below the current price (02/07/2014).
Downside to short thesis a) Scenario 3 is the best case scenario for RBA in my view, which reflects consensus numbers. Applying 30x multiple to a $0.88 2014 EPS yields a price of $26.4/sh implying a downside of 13% to a short position taken today. This scenario of the company suddenly growing its GAP at 10%+ after years of mismanagement seems highly unlikely without a change in strategy. b) The short interest is very high (~20% of float) could result in a short squeeze if scenario 3 occurs
The risk-reward of owning the stock is very unfavorable at the current price which is very close to its 52 week high. I hence recommend a short position on RBA.
I do not hold a position of employment, directorship, or consultancy with the issuer. Neither I nor others I advise hold a material investment in the issuer's securities.
Catalyst
a) New management to take over later in 2014 will be under pressure to increase GAP, which in my view can be achieved through a reduction in commission rates and lower margins and declining/stagnating earnings, dividends b) Earnings miss in the next few quarters because consensus is building in very optimistic assumptions
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