Description

Solera Holdings is a high quality business with attractive revenue growth prospects, improving margins, strong free cash flow generation, a defensive business model and exposure to a variety of rapidly growing emerging markets (in addition to its core operations in the US and Europe) trading at a reasonable price – in other words, perhaps everything one could ask for in the current market environment.  The company’s business is simple: it provides the software and services that enable insurance companies to process auto claims.  This means that Solera’s products are deeply integrated into an insurer’s back office, typically in the form of a multi-year contract (in the US) or an evergreen contract (outside of the US).  Solera’s products enable insurers to automate claims processing, which is their largest cost item, saving 15-20% over manual (read waste, fraud and inefficiency-prone) processing.  The company also sells its products to the thousands of repair shops, junkyards and independent assessors that conduct business with the auto insurers.  The beauty of this latter set of customers is that insurers require them to use Solera’s products.  These contracts are similarly long-term in nature.  Geographically, Solera derives north of 60% of its revenues outside the US, primarily from Europe but increasingly from higher growth markets like Latin America, India and China.  For a more detailed description of the company’s business, I recommend reviewing Solera’s May 2007 IPO prospectus.

 

Background

Solera was formed approximately thirty years ago by Swiss Re in an effort to reduce the notorious waste and inefficiency of the auto claims process.  It was sold some years later to the payroll processor ADP, where it became a bit of a backwater.  In April 2006, a management team led by the former COO of Solera’s chief competitor purchased the company from ADP with private equity sponsorship from GTCR.  In May 2007, the company went public in an IPO that attracted only modest attention.  Since that IPO, Solera has posted a couple quarters of good results and the stock has traded well in an otherwise ugly market.  I believe that as more investors discover the story and appreciate the company’s growth prospects and strong competitive position, the stock will trade even better.

 

Thesis

·         High quality business model.  Solera operates a high recurring revenue model with long-term contracts, a sticky product and minimal customer turnover.  In fact, the company’s largest customers have been customers for 15+ years on average.  The fact of the matter is that integrating yourself deep into the back office of an insurance company is a good way to entrench yourself.  The business tends to have high, quite stable margins as well.  In Solera’s case, EBITDA margins have been in the 29-32% range quite consistently – and this was during a period in which the cost structure was not optimized, nor was much attention paid to the business managerially.  The company also has minimal reinvestment requirements (recurring capex of roughly $20 million compared with EBITDA exceeding $160 million in FY08), which leads to strong free cash flow and returns on invested capital.  Lastly, barriers to entry are considerable.  Underlying Solera’s software products is a massive database of automobile data that must be constantly updated for every model and model derivation.  This database must cover roughly ten years’ worth of data on a trailing basis as well.  Furthermore, long-term relationship and contractual arrangements tend to minimize competitive threats.

 

·         Favorable long-term secular trends driving growth.  While Solera’s US operations are growing only modestly (+4-6%), its operations in the rest of the world have strong growth prospects.  Several factors are behind this.  First, the company has a dominant position in Western Europe where 50% of auto claims are still processed manually.  Second, the company is well-positioned in markets like Latin America and Eastern Europe where accident frequency is dramatically higher than in developed markets and governments are moving to make auto insurance mandatory, which has an obvious positive effect on the business.  Third, Solera was an early operator in markets like India and China where the company has pilot programs with local insurers that are just now becoming revenue producing.  India and China are clearly compelling growth markets where Solera currently faces very little competition.  In fact, outside the US, Solera is usually the overwhelming market leader, which is a legacy of its roots as a division of a global European insurer.  Fourth, both the number of cars on the road and the number of models manufactured by different OEMs continues to grow, especially in Asia.  Since 2001, the number of automobile manufacturers has grown 30%, while the selection of vehicles is up 50%, driven largely by Asian manufacturers.  This trend increases the value to Solera’s products as insurers must keep pace with this growing diversity in markets worldwide.

 

·         Opportunity for margin expansion.  While a division of ADP, Solera was a backwater where “non-partner track” managers were sent.  As a result, the company suffered from a series of issues, principally in the US: bloated cost structure, relatively poor customer service and a track record for not pushing customers on price increases, even when they had the contractual right to do so.  Under new management, the company has started to reverse these trends.  In particular, management has focused on eliminating costs (e.g. duplicative software design centers doing work on the same car).  Coupled with revenue-driven operating leverage, margins have already started to improve: in the first quarter of FY08, EBITDA margins expanded nearly 500 basis points to over 33%.  While this was an unusually large jump, we expect EBITDA margins to continue climbing, eventually passing 35%.

 

·         Rational competitive environment.  In the US, Solera is the #2 player behind Mitchell International.  Just behind Solera in terms of market share is CCC Information Services.  Both Mitchell and CCC are more or less direct competitors, although neither has a sizable presence outside the US.  Importantly, both companies are recent LBOs that reportedly have considerable financial leverage.  Our conversations with various sources in the industry have led us to believe that the pricing and competitive environment is quite stable given the constraints imposed by this leverage and the reluctance of their private equity owners to initiate a price war with Solera.  The company’s chief competitor in Western Europe is EuroTaxGlass, a UK-based firm with a somewhat more diverse business model that is also a recent private equity LBO.  Conversations with European industry sources revealed that ETG has actually attempted to compete with Solera on price, but has been categorically unsuccessful because customers strongly preferred Solera’s product.  In emerging markets, Solera is usually the only game in town, a position buffered by the company’s longstanding relationships with both US and European insurers and OEMs (who outside the US tend to own the repair facilities). 

 

Financials

I believe that Solera will generate revenue growth of 8-10% for the next several years.  EBITDA growth should be north of 15% as the company benefits from ongoing operating leverage, while growth in FCF/share should approximate 25-30%.  My summary financials are as follows (note that for purposes of this analysis, free cash flow goes entirely to debt repayment, which is obviously not the most accretive option):

 

FY: June                2007        2008        2009        2010

 

Revenue                $472        $514        $558        $603

   % Change          10.0%     9.0%       8.5%       8.0%

 

EBITDA                  144          169          198          229

   % Margin           30.5%     32.7%     35.5%     37.9%

 

FCF                                        87            115          141

 

FCF / Share                         1.34         1.78         2.17

FCF / Share (CY)                  1.56         1.98        

 

I believe that the quality of Solera’s business model and its attractive growth prospects merit a free cash flow yield of 5-6%.  Based on calendar (not fiscal) year free cash flow per share of approximately $2.00, I believe Solera will be worth $35-40 over a twelve month time frame, or up 40-60% from today’s price.  I recognize that these multiples are perhaps a bit more aggressive than normal for a VIC write-up, but if I have learned one lesson this year, it is that in uncertain times, investors are willing to pay for quality and growth, and Solera has both.

 

Risks

·         Share losses prompt competitors in the US to become more aggressive on pricing.  I think this is unlikely given the balance sheet leverage at Mitchell and CCC – in both cases rumored to be greater than 6x debt/EBITDA.  Furthermore, private equity ownership should limit the likelihood of a price war as cooler minds prevail.

 

·         Solera acquires Mitchell or CCC and overpays.  Again, I think leverage is a limiting factor.  For starters, there is no financing available for high leverage LBOs at the moment, and an acquisition of either would force Solera to have access to such financing.  Moreover, such an acquisition would likely rile up the anti-trust regulators, to say nothing of active shareholders focused on other means of value creation.

 

·         First time CEO.  Tony Aquila, Solera’s CEO, is a first-time public company CEO.  He has the reputation of being an excellent salesperson (“he could sell the pope a double bed” according to one competitor), but that is no guarantee he will succeed in an executive role.  I believe this risk is mitigated by the fact that the company has a CFO with public company experience and ongoing private equity oversight at the board level.

 

Catalyst

• Accretive tuck-in acquisitions, likely small or local players in Europe.

• Acquisition of licensee, especially in Japan, where Solera long ago licensed out its product to a consortium of Japanese insurers. Apparently the Japan overwhelmingly runs on Solera’s platform.

• Management opts to keep the balance sheet at a constant leverage level and use excess free cash flow to repurchase stock, especially stock owned by its private equity sponsor which can further reduce an overhang on the stock.

• Countries like India officially mandate auto insurance (note that China did so about a year ago)