Description

At the risk of re-gifting, my gift this holiday season is the same as last year: a long pitch on Solera Holdings. Last year at this time, the stock traded at $25. It’s now under $22, despite what I believe is an even more compelling investment case. By way of review, Solera operates a simple business model: 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 over 70% of its revenues from outside the US, primarily from Europe but increasingly from higher growth markets like Latin America, India and China. I believe that the company’s results since its May 2007 IPO demonstrate that is a high quality business with attractive revenue growth prospects, improving margins, strong free cash flow generation and a defensive business model. Its exposure to a number of growing emerging markets (in addition to its core US and European operations) positions the company well from a longer term perspective.

The core of my investment thesis on Solera remains unchanged from one year ago:

·         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 business has high margins (EBITDA margins > 35%) and minimal reinvestment requirements (recurring capex of roughly $20 million compared with EBITDA of $186 million in FY08), leading to strong free cash flow and ROIC. Lastly, a massive, difficult to replicate proprietary database and long-term customer contracts tend to minimize competitive threats.

·         Favorable long-term secular trends driving growth. Solera’s US operations are growing only modestly, but 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. Prior to the company’s 2006 LBO, it was a backwater division of ADP 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 significantly reversed 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 FY08, EBITDA margins expanded nearly 400 basis points to over 34%. While this was an unusually large jump, we expect EBITDA margins to continue climbing, eventually hitting 40%.

·         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). 

So why is Solera a more compelling long today, given the credit crisis and global recession, to saying nothing of the steep decline in new car sales worldwide and the drop in miles driven? First, while it goes without saying that Solera certainly isn’t immune to economic weakness, I do believe they are far better positioned than most. For reasons articulated above, the basics of Solera’s business model should prove defensive in challenging times. Second, the declines in new car sales and miles driven sound scary, but less relevant for Solera than one might think. With respect to the former, Solera is chiefly concerned with the size of the car “park” or overall fleet. Despite fewer car sales, the size of the car park really isn’t changing as folks are simply hanging on to their existing vehicles longer. In terms of the latter, a drop in miles driven, the evidence suggests that the biggest decline is in highway miles, which are the least accident-intensive miles. The famous statistic that 90% of accidents happen within a few miles of one’s home is generally accurate, and these miles tend to be mostly stable, implying a relatively constant level of accident activity. The largest drivers of Solera’s long-term growth remain intact: the conversion of paper to electronic claims processing and the general adoption of automotive insurance and insurance processing in emerging markets. Third, the company’s balance sheet is in fine shape (< 3x debt / EBITDA leverage), with no near term maturities and ample free cash flow generation. Fourth, the overhang of GTCR’s 30%+ ownership stake in the company is gone after the firm exited its position in 2008. Finally, the stock is cheaper than one year ago based on my estimates of forward free cash flow generation.

A final factor is that the stock is currently in the penalty box because of a recent equity offering. Investors were annoyed when management announced a secondary offering that would be used to finance a handful of acquisitions. Solera has not been an acquisitive company to date, so the revelation that several deals were in process was a surprise. Management opted to raise equity given obvious constraints in the credit markets and a desire to be more conservative with the balance sheet generally. While we weren’t thrilled initially with the this transaction, we acknowledge management’s conservatism and are excited about the acquisitions the company is targeting, two of which have already closed, a small deal in Brazil and a much larger deal (> $100 million) in the UK. Both deals were done at attractive valuations, even before any cost synergies, and should be accretive to margins and earnings (even pro forma for the equity issuance).

Financials

I believe that Solera will generate organic revenue growth of 6-8% for the next several years. EBITDA growth should be in the mid-teens 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        $540        $596        $648

   % Change                 10%        14%        9%          6%

EBITDA                        144          186          221          252

   % Margin                    31%        34%        35%        38%

FCF                                                  99            131          162

FCF / Share (FY)                            1.52         1.87         2.27

FCF / Share (CY)                           1.70         2.07         2.43        

 I believe that the quality of Solera’s business model and its attractive growth prospects merit a free cash flow yield of 6-7%. Based on calendar year free cash flow per share of approximately $2.43 in 2010, I believe Solera will be worth $35-40 over a twelve month time frame, or up around 60-80% from today’s price.

Risks

·         Macro slowdown worsens, claims activity declines and/or insurance carriers push back on pricing or new product sales. As mentioned previously, Solera is not immune to macro pressures despite the defensiveness of its business model. That being said, we believe the company is insulated to a reasonable degree by the historical non-cyclicality of auto claims activity and the strong value (i.e. lower costs) Solera’s services provide to insurers.

·         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.

·         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. We are encouraged by his progress in the last 18 months, however.

Catalyst

• Continued strong quarterly performance.
• Additional accretive tuck-in acquisitions of the same nature that the company has announced recently.
• 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 two years ago)