Description

Note: The company trades on TSX but reports in USD.

Uni-Select (UNS) is an auto parts accessories distributor in Canada and the United Kingdom and an auto refinish distributor in the US. In Canada, UNS distributes products through 75 company owned stores and 1,100 independent member stores operating under the BUMPER TO BUMPER, AUTO PARTS PLUS and FINISHMASTER banners. In the US, FinishMaster is the largest distributor of paint products and operates over 200 company-owned stores. In 2017, UNS acquired The Parts Alliance which distributes through 184 corporate stores and 27 independent member stores. Historically Uni-Select sat between highly concentrated paint suppliers (PPG, Axalta, AkzoNobel) and highly fragmented collision repair shops. Manufacturers are unwilling to deal with the 30,000 repair shops individually and take on their credit risk. UNS is able to buy in bulk from manufacturers while offering repair shops fast delivery through its store network. As a result, UNS enjoyed stable margins and high returns on capital. However the competitive landscape has fundamentally changed and I think there is more downside to the stock.

Relentless consolidation of repair shops

Multiple Shop Operators (MSO) represented 27% of US industry revenue in 2017, up from 9% in 2006. The number of independent and dealership repair shops declined from 25% from 2007 to 2017. Looking back further, there were over 50,000 repair shops in the US in 2000, but just 32,000 today.

The repair shop industry has attracted a lot of investors to capitalize on the consolidation trend. Repair shops are highly cash generative because they typically get paid by insurance companies sooner than they pay the suppliers (distributors). Consolidating multiple shops increases buying power and eliminates duplicate administrative functions such as working with insurers. One-shop owners who started their small business decades ago are also looking to cash out.

Repair shops receive most of their revenues from insurance companies who increasingly dictate that vehicle owners take their cars to shops operating under their Direct Repair Program (DRP). This is similar to preferred providers in the managed care world. Raising repair costs have pushed insurers to professionally managed MSOs with streamlined processes, and insurers are becoming more stringent on what they would pay for.

In 2018, Axalta commented:

And finally, our customers are becoming more and more demanding. Color match is absolutely critical. Insurance companies no longer reimburse for over-spray. If you think about a panel on a car that needs to be repaired, historically, they would pay for blending to allow that paint to really blend in and look quite nice. Today, if you're lucky, they paint or repair that panel. In many instances, they pay to repair that spot. If the paint doesn't match perfectly the very first time we have not done our job, then the body shop incurs more cost. So our field technical service becomes an incredibly important part of our value proposition to our customers by helping them solve their problems real-time.

The prevalence of DRP has put more pressure on independent one-shop repair centers. Very few people have a preferred repair shop in their mind when they call their insurers, so they typically go where insurers tell them to go. Insurers also use tactics such as refusing to offer warranties on repairs and having customers wait a long time for rental cars if they go to a non-DRP shop.

This year, Caliber and Abra merged to create a 1,000-shop national MSO with presence in 37 states. Hellman & Friedman, Leonard Green and OMERS will own the combined company. Caliber has also started offering amenities such as online scheduling , free Wi-Fi and kids play area. These services are simply not something independents can afford. After the merger, Caliber-Abra became the largest operator in the US (1,000 shops), followed by Gerber (626 shops, owned by Boyd Group traded on TSX) and CARSTAR (600 shops). Another national MSO, Service King, has 300 locations and is backed by Blackstone and Carlyle. Even after considerable consolidation in the last decade, the largest player Caliber-Abra still only has 3% of the US market share and consolidation will likely accelerate from here. A CARSTAR executive commented:

So I think this is probably the first of a few big deals that will be coming in the next 18 to 24 months to further consolidate the industry.

We remain completely dedicated and focused on our vision towards our 1,000-store goal and $2 billion in sales by 2021, but this merger  will likely accelerate those plans just because the market dynamic has certainly changed and this should provoke and really pique additional interest for more independent collision centers to be part of a network. This deal really just further cements the importance of scale within the business today.

FinishMaster’s exposure to MSOs has shown a similar trend. From Q4 2017 to Q1 2019, MSO exposure to MSOs has crept up from sub 40% to 51%. From 2016 to 2018, FinishMaster’s segment EBITDA margin has decreased from 12.4% to 9.2%. In Q1 2019, the segment’s EBT margin declined 330 bps y/y to 4.4% (after the adoption of new lease accounting standards, the company started using EBT as the preferred measure of margins).

As national operators, not just regional chains, continue to grab share, margins will likely continue to deteriorate. UNS management said in Q4 2018:

What you have to understand is the margins are quite different when we do business with national accounts. The reality is, it remains the fastest-growing segment and we took a view of there's a long-term benefit for the business that we need to be involved in that business.

Suppliers are squeezing and disintermediating UNS

As a testament to FinishMaster’s eroding moat, the company is having a harder time passing on regular price increases to customers and no longer getting “special buys” from suppliers. The North American refinish market is a zero to low-single-digit grower in terms of volume, and paint manufacturers have historically relied on price increases to grow revenue. In fact, UNS said US refinish volume declined 2~4% in 2018 and expects the decline to continue in 2019.

Manufacturers have also started working directly with large MSOs. PPG said in as early as 2017:

Yes. it really varies, but I would say, as a rule, larger body shop chains, for example, some of the MSOs that we've talked about  in prior calls, in many cases, we negotiate directly with them and the distributor can be a third-party in that agreement. In some cases, there may be multiple distributors who serve that body shop chain.

This year, something unprecedented also happened. One of Uni-Select’s suppliers changed vendor financing terms and demanded that the company pay off $55 million of payables this year. While the company says this is one-time in nature, its increasing debt and lower cash flow might prompt further tightening of payment terms from manufacturers. UNS has $400~$500 million payables depending on time of the year and any forced repayment would put severe constraint on cash flow.

MSO Consolidation is also underway in Canada and Europe

The same drivers for the consolidation happening in the US are affecting Canada as well. Fix Auto already has more than 200 locations in Canada and aspires to be the next big Canadian franchise chain after Tim Hortons.

MSOs are being created in Europe as well. Axalta said in 2018:

A little bit more on Refinish, because it tends to -- it's the engine that drives our company, almost half of the profitability. Again, market share in 3 of the 4 major regions of the world. This is an industry that continues to be driven on consolidation, higher productivity. You're now seeing MSOs being created in Europe across borders, people like people like LKQ, people like private equity, Blackstone in there.

Leverage is high and the company can’t delever in the near term

The company ended the quarter with 4.5x debt to EBITDA and management said leverage would stay the same in 2019. The company refuses to disclose the debt/EBITDA covenant in its credit agreement and the publicly filed credit agreement has the covenant redacted (which I think is a yellow flag). Based on the company’s disclosure that they have $119 million of remaining borrowing capacity under the revolver as of Q1 2019, I think the debt/EBITDA covenant is likely 5.5x. LTM EBITDA would only have to decline from $113 million to $91 million for the company to breach the covenant, assuming constant debt level.

It wouldn’t take much more margin compression for this EBITDA decline to happen. TPA is already under pressure due to Brexit uncertainties and organic growth has turned negative in Q1 2019. Segment EBT margin declined 430 bps to 2.3% in the quarter. Since acquiring TPA, UNS has aggressively built greenfield locations, expanding corporate owned locations from 161 to 184. The added fixed cost will have a greater impact on margins if sales continues to decline.

In Canada, the company has been converting independent members to corporate owned stores in order to driven organic growth. I think this is akin to a franchiser buying franchisees to drive sagging sales. From 2017 to 2018, corporate owned locations increased from 54 to 65 which increased fixed costs. Canadian paint volume was down in 2018, according to UNS. In the event of economic weakness or gross margin pressure, the higher fixed cost structure will not serve the Canadian segment well.

I estimate that if would only take 200 bps margin decline in FinishMaster US, 100 bps decline in Canada and 100 bps decline in TPA for the company to breach my estimated debt/EBITDA covenant.

While management refuses to disclose the covenants, their comments on the Q1 2019 call suggest that there can be a secured debt offering:

We will be managing within the covenants ratio that we have. I'd like to remind everybody that this credit facility is a $625 million credit facility that is currently unsecured. It leaves us plenty of flexibility to work on our capital structure if required.

UNS said it generated $80 million of free cash flow in 2018. But this is a dishonest calculation of FCF. It adds back $5 million net investment in working capitals, which is odd for a distributor to do. It also does not include the $40 million of merchant advances (net of $6 million repayments from customers). True FCF in 2018 was $40 million and $28 million after dividends. After $55 million of outflow from the supplier vendor financing change and some margin declines, UNS would be cash flow negative in 2019. If these issues continue, UNS would not be able to cover its dividends.

Facing industry headwinds, UNS initiated a cost cutting program in 2017, aiming to take out $20 million costs by 2020. This program was expanded to $25 million and then $35 million. As of Q1 2019, $21 million cost savings have been realized. Cost savings realized so far have not stemmed margin decline, and I doubt if the remaining $14 million will move the needle.

Valuation

TTM EBITDA $113 million

Capex $28 million

EBITDA-Capex: $85 million

TEV: $910 million

EV/EBITDA-Capex=11x

Given my expectation that EBITDA would continue to decline and debt would likely continue creeping up, I think this multiple is too rich. In addition, customer incentives (net of repayments) typically exceed amortization of customer incentives by about $10 million and this cash drag is not reflected in the $85 million above.

Strategic review

In September 2018, UNS started reviewing strategic alternatives. 9 months have passed and there are no updates regarding the process and in Q1 2019 the company appointed a permanent CEO. I view the likelihood that the company or any of its parts would be sold to be low given the high leverage and fundamental challenges facing the distributor model. FinishMaster is also the largest refinish distributor in the US (~3x the size of No.2 National Coating & Supplies) so I think acquisition of FinishMaster by a competitor is unlikely.

Catalyst

Continued margin decline

Covenant breach 

Dividend cut