Historically, Ritchie Bros Auctioneers (RBA) has commanded a dot-com multiple based on a solid business model and a respected, but highly promotional, management team.
We believe the historical business model has lulled investors into a false sense of security. With secular headwinds and potential structural changes to the business (most notably egregiously high fees), we believe the company’s extremely high valuation multiple (23x consensus earnings and 13x EBITDA) may come under attack. Recent data points suggest that the company’s 2010 auction results could be very disappointing, which could put 2010 earnings estimates in jeopardy. We believe aggressive 2010 EPS consensus estimates of $0.97 could ultimately end up being only $0.60 to $0.70 per share. In the long-term, pricing pressure could result in earnings power of only $0.90 per share. With stagnant growth and cyclical headwinds, we think the stock could lose its premium valuation multiple. As a result, we think there could be 45 to 50% downside from current levels.
Ritchie Bros Auctioneers sells used equipment at 39 physical auction sites. In 2009, RBA sold $3.5 billion worth of used equipment ("gross auction proceeds" or GAP) and will collect roughly $380 million in revenue. The $380 million of revenue represents a whopping 10.8% auction revenue rate. The consignors (sellers) that are subject to RBA’s egregious fees are rental companies, lenders, dealers, manufacturers, small contractors and farmers. RBA's entire financial model is thus dependent on willing sellers of used equipment.
RBA had a long history of beating results. This steady history of execution is in stark contrast to the last two quarters, which missed GAP estimates. As can be expected from any promotional management team, there were amusing excuses for the disappointments, including customers waiting for the "right time" to sell, uncertain future construction activity levels, reduced distressed selling by lenders, an inexperienced sales force and concerns about bonding risk. That is one heck of a laundry list, to say the least.
The objective observer may draw a more rational and concerning conclusion: the tailwinds from the countercyclical nature of RBA’s business are subsiding at the same time that customers are looking for other channels to sell their equipment. Over the past few years, a perfect storm of tight liquidity, credit and destocking / defleeting forced many of RBA’s customers into distressed liquidations. To add insult to injury, these customers were subjected to outrageously high fees. Now, evidence suggests that RBA’s customers no longer need to sell elevated levels of used equipment and those that do are selling through cheaper channels. This is a very troubling combination for RBA shareholders.
We believe RBA's business was a huge beneficiary of the global economic downturn that began in late 2007 and troughed in mid-2009. As liquidity evaporated across the construction, farming and equipment rental industries, companies were forced to flush used equipment and excess inventory as quickly as possible. The secondary market for used equipment, including RBA's auction sites, remained liquid during this time. As a result, RBA's auction volumes held up extremely well. However, the used equipment flush started to slow in the fall of 2009, which “coincidentally” lined up with RBA's most recent GAP misses. Two years after the credit crisis began, RBA's customers are finally experiencing healthier lending and capital markets. As a result, equipment owners are showing disdain toward RBA’s high fees and are exhibiting a lack of desire to participate in their auctions.
A good example of this dynamic is United Rentals (URI), who has historically been one of RBA’s largest customers. In the first half of 2009, URI sold $151 million worth of used equipment. However, the combination of stabilizing rental utilization rates with URI’s own debt refinancing led to a significant slowdown in the company's defleeting efforts. In the second half of 2009, used equipment sales were down nearly 50% to $78 million (including the lowest amount in 4Q’09 at just $37 million). On URI's latest conference call (February 4, 2010), URI management said they will "continue to defleet this year but at a slower pace." We expect URI, as well as other similar equipment owners, to have used equipment sales that are down in 2010.
Egregiously High Fees
We believe there are two reasons customers despise using RBA's auctions: egregiously high selling commissions and unreserved auctions. (We would like to note that investors should do their own research, as we have, on RBA's customers and their disdain for high fees.) Anyone who has paid a realtor a 3% to 5% commission knows that it is a painful transaction cost, and sellers will seek alternative sales channels or lower fee options if possible. Now imagine paying nearly 11%! This is the harsh reality for RBA's customers. In the quarter ended 9/30/2009, Ritchie Bros auction revenue rate was 10.95%. In fact, RBA's selling commission is one of the highest we could find (see table below):
|Auto Auctions (CPRT & KAR)||3-5%|
|Residential Real Estate||3-5%|
|Ritchie Bros. (3Q09)||10.95%|
As a result of these high fees, we believe customers will try to avoid using RBA. For example, United Rentals has historically sold 20 to 25% of their used equipment through auctions (RBA and/or others). However, since the start of the credit crunch, URI has sold over 50% of its used equipment through auctions. Now that alternative channels (e.g. selling through their retail footprint or to existing rental customers) have begun to open up, we believe URI will return to selling only 25% of their used equipment at auction. In 2010, we expect URI to sell roughly 15% less used equipment (down from $229 million in 2009). If URI returns to its historical auction sales mix, then its used equipment sales at auctions would decline 55% in 2010. It is our belief that the dynamics at URI are not unique. Indeed, our research suggests that other RBA customers are following a similar path. The result should be 2010 GAP volumes that highlight the systematic problems at RBA.
Another thorn in RBA’s customer side has been the unreserved auction format (no minimums). Under this format, sellers bear all of the risk if there is limited demand. It’s our understanding that the second largest rental equipment company, RSC Industrial (RRR), refuses to use RBA’s auctions due to the unreserved nature of their auctions. We would hazard a guess that the 10.95% fees don’t help either (and, again, we would encourage shareholders to do their own work to confirm our findings). As if its refusal to work with RBA was not a strong enough indication of its antipathy towards RBA’s auctions, RSC Industrial recently launched its own website for used equipment sales. We believe this is an additional headwind for RBA and a red flag worth noting as other large customers such as Deere (DE) and Hertz (HTZ) use sales channels that circumvent RBA’s auctions.
We believe RBA may ultimately be forced to cut its fees in order to increase volumes and begin to mollify its disgruntled customers. We view wholesale car auction companies Copart (CPRT) and KAR Holding (EFC) as potential models for RBA. CPRT and KAR also operate capital intensive businesses with large yard operations. They sell less mobile inventory (scrapped cars) and charge fees that are half of RBA’s (4-5% of gross auction proceeds). We believe this fee level would drive more demand for RBA's service and may be the only way to spur growth.
RBA's stated long term goal is to generate $10 billion of GAP. While investors frequently cite this figure, we fear that there is not much sensitivity analysis around what may be required to drive this GAP goal. Assuming GAP grows 10% per year, in ten years RBA would get to $10 billion GAP. If fees were more inline with CPRT or KAR (5%), in ten years RBA could generate $500 million of revenue. At a very generous margin of 30%, with a 35% tax rate, the company would generate roughly $0.90 of earnings in 2021. At a 15x multiple, ten years from now, the stock could trade around $13 or $14 per share.
Do Shareholders Throw In the Towel With Another Miss and Guide Down?
Ritchie Bros.' marquee event each year is its mid-February auction in Orlando. The auction is the company’s largest and is the first large auction of the year. Last February, the company sold "more than 8,300 lots...generating $184 million in gross auction proceeds" from 550 consignors at the Orlando auction. On December 14th, 2009, the company detailed grand plans for their Orlando auction, which is set to start February 15, 2010. It appears that interest in the Orlando auction is far less than management initially expected back in December. On January 28, 2010, just a month-and-a-half after the initial plans were announced, the company inconspicuously cut its Orlando auction from six days to five days. Management did not disclose why they cut back the Orlando auction, but it appears to support our belief that sellers are less willing to use RBA's auctions. In the press release, management stated that they expect to sell less than 6,000 units with roughly 400 consignors in Orlando. If management’s estimates are correct, the number of sellers would be down 27% and units sold would be down 27%. The result at last week’s Phoenix auction is a further harbinger of a weak 2010. The Phoenix auction generated only $22 million of GAP, down 15% year-over-year.
In November 2009, management guided to 2010 GAP of "over $4.0 billion," or greater than 12% growth over 2009. With weak results in Phoenix, and weak results expected in Orlando, we believe the $4.0 billion of GAP guidance will prove to be wildly optimistic. As a result, we believe analysts will have to dramatically cut their 2010 earnings estimates, and management’s tenuous credibility from the past few misses, will be further damaged (loss of confidence = lower multiple). If 2010 GAP declines 10% with a 10% auction revenue rate, a 27% operating margin (some minor negative operating leverage), and a 30% tax rate, we estimate EPS in 2010 will be roughly $0.60 per share. At 17x 2010 earnings (a 20% premium to the S&P 500 and inline with CPRT’s valuation), we believe shares could trade down to $10.50 per share. At this level, the new realities of RBA’s end markets and splintering customer relationships would finally be priced into the stock.
Disclosure: Short RBA. No position in URI, RRR, DE, HTZ, CPRT, KAR