Elon Musk recently tweeted that there is "Stormy weather in Shortsville" to investors short on Tesla, and we argue that the same weather pattern is heading for short sellers on FleetCor (NYSE:FLT).
Citron research claimed that FleetCor Technologies purposefully engages in predatory (pg 1) and abusive (pg 4) business practices, operates on an inherently deceptive business model (pg 13), and lacks the technological innovation to compete effectively (pg 11). We disagree and believe this is a quality company.
Competitive Advantages -
FleetCor competes in a vast marketplace. Wex, their main competitor, any bank that offers card-based payment solutions, and a number of smaller, independent firms erode their pricing power. Both Wex and FleetCor act as massive middle men in what they call "closed-loop networks" between merchants and customers. This allows each company to establish one on one relationships with customers, which helps sustain profitability through exclusivity, minimum contractual payments, and fee structures. However, we've have found that Wex lacks the scale, margins, and efficiency that FleetCor has in sustaining a transaction-based and fee-supported business model. This is because FleetCor is highly diversified - geographically, in their supporting business functions, and in their customer base - while Wex is not. Winning contracts is sometimes a game of reach, and FleetCor has been winning due to strategic acquisitions in multiple geographic regions and industries.
Once the relationship is established, FleetCor retains customers through their ability to offer different contractual terms to different types of customers and their needs. According to their 2016 10K, "exclusivity, mandatory minimum payments, and pricing terms vary based on scope of use, usage volumes, incentives, and contract duration." On the other hand, Wex didn't go into as much depth with this kind of contractual flexibility in their 10k, leading us to believe that they don't have the same functionality.
Citron's research cited that Wex has received sixteen billing complaints in the last six years with the FOIA, while FleetCor has received 438 complaints. These numbers appear to be very concerning, but billing complaints compared to total transactions is a much more accurate way to represent the metric. Just last year, FleetCor had 2.27 billion transactions across the globe, while Wex had just under 385 million, so scale of operations skews number of complaints between the two firms. These numbers represent a miniscule portion of both companies' total transactions over the last six years (.000008% for FleetCor, and .0000007% for Wex). Both are materially equal to 0%, and if you want to slit hairs, it makes sense that complaints would go up if FleetCor operates on six times the scale of transactions as Wex.
Additionally, FleetCor generated $1.832B in Revenue, while Wex generated $1.018B, up an annualized 26.44% and 18.22% from their lows in 2009, respectively. This successful top-line growth is evident of FleetCor's ability to attract and retain market share, and their Operating Margins over time proves how efficient FleetCor is at managing costs and utilizing economies of scale. This is because FleetCor was able to increase Operating Margins from 33.9% in early 2009 to 41.9% as of FY2016. Wex experienced a drop from 28.2% to 16.4% over the same time period. See charts below for comparison.
The net effect of increasing market share, and by default size of the business (measured here by Total Revenue), is increased economies of scale. This is pictured below by decreasing marginal cost of production, which we measured by dividing Total Operating Expenses by Total Revenue. The takeaway here is that FleetCor has realized a lower marginal cost of production due to their ability to realize synergies from M&A activity. Wex has made some acquisitions, but an increasing portion of operating expenses are "Service Fees" (which FleetCor doesn't have). According to Wex's 2016 10K, Service Fees increased because one of their recently acquired businesses requires additional back-office support, meaning that while both companies acquire smaller businesses and client portfolios, Wex doesn't realize cost synergies, while FleetCor does.
FleetCor has partnerships with BP, Shell, Speedway, Mastercard, Uber, and nineteen of the twenty-five biggest trucking companies in the world, which is only possible with the size and scale that FleetCor operates with. As noted above, FleetCor is a globally-diversified, large, well-integrated, mature company. Boasting over 70 acquisition since 2002 and geographic diversification in over 53 countries, with 92% of 2016 Revenue coming from the US, Brazil, and the UK, FleetCor is by no means a mom-and-pop shop.
Most short sellers are discounting the fact that FleetCor has outperformed their closest competitor for close to ten years. Since 2008, their Revenues have grown 21% compounded (compared to 11% for Wex), and since 2010, their stock price grew at an annualized 26% (compared to 17% for Wex), and their Total Transactions has grown 48% (compared to 6% for Wex). There has been no material change in their corporate structure, operations, or macroeconomic climate that may hurt their competitive advantages, so we expect this growth to continue.
To that end, most short sellers have mentioned the fact that FleetCor spends $0 in R&D. They propose that the lack of R&D investment impacts FleetCor's technological capabilities negatively. However, FleetCor spent (p 11) over $150 million last year (hidden in operating expenses) to maintain their multitude of technology centers spanning five continents. The advantage here is that FleetCor has been able to avoid the uncertainty in returns from in-house R&D expenditures by investing in smaller, more specialized firms outright. Technology isn't FleetCor's bread and butter, but it is the driver behind the efficiency of the business. By expensing upkeep, and outright investing in technology firms, FleetCor has been able to avoid losses on failed R&D investments.
We expect FleetCor to continue on as they have been operating for more than a decade. Specific factors that we believe have increased equity value, paired with the recent downtrend, have resulted in our belief that the current price of $136.40 is a reasonable entry price. Those factors are: continued M&A activity, macroeconomic trend reversals, organic growth in Total Transactions, and continued capitalization on market inefficiencies.
FleetCor's management has committed to making two new acquisitions by the end of 2017, which will expand their reach into more top 20 GDP countries. The need for FleetCor's services is represented best by their recent EUR 300M contract, wherein FleetCor implemented their closed-loop system between Shell and a company called Logica. We expect more deals like this to drive organic growth because global payment processing systems aren't currently closed-loop systems, which means that there is massive untapped global demand. In order to incentivize that demand, given the sizeable switching costs, FleetCor pairs their lower cost structure with a data analytics platform for swipes and driver patterns, which other firm's can't do. This is a competitive strength because FleetCor adds the differentiated product offering from smaller firms to cost advantages available to larger firms. Again, they were able to implement this successfully by acquiring quality firms, instead of investing in R&D.
In the 2016 10k, management cited that a number of market-driven headwinds impacted their profitability. A few of the more important factors are contained below:
- Low oil prices - FleetCor is paid as a percentage of the total transaction at each swipe at a gas station, so last year's oil prices have materially decreased fee income. This was cited in Citron's research, but fee income is luckily a small part of their business. And, now that oil prices have recovered, this should support earnings growth.
- Higher interest rates - FleetCor's Bad Debt Expense increased 46% from 2015-2016, so higher interest rates due to more hawkish monetary policy may adversely effect FleetCor's customers overall creditworthiness, and in turn, their earnings. Additionally, FleetCor suffered a recent selloff as their interest expense came under scrutiny. The company does have outstanding loans at 3.22% yield, but given their high proportion of cash earnings and 10x interest coverage, this could be a non-issue (see graph below for cash earnings accruals and interest coverage). We measured normalized accruals through the Operating Cash Flow method, expressed as a percent of operating assets to include efficiency. In this metric, lower values dictate a higher proportion of cash earnings. This is important for FleetCor because it means they have highly liquid operations, which helps in making interest payments, covering bad debt expenses, and investing in their business. Additionally, Fleector has a revolver outstanding until 2019, with $467M available as of March 31, 2017 (contained in 1Q2017 10Q filing, under Sources of Liquidity). All in all, we believe FleetCor is liquid enough to cover interest expenses in the face of higher interest rates. Admittedly, we don't expect a reversal in this macroeconomic risk, but the company's liquidity should provide some cushion.
- Decline in demand for fuel - as customers demand less fuel, FleetCor's transaction volumes decrease, which decreases top-line revenues. After weathering the past five to eight years of rocky economic recovery, the company experienced lower profitability than what was otherwise possible. Now that global economies are entering periods of stimulative monetary policy and the US economy are decidedly in a better spots, FleetCor's total transactions should improve as economic growth continues.
Citron called for a target price of $85, which is well below the current price and our target. Accordingly, we used our research above to create a fair value equity estimate.
In order to price FleetCor Technologies, the team leveraged a newly developed model that incorporates Monte Carlo Simulations, a Regression Analysis, and probabilistic equity value estimates. Equity value was estimated using a modified Residual Income approach. Each of these factors is broken out in the explanation below.
The team used a Regression Analysis to forecast revenue because FleetCor's revenue is directly tied to macroeconomic factors. Their business model lends itself to factors such as GDP growth, US Trade Inventories, Gas Price Inflation, and Global Gas Production. This is because many of their transactions are a function of how often consumers are swiping their fuel cards, how many times they stay in lodging, and general economic production. In order to forecast Total Transactions, these variables were predicted, and regressed to Total Transactions. Regression accuracy tests are included below. While some of the contained correlations aren't significant, we included them in the model because other variations of macroeconomic indicators produced a less accurate accuracy plot.
The select macroeconomic variables were predicted using Monte Carlo Simulations. We felt balancing variability out with 1000 iterations of each predicted variable was sufficient, while still avoiding reversion to the historical mean with a larger number of iterations. Additionally, 1000 iterations increased the sample size enough to reach a normal distribution. This was performed five times for each predicted variable, as we needed values for the five forecasted years.
Once we arrived at a forecast for Total Transactions, the team used historical precedents to forecast Revenue per Transaction (NYSE:RPT). Due to the lack of barriers to entry in the market, FleetCor's RPT has been continually pushed down. This is because banks have been able to capitalize on the same technological developments, and smaller firms have been able to capture and hold smaller geographic/industry sectors. Accordingly, the team forecasted a forward trend in these numbers by fitting the historical decrease in RPT to an exponential best fit line, and then used that trend as a precedent to estimate future RPT. The forecasted and actual RPT lines differ because the linear trend in actual RPT wouldn't make sense to forecast. So, the team went with an exponential trend, which aligns with our belief that future RPT will be pressured downwards while still remaining above $.50.
As you can see from the chart included below, our estimates are fairly conservative compared to the mathematical estimate. This is because we wanted to build in the probability of increased pricing pressure as bulge bracket banks increase card carriers, the adoption of technology increases, and the number of acquisitions increases (which increase economies of scale, and enables FleetCor to lower prices). We believe these will depress prices for FleetCor, but increased technological capabilities and economies of scale will enable FleetCor to counter the changing market landscape through effectively managing costs. We used an exponential line to check our estimates, because RPT can only decrease to a point. If it ever fell below $.51, they wouldn't be able to cover 2016 expenses, and we don't expect it to grow significantly because of the competitive environment.
Once the team used the above methodologies, equity value was estimated using a modified Residual Income Model. Standard DCF, Residual Income, and DDM models were considered for this valuation, but were decided against for the following reasons:
- Standard Residual Income - changes in Equity Charge are nearly impossible to forecast because FleetCor is driven by acquisitions.
- DCF - because of FleetCor's acquisition-driven growth strategy, a three statement DCF isn't within the scope of our resources.
- DDM - this model is often used in stable, long-standing companies, and FleetCor IPO'd just before 2009. We felt this didn't provide for enough historical data to provide proper context to make accurate forecasts. Also, FleetCor doesn't pay a dividend, and determining when the company would reach the dividend phase of its life cycle is anyone's guess.
To that end, we've adjusted the classic Residual Income model to account for operating performance in lieu of Equity Charge. This was accomplished by adding back the non-cash D/A expense, and then accounting for required return on Operating Assets and creditors through a WACC adjustment (here, operating assets includes PP&E, Receivables, Prepaid Expenses, and Cash). Finally, we determined Equity Value by adding in the sum of Residual Income to the Firm, Residual Income in Perpetuity, and Equity Book Value, as is standard practice.
From there, the team performed 100 iterations of the model, allowing the random normal distributions in the Monte Carlo simulations to recalculate all of the forecasts for each macroeconomic variable, which ultimately recalculates Revenue. Iterations were stopped at 100 for the valuation model because that's when the normal distribution was reached, and any more iterations weren't needed. While this isn't standard practice in determining equity value, we believe these iterations remove a lot of variability in forecasting those economic variables, and in turn, remove some degree of our own biases in forecasting revenue. The distribution of equity value estimates is contained below. Judging by the normal distribution, we feel the median estimate of $185.35 per share is a fair estimate.
Valuation Sanity Check -
Even though our valuation method went through 100 iterations, we checked our estimates for all of the line items for the target price of $185 (contained below).
- We built in a drop in D/A as a percent of PP&E off of the assumption that because their PP&E for the last 5 years was extremely small, D/A as a percent of PP&E wasn't sustainable at 148%. At some point in the near future, management would have to decrease D/A expenses in order to maintain earnings stability, especially as assets are expected to increase.
- PP&E is growing at a lower rate because we believe management will make sustainable decisions in-line with the rest of their strategy. Of course, we expect acquisitions to continue increasing, because that's part of FleetCor's competitive advantage. However, the growth rate of those acquisitions is expected to decrease as synergies become more difficult to manage with increased scale.
- Cash as a percent of operating assets decreased over the next 5 years as well because we believe they will have less cash as they continue acquisitions.
- Operating assets is a function of Cash, Receivables, PP&E, and Prepaid Expenses, so it would logically decrease in growth over the next 5 years as well.
- We built in an increase in WACC to account for the hawkish long term monetary policy from the Fed, as well as their current capital structure. This is because they may finance acquisitions with any mixture of equity, debt, and cash. As leverage increases, Beta usually does, too, which will increase their equity risk premium. Secondly, if they finance acquisitions with debt at considerably higher rates, their cost of debt will increase.
- Over time, we expect revenue growth to flatten out as RPT is pushed down from increased competition, and future acquisitions and the improving macroeconomy generate more business for FleetCor. However, due to recent and expected synergies, FleetCor will be able to compete on costs, and increase shareholder value.
- The sharp drops in Revenue in 2019 is due to expected decreases in Gas CPI from the Monte Carlo simulations, while the sharp increase in 2017 is a result of higher RPT in early forecast periods paired with higher expected US GDP and Gas CPI for that year. To be clear, we expect RPT to slowly decrease as time goes on. But due to the higher expected RPT in 2017 (compared to 2021), increases in expected GDP and Gas CPI in 2017 have a large effect on increasing revenue in that year than in the years following.
- Notice how Adj. NOI and Residual Income react to changes in Revenues. Overall, we expect those margins to increase slowly over the forecast period, which is evident of expected cost synergies.
Given our research and a collection of Wall Street's finest sell-side research firms (see Evercore and Wells Fargo), we believe the recent selloff shouldn't vindicate calls for a short position. Rather, it has provided the attentive investor with an opportunity to capitalize on expected growth at a reasonable price.
Disclosure: I am/we are long FLT.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Special thanks to Jack Hoffman, who supplied supporting research for this article