Nesco: Capitol Warrants Are A Buy On The Upcoming Merger With Nesco

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Summary

  • We recommend buying the warrants of Capital Acquisition Corp (NASDAQ:CICWS) on the upcoming merger with Nesco.
  • The transaction creates Nesco, a provider of specialty rental equipment which has 40%+ EBITDA margins and growing at double digits, at a significant discount to comps.
  • Transaction close and valuation re-rate should drive upside for the shares and warrants in particular.
  • Insider behavior makes us even more bullish on the warrants ahead of the expected deal closing in July after the July 16th proxy vote.

Transaction Summary

Nesco is going public by merging with Capitol Acquisition Corp (NASDAQ:CIC), a SPAC sponsored by Mark Ein who previously led three successful SPAC IPOs of Cision (NADSAQ:CISN), Linbald Expeditions (NASDAQ: LIND), and Two Harbors (NYSE:TWO). Ein has $11.5m invested in Nesco warrants at a cost basis of $1.50 and we believe Ein will follow a similar playbook as he has done in the past and effect a warrant exchange into shares at an extremely attractive premium once the deal closes.

Nesco, a leading provider of specialty equipment rentals in North America to utilities, railroads and telecom customers, has been through three successful rounds of private equity ownership. Platinum Equity bought the Company in 2011 from Hammond, Kennedy & Whitney Inc. (who had previously purchased it in 2007) and sold it in 2014 to Energy Capital Partners for $875m. With the upcoming merger with CIC, the Company plans to recapitalize its balance sheet to position it for fleet expansion.

In the transaction, Energy Capital Partners will maintain 70% of their existing equity in the business retaining upside on Nesco’s future prospects with the upcycle in infrastructure spending expected to drive further growth in demand for the company’s fleet. Nesco shareholders will receive $75m in cash, 2.5m warrants, and 17.4m of common stock for a 28% stake in the Company pro forma.

Additionally there is an earn-out mechanism where Energy Capital Partners and Capitol Sponsors can receive up to 1.8m and 2.8m shares, respectively, with half of the shares vesting if the stock reaches $13 and the remainder when the stock reaches $16. We see the earn-out for 4.6m shares as a bullish sign as this almost 7% of the company’s common stock.

The combination with CIC will enable Nesco to significantly deleverage its balance sheet by around $250m or 2x EBITDA using the $411m of cash in the trust enabling it refinance its capital structure with a new $350m ABL facility and $400m of second lien notes. On a pro forma basis, only $75m of the ABL facility will be utilized leaving capacity for working capital and fleet adds. Leverage would sit at around 3.4x 2019 EBITDA ,which is significantly lower than 5.5x before the combination.

The transaction values Nesco at $1.1bn or around 7.0x 2019 EBITDA and 6.0x 2020 EBITDA. Nesco has guided to around $137-141m of EBITDA in 2019 ($162-166m pro forma for a $42m add on acquisition which will close in July) and $170-178m in 2020 ($190-198m pro forma for the add on). Nesco has around $300m of NOLs with a PV of $57m which can be used to offset future taxes.

Nesco will be created at a sizeable discount to specialty rental peers like WilScott (NYSE:WSC), McGrath (NASDAQ: MGRC), and MobileMini (NASDAQ:MINI), which trade at an average of 8.7x 2019 EBITDA and 7.8x 2020 EBITDA and a 2-3% dividend yield – Nesco is growing revenue and EBITDA at double digits and has better margins > 40% compared to these peers with less cyclicality. As a result, the merger creates an opportunity to buy a levered equity with significant growth prospects and relatively defensive end markets. A rerate to peer multiples could result in a stock price of $13-20 per share, which would mean significant upside for the warrants.

CIC shares (NASDAQ:CIC) are currently trading at $10.22 which is roughly the value of the cash in the trust and for this reason present a nice risk reward here with almost zero downside and significant upside post-closing.

The warrants are trading at $1.19 with each warrant representing the right to purchase a whole share at $11.50 with an expiration in 2024. The warrants are cheap with an implied volatility of 26% - one reason that we think the opportunity exists is perceived risk of the deal closing.

The Capitol sponsors are extremely bullish on the warrants and have provided non-interest bearing working capital loans to the Company of $1.5m which convert to 1m warrants at $1.50 per share 30 days after the business combination which is well above the current trading price of the warrants (p.150 of proxy). The warrants are the only upside for these loans which bear zero interest and cannot be repaid from trust funds if a deal does not happen. Including the working capital loans, the Capitol Sponsors have invested $11.5m in warrants at a cost basis of $1.50 and have forfeited some of their founder shares as part of the transaction.

This suggest to us that the Sponsors will make sure that there is sweet upside for the warrants through a warrant exchange into shares as Ein has done in the past whilst at the same time reducing overhang and dilution for common shareholders.

Deal Closing Considerations and Upcoming Catalysts

The proxy vote is scheduled for July 16th (here) and we expect the merger to close shortly thereafter. Nesco is not required to consummate the transaction if the cash in the trust drops below $265m – this means that 65% of CIC shareholders need to support the merger in order for the deal to go through which is around 26m shares. Since the deal was announced on April 8th, more than 33m shares have been traded in aggregate so arb investors who wanted to get out of the shares would have already had an opportunity to do so. A higher level of redemptions would mean an additional turn of leverage on the business at 4.3x versus 3.4x assuming no redemptions occur.

We see the following near term catalysts for the stock and the warrants:

  • Proxy vote on July 16th followed by acquisition closing
  • Guidance revision and closing of $42m add on acquisition
  • Analyst coverage and re-rating in line with comps
  • Warrant exchange

Business Overview

Nesco is one of the largest specialty equipment rental providers to the electric utilities (“T&D”), telecom, and roads in North America. Nesco offers its fleet of specialized equipment to a diverse customer base for the maintenance, repair, upgrade and installation of critical infrastructure assets including electric lines, telecommunication networks and rail systems. Based in Indiana, Nesco has a broad geographic footprint across the US, Canada and Mexico which includes 13 operated facilities, 44 third party service locations, and 4 parts, tools and accessories facilities.

Fleet Portfolio

Nesco’s fleet consists of ~4,000 rental units with an average age of 3.8 years and a typical life of 15-25 years. The Company’s fleet portfolio includes bucket trucks, digger derricks, line equipment, cranes, pressure diggers, and underground equipment, which are used in construction for utilities, rail and telecom.

Source: Nesco Investor Presentation (here)

Nesco has a diverse customer base of 1,860 customers including utilities, telecoms, railroads and related contractors with ~90% of revenues to recurring customers and with no customer representing more than 11% of sales. For Nesco’s customers, the benefits of renting versus owning specialized equipment for include reduced capital outlay lower storage and maintenance costs, better customer care, and lower costs compared to ownership due to health and safety regulations. Nesco’s breadth of equipment and diverse geographical reach allow the Company to meet demands of large national customers, which are an important source of recurring business from large multi-year projects.

Source: Nesco Investor Presentation (here)

Unit Economics

With an average cost of $100k, the unit economics of Nesco’s rental business are extremely attractive with a payback period of 3 years and a useful life of 7-8 years, which can be extended to 15-years by remounting the equipment onto a new chassis with some additional investment. With an EBITDA payback period of 3 years, a useful life of 15 years and a salvage value of around 25% of the original equipment cost, the original capital investment results in an unlevered IRR of around 29% and a MOIC of 3x on the original investment over the 15 year life. Given that the Company’s current fleet portfolio is fairly young at 3.8 years, there is approximately 11 years of remaining life left with the existing fleet. An illustration of the unit economics is shown below.

Source: Nesco Investor Presentation (here)

Nesco’s end-market mix is weighted 81% to T&D utilities, 13% to telecom, 6% to rail and 2% to signage and lighting. Unlike the broader specialty rental industry, Nesco has zero construction industry exposure, which makes up about 39% of specialty rental end markets.

Source: Nesco Investor Presentation (here)

Nesco’s unit economics compares favorably to other niches within the specialty rental equipment space with higher utilization, shorter payback periods, better rental yields and lower cyclicality.

Source: Nesco Investor Presentation (here)

Market Opportunity

Investment spending across T&D, telecom and railroads exceeds $100 billion annually comprised of: $60+ billion in T&D, $30+ billion in wireless telecom and $10+ billion in Class I rail. Capital investment in Nesco’s end markets has grown at an average of 7.8% from 2001-2017, outpacing GDP growth, which averaged 3.9% in the same period, and has shown greater resilience through economic cycles. T&D investment, which makes up more than 80% of Nesco’s end market mix actually grew by 0.1% during the recession years of 2008 to 2010 when US construction spend fell by 25%.

Source: Nesco Investor Presentation (here)

Positive tailwinds are expected to drive significant growth in spending in each of Nesco’s end markets. The significant increase in Nesco’s customer backlog is a good indicator of continued growth.

  • T&D Utilities: T&D utilities are in the early innings of a decade long secular up cycle driven by ((i)) the need to replace an aging grid with 40-50% of existing T&D infrastructure beyond useful life, ((ii)) the need to extend the existing power grid to integrate renewable and gas generation, and ((iii)) to support additional electricity demand which will require incremental investment of $90 billion in transmission by 2030.
  • Wireless Telecom: Wireless infrastructure typically requires recurring maintenance. On top of this, the 5G upgrade cycle is driving a new wave in infrastructure spending with 5G capex by the Big 4 wireless providers expected to total $240 billion over the next decade while growing at a 40% CAGR to 2023. Nesco’s equipment is well suited to service the typical deployment locations on telephone poles, streetlights and sides of buildings.
  • Rail Infrastructure: Class I railroads spend $11 billion annually to maintain, upgrade and repair their rail systems. Urban congestion and growing freight transportation needs have driven nationwide investment in improving rail infrastructure. In 2019, the US Senate approved $16 billion in spending support for commuter rail and transport projects. Spending could get a further boost from the $2 trillion infrastructure plan under consideration to upgrade the nation’s highways, railroads and broadband.

In addition to projected end market growth, there is a secular shift between equipment ownership to rentals, which is expected to increase the penetration of rental equipment for the broader specialty rental industry from 53% to 65% over the next decade. In Nesco’s end markets, current penetration levels are only 20 to 25% for rental equipment, which would suggest that these categories could grow faster than the broader market in terms of increasing penetration.

Source: Nesco Investor Presentation (here)

Company Growth Drivers

Nesco plans to grow organically by investing in capex to expand its fleet ito meet excess demand and leveraging cross-selling opportunities and inorganically through strategic acquisitions to consolidate an extremely fragmented industry.

Organic Fleet Expansion

Post-transaction, Nesco will be able to use a combination of existing cash on balance sheet, availability under credit facilities and organic cash flow to make organic investments in fleet expansion. The excess demand for Nesco’s fleet has been increasing and is expected to accelerate due the positive demand factors discussed above. Nesco actually had to turn away 4,000 rental opportunities in 2017 and 2018 due to insufficient fleet availability. Over the next 3 years, Nesco plans to invest $177m in growth capex to add 1,775 units to its fleet, an expansion of 44%.

Source: Nesco Investor Presentation (here)

Cross-selling opportunities

Nesco believes that there is an opportunity to optimize cross-selling for the rental of parts, tools and accessories within its existing customer base. The Company established the parts, tools and accessories division in 2015 and subsequently acquired two companies – Bethea in 2017 which added manufacturing of blocks, the leading parts rental product and N&L in 2018 which brought certified expertise in regulation-mandated dielectric testing and manufacturing of certified live-line tools. The parts, tools & accessories division generated $29m of revenue in 2018 across 2 locations and this is expected to grow to $80m by 2021 across 6 locations.

Market consolidation

The specialty equipment rental space is highly fragmented with many regional and local players providing an opportunity for Nesco to be a potential consolidator. Since 2012, Nesco has completed 6 acquisitions at a weighted average multiple of 5.7x and 4.0x pre and post synergies as shown in the table below.

Source: Nesco Investor Presentation (here)

Business Plan and Valuation Considerations

Over the next three years, Nesco plans to undergo further fleet expansion investing $177m in growth capex to expand its fleet by 1,775 units, which will add $72m of revenue and $52m of EBITDA annually by 2021 excluding any acquisitions.

The core assumptions underlying the business plan projections are (1) the assumption of continued excess demand from customers which supports the fleet expansion strategy , (2) increased parts, tools and accessories penetration of existing equipment rental customers through growth in the number of servicing locations, and (3) increased demand for Nesco’s fleet due to secular drivers in the utility, telecom and rail end market including the need to replace and expand the existing grid, increasing telecom infrastructure spend on 5G and projected increase in rail capital spending to support freight demand and for commuter rail projects.

Driven by fleet investment, revenues are projected to grow at a 15% CAGR from 2018 to 2021, in line with Nesco’s 2016 to 2018 revenue CAGR of 15% where the average fleet was expanded by 500 units. This revenue growth projection is supported by industry estimates of a 12% CAGR for total transmission project spend between 2018-2020, and a 20% CAGR for total telecom construction spend from 2018-2020 and further validated by the excess demand that Nesco has experienced.

From 2016-2018, Nesco was able to achieve a 700bps EBITDA margin improvement from 42% to 49%. EBITDA growth is projected to outpace revenue growth due to further margin expansion to 54% due to ((i)) an increase in higher margin specialty equipment rental revenue in the overall mix and ((ii)) increased operating leverage inherent in the business model.

Per the latest investor update presentation (here), Nesco has reaffirmed 2019 and 2020 EBITDA guidance of $137m and $170m, respectively. Due to excess demand, Nesco has had to turn away rental opportunities due to the lack of equipment and has accelerated the timing of fleet investments and PTA location openings in response to excess demand. These organic initiatives could boost EBITDA by $3.5m in 2019 and $7.5m in 2020 to $140.5m and $177.5m. Additionally, Nesco will complete an extremely accretive add on acquisition in the equipment rental business for $42m in July at 5.1x adjusted EBITDA pre-synergies and 3.4x post-synergies. Nesco is projecting pro forma EBITDA post-acquisition of $162m in 2019 and $198m in 2020 on the low end and $166m in 2019 and $197m in 2020 including the boost from cross selling.

Nesco enjoys extremely high unlevered free cash flow conversion of >80% of EBITDA due to limited maintenance capex needs at 13% of sales. Offsetting some of the growth capital investment are proceeds from sales of used equipment at roughly 25% of the original equipment costs. From projected FCF generation, we expect Nesco to steadily deleverage to ~3.0x at the end of 2020 and 2.5x by 2021.

From a valuation perspective, we think Nesco should trade in line or at a premium to peers given the better margins, growth profile and defensive business mix. At an 8.7x multiple, we think that the stock could trade between $13-20 if the growth targets are achieved. We feel that this is realistic given the underlying secular trends in the T&D, rail and telecom end markets. This would mean that the warrants could be valued at $3-7.50 taking into account that there is a warrant redemption triggered if the share price hits $18.

Conclusion

In summary, we think that there is a compelling opportunity to buy CICWS at a sizeable discount to where insiders hold the warrants (at $1.50) ahead of the proxy vote on July 16th. Overall, we think that the Nesco deal has upside on industry growth prospects and that insider behavior points towards significant upside for the warrants on a potential exchange into shares or re rating of the underlying stock.

This article was written by

Value Detective profile picture
402 Followers
Analyst writing about special situations, distressed, and event driven opportunities

Disclosure: I am/we are long CICWS. 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.

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