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Buy Quality on the Cheap

|Includes: Quality Distribution, Inc. (QLTY)

With a double-dip seemingly off the table, it now makes sense to turn one’s attention to recovery stories with a robust internal growth story.  Although its market cap is only $135 million, Quality Distribution, Inc. (QLTY-$6.48) runs North America’s largest bulk chemical tank truck network, with an estimated 14% market share in this $4.0 billion industry. While my target over the next 12-18 months is $12-$15 based on $1.00 in earnings for 2012, I fully expect to see low to mid $20s within the next 3-5 years


The Quality story has been unfolding for years.  Founded in 1994, the predecessor company was acquired by Apollo Management in 1998 and acquired Chemical Lehman Tank Lines.  Over the next few years, the company changed its name to Quality Distribution and began its conversion to the current asset-light business model, culminating in a moderately successful 2003 IPO. However, it continued to struggle with an excessive debt burden and operational issues until fairly recently.  Gary Enzor was appointed CEO in June, 2007, and under his leadership the company has completed the transition to a high ROIC asset-light business model, divested non-core operations, acquired intermodal container and services company Boasso, and positioned the company for rapid growth over the next few years.


My estimates and valuations are as follows:


                                    Revenue (mil)             EPS                  P/E

2009A                          613.61                         .07                   na

2010e                          692.9                           .42                   15.43

2011e                          755.0                           .74                   8.76X

2012e                          791.0                           1.00                    6.4X


My earnings estimates are above the consensus, but are below the highest estimates.  The difference is mainly that I have somewhat higher operating leverage assumptions.  Key to my expectations is the high return, asset-light business model in which Quality handles marketing and provides sales, back office/technology, insurance support, as well as leased trailers to Affiliates, or owner/operators who own the trucks and terminals.  Under a typical revenue sharing and leasing arrangement, Quality keeps 15% of the revenue and collects an 8% rent on the trailer.  As Quality has over 1000 unused trailers, and each trailer can generate as much as $100,000 per year, there is the potential to grow revenues by over $100 million and operating profits by $15-20 million with little incremental investment.


Recent performance has been stellar.  Quality has beaten street expectations in each of the last four quarters.  They are expanding market share.  And despite the economic downturn, both EBITDA margins and Cash earnings actually showed year-over-year improvement in ’08, ’09 and 1H’10. Second quarter revenues were up 13.1% and EBITDA improved 34.4%.  Adjusted EPS were 10 cents vs. 2 cents on 2009.  Clearly, the transition is beginning to show some results!


A risk factor is that Quality still has some fairly expensive debt, specifically $135 million in 10% Senior Notes due 2013 and $81 million in 11.75% Senior Subordinated PIK Notes also due in 2013.  Debt maturities before 3013 are modest.  However, with $58 million in LTM EBITDA and Maintenance Capex running around 1% of revenues, I estimate that they can pay off at least $20-25 million of debt per year from free cash flow.


The company filed a $65 million share offering last spring intending to reduce debt with the proceeds.  In light of the subsequent market downturn, the stock went from $8 to under $5, and the offering has yet to be priced.  Management appears to be in no rush to price a deal at these levels.  The stock has begun to recover, and the chart is starting to look pretty good.


 That said, the offering still creates somewhat of an overhang, and it is often a thinly traded stock.  So it makes sense to use limits, perhaps buy half a position ahead of the deal, and complete it once the offering is priced.  Given the company’s market position and management’s excellent execution, shareholders should be richly rewarded.

Disclosure: Disclosure: The author is long QLTY