jebmo’s posthaven

ECN Capital trades primarily on the Toronto Stock Exchange under the ticker ECN.

ECN Capital (OTC:ECNCF) is a quintessential Joel Greenblatt opportunity. It is a seemingly complex, leveraged, spin-off. The share price has suffered due to constrained and poorly informed counterparties dumping stock for uneconomic reasons, typical of the price action seen following spin-off transactions. The chances of price dislocation are further increased when considering its relatively small market capitalization (~$1.3B CAN) and that it trades on the TSX. But one only has to look at the insider activity to know what they must think of the transaction: for example, the former CEO of Element Financial, Steve Hudson, has become the new CEO of ECN and has loaded up on ECN stock through open market transactions at these depressed prices.

On October 3rd, 2016, Element Financial split into two companies:

1) Element Fleet Management: This company is focused on leasing and management of large fleets of very uniform asset types. It focuses on generating consistent earnings and its mandate is narrow. It made up about 80% of the equity of the former company. Its earnings growth will come organically by increasing fleet management services over time.

2) ECN Capital, is the ugly duckling: Assets including C&V (commercial and vendor), Rail and Aviation. Thus, financing a very broad range of asset types and exercising a broad mandate to seek growth opportunities. It is looking to acquire assets, securitize assets and collect asset management fees, or outright sales. It will capitalize on any instance where opportunity and competence intersect.

Its competitive advantage comes from the fact that it works in partnership with the vendor so that they can offer customers convenient financing options at yields which are attractive and meet their cost of capital. For example, its relationship with Trinity Industries (NYSE: TRN), the leading NA railcar manufacturer, gives it direct access to high quality customers interested in a broad range of railcar types. In its C&V business, ECN's sales staff are co-located with the vendors, it doesn't have a network of standalone retail offices like bank branches.

ECN knows the leasing and financing industry well; for example, CEO Steve Hudson has been doing this for over 30 years. This is his third time at the helm of a specialty finance company. His adventures began in the 1980s with Newcourt. In his first instance leading a finance company, things did not end ideally because of the structure with which the business was capitalized. In retrospect, he refers to commercial paper as the "heroin" of financing because it was all fun and games until, reportedly, in March 1998 when the cost for borrowing shot up 2.4% overnight due to political turmoil in Russia. His lesson learned is to match the term of the debt with the assets being financed. The second time was with Element Financial which was much more successful as can be seen from the stock performance from inception up until the date of the spin-off. Now that Element has morphed into a fleet management business that is increasingly getting its revenue from services, he is basically now doing it all over again with ECN. The following two links do a very good job summarizing Steve Hudson's history so I won't go into all the details and will just refer the reader to these.

(Financial Post report)

(Globe and Mail report)

Of course, when Element Financial was split into the Fleet and ECN, Mr. Hudson also received his ECN shares because of his previous Element Financial holdings. However, in November 2016, he divested a substantial portion of his remaining Fleet shares to use to proceeds to purchase additional shares of ECN. "These transactions re-balance my holdings in ECN Capital and Element Fleet Management so that they are now approximately equal and continue to represent the largest single investments in my portfolio," Steve said about the transaction. The rebalancing is a vote in favour of ECN because if he had not rebalanced, this would not have raised any eyebrows. If anything, the rebalancing was slightly controversial as it was achieved by selling Fleet Management stock. According to SEDI, Steve Hudson currently holds over 10 million shares of ECN.

Much of what Element Financial achieved was through accretive acquisitions. So, when ECN management says they plan on growing a business in a domain for which they are clearly competent, by using the same strategy as they always have (as Element Financial), this is a highly probable scenario. The difference is, that due to the spin-off, they are now (re)starting from a smaller asset base, so that investors can benefit in greater proportion from the transactions.

Element Fleet Management, March 2017 Investor Presentation

What you are buying when you buy ECN Capital are diversified assets that produce highly recurring revenue, a highly experienced and aligned management team (the combination of which creates a great platform) at a significant discount to book and no growth premium.

Sale of US C&V

On February 21st, ECN announced the sale of its US Commercial and Vendor business to PNC at a 16% premium to the $1,391M book value. At the same time, it announced the monetization of a further $392M from its trucking business. It effectively monetized over 20% of its assets and increased book value by 10% in one day as result of the premium that it achieved. Does this sound like a company that should be trading below book value?

ECN Capital, February 21st Analyst Update

Upcoming Sale of Rail Assets

It will likely be funding its business further using its rail assets. As mentioned in the Q4 conference call:

"we are currently evolving optimal ownership structures for our (RAIL) business with interested parties," Steve Hudson said.

This is to say, it will be selling rail assets using a structured vehicle that will enable it to collect a premium and management fees. And this will likely be happening in the coming quarter. It had previously guided that it was going to be in the first quarter of 2017. In the conference call, an analyst asked them about timing.

"all I can say to (sic) this evening is that, there's lots of interest on rail cars… So we apologize for being a quarter late. But our job is to maximize value and there's broad interest in these assets in and outside of funds." David Mckerroll (President, Rail) said.

Implying a sale will be announced the coming quarter. As will be shown below, this will also be sold at a premium to book.

Valuation

Now that it appears that the forced selling has subsided, the current price may be more reflective of current earnings. However, if the non-recurring costs associated with the separation from Element Financial and various other one-off costs are removed, then this moderates to a P/E of 14. Not bad but hardly a screaming buy.

The undervaluation is most apparent when looking at the book value. There are several data points that can be relied upon to substantiate that the book value is reflective of the market value. As mentioned earlier, the recent sale of its US C&V portfolio, a sale of over 20% of its assets at a premium, is one data point. The other is that it recently communicated that it reviewed its assets values and confirmed values meet or exceed current book values when based on recent market transactions.

Q4 2016 Conference Call Presentation

I have, for convenience, taken the data from its Q4 2016 balance sheet and adjusted its assets to account for the sale of the US C&V business. One can see the very low level of intangible and non-operating assets on its balance sheet.

The $542M of cash returned to the company through the C&V sale (after settlement of liabilities) has helped fill the war chest. With leveraging the company has mentioned, it now has the liquidity (and intention) to acquire up to $3B in additional assets.

However, let's consider the most prudent use of capital, a buyback. Currently, one can buy shares for about 70 cents to the dollar; however, under this scenario (i.e., highly accretive $542M buyback), you are getting shares for 60 cents on the dollar.

I am not implying that it would execute a buyback, but it certainly sets the bar in terms of opportunity cost of any use of cash. Any allocation of capital will result in shares being undervalued by at least 40%

And the 60 cents on the dollar figure is based on book value,

1) it does not include off-balance sheet assets, i.e., fees that it collects on its managed asset fund, ECAF,

2) it does not include any premium to the rail assets, or otherwise

3) it does not include any growth premium

But, as Charlie Munger has said, "If we see someone who weighs 300 pounds or 320 pounds, it doesn't matter - we know they're fat."

However, let's pull out our scale and find out just how fat ECN is. Below is a slide extracted from its Q4 conference call. It demonstrates the diligence with which ECN has been evaluating potential deal targets.

The benefit of an acquisition versus a buyback would be the opportunity to subsequently securitize the assets and get the subsequent fees and gains associated with this process, similar to what it will be doing with its rail assets.

Further to the type of business that it is looking to acquire, the following quote was particularly helpful from its Q4 conference call:

"we look for businesses that have got, they got sustainable ROEs and that 12% number you referenced both stacks as our target. In some cases, the platform has lots of growth, you might back that down a point or two, but you need to see the growth to drive between levels higher than that. And as we all know the ROE is a function of ROA and leverage. We like to play and I will call prime or super prime assets we're not a sub-prime player.

So, we look for leverage is in the 4:1 and some of that to is looking at little higher leverage, which will drive higher ROEs over the mid to long term. So, I think we're confident - we're comfortable with that target. And so, I would hope we would do much better over the longer term. But that target for ROE is fine over the mid to long term with the exception that if you do a deal, you might come down a bit, but you have to see a clear path through to how to get it back to plus 12"

With that in mind, let's look at how a 12% ROE ($542 in Equity, $3B in assets, as they have mentioned) business would transform ECN,

Post-acquisition, it will achieve a blended ROE of 7.4%. This is just about, or slightly above its cost of equity. For example, its preferred shares yield 6.5%. This now means, on an earnings basis, that its equity should be trading at, or slightly above, book. This still does not account for future growth after the acquisition. However, post-acquisition, the market will have built confidence in management and a slight growth premium for the assets is then expected and warranted. This further justifies that these assets are at least a 40% discount to intrinsic value.

There you have it, whether on an earnings basis or looking at assets, shares are trading at least at a 40% discount to intrinsic value. This implies a fair value of $5.66. Compared to a current price of about $3.4, it implies a 66% return. Because management has given themselves 12 months to complete their acquisition, that is my target price for within the next 12 months.

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