School Specialty (SCOO): Entrenched Industry Leader Exiting Turnaround and Deleveraging Representing Material Equity Upside

Investment Thesis:  School Specialty is the leading provider of supplies into the preK-12 education market, where is generates a majority of revenue through consumable items and sells into 63% of the total school market and even greater brand visibility on the teacher level.  Through proprietary brands, curriculum services and consumable products as well as a consultative sales and product development approach, the Company has entrenched itself with customers.  The Company entered bankruptcy in January 2013 with a bloated cost structure and high leverage, and emerged 6 months later with a margin improvement plan which has been successful thus far and much more moderate leverage.  The Company has improved margins even while education budgets have remained stagnant and is poised to continue to generate cash if the current environment persists and increase cash generation upon   Due to the bankruptcy the Company’s current EV/EBITDA is ~6.33x (lower depending upon acceptance of certain add-backs), of which leverage accounts for ~3.85x (again, lower depending upon add-backs).  This 6.3x max valuation is a discount based on the aforementioned strengths which lead to positive cash generation that will enable the Company to continue to delever over time.  Furthermore, as the Company continues to delever there could be an opportunity to refinance the high rate ABL revolver (4.00%+) and Term Loan (9.50%).  As outline further below, the Company could generate a sufficient equity IRR of ~13% over 5 years solely through the repayment of debt and a constant EV/EBITDA, while in practice a reduction in leverage along with continued cash generation (which has been improving in recent periods) could result in value expansion as well.  Please note the stock is very thinly traded and about ~63% is held by the top 5 owners (all hedge funds) and as the equity may not trade rationally over the short term.  I have also made various attempts to get into the name and continue to do so however my brokerage has been unable to execute the orders, my order size may be too small so perhaps larger investor with the required risk tolerance would have an easier time.

School Specialty Overview and Background:

School Specialty is the largest provider of non-textbook supplies to the preK-12 education industry in the United States.  The Company was founded in 1959 and acquired by US Office Products in 1996 and spun out in 1998.  In 2005 the Company had agreed to get purchased by Bain for $1.5Bn, however the deal was terminated due to the termination of certain financing agreements.  In January 2013 the Company entered bankruptcy as a result of a bloated cost structure, education budget cuts, a poorly executed new pricing strategy roll-out and overleverage.  In June 2013 the Company emerged from bankruptcy with significantly less debt and a plan to right-size the cost structure.  Soon after emerging from bankruptcy the Company hired a new Interim CEO and in April 2014 hired current CEO Joseph Yorio.  In February of 2016 Steel Partners made a $75/share offer to buy the Company at which time the Company was trading for ~$70/share, the buyout was never consumated.  Today, the Company functions through two primary business units:

Distribution (~85% revenue): The Distribution segment supplies products, solutions and services to the preK-12 market, channel partners, and the healthcare market.  The Company’s Distribution segment is comprised of the following product groups: Supplies, Furniture, Instructional Solutions, Student Organization and Planning Products, A/V and Security.  The Company sells both third party and private label supplies, functioning as a sole source supplier of a number of third party products.  This segment includes a classroom/school design and furniture business.

Curriculum (~15% revenue): The Curriculum segment is a publisher of proprietary and nonproprietary core, supplemental and intervention curriculum in the following areas: Science, Math, Comprehension, Vocabulary, Spelling & Grammar, and Reading & Math Intervention.  The Curriculum segment designs its products to meet state by state standards and will also work with customers to specialize products.

The Company estimates that ~70% of revenue comes from consumable products and that 90% of business is repeat business from existing customers.   Furthermore, the Company estimates that they sold product into 63% of the 137,000 schools in the united states and reached a majority of the 3.1MM teachers in those schools in 2015.  The Company’s proprietary products accounted for ~40% of revenue.  Both business segments sell digital product options.

Key Strengths:

• Market Penetration: The Company estimates that in 2015 it sold into 63% of the ~137,000 schools in its market (US preK-12) and reached a majority of the 3.1MM teachers in those schools.  The Company is the largest non-textbook supplier to this end-market and entrenches itself within customers via proprietary, consumable and specialized products.  The Company’s revenue has been stable since the bankruptcy, growing 1.42% from FYE 2014 to FYE 2015 and 1.93% from FYE 2015 to LTM 9/30/2016.
• Consumables and repeat revenue: Repeat revenue accounts for 90% of revenue and 70% of revenue is generated through the sale of consumable products. This sale of consumables and generation of repeat revenue results in more stable cash flows and further entrenches the Company within a customer’s operations, as the customer must reorder the consumable items each year and can expect consistency through replacing the order with School Specialty.  Furthermore, the Curriculum business provides relatively sticky revenue in that it works with customers to specialize curriculum’s to specialized needs.
• Product Breadth and Depth: School Specialty is the largest distributor of non-textbook supplies to the markets they serve, providing supplies ranging from arts and crafts to science to janitorial supplies, creating a comprehensive supply source for an increasingly sole source focused market. The Company provides over 100,000 items, of which 40% are proprietary products (which generate higher margins) and the Company provides certain third party products as a sole supplier.
• Improved Cost Structure leading to Margin Growth and stable cash flow: EBITDA margins have improved in each period since the bankruptcy as the Company has reduced its bloated cost structure through headcount reductions, reorganization/alignment of business units, realigned base compensation vs. performance bonus system, distribution channel improvements and more.  EBITDA margins from FYE 2014 to LTM 9/30/2016 have increased 1.66% from 5.44% to 7.09%.   Furthermore, throughout this period Free Cash Flow (EBITDA less Interest less Taxers less Capex less Mandatory Debt Amortization) has average ~$9MM.  As the Company continues to focus on paying down debt,  note $36.5MM net debt reduction from 3Q 15 to 3Q 16, interest expense is expected to decline leading to improved cash flow.

Risks and mitigants:

Competition: The Company operates in a competitive and fragmented market, with a majority of players being family or employee-owned, regional companies.  School Specialty is the largest player in this fragmented market with material market penetration and the widest breadth of products.  The Company’s scale allows for competitive pricing, supplier power, and increased resources when compared to smaller local players.  Approximately 40% (~$255MM) of the Company’s FYE 2015 revenue was generated through the sale of proprietary products, meaning aside from solely distribution, the Company’s proprietary business alone is a material player in the industry.

Leverage: The Company’s 9/30/2016 leverage is ~3.77x Senior and 4.20x total (based on ~$45MM EBITDA), with senior and total debt of $172MM and $192MM which represent a $36.5MM reduction in net debt from 9/30/2015.  Additionally the Company refinanced its debt on with better terms in 2015.  The Company’s debt levels are significantly below pre-bankruptcy levels of over $300MM while EBITDA has expanded since.  The Company has and is expected to continue to prioritize debt paydown going forward, which should result in increased equity value conservatively assuming a constant enterprise value (further discussed in valuation section below).  In practice, a meaningful reduction in debt with continued cash flow stability would likely cause valuation multiple expansion.

2013 Bankruptcy: The Company entered bankruptcy due to a combination of factors including state budget cuts, high leverage, and a high cost structure.  Since bankruptcy the Company has realigned it’s salesforce model, integrated disparate departments to optimize efficiency and reduced headcount from 1,450 to 1,180 in 2015, all resulting in an annualized SG&A reduction of ~$20MM.  The Company’s bankruptcy had a negative effect on the confidence of customers in the Company’s ability to fulfill large projects, which primarily effected  the remodeling and construction project revenue, which does not account for a significant portion of total revenue.  The Company has proven the ability to maintain its leading position in the market post-bankruptcy through revenue growth and significant market penetration (estimated at 70% of addressable schools FYE 2016 and 63% for a shortened FYE 2015).  Furthermore, the Company’s post-bankruptcy performance improvements have come well budgets remain muted, which demonstrates that Company’s ability to withstand end market headwinds under the improved cost structure.

Industry and Budget Overview:

Demand for the Company’s products is a function of preK-12 student population, while expenditures on the Company’s products is driven, in a large part, by education budgets.  Historically, this market has been stable and growing, even through historical headwinds in the greater economy (1981-83, 1991-1992, and 2001-2002), while the 2009 recession had a negative impact on education spend.  Total expenditures for public elementary and secondary education decline from $610Bn in 2008-09 to $602Bn in 2011-2012.

In 2014-15 public education funding for school districts came from three primary sources: state funding (44%), local funding (44%) and federal funding (12%).  While the recession resulted in reduced budgets which affected education spend, budgets are expected to expand going forward.  Furthermore, education budget allotment is often tied to the number of pupils which is expected to rise in the coming years, which should positively affect education spend.

While the Company experienced negative performance due in part to the recessions effect on education spend, the post-bankruptcy cost structure and debt levels position the Company for better performance while facing demand headwinds.  As the Company has generated improved performance in a stagnant budget environment, the projected increase in elementary and secondary education spend should positively impact School Specialty.

Valuation:

The Company’s current EV/EBITDA of ~7.06x (on LTM 9/30/2016 Adj. EBITDA of $45.8MM) is comprised of ~4.2x total debt and ~2.4x total equity.  The below analysis assumes conservative EBITDA growth of ~2% annually from 2017 through 2021, as a result of increased cost savings due to reorganizational strategies as well as projected industry growth, all free cash flow is then assumed to pay down debt, while a constant EV/EBITDA multiple is used to derive an equity value in each period assuming no multiple expansion.  As shown this results in relatively material per share equity growth over the projected period, which leads to a ~12.7% equity IRR.

Assumptions:

• 2% EBITDA, Capex, Working Capital, and Taxes growth from 2017-2021.
• Constant EV/EBITDA multiple
• Debt paydown converted to equity value
• Constant shares outstanding

Public Comps: The below public comparables universe ranges from school/offices supply companies to curriculum and education content providers.  As shown the Mean EV/EBITDA of 9.5x is meaningfully above the 7x SCOO valuation, while SCOO’s leverage of 4.20x is 1.7x above the mean leverage level of the comparables universe.

Ownership and Management: The Company has a concentrated and sophisticated shareholder base (see below for top shareholder breakout).  In early 2016 Steel Partners offered to buy all outstanding shares for $75/share when shares were trading ~$70/share, the offer was not accepted.  The sophisticated shareholder base should result in a high level of shareholder accountability, however also results in very low traded volume and could result in extraneous factors leading to price swings.  The below table breaks out major shareholders:

CEO Joseph Yorio assumed the position in April 2014 and made $1.2MM in cash compensation in 2015.  Prior to joining SCOO, Mr. Yorio was CEO and Chairman of NYC Global, a distribution and logistics Company, and CEO of Academi (FKA Blackwater).   The Company’s CFO, Ryan Bohr, has been with the Company since 2014 and prior to SCOO co-founded Torch Lake Capital Partners, a special situations private equity fund.

The Chairman of the Board, James Henderson, was a former executive at Steel Partners, served in interim executive roles at SCOO post bankruptcy and is currently the CEO of  ModusLink.  Mr. Henderson received $133.3k in compensation for his board capacity in FYE 2015.

Conclusion:

               Given the Company’s ownership structure, lack of equity liquidity and prior bankruptcy, School Specialty would only fit in a portfolio with a high-risk tolerance and patience, however given the aforementioned credit strengths and current valuation, the Company is in a position to create long term shareholder value through the continued generation of cash flow and reduction of debt.

Upside Catalysts:

• Continued pay down of debt
• Take Private
• Increase in K-12 spending

Downside Catalysts:

• Forced selling from a fund
• Margin Pressure leading to inability to delever

 

Disclosure: I am long SCOO

Transcat, Inc: Leading non-discretionary service provider at attractive valuation

Transcat Inc. provides non-discretionary services and products to over 25k customers in a diverse range of end markets.  The Company provides calibration and other services for testing equipment to the pharma, biotech, aerospace and defense, energy, utility, industrial and other industries.  In recent years the Company’s service segment has grown to comprise a majority of revenue versus the value-added distribution segment.  The below article provides a comprehensive overview of the opportunity, including the major strengths of the Company, mitigation of risks, a valuation discussion and a more in-depth discussion on the Company, its customers, end markets served and competition.

http://seekingalpha.com/article/4037912-transcat-inc-undervalued-leading-non-discretionary-service-provider-executing-roll-strategy

 

National Presto Industries (NYSE: NPK): Two undervalued business units with a very clean balance sheet and 4.7% dividend

National Presto Industries (NYSE: NPK) is comprised of two distinct operating units, a defense business and a housewares/small appliances business, and currently trades at a 9.1x EV/EBITDA.  The Company also recently divested a third business, Absorbent Products, which was historically a drain of cash on the combined business.  The attached presentation (below) provides an overview of the remaining businesses, the upside valuation potential, downside risk mitigation, and opportunities for the business to realize greater value going forward.

Click Here for NPK Presentation: npk-v2

HNZ Group: Revenue Diversification, Healthy Margins and Clean Balance Sheet on Industry Leader at a Discount

Note: $ is CAD, unless otherwise noted

Thesis:

HNZ Group has a clean balance sheet and has adequately controlled costs during sustained softness in what was historically its primary end market of onshore energy industry transportation.  The Company has also diversified revenue by product/service, end market and geography throughout this period, which should contribute to revenue stability and potential growth, positioning the Company to weather continued headwinds in the energy market.  The Company is one of the strongest players in the space financially, and could use this to its advantage to win contracts away from financially distressed competitors and opportunistically approach discounted acquisitions of assets.  Furthermore, the Company’s current valuation (4.1x EV/EBITDA,) is well below a number of peers and below asset value (0.67x EV/PPE 11/16/2016), in part due to concerns about Onshore demand which the Company has diversified away from.  As such, HNZ could represent value upside, as the Company continues to stand-out financially and operationally and capitalize on the aforementioned industry dynamics, as well as the potential to get into a healthy name at a discount that has been known to distribute cash to shareholders when available (or reinvestment the cash if compelling investments are available).  Even with sustained end market stagnation, HNZ could experience growth through taking contracts from financially unstable competitors.  As CEO Don Wall said in a July, 2016 interview with Edmonton Journal, “We have cash in the bank, we have positive cash flow, we trade at a very low multiple and we have some competitors that are weak.  So I think we’re going to be able to capitalize on some of that.”  From a catalyst standpoint the Company could stand to gain from a rebound in energy prices increasing demand or sustained energy headwinds negatively impacting more highly leveraged competitors allowing HNZ to take market share.

Brief Company Overview:

HNZ Group Inc. (“HNZ” or the  “Company”) (TSX: HNZ) provides helicopter transportation and related support services, as well as helicopter maintenance and repair services, globally.  The Company provides its services through three primary segments: Offshore Helicopter Transportation (~43.8% LTM 9/30/16 revenue), Onshore Helicopter Transportation (~33.0%), and Ancillary Services (Repair and Maintenance primarily) (~21.2%), with other revenues accounting for ~2% of revenue.  The Company serves its customer through a 120+ owned helicopter fleet.  The Company’s customers operate in various end markets, including: Oil & Gas (O&G), Search and Rescue (SAR), Fire Suppression, Defense, Leisure, and other Commercial and Industrial end markets.  The Company operates in the United States, Canada, Australia, Asia, New Zealand, Europe, Antarctica, the Middle East, and Asia.   HNZ as it is known today was formed in 2011 when Canadian Helicopters Group purchased Helicopters NZ Limited for $127MM and assumed the name HNZ Group.  On June 1, 2015 HNZ acquired a 49.9% interest in Norsk, a provider of helicopter based services to customers in Norway, for $4.02MM.  Additionally, the Company made an investment by creating Acasta HeliFlight to provide specialized transportation services in Northern Canada for a variety of needs (industrial & commercial).

Due to softness in the O&G industry occurring concurrently with the roll-off of a DoD contract in Afghanistan in 2014 and 2015, top-line performance experienced reduced demand in 2014 and 2015, with revenue declining 18.7% and 9.1%, respectively, while  LTM 9/30/2016 experienced 11.4% growth over FYE 2015.  To preserve the Company’s cash flow and strong balance sheet, the Board decided to suspend the Company’s dividend payments in late 2015 (affecting 2016 expected dividends). As noted, the Company operates with a very clean balance sheet with (as of 9/30/16) $15.6MM cash, $36.2MM AR, $42.6MM Inventory, $193.4MM PP&E, and $30.5MM AP, while the $125MM revolver is undrawn.

In addition to preserving a clean balance sheet the Company has been partially successful in diversifying revenue with the growth of the Offshore and Ancillary Services businesses, therefore reducing reliance on the historically largest component of revenue, the Onshore segment.  This diversification is coming at an important time, as Onshore revenue is experiencing the greatest impact of the O&G downturn, leading the Company to a non-cash trade name impairment related to the Canadian Onshore unit of $17.4MM ($15.1MM net tax impact).  In 2015, The Company won a contract from the US DoD in support of the North Warning System which could contribute as much as US$61MM in the next 5 years as well as Shell contract in Canada to support an offshore project (which included the Company’s first SAR operation .  Revenue diversification combined with cost control helped the Company post a surprise $0.12/share first quarter profit in 2016.

Management has shown dedication to maintaining a strong balance sheet and cost discipline.  Management has dealt with cash flow in multiple ways historically, which shows that at a minimum they are cognizant of the need to efficiently deploy excess capital:

• Growing Cash Balances: In recent periods the Company has suspended its dividend and grown cash balances by ~$10.8MM in ~2.5 years. Though this does not appear to be the most attractive decision for shareholders, this could prove a value enhancing decision for two reasons: (i) the Company could use cash to purchase assets from distressed competitors or invest capex to win contracts away from these competitors without having to leverage up and (ii) liquidity could be necessary if the downturn in certain end markets is sustained and a greater macro-economic event negatively impacts other end markets.
• Acquisitions/Investments: Though the Company has not made any particularly large acquisition moves, the investment in Norsk demonstrates managements opportunistic approach to deploying capital for long term growth.
• Dividends: Although the Company suspended dividends coming into 2016 to preserve cash flows, the Company had paid out $1.10 per share annually in the years leading up to 2016, demonstrating managements willingness to return capital to shareholders in times of unattractive reinvestment opportunities.

Risk Overview:

Primary Risk- Sustained Downturn in Primary End-Markets: The sustained softness in Company’s primary end-market, O&G, which could persist into the near future or beyond, has had a material impact on the Company’s performance with revenue down 26% from FYE 2013 to FYE 2015 and EBITDA margins down 18.75% in the same period.  As mentioned the Company has been able to diversify revenue away from the most affected unit (Onshore) to the Offshore segment (which provides transportation to Offshore O&G projects that have been, to an extent, less impacted recently) and Ancillary Services, which led to revenue growth of 11.4% LTM 9/30/2016 over FYE 2015 and EBITDA margin expansion of 4%.  The Offshore segmented has grown at a 20% CAGR in the one and a three-quarter years to LTM 9/30/2016 due to a relatively more stable end market (than Onshore) as well as international diversification, including the investment in Norsk which provided a meaningful presence in a very active off-shore market.  The Offshore segment has demonstrated the ability to win meaningful contracts, as evidenced by a 2-year ~$20MM Shell contract in Canada, which included the Company’s first SAR operation.  The Ancillary Services segment (which houses an attractive maintenance and repair operation) has grown at an 15.6% CAGR from FYE 2012 to LTM 9/30/2016 as the Company generates increasing revenue from HeliWelders (Canada), Nampa Valley Helicopters (United States) and HNZ Topflight, a flight training center located in Canada.  Through HeliWelders and Nampa the airframe repair and maintenance and repair and overhaul services for various helicopter models.  This segment provides maintenance, airworthiness and instructional support to the Contracted Flying and Training Services Project with the Department of National Defence (Canada).  Management is currently positive about new opportunities, noting that the Company is currently tracking 14 qualified opportunities as follows: 8 production, 4 exploration, 1 ring pilot and 1 SAR.

The Company’s clean balance sheet, ability to scale capex (which has gone from 16% and 14% of revenue in FYE 2012 and 2013, respectively, to 4% and 5% of revenue in FYE 2014 and 2015, respectively) and cost cutting initiatives combined with the aforementioned revenue diversification have enabled HNZ to weather material industry headwinds and grow cash from $4.2MM FYE 2013 to $15.6MM LTM 9/30/2016.  While the suspension of the dividend is not typically attractive, it is preferential to preserve the balance sheet and cash flow and avoid being dragged down by overleverage like major competitors (notably CHC).

Additional Risks:

Contract Rolls: The Company does not make public their contract waterfall, and therefore an investor there is the risk that a material portion of contracts could expire in a near term time window.  IF this were the case, recent contract wins give comfort that company is able to competitively bid for new business.  Although financially distressed competitors depress profitability on contract renewals, these competitors could not do so indefinitely and the Company has shown the ability and has the capital structure to scale fixed costs to weather demand interruptions.  Furthermore, the Company’s competitive and financial standing should allow them to win contracts away from distressed competitors as they provide surety of execution or competitors are unable to bid during workout processes.  As demonstrated in revenue growth of 11.4% from FYE 2015 to LTM 9/30/2016, the Company has been able to win new contracts in current conditions.

Temporary PP&E Value Decline: A macro-economic decline or further decline in certain end markets could cause an environment in which helicopter transport demand is meaningfully lower than supply, therefore affecting helicopter values, especially if an influx of helicopters come up for sale as struggling competitors look to generate cash.  HNZ is insulated from this risk due to a number of factors, including aforementioned low fixed costs/variable cost structure and relative diversity of end markets.  Furthermore, as the Company has shown the ability to withstand demand headwinds, they could likely avoid a scenario in which they would sell assets before prices began to normalize.  Additionally, the Company has historically realized a gain on helicopter sales above book value, indicated there might be a level of cushion for prices to drop before losses on asset sales would be booked.

Customer Concentration: The Company’s top two customers account for 19.7% and 11% of FYE 2015 revenue (Shell and Rio Tinto).  The Company’s performance going forward depends on its ability to continue to service these customers and win contracts with new customers.  The Company has demonstrated this ability with wins in various end markets over the past year (North Warning System and Shell Canada for example).  The Company’s diversification across operating units and geographies should reduce reliance on individual customers in the future.  Additionally, the relatively precarious financial positioning of a number of industry players (namely CHC who is going through Ch. 11 proceedings) should provide the Company with an advantage in bidding for a number of contracts on which these companies would historically typically represent competition, as customers will take into account the bidders ability to continually meet the contracts needs.

Currency Risk: The Company lost $0.82MM, $1.1MM and $1.1MM on FX in FYE 2015, 2014, and 2013 respectively.  Due to arrangements with both foreign based suppliers and customers the Company is exposed to fluctuations in the US Dollar, New Zealand Dollar, and Australian Dollar.  Approximately 42%, 10% and 4% of the Company’s revenues are earned in USD, NZD and AUD while 47%, 9% and 4% of expenses are paid in the currencies, respectively.  The Company relies primarily on a “natural hedge” to mitigate the associated currency risk and does not have forward contracts.  If the Company continues to lose money on FX losses, it could benefit HNZ to enter into formal hedging arrangements.

Foreign Equity-Owner Voting Cap: Per the Company’s filings (and Canadian Transportation Agency (CTA) regulation) 25% or less of votes cast can be accounted for by non-Canadian shareholders, and if more than 25% of votes cast come from non-Canadian shareholders, the votes above that threshold will not count.  Furthermore, non-Canadian ownership would require an exemption from the Minister of Transportation, Infrastructure and Communities (for an example of this see Canada Jetlines June 13, 2016 letter to the Minister (which received local support) or Alpine Helicopters history, which received exemption in 1999 and was notified of termination of exemption/non-renewal effective 12/31/2012).  Though these regulations do not have a significant impact on the continuing operations of the Company, it could affect the Company’s ability to attract a buyer if at any point the Company believes it could realize the most value for shareholders via a sale.  An interested buyer could however pursue a structure that conforms to these regulations or seek an exemption from the Minister.  Additionally, there is talk that Canada could follow the EU’s lead an increase the foreign ownership limit to 49% (which would still prevent majority ownership by non-Canadian). UPDATE: Recently changes to this regulation allow foreign ownership up to 49%, however no individual foreign owner can hold above 25%.

Strength Overview:

Clean balance sheet, with relatively low fixed costs, and variable capex: As aforementioned, the Company has remained steadfast in preserving a strong balance sheet, with CEO Don Wall commenting in a recent Edmonton Journal article, “Debt is a killer and we are very mindful of that.  We see it all the time in our business.  Guys get hungry.  I don’t know if they want bragging rights or what, but they just overpay for things.”  In addition to a nearly debt-free balance sheet, the Company has shown the ability to scale capex (presumably due in part to its correlation with flight hours which are down) and have initiated additional cost saving measures to preserve cash flow (including the suspension of the Company’s dividend which had been $1.10/share annually for the past 5+ years and a reduction in executive management compensation, though some may argue this was too high in previous periods).  This balance sheet and cost-control discipline has enabled the Company to maintain what could prove to be an important advantage over competitors (see below for further detail on competition).

Revenue diversification by product/service, end market, geography: As aforementioned the Company has been moderately successful in diversifying away from onshore energy reliance in recent years, contributing to 11.4% revenue growth from $188.7MM FYE 2015 to $213.4MM LTM 9/30/2016.  Revenue diversification is highlighted with Onshore revenue accounting for 50% of revenue FYE 2014 declining to 33% of revenue LTM 9/30/2016, while Offshore revenue increase from 32% of revenue to 43.8% of revenue over this period and ancillary service revenue grew from 15% of revenue to 21.2% of revenue. Though softness in end markets has had a material impact on top-line and margins, the growth of the Offshore and Services businesses have contributed to revenue growth of 11.4% from FYE 2015 to LTM 9/30/2016, as Offshore and Ancillary revenue grew 17.7% and 12.7% in this period, respectively, while onshore lagged with growth of 2.1% in the same period.  The Company’s 49.9% investment in Norks represents entrance into an attractive and active offshore market with a local brand name.  The Maintenance and Service revenue growth is particularly attractive as this growth should be even further removed from a continued decline in O&G or a greater macroeconomic downturn.  The Company’s recent contract renewals/wins demonstrate the success of diversifying away from Onshore revenue:

• Offshore: North Warning Systems 5 year (requiring renewal every sixth months) (2015) ~US$61MM
• Offshore and SAR: Shell Halifax 2 year (2015) $20MM
• Offshore: New Zealand Consortium 5 year contract April 2016 $60MM+
• Offshore: Five year extension on Shell Philippines (2016) $61MM+ (USD$47MM+)

Competitive Positioning and Barriers to Entry: At 0.17x HNZ is the lowest leveraged among its peers, with the next lowest leveraged, Air Methods (which operates predominately in the air medical space) leveraged 3.02x.  HNZ is also a leader amongst the below peer group in ROA, with the second highest ROA behind Air Methods, and EBITDA Margin, behind only Air Methods and Era Group, while HNZ is ranked last by EV/Revenue and EV/EBITDA.  The overleverage of a number of competitors combined with sustained demand headwinds has caused at least one bankruptcy already (CHC) and has the potential to cause further damage (Gulfmark, Erickson, among others).  HNZ’s positioning among the most financially strong industry players could afford the Company the opportunity to bid competitively on contracts that have historically been won by these financially stressed competitors.  An additional opportunity that could present itself as some debt-burdened competitors work out their financial future could be the opportunity for HNZ to purchase some assets at a discount, for instance CHC’s restructuring plan is expected to reduce the CHC fleet from ~230 helicopters to ~75, while other non-chopper assets, especially in the MRO space, could represent a compelling acquisitions target (ex. CHC Heli-One MRO unit).  In addition to a strong competitive positioning, the Company operates in an industry with material barriers to new entrants including the upfront capital costs of building a fleet, the limited supply of pilots (which according to certain publications there is a pilot shortage, ex. see Multibriefs 3 part 2015 article “The perfect storm for a pilot shortage”), and the regulatory governance of the industry and industries served. (comps as of 6/30/2016)

HNZ Group- 16% EBITDA Margin, 4.58x EV/EBITDA, 0.17x Leverage, 3.04% ROA

Era Group- 19% EBITDA Margin, 7.92x EV/EBITDA, 5.07x Leverage, 0.002% ROA

CHC Group (BK)- 2.10% EBITDA Margin, 64.02x EV/EBITDA, 62.48x Leverage, -3.7% ROA

Air Methods- 27% EBITDA Margin, 6.72x EV/EBITDA, 3.02x Leverage, 8.51% ROA

Bristow Group- 11% EBITDA Margin, 8.8x EV/EBITDA, 6.9x Leverage, 1.3% ROA

Discovery Air- 13.5% EBITDA Margin, 9.35x EV/EBITDA, 9.1x Leverage, 0.64% ROA

PHI Inc- 16% EBITDA Margin, 5x EV/EBITDA, 5x Leverage, 2.0% ROA

Gulfmark Offshore- 8% EBITDA Margin, 33x EV/EBITDA, 31x Leverage, -2% ROA

Erickson Inc- 14% EBITDA Margin, 13.3x EV/EBITDA, 13.2x Leverage, -.6% ROA

Asset Value: The Company’s PP&E (primarily helicopters) as of 9/30/16 was $193.4MM, while the Company’s EV as of 11/16/16 was $128.8MM, representing a TEV/PP&E of 0.81x.  Additionally, as book depreciation on helicopters can often exceed actual deprecation, the Company has realized gains on asset sales in each period since 2013.  If HNZ was to trade solely at book value of PP&E the Company would trade at a ~14% premium to today ($13.00 today), however given aforementioned growth prospects the stock should trade higher.

Ownership and Executive Compensation Overview:

• The top two shareholders with 18.85% and 18.50% ownership are Fonds de Solidarite FTQ and Sentry Investments Corp., both Canadian asset managers. The third largest shareholder, Canadian Asset Manager 1832 Asset Management, holds ~13.77% of outstanding shares.  The top shareholder, Fonds de Solidarite, has retained its equity in the Company since partnering in a management buyout of one of the legacy companies in 2000 (prior to going public).
• Management and insiders own ~5.4% of outstanding shares, with CEO Don Wall being the largest of these holders with ~3.98% of common stock outstanding.
• CEO compensation is down considerably FYE 2015 to $635k, from $1,192k FYE 2014, which represented a reduction from FYE 2013 CEO compensation of $5,520k.
• Compensation for other executives (including EVP of International and COO) has been reduced (at a lower % level) over the same period.
• Of the 6 person board (including the CEO), two members joined in 2013 and 2014 (1 each year), with the remainder of the Board joining in 2007 or prior. On a whole the Board members seem to have relevant industry experience.  Board Members received between $61.3k and $143.4k in compensation in FYE 2015.

 

Upside Catalysts:

• Ability of HNZ to capitalize on financial distress of competitors and win material contracts globally, .
• Rebound of energy markets positively impacting demand in Onshore and Offshore segments.
• A buyer recognizing the ability to purchase an attractive business with material collateral coverage at a discount due to demand headwinds which the company has been adequately mitigating.

Downside Catalysts:

• Further material decline in energy industry, primarily if low-cost high-activity offshore energy experiences a material decline.

Sources:

Company Filings

Capital IQ

Edmonton Journal

Canadian Transportation Agency

Multibriefs

Helicopter Magazine

Earnings Call Transcripts

CNW- a Cision company

 Disclosure: I am long HNZ Group.