Redde Northgate (LON:REDD): a classic value opportunity?

With a new Prime Minister in place and perhaps some semblance of stability returning to financial markets, I’ve been hunting through the StockRanks for potential contrarian buys. In other words, stocks with high quality and value ranks, but lower momentum scores.

You can find a list of high QV Rank stocks here.

One company that’s caught my eye is Redde Northgate (LON:REDD) - the FTSE 250 vehicle hire and accident repair group.

Redde’s share price has fallen sharply this year:

This slump has left the stock looking potentially cheap, with a dividend yield that’s slightly higher than its P/E ratio. As Paul commented in September, this combination is a rare find these days, especially with rising earnings.

As it happens, I already own Redde Northgate shares in my rules-based SIF folio. But in truth, I’ve never had a very strong conviction about this business. However, I’m starting to think that a more optimistic view may be justified.

A positive mix

Redde Northgate was formed in early 2020 when van hire specialist Northgate merged with accident management group Redde.

Northgate has been a beneficiary of the broader market shift from vehicle ownership to rental. By leasing their van fleets, operators can offload responsibility for many non-core activities. Leasing or rental may also reduce balance sheet debt.

Today, Northgate owns or leases around 126,000 vehicles and supports a further 600,000 managed vehicles in the UK, Ireland and Spain.

Redde’s focus is on providing accident management, fleet management, repair and legal services to UK insurers and fleet operators.

Northgate is much larger and more profitable than Redde:

Source: REDD FY22 results

However, I’m starting to think that in addition to creating cross-selling opportunities, the addition of Redde has given the business a more defensive profile.

Hire demand from some sectors might ease during a recession. But I’d imagine that with clients such as Tesco and Admiral, demand for accident management and repair services might be more consistent.

According to the company’s most recent update, demand for claims management and repair services has rebounded as traffic levels have returned to normal. Management say they’ve seen little sign of any impact from high fuel prices or recessionary fears.

It’s too soon to be sure, but barring a very severe recession with a sharp rise in unemployment, I don’t see much reason for traffic levels to drop.

A good, cheap business?

I mentioned Redde Northgate’s cheap rating and high yield at the start of this piece. A forecast yield of almost 7% and a P/E of 6 may certainly be tempting, but they’re not enough in themselves to justify a high QV score.

To get a fuller understanding of the fundamentals, I’d like to look at the firm’s quality and value metrics in more depth.

Assets: Redde’s latest balance sheet showed net tangible assets (mainly vehicles) of 279p per share. With the stock at 318p as I write, the current market cap is almost fully backed by physical assets.

Free cash flow: Redde Northgate generates plenty of cash, but it also uses plenty. The accounts present two main cash metrics:

• FY22 steady state cash generation: £216.4m
• FY22 free cash flow: £12.3m

The steady state figure excludes too many items for my liking, including interest and tax costs. However, I accept the logic in excluding growth capex, which can vary widely from year to year.

Stockopedia’s data provider gives a figure of 29p per share for 2022 free cash flow.

My calculations give a more generous 50p per share. In either case, I’m happy that last year’s dividend of 21p was covered by free cash flow (excluding growth capex).

Debt: Hire businesses tend to use a fair amount of debt to finance their fleets. One metric I like to check is the loan-to-value ratio. I see this as a good indicator of debt sustainability. Helpfully, REDD provided this information as part of a snapshot of its financial covenants at the end of last year:

Source: FY22 results - financial covenants

All of these ratios look quite acceptable to me. Although bear in mind that net debt/EBITDA ratios can inflate quickly if there’s a reduction in EBITDA. This might happen if Redde’s fleet utilisation drops in a recession, for example.

Quality & profitability: As a hire business, profit margins are never likely to be sky high. But Redde Northgate’s latest numbers look quite respectable to me.

One caveat to consider is that last year’s vehicle supply shortages will presumably have boosted Northgate’s pricing power. Over time, I’d expect this effect to ease. Broker forecasts seem to reflect this view. Estimates I’ve seen suggest the group’s operating margin will fall back to between 10% and 11% over the next couple of years.

Risk factors

I feel more positive about Redde Northgate’s business model and financial qualities than I have in the past. But I can still see some potential concerns.

Used vehicle residual values are now starting to soften, according to the company. The supply of new vehicles is slowly improving and I’d guess that some businesses may be starting to postpone vehicle purchase decisions.

If declining residuals are echoed by weaker rental demand, margins and earnings could come under pressure.

Finance costs may also rise, as the group’s main bank facility rate is linked to leverage. Fortunately, management completed a timely refinancing last year. The group’s overall interest rate was just 1.9% at the end of April.

On the claims management side of the business, regulatory change is a possible concern. Recent new rules relating to soft tissue injury claims (whiplash) have already reduced the profitability of this sector. Other changes might be possible in the future.

My verdict

I don’t think investors can escape the cyclical risks inherent in this business. But I’ve become more comfortable with the rationale for the merger and am cautiously optimistic about the growth potential of the combined group.

Fundamentally, the business seems to be in good health – a view reflected in the high F-Score:

With the stock trading on less than seven times earnings, a cautious outlook already seems to be priced into this stock. The forecast dividend yield of 7% implies that the payout should be covered twice by earnings, reducing the likelihood of a near-term dividend cut.

On balance, I can see quite a lot to like here, although as always these are only my thoughts. In such uncertain times, it’s doubly important for investors to DYOR and form their own views.

Disclosure: Roland owns shares of Redde Northgate.