Monday, July 14, 2008

Ritchie Brothers: Fully Priced

Ritchie brothers (NYSE: RBA) is a great company. Does that automatically make it a buy? Absolutely not. Great company or not, in order to qualify as a buy for us, a company must be trading at a discount to its intrinsic value.

In the last five years, the stock is up 500%, while earnings are up "only" 300%, suggesting a lot of the value in this company has been recognized recently. Obviously it's not sustainable for a company's stock price to constantly outperform its earnings, so in a situation like this you want to be sure the company still has a margin of safety despite its price run-up.

The company appears to have great earnings potential going forward, however. RBA is a global company currently claiming only a 3% market share of the world's commercial used truck and equipment market. Despite this, the company claims to be larger than the combined value of its 50 closest competitors, leaving it both the strength and the opportunity to grow!

Ritchie appears to be trying to take advantage of this opportunity, heavily investing in acquiring new auction sites. They appear to have existing relationships with both buyers and sellers of industrial equipment, which makes it tough for competition to turf them. They plan to grow EPS at 15% per year by gradually adding auction sites around the world.

With this in mind, my valuation of the shares comes to around $25, which is close to where it trades today.

However, there are some risks with RBA. This is a high fixed-cost business, requiring investment in personnel, offices and permanent auction sites. That means when sales aren't as high as forecasted (say in a downturn, or something unexpected happens), the company can't just scale down its costs accordingly, as it has fixed charges it has to maintain in order to remain effective. However, it has mitigated this effect to some extent by spreading itself out geographically.

But to increase shareholder value, management has plenty of room to improve its capital structure. Even though it has some $320 million in land and buildings at book value (most likely a conservative statement of their market value), they carry only $45 million in debt. Although this is the safest way to do business, they could easily triple debt levels and still have great interest coverage and high levels of equity in their properties. But this would allow them to take better advantage of cheaper capital and the tax shield offered by interest payments and thereby increase shareholder value above that which it trades today.

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