What's gone wrong inside the Eroad business?
One of the things I haven't been able to shake off since my last dive into Eroad's affairs is that it's aiming to maintain its market share in the North American market.
Now that might be an admirable aim for a well-established market leader facing fierce competition to displace it in a market.
But for an upstart, supposedly disruptive, technology company that currently holds, on its own numbers, less than 2% of the $10 billion total addressable market?
Chair Susan Paterson told me it was a matter of ensuring Eroad didn't grow faster than its ability to manage that growth.
True, that still does mean actual growth, since Eroad estimates the market is growing at between 11% and 13% a year – it estimates the North American market will be worth $22 billion by 2030.
But it still strikes me as a singularly unambitious goal.
It also reminds me of Xero's situation in the North American market for small business software and nobody, including Xero itself, finds its current small share of the market acceptable – it's between about 3% and 5%, depending on whose numbers you believe.
Xero dominates its home markets of New Zealand and Australia (as well as Britain) and similarly, Eroad commands about 80% of the NZ market for transport telematics.
Whatever its aspirations, Eroad's shareholders, particularly its retail shareholders, delivered a resounding vote of no confidence in their company last week.
Shareholders' verdict
More than 73% of retail subscribers refused to participate in the latest $50 million capital raising.
The shares had been offered at 70 cents each and the market price of the shares fell as low as 65 cents last week. From $1.39 ahead of the capital raising announcement.
It's an astounding change in sentiment compared with Eroad's previous capital raising in August 2021, just after it announced its plan to buy the Coretex business.
The company was then offering retail shareholders up to $16.1 million worth of shares and received applications for nearly $43 million, ending up accepting $20 million. Shareholders participating paid $5.58 per share. That retail offer was not underwritten, unlike the current one.
In this latest capital raising, the underwriters were forced to take up 33.6 million shares, or 47% of the $50 million raised.
It's all the more remarkable when you consider the 70 cents offer price was just over half the last market price of $1.39 ahead of the capital raising announcement and a discount of 37.7% to the theoretical ex-rights price.
Apart from an obviously botched capital raising process, what went wrong that investors now value Eroad so poorly, as well as before the Volaris offer emerged?
Was buying the Coretex business a mistake? It certainly didn't go to plan.
Eroad had been prepared to pay up to $188.3 million for Coretex with $157.7 million paid upfront when the transaction settled.
Expensive in hindsight
Eroad said then that the upfront payment “equates to an attractive” 3.1 times enterprise value-to-annualised monthly recurring revenue (AMRR), and that looks expensive by comparison to the rejected Volaris offer for Eroad at $1.30 per share.
Craigs Investment Partners analyst Joshua Dale estimated the Volaris offer represented just 1.3 times AMRR for the combined Eroad and Coretex businesses.
Of course, interest rates were extremely low in mid-2021 and technology share prices were on a tear.
Now, US 10-year Treasury bonds are at yields not seen since 2007, at 4.57% yesterday, compared with just 1.3% when the Coretex deal was struck, so you can't help but say hindsight shows Eroad paid too much.
The saving grace was a large portion of both the upfront and earnout payments was made in Eroad shares.
When the acquisition was announced, Eroad shares were trading at record levels above $6, and just over half the purchase price, including the earnout, was to be paid in Eroad shares, with the price fixed at $6 each.
About 18 months later, when the earnout was due in December 2022, only a nominal $19.5 million of the original $30.6 million was due and nearly $11 million of that was due in Eroad shares.
Cheaper in reality
The 1.8 million shares issued at a nominal $6 each were actually worth just $1.7 million then at the market price of 93 cents.
But, given the hugely disrupted condition of logistics, transport and supply chains that emerged in the aftermath of the covid pandemic, you might say the Coretex business had to have performed extremely well to have achieved two-thirds of the maximum earnout.
Quite apart from that acquisition, then-chair Graham Stuart told the 2022 annual shareholders' meeting in July that year that “Eroad's performance in North America prior to the merger with Coretex fell well short of our expectations.”
Certainly, Craigs' Dale doesn't think Coretex was a bad acquisition.
In fact, in a note published in February this year, Dale noted Coretex had offered numerous benefits to Eroad, including increasing its presence in the North American enterprise customer market “by a factor of five,” and providing it with capability in some specialist areas, such as trailer tracking for the refrigerated transport and construction sectors.
“It has, however, become increasingly apparent to us that Coretx is more strategically important than we had first realised at the time of acquisition,” Dale said.
Becoming obsolete
Essentially, he argued in a deep dive into the North American telematics market, that more and more truck manufacturers were building data recording capability into the dashboards of their vehicles destined for the US market.
Although it's early days, this trend will turn Eroad's EHubo2 devices, which are currently retrofitted onto trucks, “increasingly undifferentiated and commoditised,” Dale said.
Telematics companies' software for analysing data – such as measuring the speed at which a truck is driven as well as how many hours the driver had been behind the wheel – would still be in demand, but Eroad needed to be able to offer something else worth paying for, and that was what Coretex provided.
Dale noted that Coretex product suite offered capabilities that truck manufacturers couldn't easily incorporate in their vehicles, unlike Eroad’s Ehubo2 capabilities.
Eroad had built its foothold in the US between 2014, when the company listed on NZX, and the end of 2019 by providing devices that suited the US federal mandate for interstate trucks to be fitted with electronic logging devices (ELDs).
Regulators wanted to ensure both that trucks didn't exceed speed limits and that drivers didn't drive for too long, putting them at risk of causing accidents.
Sales drop off
The interim mandate was December 2017 and the final deadline was December 2019 and required about three million trucks to be fitted with such devices.
“Perhaps unsurprisingly, Eroad's unit growth was strongest in the periods preceding each of the two mandate deadlines. Since the passing of these two deadlines, however, Eroad's unit growth in North America naturally slowed,” Dale said.
This threat doesn't exist in NZ because our road-user-charges system is unique and Eroad already supplies “the killer app” for this country. Its 80% market share makes it unlikely international competitors will waste time and money trying to replicate it.
By Dale's estimation, a third of Eroad's existing business, excluding Coretex, is threatened with obsolescence.
But back to that botched capital raising. One reason the shares are now trading below the issue price – they closed yesterday at 68 cents – is that the underwriters won't want to be long-term holders of the 33.6 million shares they were left holding.
Possibly adding to that overhang, is the question of what Volaris will do with its 21.2 million shares.
It chose not to participate in the capital raising, and that reduced its stake from 18.7% to just below 13.7%.
No notice yet
It would have to notify NZX if its holding changed by more than a percentage point and there hasn't been any such notice yet. Possibly, it's talking to the underwriters.
I still struggle to understand why directors agreed to such a deep discount or why they chose an accelerated process – their explanation of the need to shore up the balance sheet simply doesn't explain either of these actions.
Dale was already discounting his valuation of Eroad shares back in February because of the “capital raise risk,” and he was far from alone in this estimation.
Jarden analyst Guy Hooper, for example, wrote in May that Eroad's balance sheet capacity “remains tight” and that it was a key constraint, “lowering confidence in the company's ability to execute.”
Indeed, chair Paterson told me the board had been looking at the capital structure “for about six months.”
So you can't say it was the capital raising per se that accounts for the depressed share price. It was well-anticipated by the market.
This was the verdict of one investor on the Sharetrader equities discussion site: “This is a complete shambles and one wonders how some board members actually achieve their positions…if this is the result of their strategic planning, then I think someone needs to go back to the basic fundamentals of business planning.”
Quite so
I can only add, quite. But it does appear that the NZ operations alone are worth considerably more than the current share price, as well as more than Volaris offered.
Dale puts its annual net profit in the latest year at about $10.2 million, assuming the corporate overheads are divided proportionately between NZ, Australian, and the US operations – he notes that that's likely to be a conservative estimate because there's less need to innovate in NZ, given Eroad's stranglehold on this market.
So, assigning zero value to the other two markets, that would mean Volaris' $1.30 a share offer would have been just 14.3 times Eroad's 2023 price-to-earnings (PE) multiple for a business that has historically achieved 11% compound annual growth. And it wouldn't be correct to say the Australian and US businesses have no value at all.
By contrast, Forsyth Barr's Matthew Leach puts the 12-month forward-weighted PE for the NZ market at 21.3 times.
That should provide some comfort that at least Eroad's directors were correct in judging the Volaris offer as too low.
It does nothing to explain why those same directors said $1.30 was too low and then decided it was a good idea to sell new Eroad shares in a great hurry at 70 cents.
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