Aaron’s Reports Record 3Q 2020 EPS; Maintain BUY, Increase Fair Value Estimate to $74 Per Share

• On October 29, 2020, before the market open, Aaron’s Holdings Company Inc.(NYSE: AAN) reported 3Q 2020 results which included revenue of $1.1 billion, a 9.2% increase from the prior year period, EBITDA of $178.3 million, versus $87.1 million in 3Q 2019, and adjusted EPS $1.80, compared to $0.73 a year prior.
• Management highlighted the company’s consolidated revenue strength as being attributable to continued customer payment activity, which is in part due to the various government stimulus programs associated with the current COVID-19 pandemic.
• On a segment basis, Progressive Leasing increased revenue by 13.7% versus 3Q 2019, to $601.1 million, with EBITDA margins expanding to 19.2% in the quarter (versus 11.9% in the prior year period). Revenue benefited from a 3.4% increase in customer invoices, consisting of a 0.4% increase in active doors and 3.0% increase in invoices per active door, while segment profit was helped by operating expense control.
• The Aaron’s Business segment increased revenue year-over-year by 3.4% to $441.0 million while EBITDA increased to $65.1 million ($25.7 million in the prior year period). Similar to the Progressive Leasing business, strength in customer payment activity and lower merchandise write-offs benefited the segment’s margins.
• While the long-term investment case for AAN and Progressive business may be up for debate, the current economic environment appears favorable. Given the current COVID-19 crisis, the apparent increase in desirability for suburban home dwellings, vs. urban apartments, may in fact result in increased preference/need for rent to own businesses such as AAN. As demand for suburban houses has grown, home prices have also increased. New suburbanites may have to stretch budgets to secure a home, which may constrain their appliance, furniture, and home décor budgets, which may skew the perceived favorability of a rent-to-own solution. Alternatively, a persistently high unemployment rate could also benefit both post-spin companies as constrained budgets may be able to afford the rent-to-own model for household necessities (i.e. replacing a broken refrigerator) versus traditional upfront payment options. The ability to drive increased sales per store/partner location should support our case for a rerating of the Progressive business and support the post-spin AAN valuation.
• On a pre-spin basis, shares of Aaron’s Inc. can be fairly valued at $74 per share (previously $72 per share), consisting of $62 per share of businesses to be contributed to Progressive Leasing, and $14 per share for the parent company and accounting for current net debt of approximately $2 per share. The fair value was updated to reflect the current balance sheet.
• Given the implied upside to the current share price, we initiate coverage of Aaron’s Inc. as a BUY ahead of the planned spin-off of Progressive Leasing.
• Management will hold a conference call this morning at 10:30 am EDT.
• The company also disclosed that it is “on track” to complete the planned spin-off of the Progressive Leasing business in 4Q 2020.
• For more details, please refer to The Spin Off Report dated October 6, 2020.

PM segment results impress in 3Q 2020 and the outlook remains bullish; strategic review yields new restructuring measures at PM with additional details on the broader “value creation roadmap” expected at a virtual Investor Day in December; fair value increased to $23 per share (from $21 per share)

• In the first 9-months of 2020, LDL’s consolidated sales fell ~14% to $554 million, as strength in PM’s filtration business (up 38% in 3Q and ~29% YTD) was more than offset by weakness at TNW (down 15.5% YTD) and TAS (down 25% YTD, including a ~60% decline in 2Q due to the auto industry shutdown).  Adj. EBITDA fell ~28% to $49 million (on a consolidated margin that fell 170 bps to 8.8%).
• For 3Q 2020, LDL posted consolidated sales down less than 1% to $207 million (versus our $182.5 million forecast and consensus of $165 million) while adj. EBITDA fell ~16% to $17.55 million (compared with consensus of ~$13.5 million).
• LDL ended 3Q 2020 with a net leverage ratio of 3.4x (vs. 3.5x at the end of 2Q 2020 and its 6.5x covenant), including cash of $122 million and debt of $283 million. (Note: LDL’s leverage covenant steps down to 4.5x in 2Q 2021 and its next relevant debt maturity is in August. 2023.)
• The company does not provide earnings guidance, but we thought management’s conference call commentary surrounding the sustainability of PM’s current margin profile (~20%) in 2021 as particularly encouraging. As well, in terms of the balance sheet/cash flow outlook, LDL noted that it expects $12 million of debt repayment in 2020 and that it will likely meet its leverage target of 2.5x or below in 2H 2021.
• In regards to the strategic review, LDL announced several restructuring measures at PM, specifically the closure of two European facilities and the idling of a production line in the U.S, which are expected to yield $5-$6 million of annualized cost savings.  Notably, LDL indicated additional details on its “value creation roadmap” will be provided at an Investor Day in December.
• Our fair value estimate is increased to $23 per share (from $21 per share), reflecting a ~6x blended multiple (unchanged) on 2022E adj. EBITDA of ~$86.5 million (previously $80.5 million) as well as projected net debt of $125 million (previously $134 million).

On October 8, 2020 before the market open, DTE Energy Company. (NYSE: DTE) announced a plan to separate its Midstream business from its regulated electric and natural gas utility business in a tax-free separation. The separation transaction is expected to be completed by mid-year 2021, subject to final approval by the Company’s Board of Directors, regulatory approvals and other conditions.

DTE, with a current market capitalization of approximately $24 billion, is a diversified energy company involved in the development and management of energy-related businesses and services in the United States and Canada. The company generated consolidated 2019 revenues and EBITDA of $12.7 billion and $3.1 billion, respectively. The company’s Electric segment generates, purchases, distributes, and sells electricity to approximately 2.2 million residential, commercial, and industrial customers in southeastern Michigan. DTE’s Gas segment purchases, stores, transports, distributes, and sells natural gas to approximately 1.3 million residential, commercial, and industrial customers throughout Michigan; and sells storage and transportation capacity. This segment is essentially the results of the company’s 2016 acquisition of the natural gas pipeline assets from M3 Midstream LLC and Vega Energy Partners Ltd. for $1.3 billion.

The separation announcement represents the culmination of a series of strategic discussions that began in the summer of 2019 to identify value-unlocking opportunities. After an aggressive expansion into the sector, several power companies that purchased natural gas infrastructure in search of growth have retreated from the space. Moreover, investor and political pushback against fossil fuels has curtailed buildout of new pipelines. Most recently, in July, Dominion Energy Inc. (NYSE: D) sold the majority of its gas pipeline and storage assets to Berkshire Hathaway Inc.

Following the separation, the Midstream will become the only independent, mid-cap, C-Corp regulated natural gas-focused midstream investment opportunity with exposure to the Marcellus, Utica and Haynesville shales and connection to major demand markets. The company owns 900 miles of FERC (Federal Energy Regulatory Commission) regulated gas transmission lines and 1,450 miles of gathering lines, as well as 91 Bcf of regulated gas storage capacity in Michigan serving local distribution companies, power generators and other end-user markets in major demand regions across the Midwest, the Northeast and Canada. Midstream targets a capital structure of approximately 4x debt-to-adjusted EBITDA and approximately 2x dividend coverage ratio in 2021.

Post-spin DTE will become a predominantly pure-play regulated electric and natural gas utility, whose operating earnings are expected to be in-line with pure-play peers. The separation is not expected to have any adverse impact on DTE Energy’s utility operations, customers or customer rates. Approximately 90% of DTE Energy’s operating earnings would be generated by its regulated utility business compared to 70% today. Approximately 92% of capital investments would be devoted to DTE Energy’s utility operations. The Company is targeting a long-term operating EPS growth rate of 5% to 7% off its 2020 original guidance. This includes 7% to 8% long-term operating earnings growth for its regulated electric business and approximately 9% for its regulated natural gas business. This growth is supported by $17 billion of planned utility capital investments over the next five years – a $2 billion, or 13%, increase over DTE Energy’s prior plan.

In approaching a valuation for DTE we use a sum-of-the-parts methodology given the variety of businesses within the current corporate structure. As a basis for our earnings estimates we base our DTE Gas and DTE electricity growth forecasts on the initial 2020 guidance issued by management, while noting that this guidance was revised this morning, however the long term outlook for the businesses are referenced by management off of the original guidance. For the other businesses (midstream, power & industrial projects, and energy trading) our estimates are based off of the revised guidance.

Based on the initial guidance for the utility businesses, the utility could be reasonably forecast to generate operating earnings of $955 million in 2020. Incorporating 8% and 9% annual growth for DTE Electric and DTE Gas, respectively, the utility business is forecast to earn $1.0 billion in operating earnings in 2022. Based on current shares outstanding of 192 million, the utility business would generate 2022 EPS of $5.38 in 2022. Natural gas utilities appear to trade at a slight discount to peers of DTE Electric, with forward P/E’s of 17x versus 19x, respectively. Applying the respective multiples results in the utility business being valued at $100 per share.

The spin company, containing the Gas Storage & Pipelines business, is currently expected to generate approximately $291 million in operating earnings. Historically the business has increased earnings by 18% annually. Assuming a similar growth rate, spin co would earn $1.79 per share in 2022. The spin company can be compared to other midstream C-corps, which trade at 11.0x -13.0x forward EPS. Applying a 12.0x multiple o forecasted earnings implies a spin company valuation of $21 per share.

In terms of the far smaller Power & Industrial Projects and Energy Trading businesses, we base our estimates on the revised guidance midpoint, and apply historic 5-year growth rates, which results in respective 2022 segment EPS of $0.84 and $0.22. In terms of valuation, we apply a 15.0x multiple to each segment which is a slight discount to DTE’s current 2022 P/E of 16.6x. We value the Power & Industrial Projects business at $13 per share and the Energy Trading business at $3 per share.

Including corporate and other expense of $11 per share, which is $127 million in expenses capitalized at 17.2x (the weighted average of the segment valuations), DTE’s businesses can be valued at $126 per share. Incorporating the newly raised quarterly dividend of $1.085 per share, on a preliminary basis we fairly value shares of DTE at $130 per share.

TFII increased its 2020 EPS and FCF outlooks to “at least” C$4.00 and C$600 million, respectively (from C$3.40-$3.75 and C$425-$460 million); quarterly dividend raised to $0.29 per share (from $0.26); our fair value estimate is lifted to C$67 per share (from C$62 per share)

• In the first nine months of 2020, TFII’s consolidated sales declined ~4.5% to ~$3.29 billion while adjusted EBITDA and free cash flow increased ~6% and 138% to ~$685 million and ~$561 million, respectively.  Adjusted EPS increased 4% to $3.11 (compared with $2.99 in the prior period).
• The company ended 3Q 2020 with a net leverage ratio of 1.63x (versus 2.25x at the end of 2019 and its 3.5x covenant) as well as increased its quarterly dividend by ~12% to $0.29 per share (from $0.26 per share).
• In terms of anecdotal financial guidance, TFII increased its full-year 2020 EPS outlook to “at least” C$4.00 (compared with its previous commentary of C$3.40-$3.75 and C$3.94 in 2019) with free cash flow of “at least” $600 million (compared with its previous commentary of C$425-$460 million and C$463 million in 2019).
• For 2021, without citing specific benchmarks, management continued to express confidence in a reassertion of its earnings power given recent cost cuts, expected synergies from recent acquisitions and a more normalized operating environment.
• On the topic of M&A, the company’s near-term focus seemingly remains on tuck-in acquisitions/integrations (as opposed to divestitures) although the company could look, given the strength of its balance sheet, for more transformative deals over the 12-18 months.  (Recall, the company raised ~$230 million via an IPO of U.S. shares on the NYSE in February 2020.)
• Our fair value estimate for TFII is increased to C$67 per share based on a blended multiple of ~7x (unchanged) on 2021E EBITDA of C$935 million (previously C$895 million) and projected net debt of C$820 million (previously C$1.05 billion).

 Drop Coverage of Otis Worldwide Corporation Effective Immediately

• United Technologies, renamed Raytheon Technologies Inc.  (NYSE: RTX) completed the spin-offs of Otis Worldwide Corporation (NYSE: OTIS) and Carrier Global Corporation (NYSE: CARR) on April 3, 2020.
• Given the transaction has now passed our coverage mandate of 90 days post-spin, we DROP coverage of Otis Worldwide effective immediately.
• Our prior estimates and fair values for OTIS should no longer be relied on.

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 SYNNEX Files Form-10; Updating Fair Value Estimates; Maintain NEUTRAL

• SYNNEX Corp. (NYSE: SNX) filed an amended Form-10 registration statement with the SEC for the spin-off of Concentrix, which is expected to be completed in 4Q 2020. As background, Concentrix, with annualized revenues of $4.7 billion, provides technology-enabled business process outsourcing (BPO) services focused on customer engagement, process optimization, technology innovation, front- and back-office automation, and business transformation services. Concentrix is expected to trade on the Nasdaq under the ticker CNXC. SNX shareholders are expected to receive one share of CNXC for each share of SNX held as of the record date (to be determined). 
• We are revising our pre-and post-spin estimates to reflect updated pro forma financials and pro forma balance sheet information for Concentrix as of August 31, 2020. Post-spin CNXC will be capitalized with $1.1 billion in long-term debt, the proceeds of which will be distributed to SNX as a one-time distribution. Our previous estimates had been based on the assumption that Concentrix would be capitalized with $1.3 billion in net debt (2.4x F2021E EBITDA). 
• The post-spin fair value estimate for Concentrix has been revised to $75 (versus $73 previously). The post-spin fair value estimate for SYNNEX is adjusted to $81 per share (versus $69 previously). The changes in fair value are a result of updated pro-forma balance sheet information and a slight increase in the applied EV/EBITDA multiple to 7x (versus 6x previously) following the company’s favorable FQ3 (Aug) earnings report on September 24, 2020.
• On a pre-spin basis we assign a fair value estimate of $156 per share to SYNNEX (versus $142 previously). With the pre-spin sum-of-the-parts estimate approximating SNX’s current consolidated share price, pre-spin shares are not recommended for purchase.
• Following the separation, SYNNEX will remain focused on IT distribution, logistics, and integration services, with annualized revenues of approximately $19 billion. The company will remain among the top three Americas and Japan IT distribution companies. We expect the company to maintain its leadership position while shifting its revenue mix toward more value-added services—which should improve margins over time. That said, in the near term, the business will remain pressured by reduced IT capital expenditures by companies as a result of the COVID-19 pandemic, and continued year-over-year revenue declines will make it difficult for the company to generate meaningful margin improvement. 
• Concentrix will be similarly impacted by the softness in IT related spending, but has a stronger growth profile than SNX longer term as the company benefits from the accelerating secular trend of outsourcing BPO software, a core addressable market quantified at $85 billion and projected to grow at a 3%-5% CAGR over the next five years. While similarly pressured by the impact of COVID-19 on the leisure and hospitality industries, Concentrix should continue to benefit from strength in the technology, e-commerce, banking, and healthcare sectors.
• For more details, please refer to The Spin Off Report dated September 21, 2020

Drop Coverage of Ingersoll-Rand Inc. Effective Immediately

• Ingersoll-Rand Inc. (NYSE: IR) was spun-off from Trane Technologies plc (NYSE: TT) on February 29, 2020.
• Given the transaction has now passed our coverage mandate of 90 days post-spin, we DROP coverage of Ingersoll-Rand effective immediately.
• Our prior estimates and fair values for IR should no longer be relied on.

Drop Coverage of Trane Technologies plc Effective Immediately

• Trane Technologies plc (NYSE: TT) completed the spin-off of Ingersoll-Rand Inc. (NYSE: IR) on February 29, 2020.
• Given the transaction has now passed our coverage mandate of 90 days post-spin, we DROP coverage of Trane Technologies effective immediately.
• Our prior estimates and fair values for TT should no longer be relied on.

Fortive Completes Spin-Off of Vontier; Maintain NEUTRAL Rating on Fortive and Vontier; Adjust FTV Fair Value Estimate to $70 (from ($63); Adjust VNT Fair Value Estimate to $31 (from $40)

• Today, Fortive Corp. (NYSE: FTV) completed the spin-off of 80.1% of Vontier Corp. (NYSE: VNT) before the market open. FTV shareholders received two share of Vontier for every five shares of Fortive held.
• We adjust the post-spin fair value estimate for FTV to $70 (versus $63 previously), reflecting recent valuation expansion in the sector. For VNT, we adjust the fair value estimate to $31 per share (from $40 previously), representing a multiple of 12x EBITDA (versus 15x previously). We rate both FTV and VNT Neutral.
• We expect post-spin Fortive to continue its strategic focus on deleveraging and liquidity while making strategic acquisitions and investing in new products and an expanded sales force. Order growth trends appear favorable, particularly in North America, positioning the company for a potential return to more normalized growth. A recurring revenue stream helps insulate from cyclicality and provides visibility, and a growing software business offers optionality on earnings upside. With approximately $8 billion in deployable capital for growth-oriented mergers and acquisitions, we expect the company to expand into software and services. That said, with FTV shares trading in line with premium diversified industrial peers, at approximately 17x 2021E EBITDA, it appears that investors are discounting for improving trends.
• As background, Vontier’s transportation and mobility products and services are deployed in over 260,000 retail fuel stations and convenience stores globally. The company’s substantial scale and product breadth establish a strong position from which to capitalize on key long-term market trends, including increasing vehicle ownership and infrastructure buildout, particularly in high-growth markets where the company believes it has significant opportunities to expand its customer base. We expect the company to similarly focus on strategic acquisitions while expanding its telematics offerings. A sooner-than-expected transition to EMV (Europay, Mastercard, and Visa)-compliant technology at pay stations could provide upside to revenue and earnings over time.
• For more details, please refer to The Spin Off Report dated September 14, 2020 and UPDATES dated October 1, 2020 and September 16, 2020.

On October 8, 2020 before the market open, IBM Corp. (NYSE: IBM) announced a plan to separate the Managed Infrastructure Services unit of its Global Technology Services division into a new public company (“NewCo”). The tax-free separation is expected to be completed by the end of 2021 and is subject to customary closing conditions, including Form 10 registration with the U.S. Securities and Exchange Commission, receipt of a tax opinion from counsel, and final approval by IBM’s Board of Directors

IBM, with a current market capitalization of $105 billion, is a manufacturer of enterprise hardware, middleware and software, and provides hosting and consulting services. The company generated consolidated 2019 revenues and EBITDA of $77.1 billion and $16 billion, respectively.

The separation makes strategic sense given the diverging needs for application and infrastructure services. In recent years, IBM has de-emphasized its legacy businesses to focus on the growing cloud opportunity, in an effort to offset slowing software sales and more seasonal demand for its mainframe servers. Following the separation, IBM will continue to focus on its open, hybrid cloud platform and AI (Artificial Intelligence) capabilities—a $1 trillion market opportunity. Given IBM’s historical position in enterprise IT infrastructure, the company’s hybrid solution offers customers the ability to leverage their existing infrastructure and mix and match private and public cloud-based offerings. This strategy was enhanced by the $34 billion acquisition of Red Hat Inc. in July 2019. In addition, the separation will allow IBM to streamline its operating model and consolidate shared services. Post-spin IBM, which will generate revenues of approximately $59 billion, will also transition from generating roughly half its revenue in services to generating more than 50% of sales from recurring revenue.

Following the separation, NewCo, (to be named at a subsequent date) will be the world’s leading managed infrastructure services provider, with revenues of approximately $19 billion. The company will hold relationships with more than 4,600 customers in 115 countries, including more than 75% of the Fortune 100, a backlog of $60 billion, and more than twice the scale of its nearest competitor. The separation will also allow the company to partner fully across all cloud vendors, opening new avenues for growth, while maintaining a strong strategic partnership with IBM and continuing to serve existing and new clients

Following the separation the parent company can be compared to enterprise IT hardware and software manufacturers including Cisco Systems Inc. (NASDAQ: CSCO), Hewlett Packard Inc. (NYSE: HPE), and VMWare (NYSE: VMW), among others, which currently trade at approximately 15x EBITDA. Assuming revenue growth of 2% and 3% in 2019 and 2020, respectively, post-spin IBM could reasonably generate 2021 revenues of approximately $62 billion. At an estimated EBITDA margin of 25%, the post-spin parent would generate 2021E EBITDA of $15 billion. Applying a 9x multiple, approximating IBM’s current consolidated multiple, to estimated 2020 EBITDA results in an enterprise value of $139 billion for post-spin IBM.  Note that the applied multiple represents a slight premium to Cisco, given the latter’s mix of lower-,margin equipment sold to telecommunications service providers, and a discount to VMWare, at the upper end of the valuation range, given the latter’s high-margin and recurring revenue growth business model in software.

The spin company will primarily will be a provider of network integration and managed network services, which could be compared to professional services companies such as Accenture plc (NYSE: ACN), Cap Gemini Corporation (CAP.EN), and Genpact Ltd. (NYSE: G), among others, which currently trade at a broad range of valuations from 10x to 16x. Assuming revenue declines of 6% and 4% in 2020 and 2021 respectively, the post-spin services company could be expected to generate revenues of approximately $17 billion in 2021. At an estimated EBITDA margin of 15%, the post-spin company would generate 2021E EBITDA of $2.6 billion. Applying a 15x EBITDA multiple, a modest discount to Accenture at 16x, to estimated EBITDA of $2.6 billion generates an implied enterprise value of $39 billion for the post-spin company.  We view the discount as warranted given NewCo is just under half the size of Accenture.

Factoring in for net debt of $56 billion, IBM can be fairly valued at an implied market capitalization of $122 billion, or $137 per share on a pres-pin sum-of-the-parts basis, representing approximately 4% upside to the shares current intraday price. IBM shares have declined approximately 2% year-to-date, versus a 6% increase for the S&P 500 over the same period. Notably, shares have appreciated approximately 7% on today’s news in intraday trading.