|Shares Out. (in M):||76||P/E||0||0|
|Market Cap (in M):||1,850||P/FCF||30||30|
|Net Debt (in M):||400||EBIT||55||55|
|Borrow Cost:||General Collateral|
I am short Advanced Drainage Solutions Inc (ADS), which has the unique distinction of being a pos that literally handles pos. The stock has gotten a little away from me since I began my writeup, but it’s still got over 50% downside and I don’t believe any huge threat of ripping higher.
ADS is the largest plastic drainage pipe and fittings manufacturer in the US, with 61 plants, 29 distribution centers, 650 trucks, and 1,100 trailers. 83% of revenue is levered to new construction, primarily commercial construction but also residential and to a much lesser degree, infrastructure. About 13% of revenues are located internationally. The company boasts that it is 10x larger than its nearest competitor in the plastic pipe market, although I don’t really know if that matters much since scale is more about local rather than national presence. I would point you to the company’s website to get a better understanding of their products, but I dunno, they’re pipes and fittings [shrug].
Plastic pipes have been taking share from traditional reinforced concrete pipes as the technology has improved and the strength of the pipes has gotten better. The all-in cost of plastic pipes is slightly higher and carries more liability than reinforced concrete because they need to be buried more delicately since they rely on surrounding soil integrity for strength.
The company was founded in 1968 and has changed private equity hands a number of times over the years. Most recently, American Securities purchased their stake from Berkshire Partners in 2010, although I don’t believe they did remarkably well on the investment (I think they bought in at ~$14/share). ADS had its public offering in July 2014, selling 15.1 million shares at $16, which was down from its targeted range of $17-19/share. American securities sold 8 million of their 27 million shares in the IPO and another 10 million shares at $21.25/share in a secondary last December (slightly troubling that this was done essentially during the time that accounting problems were likely emerging internally). University of Notre Dame’s endowment was also a very long-time shareholder but sold all of its shares shortly after the IPO.
The CEO, Joe Chlapaty, has been with WMS since 1981 and participated in one of the buyouts in the late 1980’s. Today he owns 10 million shares (13%) although the majority of that is in a trust (which I believe is a charitable trust). It’s not clear to me how he managed to purchase such a large amount of stock and not still have some serious outstanding debt against it...the company has not yet disclosed whether any of his shares have been pledged. ADS’s ESOP owns 26% of the company and this was purchased at the same time as Joe, and the ESOP required a loan which is still outstanding. ADS also has a corporate jet that Joe is allowed to use for personal reasons, if you're into that sort of thing. I don’t think he seems like a bad guy or anything, but I really don’t understand the true ownership structure and how it came to be.
I like to scan NT-10K/Q filings because every once in a while a good company runs into problems and the stock collapses on the accounting fear. I came across ADS in June when they missed their 10K filing deadline and I saw that this was not some stupid penny stock...I figured it might be a buying opportunity. ADS is on a March 31 fiscal year-end, and the 10K is the first filing that was missed. They have missed the following two 10Q’s and after speaking with the company, they don’t sound anywhere close to being done with the restatement. In my experience, restatements like this take anywhere from 12-24 months to complete and cost anywhere between $25-50 million.
The company has made three separate disclosures about the accounting problems and the forthcoming restatement, and the evolution of the language in the three releases is trending in the wrong direction. What started out as a seemingly harmless inventory costing analysis has quickly expanded to other areas of the company that are completely unrelated to inventory. The issues cited by date of filing are:
Volatile Raw Materials
Capitalization of G&A
This is an ominous trend that suggests this is a junior varsity company and management team. I follow accounting restatements pretty closely, and I can’t recall another company that managed to blow it so quickly out of the gate. Preparing for an IPO is like getting a full body cavity search, and ADS couldn’t even make it through a single fiscal year without going dark...no 10K, no proxy...pretty incredible, actually. What’s amazing is that the stock never really budged throughout this and is still 50% higher than its IPO price today. On November 9, the CFO was given the corporate viking funeral, announcing his “retirement” effective March 31, 2016. I’m not really sure how a fresh CFO will impact the restatement process but I’m guessing it could slow it down as the new guy gets up to speed. Overall, there is some reason to be concerned here, and at a minimum I think the company deserves a lower multiple for all of this.
Regardless of how the accounting issues shake out, I think ADS is good short because the company is materially overvalued. There are two parts to the bull story that are responsible for the (now fading) strength in the stock. First, plastic pipe made from high-density polyethylene (HDPE) is taking share from traditional reinforced concrete pipe. This is true although it’s a little difficult to estimate the organic growth rate for plastic pipes since this is still a cyclical business. Some of the market share gain by plastic is likely because concrete prices have risen substantially in the last few years (see the chart of US Concrete - yikes). In any event, this part of the story has some merit, if you’re into buying ultimately cyclical companies with very poor returns on capital. Second, people are fixated on the notion that lower polyethylene prices will drop to ADS’s gross profit margin line. I believe this is not the case for two reasons. First, ADS’s gross margin over the last six years has been pretty stable at around 20% (with some short-term fluctuations) despite polyethylene prices bouncing around all over the place. There’s no evidence that rising or falling polyethylene prices help or hurt ADS’s gross margins at all. Second, even though ADS is the largest plastic drainage pipe manufacturer in the US, this is far from a monopoly, and they still compete against a number of other plastic pipe makers as well as reinforced concrete. So to the extent ADS would benefit from lower polyethylene prices at all, it would be very, very short-lived.
Aside from the bull story being fairly questionable, ADS looks plain-old overvalued when doing an honest analysis of its financials. ADS is yet another in an increasingly long line of companies that abuse adjusted EBITDA like a rental car. If a company has a gigantic delta in its adjusted EBITDA vs cash flow, there is probably something strange going on. I'm actually trying to setup a screen that filters companies by the number of adjustment lines in their proforma results. In the 8K released on 8/17/15, the company provided some estimates on the impact of the as-yet restated financials:
First of all, their adjusted EBITDA is bogus. So for 2015, the adjusted EBITDA was $153.6 million. But they are going to haircut that by another $5.0 million as part of the restatement, and I believe any honest analysis should include both options and deferred compensation expense. This would put the “real” EBITDA at about $130 million. The adjustment also puts GAAP net income negative at -$3.9 million. Yes, they claim to have $154 million in EBITDA, but after taxes, interest on debt, interest on the convert, there isn’t anything left over. So how good is this business?
Capex runs about $40 million annually and they capitalize $3 million of software development as well (why a plastic pipe maker is capitalizing software is beyond me). The cash flow from operations is surprisingly steady over the last four years at $60-70 million. There have been a couple acquisitions along the way but I’ll generously exclude those from FCF even though they’ve aided growth. Basically, ADS has normalized EBITDA of ~$130 million, normalized EPS of ~$.00, and normalized FCF of ~$30 million.
Another thing to watch out for is that the reported share count of 53.3 million is incorrect because the ESOP owns a convert preferred for another 20.1 million shares (26.1 million shares; $12.50 par; 2.5% cumulative; convertible into common at .7692 per share) that the company excludes from its fully diluted share count. Bloomberg misses this, so the reported market cap needs to be adjusted 38% higher. When all options, restricted stock, and the convert are factored in, ADS’s share count is 76 million. Interestingly, the trustee (Fifth Third Bank) of the ESOP can put the convert back to the company in the event ADS’s stock gets de-listed from the NYSE...keep in mind they have now missed their last three filings and are in non-compliance status. (Evidently this is an IRS rule) I would imagine this is a very low-probability event, but it’s kinda interesting nonetheless...has a company ever gotten blown up by its own ESOP??
With comps trading at 8-9x next year’s EV/EBITDA, this values ADS stock at about $10/share, which equates to about 20-25x P/FCF...there are essentially no GAAP profits. This seems about right to me and is very close to where the company was issuing options to management shortly before the IPO ($8.10/share). Comps would include Mueller Water, Polypipe Group, Circor, Watts Water, and Pure Technologies. Call me old fashioned but I like GAAP net income and normalized FCF. To be honest, I don't even know how companies like Mueller Water trade at 8-9x EV/EBITDA but what the hell do I know.
Analyst estimates are bonkers. The Deutsche Bank analyst has ADS doing $235 million in adjusted EBITDA (which again, is fake) in the current fiscal year vs $149 million the year prior (on an bogus-to-bogus basis) and then $260 million in FY17. This implies that margins will practically double vs historical averages, from ~10% to almost 20%. Actually, the math on the incremental adjusted EBITDA margin works out to 56% between FY15 and FY17 ($104 million in incremental adjusted EBITDA vs $195 million in incremental revenue). ADS previously guided to FY16 revenue of $1.32-1.37 billion and adjusted EBITDA of $190-215 million (15-16% margins) even though margins have been flat for years. Now they're supposedly going to magically increase to record levels (being public will do that to you), yet they had even managed to miss on adjusted EBITDA prior to going dark (9.1% in the last quarter before going dark). If nothing else, I think this helps validate the idea that management really isn't ready for this whole "public company" thing. In any event, the stock is expensive even if you believed these (incorrect and fake) EBITDA estimates.
ADS is a fairly levered company with $400 million in debt and $3 million in cash at last report (3/31/15). The debt is split mainly between a revolver, term loan, and senior notes. Debt/EBITDA is about 3.1x...not precarious but not immaterial.
|Subject||Still no financials|
|Entry||02/01/2016 10:31 AM|
The Company is suppose to file their updated financials today.....if they can't or its delayed again this is done.
|Subject||Re: Re: Still no financials|
|Entry||02/03/2016 04:09 PM|
Thought the write-up was great and wanted to get your take on a couple things.
The accounting issues are clearly troubling, but seem minor in nature. 5m impact on 2015 EBITDA (negative) and now some minor issues related to a Mexican JV. In fact the Company states that the changes will actually have a positive impact in 2016 on COGS.
Completely agree that a lot of the accounting adjustments are bogus and FCF is minimal, but what do you think the catalyst is that breaks this? Once the copmany restates (and assuming the restatement isn't huge which it probably won't be), couldn't we go back to business as usual (despite the fact that this is materially overvalued)? Once this overhang is removed, couldn't this re-rate upwards?
As we've seen, lots of companies out there continually use adjusted metrics to show growth despite the fact that real cash flow generation is generally lacking.
|Subject||Re: Re: Re: Still no financials|
|Entry||02/03/2016 05:58 PM|
One follow up as well. I just spoke with the aforementioned DB analyst. Almost all the growth over the next two years is coming from input cost declines (polyethylene); i.e. something that isn't sustainable. But to your point that historically they weren't impacted by moves in the price, apparently that's because now the link b/w polyethylene and oil is much stronger and so the change in polyethylene prices has been much more dramatic than it was in the past, hence the benefit to margins.
On the ESOP addback, these are shares within that 30% that the ESOP owns that are being allocated to employees. They are already included in the diluted share count but just haven't been allocated. So it truly is 1) non-cash and 2) already outstanding, so I would say that adding it back is actually fine.
|Subject||Re: Re: Re: Re: Still no financials|
|Entry||02/03/2016 07:14 PM|
I'm not following you on the ESOP shares. The diluted sharecount is 76 million. If you think adding back the non-cash vesting/awards is fine, I get it, that's okay.
DB is stupid, just plain stupid. Same shop that told me CENX would generate $450 million in EBITDA in 2016. I have utter disdain for the sell-side in general. I don't even understand the mumbojumbo that nitwit fed you, but this is a 20% gross margin business, how competitive do you think it is?? This is far from a monopoly, this is a competitive business. Besides, didn't the DB analyst actually downgrade it and basically throw in the towel on the margin story??
|Subject||Re: Re: Re: Re: Re: Still no financials|
|Entry||02/03/2016 07:28 PM|
I have utter disdain for the sellside as well! Just like to listen to the bull case, no matter how absurd.
Roughly 60% of COGS is raw materials and of this 60%, 56% is recycled HDPE, 40% is virgin HDPE and 4% is other. When you run the math you can come up with some crazy numbers on a spread sheet with the input cost declines. In 2009 and 2010 you saw this when margins went from 17.8% to 26.1%.
I feel like people who are long are basically playing the declining input price game which isn't sustianable long-run; but if the input cost structure is as above, the massive decline in HDPE prices can get you higher margins in the short-run.
I do think the competition-related issues will likely manifest in a significant decline in sales growth going forward; my concern is more outsized gross margin expansion than anything else.
|Subject||Re: Re: Re: Re: Re: Re: Re: Still no financials|
|Entry||02/04/2016 09:35 AM|
My understanding is that in the short-run, declines of HDPE prices help because it takes time for competitors to bring down prices to compensate. Hence the theme of playing lower input costs in the coming year as a reason people are involved on the long side right now.
|Subject||Let's Play a Game?|
|Entry||02/17/2016 05:57 PM|
I wonder what other accounting issues have been found. I bet A/R or who knows..maybe we get lucky and have some related party fun.
|Subject||added to our short|
|Entry||02/22/2016 09:38 AM|
Credit agreement pushed out even further - Company trying to buy itself time. Where there is smoke, there is fire.
|Subject||accounting control issue update - says nothing - no q&a allowed|
|Entry||02/23/2016 04:52 PM|
Nothing new here as WMS does a Q&A-less call to assure the market that they are diligently working on makign things right.
Advanced Drainage Systems, Inc. Restatement Update Call
February 23, 2016
Advanced Drainage Systems, Inc. (the “Company”) is providing a copy of its prepared remarks in connection with the February 23, 2016 public conference call and live webcast. As previously announced, the public conference call and live webcast will begin February 23, 2016 at 4:30p.m. ET.
Introductory Remarks of Mike Higgins, ADS Investor Relations
Thank you. Good afternoon. With me today is Joe Chlapaty, our Chairman and CEO, and Scott Cottrill, our new CFO.
Before we begin I would like to remind you that some comments today will include forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995 including statements regarding the restatement process and the filing of the Company’s fiscal 10-K and other restated filings. Factors that could cause actual results to differ from those reflected in any forward-looking statements include, but are not limited to, those factors identified in the Company’s February 2, 2016 press release as well as other factors identified in the Company’s filings with the SEC, which factors could cause actual results to differ materially from those expressed in these forward-looking statements.
While we may update forward-looking statements in the future, we disclaim any obligation to do so. You should not place undue reliance on these forward-looking statements, all of which speak only as of today.
We will make a replay of this conference call available via webcast on the Company website and a copy of these remarks have been filed today with the SEC on an 8-K.
With that, I’ll turn the call over to Joe Chlapaty.
Remarks of Joe Chlapaty, Chairman and Chief Executive Officer
Thank you, Mike, and good afternoon to everyone. We want to thank all of you for joining us today. The purpose of today’s call is to provide you with an update on our restatement process. While this will be a brief update, we wanted to ensure you heard directly from us on the
progress that has been made to date. Please note we are limiting the call to prepared remarks focused on the restatement which reflects the full extent of information we are able to share at this time.
As you might imagine, this has been a difficult period for me, the management team, the Board of Directors and the entire Company. We have dedicated a significant amount of time and resources to this effort, which is a reflection of the complexity and sheer volume of work that goes into a restatement as well as our commitment to getting it right. I, along with my team am continuing to move in a deliberate, thoughtful and reliable manner to ensure our historical financial statements and FY2016 results properly incorporate all the necessary changes. Our team continues to work closely and collaboratively with our independent auditors, and I am encouraged by the progress we are making. In fact, we believe we are in the final stages of the restatement process. However, at this time, we will not meet the end of February filing date as previously estimated. Given our current belief that the end of the process is near, we will not be providing a specific revised timeline. We will continue to provide updates regarding the restatement process as appropriate until the necessary reports are on file with the SEC.
Since last summer, our employees, management team, independent auditors and outside advisors have worked extremely hard to fully understand the facts and circumstances underlying the accounting and control issues that were discovered. At the same time, we have been assessing and making changes to ensure that the appropriate systems and controls are in place.
Our commitment to getting it right gives me comfort knowing that we will come out of this process a stronger and better company. While Scott will touch on this in more detail in just a moment, we have already begun the process of implementing changes to our finance and accounting function, and at the top of that list is the appointment of Scott Cottrill as our new Chief Financial Officer. We are fortunate to have Scott on our team and are confident that under his leadership, our financial and accounting function will continue to strengthen.
As you saw in our press release issued yesterday, the Board of Directors has approved a regular quarterly cash dividend to stockholders in the amount of $0.05 per share. The decision to continue returning cash to our stockholders through a quarterly dividend underlines the confidence we have in the overall financial strength of our business including a healthy balance sheet and strong liquidity.
With that, I will now turn the call over the Scott to provide additional comments on the restatement.
Remarks of Scott Cottrill, Chief Financial Officer
Thank you, Joe, and good afternoon everyone. As you know, I joined the Company a few months ago in the midst of the restatement. To say that I have jumped in with both feet would be an understatement. However, I joined ADS because I believe in the Company, its growing position in the market, its management team and our significant potential to create shareholder value. Much of my time and attention thus far has been focused on our accounting and control issues – and necessarily so. I am now going to spend the next couple of minutes updating you on the enhancements and improvements we are making in the finance and accounting areas.
Our remediation efforts can be broken down into the following areas:
Again, while this summary was in no means meant to be fully inclusive of all of the actions we are taking, we felt it important to provide you with this summary and overview.
As Joe mentioned, we believe we are in the final stages of the process and are working diligently to complete the restatement and file our Fiscal 2015 10-K and Amended Quarterly Reports as soon as possible.
I look forward to the opportunity to meet with each of you in the near future to discuss not only the restatement, but our business and our operating performance.
With that, let me turn it back to Joe.
Closing Remarks of Joe Chlapaty
Thank you, Scott.
We recognize that we have had limited disclosures throughout this process, particularly as it relates to our business performance. This reflects our philosophy and priority to complete the restatement process in a deliberate, thoughtful and reliable manner. And like you, we look forward to putting this process behind us so that we can shift the emphasis of our communications back to our business operations. With this in mind, I am committed to issuing our preliminary, unaudited financial results for the first nine months of fiscal 2016 as well as provide an update to our full year guidance as soon as possible following the filing of the Fiscal 2015 10-K and amended fiscal 2015 quarterly reports. We look forward to discussing our business and financial performance with you at that time.
Lastly, I want to take this opportunity to emphasize our continued confidence in our strategic direction and the future of ADS. For those of you who have supported us since the IPO, I can assure you that I, along with the rest of the management team, carry the same level of passion and excitement for the business as we always have. Thank you again for your patience and support.
Operator that concludes our call.
|Subject||restated 10-K finally emerges - short case improves - SEC investigation|
|Entry||03/29/2016 11:33 PM|
as expected, declining profitability and a whole host of issues in their foreign entities. not sure how they establish credibility with their lenders and the markets. this remains a great idea.
|Subject||SEC investigation - lowered guidance - numbers appear bogus|
|Entry||03/30/2016 09:58 AM|
Looking forward to the conference call here. We don't see how anybody can trust their numbers. At 8x new heavily adjusted EBITDA, this is a $14 stock, at best.
|Subject||nothing smells right|
|Entry||03/30/2016 11:08 AM|
Here is our analysis post call. We would be interested in hearing what others have to say.
The beneficial factors that Management touted are mostly temporary timing issues driven by falling oil/gas costs. Despite taking this long to speak to the market, there was mo clarification on the real issues, like the cost for all these consultants and ‘building out the structure’.
1. The Company completely dodged the SEC question and wouldn’t tell us when the matter became an investigation – but in either case, it was ‘a few months ago’ – why weren’t we told then?
2. Free cash flow is absolutely abysmal. Why, when their depreciation is huge, can they only convert 70% of EBITDA into operating cash? They should do better than 100%. This will be third consecutive year of de minimis free cash flow despite few large investments. Their adjusted EBITDA numbers are bogus – they do not ever line up with cash, which should be the overall goal of these adjusted numbers ie to present a better picture of how much cash the group is generating.
3. The accounting restatement – from operating leases into capital leases – will give them a $10MM benefit to EBITDA, because instead of running these costs through the P&L they are now split between depreciation (not included in EBITDA) and finance costs (not included in EBITDA).
1. Benefits that the Company is enjoying are temporary.
2. Cost additions to SG&A are permanent, and they were woefully inadequate before.
3. SEC investigation we were not told about until now raises very large red flags.
4. Cash flow will be terrible, even worse this year because their consultancy costs will be excluded from their pro-forma numbers but will be eating cash.
5. It turns out the PE house sold out on bogus numbers.
If we are missing something, please fill us in.
|Subject||Re: Re: nothing smells right|
|Entry||03/30/2016 12:09 PM|
shares are not expensive to borrow either. keep going though the restated 10-k, as it is alarming...
Anyhow, pro-forma market cap is $1.6bn if you dilute for the management ESOP and the schemes.
Here is another highlight from the restated 10-K on culture...
A contributing factor to the material weakness in the control environment was certain aspects of the Company’s “tone at the top” set by senior management, which is the atmosphere and culture created by the Company’s leadership and establishes the environment within which the Company’s financial reporting process occurs. The following areas related to tone at the top were identified as contributing factors to the weaknesses described in the control environment that require remediation:
|Subject||Re: Re: Re: Re: nothing smells right|
|Entry||05/27/2016 12:20 PM|
Utah, any updated thoughts here? clearly the stock has gone on a bit of a tear in the absence of formal filings/any information at all (information vacuum helping them again). The move in raw materials would imply whatever tailwind WMS was/is getting the last few quarters will dissipate fairly quickly (it looks like PE prices are actually higher YoY this yr). But the stock has a mind of its own...
I am short, and thinking to add. Just wondering what I'm missing besides the obvious (squeeze).
|Subject||Re: Re: 1Q-3Q FY16 financials were released|
|Entry||06/01/2016 10:13 PM|
It is pretty clear looking at the 1Q-3Q 10-Qs that the raw material margin benefit here is largely overstated in WMS' adjusted numbers.
Thru 3Q this year, gross margin came in at 22% vs last year at 18.5%; this is ~$36.5mm in gross profit dollars from COGS leverage.
But derivative losses - which run below the line and are entirely PE and fuel hedge related - increased to $18mm (vs $5mm last yr). This is fully 50% of the purported COGS benefit, making margin growth look much less impressive.
There are many other problems with WMS' adjusted EBITDA numbers, but here is another one - they add back ~$8mm of these derivative losses to adjusted EBITDA, when really they enjoy the full benefit of COGS tailwind above the line. Yet another fictitious add-back.
|Entry||07/01/2016 01:53 PM|
Has any scrubbed the FY17 guidance to get a sense of potential upside risk from raw mat deflation? Backing into it, it looks like their guidance implies ~24% gross margins. Is there any risk this can go higher or is this a reasonable estimate? And what's the bull argument on being able to hold onto these gains?
|Subject||Re: Re: Updated thoughts|
|Entry||07/01/2016 02:46 PM|
Thanks Katana. Their G&A in FY16 was $187mm which included $28mm in restatement cost = $160mm normalized. However they are telling investors to expect $15-21mm/yr ($18mm mid-point) of structural higher G&A to deal with investments they are making in infrastructure/reporting etc. So I'm assuming ~$178mm in FY17. When we run that we can back into their GM guide = 24.0%
|Subject||Re: Re: Re: Updated thoughts|
|Entry||07/04/2016 06:35 PM|
Katana - one other question: how does hedging work for this company (i.e. what % of raws do they hedge and does it show up in COGS or below the line)? We are struggling to get this question resolved. Our understanding is 45-50% of COGS are resins and ~5% of COGS are diesel fuel (transportation costs). There is also a discrepancy between what IR has said and the 10-K on where hedging shows up (10-K says physical resin hedges show up in COGS). Thanks for any clarification
|Subject||Re: Re: Re: Re: Re: Updated thoughts|
|Entry||07/06/2016 10:27 PM|
This one is going go to get down to whether or not they can hold price and maintain the higher gross margins. Has anyone done any diligence on this (competitor calls, customer calls) to get a sense of whether they have the pricing power to hold onto margin? They do have high market share (80%+) so the risk is the margins don't contract. History would say the margins mean revert but that's based on 2009 (when end markets were much weaker).