|Shares Out. (in M):||28||P/E||8||90|
|Market Cap (in $M):||376||P/FCF||0||0|
|Net Debt (in $M):||590||EBIT||69||16|
|Borrow Cost:||Available 0-15% cost|
This is a recommendation to short Celedon Group, Inc.’s common stock (CGI - $13.50).
CGI’s core business is a truckload freight transportation company doing business in North America. In addition, its Quality Companies subsidiaries “provide leasing and ancillary services to owner-operators”. Quality is the source of CGI’s gain on sale profits. CGI also has a small “asset-light” business that provides freight brokerage, warehousing, LTL consolidation and logistics services. This report won’t focus on the asset-light business because it is less than 20% of operating income.
CGI has aggressively expanded through 1) acquisitions, 2) purchases of tractors and trailers for its own business and 3) ramp-up of Quality. In the last six years, assets jumped 357%, debt skyrocketed over 1,000% and shares outstanding grew 26%. In the last quarter alone, debt jumped 91% y/y and interest expense was up 170% y/y.
As a result of this aggressive expansion, CGI now finds itself with the highest leverage among its peers (SIC 4213: trucking, no local) at what is probably the top of the cycle in a cyclical industry. On an apples-to-apples basis, the company trades at 8x EV/EBITDA, versus comps at 5x. CGI’s adjusted debt to adj EBITDA (see “Valuation” below) is over 5x, twice the peer average. Since the company has 5 turns of debt, at a peer-equivalent EV/EBITDA valuation the equity would be worthless.
Last quarter the company reported growth in operating income of 57%, but operating profits from the core business were down 11% (or more if my suspicion about its lease accounting is correct). This decline is not apparent due to gain on sale of equipment and opaque lease accounting. The most recent 10Q and 10K conflict with management’s statements about the accounting. Analysts are “confused”, say the business is “complicated”, want “clarification” and have “a lot of questions on Quality”, a key business for CGI.
The company formed an LLC only two days before the end of the quarter to sell $13.6m of equipment to it. Management claimed that their current third party financing company, Element, “desire[d] to limit participation in the third party fleet market”. However, management’s claims contradict what Element has said, because according to Element, fleet management is its “core business” and Element grew its third party fleet business 80% last quarter.
Based on my calculations, this overleveraged company is very close to violating the debt/EBITDAR covenant on its primary credit facility. There was no mention of this in filings or the conference call.
I think earnings estimates are far too high next year.
The industry appears to be decelerating, or perhaps declining. The Cass Freight Expenditure Index is declining at an accelerating rate and the October report states that “At this point in time there is abundant capacity in the trucking sector, which has depressed spot rates.”
I believe a dilutive equity financing is likely.
A very large portion of management's compensation is tied to earnings targets, meaning management benefitted directly from higher profits from gain on sale and lease accounting. Management sold millions of dollars of stock in the last two years and hasn’t bought any shares during that time.
Quality, Element and the Recently Formed 19th Capital Group, LLC
The entities: Quality, Element and 19th Capital Group
o CGI’s “leasing and ancillary service business.” Quality buys trucking equipment, sometimes leases it and then sells the equipment to third parties, or sells the equipment straight to third-parties, who then lease it. The SEC filings conflict with the latest conference call as to whether or not Quality leases the equipment and then sells the lease and equipment to Element, or if it just sells the equipment and Element originates the lease (see below.)
o From the 10Q: Quality Companies business unit offers "tractors under management" to independent contractors, motor carrier fleets, and financing sources. Quality’s services include tractor purchasing and sales, driver recruiting, lease payment remittance, insurance, maintenance, and other services. A portion of the tractors under management are contracted to Celadon by independent contractors who drive for us. The remaining tractors are contracted to other fleets. Quality’s business has grown rapidly, from 750 tractors under management at June 30, 2013, to 4,900 tractors under management at June 30, 2015. Additionally, Quality has placed initial orders for 13,000 tractors scheduled for delivery over the next several years, at an aggregate estimated purchase price in excess of $1.5 billion.
o Per the CGI 10K: In March of 2014, we entered into a transaction with Element Financial Corp. ("Element"), under which Element purchased our portfolio of independent contractor leases and will directly provide financing to our independent contractors. The portfolio was held in our Quality Companies business unit ("Quality").
o From the September 2015 10Q: “We routinely sell equipment to Element Financial Corp. ("Element") under our agreement with Element for use by independent contractors. Total net sales proceeds of units purchased with the intent to sell during the quarter ended September 30, 2015 were $152.5 million. In accordance with ASC 605-45, we recorded these transactions on a net basis as an agent versus grossing up the sales in revenue and costs of goods sold as a principal. The net gain as a result of these transactions in the quarter ended September 30, 2015 was $12.9 million. The $9.9 million of operating income reported under the equipment leasing and services segment is a result of the $12.9 million in gains recorded on a net basis for the quarter ended September 30, 2015.”
o From Element’s last earnings release: “Element Financial Corporation (TSX:EFN) (“Element” or the “Company”), one of North America’s leading fleet management and equipment finance companies…”
· 19th Capital Group:
o Two days before the end of last quarter, CGI and LMC formed 19th Capital Group, which bought $13.6m of leases and associated assets from Quality.
o From the CGI proxy: During the first fiscal quarter of 2016, we entered into a joint venture called 19th Capital Group, LLC ("19th Capital") for the purpose of financing additional growth of our Quality Companies business segment ("Quality Companies" or "Quality"). The capitalization of 19th Capital included $4.0 million of cash from Tiger, ELS LLC ("Tiger"), an entity controlled by LMC, for 66.7% of 19th Capital's Class A interests and $2.0 million of cash from us for 33.3% of the Class A interests. In addition, LMC and we determined that the success of 19th Capital was highly dependent on the active involvement and aligned interest of management of 19th Capital, Quality Companies, and us, in order to continue to grow the third party fleet business. Accordingly, participants from each of those management teams have been granted incentive units in the form of Class B interests that participate in profits of 19th Capital after return of all current and future invested capital.
o We account for our investment in 19th Capital using the equity method of accounting.
What is Going On?
These charts of trailing 12-month operating cash flow and equipment held for resale provide a good backdrop.
For the operating cash flow chart, I used trailing 12 months to smooth things out. However, what this chart doesn’t show is even worse: the company burned $48m in operating cash flow in the last two quarters combined, an $86m drop from the same six month period a year ago.
Here’s what I think is happening:
The company was struggling to meet numbers and/or it got too aggressive on its expansion of Quality. It ramped up its equipment purchase and sale/leasing business, but the third party financing company (Element) that was buying the “equipment held for resale” balked at taking as much equipment as Quality expected to sell. CGI was stuck with ever increasing amounts, resulting in the sharply growing current asset, “equipment held for resale” and the plummeting operating cash flow shown in the chart.
Why 19th Capital Group?
Management in the proxy sated one of the reasons to form 19th was to: “move portfolio off balance sheet, with no financial statement consolidation expected”
The proxy filed on October 27, 2015 also stated: “we believe Element's capacity to grow fully with Quality Companies could be limited by their account concentration limits as well as their desire to limit participation in the third party fleet market.”
But Element contradicts this in its latest earnings release, calling fleet management its core business and Element grew its third party fleet business 80% last quarter: “During that two year period we have consciously and meaningfully shifted the mix of our earning assets into our core business, fleet management. 3Q15 originations increased to $1.9 billion in Q3-2015 up 61% from $1.2 billion in the same period last year.” Fleet Management accounted for $867.9 million of Q3 originations. In the year ago quarter fleet management originations were $482.5m
These conflicting statements and the fact that CGI formed 19th Capital with only two days left in the quarter lead me to believe that something else was at work.
I think there are two reasons:
1. My calculations show that without the sale of the lease portfolio to 19th, CGI would have violated, or would have been very close to violating, a covenant on its primary credit facility.
2. Element is getting nervous about doing more business with Quality; as CGI’s 8k vaguely puts it: “Quality Companies' business in markets where access is currently limited due to financing constraints”
Calculation of Debt Covenant
The company must maintain on a consolidated basis the Lease Adjusted Total Debt to EBITDAR Ratio not exceeding 4.00 to 1.00 as of any fiscal quarter end. My calculations above show that without the sale to 19th, the company may have tripped its covenant. My calculations could be wrong, so please do your own work. I do think that this short will work regardless.
This comment from the last conference call was interesting: “You take the cash on the balance sheet that came in at the end of the quarter, but not in time to pay down our bank line”
I focused on companies with a market cap <$1B. CGI’s market cap is $376m.
Adjusted EBITDA excludes gain on sale of equipment for all companies shown.
Average EV/adj EBITDA excl gain on sale is 5.0 for the <$1B market cap companies, 7.9x for CGI and 6.4x for the entire universe, excluding CGI.
EV/EBITDA multiples adjusted for operating leases are lower across the board and don’t change the conclusion.
CY 2016 Estimates
I think the company might make only $0.15in CY16, compared to expectations of around $1.70. My estimate has a wide range, but at a minimum it seems likely consensus of $1.70 is far too high. Items that I have factored into my model:
Gain on sale drops from $32m to $9m; this is a somewhat speculative assumption, but I think in light of the issues above, stretched balance sheet, and potential industry slowdown, I think it is reasonable.
Y/Y comparisons will become more difficult starting with the December quarter. In the last twelve months, the company spent $117m on acquisitions and assumed $52m of debt.
The largest acquisition was about a year ago on October 24, 2014. CGI acquired the outstanding membership interests of A&S Services Group, LLC ("A&S") for $55.0 million in cash and the assumption of $52m in debt. Based on the company’s pro forma disclosures, I estimate this acquisition added about $35m per quarter in revenue, or about 16% of quarterly revenue.
On January 20, 2015, CGI acquired Taylor Express, Inc. for $51m. Very roughly I think this added about 4% to quarterly revenue.
The company made other “immaterial” acquisitions for which it provided little information.
The company’s organic utilization is declining about 10% y/y. The company plans to “focus on yield improvement over the next six months”, but I think it will be difficult with a backdrop of declining freight expenditures.
Industry pricing is also recently under pressure, and the Cass freight expenditure index is declining
How Does the Accounting Work for Quality / Leasing / Equipment Held from Resale?
I suspect “equipment held for resale” is actually a misleading name for lease receivables. More precisely, based on management’s comments on the conference call, I think $150m of equipment held for resale is actually a lease receivable. I believe that it is taking longer than the company expected to sell these leases, hence the skyrocketing equipment held for resale.
I suspect, but can’t confirm, that accompanying the booking of these receivables is probably non-cash, sales-type (or capital) lease income that is artificially boosting profits. It won’t change my thesis much if this suspicion is not correct. I can get into more detail in the messages if anyone is interested in how I think the lease accounting is boosting profits (over and above the gain on sale piece).
The most recent 10Q and 10K conflict with management’s statements about Quality and the accounting.
Management on the last conference call:
“Due to significant growth of our Quality division, approximately $175 million of our current balance sheet debt reflects assets held for sale. This amount represents approximately $25 million of equipment inventory and a $150 million of assets that are under lease to third parties. Quality ends up leasing equipment out and then you basically sell that lease on portfolio.
“So it's equivalent that has already been leased off that's in the process of being sold, which is kind of what we've done along with our third-party financing arrangement. So therefore Quality does not hold any of the assets on the books. So those would be the leases in the essence of revenue stream that has not been sold yet, but there are assets that are not to be remarketed to be sold.”
Management: “But if you think about the $175 million ends up being more transitory in nature, more like a financing line that you'd have planned for a dealership type thing. So it's not really, yes or no, I think it does include, because you're backing that out.”
There is no mention of Quality leasing the tractors in the most recent 10K and 10Q and then selling the leases (beyond the initial portfolio sale to Element in 2014). Here’s how these filings describe these transactions:
10K: “Pursuant to these agreements, we use our volume purchasing power to purchase tractors on favorable pricing terms, which we then sell to Element. We believe Element acquires substantially all of these tractors through the incurrence of debt. We then refer our independent contractor drivers to Element, who leases tractors to such independent contractors or finances the drivers’ purchase of tractors.”
10-Q filed with the SEC: “Pursuant to these agreements, we use our volume purchasing power to purchase tractors, which we then sell to the Quality Financing Parties [defined in 10-Q as 19th and Element]. Quality then refers independent contractor drivers or fleets to the Quality Financing Parties, who lease tractors to such independent contractors or fleets or finance the drivers’ purchase of tractors.”
However, in the most recent proxy: Under the Lease Portfolio Agreements, Quality sold a portfolio of independent contractor leases for approximately $13.6 million.
Analysts are “confused”, say the business is “complicated”, want “clarification” and have “a lot of questions on Quality”
I bet. Last quarter’s conference call:
Analyst #1: So on the $175 million equipment held for sale, I understand that $40 million-ish trailers held, but the 150 component, I'm still -- you said they're on lease to be sold already. So is that coming out of the Celadon fleet? I mean, that shouldn't have anything to do with Quality, right?
Analyst #2: I guess, I'm again a little confused, why you would get gain if they're doing kind of the remarketing?
Analyst #3: So I think if you hear the call, the story has gotten very complicated.”
Analyst #4: “I just want a clarification. I think it's related to Quality…”
Analyst #5: “I wanted to ask, I know there's been a lot of questions on Quality. The announcement that we saw earlier this month with the sales attractive portfolio in joint venture that was created and us seeing more of those. How does that sort of tie into that business and how should we interpret that transaction?”
Misses earnings estimates
Violates debt covenant
|Subject||Board member resignation|
|Entry||12/04/2015 02:23 PM|
From 8K: "On Wednesday, December 2, 2015, Stephen Russell resigned as a member of the Board of Directors (the “Board”) of Celadon Group, Inc., a Delaware corporation (the “Company”), due to health reasons.
Interesting timing I think, though for all I know it has nothing to do with the business.
|Entry||12/04/2015 03:36 PM|
I think the weakness in the truck market is going to make it harder for CGI to sell the tractors that it needs to. A 15% hit to the book value of PP&E and equipment held for resale would cut net tangible book value of this comany about in half to $6/share.
|Entry||12/18/2015 03:01 PM|
Roc - thanks for the great write-up and interesting idea. We agree with the work you have done here. Have you been able to speak with any of the sell-side analysts to ask them WHY they include the gains on sales in their EPS / valuation?
From Cowen a week or two ago:
Lowering Estimates and Target, Reiterating Outperform Rating We are lowering our FY16 EPS estimate to $1.63, from $1.80. Our CY15 and CY16 EPS estimates drop to $1.63 and $1.80, from $1.70 and $1.90, respectively, as freight market conditions have decelerated further in recent weeks. Our price target drops from $30 to $27, based on our new CY16 EPS estimate and a 15x multiple, which, we believe, is more reflective of current market conditions than our prior 16x multiple. The shares are oversold at current levels, in our opinion. The stock price has been essentially cut in half since the Spring highs, compared to an average drop of 35% for TL peers. It is now trading at a roughly 30% discount to the group, an unwarranted discount given CGI's sound underlying fundamentals and strong free cash flow characteristics, in our view
I don't have access to Cowen's analyst, but I have no idea why they capitalize the gains on sale, especially since it appears that these only recently became such a big part of the earnings. I understand that the Element relationship and fleet upgrades have changed the business model somewhat, but historically, it appears that the gains were nominal, as one would expect:
|Subject||Re: Re: KNX|
|Entry||12/18/2015 03:46 PM|
Thanks for the comments. I haven't spoken with the analysts as I don't have access, but reading the conference call transcript, it doesn't sound to me like most of them understand Quality or how the accounting works for Qualtiy. I get the confusion because the company makes conflicting statements related to the accounting on the conference call and in the SEC filings. And the company makes it sound like the Quality division is getting its profits from something far more stable and sustainable than gain on sale (see below), but really we all konw it's just lumpy, transitory gain on sale income. This wouldn't be the first time I've seen analysts do what the company wants. Ha, what's new.
Management on the last conference call: "Well, the way Quality works, I think that basically provides the assets to services that the driver comes in, and they're basically, the way we look at it is more like a franchise, e-franchise type relationship, that individual from independent standpoint is able to go and run for a fleet and Quality then basically does the back office."
|Subject||Def think CGI has some structural issues but...|
|Entry||12/20/2015 09:52 AM|
Trucking stock multiples have approached 2009 levels.... Oil is at record lows which should help companies disproporationately who run at lower operating ratios... lower deadhead/out of route mileage costs...
Leverage works both ways....
If we see a rebound in multiples, this could whipsaw the other way.
I am curious to hear commentary why people think truckload finacials/multiples will deteriorate further. I personally think KNX is a little bit of an outlier. KNX does a lot of spot/irregular route business that has seen pricing come in while contract has gone up... I am not so convinced that KNX is instructive on the whole industry and even if it is...the multiples kind of reflect it...at least based on historicals..
|Entry||01/27/2016 08:23 PM|
Roc - any view on the results tonight? Thanks
|Entry||01/30/2016 08:22 PM|
I would like to see the 10-Q to get more details, especially around its Quality division and this comment in the earnings announcement press release: “lower sales volume of assets in the quarter related primarily to the holiday season as well as the timing of funding within the period”. A main point in this recommendation was/is that management scrambled at the last minute in the Sep15 quarter, forming an LLC two days before the end of the quarter to establish a funding source and sell equipment to the LLC, possibly to avoid tripping the covenant on its debt. This was similar to some of the desperate channel stuffing that we saw leading up to the 1999 tech bust.
I’ve never seen something like this end well with a company this highly leveraged (or otherwise). How in the world were there timing issues with funding in the Dec quarter when the company established a new funding partner at the end of the Sep quarter and also has Element as a funding partner? Something doesn’t smell right. Well, several things, including its accounting for depreciation and capital leases and sales-type lease accounting.
CGI missed consensus EPS for the Dec15 quarter by about 25%, despite D&A expense dropping a whopping $2.4m q/q. IF D&A had remained at the average % of gross P&E for the last 8 quarters, EPS would have been 5c lower and they would have missed by 40%. Operating income was above what I had modeled by $2m, mostly due to the unexpected drop in D&A. In the last two months, consensus EPS for FY17(Jun) came down from $1.86 to $1.45 (Zachs) and the next four quarters are about $1.35, which I think is still far too high. My guess is that this company will report at least one quarter of losses in the next four.
I believe the company is under-reporting D&A expense for capital leases, and not just for last quarter. In FY15(Jun) D&A for revenue equipment under capital leases was $54.8m, down from $55.8m in FY14. This makes no sense because revenue equipment under capital leases skyrocketed 96% from $244m at the end of FY14 to $478m at the end of FY15. Note that if you are looking at the free cash flow generation of this company, don’t forget to deduct assets acquired through capital lease obligations, as this does not show up in the investing section. I calculate free cash flow for this company at roughly negative $30m cumulatively in the past 8 quarters excluding acquisitions and negative $220m including payments for acquisitions.
I am also suspect of the sales-type lease accounting that CGI must be using for Quality, but can’t prove anything because the company hardly discloses anything related to its lease accounting. As we know from companies like Xerox, there’s a lot of latitude with sales type lease accounting.
I think management is overly optimistic in its ability to sell down the remaining $130m of equipment held for sale at its expected profit, given the current industry overcapacity, tough pricing environment, and the company’s issues with funding sources. On the conference call, management downplayed the funding issue and the risks involved in profitably unloading that much equipment in a short time in an industry with overcapacity. Management expects to dispose of the $130m of equipment held for sale in the next 6 months. CGI expects operating income from its Quality division (sales and leasing) to be $1.5-2.0m per quarter in 2016, up from $0.7m last quarter. I find this overly optimistic too. A quote from an SEC filing is clearer about the risks than management was on the conference call:
“Historically the markets for new and used tractors have been volatile. A change in these markets could negatively impact the price at which Quality is able to acquire and sell tractors, negatively impact Quality’s ability to resell tractors at a profit, and negatively impact the interests of Element and other financing sources in purchasing the tractors and providing financing.”
Average revenue / tractor per week was down 12% y/y. It was growing in the first half of CY15.
Revenue per loaded mile was up 7% in 4Q, but I expect this metric to decelerate sharply. KNX’s revenue per loaded mile was down 1.5% last quarter. Including spot business, KNX expects pricing to be down y/y for 1H. Swift indicated that pricing is flattening out. KNX is seeing pressure on spot pricing and a lack of spot volume. Last year CGI put “a significant amount into the spot market” but I think this will be tougher this year.
In reviewing last quarter, I noticed that proceeds on sale of property and equipment were $14m in FY4Q15(Jun15) but gain on sale was 67% of that at $9m. In FY2Q15(Dec14) proceeds on sale of property and equipment were $3.8m, but gain on sale was 104% of this at $4.0m. This doesn’t make sense. The company didn’t break out deferred leasing revenue and other leasing details at the end of FY3Q, making it difficult to see if sales-type lease accounting had something to do with this.
CGI acquired Tango at Sep 30 (although it isn’t clear from the press release when it closed and there is no mention in the Sep quarter 10Q) and stated at the time that they expected “the acquired operations to be accretive beginning in the December 2015 quarter.” The company stated in the Dec quarter earnings release that there were $1m of transition related expenses for Tango, which analysts excluded from their EPS calculations.
Leased revenue equipment held for sale declined 6% from Jun 30 to Dec 31 (We don’t have the breakout of this category for Sep 30). But deferred leasing revenue fell 16%. This disconnect doesn’t make sense to me and suggests aggressive accounting that is boosting operating income (or sale of more profitable leases first, leaving less profitable leases to be sold later, which will hurt future results).
Note that net income for the six months from Jun to Dec was $18m. Other comprehensive loss increased by $15.6m during that same time. Most of the increase in this loss I believe is due to fuel derivative losses. As the company recognizes the associated expense for the fuel, the hedges will be recognized, depressing earnings at that time. In other words, the company probably won’t benefit from the decline in diesel prices to the extent some may expect. Or if you prefer, had the company recognized the derivative losses, it would have reported earnings that were 87% lower in the last 6 months.
There has not been any insider buying of the stock down here.
I covered my entire position in the $7s. I’ve been ripped too many times on stocks like this to not try to get a better entry point. However, after digging into last quarter, I plan to re-establish a position and hope for a bounce to add more (I’d be surprised if it didn’t bounce). I’m leaving this recommendation open because I think it will trade significantly lower at some point this year. I think there is a 50/50 chance the equity is a zero due to the high leverage, industry backdrop and my suspicions about the accounting.
|Entry||02/16/2016 08:25 PM|
I believe that Celadon management continues to make misleading statements in an effort to hide negatives from investors. I’ll let the lawyers sort out what to call this if it implodes. I’d be very surprised if management can keep this from imploding given the extremely tough industry backdrop and leverage involved-- it’s just too hard when the tide is going out. The company is scrambling to move assets off balance sheet in an opaque manner, while making accounting changes, such as one that boosted EPS by 33% in one quarter. Management sold millions of dollars of stock at higher prices and hasn’t bought any despite the stock cratering. Here’s my review of the 10-Q.
Analyst on Dec quarter call: “then you mentioned timing of funding within the period. Is that funding for some of these leased sales, or is that – can you explain what went on there and if that situation is resolved itself since the beginning of the year?
Management: “Again it’s not like – it wasn’t meant to be out there like there was a disruption or anything of that nature.” “Quality business is comparable last year, end of the year based on seatings, based on time of the year holidays all that, it’s comparable year-over-year, so that’s good thing.” “...we're trying to say that ongoing fundings are happening.”
New disclosure regarding Quality’s: “growth has recently slowed and is expected to remain constrained in the near future due to lower amounts of purchases by our funding sources”
Management on Dec quarter call: “I’d like to address our current operating – our leverage position. Leased assets and assets held for resale represented approximately $130 million in this December quarter, compared to the September quarter of approximately $175 million. We expect to dispose of this equipment over the next six months. We do not anticipate having any significant net capital expenditure needs for the next 12 to 18 months, so we will continue to focus on paying down debt and reducing our leverage. Our debt reduction plans over the next six to 12 months should result in a decreased leverage ratio to below 2.5x from our current position of about 3.4x leverage.”
Management implies that their efforts to move equipment off balance sheet and reduce capital spending is leading to a reduction in leverage. Management fails to note in the press release or in the conference call that the “reduction” in leverage in the December quarter was almost entirely due to the conversion of capital leases to operating leases, which is no reduction at all in economic terms. The company converted $61m of capital leases to operating leases during the december quarter, the first time the company has done this in recent history; this maneuver accounted for 90% of the reduction in net debt from Sep to Dec of $67m. Again, not one word on the conference call or in the press release about this.
Residual guarantees on operating leases jumped from $6m at the end of September to $34m at the end of December.
Analyst on Sep quarter call, held on October 29, 2015: “one of the other questions that we've been getting is just around the exposure to the used truck market.” Company: “We don't have any residual guarantees, so that's not an issue.” “...therefore we don't really have an exposure necessarily to a declining equipment market.” Note the qualifiers “really” and “necessarily”.
Contrast those statements to these facts:
A month prior to the date of this call, the company entered into an agreement with Element that established a reserve account where “Celadon/Quality shall contribute additional funds to the existing Reserve Account to be used as otherwise generally provided in the Reserve Account Agreement in order to bolster the reserves available with respect to the 2014-2015 Vintage” and this reserve account is “being held to collateralize and provide recourse for credit and asset losses.”
“Element Financial Corp., Delaware corporation (“Element”) and Celadon Group, Inc., a Delaware corporation and Quality Equipment Leasing, LLC, a Delaware limited liability company (together, “Celadon/Quality,” or “Servicer”) are parties to an Amended and Restated Reserve Account Agreement dated as of September 28, 2015 (the “Reserve Account Agreement”), pursuant to which a “Reserve Account” for Element’s benefit has been established. The Reserve Account is being held to collateralize and provide recourse for credit and asset losses experienced under certain transactions originated by Servicer and transferred to Element or transactions originated by Servicer on behalf of Element (the “Transactions”).”
Buried out of sight in exhibit 10.4 to the Dec 10-Q is a new letter agreement dated December 29, 2015 with Element Financial where Celedon was to contribute “additional” funds of $2.5m for the benefit of Element, prior to December 31, 2015. There was no mention of this material hit on the conference call or in the press release. It wasn’t even disclosed in the 10-Q, despite $2.5m being a material amount in relation to the segment’s reported operating profits of $9m for the last 6 months.
There was no mention of this in the conference call or press release, despite the fact that this one-time accounting maneuver boosted EPS by 33%. This was outlined in my previous post, though at the time I didn’t know exactly what had happened:
“In accordance with its policy, the Company reviews the estimated useful lives of its fixed assets on an ongoing basis. This review indicated that the actual lives of certain tractors and trailers were longer than the estimated useful lives used for depreciation purposes in the Company’s financial statements. As a result, effective October 1, 2015, the Company changed its estimates of the useful lives and salvage value of certain tractors and trailers to better reflect the estimated periods during which these assets will remain in service. The estimated useful lives of the tractors and trailers that previously were 3 years for tractors and 7 years for trailers were increased to 4 years for tractors and 10 years for trailers. The effect of this change in estimate was to reduce depreciation expense for the three months ended December 31, 2015 by $2.9 million, increase 2016 net income by $1.7 million, and increase 2016 basic and diluted earnings per share by $0.06. As the change went into effect as of October 1, 2015, the three and six months ended December 31, 2015 impact would be the same.”
Management on Dec quarter conference call” “We have continued to see positive results from our sales and leasing division.” “Therefore, the operating income related to our sale and leasing division was approximately $700,000 for the quarter.” According the 10-Q, operating income for this segment was a loss of $672,000, not a profit as the company stated on the call.
Management removed this line from the Sep 10-Q when it published the Dec 10-Q: “In accordance with ASC 605-45, we recorded these transactions on a net basis as an agent versus grossing up the sales in revenue and costs of goods sold as a principal.”
Does this mean that management changed the way it accounts for equipment sales and leasing? I believe this is where the cockroaches are lurking.
Two accounts in the cash flow from investing section: 1) Purchase of property and equipment and 2) Proceeds on sale of property and equipment. Last quarter, proceeds on sale of property and equipment was negative $7m. This doesn’t make any sense. Did the company pay $7m to get out of its capital leases, bury the $2.5m reserve account payment here, some combination, or something else?
Management on Dec quarter conference call: “During the December quarter, we were negatively impacted by about $1.2 million of one-time transactional charges related to the Tango acquisition.”
Management in September 30, 2015 press release: “We expect the acquired operations to be accretive beginning in the December 2015 quarter.”
There was no mention of Tango in either the September or December 10-Q, despite this being a more material acquisition than others that the company disclosed and despite the company flagging the “one-time” losses on the conference call.
There’s more, but I’m out of time….
|Subject||F3Q16 - debt growing, more accounting games|
|Entry||04/27/2016 07:36 PM|
CGI just reported its F3Q16/C1Q16 results. Roc, congrats as your thesis is definitely playing out. The headline revenue missed slightly (more on tis below) and adj'd EPS missed, per Bloomberg. And based on commentary from CVTI tonight (as well as KNX/SWFT last week) trucking fundamentals are not improving in April.
More importantly to CGI, though, their ticking time-bomb of a balance sheet plus the hidden/contingent liabilities from Quality Companies are getting worse. After last quarter's sleight of hand - where $60mm of on-balance sheet debt was sneakily reclassified as off-balance sheet operating leases - I was expecting to see on-balance sheet debt optically decline again this quarter. However, net debt actually increased 8mm q/q as equipment held for sale increased 5mm q/q...this is despite management's claim on last quarter's call that they'd sell down virtually all of their equipment held for sale/lease portfolio and delever by FY-end. Why isn't this happening? Probably because a) used class 8 truck prices are in freefall and b) the credit quality of the lease portfolio is so bad that nobody wants to buy them. On (b), this is why, as Roc pointed in a message below, CGI had to contribute an extra $2.5mm to their agreement with Element Financial (https://www.sec.gov/Archives/edgar/data/865941/000100888616000271/exhibit104.htm) despite management claims that they have no residual exposure to the leases they sell.
Moreover, lease expense ("Revenue equipment rentals"), which should be indicative of the amount of operating leases, mysteriously went up ~3x q/q...so when we get the 10Q, it'll be interesting to see how much operating leases changed. Bear in mind that CGI's leverage is calculated on a lease-adjusted basis so these accounting games CGI plays to make themselves look less levered than they are, ultimately won't prevent a default.
Last bit of balance sheet fun: CGI's goodwill increased $3mm q/q..seemingly trivial but it implies they made acquisitions (which they didn't announce)...in other words, CGI missed rev and EPS this quarter despite sureptiously acquiring other assets/companies (which wouldn't be in consensus numbers).
|Subject||Re: F3Q16 - debt growing, more accounting games|
|Entry||04/28/2016 09:55 AM|
Tml, thanks for the write-up of the quarter. In addition:
|Entry||07/27/2016 12:05 PM|
...that there has been no press release yet from Celadon announcing the date of the June quarter and fiscal year end earnings release and conference call.
In the last three years, Celadon announced the date on 7/15/2015, 7/11/2014 and 7/10/2013, making this year about two weeks overdue.
As we all know, accouting issues are more likely to be flagged by auditors at fiscal year end. Perhaps the delay this year is nothing, but I think this delay increases the chances that we are about to hear that the auditors or the SEC has a problem with Celadon's accounting.
|Entry||08/16/2016 11:24 AM|
Still nothing...any updated thoughts on why?
|Subject||Re: Re: Interesting...|
|Entry||08/16/2016 03:41 PM|
Not sure. This company engaged in some very shady shenanigans and accounting -- probably top 3 that I've seen for a U.S. company that's operating a real business in over 20 years of short selling (obviously there have been plenty of frauds, but those never had a real business). Maybe only once or twice before have I been short a stock this far below tangible book. Hopefully I don't get burned by not covering here -- but I'm waiting. One thought I had besides the company having issues with it's accounting/auditors is that it is shopping itself in hopes of being acquired. It's a risk that I unfortunately have first hand experience with, but I think the leverage here and the true earnings power (or lack thereof) is such that any acquirer will just wait for them to file.
This is obviously anecdotal and more often than not you'll see more negatives than positives because people don't bother posting the postive, but recently I was poking around on message boards and overall, my impression is that truckers are unhappy when they lease from Quality, complaining of hidded charges and inability to make a profit.
|Entry||09/22/2016 06:42 PM|
For those interested, a quick review of Celadon's 10-K vs managment's statements over the past year shows that either management has been lying, or they didn't know what was happening in their business. There's a reason the company didn't hold a conference call without citing a reason why. This is first time in many years, if not ever (I looked back to 2010, I'm guessing they've always held a call), that the company did not have a conference call.
New in the 10-K:
"The Lease Shortfall Advances, along with certain sale shortfall and other amounts, initially were subject to satisfaction from a reserve fund that amounted to approximately $74 million. This fund has been exhausted. We are required to fund the Lease Shortfall Advances directly after the fund is exhausted. As of June 30, 2016, we have advanced approximately $31.9 million to our third party financing provider under the Lease Shortfall Advances. This amount is expected to grow during fiscal 2017 if the transactions contemplated by the MOU are not completed. The actual amount could vary significantly based on collections and tractor utilization and could be substantial."
"Recently, our Lease Shortfall Advance to our third party financing provider and a depressed market for freight and used equipment have decreased our liquidity. The extent to which the Lease Shortfall Advance impacts our liquidity in the future will depend largely on utilization and collections with respect to the underlying lease portfolio, which have been volatile and cannot be precisely predicted. If we are unable to improve utilization and collections, we believe the Lease Shortfall Advance could present significant liquidity constraints. We have finalized the MOU and will be addressing definitive agreements with our third party financing provider to restructure our arrangement, which would likely include an elimination of the Lease Shortfall Advance."
Even if the new agreement with their third party financing company works as planned, I still see major liquidity issues. This business burned $220m of free cash flow last year after adjusting for sale-leaseback transactions/conversion of capital leases to operating leases and obligations incurred under capital leases.
|Subject||end game near?|
|Entry||10/12/2016 11:32 AM|
This author started writing 8 months after this idea. I think his recent report raises some good points.
|Subject||Still think this is a zero|
|Entry||04/05/2017 01:34 PM|
I don't know if anyone cares, but here's another report alleging fraud and saying CGI equity is worthless. Obviously I agree. I also agree that the equity in the recently formed JV is worthless.
|Subject||Re: Re: Still think this is a zero|
|Entry||05/10/2017 10:28 AM|
Yes, I still think it is a zero. A good short from here? I’ve found it difficult to have a sizable position on pre-bankruptcy shorts due to their volatility and odds baked in the price. I am never sure about these things going to zero, but it’s been my experience that when this fact pattern exists, in this case suspected accounting fraud, creation of JVs to move assets off balance sheet, management resignations, high leverage, management lying on conference calls (e.g. see message 9), the stocks go to zero. At this point in the life cycle of these shorts I don’t spend as much time on them as I feel I know what’s going to happen and I don’t like having big positions on $2 leveraged stocks where there’s a high probability of bankruptcy already imputed in the share price (i.e. the edge/odds calculation just isn’t as good as it was 1.5 years ago … my guess on the probability of bankruptcy is closer to the market’s at this point).
Big picture, Celedon contributed $162.5m of book value of equipment to the JV that was magically still worth book value even though competitors have for some time talked about how difficult the pricing environment has been (I think these assets are probably worth roughly $70m). The JV acquired Element’s interest in a fleet held in the Element Transportation Asset Trust valued at $659m (plus another $8m…. Net of $100m) and 19th capital borrowed a lot of money from Element to do it. My guess is the assets Element contributed are worth a lot less than the stated value, maybe $100m or more less, i.e. net value of zero or negative.
Meaning I think the equity in the JV is close to worthless, which means so is the minority interest asset on CGI's balance sheet (and Element’s). Why would element do this? My guess is that Element did not contribute anything of value and received a chance at some value from Celedon. Brighter minds have better ideas I’m sure. Many of the details are laid out in the exhibits to the last 10-Q. For example, the sub agreement: https://www.sec.gov/Archives/edgar/data/865941/000100888617000026/exhibit102.htm
From the sub agreement in 10-Q, but need to look at transaction when it was announced to get all the details form CGI’s side.
Here’s an email I sent to an investing buddy on Feb 1 when earnings came out, but before the details of Element’s side of the transaction were published with the 10Q. While details are off since I didn’t have the Element piece, I think the conclusion is the same, as I think Element’s asset contribution is overvalued (e.g. assume it’s overvalued by $100m, then they contributed zero and the math below holds).
Feb 1 email:
I think stock goes up as on the surface it was not a disaster. I still think it is a zero eventually. 35% short interest means it could go up a lot in near term.
I think operations burned $10m or more excluding the JV transactions (which for a tiny company like this are exceedingly complicated), but it won't be apparent to everyone until 10Q comes out.
I'm pretty sure CGI moved $90ish million of losses to the JV it created with its financing partner on 12/30/2016 and it is now on the balance sheet as an asset called minority interest. This number is no coincidence and it is close to what I originally estimated they would have to write down. This is similar to the trick they pulled before where they created a JV on the last day of a quarter and moved millions of equipment to it. I'm 98% sure this is an accounting fraud. A big thing that gives me confidence is the company has burned $160m of cash in the last 4 years (vs only $200m in tangible equity excluding this minority interest) and has not generated any cash in the last ten years or recently, despite a massive shrinking of its balance sheet recently.
CGI removed above and netted so now it appears as $100m in minority interest (nice round number because they could figure out the exact value of those trucks down to the penny and it magically came out to $100,000 exactly!). That's their 50% interest in the JV. Obviously I think it's worth a lot less than $100m and the difference is Element's balancing contribution is really goodwill that is worth nothing at all.
Remember you asked, why would their financing partner agree to new terms or do a JV that would help a company in dire straights? They wouldn't. I think CGI gave Element a good deal in exchange for being able to move losses off it's books. Remember, this company had the largest amount of tractors/trailers for sale as a % of assets out of all the competitors and competitors are saying that used/new equipment pricing is very tough. And CGI magically took no losses in this case? I've never seen a company like this go into a major downturn with huge capital assets for sale (that they acquired immediately before the downturn at peak pricing) that didn't take a big loss.
From 8K: "Element (i) transferred, conveyed, and assigned to 19th Capital certain of Element’s beneficial interests in certain fleet assets described in the Subscription Agreement, together with the associated lease agreements (the “JV SUBI Interests”), held in the Element Transportation Asset Trust, a Delaware statutory trust (the “ETAT”), (ii) contributed an amount equivalent to $100.0 million in cash of equity to 19th Capital, which was applied against the outstanding principal balance of the Term Loans (as defined below) as part of a prepayment made on the Closing Date and settled on a net basis, and (iii) transferred, conveyed, and assigned to 19th Capital certain of Element’s beneficial interests in the certain other fleet assets described in the Subscription Agreement, together with the associated lease agreements (the “Equipment SUBI Interests”), held in the ETAT. In consideration of the foregoing, 19th Capital (i) issued to Element membership units of 19th Capital, which, after the consummation of the Transactions, constituted approximately 49.99% of the issued and outstanding units of 19th Capital, and (ii) received certain term loan financing from Element."
So Element contributed "an amount equivalent to" $100m in cash and "certain fleet assets" with undisclosed value. But that $100m cash was applied against outstanding principal of Term Loans (as defined below) that were granted at the same time, so Element contributed no actual cash? They don't define Term Loans. Only other reference in 8k is later in paragraph where they write: "received certain term loan financing from Element." So Element loaned the JV $Xm and then put in cash of $100m so that really Element put a net $X-100m in while CGI contributed $100m of equipment that just happened to be worth book value?
The Company (i) contributed $35.3 million in cash to 19th Capital, (ii) conveyed to 19th Capital equipment (primarily tractors) categorized as equipment held for sale, leasing assets held for sale, or leasing assets used with a net book value of $63.6 million, and (iii) received credit for $1.1 million of unencumbered cash in the bank accounts of 19th Capital immediately at the consummation of the Transaction. In consideration of the foregoing, 19th Capital (i) issued to the Company membership units of 19th Capital, which, after the consummation of the Transactions, constituted approximately 49.99% of the issued and outstanding units of 19th Capital, (ii) paid to the Company $31.8 million in cash for reimbursement of previous payments made by the Company related to the Element assets, and (iii) issued the Company an obligation to distribute restricted cash of 19th Capital and its subsidiaries at the closing of the Transactions of approximately $2.5 million at such time as such cash becomes unrestricted. Going forward, the Company has agreed not to enter into additional leases as lessor in the equipment leasing business, subject to a modest exception for short-term leasing pending ordinary course dispositions from the Company’s trucking fleet.
My guess is that CGI contributed this net book value of $93.90 to the JV plus transaction costs to get to $100m. Element Loaned the JV $160m and capitalized the JV with $160m-ish of cash. $100m then went to pay off $100m of the loan of loan. $58m went to CGI (that's in the net $93.90...so CGI contributed $194m of equipment for $58m of cash and transferred $42m of liabilities). The balancing entry on JV books is goodwill from Element's side. We won't know for a few quarters until we see how the JV performs or earlier if I can get the JV financial statements.
Just guessing tangible equity of the JV is about zero based on my estimate of the true value of the equipment. There are some assets here that will pay off Element's debt. They also probably improved their position with CGI as CGI was liable for shortfall value on the equipment.
Certain Effects on the Company’s Consolidated Financial Statements
The Transactions are expected to result in significant changes to several line items in the Company’s consolidated balance sheet, as compared with balances at September 30, 2016. Such changes are summarized below. The following summary is not a complete listing of all expected entries.
Long term assets. The collection of an amount previously recorded under “Other assets” will reduce this balance by approximately $31.8 million. Also, as part of the transaction the Company received proceeds of $6.7 million in payment of deferred purchase price from a sale to 19th Capital in the June 30, 2016 quarter. The remaining $1.9 deferred purchase price will be classified as a long term asset that will be collected at a later date.
Current liabilities. The receipt of proceeds from 19th Capital for the current portion of the deferred purchase price, as well as the contributed interest in the deferred purchase price related to two transactions in which tractors were sold to a 19th Capital SPE in the fourth quarter of FY 2016 and the first quarter of FY 2017, will reduce “deferred leasing revenue" liability by approximately $11.9 million.
Equipment held for sale, leased assets held for sale, and leased assets. Equipment with net book value of approximately $162.5 million was disposed of in connection with the Transactions. These assets were primarily recorded under equipment held for sale, leased assets held for sale, and leased assets. The Company does not expect to record a significant gain or loss on disposition of this equipment.
Long term liabilities. The receipt of proceeds from 19th Capital for the current portion of the deferred purchase price, as well as the contributed interest in the deferred purchase price related to tractors sold to a 19th Capital SPE in in the fourth quarter of FY 2016 and the first quarter of FY 2017, will reduce “other long term liability” by approximately $30.7 million.
Minority investment. Celadon expects to record approximately $100.0 million as a minority investment and record results of the joint venture using the equity method of accounting. The prior equity investment of $2.0 million in 19th Capital was redeemed and will not be outstanding.