November 16, 2015 - 5:44am EST by
2015 2016
Price: 13.50 EPS 1.64 .15
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
TEV (in $M): 966 TEV/EBIT 14 62
Borrow Cost: Available 0-15% cost

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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


·         Quality

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.



·         Element

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


Credit Agreement: http://www.sec.gov/Archives/edgar/data/865941/000100888615000017/exhibit101.htm

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?”





I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.


Misses earnings estimates

Violates debt covenant

Equity financing

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