|Shares Out. (in M):||39||P/E||NM||NM|
|Market Cap (in $M):||469||P/FCF||NM||NM|
|Net Debt (in $M):||150||EBIT||60||106|
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Roadrunner Transportation Systems (RRTS) is recapitalizing its business through rights offering. This situation embodies many attributes that we look for in a special situation: completely off the radar, a likely forced selling activity, finalizing corporate action during holiday season when fewer eyes are watching, insiders don’t want you to know about it (a Conspiracy Theory Investment that beethoven brilliantly outlined in the TOWR write-up), and a highly motivated activist and insiders with skin in the game.
Highest return in a chapter 11 restructuring comes from new equity that is distributed to eligible parties before it gets offered to the public and such opportunity is playing out in public where an investor can purchase shares at a price equal to the distribution of new equity. We believe that this under-followed special situation offers investors with highly attractive risk / return profile. Investors can either long the shares now and subscribe for the rights or wait for the rights offering and build the position through rights or shares or both.
Company and situation background
RRTS is a hybrid of asset-heavy and asset-light logistics provider in the US. The company operates three divisions: Truckload Logistics (54% revenue), Less-than-truckload (20% revenue) and Ascent Global Logistics (26% revenue). Truckload Logistics division arranges the pickup and delivery of truckload, intermodal and ground and air expedited freight through its own services centers, brokers and independent brokerage agents. LTL division provides a point-to-point delivery of smaller / partial truckloads. Ascent Global is a domestic and international logistics solutions provider.
RRTS is going through a tough period which was mostly self-inflicted. In January 2017, RRTS identified accounting errors that involved unrecorded expenses and indication of goodwill impairments. These errors turned out to be an accounting fraud – two former executives were charged for their alleged participation in the accounting and securities fraud scheme that resulted in a loss of more than $245m in shareholder value. Beginning in 2014 the two conspirators found $7m in overstated accounts on balance sheet of one Roadrunner’s operating companies. Instead of writing off the full amount, they developed a plan to adjust the balance sheet by small sums each month between 2014 and 2017 to conceal the extent of the misstated accounts.
Following the outbreak of the scandal, a series of event led the company to where it is today
• RRTS appointed a new independent Chairman of the Board and replaced the former management team
• On March 2017, Elliott unveiled its 7.5% ownership in RRTS which was increased to 8.6% a month later
• RRTS entered into a $540m preferred share investment agreement with Elliott. The preferred shares were in five series requiring a hefty dividend of ~16% ~18%. Of this $240m was refinanced with a revolver and extra ~$35m preferred shares were issued
• Along with the above financing, Elliott appointed two directors into the board and received small amount of warrants
• RRTS completed restating its historical financial statements in January 2018
RRTS also struggled to turn its business around. Between 2010 and 2014, RRTS grew its topline by more than 25% yearly through aggressive acquisitions while in the recent two years the growth dropped to a low single digit. On the back of deteriorating balance sheet and high preferred dividends, RRTS was unable take advantage of the favorable market conditions in 2018.
On 8th October, RRTS received notice regarding continued listing standard from NYSE. RRTS’ market cap had fallen below the NYSE’s continued listing standards relating to minimum average of $50m for over a consecutive 30 trading-day period. RRTS said it intends to submit a plan to NYSE to regain listing compliance within the required 18-month timeframe. The company has 45 days to submit the plan to the NYSE.
On 18th October, RRTS received a similar notice, but this time for a different standard – failing to keep its stock price above $1.00 per share over a 30 trading-day period. The company can regain compliance with the standard if the last trading day of any calendar month during the six-month period following the receipt of the notice or on 12th April 2019, six-month following the notice date.
On 23rd October, RRTS filed a preliminary proxy that details the rights offering. Management laid out forward-looking statements with adjusted EBITDA and proforma capitalization with and without rights offering. RRTS also proposed to amend the Certificate of Incorporation to accommodate for a reverse stock split.
On 7th November, RRTS released 3Q earnings. Operation showed moderate improvement, limiting operating loss and showing top-line growth despite the sale of one of the operations in 2017. Management also reiterated the business improvement plan.
On 9th November, RRTS announced the signing of Standby Purchase Agreement with Elliott. This agreement confirmed the backstop commitment by Elliott and over-subscription rights to shareholders other than Elliott. The company also agreed on amending the credit agreement of ABL facility to accommodate for the rights offering.
On 19th December, shareholders approved of the recapitalization and amendments to the company's registration to accomodate the recapitalization.
Investment rationale – rights offering with a backstop agreement
Primary purpose of the rights offering is to retire the onerous preferred shares that Elliott owns. Any unsubscribed rights will be backstopped by Elliott, while Elliott will participate in the basic subscription but not in the oversubscription. By providing the backstop Elliott is effectively converting its debt (preferred shares) in to equity, hence why we think this is essentially a loan-to-own transaction. Current shareholders will get heavily diluted, unless they choose to participate in the rights offering. A reverse stock split will follow the rights offering to comply the NYSE listing requirement of maintaining share price above $1.
On 13th November, RRTS filed a definitive proxy for the rights offering, reverse stock split and other various amendments to the Certificate of Incorporation. Some key figures to the finalized offering,
• 900,000,000 shares of common stock upon exercise of rights to purchase shares at $0.5 (raising $450m) – current number of outstanding shares is 38.5m
• Each right therefore, provides the right to buy 23.14 shares at $0.5 per share
• Unsubscribed rights will be backstopped by Elliott at the same price as the basic subscriptions price of $0.5
• Rights will be tradeable starting from 9th January to 31st January
• After the rights offering, company will conduct a reverse stock split, which will be in the range of 1-for-35 to 1-for-100
As most of the proceeds from the rights offering will be used to retire the preferred, an incremental dollar that Elliott puts in to backstop the offering has a different value depending on the result of Elliott's ownership of RRTS after the recapitalization. Using the management’s 2020 projected EBITDA and forward capitalization as a base, we can back calculate the implied EBITDA multiple that Elliott is incrementally paying for the resulting ownership. Assuming none of the shareholders participate to the rights offering, Elliott is incrementally paying $45m ($450m - $405m preferred) to purchase an extra 83% of ownership. This implies around 6.0x on management’s 2020 projected EBITDA of $106m. However, if say 50% of the shareholders participate to the offering, that same $45m incremental dollars represent only an extra 35% ownership of RRTS, implying around 10x 2020 projected EBITDA. For this motive, we believe that Elliott may want fewer investors to subscribe to the rights and hence, could be downplaying the situation. This also leads us to believe that the management’s adjusted 2020 EBITDA forecast with a 4.5% margin (when industry peers EBIT margin is around 8.5%) is perhaps overly and intentionally conservative (more on this later).
There are more clues that point to Elliott’s intentions. The proxy says:
We will use any remaining net proceeds for general corporate purposes, which amount will vary based upon the amount of rights exercised by stockholders other than Elliott because our transaction fees are structured such that we pay an additional fee for rights exercised and shares of common stock purchased by stockholders other than Elliott. Assuming 0%, 25%, 50%, 75%, and 100% of our stockholders other than Elliott exercise rights and purchase shares of our common stock in the rights offering, we estimate net proceeds remaining for general corporate purposes will be $33.7 million, $31.3 million, $28.4 million, $23.8 million and $17.9 million, respectively, if the rights offering closes by January 31, 2019
The difference rises from the fact that expenses for RRTS to service ex-Elliott shareholders rights is higher than servicing Elliott’s rights. At the same time, RRTS’ ABL requires RRTS to retain $30m in net cash proceed from the offering, so any shortfall below this, Elliott has agreed to waive the accrued and unpaid dividends so that the proceed from the offering does not fall below $30m. We see from the above projections that when half of the stockholders other than Elliott, the net proceeds falls below $30m. This gives additional incentive for Elliott and the management to want fewer ex-Elliott shareholders to participate. As a context, the difference between the 0% and the 100% scenario is $16m ($33.7m - $17.9m), while RRTS paid $14m on ABL interest in 2017 - the difference is material to RRTS.
With this skepticism in mind, we tried to figure out what Elliott’s intentions could be in varying circumstances. First here is a quick back of the envelop calculation of Elliott’s commitment after the rights offering would be ~$413m in total
• Preferred share $335m
• Common share before rights offering $33m (Elliott’s cost base for the commons)
• Backstop funding of $45m
Regardless of how many old or new shareholders subscribe to the offering, Elliott is committing $413m, but the only difference is the resulting ownership after the offering. We organized the outcome of the rights offering and Elliott’s objective in a 2x2 matrix – Resulting Elliott holding % after the offering (large, small) x Elliott’s intentions (make money, breakeven), and explored each scenario with back-of-the-envelope figures. Given Elliott’s accrued dividends and an entry price of ~$6, it is prudent to consider the case where Elliott would just want to breakeven. On Elliott’s intention to make money cases, we assumed that Elliott will want to roughly make a 17% annualized return (given its dividend rates on the preferred) on its $450m investment in three years and held the company’s EBITDA multiple at 6x.
1. Elliott ends up with large shareholding and wants to break even: This is by far the easiest case to achieve for Elliott. Assuming Elliott ends up with around 95% of the company (i.e. majority of current shareholders decide not to participate), the management would need to achieve around $100m EBITDA for Elliott to break even on their $413m investment. This is in line with management’s 2020 EBITDA forecast of $106. In this case, the implied share price is roughly 3% below the current theoretical ex-rights price.
2. Elliott ends up with small shareholdings and wants to break even: Due to large participation of the existing shareholders, Elliott ends up backstopping for fewer shares and ends up with roughly 28% of the new capitalized RRTS. If Elliott wants to break even the company needs to achieve around $280m EBITDA. Shares get a huge upside of 220% but the run-rate assumption is aggressive without some acquisitions. (more on this later)
3. Elliott ends up with large shareholdings and wants to make money: To achieve Elliott’s target return of roughly $660m, the company needs to achieve an EBITDA of $153m. Share price results in c.50% upside from the current ex-rights price.
4. Elliott ends up with small shareholdings and wants to make money: Elliott’s resulting ownership is the same as Case 2, and the required return for Elliott is the same as Case 3. By working backwards from target return, EBITDA should be around $440m – even more aggressive than Case 2. The implied upside here comes to 411%. In this case, the resulting RRTS is a $2.4bn market cap company, when RRTS’ market cap hovered around $1.0bn before its troubles. To achieve this level organically certainly looks challenging but not unattainable through disciplined buy and build.
The cases reflect the extreme ends and the actual result will be in the spectrum of the above. The most important outcome of the analysis is that the current stock price (with rights) has meaningful downside protection based on any combination of the outcome of the shareholding and Elliott’s intentions. Our expectation now, is for the outcome to fall somewhere between Case 3 and Case 4. Definitive proxy reveals certain changes that gives Elliott more control over the business and we believe it shows Elliott’s confidence to restructure and turn around the business. For example, no. 11 of the proxy vote is to “approve an amendment to....to permit stockholders holding a majority of our outstanding common stock to remove directors with or without cause” – clearly giving more power to Elliott. Also post the offering, Elliott will represent the board in accordance to the resulting shareholding. Elliott currently represents 2 out of 10 members. Unlike other situations Elliott is involved in Europe (notably the board fight within Telecom Italia), RRTS is an American company sharing American way of doing business. RRTS looks to be much more susceptible to the restructuring process dictated by Elliott. RRTS is also an incomparably simpler business.
Investment Rationale – keeping a low profile
We wouldn’t go far as to call this a sand-bagging but given the insider’s intentions outlined, we think the management’s forward-looking statements could be somewhat artificially suppressed. RRTS employs a hybrid model of asset-heavy and asset-light business. Asset-heavy peers such as Saia and Marten, record around 13-20% EBITDA margin while asset-light peers such as CH Robinson record around 6%. Current asset-lite business of RRTS records around 6% EBITDA margin, largely from growth in retail consolidation and domestic freight management. Retail consolidation resulted in growth from existing and new customers and domestic freight management benefited from higher truckload and LTL brokerage. RRTS CEO states that RRTS ought to achieve EBITDA margins of single high digits and the 2020 expectation of 4.5% shows the progress toward achieving that point. If there are any expectation of a tuck-in acquisition, this profile could also materially change. The company will conduct a full business portfolio review post the rights offering and intends to focus on asset-lite side of the industry (providing in-out bound logistics solutions and freight forwarding) and get rid of a large portion of loss-making routes on the LTL side which is the sole culprit of the company's poor margin.
During our conversation, the CEO pointed out that the company intends to become a platform company that can perform tuck-in acquisitions to increase its capacity and reach. Elliott will play a large role in execution at the board level. Therefore, the growth and margin profile of the company will significantly change depending on what, when and how many acquisitions RRTS conducts until judgement day. This leads to our next rationale on insider incentives.
Investment Rationale – insider activity and retention bonus
Our conspiracy plot thickens – reviewing the management’s activity and incentive structure, we have developed a reasonable expectation for a hard catalyst during 2019.
First, we would like to highlight the increased insider buying activity after the announcement of the Standby Purchase Agreement with Elliott. From the 13th to 16th of November,
• CEO Curtis Stoelting increased shareholding to 1.14% of outstanding stock (56% increase)
• CFO and Executive VP Terence Rogers increased shareholding to 0.21% of outstanding stock (10% increase)
• COO Michael Gettle increased shareholding to 0.69% of outstanding stock (13% increase)
• CCO (Chief Compliance Office) Robert Milane increased shareholding to 0.04% of outstanding stock (80% increase)
• Board member Christopher Doerr increased shareholding to 0.21% of outstanding stock (163% increase)
• President of Roadrunner Freight Frank Hurst increased shareholding to 0.06% of outstanding stock (160% increase)
• Scott Dobak, an Elliott appointed board member, increased holdings to 0.04% (179% increase)
• Elliott increased its shareholding from 9.6% to 13.6% (40% increase)
Absolute amount of the purchase may seem small and the increase in holdings may look pronounced given the low base, but the context of the transaction is revealing. CEO gets paid $570K base salary, so after tax that is roughly $360K. Divide that by 12, it’s roughly $30K income per month before any living expenses. On top of that the company’s stock awards value lost 93% year-to-date. $80,000 therefore we believe is not a negligible amount of money that he put in. Mostly likely he will at least exercise basic subscription to avoid dilution, so he will put even more money in.
There is more – On 9th July 2018, RRTS entered into management retention agreements with four key management members. Below highlights the list of management and the agreed proceed of the retention agreement, and what that represents relative to the individual’s base salary
• Curtis Stoelting, CEO - $3,178,000, 5.6x annual salary
• Michael Gettle, COO - $2,858,000, 5.0x annual salary
• Terence Rogers, CFO - $995,000, 2.5x annual salary
• Scott Cousins, former CIO (Chief Information Officer) - $783,000, 2.6x annual salary
Bonuses are paid if RRTS consummate a “Liquidity Event” prior to 30th June 2019.
• Liquidity Event means one or more of the following events
o Sale of all, or substantially all of the Company’s consolidated assets in any single transaction or series of related transactions to a Third Party
o Sale of ordinary shares (voting power) to a majority of the board to a Third Party
o Merger or consolidation of the Company with or into a Third Party
• Importantly, Third Party means “any Person other than Elliott Associates…”
Management has in place, significant retention bonus that triggers when RRTS is either sold or merged to parties other than Elliott. We think it is logical to conclude that management’s incentive to make a transaction (benefits coming from retention bonuses) at a fair to high valuation (benefits coming from owned shares) before 30th June 2019 is high.
The timing of the retention agreement is also interesting. May 2018 was when the rights offering with Elliott backstopping the issue was first discussed between RRTS and Elliott. Non-binding term sheet for the rights offering was shared in June, and in July issued a press release that RRTS had appointed the special committee to review and evaluate financing alternatives. So, this retention agreement (July) was signed under a solid information that Elliott was in to backstop the rights offering. Therefore, the timing of this retention bonus agreement gives reasonable comfort that the motives of RRTS management and Elliott are aligned.
This set up is highly attractive, and we can reasonably expect the company to resume acquisition in the coming years with Elliott on the driver’s seat. As shown in the previous section through Elliott’s intentions, a few acquisitions that changes the operating trajectory is imperative for Elliott to make a return. While selling the company within six-months seem unlikely, we may see an initial sale or merger that points to the company’s trajectory for the coming years.
Investment Rationale – forced selling event
There are also numerous reasons for a forced selling when the rights get traded. First, it is the year-end, it is the tax-loss harvesting season. Stock price fell from c.$8 in the beginning of the year to its current level and on top of this, current holders get heavily diluted by not participating in the basic subscription rights – perfect reason to eat the loss and get out. Second, around 17% of the top twenty shareholders (collectively owning 63%) is passive, mutual fund investors. Voting outcome on the annual meeting will show more color but we expect these mutual funds to be sellers of the rights once the rights start to trade. Third, for the same reason as the second, exit strategy could be challenging for these mutual funds as rights offering may, 1) give Elliott a majority holding and 2) become a “controlled company” within the meaning of the NYSE listing standards in which case could be against the mandates of these mutual funds.
Another visible forced selling activity is the #1 shareholder, HCI Equity Partners (HCI). HCI is a Chicago based private equity that brought RRTS public. HCI, through a now terminated consulting agreement, was instrumental in RRTS’ acquisition strategy and execution. HCI currently holds 20% of the company. The chairman of the board during the accounting scandal was Scott Rued who is a managing partner of HCI. At this point HCI’s intention on the rights offering is unclear but we believe the rights offering is a liquidity event for HCI to exit its position. In this case both stocks and rights will show added selling pressure.
Investors get two prices to choose from once the rights start trading. Annual meeting was held on 19th December, and the rights are expected to be traded between 11th and 28th January. If shares trade below the rights offering price of $0.5, accumulate with shares and if rights (to buy c.23 shares at $0.5) trade lower, accumulate with rights.
With restructuring and recapitalization out of the way, Elliott’s members on board and some low hanging fruits in the operating side (re-shuffling product portfolio, redirecting money losing routes and some industry tailwind during 2019), we expect the company could record 6-7% EBITDA margin by 2020. Industry on a TTM basis trades in the range between 7x-10x and a de-levered, fundamentally improved RRTS should trade at least around the lower end of the multiple and slowly expand as management delivers results. This results in roughly a 2x return. The company could certainly have series of disappointing quarters depending on the speed of restructuring. And by catching the nuance of the CEO the turnaround is still a long way ahead (past 2020). But the setup of outsized return in the long-term is very attractive given Elliott’s presence to quickly turn around and build a platform out of RRTS while the downside meaningfully protected as seen in Elliott’s intentions.
Elliott / management fails to execute: This is the surest way to lose money. But as mentioned, the complexity of the restructuring and the turnaround of RRTS is far lower than other situations Elliott is involved in. The business was tampered with fraudulent management and now that is in the past. The account has been cleaned up, preferred equity is going away, and the business is showing hints of improvement already.
Elliott intends to recover only part of its investment: Elliott started accumulating commons in May 2017 and went into an investment agreement for preferred shares shortly after that. Therefore, this development could have been Elliott's master plan all along, and if that were the case, Elliott would certainly want to at least break even. However, if Elliott is looking to only partially recover by selling the company, participants of the rights lose. The magintude of the loss is dampened as more investors participate into the rights offering, as explained in the investment rationale.
Liquidity / Exit risk: Once the rights get exercised, Elliott could end up with (theoretically) 96% of the company if none of the shareholders subscribe. Holding above 50% makes RRTS a “controlled company” under the NYSE standard and shareholder’s protection is lessened. Given some investor's distaste of the situation (as seen in the latest earnings call) this is not a long shot.
Timing of Elliott’s exit: As with numerous examples of large private equity / hedge fund ownership, exit points of these majority owners are difficult to predict and has a large impact on the share price. We would expect Elliott to be gunning for multiples of return on this opportunity, but it is no guarantee that in the future Elliott suddenly offers to unload shares at a discount to the then trading price due to various internal reasons.
We believe the setup of this special situation offers a very interesting opportunity. Elliott is a savvy investor who will exert more influence on the company to transform and insiders are aligned with their skin in the game. We also see some short-term catalysts around the NYSE listing issue which will be solved easily via the offering and reverse stock splits and a potential liquidity event during 2019. Looking at different angles to Elliott’s intentions also gives us reasonable margin of safety at the current price.
*capitalization figure in the place holder is management's pro-forma figure after the rights offering. Used management EBITDA for EBIT
Sale / merger
Restructuring / turn around
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