Sunday, July 26, 2015

CHC Group: This Bird is Flying too Close to the Sun

I first noticed CHC Group (NYSE: HELI) in 2014 when I was examining the Energy Industry. As a former industry analyst I thought that its business of flying workers back & forth to offshore oil rigs was highly sensitive to oil prices, despite being classified as a transportation company. HELI has the world's largest helicopter fleet (231) serving several geographic locations, of which over 81% of FY'15 (ended 4/15) revenues are to the energy end-market (i.e, E&P companies).

Source: CHC Group

What caught my eye was the company's sloppy-looking financials and its huge 10k report.  While the left-brain side is important for company analysis, it is the right-brain that makes investing more of an art than science!

The chart below shows the yearly change in SPDR Oil Service ETF (XES) versus CHC Group (HELI).  Clearly they are correlated.  Further, CHC Group performed much worse than its peer group since Jan'15 due to its high financial leverage.

Courtesy of GoogleFinance

After seeing CHC Group's recent stock price trading under $1.00, I thought why bother writing about this.  It's too late! But then I remembered all the soured investments in penny-stocks I had made as a novice trader.  At that time, I thought these volatile issues just needed to go up 50 cents and I'd sell.  However, investing in low-priced stocks is a fast-lane to the Poor-House.

This article is for all my fellow investors that have no access to brokerage-reports, not even Seeking Alpha has written much on HELI.  So then, maybe this is my social responsibility to investors!

We all know that commodity prices are weak and oil is now trading below $50/barrel. I'm a big believer of Contrarian Investing. However folks - playing a risky small company is not the way to do it - Exchange Traded Funds are.

Source: WSJ Market Data Center
Business Outlook:
CHC Group's business is closely tied to worldwide E&P budgets, of which is correlated with oil prices and the number of drilling rigs. While CHC's business is most closely tied to offshore global drilling, the chart below (from Baker Hughes) is quite useful as it shows the number of months before the industry actually hits bottom.

Below I will briefly list the main reasons why investors should avoid CHC Group.  Essentially, this is a small company bleeding cash that has a highly leveraged balance sheet.  If existing trends continue, the company will likely go into bankruptcy proceedings, or undergo a debt-recapitalization in which a private equity company such as Clayton, Dublier & Rice (CDR) takes over the company. Should this happen, equity holdes will be wiped-out.

Income Statement Issues:
  • CHC Group has never earned a profit going back at least 5 years. If the company cannot earn dollars during a healthy energy market, it will surely continue losing money in the current weak energy environment. CHC's customers are large well-funded exploration companies.  While they're good on their IOUs, they however, have large bargaining leverage with CHC Group and have already begun negotiating down the rates they give to CHC, according to the 4Q'15 conference call.
  • The company still lost money even after excluding special and non-recurring items (which it may have presented to make earnings look better than they really were).
  • Interest Expense and Fixed Charges (including lease, and pension payments) are too high for the company to support going forward. While management retired a chunk of debt ($320mm) in FY'15 that will reduce interest expense about $30mm/year, interest and leasing costs may remain too high for EBITDA to cover. The problem (see reporting issue below) is that the company's reported EBITDA is not a true representation of cash flow or even EBITDA.

Reporting Issues:
  • I have never seen a company with so many versions of adjusted financials. Companies typically report GAAP financials, meaning a standard set of accounting guidelines that can be compared with other companies. They sometimes add EBITDA to their reporting statements, especially if the company is new and growing rapidly (such as Twitter) or if they have a large base of debt and bond investors. However, CHC Group had to add an "R" (i.e., rent) to EBITDA because of a large number of leases, and that is reasonable. But they also show an Adjusted EBITDA, and wait, it gets better, an Adjusted EBITDA excluding Special Items.
  • There are numerous adjustments (i.e., costs) the company makes, I believe, mostly to boost its reported EBITDA. Certain of these should probably be excluded, that is, reduce EBITDA since they are cash expenses. These expenses may include costs due to management turnover, cash restructuring costs & severance
  • CHC Group's Press Releases to shareholders are not clear, and frankly, misleading. The first bullet point on its 4Q'15 earnings press release says that, "Fiscal 2015 revenue down 3% and Adjusted EBITDAR excluding special items down 2%".  This alludes to a company who's business condition is slightly worse than last year, which is clearly not the case.
  • The company's Balance Sheet shows debt of $1.2Bn.  However, the company's huge number of leases increases its OBS (Off Balance Sheet) debt.  The company provides a reconciliation of Adjusted Net Debt, which it values at $2.3bn as of FY'15 (April'15)
  • HELI's heavy dependence on leasing as well as its new $145mm Asset Backed Loan (ABL) significantly reduces transparency.  CHC will use its ABL line to outright buy new helicopters while returning those helicopters that come-off lease. This will affect how income is presented including their timing.  Furthermore, it is uncertain what assumptions management used to attain the net present value of its leases.  For example, it could lower its adjusted debt by simply increasing the rate it utilizes to calculate the present value (loan equivalent) of its leases.
  •  Free Cash Flow:  I typically examine GAAP free cash flow since this is less easily manipulated.  I take operating cash flow then subtract capital expenditures (CapEx).  It's very easy.  However, even here, the company adds a confusing version of its "Total Adjusted Free Cash Flow".  The company makes a bunch of adjustments, of which, the net effect is to sharply boost FCF to a still negative $164mm.
  • In the 4Q'15 conference call, outgoing CFO Joan Hooper refused to answer  questions on its future outlook saying it would not give any guidance of any kind. Typically, when a company readjusts its business via layoffs etc., it gives a proforma outlook of what its cost-structure will look like. The CFO also refused to give any guidance on expected revenues, etc. for the coming year.
  • I found two small errors in the 4Q'15 powerpoint presentation, again something I have never seen before. It gives one the feeling that the company doesn't dedicate enough resources to its business and has poor reporting & governance.

Balance Sheet:
  • The company has a very leveraged *balance sheet (*including the loan equivalent of its future lease payments).
  • Though the company has already written-off $0.4bn in Goodwill, I believe further assets may be written off including $0.2bn in Intangible Assets as well as property plant & equip and a small amount of deferred tax assets (as it's unlikely the company will make money any time soon).
  • While management says they have $3.1bn in Fleet Value of 231 helicopters. Note that it only owns about 20-25% of them, including old helicopters, as per the conference call. This equates to about $0.6bn. Recall that is exactly the amount of the recent Preferred Share offering to Clayton, Dublier & Rice. So before equity investors see anything in a bankruptcy, the secured debt holders, ABL holders, and preferred debt holders would have to get their slice.  In other words, equity holders will receive nothing for their shares.
  • Despite the above mentioned $0.6bn that boosted the balance sheet, shareholder's equity is in deficit by $0.4bn due to net losses and the $0.6bn in asset impairments. In other words, there is a Negative book value on CHC Group's shares!
  • While the company highlights that it has *$500mm in liquidity (FY'15) notice that it has just $134mm in cash and that it is burning about $100mm per quarter. (*There's another $145mm in liquidity from the ABL booked after the fiscal year ended.)
  • Again, the company highlights its own version of FCF, so it was difficult for me to ascertain cash-burn. Readers should note that a company can reorganize through a prepackaged bankruptcy even with a moderate level of cash.

Management & Governance:
  • NYSE (The NY Stock Exchange) categorizes CHC Helicopter as a "controlled company"and the majority of voting power is held with First Reserve and CDR.  CHC's board is not independent and the company is exempt from governance rules. In other words, shareholder protections are weak.
  • CHC is incorporated in the Cayman Islands, which again weakens shareholder protections.
  • Executive turnover is the highest I have ever seen.  Within the last year or so, there has been a new President & CEO, Chief Operating Officer, President of the Heli-One subsidiary, SVP of Human Resources and General Counsel & Chief Administrative Officer. Management needs time to get a grip on the company's business before it is able to assess and execute an action plan.
So what's CHC Group worth?
Given that the firm does not pay dividends, hasn't made money, and has negative equity, an investor or potential buyer cannot value the company using conventional benchmarks such as P/E ratio, Price-book ratio, or dividend discount model.  A discounted FCF model may be used but the company doesn't have positive cash flow so that would be based entirely on assumptions.

So we come down to Enterprise Value (EV).  Even here, one cannot simply use reported debt of $1.2bn as there is another $1.2bn or so of OBS debt.  After including the above, adding preferred stock and netting against cash, CHC's Enterprise Value is $3bn. Buyers typically pay a multiple of EV, however, in this case a potential buyer would likely wait for a distressed situation, then pay a low multiple given that the debt would be trading at a low market value.

While the average investor may not appreciate every detail of this article, my goal was to protect you from making a hasty decision. There are many investments as well as turnaround situations that have much lower risk and higher returns.

Penny stocks are for the birds.  On 7/23/15, the NYSE notified CHC Group that they have 6 months to bring their shares over $1.00 else face a delisting.

Disclosure:  The author has no position in CHC Group (HELI) and has not received any direct or indirect compensation for this article.

Friday, July 17, 2015

Looking for a good SRI manager or Conference ? ?

Looking for a good guy or gal to manager your money? 

These guys out of Colorado (w/ a branch network in various states) are quite exceptional.  Not your slick-salesmen of sorts.  They are named First Affirmative. The two executives running the company are below:

I do not receive any fees of any kind for endorsing them but thought readers should know that there are good people out there that want to invest their clients' money the right way, aligning customers' value with their investments.

I first met the First Affirmative team a few years back at the premier SRI Conference.  Its location typically changes year to year but this year's (Nov'15) event is in Colorado (where it all started).

The conference was great for several reasons including getting to know people from various walks of life, as well as the more left brained information.  This included the educational and quantitative aspects of SRI which ranges from active-investing, climate change. measurement of SRI portfolios to sin-stocks.

We wish you all luck in your investing and in life !

Tuesday, July 14, 2015

Mosaic update: Return on risk has increased since 2013

It's been nearly two years since this website published its first article on Mosaic, of which was also on Seeking Alpha. At that time, the Potash-Fertilizer industry was reeling from the July 31, 2013 event whereby Uralkali pulled-out of the BPC potash cartel.  (This article will focus on Mosaic's vital potash business though the company also sells phosphate.)

At that time, investing in Mosaic (MOS) appealed to me as a contrarian play.  Such tactics are best for cyclical industries such as Fertilizers, Steel, and Energy. If one can be disciplined, contrarian views eventually work-out, but they may take years to work themselves through, as the industry and participants rejigger their strategies and Industry Structure realigns.  Here is a Harvard Business Review paper from the infamous Michael Porter.

(Note: Those asset managers focusing on socially responsible investing might want to examine the company as a way of diversifying their often heavy portfolio weighting in consumer-oriented companies. In other words, SRI funds are overweighted in tech and retailing and adding Mosaic would be a good diversifier.)

My worst fear at that time (2013) was that there would be a price war in potash. The industry was, and remains, in a global oversupply situation, which isn't expected to balance for several years.  The table below shows the net Supply minus Demand balance for each major fertilizer (numbers are in 000s tonnes). The numbers in brackets represent the percentage that each fertilizer is oversupplied.  So (32.8) for Potash in 2018 represents Supply that is 32.8% greater than world Demand.

Source: Food and Agriculture Association of the United Nations

Back in 2013, I expected Mosaic's share-price to decline from the $40s level towards $30-$35 where the shares have much support including on an asset value (i.e., book value) basis.  However, this never occurred.  It appears the shares are supported by another factor, let's call it the "X" factor which I frankly do not know.  I believe, however, that the smart-money is expecting Demand to eventually catch-up with Supply and for the Industry Structure to improve.  In fact, Potash recently proposed to acquire K+S (a very high-cost potash competitor) and potentially close the high-cost mines and keep its new mines that are coming on-line in Canada.

Mosaic's shares also seemed overvalued back in 2013, despite several bullish reports from the sell-side as well as Seeking Alpha writers.  It's forward P/E was at least 16-17x. However, this has come-down towards 13x, which is a large discount to the S&P500's P/E of 17x.  Also the PEG ratio has declined as forecast growth is now greater than its forward P/E of 13x (see below). Consequently, I believe Mosaic offers a good return-on-risk versus what appears to be an overvalued stock market.

While fertilizer supplies remain high, and farmer economics (via falling Corn and Soybean prices) have declined, factors are moving positive in Mosaic's direction.  These are summarized below:
  • A lower Price-to-Earnings ratio compared to historicals and the S&P500
  • Improving forecasted earnings growth (S&P Capital IQ expects 16% CAGR)
  • Initiation of another stock-repurchase program ($1.5bn worth)
  • The potential consolidation of the Potash Industry (via K+S acquisition)
  • Competitor Uralkali recently stated that its potash volumes reached their historical levels, and that it would now work on increasing its revenues (rather than selling potash at any price). It is also possible that Uralkali may rejoin the BPC marketing "cartel", however the company denied that it would.
  • Overall demand is slowly increasing.  Despite China's declining economic growth rate, note that a substantial slice of its population is moving into "meat-eating" middle and upper class.  (Note that meat production is quite ag-intensive!)
  • Declining potash production-costs (new low reached in 1Q'15)
  • Improving industry and business-segment profile in Phosphate (via the CF Industries asset acquisition)

Corporate Social Responsibility:
Mosaic is followed by my website given its leadership in ESG.  In June'15, the company published its sixth Sustainability Report which is in-depth including the usual ESG data as well as self-implied targets. Mosaic has received many awards for its CSR conduct including the prestigious CR 100 Best Corporate Citizens.
Readers may be asking, so what does this have to do with investing in Mosaic? Well it's been proven that good CSR management is reflective of good overall management and lower corporate risk.

While the pendulum of supply/demand has yet to balance for the Potash industry, Mosaic's fundamentals have certainly improved.  Since 2013, the S&P500 has risen, yet Mosaic's share-price remains relatively unchanged.  Consequently, any positive catalyst will likely boost Mosaic's share price.

Full Disclosure: The author is long Mosaic Corporation.

Monday, July 6, 2015

Sealing the Lid on The Container Store's growth

The Container Store (TCS) went public in November 2013.  Despite being founded in 1978, the company has a young culture and feeling. TCS is a specialty store of storage and organization products and is best known for its Elfa closet system. (See company history for additional background.)

I remember the first time I heard of The Container Store. I was looking for a small apartment and my realtors' sales-ladies were raving about the company. So after I bought my studio I checked out the local store and fell under its spell. Even though I'm a non-shopper, I was very excited and walked around the store for hours. While it's true that one can buy many of TCS' products at a Target, Walmart, etc., I was there to purchase a closet system. The Container Store's customer service is second-to-nothing. I wanted a closet system that was efficient, built-to-order, yet customizable for the next purchasers of my studio apartment. I bought two systems and have been happy ever since.

For years I kept TCS in the back of my mind hoping the company would go public.  When they IPOed in 2013, I was ready to purchase shares in a company that I admired. I generally don't invest in Retailers given the industry's over saturation and increasing internet penetration (i.e., competition). However, The Container Store, to me, was a one of a kind specialty retailer with a strong mission and culture, akin to a Whole Foods Markets or Starbucks. TCS founder Kip Tindell (who roomed with John Mackey at University of Texas) is a founding member of Conscious Capitalism which is a group of companies, academics etc...moving business towards an active conscious culture.

The Container Store is guided by a set of seven values-based Foundation Principles.  Several of these are focused on employees, of which receive intensive training (~ 260 hours first year training) and above-average benefits & compensation. In fact, TCS's first and foremost stakeholder is not the investor, or even customer. It's their employees - this is something I've never seen from ANY company, but which appealed to me as a Socially Responsible Investor.  It's also surprising that a private-equity firm LBOed the company (2007) while retaining this "high-maintenance" cost-structure.

Industry Structure/Growth:
TCS' sharp price decline (down 50% from its peak) drew my attention. I usually examine the Industry first because individual stocks tend to move in lockstep with their respective industry. The Container Store operates in SIC no. 5700 - typically called Home Furnishings.

Porter's 5 Forces Model
These have been good times for the Home Furnishings industry thanks to ultra-low mortgage rates, improving economic growth, increasing housing turnover (i.e., existing home sales) and rising home prices. Higher prices allow consumers to take home-equity loans, of portion of which is partly used for renovations. Industry size is large (over $200bn) though Home Organization Products are estimated to approximate $9bn and are forecast to grow 3.5% annually through 2019, according to Freedonia Group.

Industry Structure, using Michael Porter's 5 Forces model is above-average. The Container Store is the only specialty home organizer company, other competitors are long gone. Its highly trained (and expensive) sales force acts as an entry barrier to competitors. Bargaining power of suppliers is low as the company is vertically integrated via its ownership of Swedish-based Elfa Products. Bargaining power of TCS' customer-base is lower than average.  Its customers are similar to those seen wandering the aisles of Whole Foods or buying Lululemon gear for their Pure-Yoga workout. These are 30-40ish, highly-educated, affluent, busy women.

Half-time report:
So, before reading on, let's do a quick summary.  Here we have a cool company, that customers like and employees love. They're the leader in their industry, which continues to grow. Industry Structure is above-average and TCS' shares are now 50% off their peak. This must be the buy of a lifetime. Well, not so fast!

"Execution is Everything" - Jeff Bridges
While The Container Store looks great on paper, something's up with its execution. TCS has just 70 stores and expects to grow square-footage by 12% annually until it reaches its 300 store goal. However, the company's earnings reports look more like a company that's reached maturity. Management believes that it's good at finding locations for new stores and that new store growth will be its modus operandi. However, I believe such an approach is fraught with risks.

The company needs to get its existing-stores back onto a growth path in order to fund new-store startup costs. Existing ("Comp") store growth, while negative, is worse upon closer inspection. TCS needs to 1) improve customer traffic especially new customers, 2) convert the traffic into higher average ticket prices* and 3) retain existing customers. (*Average ticket prices = total revenues/total transactions). The chart below shows The Container Store's historical comp-store downtrend.

In the table below, you can see the latest Net sales attribution for the latest year (i.e., "fiscal 2014"). Comparable-store sales declined nearly $4mm, however this included about $4mm in online sales.  So in actuality, the bricks & mortar comp-sales decline was $8mm! A better metric is customer traffic, which the company gives in conference calls.  Using this metric, customer traffic declined four consecutive quarters. (In all fairness, 4Q'15's decline was related to bad weather.)

Highly Leveraged Balance Sheet
The 2007 LBO loaded The Container Store with debt, which will be difficult to pay-down given the business model's dependence on the (little) free cash flow to be used towards new stores and key initiatives (e.g., POP!). The Container Store's revolving credit facility and term loan are rated B2/B (Moody's/S&P) and are secured by all assets of the company. Normally high debt reduces a company's cost of capital, since a higher proportion of capital costs would be attributed to debt (which is cheaper than equity).  However, at a certain point (intersect on chart), increasing levels of debt ("New Capital" on chart) increase the total Marginal cost of capital.  At that time, TCS' share price will be more correlated with its credit risk as per the Merton model.

Growth Initiatives:
According to a Seeking Alpha transcript of the last earnings call, management will focus in three areas: 1) TCS Closets, 2) Contained Home, and 3) POP!  The company is placing most of its resources into TCS Closets which is a high-end offering, and which will include customer-financing as the average ticket is $10,000. Contained Home is an in-home design service (average ticket: $2,000). POP! is the company's customer frequency and reward program. I believe these initiatives are a smart strategy given they take full advantage of TCS' affluent/busy customer-demographic and leverage the company's highly-trained employees. However, the programs will likely take a year before boosting comp-sales and profitability.

Discounted Cash Flow (DCF) model assumptions:
The Container Store's wish list is for long-term Gross Margin above 60% (FY'15: 58.6%) and SG&A at 45% (FY'15: 47.7%). The SG&A percentage excludes another 1.1% pre-opening costs (see table below) which I believe should be included in SG&A. (For comparison, this compares with the industry average of approximately 22-25%.)

Together this could yield a 4% increase in EBIT margins in a best-case scenario. My 3-Stage DCF model also considers a best-case scenario of positive and rapidly growing Free-Cash-Flow (FCF) as well as a Weighted Average Cost of Capital (WACC) of 10%.  I calculated FCF by using the midpoint number between Adjusted EBITDA and operating cash flow.  (I usually use operating cash flow which is lower and less subject to manipulation.)

DCF model results:
After inputting the above best-case assumptions as well as a 3% terminal growth rate and net-debt of $310mm, the result was a share-price estimate of $10.42. There is also the probability the company may have a secondary equity offering of, for example, 5 million shares, which could reduce the forecast value by $1/share. The matrix below shows results after lowering assumptions for Growth and the Discount Rate ("WACC"). They are all trading substantially below the company's current share price of ~ $17-18.

 Peer Valuation comparison:
Other measures of value tell a similar story. Price/Book value (~ 4x) and Price/Earnings (~ 52x forward) are not worth mentioning given its leveraged balance sheet and near-term earnings suppression.  The more useful metric is Enterprise Value("EV")/EBITDA. This metric values the company at a 30%-50% premium to the Median, depending on the time-period utilized. There are a few companies (e.g., Tuesday Morning) with high EV/EBITDA multiples but their earnings growth is supportive of the higher multiples.

Source: Data provided by Bloomberg LLC

So what's an investor to do?
My goal wasn't to berate The Container Store, but to show how great companies don't always make good investments. While I admire the company's culture and mission, it is in the midst of a risky transformation which will take a year to gain traction. I am hoping to be a buyer but not until comp-sales reinvigorate to the mid-single-digits.

Full Disclosure: The writer does not own shares of TCS as of July 6, 2015.

Helios and Matheson: I’ve seen this movie before, and it ends badly !

Summary:   My career as a penny-stock equity analyst gives a unique perspective to the issuer  HMNY is insolvent and the likeli...