The company's operations have dramatically improved over the last three years in a very difficult operating environment, but the market value has languished, such that it trades at a little over 1x EBITDA.
Black and his brother-in-law Richard Ressler control the Board and also own the bulk of convertible debt that converts at $80 / share.
The Board recently decided to "take the company dark" meaning they have de-registered its shares and will stop filing financial statements.
This is not an unusual step for a small cap company in a highly competitive industry dominated by private competitors. But the decision raises new risks about the concentrated ownership that weren't as paramount as they are now.
If those risks were mitigated - if some structure were created that alleviated uncertainty about their intentions - and if the corporate governance improved (ideas: split the CEO / Chairman roles, have a shareholder meeting, add independent directors), it could enable the shares to trade at a higher multiple and provide equity capital for growth, investment and potentially acquisition. It would also reward patient investors.
ESWW is a tiny $10M market cap company that manufactures and distributes aftermarket "diesel particulate filters" (DPF) for highway and off-highway trucks. The company benefits from environmental / clean air regulations and these regulations are expanding beyond California, which has the most stringent regulations in the US and was one of the first states to implement them.
The stock market must see a declining need for aftermarket DFP products because the valuation is very low. However, I observe that there seems to be no lack of aftermarket products available for just about any large product, be it appliance or automobile. Some of these products are sold at high margins. Why should DPF's be any different?
California's Air Resource Board - CARB - requires that aftermarket DPF filters be installed on older model trucks at a fully installed cost of ~$10k-$25k depending on the engine model. New model trucks come installed with DPF's.
Despite these "cleaner" new builds, there remains a large fleet of on and off-highway trucks, buses, municipal fleets, construction vehicles, mining equipment, military equipment and marine vehicles across the US and around the world that won't be replaced anytime soon and will require DPF filters. ESWW manufactures and sells them. Also, DPF's on new trucks will need to be replaced every 3-5 years. So, the market isn't going away.
ESWW sold enough DPF's in 2014 to report $25M in sales and $6M in EBITDA, yielding a 26% margin. It was the third straight year of EBITDA improvement since Mark Yung took the reins as Chairman and CEO at the end of 2010, cleaning up a mess created by the prior owners. Bravo to Mark as well for the $4M in FCF!
Revenues took a step function jump in 2013 after the purchase of Cleaire out of bankruptcy. I wrote a bit about that story here ...
... Distributors I've spoken with have raved about the acquisition and how it completes the company's line of products. Revenues in 2014 benefited from a large order to retrofit ~1,000 of Chicago's "1,000 Series New Flyer" municipal buses.
The market must assume there are no other large orders in the offing and that the market is falling off the cliff, because despite the improvement in results, a search on Yahoo! finance shows the stock trades hands for just over 1x EBITDA.
As the above table illustrates, I look at the valuation two ways, as reported and "assuming total dilution". The "as reported" figure includes in net debt, a liability related to the company's outstanding convertible debt. This refers to $5M in convertible debt issued at a discount, paying 10% interest that compounds quarterly, due in March 2018, and convertible into max 153K at $80 / share. It's a complicated structure but I think the debt conversion amortizes as it nears maturity so the company only includes in the "as reported" diluted sharecount a portion of the total 153k dilution.
This non-cash liability - an "option derivative liability" - quantifies the potential of conversion; it increases / decreases as the stock price approaches / departs from $80.
Rather than use a non-cash balance sheet item that varies with stock price, I simply assume full conversion by including all 153k shares to the diluted count (I add the difference between what they include and the total) and exclude the "option derivative liability" from my net debt calculation.
"As reported", the company is currently valued at 1.3x trailing EBITDA. Assuming total dilution, the company is valued at 1.6x EBITDA.
If this company were to trade at a "normal" industrials valuation of 8x-10x EBITDA, it would be worth, on a fully diluted basis, $250-$300 / share.
I think there are a few reasons but top of the list is the concentration of ownership. From the 10K filed 3/31/15: "A group of our shareholders collectively own 95,736 shares, which is equivalent to 71.1% of the outstanding shares of the Company as of March 31, 2015, on an undiluted basis. As such, all or some of these shareholders may be able to control aspects of our business operations including the election of board members, the acquisition or disposition of assets, the Company’s business plans and strategy, and the future issuance of shares."
This group of shareholders who own 70% of the company and control the board are primarily colleagues, peers and family of Leon Black, the founder of Apollo Global Management, and his brother in law Richard Ressler of Orchard Capital. Here is the owners list from the 10K.
And the board + key executives list.
But those are just the equity holders. The debt holders are concentrated in an even smaller group:
"On March 22, 2013, the Company entered into a note subscription agreement and a security agreement and issued senior secured five (5) year convertible promissory notes (collectively the “Existing Loan Agreements”) to Black Family Partners LP, John J. Hannan, Orchard Investments, LLC and Richard Ressler (each individually an “Existing Lender” and collectively the “Existing Lenders”) who are current shareholders and may be deemed affiliates of the Company."
The concentration of ownership of the debt and the equity creates risk and uncertainty about their intentions.
The second reason for the misvaluation may be Board governance and control.
Of the Board's eight positions, five are held by AGM / Orchard people. The aforementioned CEO / Chairman Mark Yung works at Orchard Capital. Plus, four of the eight members of the board work at AGM: John Suydam (AGM's counsel), John Hannan (an AGM partner), and the brothers Benjamin and Joshua Black (both associates). So when you get to the debtholders, it's just Black / AGM and Ressler / Orchard, and they control the Board.
On 4/1/15, the Board decided de-registered the shares of ESWW, announced it would stop filing financial statements and will trade on the "pink sheets".
This is called "going dark". It is not a terribly uncommon event in the world of micro-cap investing - the costs of being public are roughly $1M / year - and on the face of it, a cost saving measure and an effort to retain some financial privacy in a highly competitive market dominated by small private and secretive companies is a good idea.
But "going dark" further eliminates the opportunity to generate equity capital for growth and investment.
To date, management's responses to most my questions have been evasive and perfunctory regarding operations, goals, strategies, how a shareholder will get financial statements and just about everything else.
I was simply told the decision to go dark was driven by a desire for privacy and as a cost reduction measure. But this same board last year voted itself a 20% raise in "director fees" and with a higher payment to Orchard Capital for the services of its rent-a-CEO. (From the most recent 10K: "In August 2013, the Board of Directors on the recommendation of the Compensation Committee approved a change in the fee structure for outside directors. The cash fee component of the compensation for the chairmen of each of the Audit Committee and Compensation Committee was increased to $3,000 per month from $2,500 per month".)
I hope to benefit from the efforts undertaken by the talented Mr. Yung who has turned this company profitable. His work has been spectacular.
But risks I did not consider as a huge concern last year - the concentrated ownership - now seem paramount.
With the company more than doubling revenues over the last three years and generating $4M in FCF in 2014, there are opportunities for investors if there were less uncertainty about the intentions of the concentrated ownership and also if the Board improved its governance. Some ideas would be to split the CEO / Chairman roles, add independent directors and maybe even hold its first shareholder meeting in 10 years.
If the risks of the concentrated ownership were mitigated and the governance improved it may unlock the misvaluation and create equity capital for growth and investment and reward patient investors.
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