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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Wednesday, November 25, 2015

revisiting ESWW so I can sleep better at night

I've written a few short pieces in the past on ESWW, a tiny US manufacturer of diesel particulate filters, and just wanted to take a pre-holiday opportunity to revisit what's going on and as usual am happy to share what I find here.

The lede is that the stock has been a bit more active than usual and there's a new CEO. I like the former CEO a lot and he'll remain on as Chairman and apparently still work closely with the company and this is great news.

The new hire, Patrick Barge, has great experiences on paper and - who knows - he could be the person who lifts the company from the gritty turnaround that's achieved operational excellence and cash flow on a shoe string budget to an innovative company focused on R&D and new product manufacturing in the transportation diesel emissions after market. If the Volkswagon scandal tells us anything its how ubiquitous these systems are even though few end-customers know about them and they are little valued until the penalties of non-compliance become onerous. And I'll get to that aspect later.

The bigger picture as an investor is how deep into the weeds is it worth going for a company with just a few hundred thousand shares outstanding and a highly concentrated ownership structure (80% owned by one group) that concurrently holds the company's expensive convertible debt. Going into the investment, I thought "what could go wrong investing alongside a titan of finance" and although the business seem to be going in the right direction, the uncertainty around ownership will remain an issue until the debt converts or is paid off or the owners do something else. Whether or not the risk and concern of that "something else" is worth the massive valuation discount when I bought it is too soon to tell, but either way, it's a lesson I've paid to learn.

Barge according to his self reported resume is a mechanical engineer who rec'd a masters at this now defunct graduate school for the french textiles industry, many of whose graduates work in engineering, sales or quality control in various industrial or technology companies (BASF, Suez, Johnsons Controls and Thuasne). He appears to have "grown up" - so to speak - at Cummins where he worked in air and liquid filtration systems - including diesel emissions - with increasing levels of responsibility, most recently running the European geography of Cummins Emissions Solutions where he ran a P&L north of $300M.

Prior to that - and for a longer period - he was at Cummins corp HQ in Indiana doing R&D and new technologies where his budget was $150M with "700 employees in 6 technical centers located in 5 global locations".

This all sounds like good news, but it's still his first go around in the C-suite and there's no getting around that. And then there are questions ...

Why does someone go from +$300M budget and multi-national management to $25M peak revenues and two facilities? How much will they have to invest in new machinery to build out the operations this guy is used to? In what direction does the business go in the hands of an engineer with R&D experience sitting in an under utilized but high tech emissions testing facility an hour's drive from Trenton? Are they moving from a mesh metal weave to fabrics and if so is there a local supplier of polymers / fabrics who might have more insight into the market? What does he know about cash flow generation? Will he be able to thrive like his predecessor on a shoe string budget? etc. etc.

... in the absence of a conversation with him, I'm left to grasp at quotes from the press release on the hire ...

Old CEO: "We are thrilled to have Patrick join us as CEO at this critical phase of growth for ESW Group ... I look forward to working closely with him to drive growth within our rapidly evolving diesel aftertreatment and emissions market"

New CEO: "I am excited to leverage my relevant experience and seasoned leadership to help the ESW team achieve the next level of success within the aftermarket and OEM channels, as well as in the development of other potential markets"

So it sounds to me like the former CEO will remain a hands on Chairman (yay!) hopefully managing the financial / cash flow strategies as he's done so excellently in the past and the new CEO who is an expert in the niche industry, will have a lot of room to position the company more deeply into existing markets and also into new as yet unnamed markets. And the focus is growth.

In short, it looks good on paper.

I originally bought the company b/c Mark Yung was turning around a poorly run business that was thinly traded and valued at 1x-2x EBITDA, (the calculation of enterprise value being dependent on how one looked at the convertible option derivative liabilities).

The company's management prior to 2010 had a colorful history (ie a bunch of crooks), but in 2010 Yung took over in and hit the cover off the ball in a market with terrible crosswinds including changing regulatory deadlines, intense competition and highly reluctant customers. From 2010 to 2014, while acquiring one troubled competitor out of bankruptcy, he more than doubled revenues, grew EBITDA margins from -40% to +20% and FCF from - $2M to +$4M. The last we heard, ESWW had a banner 2014 year, with $25M in revenues, $6M in EBITDA and ~$57 in EPS.

Unfortunately, we don't know much about the financials anymore since the company "went dark" in April 2015,  and there hasn't been any new financial information since.

We know however that theirs is a lumpy business and that two major drivers of performance in 2014 - a municipal contract in Chicago and CARB compliance deadlines in California - are unlikely to repeat. The former b/c the contract was due to complete and the latter b/c of lack of enforcement by the CARB of regulations that require legacy trucks to retrofit with expensive diesel particulate filters as well as resistance from truck drivers against installing retrofit DPF's, fires supposedly caused by DPF's and a lawsuit from the California Alliance for Business against the CARB (and other parties - case # 13CV01232  - in Glenn County Court, CA).

This is where we circle back to VW. When CARB starts to enforce the regulations with costs more onerous than the retrofit investment, then we'll see a change in adoption. But so far they haven't and California distributors of DPF filters and their suppliers are suffering.

It's hard to be sure whether or not the groups opposed to CARB are gadflies, wackadoodle freedom fighters or have a legitimate claim, but they fight with an unusual zealotry and with a good social media presence, so that can't be overlooked. We're also in an environment where the regulations seem to fall heaviest on the smaller independent businesses who tend to be a sympathetic group even if they are rolling coal.

But as crazy as this fight appears, I'd be surprised to see environmental regulations rolled back. And by the way, there are a lot of these DPF's on the road, in all kinds of diesel cars and trucks, so there's a wide opportunity around testing, cleaning, OEM supplies, aftermarket replacements, etc. This is a wide space they can play.

Now that the company seems to have someone who can anticipate and manage the market and not just a financial and operating guru who got the ship on an even keel, then it seems like the business could be set up for a bright future even if 2015 is a down year.

About 700 shares traded hands this week, a large amount relative to avg daily vol over the last three months of 40 shares. I don't know how one would assess the opportunity since they've gone dark except maybe using CDTi's "Heavy Duty Diesel Systems division" as a proxy though their product is a pos (I've been told) and their products have verification issues with CARB. Through 9-mos sales in that division are down 25% y/y weighed down by some of the similar issues facing ESWW. Except in my channel checks  with distributors, they love the ESWW product and speak less highly of CDTi's.

Taking everything together, a still difficult environment, slow rollout of penalties to motivate compliance for older fleets and a lack of large contracts I still think even if 2015 is a down 25% year, with the new CEO steeped in this world paired with a Chairman who can focus on the financial aspects the potential for a brighter (and cleaner) future remains high. We will remain patient investors.

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