Description

I am short Advanced Drainage Solutions Inc (ADS), which has the unique distinction of being a pos that literally handles pos. The stock has gotten a little away from me since I began my writeup, but it’s still got over 50% downside and I don’t believe any huge threat of ripping higher.

Company Background

ADS is the largest plastic drainage pipe and fittings manufacturer in the US, with 61 plants, 29 distribution centers, 650 trucks, and 1,100 trailers. 83% of revenue is levered to new construction, primarily commercial construction but also residential and to a much lesser degree, infrastructure. About 13% of revenues are located internationally. The company boasts that it is 10x larger than its nearest competitor in the plastic pipe market, although I don’t really know if that matters much since scale is more about local rather than national presence. I would point you to the company’s website to get a better understanding of their products, but I dunno, they’re pipes and fittings [shrug].

Plastic pipes have been taking share from traditional reinforced concrete pipes as the technology has improved and the strength of the pipes has gotten better. The all-in cost of plastic pipes is slightly higher and carries more liability than reinforced concrete because they need to be buried more delicately since they rely on surrounding soil integrity for strength.

The company was founded in 1968 and has changed private equity hands a number of times over the years. Most recently, American Securities purchased their stake from Berkshire Partners in 2010, although I don’t believe they did remarkably well on the investment (I think they bought in at ~$14/share). ADS had its public offering in July 2014, selling 15.1 million shares at $16, which was down from its targeted range of $17-19/share. American securities sold 8 million of their 27 million shares in the IPO and another 10 million shares at $21.25/share in a secondary last December (slightly troubling that this was done essentially during the time that accounting problems were likely emerging internally). University of Notre Dame’s endowment was also a very long-time shareholder but sold all of its shares shortly after the IPO.

The CEO, Joe Chlapaty, has been with WMS since 1981 and participated in one of the buyouts in the late 1980’s. Today he owns 10 million shares (13%) although the majority of that is in a trust (which I believe is a charitable trust). It’s not clear to me how he managed to purchase such a large amount of stock and not still have some serious outstanding debt against it...the company has not yet disclosed whether any of his shares have been pledged. ADS’s ESOP owns 26% of the company and this was purchased at the same time as Joe, and the ESOP required a loan which is still outstanding. ADS also has a corporate jet that Joe is allowed to use for personal reasons, if you're into that sort of thing. I don’t think he seems like a bad guy or anything, but I really don’t understand the true ownership structure and how it came to be.

Accounting Problems

I like to scan NT-10K/Q filings because every once in a while a good company runs into problems and the stock collapses on the accounting fear. I came across ADS in June when they missed their 10K filing deadline and I saw that this was not some stupid penny stock...I figured it might be a buying opportunity. ADS is on a March 31 fiscal year-end, and the 10K is the first filing that was missed. They have missed the following two 10Q’s and after speaking with the company, they don’t sound anywhere close to being done with the restatement. In my experience, restatements like this take anywhere from 12-24 months to complete and cost anywhere between $25-50 million.

The company has made three separate disclosures about the accounting problems and the forthcoming restatement, and the evolution of the language in the three releases is trending in the wrong direction. What started out as a seemingly harmless inventory costing analysis has quickly expanded to other areas of the company that are completely unrelated to inventory. The issues cited by date of filing are:

This is an ominous trend that suggests this is a junior varsity company and management team. I follow accounting restatements pretty closely, and I can’t recall another company that managed to blow it so quickly out of the gate. Preparing for an IPO is like getting a full body cavity search, and ADS couldn’t even make it through a single fiscal year without going dark...no 10K, no proxy...pretty incredible, actually. What’s amazing is that the stock never really budged throughout this and is still 50% higher than its IPO price today. On November 9, the CFO was given the corporate viking funeral, announcing his “retirement” effective March 31, 2016. I’m not really sure how a fresh CFO will impact the restatement process but I’m guessing it could slow it down as the new guy gets up to speed. Overall, there is some reason to be concerned here, and at a minimum I think the company deserves a lower multiple for all of this.

Regardless of how the accounting issues shake out, I think ADS is good short because the company is materially overvalued. There are two parts to the bull story that are responsible for the (now fading) strength in the stock. First, plastic pipe made from high-density polyethylene (HDPE) is taking share from traditional reinforced concrete pipe. This is true although it’s a little difficult to estimate the organic growth rate for plastic pipes since this is still a cyclical business. Some of the market share gain by plastic is likely because concrete prices have risen substantially in the last few years (see the chart of US Concrete - yikes). In any event, this part of the story has some merit, if you’re into buying ultimately cyclical companies with very poor returns on capital. Second, people are fixated on the notion that lower polyethylene prices will drop to ADS’s gross profit margin line. I believe this is not the case for two reasons. First, ADS’s gross margin over the last six years has been pretty stable at around 20% (with some short-term fluctuations) despite polyethylene prices bouncing around all over the place. There’s no evidence that rising or falling polyethylene prices help or hurt ADS’s gross margins at all. Second, even though ADS is the largest plastic drainage pipe manufacturer in the US, this is far from a monopoly, and they still compete against a number of other plastic pipe makers as well as reinforced concrete. So to the extent ADS would benefit from lower polyethylene prices at all, it would be very, very short-lived.

Aside from the bull story being fairly questionable, ADS looks plain-old overvalued when doing an honest analysis of its financials. ADS is yet another in an increasingly long line of companies that abuse adjusted EBITDA like a rental car. If a company has a gigantic delta in its adjusted EBITDA vs cash flow, there is probably something strange going on. I'm actually trying to setup a screen that filters companies by the number of adjustment lines in their proforma results. In the 8K released on 8/17/15, the company provided some estimates on the impact of the as-yet restated financials:

First of all, their adjusted EBITDA is bogus. So for 2015, the adjusted EBITDA was $153.6 million. But they are going to haircut that by another $5.0 million as part of the restatement, and I believe any honest analysis should include both options and deferred compensation expense. This would put the “real” EBITDA at about $130 million. The adjustment also puts GAAP net income negative at -$3.9 million. Yes, they claim to have $154 million in EBITDA, but after taxes, interest on debt, interest on the convert, there isn’t anything left over. So how good is this business?

Capex runs about $40 million annually and they capitalize $3 million of software development as well (why a plastic pipe maker is capitalizing software is beyond me). The cash flow from operations is surprisingly steady over the last four years at $60-70 million. There have been a couple acquisitions along the way but I’ll generously exclude those from FCF even though they’ve aided growth. Basically, ADS has normalized EBITDA of ~$130 million, normalized EPS of ~$.00, and normalized FCF of ~$30 million.

Another thing to watch out for is that the reported share count of 53.3 million is incorrect because the ESOP owns a convert preferred for another 20.1 million shares (26.1 million shares; $12.50 par; 2.5% cumulative; convertible into common at .7692 per share) that the company excludes from its fully diluted share count. Bloomberg misses this, so the reported market cap needs to be adjusted 38% higher. When all options, restricted stock, and the convert are factored in, ADS’s share count is 76 million. Interestingly, the trustee (Fifth Third Bank) of the ESOP can put the convert back to the company in the event ADS’s stock gets de-listed from the NYSE...keep in mind they have now missed their last three filings and are in non-compliance status. (Evidently this is an IRS rule) I would imagine this is a very low-probability event, but it’s kinda interesting nonetheless...has a company ever gotten blown up by its own ESOP??

With comps trading at 8-9x next year’s EV/EBITDA, this values ADS stock at about $10/share, which equates to about 20-25x P/FCF...there are essentially no GAAP profits. This seems about right to me and is very close to where the company was issuing options to management shortly before the IPO ($8.10/share). Comps would include Mueller Water, Polypipe Group, Circor, Watts Water, and Pure Technologies. Call me old fashioned but I like GAAP net income and normalized FCF. To be honest, I don't even know how companies like Mueller Water trade at 8-9x EV/EBITDA but what the hell do I know.

Analyst estimates are bonkers. The Deutsche Bank analyst has ADS doing $235 million in adjusted EBITDA (which again, is fake) in the current fiscal year vs $149 million the year prior (on an bogus-to-bogus basis) and then $260 million in FY17. This implies that margins will practically double vs historical averages, from ~10% to almost 20%. Actually, the math on the incremental adjusted EBITDA margin works out to 56% between FY15 and FY17 ($104 million in incremental adjusted EBITDA vs $195 million in incremental revenue). ADS previously guided to FY16 revenue of $1.32-1.37 billion and adjusted EBITDA of $190-215 million (15-16% margins) even though margins have been flat for years. Now they're supposedly going to magically increase to record levels (being public will do that to you), yet they had even managed to miss on adjusted EBITDA prior to going dark (9.1% in the last quarter before going dark). If nothing else, I think this helps validate the idea that management really isn't ready for this whole "public company" thing. In any event, the stock is expensive even if you believed these (incorrect and fake) EBITDA estimates.

ADS is a fairly levered company with $400 million in debt and $3 million in cash at last report (3/31/15). The debt is split mainly between a revolver, term loan, and senior notes. Debt/EBITDA is about 3.1x...not precarious but not immaterial.

Catalyst

Stuff