Description

Description

Celadon (“CGIP” or the “Company”) is a Top 15 North American truckload carrier with ~$1B of revenue and a fleet of ~4,000 trucks primarily serving the over-the-road (“OTR”) segment of the market. CGIP was previously written up as a short by roc924 in November 2015 with the stock collapsing a year and a half later given accounting fraud allegations around its leasing business ultimately necessitating four years of restatements, a subsequent SEC/DoJ investigation, and eventual delisting in April 2018. We applaud the short call but believe the deck has been reset at this point with a completely new senior management team with both operational and turnaround experience (both already in full-swing), as well as a significant inflection in freight fundamentals (strongest freight cycle in a decade), and view CGIP as an intriguing long opportunity offering 100%+ upside with a number of catalysts on the horizon.

Catalysts

Near and intermediate-term catalysts include:

• Operational updates

• Close refinancing

• Finalize restatement

• Relist on an exchange

Model/Valuation

We show CGIP could be a $6-$8 stock in the near-term under our base case scenario (~100% upside), while our upside case suggests a $16-$20 stock in the intermediate-term (400-500% upside).

*CGIP fiscal year-end is 6/30; Base case represents FY 2019 (6/30/2019); Upside case represents FY 2020 (6/30/2020)

Company Background / Timeline of Events

Historically, CGIP operated an irregular route OTR network as well as carving out a nice niche as the largest carrier for the NAFTA auto supply chain. The Company typically generated a mid-90’s operating ratio (“OR” and represents the opposite of operating margin, so 94% OR is equal to a 6% operating margin) and was viewed by investors as a solid, middle-of-pack operator.

In 2013 management shifted gears and established a leasing subsidiary called Quality Companies (“Quality”) and further expanded the business in 2014 through a transaction with Element Financial (“Element”). Quality’s business grew rapidly with its leased fleet increasing from 750 trucks at 6/30/13 to 11,300 trucks at 6/30/16. Beginning in late 2015 and persisting until early 2017, the trucking industry was plagued by a freight recession (oil collapse and resulting industrial downturn) and abundant capacity in the market. As a result, there was minimal demand for new trucks as well as a glut of used trucks leading to a significant deterioration in truck pricing. CGIP was stuck holding a massive number of trucks as Element balked at buying that much equipment, which subsequently led CGIP to form a JV called 19th Capital (beneficially owned by CGIP executives) to sell off portions of its lease portfolio.

From September 2016 through May 2017, CGIP used off-balance entities (19th Capital, Element JV) and manipulative accounting practices to misappropriate its financial condition to investors and creditors. I will not get into the specifics as Prescience Point published an extremely thorough short report outlining the fraud in April 2017 (link).

Soon after in May 2017, the Company’s auditors withdrew its reports for 6/30/16, 9/30/16 and 12/31/16 and CGIP’s COO resigned.

The turnaround effort began in July 2017 but has been a bumpy ride for CGIP.

• July 2017 – Released a dual announcement that the CEO and chairman of the board will retire, while appointing Paul Svindland as the new CEO.

• September 2017 – Divested its flatbed division and transferred ownership of its driving schools to a 3rd party

• October/November 2017 – Appointed a new CFO, COO, and chief accounting officer

The stock worked in 2H17 as investors responded favorably to the management team reset and divestiture of non-core assets, as well as the significant inflection in freight fundamentals which began in mid-summer of 2017.

• April 2018 – Announces restatements will be required for 2014-2017 financial statements after thorough review of historical accounting policies and procedures by new management team which are expected to reduce net income by $200M-$250M, while also writing down the Element JV to zero

CGIP shares declined throughout 1Q18 given additional credit agreement amendments and inability to file quarterly results; however, the next shoe to drop was on April 2, 2018 as the Company indicated it will have to restate its financials going back to 2014, with the share price cratering to ~$1.

• April 2018 – Announced expected refinancing terms and new term loan partner which would include an equity component

• July 2018 – Announced new credit agreement amendment, termination of term sheet with potential investment partner, operations update, and formally acknowledged on-going SEC and DoJ investigation

CGIP’s refinancing process has persisted since May 2017 as incumbent bank group lenders have agreed to amendment after amendment as the Company seeks additional capital. In April 2018 CGIP indicated that it had received a proposal from a sophisticated investment firm (GSO Capital Partners – part of Blackstone) to refinance the bank debt including an equity issuance of 19.5% of current shares outstanding. The proposed capital structure would have been a $200M term loan (at rate of L + 11%) terming out the bank revolver and a new $100M ABL facility provided by the incumbent bank group. The Company expected the refinancing to close by June 15.

On June 18 CGIP announced that negotiations with certain lessors were on-going and the expected closing date was pushed back to July 15. On July 3 CGIP announced that the previous term sheet agreement with GSO was terminated and that they would be resuming the refinancing process. In the interim, the incumbent bank group has agreed to extend the existing revolver to December 12.

According to management, the terms of the potential transaction with GSO were agreed upon in early March but as the actual closing date approached GSO terminated the agreement given that CGIP was formally sent a subpoena on June 13 from the DoJ. While it was public knowledge that there were on-going SEC and DoJ investigations, CGIP was never actually sent a subpoena by the DoJ until this date. Additionally, management made it very clear to GSO that the Company itself was not a target of the DoJ investigation (former management team members were formally indicted on May 24). That said, since Blackstone is a public entity its by-laws precluded it from doing a deal where there is an ongoing DoJ investigation.

Despite the GSO deal unraveling, management is actually relieved that the transaction was terminated given the equity requirement, onerous interest rate, and the view that the original terms were not representative of current the operating results of the Company as of June/July. With respect to the DoJ investigation, the Company is not currently party to the lawsuit; however, they have indemnified the former executives and will cover certain legal expenses. CGIP’s current insurance will cover expenses up to $10M, while the Company has placed a cap of an additional $5M that they will contribute to paying the legal fees after which the former executives must foot the bill themselves.

Investment Thesis

1)    Completely new senior management team with both operational and turnaround experience.

The entire previous management team responsible for the accounting fraud at CGIP is no longer with the Company, while new CEO (Paul Svindland) has over 20 years of transportation industry experience and has also spearheaded a public transportation company turnaround previously as COO of Pacer (PACR and an intermodal company). Paul was hired in October 2012 and PACR was acquired by XPO Logistics (XPO) in January 2014. He helped deliver a ~95% return prior to deal announcement (~111% return including take-out price) over this time period compared to peer group average return of ~46%.

Additionally, the new CFO, COO, CAO, and other division heads have significant industry experience with reputable public transportation companies.

2) Significant operational runway given simplification of strategy and previous management’s lack of focus on core truckload business.

CGIP operates two segments asset-based and asset-light (primarily truck brokerage). The asset-based segment is segregated into four units: 1) CTSI (core OTR business), 2) International (NAFTA auto supply chain), 3) A&S (dedicated business), and 4) Buckler & Taylor (bulk and specialized). The CTSI business is where the operational challenges have been the greatest given a less than optimal strategy as discussed below and structural impediments (operated at an above 110% OR at its worst), while the other three business units (International, A&S, Buckler & Taylor) have remained profitable throughout the duration of the accounting fraud and initial turnaround. The previous management team focused solely on growing the Quality business resulting in a lack of operating discipline and deteriorating profitability at core CTSI business. CGIP took the meaning of irregular route carrier to the extreme as it operated ~4,900 lanes in its network at the peak, while also employing ~1,300 owner-operators (owner-operator growth was a function of leasing as many trucks as possible given primary goal of growing the Quality business) in a forced dispatch operation. This strategy was less than ideal to say the least given the unlikelihood of achieving adequate density in the network as well as having to balance the notion of forcing a driver to accept a load on a lane he does not want to given an owner-operator’s independent contractor status.

While CGIP’s previous financial statements are not reliable, we think it is instructive to show the actual magnitude of OR decline relative to peers over the 2014-2016 time period. On an apples-to-apples seasonal basis comparing 4Q16 and 4Q13, CGIP’s asset-based OR deteriorated 610 bps compared to the truckload peer group average deterioration of 100 bps and 15 bps ex-CGIP. Despite fraudulent accounting and elevated equipment gains from significant growth of Quality leasing portfolio, the Company’s OR performance was the worst among public truckload peers.

New management has articulated its strategy is to turn the asset-based business into a more “regular route” truckload operation with a more defined set of lanes and customers to drive network density and improved utilization, as well as focusing on rate realization and stronger customer mix to drive increasing revenue per loaded mile (“rev/loaded mile” or yields), all of which will support OR improvement. Fundamentally, the new management team is taking the reins of a terribly run trucking operation and installing trucking 101 tactics to improve the business.

While this undertaking is not heroic per se, it does take time for the operational improvement to manifest itself, with management being very clear throughout turnaround process that operating results would get worse before they got better given inherent costs required to right size the fleet, reposition equipment, trade-in old equipment, etc. Management has indicated initial positive operating results began in the April 2018 timeframe concurrent with the typical seasonal uptick in freight demand and have improved sequentially each month through July, while costs associated with the turnaround are around 80% realized at this point.

Below is a comparison of various asset-based operational metrics and fleet count statistics as of the last public filing (fiscal 2Q17, calendar 12/31/16) and our current estimates which are based on operational updates included in CGIP’s public filings over the past year as well as our discussions with management over the past two months.

In our opinion and outside of rate improvement, which has been driven by the inflection in freight fundamentals and generally consistent across public peers, the most impressive strides to date include the reduction in freight lanes (600 from 4,900), increased utilization (1,955 miles/truck from 1,761 miles/truck), reduction of deadhead (8% from 18%), and decrease in auto exposure (18% from 27%), which carries a much lower rev/loaded mile than the rest of the business ($1.45 on average vs >$2.10 on average for other 80%). Management indicated in April that they expected the asset-based business to return to profitability by mid-summer, and while not explicitly confirming this in our discussions, they acknowledged that they as well as the current bank group are very pleased with current operating results and the anticipated trajectory through 2H18. Reading between the lines, we believe the asset-based OR is now in the high-90’s with the potential to improve to the mid-90’s over the next 6-12 months.

Management has further indicated that it anticipates another $0.10-$0.12 in yield improvement by year-end 2018 (implying ~$2.10-$2.12 rev/loaded mile), while its current operational metric goals include revenue per seated truck/week of $4,000 and utilization of at least 2,000 miles per seated truck/week. Longer-term management views CGIP as a 90% OR carrier.

3) Refinancing increasingly likely as strongest freight market since 2003-2006 cycle supports operational turnaround and provides potential financial partners increased confidence in committing capital.

We expect CGIP will be able to complete the refinancing by the artificial December 12 deadline (current credit agreement termination date, which has been extended multiple times) primarily driven by the Company’s improved operating performance as current freight fundamentals have likely served as immense tailwind for the turnaround. It’s interesting to note that the most recent credit agreement extension was for five months compared to previous extensions of typically one month. We believe this is further evidence of greatly improved financial performance as the bank group is comfortable extending terms for a much longer period than previously.

Our view on the refinancing was largely confirmed by management as they indicated the greatest challenge to closing the refinancing had been deterioration in EBITDA not a lack of audited financials or on-going SEC/DoJ investigation. Additionally, management specified CGIP has a current qualified opinion from a Big 4 accounting firm, have hired a banker, are in the process of finalizing an updated investor presentation, and plan to begin a roadshow in early September. They are also confident equity consideration will not be a prerequisite to completing the refinancing and that a transaction will be closed prior to mid-December, while actually indicating that it could be sooner than that. The expected capital structure will be similar to the GSO proposal excluding the equity component: $200M term loan and $100M ABL facility with CGIP also having ~$350M of equipment leases on its books.

Overall, we believe a completed refinancing will remove a massive overhang on the stock by solidifying CGIP’s liquidity/solvency position and providing a basis for capital structure repair in the intermediate-term.

4) Restatement is important but the actual filing of recent quarterly results will be even more significant as investors will see concrete evidence of the operational turnaround.

The current restatement process began in earnest in November 2017 once the new CFO and CAO were hired and now includes the following:

• Restate FQ and FY 2014, 2015, 2016 financial statements

• Restate FQ 1Q17, 2Q17

• File/restate FQ 3Q17, 4Q17 and FY 2017

• File/restate FQ 1Q18, 2Q18

• File 3Q18, 4Q18 and FY 2018

• File 1Q19, 2Q19

The restatement deadline is 3/31/2019, but management is optimistic it will be done by year-end as they have allocated all resources including hiring a Big 4 firm to help the current auditor (BKD) complete the process. While completing the restatement is crucial and removes another overhang on the stock, we believe the more important aspect of the restatement is the actual filing of recent quarterly results, which will give investors a clear picture of the trajectory of the operational turnaround.

5) Recent disclosure gives us incremental confidence that near-term catalysts will come to fruition, while management incentives support upside intermediately.

CEO and CFO PRSU exercise terms require CGIP share price to be >$8 for 20 consecutive trading days or for CGIP to achieve a consolidated annual OR <95% which on ~$1B of revenue implies >$50M of EBIT and assuming standard D&A policy for truckload carriers would imply EBITDA of $150M-$170M and $6-$9 stock assuming 4.5x EBITDA multiple. While stock options suggest material upside (>100%) at a minimum of ~$6.50.

Additionally, CGIP filed an 8-K on August 10 detailing Fiscal 2018 (FY 6/30/18) incentive compensation for the management team. The Board determined the management team made progress on goals 2-5 below and awarded the following cash bonuses:

1)    Completing a financing that achieves the capital structure goals of the Company based on its October 2017 strategic plan (the “Fiscal 2018 Plan”)

2)    Overseeing management and external resources and achieving a financial operating turnaround consistent with the Fiscal 2018 Plan

3)    Achieving asset dispositions to de-leverage as outlined in the Fiscal 2018 Plan

4)    Achieving certain operating margin improvements

5)    Establishing a corporate culture based on accountability, safety, integrity, and transparency

More interestingly, the Board approved additional cash bonus opportunities going-forward (exclusive of normal cash incentive bonus) by setting the following three performance goals and potential pay-outs for the CEO, CFO, and COO:

1)    Capital structure goal – at least a $60M reduction in borrowing indebtedness under the Company’s revolving credit facility in order to comply with the December 1, 2018 maximum

borrowing amount required by the credit facility or (B) a refinancing or extension of the credit facility resulting in a long-term financing structure with a term of not less than one year

2)    Restatement Goal – completing the Company’s current restatement of historical financial statements, the audit of the Company’s financial statements for fiscal 2017 and 2018, and the

filing of such financial statements with the SEC

3)    Relisting Goal – becoming relisted on NASDAQ, the NYSE, or a comparable nationally recognized stock exchange

Total potential cash pay-outs for achieving the performance goals are ~$730K for CEO, $318K for CFO, and $550K for COO. While the time frame around achieving the performance bonuses was not articulated, we believe it would likely be a FY 2019 event. Nonetheless, the recent disclosures around FY 2018 cash bonus payments for achieving operational thresholds, long-term PRSU’s and options, and recent performance goals put in place, increase our confidence in CGIP closing the refinancing, completing the restatement, and relisting shares, all of which should support increased investor interest in the story and a probable double in the share price, in our view.

Further, and while potentially insignificant, we recently learned that CGIP will present and answer questions at an Investor Conference in early November. It would appear to us that the Company would have to issue a Reg FD disclosure prior to attending that event given discussions with investors will likely cover the refinancing and restatement process as well as current operating trends.

6) We acknowledge “peak cycle” fears among investors for transports, particularly truckload names, but believe the CGIP turnaround can work even if the cycle plateaus; however, we also view it as the most attractive way to play a potential elongated cycle given greatest margin upside potential as well as it being the cheapest name among the truckload group.

Current sentiment on transports is overwhelmingly weak given “peak cycle” fears with many investors viewing the unrelenting strength in NA Class 8 truck orders YTD as an indication that a wave of capacity will enter the market in late 2018/early 2019, ultimately restricting the current unprecedented pricing power that trucking carriers have in the market. During 2Q18 earnings, truckload names generally reported strong financials but stocks traded poorly given the concern around decelerating rates of improvement in yields.

Stephens addresses the current dynamic well in the charts below showing significant earnings revisions YTD but massive multiple compression.

Despite the surge in NA Class 8 orders YTD, we note public truckload carriers are actually still seeing fleet counts decline given severe driver constraints, which suggests the current capacity situation is not a truck issue but solely a driver issue.

Additionally, freight demand remains at all-time highs and is actually exhibiting accelerating strength into 2H18 with the July Cass Freight Shipment Index flat sequentially July/June vs the 10-year average sequential decline of -3.3%.

While we believe the CGIP turnaround will work if the current freight cycle plateaus given the significant margin runway and basic blocking and tackling management has in front of them, we also view the potential for elongated cycle as a very real possibility, if not a probable event, given structural headwinds in the industry (i.e.- driver constraints, e-commerce driving additional and more rapid freight flows relative to historical distribution networks, etc.), as well as our view that tax reform related investment spend could have a longer tail than current consensus expectations, and would expect the Company to realize a much greater benefit than other truckload peers in such a scenario.

7) Base case valuation of $6-$8 near-term with upside case of $16-$20.

Our valuation cases incorporate our best estimates of current operating metrics which are generally consistent with operational updates included in CGIP’s public filings over the past year as well as our discussions with management.

Base Case (near-term opportunity)

We estimate ~$990M of consolidated revenue (in-line with annual run-rate of reported May revenue of $83.5) and a consolidated OR of 94.9%. Based on our depreciation build (~11% of revenue consistent with truckload peer average of 10-12%) we estimate ~$160M of EBITDA. We apply a 4.5x EBITDA multiple, which is an appropriate discount to reflect refinancing/restatement/DoJ risk and higher leverage profile relative to peers, compared to current truckload peer average FY2 multiple of 5.8x. Deducting current net debt of ~$511M implies an equity value of ~$205M or $7.40 per share. We estimate interest expense of ~$36M ($161M of revolver debt @ current rate of 13% and $350M of equipment leases @ 4.2% which is at the high-end of the 1.4-5.4% cited by management). CGIP will not be a tax payer given current NOLs and expected NOLs from losses following the restatement. We estimate EPS of $0.50-$0.55 and apply a 11x P/E multiple, compared to current truckload peer average FY2 multiple of 14.7x, which implies a ~$6 stock.

Upside Case (intermediate to longer-term opportunity)

We estimate ~$1,055M of consolidated revenue given increased rate realization expectations ($0.10-$0.12 of additional rate/loaded mile) and a consolidated OR of 92.8%. Based on our depreciation build (~11% of revenue consistent with truckload peer average of 10-12%) we estimate ~$185M of EBITDA. We apply a 5x EBITDA multiple, which is still an appropriate discount to reflect refinancing/restatement/DoJ risk and higher leverage profile relative to peers, compared to current truckload peer average FY2 multiple of 5.8x. Deducting net debt of ~$470M (reflecting ~$40M of debt paydown) implies an equity value of ~$450M or ~$16.50 per share. We estimate interest expense of ~$30M ($121M of revolver debt @ 13% and $350M of equipment leases @ 4.2% which is at the high-end of the 1.4-5.4% cited by management). CGIP will not be a tax payer given current NOLs and expected NOLs from losses following the restatement. We estimate EPS of $1.65-$1.70 and apply a 12x P/E multiple, compared to current truckload peer average FY2 multiple of 14.7x, which implies a ~$20 stock.

We note our upside case does not reflect the potential to refinance debt at a potentially lower interest rate as CGIP delevers. Assuming a top-line of ~$1,000M, we show the EPS sensitivity for various OR levels and interest rate assumptions for revolver debt ($161M currently) while keeping the interest rate on equipment leases ($350M currently) constant.

Additionally, we note that at current interest rate of 13%, every $10M of debt reduction is ~$0.05 of earnings.

Downside Case

Our downside case assumes revenue consistent with our base case, a slightly higher OR (95.8%), assumes equity dilution of 19.5% in order to close refinancing, and slightly lower valuation multiples. While there is inherent risk around the refinancing, restatement, and DoJ investigation, we believe a realistic downside scenario is $1.50-$2.50. Additionally, if CGIP were on the cusp of bankruptcy, we would expect it to attract significant M&A interest given the ~4,000 drivers the Company could offer another carrier, particularly considering the current driver shortage plaguing the industry.

Risks

• CGIP is unable to secure financing at an attractive rate or without equity component

• Restatement drags on longer than expected

• CGIP becomes actual target of the DoJ investigation

• Freight cycle turns before CGIP is able to delever somewhat

• Little to no balance sheet protection expected post the restatement

• Last fleet refresh was in 2016 so average age of fleet has ticked up; however, management has indicated that they are in active discussions with multiple OEM’s to initiate annual refresh schedule at attractive rates

• NAFTA concerns

Catalyst

Catalysts

Near and intermediate-term catalysts include:

• Operational updates

• Close refinancing

• Finalize restatement

• Relist on an exchange

I do not hold a position with the issuer such as employment, directorship, or consultancy.

I and/or others I advise hold a material investment in the issuer's securities.