What do you call a stock that's down 90%? A stock that was down 80% and then got cut in half. -- David Einhorn
I believe Swisher Hygiene (SWSH) is overvalued by 75%-150%. At its current price of $1.71, I believe the stock trades at an absurd multiple of any conceivable future earnings. Though down 50% year to date, I expect that Swisher will decline by at least another 50%.
Swisher Hygiene is a provider of basic cleaning and sanitation services to small and medium sized businesses. Backed by Wayne Huizenga and Steven Berrard, the company attracted countless investors who were eager to get in early on the next Blockbuster/AutoNation home run. Unfortunately, after two years since going public through a reverse merger, Swisher looks more like a strike out. The company is the product of a roll up strategy of noteworthy velocity. In 2011 Swisher completed over 50 separate acquisitions, earning it recognition from The Wall Street Journal as 2011's "Most Acquisitive Company."
With average annual sales of less than $4MM, integration of the acquired "mom and pop" businesses was a challenge of monumental proportions. It was a challenge that appears to have gotten the best of management. On March 28 of last year, Swisher announced that it would need to restate its financials for the first three quarters of 2011, primarily related to adjustments in the accounting for business acquisitions and the calculation of the allowance of doubtful accounts receivable. The company estimates this restatement will result in $4.6MM of additional losses for the period. Nine months later, restated financials are still nowhere to be found.
The company's well-known CEO, Steven Berrard, resigned in August, CFOs came and went and shareholders brought forward a class action lawsuit. Perhaps not surprisingly, this resulted in a dramatic 64% drop in the share price from March through the middle of November. However, since hitting a low of $1.10 on November 15, the stock is up 55%. I believe the share price appreciation is the result of a combination of the market misinterpreting the sale of Swisher's Waste business and short-covering associated with the NASDAQ's decision to let Swisher continue to trade throughout the full duration of is 365-day filing delay grace period. It is my view that the Swisher currently presents a very compelling short opportunity.
Swisher is a distant number two in the "number one and number two" business (discussion of the company almost mandates a few immature bathroom jokes). Swisher serves basic cleaning and hygiene needs for mostly small and midsized business, with a weighting toward the food service industry. While restroom hygiene is its main offering, the company also provides a variety of cleaning and safety services. Customer relationships generally consist of delivering consumable products (soap, paper towels etc.), selling/renting a variety of longer-lived products and light machinery (bar mats, mops and washing machines) and periodic manual cleaning of customer facilities. Though customer turnover is low and the recurring revenue nature of the business is attractive, operating margins are thin (particularly without significant scale), growth is limited and barriers to entry are almost non-existent. It is an average business at best. Ecolab (ECL), the largest player in the industry, posts 20% operating margins and low teens ROIC on sales, which are roughly 15x those of Swisher.
Roll Up Strategy
Steven Berrard and Wayne Huizenga acquired a controlling interest in Swisher Hygiene in 2004 from founder Patrick Swisher for $8MM, following Mr. Swisher's 30-month "all inclusive stay" at a federal penitentiary for tax evasion. Over the next six years, Berrard led a campaign to acquire over 30 entities, which consisted primarily of previously independent franchisees. From 2005 to 2010 he grew the business from $36MM in sales and a $3.4MM operating loss to a run rate of $60MM in sales and a $7.3MM loss. With route expenses and SG&A totaling a whopping 69% of sales, Berrard likely realized that the strategy's sole hope for success was to grow sales as fast as humanly possible and hope that something just might fall to the bottom line.
Because the business had never demonstrated an ability to generate a profit (in fact operating margins worsened from 2006 to 2010, going from -9% to -11%), the traditional route of accessing capital via a public offering was not likely available. Instead Berrard found the capital markets equivalent of an unlocked back door - a reverse merger with a publicly traded shell company sitting on a pile of cash. In November 2010 Swisher Hygiene completed a reverse merger with Toronto-based CoolBrands. Formerly the third-largest ice cream company in North America, CoolBrands had sold substantially all of its operating assets to stave off bankruptcy. Left with $61MM and an active Toronto Stock Exchange listing, CoolBrands' CEO, and long-time friend to Berrard and Huizenga, Michael Serruya was apparently quite persistent in pursuing the two to use his company as the means for taking Swisher public.
After the merger was completed, Berrard was off to the races putting the cash to work and issuing over 100MM shares to acquisition targets and unnamed institutional investors through private placements. All told, Swisher acquired 57 businesses in 2011 for a total purchase price of $160MM. Through the first nine months of the year, Swisher had posted $146MM in sales and recorded an $11.25MM operating loss (adjusted to remove acquisition and merger expenses). Even after tripling sales, the roll up strategy still offered no signs of turning the corner. However, in March it became clear that operational challenges weren't the only thorn in the company's side.
One of the very first actions that Berrard took following the reverse merger with CoolBrands was to fire previous auditor PricewaterhouseCoopers and downgrade to BDO Seidman (it was even included in the merger press release). Thanks to lackluster numbers coming out of the gate, Swisher may have been keen to massage what numbers it could to show a slightly better image of the company. In the midst of rapid growth and numerous acquisitions, bad debt and allocation of business acquisition expenses would have been the low hanging fruit for earnings manipulation. On March 28, the company announced that it would need to restate its 2011 numbers due to errors in the reporting of bad debt and acquisition expenses. While it is difficult to gain insight into the irregularities associated with allocating acquisition expenses, bad debt provisions are much easier to observe.
From 2010 to 2011, third-quarter sales increased over 315%. Accounts receivable grew 350%, increasing from 44% of sales to almost 48%. It would stand to reason that bad debt allowance would have increased by a commensurate amount. But it didn't. Instead bad debt provisions increased a paltry 34%, less than one-tenth the increase in accounts receivable. Despite the fact that Swisher's customers were largely comprised of businesses most infamous for failure, independently owned bars and restaurants, (not to mention the fact that Swisher had no experience with their credit quality), Swisher management had come to the remarkable conclusion that its bad debt provisions should be roughly one-third the allocations made by its closest peers (Ecolab, G&K and Unifirst).
Had Swisher taken a more reasonable bad debt allowance for Q3 2011, then it is likely that adjusted EBITDA would have been $1-2MM lower for the quarter ended September 30, which would have reduced reported numbers by 20% - 40%. Once the adjustments related to acquisition expenses are factored in, it is likely that Swisher will in fact report numbers that fully utilize the $4.6MM loss increase estimate. This would cause reported Adjusted EBITDA to drop from $7.3MM to $2.7MM, a 63% decline. Thanks to the recent sale of Swisher's Waste business, restated numbers for the business that remains today will be even less encouraging.
Sale of Waste Business
On November 16, Swisher sold its waste collection business to Progressive Waste Solutions for $123.3MM. The stock shot up 50% intraday before settling at a 24% gain. There are several reasons why I believe the market misread the implications of this sale.
In the statement announcing the sale, Swisher referred to the transaction as a sale of Choice Environmental Services, with Interim CEO Thomas Byrne stating, "we determined that we could provide our customers with the same benefits through a less capital intensive, more cost-effective approach by partnering with other service providers to cross-sell waste services on a national scale." This announcement was only part of the truth, about 77% to be exact. In reality, the transaction was a sale of Swisher's entire Waste segment, which included Central Carting and Lawson Sanitation. By referring only to Choice Environmental, investors (myself included) looked at the sale price, compared it to their 2011 purchase price of $91.6MM and concluded "wow, they realized a 35% gain on this investment."
The reality is that Swisher's total purchase price for the unit was $118MM, as it paid $11.4MM for Lawson and $15MM for Central Carting. Instead of a 35% return, Swisher earned a 4.5% return. Once you factor in transaction expenses and the $1MM Swisher paid ousted CEO Berrard to work on the sale (you may note that Swisher conveniently omits this filing from its otherwise exhaustive list of press releases), the return was zero if not slightly negative. Furthermore, the sale of the cash generative business (Waste was 28% of total cap ex, despite accounting for 90% of total EBITDA) was completed at an unimpressive multiple of ~9x EBITDA to an acquirer whose synergies will bring the multiple down at least a turn or two.
Beyond what I believe was a misreporting of the sale, I think the market also misinterpreted the implications of the sale, both by way of the fact that it even occurred and what the company did with the cash. This is a roll up strategy. The plan is now, and has always been, to grow the business rapidly so that the operations could scale up to support the high fixed cost burden. A sale of Swisher's only profitable business unit (Waste EBITDA margins are 18.4%, while the remaining business is an anemic 0.7%) means that something is going dramatically wrong. So why did they sell? I have one guess.
Each month from May through October Swisher released a filing stating that Wells Fargo had agreed to waive the event of default on the company's credit facility that should have followed from Swisher's delinquent financials. Initially, the credit facility permitted the company to draw up to $100MM. That capacity was cut to $50MM in August and then to $25MM in September. When Swisher sold the Waste business they used part of the proceeds to pay down the outstanding $17.2MM on the credit facility. My read is that Wells Fargo was not going to waive the filing default any longer and they required Swisher to pay off the balance. If Swisher had the money then they would surely have preferred to pay it off with cash on hand (they reported $83.7MM in cash on 9/30/11) instead of parting ways with the only profitable part of their business. But they didn't. It is my view that the sale of Swisher's Waste business implies not only that the roll up strategy is dead, but that the remaining business may be insolvent. The financials of what remains support this perspective.
Thankfully, Swisher started reporting the business in two segments, Hygiene and Waste, in Q2 2011. Though the restated numbers will change things slightly (not for the better), it is pretty straightforward to paint the picture that the remaining Hygiene business is not profitable. Following is a breakdown of Swisher's Hygiene business for Q2 and Q3 of 2011:
|Cost of Sales||$7,670,169||$20,492,636|
|EBITDA less Cap Ex||-$5,028,401||-$3,948,933|
After backing out roughly $78MM in net cash, Swisher's current enterprise value is around $220MM. It is unfathomable to me that the financials outlined above (which again will be restated downwards) could support such a valuation. In the third quarter filings the company indicated that run rate sales, incorporating post-9/30 acquisitions, was $320MM. Removing the $72MM in sales associated with the Waste business leaves us with $248MM. At its Q3 EBITDA margin of 0.7%, this would imply that Swisher is valued at 127x run rate EBITDA. In order for the valuation to approach the 8x multiple of its peer group, Swisher would have to improve its margins almost 1,180 basis points. That's just not happening.
If I were to consider Swisher from the long side I would be hard pressed to value it at much more than the cash that remained after the sale of the Waste segment. At $78MM and 175MM shares outstanding, that would value the business at $0.45/share, 74% below its current price. As demonstrated above, the Hygiene business currently burns a significant amount of cash. Nothing in the business' past, present or future (in my opinion) would cause that to change. Furthermore, with the existing class action lawsuit and a decent chance for additional lawsuits down the line (particularly from acquisition targets who took shares), legal expenses will very likely eat into the cash pile.
Valuing the company from the short side, I take two approaches: invested capital and a multiple of a completely arbitrary EBITDA estimate. The first is significantly more conservative. Swisher spent $161MM on acquisitions through the first nine months of 2011. In the reverse merger with CoolBrands, the pre-existing business was valued at $57MM. While A) I do not believe that the pre-existing business was worth anything close to this (remember, Serruya was the one who wanted a deal) and, B) I am confident that Swisher paid more than any rational acquirer would have dreamed for the +50 businesses they picked up in 2011, this implies around $218MM in total invested capital for the business. As noted earlier Swisher invested $118MM in the Waste business that was sold last month, so backing that out we are left with $100MM in invested capital. That leaves $0.57/share. Add in the $0.45/share in remaining cash proceeds and you get $1.02/share, 40% below the current price.
Now it should be noted that this approach is most relevant if you are considering the value of a business from the perspective of a potential acquirer. I believe that when the Waste business was sold for roughly 1x invested capital that put a ceiling on the valuation of the remaining business. In reality, I think that the remaining business is worth substantially less. It burns cash and, as evidence by the wheels coming off this roll up strategy, it is difficult to scale. Furthermore, the most likely (aka, only conceivable) buyer is Ecolab. When I spoke with the company about the industry they were very direct in their criticism of Swisher's misguided strategy. They said customer retention in an acquisition is low and scaling up small outfits with single-location customers is very difficult to make work. At the end of the discussion when I asked whether Swisher was an acquisition candidate they made it very clear that they had no interest in picking up where Berrard left off. Suffice to say, I think the business is worth significantly less than its invested capital.
The second approach is to essentially make up a "normalized" EBITDA margin and apply a peer group multiple. In Swisher's prospectus dated August 19, 2011, the company breaks out financials for a few of its acquired entities. Pro-Clean of Arizona, whose business most closely resembles Swisher's aggregated operations, posted a 4.2% EBITDA margin in 2010. Applying a 4.2% margin and giving the business an 8x multiple results in a value of $0.92/share, including cash. Again, however, this valuation approach is not likely reasonable. For one, Swisher's SG&A as a percent of sales is 900 basis points higher than Pro-Clean was a stand-alone (so much for achieving scale). Second, cap ex was 78% of Pro-Clean's 2010 EBITDA and Q1 2011 sales only grew 5.5%. This is a fairly capital intense business in which an 8x EBITDA multiple can be +35x free cash flow.
All told, from a valuation perspective, I think Swisher is an attractive short candidate down to levels around $0.70, 59% below the current price.
Last, I think that now offers a very favorable window to short Swisher. The stock is up almost 70% from its low thanks to a misinterpretation of the Waste business sale and significant short covering. By announcing that the stock would not be delisted prior to year end, I expect that many who were short (and had very meaningful gains) decided to cover before year-end to lock in 2012 tax rates. From November 15th to December 15th the short interest declined from 10MM shares to 9MM shares. I expect that additional short covering is occurring as we approach year end.
The primary risks here are that I am wrong about the earnings power of the remaining business and that I am underestimating Berrard and Huizenga's desire to avoid a black mark on their records. As for the first risk, it's always possible, but there a lot of historical financials that support my view. And for the second, this isn't the first time these guys have lost money and it likely won't be the last. Also, Huizenga's net worth is estimated at $2.3B. Swisher's current market cap is $323MM. I don't think Wayne is about to put his neck out to save this obvious failure.
The fund I work for currently maintains a short position in Swisher Hygiene. This report is not a recommendation to buy or sell any securities. The author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be accurate as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information.
Disclaimer: This article represents best efforts to convey a fact-based opinion. My conclusions may be incorrect. This is not a recommendation to buy or sell any securities. I am short SWSH and may change my position at any time without notice.