When I first wrote about YRC Worldwide (YRCW), there were several bullish rebuttals to my claim that the stock was overvalued. These claims focused around the company being in the midst of a turnaround and how it has large upside due to the fact that annual revenue sits close to $5 billion while the market cap sits around $270 million.
Before getting into YRCW's notes to its Q1 financials to assess the feasibility of its proposed turnaround, I will reiterate that the low price to sales metric isn't a function of the company being undervalued, but merely a function of it being highly leveraged.
When looking at a company like YRCW, we can't look only at the market cap, compare the financial ratios associated with it and call it a day. YRCW is a highly indebted firm with negative book value and no revenue growth. Enterprise Value is the much more appropriate valuation metric for the company. EV is calculated as a company's market cap plus its debt less its cash. From YRCW's latest financials it has just under $200M in cash (including restricted cash) and $1,370M in long-term debt (including the portion maturing within 12 months). If YRCW has a market cap of $270M, the total enterprise value for the company is $1.44 billion. Not exactly the small cap company that some would have you believe. Note that this calculation excludes the over $500M in pension obligations currently on YRCW's balance sheet.
Taking that EV of $1.44 billion and comparing it to the revenue figure of $4.8B get an EV to revenue ratio of 0.3x. That's still pretty low when looked at in isolation but when you look at it in comparison to Arkansas Best Corporation (ABFS) which also has an EV/R of 0.3x you can see that the ratio doesn't foretell a company that is undervalued, but a company that is in an industry which has low profit margins and is generally out of favor. Con-way Inc. (CNW) has an EV/R of 0.48x but is profitable so its stock can justify a higher revenue comparable because its margins are higher and the company is not subject to high bankruptcy risk.
The second part of the bullish argument is that YRC Worldwide is on the verge of a turnaround. No one can argue against the idea that its financials are improving. The mistake in the reasoning is assuming it will be easy for the company to continue to improve and buy into a stock that has gained over 300% in a matter of two months. Especially when considering that YRCW's financial turnaround was initially seen in Q2 2012 but fell on deaf ears thanks to the looming debt crunch.
Referring to YRCW's notes to its Q1 financial statements, I refer you to the Financial Condition/Liquidity and Capital Resources section. Most people would be aware that the company needs to refinance or restructure their debt due in late 2014 and that Standard & Poor's rates the company's debt as 'CCC', but it is good to read through that section carefully to fully consider the risks associated with buying the stock.
The Credit Facility Covenants outline the minimum EBITDA, Leverage Ratio and Interest Coverage Ratio, which the company must adhere to in order to comply with their debt covenants. Finally, it has a minimum cash balance requirement of $119.4M starting in November to ensure that the notes due February 2014 can be paid off. Considering the company's thin margins and its pension obligations for the remainder of the year for its single-employer pension plans and multi-employer pension funds of $50.4 million and $60.9 million, respectively, it will be a tight squeeze as evidenced by this quote from the notes:
"We believe that our minimum cash balance covenant represents our highest risk of default over the next twelve months. If our future operating results indicate that we will not meet our minimum cash balance covenant, we will take actions to improve our liquidity, which include (without limitation) deferring the timing of our capital expenditures..."
The timing of YRCW's capital expenditures is an important consideration. I direct you to Section 3, Liquidity, which contains much of the information listed above, but also has important notes in the "Risks and Uncertainties Regarding Future Liquidity" section, with particular attention to the following quote:
"Our capital expenditures for the three months ended March 31, 2013 and 2012 were $17.2 million and $15.1 million, respectively. These amounts were principally used to fund replacement engines and trailer refurbishments for our revenue fleet and capitalized costs for our network facilities and technology infrastructure. In light of our recent operating results and liquidity needs, we have deferred the majority of capital expenditures and expect to continue to do so for the foreseeable future, including the remainder of 2013. As a result, the average age of our fleet is increasing, which may affect our maintenance costs and operational efficiency unless we are able to obtain suitable lease financing to meet our replacement equipment needs."
The turnaround proposed by people bullish on the stock assumes continued reduction in operating costs and more favorable pricing. How will the company be able to do either when holding on to older equipment? Everyone who has owned an older vehicle knows the risks associated with your car breaking down as it ages. Not only are there substantial maintenance costs, but your vehicle is out of commission for a day or more. For the average person, that's a minor inconvenience. For YRCW that's a catastrophe that involves missing several shipments to its customers. And to keep those clients that means pricing discounts or some other incentive that negatively impacts YRCW's bottom line.
YRCW is telling everyone that the company is playing a game of Russian Roulette with its aging equipment, yet this is going largely ignored by the people who are bullish on YRCW's stock at $31. James Welch, CEO of the company is seen as its savior. Certainly he has done a good job in turning around the company thus far, but is not perfect. If these capital expenditures were needed to ensure optimum operating efficiency for the company's fleet, then the financial leases should have been negotiated proactively. Instead they are now a footnote as a significant but mostly overlooked risk to YRCW's turnaround. Because the company is intentionally falling behind on their capex spending for their fleets, we can assume that the free cash flow achieved in the past few quarters is overstated. This activity is typical myopic behavior we have seen with other companies, which pump up the financial statements and stock price in the short term at the expense of long-term viability.
In the next paragraph following the warning on the reduction in their capital expenditures, the company claims:
"We believe that our cash and cash equivalents, results of operations and availability under our credit facilities will be sufficient for us to comply with the covenants in our credit facilities, fund our operations, increase working capital as necessary to support our planned revenue growth and fund capital expenditures for the foreseeable future, including the next twelve months."
This is a direct contradiction to what the company stated about their capex situation in the preceding paragraph where they are delaying the majority of the spending for the foreseeable future, but moving on:
"Our ability to satisfy our liquidity needs beyond the next twelve months is dependent on a number of factors, some of which are outside of our control."
They go on to list six risk factors which investors interested in YRCW should carefully read. But to summarize them, they must continue to lower costs and improve on pricing and shipping volumes, all three of which are at risk of achieving given their aging fleet. They must secure financing for their revenue equipment, which the company implies is not an easy thing to do as it has already fallen behind its capex spend. YRCW must also restructure or refinance their debt. A refinancing could go either way with respect to the company's stock price, depending on how favorable the terms happen to be. However, another restructuring pretty much ensures another significant dilution that ends up being very negative for current shareholders.
Things might turn out alright for YRCW, or they might not. If they do, purchasing the stock at $31 means you bought into a company, which is valued about the same as ABFS when using the EV to Revenue metric. If YRCW manages to pull a small profit in the near future, the upside appears to be CNW's EV to Revenue metric of 0.48x, a little more than a 50% gain. However, if things do not go well for YRCW and their aging fleet breaks down or they are unable to obtain favorable financing for their equipment or to satisfy their upcoming debt repayments, the stock is at risk of a significant slide. The downside risk is greater than the upside potential at this point in time for YRCW.
Additional disclosure: I own put options