Last year I wrote an article detailing how Echo Global Logistics (ECHO) was using one-time non-cash SG&A benefits in order to beat each quarter’s earnings estimates by a penny. To make a long story short, the issue came out on their next earnings call, investors began to understand that accounting adjustments were masking an underlying deterioration at Echo’s business and management was forced to provide more transparency around its estimated earn-out provision changes. In the analyst downgrades and stock selling that followed, I covered part of my short. I thought that would be the end of the story and I would be covering the rest of my short at lower levels in the following weeks and months.
Fast forward to today. Although the capacity in the trucking market is still tight, Echo has done a better job passing along pricing increases to its customers so net revenue margins have expanded. Last quarter, they beat earnings expectations by a penny (as usual) without excessively relying on contingent liability reversals to benefit SG&A. Wall St. analysts roundly congratulated them on a “clean” quarter. The Echo story is back on track, right?
Well, not quite. While Echo management did not depend on contingent liability reversals from earn-outs to beat its earnings estimate, and likely knew that investors would not accept such “beats” anyway given focus on the issue, they did sneak in another one-time benefit to SG&A that allowed them to “beat the number”. Kudos to SunTrust Robinson Humphrey analyst Sterling Adlakha for reading the proxy closely. From the Thomson StreetEvents transcript of Echo’s Q1 2011 call:
Sterling Adlakha - SunTrust Robinson Humphrey - Analyst
Okay, that's great. I just have one last one. In the proxy statement there was a mention of selling the ownership interest in Fooda for $325,000 I think it was. Is that -- that was done in February. Is that in the P&L? And if so, where is it in the P&L?
Dave Menzel - Echo Global Logistics, Inc. - CFO
That's an offset, so to speak, in the G&A expenses.
So despite the apparent improvement in business, Echo is still relied on one-time SG&A benefits to beat its analyst earnings estimate, and once again the company’s management simply slipped it into a filing hoping no one would notice. In fact, the $325K benefit from a related party transaction was mentioned nowhere in the 10-Q, and was revealed only in the proxy. While the distortions are not as great as they were in the first three quarters of last year, I estimate that adjusting for taxes this benefit (combined with about $100K in contingent liability reductions) would have enabled Echo to only meet, not exceed, analyst consensus EPS expectations. For the curious, here is where the $325K benefit came from according to the proxy:
Relationship with Fooda, Inc.
In December 2010, Orazio Buzza, our former Chief Operating Officer, Vip Sandir, a former Echo employee, and certain current Echo employees (collectively, the “Fooda parties”) started Fooda, Inc., a business that facilitates the delivery of lunch to business premises. In exchange for any rights that Echo may have had in Fooda's business as a result of the Fooda parties developing the business plan during the course of their employment with Echo, the Fooda parties caused Fooda to issue to Echo a 13% ownership interest in Fooda and paid Echo $100,000 in cash. A fund affiliated with Eric P. Lefkofsky and Bradley A. Keywell also invested in Fooda. In February 2011, Echo sold the 13% ownership interest in Fooda to Messrs. Buzza and Sandhir for $325,000 in cash.
Nice work if you can get it. Now the accounting issues are all well and good, but I would be remiss not to point out that they are minor as compared to last year. One-time SG&A benefits were “only” 12% of reported operating income in Q1 of 2011, while they were as high as 62% in the first quarter of last year. The bigger question is whether Echo’s business performance will be strong enough to justify what I consider a lofty multiple of 26x this year’s estimated EPS. One potential issue for Echo is the impact of CSA regulations being implemented over the course of this year. I believe CSA along with some other regulatory changes could reduce trucking industry capacity and squeeze Echo’s net revenue margin in a repeat of last year. The same issue is a potential headwind for CHRW.
More fundamentally, I think a lawsuit filed against Echo Global Logistics in Canada may also potentially shed a light on Echo’s business practices and the satisfaction in its customer base. I am guessing that Normerica is the large enterprise customer whose loss caused enterprise revenue to be down sequentially in the fourth quarter of 2010, and from their complaint it does not exactly sound like they will be a great customer reference for Echo. In Echo’s 10-K they disclosed that although Normerica was refusing to pay a $2.7M disputed receivable and suing them for $2.5M, the company saw no reason to reserve against either of those amounts. If Echo loses the lawsuit, the impairment of its disputed receivable and damages could wipe out more than a quarter’s operating profit.
2011 should be an interesting year for Echo indeed.