A messy situation is brewing at Gas Natural (NYSEMKT:EGAS) and investors need to proceed with caution. We believe the stock is heavily owned by retail investors looking for dividend yield; we think these investors need to realize EGAS is not a "widows and orphans" utility company. Sticking around to collect the dividend yield is like picking up pennies in front of a steamroller.
EGAS filed a NT 10-Q after the market closed last Friday (releasing bad news over the weekend is a classic signpost of stock market shenanigans) which notified the SEC that the Q3 report would be delayed. The reason given was as follows:
"On November 13, 2013, the Public Utilities Commission of Ohio issued an Opinion and Order (the "Order"), related to the gas cost recovery cases involving Northeast Ohio Natural Gas Corp. and Orwell Natural Gas Company, which are two of the operating subsidiaries of Gas Natural Inc. (the "company"). The company needed to analyze the Order to determine its impact, if any, on the Form 10-Q for the period ended September 30, 2013. As a result, the company could not timely file its Form 10-Q related to the third quarter of 2013 without unreasonable effort or expense."
We were able to track down this Opinion and Order and the contents shocked us. The report read like a piece from Muddy Waters or Citron Research; it is not what one would expect from the normally conservative Public Utilities Commission of Ohio (PUCO). The report is very informative and should be read in its entirety by anyone considering an investment in EGAS.
Our analysis of the PUCO report suggests that a full scale Commission-ordered investigation of EGAS is imminent. The risk of regulatory action is significant because EGAS derives over 85% of its revenue from regulated utilities operations. The end result of the regulatory action is unknown but it could have a material impact on EGAS operations and the stock price.
In addition to the heightened regulatory risk, the PUCO report also raises some serious questions about the quality of management, effectiveness of internal controls, and the preponderance of related party transactions. The market does not yet appear to be pricing in the findings of the PUCO report. We see potential downside for the stock being tangible book value or $7.45 per share. Further downside potential exists should the Commission take significant corrective measures against EGAS.
Market Slow to Digest the Findings of the PUCO Report
We do not think investors have fully digested (or even read) the findings of the PUCO report. We think the stock is likely to experience significant selling pressure as these issues come to light. The PUCO report found numerous instances of dubious related party transactions and utility customers being overcharged. The report highlights the multiple ways in which EGAS manipulates the regulated utility business in order to enrich the non-regulated affiliated companies. The end consumer ultimately pays the price for these schemes via higher utility costs.
Findings of the PUCO report:
-EGAS disregarded the Commission's order to terminate its supply contract with an affiliated company and initiate a competitive RFP for purchases of local gas production.
-EGAS instead rigged the RFP so that an affiliated company, John D Oil & Gas (OTC:JDOG), would win the contract.
-JDOG then systemically overpaid for natural gas purchases which resulted in premium payments due to JDOG at the expense of utility customers.
-EGAS charged customers with a processing fee, which was paid to Cobra (affiliated company), for gas that was never actually processed.
-When an employee attempted to verify that the volumes being charged a processing fee by Cobra were actually being processed, she was fired.
-Evidence that EGAS manipulated several GCR filings.
Recommendations of the report
-Void all contracts with JDOG.
-Immediately commence a new RFP process for the JDOG supply agreement.
-Refund customers for artificially high gas prices resulting from JDOG supply contract.
-Refund customers for the processing fees on gas that was never processed.
-Refund customers for premiums paid to JDOG.
-Initiate a Commission-ordered investigation of EGAS.
The PUCO report is a result of an audit (referred to as 2012 GCR Audit) of EGAS by the Public Utilities Commission of Ohio. The audit was designed to see if EGAS is properly billing its customers for natural gas in accordance with regulated recovery practices. The 2012 GCR Audit was actually a follow up to an audit in 2010 which raised questions about EGAS's enforcement of contract terms, appropriateness of purchase price provisions, and related party transactions.
The 2010 audit found evidence that EGAS was paying higher than normal prices for gas from related parties and then passing along this inflated cost to regulated utility customers. The 2010 audit also raised questions about the corporate structure of EGAS. The Opinion and Order from the 2010 stipulated that EGAS would terminated the effective contracts for gas purchases from affiliated companies and implement an RFP for competitive bidding for gas supply.
Did this happen?
Nope. EGAS sent out an RFP on October 1, 2012 (nearly a year after the agreed upon deadline) and not surprisingly, its affiliate, JDOG, was chosen as the winning bidder. The PUCO report asserts the RFP issued by EGAS contained purposefully ambiguous language and lacked historical information. The shortcomings of the RFP were intended to discourage other bidders from making competitive offers. It should be no surprise that JDOG was the only entity to submit a proposal.
Beginning in 2008, EGAS started using JDOG as the sole entity responsible for gas purchases. Prior to that time, from 2000-2007, EGAS purchased local production gas at an average rate that was $1.03 per Mcf less than the average cost of interstate gas supplies. However once JDOG began purchasing gas production, the average cost of local gas became $0.85 per Mcf more than the average cost of interstate gas. The inclusion of JDOG appears to have resulted in the systemic overcharging of utility customers. Clear evidence of this overcharging is the fact that JDOG was selling gas to Piedmont Gas Company's, an independent utility company, at prices that were significantly lower than the prices paid by the affiliated companies (Northeast and Orwell) to JDOG during this period.
It also appears that JDOG made gas purchases that were unnecessary so that it could generate premium payments for itself. JDOG would purchase gas that was not needed and put it into storage even though these purchases were causing supply imbalances. We won't go into all of the gory details but they are all available in the 65 page report.
Suspicious Timing of Massive Insider-Selling
Both the CEO and the CFO of EGAS unloaded a massive amount of stock just days before the PUCO report was released. On October 31st, Richard Osborne (CEO) sold over 1 million shares (71% of his stake) while the CFO, Thomas Smith, dumped 87% of his stock. The stock had been trading at ~$10.40 prior to this selling. To add insult to injury, EGAS also issued 80,000 shares as part of the offering. There is no strategic rationale for this equity offering as EGAS does not need an $800k cash infusion with $11m already sitting on the balance sheet. It seems to us that EGAS included the company's equity offering to obfuscate the massive insider dumping. With management running for the exit, why should investors stick around?
Concerns About Management
Obviously the systematic overcharging of utility customers is the biggest concern here but the PUCO report also provides some very damaging evidence against the management team at EGAS. The findings of the report calls into question the overall competence and integrity of management. There appears to be virtually no internal controls or Sarbanes-Oxley compliance. The Ohio utility company had at least four different Controllers from 2005-2013. Our research indicates the CFO (Mr. Smith) typically works from home and is only physically in the office one day per month.
There is also evidence that EGAS purchased and was paying for a Cadillac Escalade for one of Mr. Osborne's sons even though the son was not an employee of the company. There is also evidence that EGAS made personal loans to Mr. Osborne. It appears that EGAS was essentially used as slush fund for Mr. Osborne despite being a regulated utility company. Corroborating details can be found in the PUCO report. We reached out to the management team on several occasions but we never received a response from anyone at EGAS.
A few of the notable excerpts from the report:
"The evidence shows that there is a severe organizational dysfunction within the companies and between the regulated companies and their non-regulated affiliates."
"Staff recommended that the Commission order an investigation into the management practices of the companies. Staff urged the Commission to not only inquire into the companies, but to include their related and affiliated regulated companies, as well. Staff emphasized that this is, in fact, an unprecedented recommendation; however, it comes following a series of extremely frustrating audits of the companies, rife with self-dealing that demonstrates a remarkable lack of control."
"This is most notable in the testimony of Mr. Smith, who admitted he was unaware of whether he held corporate titles, including president, to various related companies of Northeast and Orwell, including Spelman, Lightning, and Gas Natural… He also indicated that he thought he was president of Gas Natural... but I can't be certain."
"Ms. Rolf testified that the companies had internal auditing controls, but these controls were not followed and no one was designated to make sure those controls were implemented."
"The evidence reveals that checks would be cut and held because there were no funds available to pay them and that receivables were given a similar treatment with invoices to related parties left unpaid for, at times, more than a year. There was also evidence that the companies regularly "flushed accounts," inappropriately offsetting payables and receivables."
"There was testimony from two individuals who previously worked for the companies alleging manipulation of GCR filings."
Cindy Rolf, a staff accountant for the Companies, testified that she was responsible for filing GCR reports for Northeast and Orwell with the Commission and that once, in 2012, Mr. Smith, the president of Northeast and Orwell, asked her to modify the GCR rate to be higher than it should have been (Tr. II at 352).
Ms. Rolf also alleged that Mr. Larry Brainard, the Ohio controller for the companies, requested her to find a situation where they could issue an invoice to show the companies purchased less gas than it sold, which would create a greater cash inflow in that current period."
Fraudulent Processing Fee:
"Ms. Lipnis, a former employee of the companies who voluntarily testified at the hearing, asserted that at the time she attempted to verify whether the volumes that were charged that $0.25 per Dth fee by Cobra were actually processed, she was fired (Tr. Ill at 572)."
"Mr. Whelan confirmed that all of the gas volumes on the Churchtown system were charged the $0.25 per Dth processing fee and he admits none of the gas on the Cobra system that goes to Northeast customers goes through a processing plant (Tr. I at 50, 54,102-103)."
"In our Order in the 2010 GCR Audit Cases, we stated our concerns "about the companies' failure to provide the appropriate consumer protections for the regulated ratepayers, as evidenced through Staff's GCR audit findings and the testimony presented at the hearing." Unfortunately, those concerns remain as true today as they were in 2010 and appear to be symptomatic. We are concerned that the evidence shows a pattern of behavior favoring affiliates of the companies and appearing not at arm's length."
"A COI is necessary because the companies misused their affiliates by over-payment for natural gas supplies and company management failed to analyze whether the insertion of JDOG into the gas purchasing process provided any benefit to GCR customers. OCC also maintained that a COI is warranted because: the companies management has demonstrated an alarming lack of regard for the best interests of its customer and has put the interest of ownership ahead of customers; senior management lacked basic utility experience."
"The extent of the unawareness and negligence of the senior management of the companies to their managerial and fiduciary duties and responsibilities, the failure to enforce internal controls, the lack of control over access to company records, the impropriety of the compensation system for employees of the companies, and the functional absence of responsible persons serving in management positions, all of these situational deficiencies appear to be the norm, rather than the exception, and raise sufficient legitimate concerns that warrant more than a customary management performance audit in accordance with R.C. 4905.302, and Ohio Admin.Code 4901:1-14-07. OCC has urged the Commission to order a Commission-ordered investigation (COI)."
Possibility for a "Black Swan" Outcome
The end result of any forthcoming regulatory action is unknowable but given the regulated nature of EGAS's primary businesses, the potential for an "outlier" event certainly does exist. The language in the PUCO report is very strong and suggests that the continued existence of EGAS in its present form is not guaranteed. We won't speculate on potential outcomes but we do see the possibility of EGAS facing severe regulatory action. Sticking around to collect a 5% dividend yield in this stock is like picking up pennies in front of a steamroller. The fact that insiders dumped 75% of their shares in the past few weeks further supports this view.
"The Commission finds that the fact that these allegations were not disputed by the companies raises additional questions about the judgment of the current management of the companies and whether they are sufficiently responsible and capable to continue to manage a public utility in accordance with acceptable business practices, Commission rules and orders, and Ohio statutory requirements."
"The evidentiary record in these cases demonstrates a clear need for sweeping action. The Commission has the authority to make whatever changes are necessary to ensure that the companies operate in the best interests of their customers and in accordance with the law. We have rarely observed regulated companies operated in the manner evidenced here."
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: 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. 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.