I should probably start this article by saying that I have no idea how this IPO was brought to market. I mean, it's clear why the IPO had to happen but I have no idea how the underwriters and the company itself sold the idea to the public that this is a company that you want to own.
I'll never understand how a company big enough with smart enough people working at it to be in the conversation for taking a company public could sell such a convincingly bad investment to the public knowing that it will most likely not work out. Obviously the underwriters would never admit that they thought an investment was a lame duck - they have fee revenue and future IPO revenue to think about, but hopefully by the end of this article you'll understand why I am shocked and awed at times by the absolute train wrecks that somehow are allowed to go public.
This article will make the argument that Advanced Drainage Systems, Inc. (NYSE:WMS) is an excellent short opportunity with very little upside potential. The bear thesis is based on the fact that the company has an already highly efficient and well ran set of operations that has shown a historical inability to expand margins and generate a net-income that is sustainable; that the company should be operating exclusive on its credit facility by the first quarter that it reports as a public company; that the company's current debt, contractual obligations, and operating expenses due within the next thirty six to forty eight months are greater than the company's borrowing capacity and current cash generation abilities; and that the share lock-up expiration in less than 180 days should bring a substantial amount of selling from insiders. I believe WMS has negative catalysts that will press on share prices beginning now and continuing on all durations.
Who is Advanced Drainage Systems, Inc.?
"Advanced Drainage Systems, Inc. designs, manufactures, and markets thermoplastic corrugated pipes and related water management products for non-residential, residential, agriculture, and infrastructure applications in the United States and internationally. The company provides single, double, and triple wall corrugated polypropylene and polyethylene pipes; and allied products comprising PVC drainage structures, fittings and filters, and water quality filters and separators. It also purchases and distributes construction fabrics, and other geosynthetic products for soil stabilization, reinforcement, filtration, separation, erosion control, and sub-surface drainage." (SOURCE: Yahoo! Finance Stock Summary WMS)
WMS held an IPO on 7.25.2014 and sold 14,500,000 shares at $16 of which it received proceeds from the sale of 5,289,474 shares. 9,210,526 shares were sold by existing shareholders. Total proceeds to WMS were ~$84.6 million and the company used the entire balance of proceeds to pay down revolving credit debt. Barclays and Deutsche Bank were the main underwriters.
What does WMS do?
I'd like to keep this section as abbreviated as possible in an effort to get to the reason you're reading this article - how you're going to make more money shorting WMS stock than WMS made in fiscal 2014.
WMS makes and sells pipes and other ancillary products that are involved in fluid management. The fluids themselves can vary greatly as the product portfolio at WMS is deep, well produced, and versatile. WMS serves a variety of end markets and is one of the first brand names contacted to handle a job in its space, the construction and infrastructure arenas. What I'm saying is that WMS has a really solid set of operations.
The company has both domestic and international operations of what I would say are of full maturity in terms of development. For instance, domestically WMS has 48 manufacturing plants and 19 distribution centers that allow it to sell to every major market in the country. Internationally, it has two manufacturing plants and three distribution centers in Canada, four manufacturing plants in Mexico, four manufacturing plants and five distribution centers in South America and one distribution center in Europe. It should also be noted that internationally WMS has several joint ventures with brand name producers that expand its reach and its brand presence. WMS is no spring chicken, this company is the real deal from a footprint standpoint.
Finally, before moving on to the bear thesis I would like to also express that WMS has invested heavily over the past decade, with investments accelerating the last few years, into its production facilities and its long-lived assets in an effort to give itself a competitive advantage when it comes to efficiency and speed and breadth to market. All three goals have come to realization as WMS is regarded as having some of the most sophisticated and developed production and development capacity for its industry in the world. Again, I would like to reiterate the business itself is a well-oiled machine.
The Bear Thesis starts with The Bull Thesis
As a matter of fact, The Bull Thesis is a large part of The Bear Thesis. One of my main arguments for shorting WMS stock is that the company, or should I say the operations themselves, is already as efficient as I believe it can be. The company already has economies of scale. The company already has advanced production and development capacity. The company already has logistical competitive advantages in place. I don't believe that AWS has a business problem or that it could be running its business more effectively than it is now. I just think that it took too long for WMS to get to where it is and that in the meantime it ran up a substantial amount of debt and grew too fast for overall sales to make a dent in the debt and cost of its massive operation.
We'll start with the debt because I think everything always begins and ends with debt anyways:
WMS had amassed a total of ~$454 million in pre-IPO debt of which ~$84.6 million was paid down with proceeds. Even post IPO, and it's extremely important for somebody looking to short the stock to learn what that did for interest payments over the next 36 to 48 months, the company still has ~$369.4 million in debt on the books - a portion of it coming due over the next 3-4 years that is greater than the current borrowing capacity and net cash flow generation of the company. That's why it's going to be so important to get the first earnings-period conference call information in regards to if the IPO pay down of debt helped kicked any payments down the road.
To achieve that 36-48 month figure I'm not modeling in any further degradation to total revenues derived or net income but I certainly expect some of both to occur. The 36-48 month time frame prior to WMS needing to either raise debt or dilute is unrealistically bullish in my opinion but in an effort to not sensationalize and to present a worst-case scenario to my bear thesis that is the time frame within which I believe the above will happen. It mathematically is a certainty unless WMS begins to immediately operate and sustain operation several standard deviations above its historical revenue generation capabilities. So, the debt already on the books is a problem and a "significant portion" (SOURCE: WMS S-1) of it is variable so any rise in interest rates over that same time frame will exacerbate the problems. I'll break down this time frame with more specificity in the conclusion section.
Where did all the funds that comprise the debt figure go? A good portion of them went into the infrastructure of the company - WMS has a substantial CAPEX history (~$173 million over the last nine years) which has helped it come to realize those competitive advantages mentioned in the sections above, but a large portion of the borrowings also went to a few items of silliness, or more aptly called piggery. Just prior to the IPO the company paid a one-time special dividend of approximately $108.1 million to current shareholders. That figure alone is 24% of pre-IPO debt. Let that sink in. Just under a quarter of the total pre-IPO debt was caused by a cash grab from ownership who also, by the way, sold over 9 million shares into the offering that had zero benefit to the company. Ownership has been ringing the register and in size the last few months which doesn't exactly highly endorse the future of the company. This is a part of the bear thesis that we'll develop later.
The debt at WMS also has had the effect of pressing on the income statement:
Working our way from top to bottom, you can see that total revenue growth has been slow that last three years. Growth from FF12-13 was abysmal coming in at just over $3 million dollars total or less than 1%. Growth improved from FF13-FF14 to ~$52 million or 5% Y/Y. Even in a year of "growth" you can see that the company has reached what is close to or should be approaching max sales capacity without the additional development of tertiary markets and/or secondary and tertiary ancillary product lines. Again, this is a case of The Bull Thesis aiding The Bear Thesis. WMS is doing over a billion dollars in sales each year on a consistent basis. It's just having no effect further down the income statement past the top line. The top line also has a tendency to remain flat in years where new clients aren't willing to spend at levels higher than historical means. WMS knows what it will get from its top ten clients, which represented 46.7% of domestic net sales in FF14, but when its bottom 50% of clients aren't ready to write checks the company doesn't have the potential to drive revenue from other sources. That's shouldn't normally be a bad thing either. The fact is you have a company doing over $1 billion in sales and it simply does not matter. The maturity of the company and the market capture of the company are actually feeding The Bear Thesis at this point. A sad reality.
Further down you'll see that the COGS and SG&A have both grown over the three-year period and both of those have had the effect of significantly limiting income from operations which has fallen three years consecutively. COGS has risen as the primary ingredient in making the products within the WMS portfolio is tethered to crude oil derivatives and natural gas liquids and with only a 50% hedged capacity on the books the rise in pricing for both of those items has hurt gross profit. This is a long-term trend that should concern WMS bulls as either the company will need to spend more to hedge price increase and hope that it hedges effectively or the company will need to model in lower margins. Either scenario is not ideal.
That being said, looking further and further down the statement the numbers only get worse and worse with the statement capitulating at the net income line which has fallen from ~$29 million to a net loss of ~$3 million. That's $32 million on net income destroyed in 36 months. Assuming all factors staying the same, the income statement should receive some help from a lowered interest expense but the fundamental issue of the company being at a fully mature selling level still remains. I do not anticipate revenue growth north of 7%, and that would be in the most bullish scenario imaginable, in any years let along consecutive years going forward. I am of the opinion that a growth rate of 1-3% would be safe to use for modeling purposes. If that is accurate or anywhere close to accurate the rest of my Bear Thesis should hold water.
The final piece of information in this graphic that I would ask a reader to make note of would be the history of CAPEX (noted in above sections as well) and the negative trend line of Adjusted EBITDA margins even in the face of these investments. The company has tried with a herculean effort to expand margins by spending and it has just not had the desired result. Even with margins increasing 1.3% from FFY12 the negligible top-line growth and the other income statement issues have negated any effect of the CAPEX. Remember, we're talking about Adjusted EBITDA margins here. This picture could be much worse.
Moving to the cash flow statement, the company has done well to operate at cash flow break-even and this to me is the largest reason to be bullish the stock (if you are bullish) but I'm wondering with a quickly shrinking revolver how much longer this can be sustained. At some point the company is going to have to decide between continuing to invest in CAPEX or conserving cash burn as the revolver gets low. We're not at that point yet, but it's on the horizon and getting closer. Remember, The Bear Thesis has concluded that CAPEX (development of secondary products, markets, infrastructure improvements, etc.) is the only driver of growth at hand for WMS, if CAPEX slows or stops the thesis says so will revenue growth.
I'm also left to wonder that with ownership ringing the register and the possibility of the ESOP (employee stock ownership plan) trustee panic selling if the share price sees considerable short-term pressure (the trustee must act as a fiduciary for the plan) how much of an effect cash based stock expense will have on operational cash flows. The company is also on the hook for any in the money warrant expense and other stock based comp expenses that may come up on a quarterly basis.
All told, the cash flow statement isn't a huge concern for either party. Bulls shouldn't be concerned because as stated above the company does have its revolver to rely on short term and long term the company could presumably raise debt or dilute further with shares. Bears shouldn't worry because it's clear that the revolver is going to have to be the short-term lifeline and that plenty of downside risk movement should be priced into the shares prior to WMS resorting to debt and/or dilution. This section is a tie but if I was bullish this is all I would have to lean on. For those considering writing a bullish article I would recommend this cash flow statement and prayer. Not in that order either.
For clarity, the statements that WMS is currently relying solely on its revolver to avoid defaulting on its obligations and that the company's debt, contractual obligations, and operating expenses are greater than the company's borrowing capacity and cash flow generation abilities are substantiated by the following:
As of 3/31/2014 WMS had ~$3.93 million in cash with pre-IPO debt and contractual obligations due within 12 months totaling ~$117.43 million. Assuming all ~$84.6 million raised went to satisfying obligations due within 12 months - which we know that isn't true because 100% of the proceeds raised went to paying down the revolver (not the term loan, not the lease obligations, not the total revolver interest in aggregate, not to paying off all purchase agreements over the next 12 months, etc.) - that would still leave WMS in the hole ~$32.8 million. This damning fact is made even worse when understanding that this figure doesn't even factor in CAPEX or the realization of any additional cash expenses from stock-based compensation outside of historic levels (which should be higher each year indefinitely as employees now have access to the public markets). When taking the unrealistic figure above and adding just stated CAPEX for the next twelve months ($35 million - further detailed below) to it you get a figure that is greater than Cash Flow from Operations during FFY14 and cash on hand (~$32.8 million deficit + ~$35 million CAPEX = ~$68 million, Cash on hand of ~$3.9 million + Cash Flow from Operations of ~$62 million = ~$66 million). That was in a year where WMS saw 5% growth. Imagine if the company reverts closer to its three-year mean. The company is clearly, at this moment, completely dependent on its revolver.
Now, assuming that my models remain close the actual results at year end and over the next several years - essentially what I'm saying is that we don't witness exponentiating of growth at WMS and with it any unexpected booms in cash generation, we know that in the most bullish scenario imaginable (and we've already established it is impossible) that at least a ~$2 million dollar deficit will exist in the next twelve months. After 12 months WMS has another (again, using the assumptions that every penny raised went to debt and obligations due over the next 12 months) ~$108 million of debt and obligations due and at that point will have ~$161.5 million available on its revolver. WMS could arguably have another ~$104 million in Cash Flow from Operations to contribute (includes the cash flows from months 13-36 from now) which would give it total funds of ~$265 million for use. Subtracting CAPEX of ~$70 million (next two years combined) and the above listed ~108 million in debt and contractual obligations due between 12-36 months from now that alone would draw the revolver down to $87 million. Now, factor in the interest payments and obligations due 37 months from now (we already know the obligations portion that is due exactly 37 months from now won't change - they are expenses for things like leases, etc.) and assuming at best only 1/3 of the total ~$372 million of long-term debt that is due between 36-60 months from now is due on month 37 (not realistic, banks typically don't back end load the majority of long-term Term Loan debt to the final years of the maturity schedule) and you have a substantial deficit that will need to be dealt with. Well wouldn't Cash Flows from Operations derived between month 37-48 help with this? Yes, but only a modeled $62-$65 million (I'm giving bulls the benefit of no reduction in total sales growth to get that figure, which I truly believe will happen) and the company would still need the full twelve calendar months to earn those AND that would still leave a deficit between month 37-48 of at least $62 million prior to CAPEX in year 4 (starting on month 37 spanning until month 48). Typically, with Term Loans this large in amount and this far delayed the borrower has structured the loan in balloon payment fashion with large payments due on the front month of calendar or fiscal years. I'm working with the assumption that that is the case with WMS Term Loan debt which would put the company in default status on month 37 at worst and month 48 at best if my balloon assumption is wrong.
When looking at the situation even under unrealistically bullish scenarios there still remains a hole that will be sitting on the books at WMS assuming the company doesn't become the sole provider of pipe globally. This still doesn't include any upticks in cash based stock expenses. You can add those figures into the deficit if you would like but I think my point is made.
Lastly, and this is a mid-term negative catalyst, but at the time of lock-up expiration WMS should experience substantial selling. Insiders will see a company operating on the wobbly legs of its revolver - living on debt and needing to beg for more in the mid-term, they'll see a company with what should be uninspiring levels of top-line growth with what should be concerning COGS growth, a company with planned CAPEX of $35 million in FFY15 and FFY16, and a company with what could be an angry fiduciary in control of 33% of total shares. Keep that in mind, between the ESOP and the public share allotment the insiders don't own a majority of shares and that should only move further towards the public's favor with time.
Over the long term, at least 18 months out, I will realistically consider a raider acquiring shares of WMS (clearly the existing shareholders want nothing to do with this company) and possibly breaking the company apart. I would venture to guess WMS is worth more in pieces than it is all together. The transportation and production infrastructure alone is probably worth more as a stand-alone company that charges a toll fee for moving product than it is as a piece of WMS (probably worth more than WMS as an entire company). This is something I'm considering as a long-term threat to my Bear Thesis but I should have made a healthy return by the time that becomes a realistic possibility.
Where's the trade?
I have been watching the stock very closely since the IPO in the hope that the stock would get a decent run towards $17 or allow me to get short at a price above the offering. That hasn't happened and as of today's close the stock is down ~1% from the IPO. I didn't want to risk the stock dropping any further so I located shares to short and started a short position that is currently under water about 2%.
I recommend a short of WMS with a medium duration hold. I think the stock should move lower on all durations and has zero short-term upside potential. Now, could the shares move higher? Yes, and I hope they do. I am looking to aggressively short this position and will add to my starter short as soon as I can locate shares consistently. That being said, the underwriters can't legally lend shares to short for the first 30 days after an IPO so the shares may be expensive to borrow in the interim. I think the cost will be worth it as once the 30-day time period expires I anticipate quite a bit of other shares will be made available and that should create further price depression.
I look forward to providing continuing coverage of WMS in the future. Good luck to all.
Disclosure: The author is short WMS. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.