It can be outright stunning how quickly things can unravel. First, a lukewarm second quarter result, then a CEO resignation, followed up by a catastrophic Q3 result with massive cost overruns and shrinking revenue. To cap it off, add in some accounting irregularities and breaches of debt covenants, and you have the following stock chart:
Guestlogix is now in a period of forbearance with its lenders, which it continues to operate under.
In this almost true postmortem, I unpack what went wrong with Guestlogix and how we can learn from these events.
In my original article, I indicated the following:
There is some substantial improvement from its prior year which was before the acquisition of OpenJaw. A simple annualization of these results gives an adjusted EBITDA level of $6.6m USD ($8.5m CAD).
Despite a decent start, however, things went sideways in just one quarter:
Source: Q3 2015 Press Release
What we see here is the danger of projecting too much based on a quarter of operations, a risk I did identify:
One of the biggest risks we see here is the fact that there could be a sales slowdown as well that is forcing these actions as well as the clear level of bloat that we see. This type of rationalization of a cost base normally is being pushed by necessity. However, with the company's lagging share price, this also may have served as a catalyst to this push for a right-sizing of its cost base.
The first 6 months didn't give any indication of a slowdown in business. As well, I find it highly unlikely that management would schedule an Investor's Day so soon after Q3 results will be issued if they didn't at least have something positive to report on. However, the company is also trying to establish a better communication standard to its shareholders so hiding from bad news would likely be a bad start. I suspect it is likely the former, but a sales decrease cannot be ruled out.
It's a very good thing I didn't rule out the risk of poor performance as it came to pass. There was next to no rollback on the cost side, leaving Guestlogix with a bloated overhead level, resulting in substantial operating losses in the quarter.
Any company can have a bad quarter, but, in this case, it caused Guestlogix to end up in violation of both its $7.5m CAD senior revolving credit facility and its $9.0m subordinate term facility, resulting in the start of its forbearance agreement discussions as well as the start of a strategic review led by Canaccord Genuity.
If one bad quarter can cause this much devastation to a company's prospects, we can really see the power of too much leverage. In retrospect, to make the OpenJaw acquisition go through, Guestlogix clearly had to cave in to the banks to obtain funding, based on the heavy cost of debt it had to bear to make the transaction go through:
More recently, on June 8 , the company obtained a new $9m CAD ($7.2m USD) credit facility at 12% interest, expiring September 2017, with 2.4m in warrants at $0.796, expiring September 5, 2018. Guestlogix used this to retire a $5.1m promissory note due July 1, 2015 and a term loan of $2.5m expiring in September 2015.
Source: Original Guestlogix Article
My lesson learned here is that this was clearly a very aggressive financing arrangement, based on the quick payback period (roughly two years for most of it), high interest cost, and clearly strict covenants. Management was clearly betting on this becoming an immediately accretive transaction, and when the business struggled in Q3 along with a slower than required integration plan, the credit collapse came. Although I noted it as a risk, I had confidence that management realized what needed to be done, which brings me to the second issue.
This is another one where I did at least recognize that there were some risks associated with the management changes that had been occurring:
There was clearly an issue between the old CEO and the Board, and that this was likely tied to the high overheads that were occurring in Q2. However, Proud's resignation was in September, almost all the way through Q3. I was right that there were problems, however, the magnitude was obviously substantially worse than I had thought. The Board had done well to take action, essentially forcing the CEO out, and implementing a comprehensive restructuring plan. Despite all CEO Proud had done to build the company, he undid most of that in just a few short months.
What can trip up any investor, no matter how much due diligence is done, are accounting irregularities. These were disclosed in a bombshell press release in December 2015, detailing concerns with respect to the method of revenue recognition. This likely involved some prepayments that were recognized as revenue in the period it received them rather than over the duration of the contract. This gives the impression that revenues have moved substantially higher in the current period, even if they are for services earned over a longer time period. This would have painted a significantly better picture with respect to its operations than was actually the case. However, without continually receiving these payments, the charade unravels. That is when we finally saw the drastic drop in revenues in Q3 2015, unfortunately with the cost structure designed for the prepayments to be recurring. This type of accounting deceit is difficult for the average investor to pick up on, as it will only be uncovered through an audit that allocates revenues over the contract term rather than at the time cash is received to better match the risks the company needs to service.
It is unclear if this was done by Guestlogix management or the former OpenJaw management; either way, the picture painted for investors (including myself) initially was definitely not the true picture.
So What Now for Guestlogix?
At this point, unfortunately, an investment in Guestlogix is literally a gambling proposition on whether it can find a way to monetize some of its assets, turn around the operation or both in a very short period of time.
A forbearance agreement is a very short-term agreement between a lender and a borrower where the lender agrees to not hold the borrower in default of debts owing while the borrower attempts to find a solution. While it is better than defaulting the company in to bankruptcy, this process will require a drastic restructuring of the Company, likely involving liquidating some or all of the company assets/business operations. This completely defeats the original goal of combining Guestlogix with OpenJaw; even if the operations do turnaround, it will likely will not be fast enough for the lenders. I wouldn't go anywhere near Guestlogix at this point.
1. Dangers of Debt
Unfortunately, we appear to be heading in to an age of de-leveraging. Taking on too much leverage puts a company at risk as it has fixed commitments it must meet. Although we are seeing this most notably in some high flyers (SunEdison (SUNE) for example) and the oil sector (Kinder Morgan (NYSE:KMI) and Chesapeake (NYSE:CHK)), it can hit any company, however big or small. In Guestlogix's case, the high interest rate and quick payback should have given me a greater pause for the risks management was assuming to obtain this funding. It essentially required an immediate integration of OpenJaw; not only did that not happen, but it went so poorly that it ran into issues with its covenants. Add in some sketchy accounting and you have a recipe for default. In the current environment, issuing some equity or using cash on hand may be preferable as it may dilute the overall business but gives significantly more room for error.
Takeaway: Understand the capital structure supporting a company's business completely.
2. Mistakes Happen
When you are investing, especially in the world of small cap companies, even the best due diligence will still back fire. Up until Q3, Guestlogix was a company that had just made a smart acquisition, with growing sales and a relatively conservative capital structure (or so it seemed). However, some mismanagement, failure to realize synergies and some accounting chicanery, and even the best investors will get caught up in this mistake. Fraud is very difficult to foresee for almost all investors; even smart short sellers will get it wrong from time to time.
Takeaway: Learn from your mistakes so they don't happen the next time but don't beat yourself up. If necessary, take the loss rather than "hoping" to make your money back as "hope" is not an investment thesis.
3. Position Sizing and Trailing Stops
Two trading techniques helped me to mitigate my losses on Guestlogix: setting a trailing stop and scaling in through position sizing. In my first instance, after Guestlogix sold off from $0.80 to $0.50, I stopped out as I had a 35% stop loss on my position. After it stabilized, I tried again at $0.40, only to be stopped out after the company released its third quarter earnings at $0.24. However, this time I only took a half position as I was concerned that it could keep falling, which it did. Its third quarter announcement broke my thesis as it was failing to grow and to integrate the Openjaw acquisition, spurring the share drop and the hit of my trailing stop. As a result of the price drop, I also didn't add further to the position. This is a great quote from Paul Tudor Jones that has helped me when scaling in to positions that are going the wrong way:
Both these techniques allowed me to save roughly $0.24 per share in losses that I would have otherwise incurred, with the second amount only at a half position; over all I lost roughly 50% of my initial capital, but it could have been much worse. While these losses are not desirable, in small cap investing, they are a risk that will be more than paid off by the ones you get right.
In retrospect, I should have had a longer cooling off period before I was "twice bitten" to better address the situation. However, you will never get things 100% correct.
Takeaway: I have found it necessary to find ways to help me know when to sell; I have in the past had too many times where I was investing based on "hope." These techniques have helped me to take profits as well as to let my winners run longer than I would have done before. It also helps to de-personalize losses; losses will happen, it just matters how big you let them get. However, they may not work for everyone but you should have some idea of when you should sell.
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Disclosure: I/we 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.
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