It can be tough to get comfortable with shorts in a market that is already down significantly this year: a lot of the 'bad stuff' - as well as a ton of good stuff - has already been obliterated to the point where shorting down here can be pretty hairy. As such, when resetting shorts in this kind of environment, I try to look as much as possible for uncorrelated and/or idiosyncratic trades for which the outcome - whether it works or not - is as much divorced from a market snap-back as possible.
I think Advanced Drainage Systems (NYSE:WMS) sets up pretty nicely as a medium-term short from this perspective. As we shall see, it presents an attractive cocktail of accounting issues, analysts asleep at the wheel setting insanely-high expectations, and fundamentally a low-quality business. The thesis is pretty simple: analyst estimates for current/next year earnings are so insanely divorced from reality that there is a good likelihood WMS guides earnings substantially lower - even before considering the accounting restatement risk. And in the unlikely scenario where WMS meets consensus this year and next, at current levels ($21) the stock is not particularly cheap for a low-quality business (in fact, I would argue it is quite rich). Furthermore, the stock is not heavily shorted nor is borrow tight - again suggesting this is not a consensus trade and underlines the favorable risk/reward on the short side.
(Note - in the interest of getting this out quickly, this will not be the longest write-up, happy to answer any questions in the comments).
WMS is a fairly simple company: It manufactures water drainage structures and supplies, which are mostly polyethylene pipes that go into non-residential construction, residential construction, agriculture and infrastructure. According to its S-1 doc from mid-2014 (when WMS went public), ~80% of the business is pipe sales (the rest are ancillary products), while the end market for its products is overwhelmingly non-res construction (51% by sales), followed by residential construction (21%), then agriculture (19%) and finally infrastructure (9%). Most of the business (~88% of sales) is domestic. The main product - polyethylene pipe - looks like this:
(Source: WMS S-1)
WMS is apparently the largest player in the US market, with a nationwide network of 48 manufacturing plants and 20 distribution centers (as of the S-1 filing in 2014 - the number is higher now). The company claims this provides WMS with scale and integration advantages, though the market remains highly fragmented (e.g. WMS is the largest player but only has ~10% of the US market by estimated TAM), centered around local/regional suppliers and thus is very price competitive.
This is evidenced by the earnings power of the business. Since 2010, WMS has seen gross margins flatline at 20% and EBITDA margins hover around 13% despite these supposed scale advantages (note: the company has a March fiscal year end):
(Source: company filings)
While EBITDA margins in the low teens are suggestive of a low-value, low-margin business, the reality is probably a good deal worse than this and the above margins are generous. I say that because WMS is a particularly aggressive user of 'adjusted' metrics to manipulate its GAAP earnings into a heavily-massaged adjusted EBITDA number. This is hardly unique in the capital markets these days, but whenever there is a significant delta between GAAP and adjusted numbers, as well as a huge discrepancy between adjusted EBITDA and GAAP cash flows, it at least raises a couple more red flags. As the below details, 'real' EBITDA margins are a good deal lower and suggest margins in the very low teens (e.g., 10% last couple fiscal years):
(Source: company filings)
Not only are real margins low, but the cash generation quality of this business is poor: WMS has not been able to turn much of even its unadjusted EBITDA into cash, with FCF averaging just ~19% of adjusted EBITDA since 2011:
(Source: company filings)
Despite the poor economics of the business, nevertheless, you will note that EBITDA has gone up in recent years, because of a couple of trends. One of course is the recovery in residential/non-residential construction, a theme to which of course WMS is inextricably tied. A second factor has been the secular growth in polyethylene pipe vis-a-vis alternatives (like concrete pipe) due to better durability - indeed this is the major tenet of the bull case and the key point around which the stock's 'story' is promoted. I am willing to admit this has been a growth tailwind for the stock historically - especially since revenues outgrew end market growth substantially in 2011-2012 - but recent top line growth has been much more in-line with end market growth, perhaps suggesting either a slowing of the pace of adoption or that WMS has already enjoyed the low-hanging fruit of early movers away from concrete pipe. In any case, as we shall see, it is less the top-line trend that I have a problem with and more the street margin expectations in the out years.
Sell-side consensus: optimism knows no bounds
To summarize so far: WMS has historically been a low-margin, low cash-generative business in a fragmented, competitive, and perhaps commoditized space. WMS has enjoyed the recovery in end market demand and may be enjoying something of a secular tailwind in product adoption - but this has not translated into higher margins nor meaningfully higher cash flow generation.
This is where the story gets interesting, because looking at analyst consensus estimates for FY16 (recall - Mar. '16 is the fiscal year end), you would be forgiven for thinking they are modeling a different business. I have reproduced the table from earlier, this time incorporating sell-side consensus for FY16, as well as the implied incremental EBITDA and margins associated with these forecasts:
(Source: company filings, Bloomberg, my estimates)
Let's forget the discrepancy between unadjusted/adjusted EBITDA for now and give WMS the benefit of the doubt. Even so - sell-side consensus implies near 50% incremental EBITDA margins - levels the company hasn't come close to generating historically (other than FY13, a trick of small numbers) and numbers that do not jive with this capital intensive, low-margin business. Indeed, over the 2010-2015 period, WMS generated incremental sales and adjusted EBITDA of $427mm and $27mm respectively, implying normalized incremental margins of just 6.3%. Furthermore, consensus implies a significant deviation from historical absolute margins around the 13% adjusted range, to a much higher level of ~17%.
I have been wracking my brain, trying to determine what could possibly cause such an explosion in earnings power and the only reasonable explanation is a huge decrease in raw material costs (~60% of COGs) coupled with maintenance of pricing power to see those cost savings drop through to the EBITDA line. Now, the major cost input for WMS's polyethylene pipes is, surprise surprise, polyethylene - the cost of which has been coming down in the last year, in a similar fashion to other oil-linked plastic/commodity products. High-density polyethylene (HDPE) prices have fallen from ~$0.49/lb to ~$0.39/lb since March last year, a fall of ~20%. However. over the course of the year, the average price was more like ~$0.46/lb (see below), as HDPE prices spent a good portion of the early fiscal year trading higher. At an average of $0.46/lb, this would imply roughly 7% cost savings over the course of the year:
This would appear great news for WMS, but even flowing through a 7% raw material cost reduction at 60% of COGS, with no time lag on enjoying the benefits of lower costs, AND no price erosion to end customers, I can't see how incremental gross margin captured is more than ~330bps.
This is already less than consensus implies (~360bps of incremental GMs) and we know that a) WMS hedges out ~50% of its polyethylene purchases (see the S-1, p55-56) on a yearly basis, meaning even if these benefits flow through, there will be a significant lag; and b) it is quite unclear if WMS is able to capture any increased raw material spread at all.
I make this second point because looking at a long-term (2010-2015) chart of polyethylene suggests prices have jumped all over the place (see below) - but we know WMS's gross margins have basically flatlined at 20%. For example, during the oil boom - when HDPE prices tracked oil higher, rallying from $0.55/lb in Jan 2013 to ~$0.7/lb in late 2014, WMS gross margins were basically constant despite sharply higher input costs. It makes sense to conclude that - lumpy quarters aside - lower input costs are simply passed through via lower ASPs, by WMS and its competitors, and vice versa when HDPE prices rise. This certainly seems to be the case over time, if not for discrete quarters.
To me, this deftly parries the 'lower input cost -> margin expansion' argument - certainly so in the medium-term, even if quarterly margins exhibit some volatility. The impact of flowing through historical margins, even at Street consensus sales estimates - which imply 12.4% topline growth - are significant. For instance, at 14% EBITDA margins - a touch higher than FY14 levels and a full point north of adjusted margins in FY15 - would imply adjusted EBITDA of $185mm in FY16, good for a ~19% miss versus consensus (currently $224mm). And we all know how the market has been treating names - even high-quality names - that miss consensus these days...
Valuation: best case, WMS is fair versus comps and very rich versus its cash-generating power
The potential earnings/guidance miss aside, it is worth reflecting on valuation for a moment. One of the major attractions of the short trade here is, I believe, even if the company hits consensus, the stock is not cheap on adjusted numbers, while remaining quite expensive on real numbers, either versus comps or in an absolute sense.
Comps are a little tough to pin down as WMS only gives private companies as its direct comps in its S-1, while a number of other listed players either have outsized oil & gas exposure (which really muddies the comparison given what is going on in that market), or aren't pure pipe plays. Nevertheless, the below three names either have significant pipe businesses, are exposed to the drainage/water management industry, and/or operate in similar capital-heavy/low-return infrastructure-related areas:
(Source: Bloomberg consensus)
Note: the WMS numbers are consensus, NOT my numbers. You can see that even on what I believe are highly optimistic consensus numbers (which are themselves based upon aggressive add-backs), WMS trades in line or rich to comps, most all of which exhibit better margin profiles. Consensus estimates for WMS' EBITDA growth also look outsized considering expectations for growth at comps (46% expected for WMS vs. comps @ 11% expected growth).
Of course, the 'real' valuation is much richer given the low-cash returns. Being generous and according a higher EBITDA/FCF conversion ratio than ever historically experienced (recall, this averaged 19% the last 5 years) of say, 30%, would suggest FCF of ~$67mm on consensus FY16 numbers, or ~4.2% FCF yield to the equity (market cap is ~$1.58bn based on $21 share price and my estimate of ~75mm pro forma shares out). <5% FCF yield for a cyclical, low-margin, capex-heavy business in a highly-competitive industry - especially in this market environment - seems very expensive to me. And again, I feel even these numbers are too aggressive.
It is always tough to pin down 'fair' value for a stock, but given the business quality, the leverage (the company is ~2-2.6x net levered today, depending on where earnings shake out), and the market environment, I would view around 10-12x FCF as a starting point. Again according the same generous assumptions as above, that would suggest a stock price of ~$8.9-$10.8, good for 53% downside at mid-point.
Accounting Problems = Downside Tail Risk
The story thus far would alone constitute an interesting short case for a market neutral book - what makes it even more appealing is the deep downside risk associated with the current accounting investigation. To summarize very briefly: WMS went public in July 2014, where the PE backer partially cashed out at $16/share (no funds were raised for the company - another red flag). The sequence of events thereafter was as follows:
- Dec. '14: additional equity offering by PE backer (@ $21.25/shr) - again, no new shares issued
- Feb. '15: normal 3Q earnings release
- May '15: normal 4Q/year-end earnings release (reported adjusted EBITDA $154mm for the year)
- June '15: first raises potential accounting restatements due to 'inventory cost analysis' methodology discrepancies around yr-end reporting
- July '15: delays 10-K filing, in addition to inventory cost analysis investigation, company adds further detail claiming 'highly volatile raw material costs' need further investigation
- Aug. '15: announces restatement of 4yrs of reports (FY11-15), and expands scope of accounting review to three areas: "lease adjustments, inventory adjustments, and other adjustments". The stated revisions are somewhat small (~$4-6mm adjusted EBITDA change, beneficial in earlier years but a hit to FY15 numbers), but WMS admits to other mistakes (including capitalizing G&A) and says review is ongoing
- Nov. '15: WMS announces 'CFO transition' with the CFO due to leave by Mar. '16
- Dec. '15: WMS says it will file restated financials by Feb. '16
- Feb. '16: WMS delays restatement AGAIN to end-Feb, having found MORE issues (problems with accounting for Mexican JVs)
The upshot of all this is that even the heavily-adjusted, massaged earnings numbers over the years could turn out to have been doubly fake all along~!
In all seriousness, while the ultimate impact on the business could turn out to be small, nevertheless, a trend like this is worrying. At the very least, it suggests incompetent management and a lack of financial controls. Restatements and re-audits like this are expensive, and will at the bare minimum eat into reported cash flows and increase leverage. This overhang is reason alone to discount the stock - yet it trades in line with comps on aggressive consensus assumptions. A worse outcome could be a significant restatement to past earnings, much lower go-forward estimates, multiple contraction and thus a stock obliteration - but even a more mild outcome could be a net negative for the stock.
Further, there is an interesting tail risk option for the short in that WMS stock clearly has delisting risk now (it needed a 3-month waiver from the NYSE to delay the latest filing, and I think any more delays and they would really be up against it) - which is significant because a huge chunk of the shares outstanding (~27%) are in the form of a Convertible Preferred owned by the ESOP - which has the convenient feature of being puttable for cash if the company is delisted (see S-1, p151). I am not suggesting this is the most likely outcome - but given the leverage here (~$400mm gross debt, <$5mm cash), even the threat of a delisting trigger could result in a 'run on the bank' by the company's own ESOP. And at current prices, you get this optionality for 'free' (in that shares do not trade at discount to comps).
There are two main risks to the trade as I see it:
- lower input costs flow through faster than expected, allowing the company to temporarily post higher margins than I expect (perhaps even higher than lofty consensus estimates);
- the accounting scandal turns out to be a storm in a teacup and the restatements and associated costs are minor.
The second of these would, I think, result in a temporary boost to the stock (a 'relief rally'), perhaps to the low mid-20s (10-15%?) but I can't anticipate it really taking off just on this news since it is not a heavily-shorted name nor are valuations cheap (on the contrary, as discussed, the stock is actually pretty rich). Of course, I feel an announcement of restatement would be combined with a guide lower - which would likely more than offset even a relatively positive outcome on the accounting side.
The former risk - margins outperform near term - is more of a threat, though I do feel the combination of extant hedges, inability to retain windfall COGS gains, and pricing pressure, should at least be somewhat transparent to the sell-side and investors even in this scenario. Nevertheless, this is certainly the main risk to the trade in the very near term.
WMS is a low-margin, highly capital-intensive business in a fragmented, competitive industry that has historically generated low cash returns. Despite this, asleep at the wheel sell-side analysts persist in hyper-bullish out-year margin assumptions based upon lower input costs, despite no evidence that WMS historically enjoyed the benefits (or suffered the pain) of fluctuating raw materials prices. The stock trades in line with better-earning comps, despite a history of aggressive add-backs to reported numbers, and looks rich relative to cash flows even on generous earnings assumptions. Additionally, an accounting investigation has grown in scope over the last year, putting reported numbers and indeed the stock's listing in jeopardy. A more realistic valuation of the business based upon its cash generation power suggests a stock price ~50% lower in the $9-$11 range.
Disclosure: I am/we are short WMS.
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.