Author's Note: I intend to submit the contents of this article as an addendum to my whistleblower complaint with the SEC. I have also contacted the FBI's white collar crimes division, as I believe the "smoking gun" contained in this article warrants their attention. None of the information and analysis in this article is intended to be an allegation of wrongdoing on the part of Stoops Freightliner.
Public Interest Statement
I believe the information contained in this article about Celadon Group's ("CGI" or the "company") (TICKER: CGI) alleged wrongdoing is a matter of public interest.
CGI is a publicly traded company on the NYSE with a market capitalization of over $200m. The company's largest investors include institutional investment firms such as Wellington Management company, Blackrock Fund Advisors, and T. Rowe Price who hold 14.0%, 7.1% and 5.2%, respectively, of CGI's outstanding shares (as of 9/30/16). The clients of these firms include many retail investors who have invested their savings into investment funds and retirement funds managed by these institutions.
Also, as discussed in my previous articles on the company (here, here, and here), I believe CGI will likely need to raise a significant amount of money from investors via a large secondary equity offering. If my analysis in this article is true, then the potential investors in such an offering could experience a significant financial loss.
Thus, given the potentially negative financial impact that CGI's actions could have on its large and diverse investor base, I believe it is important to disclose my findings about the company to the public.
In my previous articles on Celadon Group, I reported that the company had seemingly misrepresented its financial performance by overstating its historical profits. I made this analysis based on the numerous accounting irregularities present in the company's SEC filings and earnings releases. Unfortunately for CGI shareholders, based on new information which I have recently uncovered, there is more evidence that this reporting is accurate.
In September 2016, Quality completed a large swap of around 1,000 tractors with Stoops Freightliner, a truck dealership located in the Midwest. This highly unusual transaction was brought to my attention in early November by an individual with close ties to the trucking industry. Following up on his information, I spoke with sales representatives at Stoops and Quality and was able to put together the pieces on this transaction.
What I discovered appears to be "smoking gun" evidence that CGI has misrepresented its financial performance. In Q1 2017, CGI reported a $1.3m gain on the sale of equipment. However, due to the swap transaction, the company should have likely reported a large loss instead. Thus, it appears that management did not properly account for the swap transaction in its financial statements. I estimate that CGI overstated its gain on sale of equipment and, in turn, its net income by at least $10m in Q1 2017.
This assertion is supported by management's apparent attempts to hide this transaction from the investment community. For example, CGI did not mention this transaction in its SEC filings or Q1 2017 earnings report. Given the large size of the tractor swap, I am puzzled as to why it was not disclosed. Another notable example was that management recently made the unusual decision to block my phone number from calling their corporate offices. As I will later explain, it appears that this decision was made in an attempt to prevent me from learning more about the tractor swap.
If CGI has in fact overstated its profits via the swap, the company may very well be in violation of its 4x leverage ratio covenant by a meaningful amount. Given the company's highly questionable accounting methods, it is doubtful that it would receive a waiver from its lenders for such a violation. Thus, I believe that the discovery of this transaction by CGI's lenders could push the company into bankruptcy.
The bad news does not end there. I have uncovered several serious additional "red flags" related to CGI's financial reporting and business practices. This includes several accounting irregularities in the company's Q1 2017 financial statements, as well as management's increasingly troubling and unprofessional behavior.
CGI's increasingly precarious liquidity situation also deserves examination. Some investors seem to believe that, by eliminating its lease shortfall advance obligations, the proposed JV with Element will fix CGI's liquidity issues. However, in Q1 2017, the company did not make any lease shortfall advance payments to Element. Despite not making these payments, CGI still generated a free cash flow loss of $19.8m. Thus, even if the JV is consummated, it is unlikely to solve the company's liquidity problems.
Finally, over the past few months I have received several emails from both current and former employees of CGI. In their emails, these individuals expressed a great deal of concern over the allegedly poor conduct of the company and management. Up until now, I have chosen not to reveal these emails to the public. However, given CGI's increasingly concerning behavior, I believe now is the appropriate time to disclose some of them.
Overall, given the mounting red flags surrounding the company, CGI remains a highly attractive short opportunity. I believe that, with the discovery of this swap transaction, the likelihood of an SEC investigation has increased considerably. Also, based on my analysis, I expect the company to declare bankruptcy over the next few months. Thus, I reiterate my price target of $0 for CGI shares.
Section 1: Investors Continue to Ignore an Increasing Amount of Smoke
Before discussing CGI's recent tractor swap and the severe negative implications of this swap for shareholders, I think it is important to first reestablish the low credibility of the company and its management.
In one of my previous articles on CGI, I warned investors of the foolishness of ignoring all the "smoke" surrounding the company. At the time, the "smoke" I was referring to were the numerous accounting irregularities in the company's financial statements and lack of transparency by management. I was also referring to the March 2016 and April 2016 inquiries by the SEC into the company's accounting practices.
So far, the market has continued to ignore the obvious warning signs building around the company. Since reporting Q1 2017 earnings on November 2nd, CGI's stock price has increased by over 35% from $6.15 to $8.35 as December 6th. This sharp rise in CGI's stock price is puzzling given that in my view, the Q1 2017 report only increases the concerns over its financial reporting methods.
Some of the additional red flags which I have identified over the past few weeks are as follows:
Red Flag #1: Free Cash Flow Continued to Significantly Lag Net Income in Q1 2017
In Q1 2017, CGI's free cash flow (operating FCF - capex - capital lease payments + PP&E sale proceeds) was once again significantly less than its reported net income. Based on the company's own financial reports, provided below is a comparison of the company's free cash flow and reported net income in Q1 2017:
As shown above, CGI's Q1 2017 free cash flow was $17m lower than reported net income. This large disconnect between free cash flow and reported net income is highly concerning. As I discussed in my previous articles, when free cash flow generation significantly lags earnings, this can be a warning sign that profits have been inflated.
Red Flag #2: Continued Mismatch in Change in Equipment Held for Sale in Q1 2017
In addition to poor free cash flow generation, the quarter-over-quarter change in equipment held for sale on the balance sheet once again did not match the CF statement by a large amount:
In previous articles, I argued that CGI is manipulating its working capital as a means to overstate its profits. The continued large mismatch in the change in equipment held for sale in Q1 2017 further supports this assertion.
Red Flag #3: Puzzling Increase in Other Assets in Q1 2017
Prior to Q3 2015, CGI's other assets balance had historically been very small (around $5m or lower) with very little change from quarter-to-quarter. However, since the end of Q3 2015, CGI's other assets balance suddenly increased exponentially.
For example, from Q3 2015 to Q4 2016, other assets increased from just $4.7m to $43.3m. The company attributed this large increase in other assets on its lease shortfall advance payments to Element. According to management, Element is obligated to eventually reimburse CGI for these payments. Thus, it accounted for its lease shortfall advances as a receivable in other assets.
In Q1 2017, the company did not make any lease shortfall advance payments to Element. This was confirmed by the following disclosures on pg. 13 of its Q1 2017 10Q:
"…lease shortfall advance arrangement… are for shortfalls between the required lease payments and the amount actually collected from the independent contractor or fleet…"
"The financing provider is required to reimburse us for these advances…"
"…we have accounted for the related receivable under other assets on our consolidated balance sheet, in the amount of $31.9 million as of September 30, 2016 and June 30, 2016."
As highlighted above, receivables related to its lease shortfall advance payments remained at $31.9m from Q4 2016 to Q1 2017. Based on this, it can be concluded that CGI did not make any lease shortfall advance payments in its most recent quarter.
Despite not making these payments, other assets on CGI's balance sheet increased another $3.3m from $43.3m as of Q4 2016 to $46.6m as of Q1 2017. This increase in other assets makes little sense. If CGI did not make any lease shortfall advance payments in the quarter, then why did other assets increase another $3.3m?
Overall, this puzzling increase in other assets in Q1 2017 further supports my assertion that CGI is manipulating its working capital as a means to overstate its profits.
Red Flag #4: Sudden Removal of Accrued Equipment Purchase Liabilities from Balance Sheet
Another significant red flag in the Q1 2017 financial report is the company's curious decision to remove accrued equipment purchase liabilities from its balance sheet.
Provided below is CGI's current liabilities as of Q4 2016 as disclosed on pg. 48 of the FY 2016 10K:
As highlighted in the red box above, in its FY 2016 10K, CGI previously reported accrued equipment purchases as a separate line item on its balance sheet. Next, I have provided CGI's current liabilities as of Q1 2017 as disclosed on pg. 5 of the Q1 2017 10Q):
As shown above, in Q1 2017, CGI removed its disclosure of accrued equipment purchase liabilities. In isolation, this change in disclosure would not be all that concerning. However, when taking into consideration recent events, this decision is highly suspect.
To be more specific, in previous articles, I had pointed out that the company's Q3 2016 PP&E balance was inflated relative to what was implied by its capex, PP&E sale proceeds, depreciation and conversion of capital leases. In Item #4 of CGI's October 19th response letter, management provided the following explanation for its seemingly inflated Q3 2016 PP&E balance:
"…the balance sheet includes accruals for equipment purchases that have been contracted but for which cash payment has not been made, whereas the cash flows from investing activities would not reflect non-cash activity…"
According to management, the Q3 2016 PP&E balance was inflated largely because of accrued equipment purchases. However, as I pointed out in my rebuttal to the response letter, accrued equipment purchases cannot explain CGI's inflated PP&E balance. In Q3 2016, CGI's accrued equipment purchase liabilities were only $464K. This is far less than the $22m that the company's Q3 2016 PP&E balance appears to have been inflated by.
The fact that management stopped disclosing accrued equipment purchases immediately after I pointed out this discrepancy is likely not a coincidence. I believe CGI is intentionally hiding this line item because it realizes attributing its inflated PP&E to accrued equipment purchases makes little sense. Thus, based on management's recent actions, I remain highly suspicious of its PP&E accounting methods.
Red Flag #5: Quality Continues to Purchase a Significant Amount of Trucks
In previous articles, I pointed out how the continued purchasing of large amounts of trucks by Quality made little sense. Given the soft used truck market and CGI's ongoing liquidity issues, I was confused as to why management would engage in such a seemingly self-destructive strategy.
Management's puzzling behavior has continued in FY 2017. In Q1 2017, the Quality business once again spent a large amount of cash on truck purchases. Consider the following disclosures from pg. 13 of CGI's Q1 2017 10Q:
"From time to time we will assign these leases and sell the underlying assets to third party financing companies. In addition, we sell unleased assets in the used markets."
"Total net proceeds and net gain as a result of these transactions during the three months ended September 30, 2016 were $52.6 million and $1.3 million, respectively…"
In Q1 2017, the Quality business generated net proceeds of $52.6m from truck sales. With this in mind, consider the following comparison of CGI's equipment held for sale as of Q1 2017 vs. Q4 2016:
Equipment held for sale consists primarily of trucks purchased by the Quality business. As shown above, from Q4 2016 to Q1 2017, CGI's total equipment held for sale balance declined by only $10.7m. This means that the Quality business purchased an additional $41.9m worth of trucks in Q1 2017 ($52.6m-$10.7m).
In Item #9 of its response letter, management provided the following justification for Quality's recent truck purchases:
"…at December 31, 2015 we had commitments to purchase approximately $83.5 million in equipment…It should be noted that not all of the $83.5 million of commitments related to Quality."
Unfortunately, based on recent disclosures in CGI's FY 2016 10K, this explanation does not make any sense. The following disclosure is from pg. 60 of its FY 2016 10K:
"We have planned commitments to add $24 million of tractor operating leases over the next twelve months as of June 30, 2016. Generally, our purchase orders do not become firm commitment orders for which we are irrevocably obligated until shortly before purchase."
At the end of FY 2016, CGI had just $24m of tractor purchase commitments. Furthermore, the company expected to pay for these commitments with operating leases rather than cash. Finally, as described above, these commitments are not firm commitments. Based on this, I am not sure why the Quality business spent $41.9m on truck purchases in Q1 2017.
This all leads back to the question of whether management is incompetent or if instead there is something more sinister going on? In my opinion, it is the latter. As I will discuss later, I believe Quality's recent truck purchases are linked to its tractor swap with Stoops.
Red Flag #6: Management's Recent Peculiar Behavior During Earnings Season
Another point of concern for CGI investors is management's peculiar behavior during earnings season. As I discussed in a previous article, CGI reported its Q4 2016 earnings over a month later than usual on September 1st. When the company finally did issue a report, it released the earnings report more than three hours after the market close. To top things off, management made the curious decision to not hold an earnings call to discuss that report. This type of conduct is highly unusual for a public company.
This suspect behavior has continued into FY 2017. When the company reported its Q1 2017 earnings on November 2nd, management once again decided to release the earnings report more than three hours after market close. This lengthy delay in reporting Q1 earnings caused a significant amount of frustration amongst investors and research analysts. For example, one research analyst that covers the company (whom I will keep anonymous) emailed me the following message expressing his displeasure over the late release:
So why is CGI reporting its earnings at such a late time? My best guess is management released its Q4 2016 and Q1 2017 report well after market close in an attempt to bury the bad news. One thing is certain, this pattern of obfuscation and opacity by management has only further damaged their credibility.
Red Flag #7: Management Blocked My Phone Number from Calling their Corporate Offices
Perhaps the most concerning recent development is management's decision to actually block my phone number from calling their corporate offices. On November 16th, I spoke with a couple of sales representatives from Quality about their recent swap transaction with Stoops. My findings from these conversations will be discussed in a later section.
On November 17th, just one day after these conversations took place, I was surprised to discover that my phone number had been blocked at the offices of both CGI and Quality. Video proof of this blocking can be found here.
This type of behavior should raise all sorts of red flags for CGI investors. Credible companies do not take these sorts of actions. The fact that management blocked my number just one day after I inquired about the swap is likely not a coincidence. Instead, it appears management is doing all it can to prevent the public from learning more about this transaction. Investors must ask themselves why management is so afraid of the details of the swap being revealed.
So, to end this section, I once again plead with investors and analysts to stop ignoring obvious warnings signs and demand more transparency from management.
Section 2: Quality Tractors on Fire Sale
The story of how I uncovered the "smoking gun" on CGI began in early November when an individual involved in the trucking industry and familiar with the facts contacted me. I am declining to identify this person and will refer to this source as "A." A copy of his initial email to me (with his contact details redacted) is provided below:
As shown above, "A" claimed that he could help me "put together the pieces" in regards to CGI. With my curiosity piqued, I immediately called "A" to learn what he knew. Here's what he said:
Stoops Freightliner, a division of Truck Country, is a large truck dealer with 23 locations in Iowa, Indiana, Ohio, Minnesota, and Wisconsin. According to "A," a Stoops dealership in Indianapolis had recently completed a tractor swap of around 1,000 units with Quality in September 2016 (Q1 2017). The fact that Quality and Stoops exchanged vehicles was not that peculiar. Dealers often use vehicle exchanges as a means to manage their inventory.
That being said, the sheer size of this tractor swap was in his view quite unusual. Even more peculiar is the fact that Stoops has been selling the tractors it received from the swap at bargain basement prices. Over the past few weeks, a trucking company that "A" claims to be familiar with purchased numerous Quality tractors from Stoops. According to "A," all of these tractors were priced significantly below market value.
For example, this company recently purchased a 2012 Peterbilt 587 from Stoops for almost $23K. The invoice for this transaction is provided below (with contact details, VIN # and certain pricing info redacted):
To prove that this unit was part of the recent swap with Quality, "A" also sent me the title for this tractor. Provided below is a copy of the signature page of the title. (A full copy of the title can be found here)
As shown above, Quality is listed as the seller of the Peterbilt unit, while Truck Country (a/k/a Stoops) is listed as the purchaser. Also note that the date of the sale was in September, which is when the swap with Quality took place.
"A" also sent me the invoices and titles for two additional 2012 Peterbilt 587s. These units, like the unit discussed above, were part of the swap with Quality. These two Peterbilt 587s were purchased from Stoops at an average price of around $23K per unit.
The fact that Stoops is selling the 2012 Peterbilt 587s it received from Quality for around $23K is quite puzzling. This appears to be almost 50% below fair market value for this model year and type of tractor. For example, on CommercialTruckTrader.com, used 2012 Peterbilt 587s are listed at an average price of around $45K.
To further illustrate just how outrageously cheap Stoops is pricing its Quality inventory, consider the following list of recent used tractor purchases made by one company from various dealerships (with contact details, purchase dates, VIN #s, certain pricing info and other sensitive information redacted):
Upon receiving this list, I asked "A" to help explain which tractor purchases in the list were from the Quality swap (contact details redacted):
According to "A," the used 2012 Peterbilt 587 (highlighted in the red box) is the only tractor in the above purchase list that was part of the swap (The invoice and title for this tractor are linked above). This unit was purchased for less than $23K. By contrast, the other 2012 model year tractors in the list (which were not part of the swap) were purchased at much higher prices generally ranging between $30K and $45K.
At this point, it should be clear that Stoops is pricing the 2012 Peterbilts from Quality at well below market value. That being said, I recognize that this represents just a small sample of the ~1,000 tractors involved in the swap. With this in mind, I tried to check whether the other tractors from the swap were being offered at similar bargain basement prices. In response, my source confirmed this with a simple "Yes." A copy of this email exchange is provided below (contact details redacted):
Section 3: My Conversation With Stoops
In order to further confirm the information I had culled and that "A" had provided, I reached out directly to Stoops for more details. I called the Stoops office in Indianapolis and spoke with JT Thornburg, a sales manager at the branch.
I first asked Mr. Thornburg to confirm that his dealership had, in fact, swapped ~1,000 tractors with Quality in September of this year. He confirmed that this was true.
Next, I requested a pricing list for all of the Quality tractors that Stoops was offering. Mr. Thornburg said he could not provide such a list, but did provide pricing quotes for a group of 2012 Freightliner Cascadia and 2012 Kenworth T700 tractors which were received in the swap. In total, he estimated that the 2012 Cascadias and T700s represented 50-100 of the ~1,000 tractors from the swap. The pricing quotes provided by Mr. Thornburg for these two tractors types were as follows:
- 2012 Freightliner Cascadia: $32K-$35K
- 2012 Kenworth T700: $24K-$27K
These price quotes from Mr. Thornburg further confirm "A"'s opinion that Stoops is selling its Quality inventory at well below market value. For example, on CommercialTruckTrader.com, most of the 2012 Freightliner Cascadias are listed in the $40K-$50K price range. This is significantly higher than the $32K-$35K prices offered by Stoops. Also, on CommercialTruckTrader.com, 2012 Kenworth T700s are listed in the $35K-$45K price range. This, once again, is significantly higher than the $24K-$27K price ranges offered by Stoops.
The final question that I posed to Mr. Thornburg was how his dealership was able to offer the Quality tractors at prices far below market value. He declined to answer this question. Thus, in order to figure out the final piece to this puzzle, I decided to contact Quality's sales team.
Section 4: The Value Destructive Nature of the Swap
I reached out to Quality's sales team for further clarification on the swap transaction, speaking with two different members of that team. The first person I spoke with claimed to be a general sales representative at Quality. During our brief conversation, he confirmed that Quality had completed an ~1,000 unit tractor swap with Stoops in September. When I asked him for more information, he transferred me to another individual who he said would know more details of the swap.
I was transferred to a person claiming to be the director of used truck sales at Quality. I asked him why Stoops was offering Quality's tractors at far below market prices. Was there anything wrong with these vehicles, or was Stoops simply just stupid? The response that he gave was quite shocking to me.
He explained that Stoops was able to offer the tractors at such low prices because Quality had incentivized Stoops to carry out the swap. When I pressed him for more detail, he provided me with some of the specifics of the transaction. He explained that Quality sent more tractors to Stoops than it received back in the exchange. By his estimate, for every 100 tractors Quality sent to Stoops, Quality only received around 75 tractors in return. Thus, because they were receiving significantly more value in the swap, Stoops was able to offer the tractors from the swap at a discounted price.
This naturally led to my final question of why in the world Quality agreed to such a value destructive exchange. His response was that the transaction allowed Quality to reduce its inventory which would "help calm the nerves of investors." This makes little sense. Exchanging higher valued assets for lower valued assets does nothing to ease investors' ongoing liquidity concerns about CGI. Instead, it merely serves to destroy shareholder value by reducing the company's collateral and book value.
So why did CGI decide to go through with such a seemingly foolish transaction? I will attempt to answer this question in Section 7 of this article.
Section 5: CGI's Miraculous Gain on Sale of Equipment
Before continuing with my discussion of the swap, I will first discuss why CGI's reported gain on sale of equipment in Q1 2017 is puzzling given the current market environment.
The following disclosure is from pg. 13 of CGI's Q1 2017 10Q:
"…we sell unleased assets in the used markets. Total net proceeds and net gain as a result of these transactions during the three months ended September 30, 2016 were $52.6 million and $1.3 million, respectively…"
As highlighted above, in Q1 2017, CGI reported $52.6m of net proceeds and a net gain of $1.3m from the sale of equipment.
Due to the severe collapse in used tractor prices over the past year, the company's ability to generate a $1.3m profit from equipment sales is highly suspect. Current used tractor prices appear to be at a level that is well below the depreciated value of the tractors on CGI's balance sheet. This is illustrated in the following table:
CGI depreciates its tractors to a salvage value of 40% over a period of four years. This means that a new tractor will depreciate at a rate of 15% per year for four years and then remain at a salvage value of 40% of cost until disposed. The average price of a new Class 8 tractor is around $140K. Thus, a new tractor would depreciate $21K per year (15% * $140K) to a salvage value of $56K after four years.
Based on CGI's depreciation schedule, the current book value of a model year 2012 tractor is estimated to be around $56K ($140K * 40% salvage value). In comparison, the average market value of a model year 2012 tractor should be around $40K. This is more than 28% (or $16K) less than the depreciated book value.
The difference between depreciated book value and market value only increases for more recent model years. For example, the book value of a model year 2014 tractor is estimated to be around $87.5K ($140K * (2.5 years of age * 15% annual depreciation)). In comparison, the average market value of a model year 2014 tractor is around $55K. This is more than 37% (or $32.5K) less than the depreciated book value.
From this analysis, it should be clear why CGI's reported gain on sale of equipment makes little sense. The company generates a gain on equipment sales if the market value of the equipment exceeds the book value. However, the research shows that CGI's tractors appear to be worth much less than the depreciated value reflected on its balance sheet. Thus, instead of reporting a $1.3m gain on equipment sales, it appears that CGI should have reported a significant loss.
Further supporting this assertion is the fact that CGI's peer competitors with comparable depreciation schedules have recently reported losses on equipment sales. For example, Covenant Transportation (TICKER: CVTI) ("CVTI") depreciates its tractors over five years to a salvage value of 25%. Thus, like CGI, CVTI depreciates its tractors at an annual rate of 15%.
In Q3 2016, CVTI reported a loss of $421K on the sale of $5.5m of equipment, representing a loss margin of 7.6% ($421K/$5.5m). This is in direct contrast to the $1.3m gain that CGI reported on the sale of $52.6m of equipment. Based on the current loss margin of 7.6%, if CVTI had also sold $52.6m of equipment in its latest quarter, it would have reported a loss of $4.0m.
It is also worth noting that CVTI's depreciation schedule is more aggressive than CGI's. CVTI depreciates its tractors to a lower salvage value than CGI (25% at the end of five years vs. 40% at the end of four years), so its older tractor models are carried on the balance sheet at a meaningfully lower value. This means that CVTI should report higher average gains on the sale of its tractors than CGI. This has not been the case.
In summary, CGI's ability to continue claiming gains on the sale of equipment is miraculous in the context of the current market environment. All of the data and evidence suggests that the company should be reporting a loss. With that point firmly established, I can now continue my analysis of the swap transaction.
Section 6: Tractor Swap Appears to Confirm CGI Has Inflated Its Profits
The discovery of Quality's tractor swap with Stoops is terrible news for CGI shareholders: this transaction appears to confirm that CGI has significantly inflated its profits in Q1 2017.
Based on GAAP accounting rule ASC 845, a swap of equipment is included in the P&L as a gain or loss on the sale of equipment. Accounting rules also dictate that, in a swap of assets, the assets being exchanged should be marked to fair value:
"In general, the accounting for a nonmonetary transaction is based on the fair values of the assets exchanged. Thus, the cost of a nonmonetary asset received in exchange for another nonmonetary asset ordinarily is measured based on the fair value of the asset given up or, if more clearly evident, the fair value of the asset received. A gain or loss is recognized if the cost of the nonmonetary asset recognized differs from the carrying amount of the nonmonetary asset given up…"
Based on ASC 845, the accounting for the swap transaction with Stoops should have been as follows:
- 1,000 tractors are sent to Stoops and 750 tractors are received back in the exchange (based on the 100:75 exchange ratio)
- The 750 tractors received are marked to fair value
- For example, if the market value of the tractors received is $40K per tractor, the total fair value of the 750 tractors received is $30m
- A gain or loss from the sale of equipment is recognized by CGI based on the difference between the fair value of the 750 tractors received and book value of the 1,000 tractors given up
- For example, if the book value of the 1,000 tractors is $60m, then CGI would realize a loss of $30m from the swap ($30m fair value of 750 tractors - $60m book value of 1,000 tractors)
Basically, if the fair value of the tractors received by Quality is less than the book value of the tractors given up, then a loss from the swap should be realized. If the opposite is true, then a gain is recorded from the swap.
I believe CGI should have reported a significant loss from the swap transaction with Stoops. This assertion is supported by a couple key points:
First, as previously noted, the market values of CGI's tractors are significantly lower than the depreciated value on its balance sheet. Thus, even if the swap was an even exchange of tractors (1,000 tractors for 1,000 tractors), the marking of the vehicles to fair value would result in a large loss for CGI.
Second, the swap was not an even exchange of tractors. Quality only received around 750 tractors for the ~1,000 tractors it sent to Stoops. Given significantly less than fair market value was realized in the swap, it appears a near certainty that CGI should have realized a significant loss from this transaction.
Given the large loss that CGI should have realized from the swap, I see no way that the company could have reported a gain on sale of equipment in its most recent quarter. CGI reported only $52.6m of net proceeds from the sale of equipment in Q1 2017. Based on the large size of the swap, it appears that the swap should have accounted for most of these equipment sale proceeds. Thus, the gain of $1.3m on the sale of equipment that the company reported should have been a significant loss.
So just how much did CGI potentially overstate its gain on sale of equipment? I believe the amount is likely to be significant. For example, if the company conservatively lost $10K of value per tractor from the swap, it would result in a loss from the transaction of $10m (1,000 tractors given up * $10K loss per tractor). Thus, I believe CGI may have overstated its gain on sale of equipment and, in turn, its net income by at least $10m in Q1 2017.
I believe a $10K write-down per tractor is conservative, and giving CGI the benefit of the doubt. Based on the large difference between the market value and depreciated book value of CGI's tractors (as reflected in the previous table), the value lost per tractor may be closer to $20K each or higher.
Section 7: Why Is CGI Willingly Destroying Shareholder Value?
At this point, I believe I have established the following:
- Quality carried out a swap of ~1,000 tractors with Stoops in September 2016 (confirmed by multiple sources);
- Stoops is selling the tractors received from Quality in the swap at well-below market value (confirmed by invoices and pricing quotes I received from Stoops);
- The swap is value destructive for CGI / Quality. For every 100 tractors given to Stoops, Quality only receives in return around 75 tractors (confirmed by the director of used tractor sales at Quality);
- This uneven exchange of value was agreed upon in order to incentivize Stoops to participate in the swap (confirmed by the director of used tractor sales at Quality); and
- Revealing this swap appears to prove that CGI has inflated its historical profits. Given the depressed prices for used tractors and the uneconomical nature of the swap, CGI should have likely reported a large loss on the sale of equipment in Q1 2017.
One question that remains unanswered is why CGI wanted to carry out the swap in the first place. Why was CGI so eager to carry out the transaction that it was willing to incentivize Stoops with such lopsided terms? Over the past few days, I have tried calling management with the intention of asking them this very question. Unfortunately, management has blocked my number so my access to them appears completely cutoff.
I asked "A" for his opinion on why the swap took place. His best guess, based on conversations with industry insiders, was that CGI was using the swap as a vehicle (no pun intended) to overstate its profits. He believes that the company is significantly inflating the fair value of the tractors involved in the swap. By inflating the fair value of the tractors to a price above book value, CGI can record a gain from the transaction. Ultimately, management does not care that it is losing value in the swap because they know that the fair value of the tractors can be manipulated.
Given CGI's precarious covenant situation, I think "A''s explanation makes sense. That being said, it would be helpful to hear management's take on this matter. I am calling on management to publicly provide more details about the swap in a press release. Given the significance of this transaction, I believe shareholders and the investing public deserve to know more specifics.
I also encourage investors and analysts to reach out directly to CGI management, as well as the Indianapolis sales office of Stoops. If you learn any new information about the swap, please contact me with your findings or leave a note in the comments section below.
Section 8: Discovery of the Swap Could Lead to an Immediate Bankruptcy Filing by CGI
So what does the unveiling of this swap transaction mean in terms of the company's financial situation going forward?
For starters, it appears to confirm that CGI is a significant loss-making business. In Q1 2017, CGI reported a net loss of $2.9m or $0.10 per share. However, due to the seemingly improper accounting of the swap, the company's reported net loss was likely understated by at least $10m. If $10m is deducted from the reported net loss of $2.9m, then CGI should have reported a net loss of at least $12.9m in Q1 2017.
Even more concerning is the fact that the discovery of this transaction could lead to a bankruptcy filing by the company. Lenders may press CGI for more details on this transaction, and it is possible that CGI will be found to be in immediate breach of its debt covenants.
Based on the terms of its credit agreement, the company is obligated to provide truthful and accurate financial information to its lenders. Thus, if CGI has in fact inflated its profits via the swap transaction, this may place them in immediate default.
In addition to providing truthful and accurate information, CGI is also obligated to maintain a debt to EBITDAR ratio of less than 4x. If $10m of potentially overstated profits is deducted from LTM EBITDAR, then this would place CGI in violation of its leverage ratio covenant by a meaningful amount. A detailed calculation of the company's Q1 2017 leverage ratio is provided below:
Based on reported results, I calculate that CGI's current leverage ratio is 4.1x (as shown in the left column above). Thus, the company may already be in violation of its 4x leverage ratio covenant. That being said, in its Q1 2017 earnings call, management claimed that its current debt to EBITDAR ratio is 3.8x.
However, if $10m of potentially overstated profits from the swap are taken into account, CGI would likely be in violation of its debt covenant by a significant amount (as shown in the right column above). Thus, regardless of whether its current leverage ratio is 3.8x or 4.1x, it appears that proper accounting for the swap should place CGI in violation of its leverage ratio covenant.
Given the highly questionable nature of CGI's accounting methods, it is not certain that its lenders would give the company a waiver for these potential breaches. Thus, for these reasons, I believe that the discovery of this swap transaction could be the catalyst for a bankruptcy filing by the company.
Section 9: The Tractor Swap May Explain Quality's Puzzling Truck Purchases
As highlighted as Red Flag #4 in Section 1, the continued purchasing of large numbers of trucks by Quality in Q1 2017 is puzzling. That being said, it appears that the discovery of this swap transaction may provide a logical explanation for these purchases.
The ~1,000 tractors that Quality gave up in the swap with Stoops were likely recorded as a sale of equipment. At the same time, the tractors received in the swap would likely be recorded as a purchase of equipment. Thus, I believe the more than $40m that Quality spent on truck purchases in Q1 2017 can be largely attributed to the ~750 tractors it received in the exchange.
Section 10: An Eventual SEC Investigation Appears Likely
In my opinion, the discovery of Quality's swap transaction with Stoops has greatly increased the chances of an eventual SEC investigation. For starters, this information supports my previous view that the company is using irregular accounting methods to overstate its profits. As I just detailed, this transaction indicates that CGI inflated its Q1 2017 profits by a meaningful amount.
The highly peculiar nature of this transaction (i.e. the uneven exchange of value) may likely catch the SEC's attention. The fact that CGI is engaging in seemingly self-destructive business transactions indicates that something is not quite right. Further supporting this assertion is management's seemingly desperate attempts to prevent the details of this swap from being made public (i.e. blocking my phone number and no disclosure in either filings to the SEC, on its website or in investor calls).
Section 11: Insolvency Appears to be Right Around the Corner
Due to its high amount of leverage and rapid cash burn, CGI's ability to remain solvent is increasingly questionable. Over the past two fiscal quarters, the company generated a free cash flow loss (operating FCF - capex - capital lease payments + PP&E sale proceeds) of $41.9m. This represents a run-rate cash burn of almost $84m. The company is also likely in violation of its 4x leverage ratio covenant.
Based on management's behavior, it appears that insolvency may be right around the corner. This desperation is perhaps best illustrated by CGI's value destructive tractor swap with Stoops. As I explained earlier, it appears the company may have used this swap as a means to artificially boost its profits. Management's desperation is also illustrated by the expensive equipment-backed loans that the company has taken over the past two quarters ($30m loan in Q4 2016 and $15m loan in Q1 2017). I am not sure why CGI decided to raise money in this manner rather than simply draw on its much cheaper revolver. I suspect that it is because the company's ability to draw on its revolver may have become more restricted.
Some investors are hopeful that the JV will fix CGI's liquidity issues. However, based on recent evidence, this appears to be a misguided hope. Consider the following disclosures from pg. 21 of CGI's Q1 2017 10Q:
"Recently, our lease shortfall advance obligations to our third party financing provider and a depressed market for freight and used equipment have decreased our liquidity."
"We have entered into the MOU… which we expect will include the collection of our outstanding lease shortfall advance payments and the elimination of further lease shortfall advance obligations."
"if we are successful in eliminating these payment obligations, then… we do not expect to experience significant liquidity constraints in the foreseeable future."
As shown in the above quotes, management has attributed its liquidity issues on its lease shortfall advance payment obligations to Element. Management also claims that if its proposed JV with Element is consummated, then the company should no longer have any liquidity issues. Unfortunately, these claims do not appear to be true.
As I demonstrated in Section 1 (Red Flag #3), in Q1 2017, CGI did not make any lease shortfall advance payments to Element. Despite not making any of these payments, the company still burned through $19.8m of free cash flow in the quarter. This means that CGI's core trucking business appears to be burning cash at a rapid rate. Thus, even if the JV is consummated, it is unlikely to fix CGI's liquidity issues.
Also, it is unclear why CGI did not have to make any lease shortfall advance payments in Q1 2017. Based on the low utilization of Element's trucks, the company should have made a meaningful number of these payments in the quarter. Thus, it is logical to believe the company avoided paying this obligation because it simply does not have the necessary liquidity. This is yet another sign of a desperate financial situation.
Section 12: Current and Former Employees Come Forward
Over the past few months, both current and former employees of CGI have reached out to me to express their concerns over the conduct of the company and management. Initially, I was reluctant to release their emails publicly. However, given CGI's increasingly concerning behavior (as evidenced by the swap), I think it is important for investors to know the full story.
The first email that I will disclose is from a former employee of the company. I received his email on October 12th, shortly after the release of my second article on CGI. His message to me (with his name, contact details, date of departure and unconfirmed allegations redacted) is provided below:
As shown from the message above, this individual claimed to have recently left the company due largely to the issues which I pointed out in my previous articles. He also pointed out additional issues related to CGI which I was not aware of. I have redacted out these new allegations since I am in the process of investigating them.
The most concerning information that I received was from someone who claimed to be a current employee of CGI. In the interest of protecting his identity, this individual referred to himself as John Doe in his email. He even created a separate email address for the sole purpose of communicating with me.
A copy of "Mr. Doe"'s initial email to me is provided below (with his contact details redacted):
Over a series of eight emails to me, this individual revealed some things about CGI's business practices which, if true, are extremely concerning. I am currently investigating his allegations, so I have kept most of his specific allegations confidential for now. Any meaningful developments on this investigation will be provided in a future article.
That being said, based on my analysis of CGI's financial reporting methods, I feel comfortable in revealing one specific claim made by "Mr. Doe." In one of his emails to me, "Mr. Doe" stated that he "knew for a fact" that CGI was not accurately reporting its losses to investors. His full statement on this matter is provided below:
"When it comes to accounting methods, I have little knowledge of the specifics of how they're doing things within the accounting division. But that being said, I know for a fact that the loss they advised for the past year is greater than what they are admitting."
The above statement by "Mr. Doe" supports my analysis that CGI has overstated its historical profits. A full copy of the email which contains this particular claim by him can be found here (with allegations under investigation redacted).
The fact that "Mr. Doe" would go out of his way to create an alias for the sole purpose of emailing me information about CGI is very telling. It suggests that he believes the company's conduct is so concerning that the public needs to know about it.
Once again, this all leads back to my previous point about the danger of ignoring obvious warning signs. Investors would be foolish to ignore the concerns of someone, like "Mr. Doe," who appears to have intimate knowledge of CGI's operations.
Before ending this section, it should be noted that I have no way of confirming whether "Mr. Doe" actually works at CGI. That being said, the stunning amount of detail provided in his emails strongly suggests that he is, in fact, a current employee.
The discovery of Quality's swap transaction with Stoops is the strongest evidence yet that CGI has misrepresented its financial performance to shareholders and the investing public. Also, based on this discovery, it appears that the company is currently in breach of its credit agreement and is at risk of declaring bankruptcy over the next few months. Finally, the concerning emails I received from individuals claiming to be current and former employees are another indication that CGI is engaging in questionable business practices.
As I have demonstrated through four lengthy articles, there are so many red flags surrounding the company that it simply boggles the mind. Up until this point, investors and research analysts have mostly ignored these signs of trouble. Hopefully, the concerning revelations in this article will lead them to take these warning signs more seriously.
I continue to believe CGI is the best short opportunity I have come across this year. Thus, I continue to recommend shorting CGI shares or selling shares if you are an existing shareholder.
Disclosure: I am/we are short CGI.
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.