Crius Energy Trust: The Risks Are Overblown

Summary

• Crius sold off markedly after a short selling article was published on Seeking Alpha on February 28, 2018.
• The author made several cases as to why the company's dividend and solvency were at risk and questioned the original setup of the company.
• I address these critiques and illustrate the benefits to an investment at these levels.

It was a very eventful day in trading for Crius Energy Trust (OTC:CRIUF) on February 28, 2018, after the early morning posting of Crius Energy Trust: An Unsustainable Collision Course by Seeking Alpha author Hindenburg Investment Research. The author focused on several issues surrounding the company, from its payout ratio to its liquidity of Crius to some former business dealings of its management in the setup of the company. This gave me the impetus to look behind the article's claims and see if it was truly an impaired business.

As a background, Crius engages in the provision of electricity, natural gas, and solar products to residential and commercial customers through partnerships and direct-to-consumer marketing channels. Essentially, it serves as a middleman in marketing energy services to the end user. As Hindenburg's article notes, this is not a utility and can only operate in de-regulated markets. Crius is arbitraging the payment plans it can arrange with customers with where it can obtain power from, and making the spread.

Source: Company Presentation

The company has been rapidly rolling up companies over the last 3+ years, adding close to 700,000 customers to its business through the course of six acquisitions. Hindenburg's article notes that it has had a potential 40% annualized drop in customers, based on the annotated of its Q3. This is the customer drops for the quarter; it does not reflect the organic gains which outpaced the drops. Using similar math, the 197,000 organic gains Crius had in Q3 would be 13.6% or 54.4% annually. This business is similar to telecom and cable providers bidding for your business; people will flip between each on where they can get the best deal. Crius added 69,000 net subscribers organically or 4.7% in Q3 2017, which works out to almost 19% annually. This is a good sign for the company's base business.

The Viridian marketing brand had been contributing less and less to Crius' results and likely spurred the company's push into better distribution channels. The unit was also the source of the $18.5m legal settlement that Crius agreed to surround some of its marketing practices. Crius disposed of 90% its stake in Viridian in 2016 and has fully reserved the remaining ownership stake.

The company has seen its gross margin decline in percentage terms during the last three years, which it has communicated to shareholders in a dedicated slide in its investor deck:

Source: Company Presentation

I believe part of this is due to the fact the company has been utilizing a roll-up strategy with six acquisitions in the last 4 years as detailed on page 8 of its investor presentation. It is likely still working through how best to integrate these together. I believe it is getting into more competitive segments which makes it more difficult to attract customers; the churn rates seem bear this out as customers look for the best deal possible. In an investment write up by RBC in February 2018, management noted it is focusing more on corporate customers. Larger, corporate customers enable any acquisition costs to be spread over a larger user base, which will bring down the average acquisition cost per user. Management is also intending to trim less profitable customers, which should help to better maintain its margins as well. These actions will require Crius management to execute effectively, but this is a normal business risk.

Hindenburg's article presents concerns about both Crius' payout ratio and its liquidity. I tend to see these as very intertwined, as the ability of Crius to generate cash flow is needed both to fund its dividend as well as to reduce the cost of its capital structure. The key behind this is some concerns about its calculation of distributable cash and payout ratio:

Source: Company Presentation

There are several components to this that need to be considered. Distributable cash and payout ratios are both non-standard accounting measures and as such are not audited; this doesn't mean they are false but that they can include or exclude any number of factors. In Crius' case, the first thing it excludes is the working capital increase, as it is beyond its normal course of business. To an extent, this is valid as it is greatly increasing its receivables simply due to the increasing size of its overall business. I am not sure this would be valid if it is continuing to add businesses as it becomes more of a regular course of business. That said, I expect the company to slow its acquisition spree, which would allow the conversion of this working capital into cash as it catches up to a more regular growth rate. If this is the case, then I can see the point for management to consider this as an add back.

The add back of the legal costs is also legitimate in my opinion if they are non-recurring in nature. Based on Hindenburg's research, the Viridian brand has been largely wound up and sold off. This business risk has largely been eliminated, making this payout a one-time expense rather than a regular threat to meeting its dividend obligations. Hindenburg makes the case that since it is not yet paid out, they should not be added back yet. The reserved amounts have reduced the net income level which impacts the cash flow from operations number. The company has not explicitly indicated where the accrual for the legal settlement is, but I believe though that due to the large rise in the balance of "other non-current liabilities - long term" on its balance sheet (from $4.8m to $22.8m); if it were in working capital, they would be double accounting it, which I find unlikely. Given that is not really a part of the working capital of the business, like receivables and payables are, I believe the company's treatment of this reserve in its distributable cash calculation is justifiable.

One weakness of the above payout calculation is Crius' recent dividend raises have not been reflected, due to the use of trailing twelve month numbers. The dividend now annualizes out to $0.836 CAD per unit or roughly 10.2%. This represents an annual cost of $47.7m CAD or $37.3m USD at today's exchange rate. This is much higher than the company has had over the last 12 months, $25.5m USD per the above graphic. The forecasted dividend commitment is still below management's distributable cash calculation, but the payout ratio is not quite as strong as the trailing numbers support; using the forecasted dividend rate, the payout ratio is 89.8%. This is still coverable but is not nearly as robust as it was prior to the dividend raises in 2017. Management can improve this ratio if it can realize some of the estimated $11m in synergies out of its recent acquisitions or if it can continue to grow its base business.

On the liquidity front, Crius has over $24.3m in the bank, along with $25.2m in available credit. Even after the settlement of the lawsuit for $18m, the company will have access to over $30.3m in liquidity, though the cash position will be reduced. It is clearly incumbent on the company to continue to operate well, along with making some headways into converting the working capital into cash. With respect to its financing costs, with the recent share price drop, its equity now may be more expensive than its debt. Any surplus cash should be focused on reducing these costs, either through debt reductions or share buybacks. Management gave indications to RBC in its note that both these actions would be a focus for any surplus cash flow.

With respect to an actual short position, Crius' substantial dividend would be required to be funded by anyone taking a non-option short position on the company, along with whatever the borrow cost is on the shares. This is made all the more difficult due to the monthly nature of its distributions. Hindenburg notes that it expects Crius to potential raise funds in the May to July time period, which would leave anyone short Crius responsible for roughly 5% of the cost of its short position, in borrowing and distribution costs. The longer a short in Crius is to be held, the more expensive a position it becomes.

The impact of the article on Crius' shares was dramatic as the shares dropped to a low of $7.01 CAD before finishing the day at $7.92 CAD, down over 10%, on very heavy volume of 1.8m shares, 12x normal levels. Crius has very low institutional holdings, meaning it has a very high retail shareholder base, most of whom are likely drawn to the company due to its growth and dividend yield. Institutional shareholders are less likely to be swayed by a report like this, which makes the ability to short the company more difficult; Crius does not currently have the institutional support to buffer this risk. Even with its moderate sized market cap of $464.8m CAD, this made Crius very susceptible to a negative shift in retail sentiment.

The Takeaway

Hindenburg's article has a lot of merit. I don't believe the payout ratio is as good as it seems in the company presentation, but this is mostly due to which time periods considered. I also don't think the liquidity is as perilous as it was made out to be, as its working capital build has had a temporary draw on the company during this growth phase. This should normalize itself as its operations stabilize and some of the deal synergies are realized.

Hindenburg's article questions surrounding the company formation and some of its ties are worth further review. Most of the people referenced are long gone from the company. If some have remained shareholders, they don't have any control over the company based on the institutional and insider holdings I found on Morningstar. Crius made a fairly strong statement late in the trading day in support of its business and the vetting it has gone under over the last several years during its various prospectus offerings. This gives me further confidence that this risk is minimal.

No investment is without risk; if Crius' business is negatively impacted or its margins erode further, Crius would have to consider whether its dividend can be maintained. The flip side is also true; improving operational results will allow the company to reduce its share count (and dividend outlay) through a buyback or to reduce its interest costs through debt reduction. Both these have a compounding effect as it will reduce its financing costs. A Dividend Reinvestment Plan (DRIP) doesn't really help as it would increase the shares outstanding, which would increase the dividends required.

I had only a half position going into February 28, 2018, so I made it a full one when the stock was near the mid-point of its fall. The upcoming quarterly results will bear watching, though one quarter does not a company make, either to the good or bad. I will continue to mind my stop losses but I think this pull back gives investors an opportunity to get a reduced price on a high yielding business.

If you see something in this article that you agree with, or even better disagree with, please take the time to comment below. This makes all of us better investors. I predominantly focus my investing in the small- and micro-cap company space but reserve the right to deviate from time to time. If you like what I'm doing, you can follow me by hitting the "Follow" button at the top of this article. Plus, you can follow me in real time by selecting that option.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Analyst’s Disclosure: I am/we are long CRIUF. 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.

I am long through the TSX listed units KWH-UN.TO