Beware U.S. Auto Parts Network; Stock Could Be A Zero

Summary

• PRTS’s deteriorating fundamentals appear to be only getting worse, in an environment where e-commerce throughout the country continues to experience strong and accelerating growth.
• The company’s recent share repurchases were authorized by PRTS’s Board despite an apparent conflict of interest, and resulted in the waste of precious corporate assets.
• For reasons unexplained, clear and consistent director share ownership guidelines have been disregarded by most of the company’s directors for years, allowing some to avoid large personal losses.
• PRTS’s increased use of letters of credit recently have obfuscated the true strength of the company’s balance sheet.
• CBP is alleging that PRTS has been importing counterfeits. This could lead to onerous bonding requirements that would, in the words of PRTS's CEO, cause "cessation of operations and liquidation."

Last May, after the shares of U.S. Auto Parts Network (NASDAQ:PRTS) plummeted 20% in a day to $3.11 a share, we wrote an article explaining how the company’s largest investor Oak Investment Partners (OIP) had distributed its entire 10.8 million shareholding of PRTS's stock to the investors in one of its private equity funds. We argued that most of OIP’s investors would sell these shares into the open market, and that PRTS’s stock price would likely collapse as a result. While PRTS’s stock hasn’t yet fallen to the $1.00 level that we thought was possible at the time, it has declined recently to as low as $1.72, or more than 47% below what the price was when our article was published.

Intrigued by this unusual situation where there was likely to be relentless selling pressure on the stock for an extended period of time, we decided to dig into the company, its management and its Board of Directors a little bit more. We will share below some of the important items our research has revealed.

We believe that not only are the company’s fundamentals in the midst of a period of dramatic deterioration that is unlikely to turn around anytime soon, but PRTS is being overseen by a Board of Directors that has presided over a number of serious corporate governance failures. As well, we believe the strength of the company’s balance sheet has been obfuscated through the use of letters of credit. Furthermore, and perhaps most importantly to the future value of PRTS’s equity, the company has been recently accused by the U.S. government of repeatedly importing unlawful merchandise, the implications of which could cause, in the words of PRTS’s own CEO, the “cessation of operations and liquidation” of the company.

Deteriorating Fundamentals

To reiterate what we wrote in May, PRTS is a pure-play internet retailer of aftermarket auto parts that has struggled to achieve profitability in any sustainable way over the years. And persistent worries about Amazon (AMZN) putting PRTS and all other online auto parts retailers out of business has done nothing to assuage investors' concerns about the company's future.

Although we stated in May that it appeared as if “the company is finally on the verge of turning the proverbial corner,” a deeper dive into the company’s financials, including its last few quarterly reports, tell us that PRTS is in fact nowhere near that corner.

According to the U.S. Department of Commerce, U.S. retail e-commerce sales growth accelerated from 13.9% in 2015 to 14.9% in 2016 to 15.2% in 2017. In the fourth quarter of last year, e-commerce sales grew 16.8%, which marks the highest growth rate in six years.

In the midst of this amazing environment for online retailers, U.S. Auto Parts Network’s revenue growth rates have struggled to stay above zero, and even dipped into negative territory last quarter. The following chart demonstrates the ever-widening gulf between PRTS’s growth rate and that of the rest of the domestic e-commerce world:

The main reason for PRTS’s revenue growth struggles is that fewer and fewer consumers are visiting the company’s e-commerce sites:

Unique visitors per day to PRTS’s sites declined a stunning 28% in the fourth quarter of last year. It’s amazing to think that PRTS’s unique viewers were down by more than 50% from the same quarter in 2011. While some of this decline was intended by the company as it has sought to rationalize the number of websites in its network, we believe the largely forgettable names of the company’s remaining flagship websites – www.autopartswarehouse.com, www.carparts.com, and www.jcwhitney.com – are at least partially responsible for the continued evaporation of consumer interest.

Perhaps the most important growth strategy of the company has been to grow its private label sales at a much faster rate than its branded products, due to private label’s gross margins being double those of branded merchandise. As a result, PRTS has increased its private label SKU count in its product selection by almost 30% over the last four years. However, as one can see, private label revenue growth at the company has experienced a steady and fairly rapid decline in recent years, and is getting close to turning negative:

Share Repurchases

On May 15, 2017, OIP distributed 10,806,405 shares to its limited partners. Two days later, PRTS announced that its Board of Directors approved a share repurchase program for up to $5 million worth of its common stock. At the time, we made the flippant (and not very well thought out) comment on Seeking Alpha that “this is a good signal that the company’s Board of Directors sees good times ahead, and is certainly the right thing to do for shareholders.”

Upon further reflection, we believe that this authorization was the absolute wrong thing for the Board to do.

As our article last year correctly argued, the OIP distribution was going to result in a massive overhang of stock that would crush the stock price. Our conclusion was only logical. PRTS’s Board surely would have thought the exact same thing. So, if PRTS’s Board was truly interested in growing shareholder value, we believe they would have been opportunistic and waited until a good amount of the selling pressure from the OIP shares had abated.

Instead, PRTS started to aggressively buy back stock last summer. In August and September of last year, PRTS repurchased 542,000 shares at an average price of $2.84. By the end of last year, PRTS had repurchased 1.4 million shares at an average price of $2.50. It is logical to think that some of these may have been bought from OIP investors.

With the stock price averaging $2.00 per share over the last month, the company in retrospect grossly overpaid for these shares. PRTS certainly wouldn’t be the first company to overpay for its stock.

What makes PRTS different though is who was on the company’s Board when it authorized this repurchase.

As we said in our last article, “OIP is in the business of selling its various funds to investors, and the worse one fund's performance is, the more difficult it is to convince investors to pony up for OIP's next fund.” Another thing that we believe would make it more difficult to convince investors to commit to a private equity firm’s next fund is to stick those investors with shares of an illiquid company and watch as those investors’ share sales annihilate that company’s stock price.

Therefore, we believe it would have been very helpful for OIP’s investors (and therefore for OIP) if there was a large buyer of PRTS’s stock to help balance these investors’ share sales. Fortunately, for OIP’s investors, an Operating Partner of OIP – Rob Majteles – was the Chairman of PRTS’s Board, and was therefore in a position to influence the company’s repurchase authorization decision.

Obviously, PRTS’s Audit Committee should have spent considerable time reviewing this conflict of interest prior to authorizing a share repurchase program. Fortunately for OIP, Mr. Majteles was one of four members of this committee last May.

After having spent $3.5 million of the company’s precious cash reserves buying back 1.4 million overpriced shares, PRTS filed a Form 8-K with the SEC at the beginning of the year wherein it disclosed that “On December 30, 2017, Robert J. Majteles… resigned from the Board of Directors and each committee thereof, effective immediately.”

Director Ownership Guidelines

As it pertains to corporate governance, it is a commonly held belief in America that best practice dictates that directors maintain a meaningful level of share ownership by a certain time after appointment to a company’s board to better align their interests with those of company shareholders.

Institutional Shareholder Services, for example, classifies a company’s director ownership guidelines as being “standard” if the guidelines dictate ownership of three to four times each director’s base retainer.

A review of PRTS’s historical proxy statements reveals that the company instituted director share ownership guidelines seven years ago, to a level that ISS would consider “standard.”

It would be encouraging to shareholders of PRTS that the company appeared, with this policy at least, to be committed to best practices in corporate governance, especially since PRTS in the past has been accused of “not even maintain[ing] the minimum standards of good corporate governance or controls and procedures, as required by the SEC and the Company's own internal guidelines and standards of business conduct.”

However, a review of the company’s directors’ actual share ownership positions reminds us of the classic Seinfeld episode regarding a car reservation:

“You know how to take the reservation. You just don’t know how to how to hold the reservation. And that’s really the most important part of the reservation, the holding. Anybody can just take them…”

Any set of corporate directors can institute guidelines regarding stock ownership for themselves. But really the most important part of a guideline is the following of them.

There are currently seven directors on PRTS’s Board. The only directors whose share ownership in the company is compliant with the Board’s stock ownership guidelines are CEO Aaron Coleman, Chairman of the Board Warren Phelps and co-founder Sol Khazani. Shockingly, the majority of PRTS’s directors are nowhere near being compliant with their own Board’s director stock ownership guidelines.

Josh Berman, co-founder of MySpace.com, who has been on the Board since 2007, amazingly owns just 6,533 shares of the company (total value: ~$14,000, or about 14% of PRTS’s $100,000 guideline). The last time Berman bought any stock (or exercised any options) in PRTS was a decade ago.

Barbara Palmer and Bradley Wilson have each been on PRTS’s Board since November 2013, so would have had until November 2016 to comply with the guideline. However, both Ms. Palmer and Mr. Wilson own zero shares of PRTS and, in fact, have never bought a single share in the company. Since PRTS’s stock price averaged $2.79 during the three-year period over which they were each required to acquire $100,000 worth of stock, Ms. Palmer and Mr. Wilson each likely avoided tens of thousands of dollars in losses.

Jay Greyson has been a director since June 2014, so would have had until last spring to comply. Unlike Ms. Palmer and Messrs. Berman and Wilson, Mr. Greyson does participate in PRTS’s Director Payment Election Plan, which allows for a director to elect to receive stock instead of cash for a percentage of his/her fees for serving on the Board. Even with this though, Mr. Greyson currently owns only 11,760 shares (total value: ~$25,000, or about 25% of PRTS’s guideline).

Reduction of Debt

PRTS’s management has made debt reduction a priority, and they regularly referenced in recent years how they were using free cash flow to pay down their debt. As a company’s net debt position falls, the company’s enterprise value (EV) also falls (all else being kept constant), which makes the company appear to offer better and better value to investors who like to look at EV/EBITDA or EV/Revenue ratios.

PRTS appears very mindful of this and references the company’s appealing looking EV/Revenue ratio in all of its investor presentations:

However, upon reviewing PRTS’s financial statements, something looked odd to us. Even though the company’s revolver debt fell from over $16 million at the end of 2012 to zero midway through 2016 (where it has remained), PRTS’s net interest expense keeps climbing:

Once we dug into the company’s SEC filings, it became clear that PRTS has just been substituting letters of credit (LCs) for revolver debt. The interest rate to PRTS for LCs is the same as it is for revolver debt; however, by utilizing LCs instead of revolver debt, PRTS gets to remove a liability off its balance sheet, which makes its enterprise value decline (LCs are guarantees, and not debt, per se).

In 2016, PRTS and its lender amended PRTS’s credit agreement twice to increase PRTS’ LC limit. In May, 2016, the limit was increased from $6 million to $15 million, and six months later was increased again, to $20 million (per the 2016 10-K).

Adding PRTS’s LC balance to the above chart makes the company’s large increases in net interest expense start to make sense. Unfortunately, PRTS for some reason did not disclose in its recently filed annual report what its LC balance was at the end of 2017, but considering PRTS net interest expense was up 17% year over year in the fourth quarter, it is reasonable to assume that the company is getting close to its recently raised $20 million limit.

Counterfeit Merchandise and a Legal Dispute with Customs

Earlier this month, PRTS issued a press release entitled “US Auto Parts Seeks to Protect the Right of Consumers to Purchase Aftermarket Automotive Grilles.” While the title made it sound like PRTS was fighting valiantly to protect the rights of the common man, the issue at hand is really about the decision by United States Customs and Border Protection (CBP) to impose heightened bonding requirements in response to what CBP believes is PRTS’s ongoing practice of breaking the law, and PRTS’s fight against CBP’s measures so as to avoid insolvency.

We downloaded all of the court filings related to this dispute, and what we found within them is enlightening. Please note that we are unable to provide links to individual court filings, so we have included screenshots of portions of certain documents throughout our commentary below.

In March, in response to what it believed was an ongoing unlawful practice of importing counterfeit merchandise by PRTS, a belief that was derived from the inspection of dozens of shipments of auto parts from overseas, CBP decided to impose a single entry bond (SEB) requirement of three times the value of every shipment of goods by the company:

According to a subsequent declaration made to the court by PRTS’s CEO Aaron Coleman, PRTS “receives on average approximately forty shipments (i.e., shipping containers) per week - each having a commercial value averaging approximately $42,000.” This works out to about $1.68 million per week. As a result, CBP’s imposed bonding requirement would require PRTS to pay a bond of ~$5.04 million per week, “in order to allow the entry of any US Auto product into the country.”

After it has been posted, an SEB terminates once the importer’s obligations and liability for Customs duties come to an end, which occurs when CBP "liquidates" (i.e., closes out) an entry. CBP has implemented a 314-day liquidation cycle, which is the time CBP has to liquidate an entry (although our discussions with surety companies and shipping service providers lead us to understand that liquidation can often take less than 314 days and can sometimes be extended beyond 314 days). Even if PRTS’s entries were liquidated, on average, in half that time, that would still mean PRTS would have to post each SEB for an average of 22 weeks. Within six months, PRTS would have over $100 million of SEBs outstanding. Considering PRTS’s heightened LC balance currently, the company doesn’t have anywhere near the amount of credit availability that would be required to support such an amount.

In his declaration, Mr. Coleman stated that PRTS “contacted multiple sureties, and none is willing to cover this unprecedented bond requirement without 100% collateral…US Auto simply cannot afford to pay or finance $5 million in bonding for every $1.67 million in merchandise…Absent an injunction of CBP’s Single Entry Bond Requirement, US Auto will experience escalating inventory shortfalls…Within a matter of weeks, US Auto will exhaust critical segments of its inventory, fail to fulfill the purchase orders of its consumers, damage its relations with its suppliers and other business partners. Employee layoffs, closure of distribution centers, and, finally, cessation of operations and liquidation would follow [emphasis added].”

As one would probably expect, PRTS does not agree with CBP’s assertion that PRTS has been importing counterfeit goods; however, the government appears adamant. In an April 16, 2018, response to PRTS’s motion for a preliminary injunction order, the Government stated the following:

“For nine months prior to imposing the bonding requirement that is at the heart of this litigation, CBP repeatedly found and seized auto parts imported by U.S. Auto that infringe markets recorded in CBP’s Intellectual Property Rights Search (IPRS) Database, which is publically available at Intellectual Property Rights (IPRS) search - cbp.gov. While it would seem evident that U.S. Auto should not have imported goods bearing recorded marks at all, it most certainly should have stopped this practice after CBP notified it in June 2017 that certain of its auto parts had been seized.¹

Apparently, because it disagreed with CBP as to the basis for the seizure, U.S. Auto took the position that it would simply continue importing such goods. CBP continued to discover additional infringing goods and by March 2018, had seized goods from 39 of 52 shipments CBP examined [emphasis added].”

The parties to this dispute will undoubtedly come to a resolution at some point; however, we believe there are a few very reasonable conclusions that equity investors in PRTS can draw from the court filings in this case:

1. Between March 7, 2018, (when CBP instituted the SEB requirement) and April 5, 2018 (the date of PRTS’s Amended Verified Complaint), 75 PRTS shipping containers have been refused entry at the Port of Norfolk (see below). At an average commercial value of $42,000 per container, that represents $3.2 million in revenue, or 4% of the consensus revenue estimate for PRTS’s first quarter. While it’s likely that not all the merchandise in these 75 shipping containers were destined to be sold by March 31, we believe there is a very good chance that PRTS posts a disappointing revenue quarter when it announces financial results on May 8.
2. According to the U.S. government, PRTS does not have much credibility as a compliant importer (finding counterfeit goods in 75% of examined shipping containers will typically cause one to question a company’s credibility). This has undoubtedly led to a heightened level of legal fees that will impact PRTS’s profitability in 2018. As well, with PRTS’s being in CBP’s bad books, PRTS’s importing practices will likely need to change and will also likely be subject to a high degree of scrutiny for the foreseeable future. This could result in PRTS needing to eliminate some merchandise from importation, CBP seizing more shipments in the future, or some other unforeseen consequence.
3. Depending on what bonding requirements PRTS will ultimately be held to, the results on PRTS’s finances longer term could be anywhere from very harmful to disastrous.

Questions to Management

Prior to publishing this article, we submitted the following list of questions to PRTS’s CEO Aaron Coleman, CFO Neil Watanabe, and General Counsel David Eisler. At this time, we have received no responses. Should we receive any responses, we will include them in the comments section below:

1) On May 15, 2017, Oak Investment Partners (“OIP”) distributed 10.8 million shares of PRTS to OIP’s limited partners. Two days later, PRTS reported that the company's Board of Directors approved a $5 million share repurchase program. Between then and the end of the year, PRTS acquired more than 1.4 million shares of stock pursuant to this program. During this entire time, Robert Majteles was the Chairman of PRTS’s Board of Directors. Considering that 1) it would have been reasonable to expect a large percentage of the 10.8 million distributed shares to be sold into the open market by OIP’s limited partners in the months following OIP’s distribution, and 2) Mr. Majteles was an Operating Partner of OIP throughout 2017, why should investors in PRTS stock not be concerned about the apparent conflict of interest with this repurchase program?

2) The company’s last six proxy statements contain the following paragraph (or slight variations thereof):

“In June 2011, in an effort to further align directors’ interests with those of shareholders and implementing best practices in corporate governance, the Company implemented guidelines for director share ownership. The stock ownership guidelines are for directors to own and maintain a minimum of $100,000 of our stock (a multiple of 4 times the annual $25,000 director retainer). Any new directors will have 3 years from the date of their initial election to the Board of Directors to comply.”

Despite the existence of these guidelines, four of the company’s seven directors do not currently comply. For instance, both Ms. Palmer and Mr. Wilson have been directors of PRTS for well over four years; however, neither director owns a single share of PRTS stock. Why are multiple directors of the company not complying with these guidelines, and why should investors in PRTS stock not be concerned about this apparent lack of alignment of directors’ interests with those of shareholders?

3) According to court documents filed in U.S. Auto Parts Network Inc. v. United States et al., case number 1:18-cv-00068-JCG in the U.S. Court of International Trade, the United States Customs and Border Protection (“CBP”) has alleged that PRTS is a counterfeiter, stated in a March 7, 2018, email to PRTS’s General Counsel David Eisler that “In consideration of the fact that U.S. Auto Parts Network has had over 30 shipments containing violative merchandise… arriving in the Area Port of Norfolk since June 2017”, and stated that it “by March 2018, had seized goods from 39 of 52 shipments CBP examined.” How concerned should investors be about CBP’s allegations and seizures, and the potential implications to both PRTS’ business model and financial statements?

4) Since 2016, PRTS has disclosed each quarter in the notes to its financial statements the company’s letters of credit balance. However, PRTS chose not to disclose this information in its recently filed Annual Report on Form 10-K. What was PRTS’s letters of credit balance on December 30, 2017, and why did PRTS stop disclosing this information?

Conclusion and Valuation

Fundamentally, PRTS has had a very difficult time in recent years, and the company’s declines are only accelerating. As well, the recent dispute with CBP will likely negatively impact the company’s finances in both the short and long term. And while the company may wish to direct investors’ eyes to its ostensibly strong balance sheet, PRTS’s recent decision to replace its revolving debt with letters of credit should give investors pause.

Furthermore, PRTS is governed by a questionable Board of Directors that both ignores its own policies that exist to align directors’ interests with shareholders, and recently made a very important decision regarding the use of its limited corporate resources that arguably benefits its Chairman much more than it does its shareholders.

PRTS’s trailing twelve-month EBITDA to 12/30/17 was $11.4 million. Capex (which is mainly capitalized payroll costs related to website and software maintenance) was $4.9 million and will likely continue to be an unavoidable cash drain going forward in our opinion. We believe year-over-year revenue growth will continue to decelerate, with this deceleration being driven by both the double-digit declines in traffic to the company’s websites. As well, we believe gross margin pressure will likely intensify as revenue growth in the company’s higher-margin private label business continues to shrink. Finally, we believe the company will likely experience increasing operating costs driven by the company’s CBP dispute. Add it all up, and it’s difficult for us to think that PRTS’s EBITDA will do anything but decline going forward. Therefore, we believe an EV/EBITDA ratio of 4.0–5.0x is a fair valuation multiple for the company, especially in light of the Amazon threat which isn’t going away anytime soon. We believe a calculation of PRTS’s enterprise value should include the amount of its off-balance sheet letters of credit balance – if one assumes PRTS’s LC balance remained the same between September and December, at $15.0 million, then an EV/EBITDA of 5.0x suggests a fair price of $1.01 per share:

However, if this CBP dispute that stemmed from PRTS’s supposed importation of counterfeit merchandise ends up being anywhere near as devastating to PRTS as Mr. Coleman suggested in his court declaration, we believe there’s a good chance that PRTS declares bankruptcy in the near future, resulting in a zero equity valuation.

While PRTS’s short interest is not very high currently (43,794 shares short, as of 3/29/18), there were over 600,000 shares short as recently as September of last year. As a result, we believe investors should not have too much problem borrowing shares if they decide to establish a short position. Although the situation with every broker is different, we learned recently that we are able to borrow a sizable number of shares from one broker at a nominal cost (<1% per annum).

We are short shares of U.S. Auto Parts Network currently, and we believe the fundamentals of the company argue for a continued stock price decline. We believe the biggest risk to our thesis is that somehow the company pulls out of its traffic and revenue tailspin (without resorting to aggressive discounting in order to do so); however, we have not yet heard the company articulate any coherent and believable plan to achieve this.

Until they do, we believe investors are best served avoiding PRTS as a long investment at the very least.

Analyst’s Disclosure: I am/we are short PRTS. 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.