Spruce Point issues “strong sell” investment opinion on CECO Environmental (Nasdaq:CECE): sees 30% – 60% downside potential
Spruce Point Capital Management is pleased to announce it has released the contents of a unique short idea involving CECO Environmenta Corp. (Nasdaq: CECE, “CECO” or “the Company”), a poorly constructed roll-up in the environmental control, energy, fluid handling and filtration industrial segments. We have conducted an extensive fundamental and forensic accounting review, and believe the 83% appreciation in CECO’s share price in 2016 is unwarranted given the change in the environmental regulation regime under the Trump administration, and the likelihood of a significant goodwill impairment, covenant breach and heightened balance sheet risk in 2017. As a result, we have a “Strong Sell” opinion and a price target of $4.85 – $9.00 per share, or approximately 30% to 60% downside.
Executive Summary
Spruce Point is Short CECO Environmental For the Following Reasons:
Spruce Point is short CECO Environmental (Nasdaq: CECE, “CECO” or “the Company”), a poorly constructed roll-up serving the environmental, energy, fluid handling and filtration industrial segments. Based on our forensic financial analysis, insider behavior, and anticipated changes in the regulatory environment driving its business, we believe CECO is at high risk of a covenant breach in 2017. We urge investors to consider the following when evaluating CECO:
- CECO has acquired 7 companies since 2013 at the expense of punitive dilution, and mounting leverage on its balance sheet. With 55% of its assets as goodwill and intangibles, we believe CECO is forestalling a crippling goodwill impairment of Met-Pro, its largest acquisition, and a deal it touted as a “success.” CECO’s shares appreciated 83% in 2016 on the false perception that its recent PMFG acquisition has also been a winner. However, we believe CECO pulled forward cash flow through rapid synergy realization and working capital maneuvers to pay down debt ahead of schedule. However, recent performance suggests that both CECO and PMFG are now declining organically by double digits, and management stopped disclosing key contribution metrics
- We thank Street Watchdog Research’s recent note alerting us to CECO and the fact that its single most important business driver is a stringent environmental regulation regime that drives its clients to comply with issues such as air pollution control. With the election of President Trump, and his new Executive Order designed to expedite environmental reviews and eliminate burdensome environmental compliance issues, CECO’s future is at best uncertain, and at worst materially impaired. Not surprisingly, the same day of the Executive Order, the Company’s CEO abruptly resigned, but not before cashing in options, and leaving unexpired RSUs tied to 2017 EBITDA. Based on our research, we found other key executive departures at CECO, particularly in Asia, where it touts a large and growing opportunity to gain market share
- The Company’s CFO also left his position prior to the CEO’s departure. We are concerned that CECO recently appointed its 5th CFO since 2011. Pay close attention to new language about material weaknesses of financial controls in the recent 10-K. Specifically, the Company cited issues with accounting for revenues. This should be a big red flag to investors, particularly because CECO uses the “percentage-of-completion” method of accounting, which is notoriously abused and a focus of SEC investigations according to a recent speech from the enforcement director
- CECO’s governance is weak and should give investors’ cause for concern. The current Chairman is the son of the former CEO Phillip DeZwirek, who settled with the SEC for insider trading, without admitting guilt. The rest of the Board is stacked with allies of the DeZwirek family, and many have questionable backgrounds that offer little relevant experience to CECO’s core businesses. The Board has shown a willingness to pay management cash bonuses for completing bad deals, and rubber stamping annual cash bonuses for failure to hit financial targets
We See 30% – 60% Downside As Covenant Breach Comes Into Focus:
- CECO has been touting to investors that it has been successful in delevering its balance sheet post-PMG acquisition, and that its current Net Debt to EBITDA ratio is down from 3.6x to 1.6x as of 9/30/16. On the surface, this appears impressive, but the picture is not so simple. CECO should be pointing investors to is “Leverage Ratio” covenant per its credit agreement which looks at gross leverage (not net of cash) and includes significantly more debt obligations beyond just its term loan. When factoring in CECO’s earnout obligations, leases, and outstanding letters of credit, we find that its current leverage is closer to 3.4x
- CECO has no room for misstep in 2017 given its Leverage Ratio covenants will tighten twice, from 3.5x to 3.25x in September, and finally to 3.0x in December. Based on our analysis, at CECO’s current LTM EBITDA of $56.5m, it will most certainly trip a covenant absent material improvement in EBITDA or a dilutive equity raise. CECO has also said it has no additional assets of materiality to sell to accelerate the deleveraging process. In short, the Company is stuck between a rock and hard place
- Optically, CECO’s share price looks cheap, and analyst’s argue that its valuation discount to peers will narrow, while its organic growth accelerates and its margins improve. The average analyst price target is $13.40/share, implying 7% upside. This is wishful thinking, and represents a terrible risk/reward. Don’t be fooled: there is no visibility in CECO’s business, it has suffered significant executive turnover, and its #1 risk factor just materialized. The easiest way to value CECO is on a book value basis. We expect a goodwill impairment to eliminate $79m of equity. By adjusting the book value and applying a generous 1.0x – 1.5x multiple, we get $4.85 to $7.25 per share or 40% – 60% downside. We also conservatively estimate sales declines of 8% – 12%, which at 1.0x to 1.2x multiple (in line with its small cap peers) and using our adjusted debt gets us a valuation range of approximately $6.25 to $9.00 per share or 30% – 50% downside
- Follow the money: The CEO just exercised options and dumped shares prior to resigning, and as a reminder, left on the table restricted stock units (RSUs) specifically tied to 2017 EBITDA, a critical target necessary to avoid a covenant breach. CECO’s Chairman and largest shareholder just altered the terms of his large warrant to allow for “cashless exercise” – a way to avoid tying up capital in the stock, and using stock sales to fund the warrant exercise. The remaining executive team owns virtually no equity, and has little at stake if CECO fails
CECO’s Stock Appreciation Merits Scrutiny In The Face Of Multiple Red Flags
CECO’s Poorly Executed Acquisition Spree and Deal Promotion
CECO Is A Motley Collection of Speculative Acquisitions
CECO’s Business Under Pressure
CECO Promotes Its Met-Pro Deal As A “Success Story”…
But In Reality…CECO Appears To Be Forestalling A Large Goodwill Impairment At Met-Pro
In our opinion, CECO has realigned its business segments (2014) and altered its goodwill testing methodology (2015) in order to avoid a substantial goodwill impairment. CECO now uses the market method “with a control premium” and has wide discretion to choose larger and healthier companies in its analysis. As of its last 10-Q, it appears an impairment is becoming increasingly imminent.
Notice Change in Goodwill Impairment Testing To Incorporate Market Method Testing ( 10-Q, p. 10)
“Under the first step, the Company bases its measurement of the fair value of a reporting unit using a weighting of the income method and the market method on a 50/50 basis. In prior years, the Company used the income method. The income method is based on a discounted future cash flow approach that uses the significant assumptions of projected revenue, projected operational profit, terminal growth rates, and the cost of capital…. The market method is based on financial multiples of comparable companies and applies a control premium. Significant estimates in the market approach include identifying similar companies with comparable business factors such as size, growth, profitability, risk and return on investment and assessing comparable revenue and operating income multiples in estimating the fair value of a reporting unit. Based on the step 1 analysis, the resultant estimated fair value of the reporting units exceeded their carrying value as of October 1, 2015 and no goodwill impairment charges were recorded.
Goodwill Impairment Discussion 2nd Quarter 2016 ( 10-Q, p. 10)
“The Company did not identify any triggering events during the three-month and six-month periods ended June 30, 2016 that would require an interim impairment assessment of goodwill or indefinite life intangible assets. There was no impairment of goodwill or indefinite life intangible assets during the three-month and six-month periods ended June 30, 2016.”
Revised Language: 3rd Quarter 2016 ( 10-Q, p 10) Note: CECO also says the unit was acquired in 2H 2013 (Met-Pro)
“Although the Company has not identified any triggering events in 2016 that would require a more frequent test for impairment, the reporting unit with a lower excess fair value over its carrying value (as described above), as determined in the prior year’s annual assessment, is experiencing lower than forecasted results through the first nine months of 2016. This reporting unit has goodwill and tradename intangible assets of $77.9 million and $5.0 million, respectively, as of September 30, 2016. The Company is currently in the process of analyzing internal strategic initiatives to improve operating performance, and forecasting for 2017 and future years as part of its annual impairment assessment, which is performed as of October 1, and will be completed in the fourth quarter. As of the date of this filing, the Company has not yet completed its assessment.”
CECO Promotes Its PMFG Deal As A “Success Story”…
Article by Spruce Point Capital Management
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