Description

CD&L, Inc. (Ticker: CDV) is small, non-asset-based, provider of same day and time critical deliveries. This is NOT a trucking company in any traditional sense. A recent refinancing, a somewhat confusing capital structure, and a renewed growth trajectory have created a great buying opportunity for investors who like value oriented micro-cap equities.

Basic Thesis
- Solid company trading 8.7x pro forma EPS and 5.3x pro forma EV to EBITDA with strong continued growth in revenues
- Management recently made substantial investments with the 10 top managers / board members / employees buying ~13% of the capital structure (they already owned 17% previous to this deal)
- Recent financing better aligns debt and equity, removes risk from the capital structure, and lowers interest expense
- Trades at substantial discount to public market comparables
- A yet to be exercised rights offering may be contributing to a short term overhang on the stock – completion of this should be a catalyst for appreciation
- CDV has reached a strategic inflection point where growth has taken off and operating leverage should become apparent in the earnings stream

We also wrote up DDN on 2/26/04 which is a similar company. In many ways CDV looks like DDN did a few years ago as DDN began to grow their revenue and improve their balance sheet. During this process DDN stock made a steady increase from $2 to current levels around $13. We believe CDV has many of the same attributes as DDN did just before it turned the corner. A small portion of the text herein comes from our DDN write-up.

Transport / Shipping Companies in General:

For the most part, we do not like transportation and distribution companies. Why? Well, in general these companies are capital intensive, have to deal with Teamsters and other unions, suffer fuel price volatility, and are subject to trucking/shipping capacity coming on-line relatively quickly. Also, in the process of trying to get to scale, such companies tend to become pretty leveraged. At the end of the day we see many such companies making a pretty low ROA/ROE with poor margins and tenuous capital structures.

Is CDV an exception?

Yes. The company competes in the roughly $10-$15bn same-day delivery market. Our favorite part about the company is that rather than own trucks/vans, they simply contract with drivers who personally own or lease trucks. This does the following: 1.) Takes away the capital intensity typically associated with transport / shipping business - thus better ROIC and most importantly expansion of the business does not require much capital, 2.) Eliminates the need for service operations, 3.) Means drivers are not employees and therefore little problem with unionization, hiring/firing, health insurance, etc… 4.) Allows CDV to price everything on a profitability per route basis (think Southwest Airlines). This is atypical in many transport businesses where hub and spoke models obscure route profitability (or loss). Such models often cause management teams to bid business very aggressively in an attempt to utilize fixed assets. These behaviors on an industry-wide basis tend to create overly-competitive operating environments.

Examples of CDV Work

Their business can basically be broken into four parts: 1.) On-Demand Same-Day Services: These are customer initiated requests (from existing accounts) for a particular item to be picked up at one location and delivered to another. Such items might include important legal exhibits, architects’ plans, medical samples, etc. 2.) The second part of the business is Scheduled Distribution Services. For instance a CDV driver might have a fixed route in SF where he drives around and picks-up cancelled checks at Bank of America branches. Similarly, a CDV driver might drive to all the hospitals in a specific area and pick-up blood samples and take them to a regional lab. 3.) Finally, in some cases CDV will perform dedicated fleet services (one might think of this as a sub-set of Scheduled Distribution Services). 4.) CDV in certain instance will manage the mail room or shipping and receiving departments for certain companies.


Is the same-day delivery business a good one to be in?

It can be. If you open the Yellow Pages and look under ‘Delivery’ the first thing you will see is big ads for United Postal Service, Fedex, and UPS. CDV does not compete with any of these. These are all asset based overnight delivery services. They are overwhelmingly modeled on hub-and-spoke transport networks. If you send a Fedex package from Miami, FL to Jacksonville, FL it will very likely go through Memphis first. Repeat - CDV does not compete with these types of over-night delivery businesses. CDV is same-day and mostly intra-market delivery. They do perform some inter-market delivery as well, primarily for high-value items.

To understand the competition, look at the smaller ads in the Yellow Pages and you’ll see ads saying things like “Dave and Dan’s Same Day Delivery: Boston and Eastern Massachusetts Only” or perhaps “Superior Delivery and Transport: Houston’s Answer to Same Day Delivery”. These are CDV’s primary competitors and constitute the majority of the market. They typically serve one or a few markets and often own a small fleet of trucks and hire their own drivers. The industry is fragmented and generally consists of less sophisticated local players.

Large Competitors:

DDN is the highest quality player in the business with about 28% gross margins (partly due to their near monopoly in Canada as well as success in on-demand deliveries which is 30%+ gross margin business). CDV runs at about 19% gross margins. VEXP this the third major competitor. The VEXP story is a long one but basically they’ve been a very troubled company and are on the verge of bankruptcy ($3mm in equity sitting below about $110 of debt and preferred). Their gross margin has continued to slip (now in the mid-teens) as they’ve lost business. Our diligence suggests that DDN and CDV are picking off business from VEXP. This is good from a revenue perspective but on the flip side, VEXP has been very aggressive with pricing and therefore VEXP’s condition is hurting industry profitability.

DDN: Market Cap-$153mm; Enterprise Value - $165mm; EV to TTM Revs 0.60x
VEXP: Market Cap-$3mm; Enterprise Value - $117mm; EV to TTM Revs 0.38x
CDV: Market Cap-$17mm; Enterprise Value - $mm; EV to TTM Revs 0.17x

Based on a multiple of revenues CDV looks cheap relative to other industry players.

Importance of Having a National Footprint:

Being able to sell national accounts is very important. It is what differentiates the few large players in the industry. DDN has the best footprint. VEXP is falling apart at the seams. CDV is really the only other player that can claim a national capability. Depending on what happens to VEXP – the industry may evolve into a duopoly with just DDN and CDV. If we look at the three competitors combined they only represent about 7.5% of the total industry based on the low end of the estimate of industry size ($10bn-$15bn). Thus, there’s plenty to room for CDV to grow as they take business from local players and VEXP.

The value of the network is not simply a function of the number/breadth of locations – CDV has taken years to build relationships with drivers, customers, and service partners. In addition, CDV has acquired the knowledge base about the types of work that are profitable in a given market – taking the right work and charging appropriately is fundamental to profitability.

It is also worth noting that our discussions with drivers suggest that the model is attractive to them, allowing a high degree of independence and an ability to dictate their hours and how much money they can make. Drivers have been feeling the pain of higher fuel prices and delivery companies have had to bid work slightly higher to compensate for this fact. CDV has limited direct exposure to fuel prices but to some extent will need to compensate drivers for the higher level of expense they take on.

Recent CDV Financing

CDV recently reworked its capital structure and in the process took risk out of the balance sheet, lowered interest expense, and increased management ownership levels. The key components to the financing were as follows:

- $4.0mm in senior notes held by Paribas were exchanged for Convertible Redeemable Preferred stock. The shares are convertible at $1.016 per share into 3.937mm common shares and are non-interest bearing. It makes sense to essentially treat these as equity. (the convert sits above the equity in a liquidation scenario. Having said that we would obviously not hold the common if we thought liquidation was imminent).
- $3.0mm in senior notes held by Paribas were exchanged for Series A Convertible Notes. In addition, another $1.0mm of these notes were issued by the company. The notes carry interest of 9% for two years, then 10.5% for two years, then 12% for two years. They are due in April of 2011 and are convertible at $1.016 per share into 3.937mm shares. All of the Series A notes including the additional $1mm were purchased by certain members of the CD&L management team. Large investors included the Chairman/CEO, the President, the CFO, and the South East Regional Manager. Other smaller investors included the General Council, one board member, and 5 other regional managers. (This group already owned 16.7%)
- In exchange for the remaining $4mm of Senior Debt held by Paribas, CDV issued Series B Convertible Subordinated Notes. These notes bear the same interest rate and have the same maturity as the Series A. The Series B are convertible at $2.032 per share or 1.969mm shares.
- Company entered into a Registration Rights agreement wherein shares of the common issuable up conversion of the above notes will be registered for resale.

In addition, in order for management to not appear self serving in this transaction, the company entered into a rights offering where existing investors could purchase up to $2.0mm of stock at the same price as the conversion price on the Series A ($1.016 per share). The amended filing for this Rights Offering has recently been sent to the SEC and should become effective relatively soon – we’re thinking in the next two weeks. That will establish the record date for security holders. Then it should take about 30 days to complete the rights offering. The terms are such that any common holder will have the right to purchase 1 share of CDV at $1.016 per share for every 4 shares they hold at the record date. We believe this has created a temporary overhang since existing holders will likely increase their stakes at the time of the offering. Thus, they are less likely to be in the market today when they will be able to buy at a discount to the market in 45 days. At the margin this has kept some buying pressure out of the shares. When the rights offering is completed this effect will go away. Post offering, their could be as many as 2.8mm new shares issued which will result in dilution (up to 22%) but the resulting cash will go to further de-lever the balance sheet.

6/30/04 New Capital Structure

Common – 7.659mm
Options – 0.949mm
Convert Preferred – 3.937mm
Diluted Outstanding – 12.570mm

Cash - $2.3mm

ST Debt - $5.22mm at average of 4%
Debt - Series A Convert - $4.0mm at 9.0%
Debt - Series B Convert - $4.0mm at 9.0%
Seller Financed Debt – $2.53mm average at 7.0%

Total Debt – $15.75mm WAV IR of 7.02%

Net Debt - $13.45mm

Market Cap at $1.35 per share = $17.0mm

Enterprise Value of $30.4MM

Earnings / Valuation

We are basing our valuation on an annualized 2Q 2004. We believe this is the best way to look at CDV because they did a small deal in 2Q (bought Indiana branch). If anything, the fourth quarter tends to be the strongest (holidays business etc.) and second quarter can be on the lighter side. Thus, we are comfortable that annualizing 2Q and making some pro forma adjustments is a conservative and fair representation of the current state of CDV:

Quarter Annualized
Revenues $49.3mm $197.0

Operating Profit $0.466mm
Adjustment (1) $0.623mm
Adj. Op Profit $1.089mm $4.356

Interest Expense $0.453mm
Adjustment (2) $0.177mm
Adj. Int. Exp $0.276mm $1.106

Pre-tax Profit $3.250
Tax Rate 40%
After Tax $1.950

Per Diluted Share $0.155

Total D&A $0.347mm $1.388

EBITDA $4.994

Adjustment #1: Write-off of financing amortization costs resulting from the recap. This is one-time and non-cash.
Adjustment #2: Accounts for the fact that the recap was done part way through the quarter and therefore interest expense for the quarter is a function of the blend between the old cap structure and the new cap structure. The new capital structure will result in about $1.1mm in interest expense per year and this adjustment reflects the full effect of that change.

Therefore, based on current share prices CDV is trading at 8.7x EPS and 5.3x EBITDA. It is also worth noting that CDV has very limited capex requirements which run at about $500k - $750k per year (mostly IT spend). This suggests an EBITDA – Capex to EV multiple of ~6.1x (a decent proxy in this case for pre-tax FCF to the enterprise). Thus, we think CDV is good value on the current numbers – but, we think there’s more to the story than that.

Management has said that the company would be a lot more profitable at this revenue level if it were not for the fact that they have been investing in people to grow the top line. They believe they can now effectively sell national account business just as DDN does. In pursuit of this they’ve added a number of bodies which are reflected in the large tick-up in SG&A to $8mm in the 2Q. We expect this to be the new run-rate going forward. There’s a significant continued opportunity to grow the business as their $200mm in run-rate revs represents a very small share (<2%) of the overall same-day delivery industry (estimated at $10-$15bn). Based on discussions with management and industry trends, we believe the company can grow the top line at 10%+ per year. As operating leverage kicks in we expect very strong EPS growth.

In addition, gross margin has been running at about 19%. CDV has run at over 20% gross margin at certain times in its history. Any tick-up in gross margin would drop significant earnings to the operating line (extra 1% of GM = incremental ~$2mm in operating income.) We believe that industry pricing will rationalize itself somewhat when VEXP is ultimately is forced to restructure itself. Up to this point VEXP has been fighting tooth and nail with pricing to hold on to business (went from 6/01 revs of $470mm to current run rate at about $270mm.) We would hope that CDV will experience better than 20% gross margin once the VEXP situation plays itself out. We consider potential gross margin improvement as incremental upside to our core thesis but we are not relying on the industry achieving more rational pricing behavior.

Investment Summary
- Company emerging as #2 player in growing national business; capitalizing on opportunity to take share from troubled competitor
- Recent recap takes risk out of the capital structure and lowers interest expense
- Significant cash investment by management demonstrates their belief in the company and their conviction that they can increase the share price
- Profitability under new capital structure somewhat masked by transaction costs and timing of the recap
- Underlying profitability means CDV trading at very reasonable run-rate multiples of 8.7x EPS and 5.3x EBITDA with solid earnings growth expected
- Valuation attractive relative to comparables
- As illustrated by the recent quarter, CDV is in growth mode and as operating leverage kicks-in we should see solid gains in both revenues and earnings

Catalyst

Catalysts
- In the 3Q the true underlying profitably of CDV will become apparent when the full effect of the recent recap works its way through the numbers
- CDV should continue to announce new business in their national accounts program and as they take customers from a challenged VEXP
- Expiration of rights offering should take overhang off the stock
- Potential for VEXP to go Chap 11 or 7 and industry pricing to rationalize
- General continued execution and greater transparency in their improving operations / earnings