Description

In the past, we have written up shorts that have a combination of fundamental concerns as well as accounting concerns. We believe two angles of a short thesis help inform each other, and strengthen the overall short thesis. This write up is no different. However, in the current market environment we believe aggressive accounting sins of the past will really play out when there are substantial demand and cash flow shocks to a company. To put it another way, we paraphrase a Buffett quote: “when the tide goes out, we’ll find out who is swimming naked”.

We are recommending a short position in Cubic. Cubic is a provider of transportation and defense hardware and services, with the bulk of its profit made up from fare collection systems for state and local governments. The business has had a strong run of contract wins - $1.5bn in new contracts over the past 2 years. However, despite this the company has generated negative cash flow from operations cumulatively over two years, and has seen outsized growth in receivables and inventory along with a reduction in deferred revenue – with the combination suggesting the likelihood of aggressive accounting for fixed price contracts. 

As Cubic enters a post-COVID world, we believe massive ridership declines for major public transportation systems will impact customer capex decisions, pressuring Cubic’s revenue. In addition, state and local funding challenges will reduce the size of any future pipeline Cubic previously envisioned. While current Cubic contracts will come out the other side “whole”, they will most likely face implementation, approval, labor or funding delays (especially for recent contracts with NYC, Boston and Chicago). The company is 3.8x levered and is entering a period of considerable challenges for its earnings and cash flows. We believe bullish investors believe Cubic is insulated, and a market “leader”, but investors should ultimately wake to the fact the company is a lower margin, capital intensive business with true economic earnings well short of what is advertised.

Company Overview

Cubic (CUB) is a government and public services contractor. The company operates in three segments:

1. Cubic Transportation Systems: Provider of fare payment and related systems for state and international governments. The company has contracts for “turnstiles” across the globe: London Oyster, NY Metrocard, Boston Charlie Card, Chicago Ventra, SF Clipper, DC Smartrip, Sydney Opal, etc
2. Cubic Mission Systems: Federal government contractor providing products/support around communication and UAVs
3. Cubic Global Defense Systems: Federal government contractor for the training of military personnel

While the business is split 57% Transportation and 43% Mission/Defense, operating profit is 71% weighted to Transportation (pre-eliminations). While accounting red flags apply across the business, this write up focuses on the Transportation segment, which has the most compelling fundamental issues and makes up most of the profit. 

The Transportation segment is split across state/local governments (57%) and international governments (43%). In FY2018, Cubic has won a number of large contracts: New York’s new fare card system called OMNY, MBTA’s upgrade to the CharlieCard system, a contract for fare cards in Queensland, Australia, and an update to the San Francisco Bay Area’s Clipper system. In total, the company added $1.5bn (a 73% increase) to its backlog in FY2018 with these wins and increased its North American exposure. 

The bull case around Cubic combines their steady federal defense business with an upgrade and maintenance cycle across the globe of transportation systems - from 20-30 year old coin or fare card based systems to next generation, contactless payment systems integrated with mobile payments and smartphone apps. We’ve also heard competitors (Transcore and Conduent) have been beat out over the past few years by Cubic, due to a combination of price and past performance (technology), and so Cubic’s market position to win contracts has strengthened (e.g. if you have installed and run London’s Oyster Card system, you are most likely going to win the contract for NYC). And very long-term investors view Cubic as an integral company in the trend of “next generation connected cities”. The company has also made acquisitions to strengthen parts of the business and investors expect a steady progression of margin improvement.

More recently, in a world with COVID-19, a JPM research report (dated March 10th) upgraded Cubic and noted they had >80% revenue visibility due to its backlog, and a valuation that was a 14% discount to 3 year average EV/EBITDA. The note called Cubic a “Relative Safe Haven”. A similar note from William Blair on April 27th said the company “sold off like a travel stock, but it is not a travel stock” given its steady contracts. We see this “baby with the bathwater” story as misguided, as Cubic has its own niche, idiosyncratic COVID-19 narrative that is likely to have a longer tail than that of most “travel stocks”.

Accounting Red Flags

We believe this bull case misses alarming trends in Cubic’s financials coupled with a significant impact to Cubic’s Transportation segment in a post-COVID world, based on our industry checks. 

Accounting Background

Cubic’s contracts are structured as long-term fixed price deals (97% of revenue) - starting with a set of up-front payment around the development and delivery milestones of new fare systems. That is followed by a long tail period of services/maintenance that Cubic performs as the fare system is in operation. Cash payments are lumpy as Cubic hits milestones.

Cubic’s revenue recognition, however, is entirely smoothed out via percentage-of-completion accounting. This accounting method looks at the costs spent for a certain contract relative to the total estimated cost, and recognizes that portion of the total contract value as revenue. This is a common accounting method that we are all familiar with. However, it is worth noting that this gives management considerable discretion in estimating revenue. According to Cubic’s disclosure, a one percentage point increase in the profit margin recognized once a contract is completed, results in an increase in Operating Income by $6.5mm. So for 2019’s total Operating Profit of $86mm, if CUBIC thought their $3.8bn of backlog of contracts at end of life was a 15% margin instead of 14% margin (those numbers are just for example), they could increase current years’ total profit by 7.5%.

While we believe there is nothing fraudulent going on (it all falls within GAAP rules), we believe this ability to massage revenue and profit is too tempting for management teams who are trying to hit yearly or quarterly targets. After all, it is well into the future when they revise old contracts down, and if they continue to win new contracts it will barely be noticed. On top of that, 2018/2019 transitions to ASC606 accounting increased most company’s ability to recognize revenue early. 

We believe that in the current state of the world, management teams lose the ability to aggressively recognize additional revenue, as well as lose their pipeline for new deals, leading to considerable earnings revisions.

Accounting Concerns

We believe the accounting issues for Cubic boils down to three things:  

1. Revenue was recorded potentially aggressively, boosting reported sales/income. We see that by excess receivables that have been created on the balance sheet, as well as a steady decline in deferred revenue
2. Costs have been potentially aggressively capitalized on the balance sheet instead of expensed through the income statement, boosting reported income and margins
3. Free cash flow has been non-existent for over two years now. And CFFO would look even worse if you include a stretching of payables a recently-started factoring program for receivables

We touch on these three points below. Comparisons are unfortunately challenging due to ASC606 accounting, so we have presented it both ways for an apples to apple comparison. There are some additional nuances to Cubic’s contract with the Boston MBTA, which we have put in the appendix for those that would like to dig in.

Accounts Receivable and Deferred Revenue

Cubic’s balance sheet consistent of a number of receivable accounts - Billed, Unbilled, and Long-term Receivables. While the comparison has been made confusing due to ASC606, what we have seen over the past year is outsized growth in the “Long-Term” account, when compared to revenue. On an apples to apples basis, Long Term Receivables were up 62% year-over-year, while short term receivables on the balance sheet were down -1%. 

When we calculate days sales outstanding for all of these accounts, we see a steady growth in the account through FY2019, though moderating in 2H 2019. But in the most recent quarter, the long-term account is up 50% yoy. 

All of this nets down to say that a higher and higher proportion of revenue is non-cash and will be non-cash over the long-term, while recognized revenue is not growing nearly as much. It is important to note here that, given the percentage-of-completion accounting, this non-cash aspect could have at least two dimensions. The more benign, yet still problematic, would be the extension of more favorable payment terms in recent contracts. The second possibility is aggressive revenue pull-forward based on subjective project milestones.

We couple this look at Receivables with Deferred Revenue - an account which has been considerably down for two quarters now meaning Cubic is recognizing revenue on its previously collected customer advances faster than it is collecting additional advances:

Inventory

We also see an increase in Inventory, when compared to revenue, with Inventory to Revenue Days up 24% year-over-year, continuing a trend of being up all through FY2019. 

We believe this indicates either 1) slowing of inventory turns - either in physical fare machines or UAVs (or both), or 2) increasing cost capitalization related to fixed price contracts. Both explanations would be troubling. 

Free Cash Flow

While we understand that Receivables/Deferreds/Inventory can be a challenge to analyze/interpret, reported Cash Flow compared to reported earnings (or “adjusted” earnings that everyone focuses on) can be our “forest” in place of the trees. And when we look at Cubic over the past 2.25 reported fiscal years (since the start of the fiscal year of very high backlog growth), the company has generated a whopping negative $71mm of reported CFFO, compared to $263mm of reported “Adjusted EBITDA”. And much of the difference is driven by working capital. 

In fact, cash flow is worse than reported, as the company in the past 3 quarters started up a receivables factoring program, generating $41mm of proceeds and boosting cash flow. This is the first time in the history of the company they have factored receivables. Adjusting for this one time inflow, there is a $263mm to -$112mm swing from “Adjusted EBITDA” to CFFO over 2.25 years. 

Of that swing, over the same time period, $71mm of CFFO burn is related to acquisition/integration, enterprise IT spending, and restructuring costs. Even if we give them a pass for this spending, Cumulative CFFO excluding factoring is -$41mm vs. $263mm of “Adjusted EBITDA”. 

We’ll also add - CFFO was boosted by stretching out payables over the last 2.25 two years so cash flow could look even worse if this is a onetime impact and/or reverses. 

If we step back and look at the longer term, the CFFO performance of this business is troubling, and has been declining for 6 fiscal years now. And over the past few years, we compare this to the backlog growth chart that we noted in the overview section, above.

Management clearly knows this is a weakness for the company, and has put out a goal of improving FCF generation to 100% of GAAP net income cumulatively from 2020 to 2022. Note that in FY2019, the company sold a real estate asset for $45mm, and that is included in FY2019 Free Cash Flow for it to be 23% of net income. We don’t see how Cubic can hit these targets in the near to medium term. 

Fundamental Concerns

All of those trends lead us to ask “where’s the cash?”. There are a number of potential explanations:

1. Aggressive revenue recognition/cost capitalization
2. Delays or cost over-runs in projects
3. Delays in milestone payment from state governments
4. Meaningful milestones have not been hit yet
5. A lot of working capital is required for these large contracts

Regardless of the explanation, we believe that any of these answers (or a combination) should cause investors to question the long-term value that Cubic is generating from these large contracts. Even if we give them the benefit of the doubt, Cubic looks like a (working) capital intensive, low margin and lumpy business that trades at a double digit multiple. Perhaps they bid too low to win all these contracts from competitors in 2018? If we believe some of the other explanations above are valid, then forward cash flow and earnings for Cubic are going to be challenging while most are expecting a “steady” business. 

And perhaps most importantly - and where we spent the bulk of our time and conversations - is around what happens in a downturn scenario like we have now, especially given our thesis that Cubic is entering a challenging environment on unstable footing. 

It is not a surprise that Cubic’s major contracts, coinciding with population centers, are all experiencing major declines in ridership. While this table may be obvious, we’ve listed Cubic’s major North American system installs, with the bottom 3 being the most recent and largest contract wins for upgrades (representing some $200-250mm of annual revenue, or 10-15% of revenue):

In addition, we believe these transit systems are being hit with a “double whammy” - ridership is down AND transit employees (who are considered essential) have been getting sick. Most notably in NYC, over 5,000 people and over 80 deaths have occurred, causing public outcry around employee safety. 

We think this means that public transportation systems are going to be one of the hardest hit and slowest things to come back post-COVID. This is both on the consumer side (safer to take an uber vs. ride the subway), and on the governmental side as they try to control the number of sick workers and deal with the fallout.

We had a number of industry discussions to understand the impact to Cubic during these challenging times. Interestingly enough, we believe Cubic will be “fine” - contracts will eventually get done and paid for. However, Cubic will see an extended period of cash flow and earnings angst as public transit agencies figure out what to do over an extended period of time. This could include payment delays, delays on system rollouts, lack of labor, changing of scope, or even temporary deferrals of projects. 

For Cubic, while they do NOT get paid on a per-ridership basis, their contracts are major capex decisions. With major systems all running deficits for the foreseeable future, we do not see how meaningful capex decisions get made to upgrade fare card systems. Or if there is capex being spent (there is an argument that cities will want contactless payments), the rollout could be at a lower margin, or slower than the past, given budget constraints. This will likely create an air pocket for Transportation demand that will have a much longer tail to it relative to most COVID-impacted public companies.

Below we go through two of Cubic’s major, $500mm+ programs recently won (representing ~1/3rd of backlog):

1. NYC MTA OMNY - Prior to COVID, the MTA was slated for an aggressive 2020-2024 capital program at a cost of $51.5bn. That program included $650mm for the OMNY contactless payment program, which has already started rolling out (most notably on the 4-5-6 line). Half of the funding for MTA’s capital program was to come from congestion based tolls ($15bn) and additional taxes ($10bn). At current rates, the MTA is expected to lose $6bn this year, and we’re not sure how the city can roll out congestion pricing on time (Jan 1, 2021), so we believe this $51.5bn capital program is going to be challenged going forward. And due to labor issues, The OMNY system installation is currently halted. Although the MTA is asking for and getting additional state and federal funding, we still see considerable delays for capital the projects as a lot of these funds just cover a portion of operating losses.
   
   
2. Boston MBTA - Starting in 2018/2019, the MBTA embarked on a 2 year, $900mm project to upgrade fare payment systems. That program has hit a few challenges, according to the MBTA:
   
   “a combination of technical challenges, public desire for input and growing scope prompted re-evaluation….We had structured a contract in such a way that made some assumptions about our partner [CUBIC] and about our own capabilities and about what the community wanted," MBTA General Manager Steve Poftak told reporters Friday. "I think at the end of the day, all three of those assumptions were off, and what we've done here is a course correction." (12/9/19)
   
   According to Cubic’s latest 10Q, the contract was renegotiated in late December. A design and build phase through 2021 and operating phase from 2021 to 2031 was revised and pushed out by 3 years, to 2024.
   
   As mentioned before - Cubic is “fine”. They were paid $30mm for this contract modification. However, we question the revenue they already recorded and when the cash flow will show up, because of the original 2021 timetable? Will they have to restate prior profit already recognized?

One discussion with a former high-level Cubic executive indicated that for most of Cubic’s major projects, they would be entering a “cat fight” phase - sitting down and negotiating what happens to these contracts. In most scenarios, Cubic wins its fair share, with no contract cancellation. However, negotiations could last up to a year and during that time earnings and cash flow will be challenged. The former Cubic executive cited a time in the 1990s, when a $10mm cost over-run on an $200mm contract took one year to resolve, which included an accounting write off for Cubic. 

We also believe, from our industry discussions, that if Cubic’s contract (which would be hundreds of pages) had any type of “force majeure” clause, it could be exercised, which could put Cubic and the MTA into a prolonged legal battle. 

Finally, we see this pandemic as severely stressing state (and local) governments. These governments fund roughly 50% of most major transit systems (the other 50% comes from fare collection). So we think any plans for upgrades by other systems are going to be put on hold for a long period of time. One example would be rolling out the OMNY program to the LIRR, which was planned after a successful OMNY subway rollout and not included in backlog. 

Why This Matters

Cubic is a mostly fixed cost and levered entity. Other than manufacturing and installation employees, most of its workforce is fixed project-management, software development, and design/engineering type roles. According to a former executive, a 15-20% hit in top line could translate to a 30-40% hit in earnings. 

On top of that, Cubic is 3.8x levered on a pro forma basis after a string of recent acquisitions (all at 10-15x+ EBITDA multiples). A 30% hit to FY2020E EBITDA would take leverage up to 5x, not including any additional cash burn. 

In addition, Cubic has currently already back-end loaded its year, with ~50% of its full year EBITDA estimate to come during the 9/30 fourth fiscal quarter. Last year, the company experienced a similar pattern, throughout the year expecting ~50% of EBITDA in FQ4. They ended up missing expectations ($77mm of EBITDA vs. $81mm estimate) and guiding full year FY20 EBITDA at $180mm vs. $190mm estimates.

Valuation and Downside

While we don’t have a scientific way to know how much top line would decline, if we take top line down in aggregate 8% YoY, by reducing estimates for the Transportation segment by 20% this year and leaving everything else the same, we get to a ~13% reduction in estimates vs. consensus. This would imply a few month shutdown for the transportation business, similar to many other businesses right now. However we do not see a considerable snap-back in FY2021E as public transportation woes stay drawn out. With a modest cut in expenses, we get to EBITDA numbers that are approximately 30% lower than the pre-COVID consensus for Cubic and flattish margins.

If we apply a slight multiple discount to Cubic’s 3 year average (~10x), and include $100mm of additional cash burn during these trying times, we can get to >30% downside:

We believe both earnings and EBITDA can go even lower, given the degree of accounting red flags that Cubic has accumulated. According to their disclosure, if there was just a 2-4% change downward in expected profitability of contracts, the company would take a $13-26mm earnings hit in the current year (which would be roughly 15-25% of pre-COVID EBIT). That would be on top of any other revenue/earnings loss as contracts are stretched out and renegotiated and new installation contracts slow materially. 

Risks

• Additional large wins from metro areas looking to upgrade Transportation systems, despite budget shortfalls - mainly to accelerate contactless payments. 
• The company has talked about a robust pipeline, and bids they have put in for Hong Kong, Singapore, Montreal, Toronto, Dublin, as well as other unnamed contracts. Given Cubic’s momentum, it’s likely that they win many of these, however we believe awards on these contracts will be delayed with the global slowdown similar to Cubic’s existing contracts. Further, given the accounting concerns we have pointed out, Cubic has likely won prior projects with discounted bids.
  
  
• Company continues to over-estimate contracts using % of completion accounting leading to numbers “meeting” or “beating” estimates, which is good enough
• Since many of their contracts are in “maintenance” and some of the work (such as software development) does not require any physical, on-site labor, people view revenue as “protected”
• However we believe it becomes much harder to recognize as much revenue contracts have real delays associated with them, or there is not sufficient new business pipeline to keep “over-estimating”
  
  
• Half of Cubic’s revenue comes from non-transportation related contracts, and instead from the DoD
• While that may be the case for top line, most of Cubic’s profit comes from its Transportation segment which is where we focused
  
  
• Investors continue to ignore weak cash flow generation arguing contracts will pay off, as they have bid up the multiple of Cubic the last few years without giving regard to lack of FCF generation
• CUB’s multiple has expanded from 8-9x in 2015-2017, to 11-12x in 2018-2019. That is despite a decline in cash flow, so investors have seemingly bid up Cubic due to its competitive position/backlog, more so than its cash earnings. If cash continues to deteriorate, we see downside risk here

Appendix - Boston Contract

There is a particular nuance with Cubic’s Boston contract, which is structured in a consolidated, special purpose vehicle. 

We’ve been told the structure came about to allow for the MBTA to say the project is fully “Boston-based” so to do that they have:

1. Created a SPV, of which Cubic owns 10% while another design/engineering firm owns 90%
2. The SPV signed a contract with the MBTA, and then subcontracts the work to Cubic
3. The SPV has raised non-recourse debt through a revolver of $212mm (from local banks in Boston, as required by the state. This financing was at 7-10% rates, we’re told - higher than market rates)
4. Cubic receives milestone payments from the SPV, funded by this debt
5. The SPV will receive payments from the MBTA, eventually

Under GAAP accounting guidance, this creates a variable interest entity that Cubic is required to consolidate. So the debt receivable of the SPV shows up a financing receivable to Cubic - but since the cash is ultimately to be paid to Cubic, then a financing receivable is a receivable to Cubic for work performed.

In addition, the company muddies the water by adjusting FCF for the Boston contract to present FCF “as though the SPV was not consolidated”. Since Cubic is the one performing the work on the Boston contract, and that contract is clearly delayed, we believe it should not be added back. We’d also add that this level of complexity adds another area where Cubic can “massage” reported results.

Catalyst

• Further weakness in transportation or Cubics contracts (ridership, funding, delays, implementation, etc)
• Earnigns and guidance reduction