Wednesday, August 22, 2007

Advanced Environmental Recycling Tech: Quality Decking -- Lousy Stock

You should not buy a stock because it's cheap but because you know a lot about it. ~ Peter Lynch (Former Fidelity Magellan Fund Manager and Author)

If that were true—would we not all be millionaires? The 10Q Detective believes that this advice—taken out of context—has probably lost more monies for investors than it has made for them.

Advanced Environmental Recycling Technologies (AERT-$1.43) manufactures a line of low-maintenance composite building products, which are used as a non-wood alternative building material for the homebuilding market, including decking, door and window components, and exterior trim.

A read of online message boards is swimming with glowing testimonials from owners of AERT’s product(s). How many—we wonder—are from the approximately 1,600 holders of record of the Class A common stock?

The Company’s proprietary
MoistureShield decking is formulated from a mixture of recycled wood fiber and plastic for long lasting beauty and low lifecycle cost. Unlike traditional wooden decking, composite decking material does not need staining, painting or sealing to maintain its natural look. The deep wood grain texture has the appearance and texture of real wood, and its water/termite resistant composition shields the wood fiber from moisture and rot damage.

The Company’s revenues are derived principally from a number of regional and national door and window manufacturers, regional building materials dealers and Weyerhaeuser, the Company’s primary decking customer.

AERT’s recycling and manufacturing facilities make Decking board, handrails, and stair applications for Weyerhaeuser under the
ChoiceDek brand (carried exclusively at 1,300 (+) Lowes Home Improvement stores).

You shouldn't just pick a stock - you should do your homework. In our view, this is sager counsel from the Fidelity stock-picking legend.


Net sales for the second quarter ended June 30, 2007, fell 9.8% to $25.3 million compared with the prior year. Despite a strategic plan to diversify its distribution channel, which includes leading national companies such as the Weyerhaeuser Company, Lowe’s Companies, Inc. and Therma-Tru Corporation, sales to Weyerhaeuser still comprise about 80% of total gross sales.
MoistureShield decking sales were up 75% year-over-year (and comprise about 10% of aggregate sales), but ChoiceDek decking sales were lower by 15.6 percent. Ergo, overall decking sales were down 7.5% versus second quarter 2006.

Sales of OEM parts like door rails (to Therma-Tru Corporation) and windowsills (to Stock Building Supply Co.) were down significantly (41%) from the prior year because of the slowdown in new home construction.

In 2Q:07, gross, operating, and net margins fell 14.5%, 13.2%, and 7.6%, respectively. Year-over-year, raw material costs increased 680 basis points, due to the increased use of colorants and additives and increased use of higher grades of polyethylene. In addition, the slowdown in the building products industry translated into lower unit volume sales by cabinet and hardwood flooring manufacturers—meaning less scrap wood fiber available for purchase by AERT (acting to raise the cost of wood raw materials).

In addition, slower sales left the Company with some under-used manufacturing and administrative capacity, which increased overhead costs relative to sales and reduced profit margins.

The net loss for the 2Q:07 was $(383,919), or $(0.01) per share, compared with net income for the 2Q:06 of approximately $1.72 million, or 4 cents per share.

Liquidity and Capital Resources

At June 30, 2007, AERT had a working capital surplus of $365,604 compared to a working capital deficit of $(3.5) million at December 31, 2006, due primarily to a $5 million financing from Allstate investments in June 2007. Loan proceeds were used to reduce accounts payable and pay down a working capital line of credit, among other uses.

Hold the applause—the balance sheet is weaker than management makes it out to be: back out $16.3 million and $1.8 million of inventories and prepaid expenses, respectively, and AERT is running a working capital deficit of about $(10.2) million.

Operating cash flow for the six-months ended June 30, 2007, was $(4.73) million.

AERT’s capital improvement budget for 2007 is currently estimated at $4 million (excluding a proposed new waste recycling facility in Oklahoma, which is designed for less desirable, but low cost, forms of waste polyethylene and additional sources of waste wood fiber), most of which will be funded from either cash flow or a long-term lease.

The 10Q Detective applauds AERT’s management for looking to lower its cost of goods structure, but moving forward with the initiative will require monies not in the Company’s strongbox—yet. For example, just the first phase of the Oklahoma project will require $15.0 million in financing.

AERT is looking to the Adair County Oklahoma Economic Development Authority to finance the construction of the proposed new waste recycling facility through the issuance of tax-exempt industrial development bonds. Although the Company recently received initial regulatory environmental approval, there is no assurance that the anticipated funding will materialize. Without funding, AERT would have to pay for a large portion of the project costs from cash flow, ensuring the project would be delayed.

Approximately $3.5 million was available to borrow on an existing $15.0 million line of credit at June 30, 2007.

Long-term debt currently gobbles up 77 cents of each dollar in shareholder equity.

AERT will find it difficult to tap the credit markets, for AERT is currently in violation of two covenants from a 2003 bond agreement with Allstate Insurance Company: (i) accounts payable (not more than 10% of a/c payable in excess of 75 days past invoice date / June 2007: 11.1%) and (ii) debt service covenants (long-term debt service coverage ratio for last four quarters of at least 2.00 – 1.00 / Jun 2007: -0.03).

Corporate Governance

Irrespective of the Company’s cyclical financial and stock performance, AERT has been kind to the Brooks family.

Matriarch Marjorie S. Brooks, who beneficially owns 30.1% of the total voting stock, is the secretary, Treasurer and a director. Her sons, Joe G. Brooks, Stephen W. Brooks, and J. Douglas Brooks are the Chairman and co-Chief Executive Officer, co-CEO and director, and senior VP-sales and marketing, respectively.

In the second quarter of 2007, the Company purchased approximately $894,000 of certain of its raw materials through Brooks Investment Company, which is controlled by Marjorie S. Brooks. Additionally, the Company was charged interest costs by Brooks Investment Company of approximately $6,000 related to those purchases!

Mrs. Brooks is paid a ‘credit enhancement fee’ for providing a personal guarantee on the balance outstanding on the Company’s $15 million bank line of credit. This fee is intended to compensate Mrs. Brooks for her $4 million personal guarantee on the Company’s industrial revenue bonds. For the three and six months ended June 30, 2007, the Company recorded fees of $68,284 and $132,681, respectively, related to this arrangement.

On May 29, CEO Joe Brooks disposed of 247,000 shares (at $1.41) that he exercised at 46 cents to 56 cents per share.

The prior month, brother Stephen sold 500,000 shares (at $1.52) that he acquired via previously awarded stock options at strike prices between 38 cents – 56 cents per share.

Time has not been as equitable to long-suffering Class A stockholders—unless they were good market timers: The price spiked from $1.70 in January 2006 to an intra-day high of $3.71 on June 15, 2006. Save for that anomaly, the share price has quietly tiptoed around the $1.50 level for the last five years.

Investment Thesis

Despite weak conditions in the building materials industry, AERT believes that sales can rebound in the 2H:07. Management’s growth and profit strategy is focused on (1) increasing sales, (2) increasing gross margins, (3) lowering overhead costs, and (4) reducing debt-servicing payments.

Granted, AERT has a contract with Weyerhaeuser requiring the integrated forest products company to purchase a minimum number of truckloads of ChoiceDek Premium decking and accessories, which amount was set by Weyerhaeuser each year subject to a minimum annual quantity of 1,850 truckloads—irrespective of inventory levels. Nonetheless, in a summary of its 2Q business performance on August 3, Weyerhaeuser told investors: “weak demand in housing continues to affect” the wood products segment (which does not bode well for growth in 3Q decking sales at AERT).

AERT is looking capture customer sales by expanding its wood composite footprint in the $5.1 billion outdoor decking (deck boards and handrail systems) market. Wood/plastic composite products total only about 19% of this market, but an independent, industry group estimated that annual unit sales of wood/plastic composite decking products grew about 25% per year from 2000 to 2005 and are expected to continue double-digit annual growth for the foreseeable future. Most end-user sales are for remodeling jobs.

AERT is introducing three new ChoiceDek products (and a minimum of two colors stocked) in all stores and expanding its MoistureShield decking product line into nationwide distribution by the end of the first quarter of 2008.

Although the 10Q Detective agrees that AERT’s core competency is extracting value from turning recycled plastics into new products, management has yet to demonstrate that it can successfully launch a non-deck product. For example, the Company is behind schedule in launching its new outdoor fencing product (LifeCycle).

In addition, even though the new Springdale South factory is finally operational, we believe margins will continue to be adversely affected by continued management inefficiencies (less than expected demand for expanded product offerings) and rising raw material costs. The onus is on management to show that it can execute on streamlining logistics and increasing automation to improve yield and lower labor costs.

Given the uncertainties as to when and at what pace existing business segments will recover, the 10Q Detective is avoiding purchase of AERT shares.

You have to research the company before you put your money into it. ~ Peter Lynch.

After doing our due diligence on AERT, we do not beg to differ on this advice.

Investment Risks & Considerations

The loss of one or more key customers could cause a substantial reduction in revenues and profits. As previously mentioned, AERT’s principal customer for its decking material is Weyerhaeuser, which accounts for about 80% sales. In addition, Therma-Tru and Stock Building Supply each purchase a large portion of the Company’s industrial products.

AERT’s products are used primarily in home improvement and new home construction. The home improvement and housing construction industries are currently subject to a cyclical downturn caused by general economic conditions. In particular, the present credit crisis has lead to reduced homebuilding and/or home improvement activity. A sustained reduction in such activity would have an adverse effect on the demand for AERT’s products.

Future sales of shares could be dilutive and impair AERT’s ability to raise capital. The conversion of a significant number of existing outstanding derivative securities into Class A common stock could adversely affect the market price of the stock. At December 31, 2006, there were “in-the-money” warrants outstanding for 4,606,132 shares of Class A common stock at an average exercise price of $1.21, and options outstanding for 2,872,130 shares of Class A common stock at an average exercise price of $1.09. The exercise or conversion of a material amount of such securities would result in a 16% dilution in interest for other security holders.

Editor David J. Phillips does not hold a financial interest in any of the companies mentioned in this article. The 10Q Detective has a Full Disclosure Policy.

No comments: