Riley Investment Management Discloses 5.9% Stake in World Air Holdings (WLDA); Expresses Disappointment, Wants a Sale
A Copy of the Letter:
Ladies and Gentlemen:
Riley Investment Management holds approximately 6% of the outstanding shares of World Air Holdings, Inc. We wanted to share with you several concerns that we have as a large shareholder. Clinton Group, your other largest shareholder at 5.3%, touched on a few of these issues in their recent 13D filing. We believe that their opinions and ours are shared by virtually the entire shareholder base.
In summary, our concerns include the company’s continued weak financial controls and ongoing late public filings, the allocation of shareholder capital, and the absence of shareholder representation on the Board of Directors. We have detailed these concerns in more detail below. The lack of urgency shown on the part of management and the Board of Directors to address the financial issues is unacceptable for any publicly-traded company and, coupled with the lack of shareholder participation which could lead to change, seems to us to be a large part of the reason why the shares of the company trade at a 28%-50% discount to our fair intrinsic value calculation. We value WLDA stock at $13.60 - $16.00 per share on a fully diluted basis. This is based on a 5-6x EBITDA multiple (assuming $60 million 2007 EBITDA estimate and $40 million in net cash on the balance sheet). We think new shareholder participation on the board can lead to more disciplined controls and cause World Airways’ share price to be fairly valued.
Additionally, we note the company has stated publicly that it is currently reviewing strategic alternatives which may include selling the company. We believe that the company should be sold or taken private and urge the company to aggressively pursue such a strategy. If this is an avenue that the company is seriously considering, we do not understand why it has been well over six months since Legacy Partners was retained to explore strategic alternatives and no progress or announcements have been made. We request that the board of directors immediately enter into discussions with us, with a goal to add significant independent shareholder representatives to the board of directors and demonstrate to the owners of the company a commitment to maximize shareholder value. Although the items listed below are very detailed and numerous, we feel that it is necessary to help you understand the constant and unresolved problems at the company.
The company’s continued and repeated weak financial controls and numerous late filings are inexcusable. Management has blamed many late filings to the North American acquisition, but that acquisition occurred about two years ago. Furthermore, these problems suggest lack of proper due diligence before the acquisition and highlight the need for stricter board supervision of management
Since the North American acquisition closed, the company has been late filing each and every 10Q and 10K, and had to restate 2Q05 results. The company also delayed filing its 8K related to the acquisition until October 20, 2005 – 6 months after the deal closed – citing accounting issues and the need for a re-audit of North American’s historical financial statements. In a November 14, 2005 press release announcing that the company would need additional time to file its 3Q05 10Q, Randy Martinez said, “we are still in the process of implementing new financial processes and controls at North American…” We strongly feel that these accounting issues should have been identified prior to the acquisition and during the due diligence process. At worst, they should have been quickly addressed and corrected within a few months.
After several extensions granted by Nasdaq and the eventual delisting of WLDA shares from Nasdaq on May 22, 2006, the company finally filed its 2005 10K report on July 7, 2006 and its 1Q06 and 2Q06 10Q reports on August 1 and September 5, 2006 respectively. Management suggested at that point that it had implemented the necessary financial controls required to file within a reasonable time frame going-forward. Specifically, Randy Martinez was quoted in the company’s September 5, 2006 press release saying “We are now in position to return to filing timely financial results.” This led many shareholders to believe that quarterly filings for the last two quarters of 2006 would be on-time and a Nasdaq re-listing would happen in the near-term. However, on November 14, 2006 the company again announced that it would require additional time to file its 3Q06 10Q report and would miss its deadline to file on time, due partly because the company had recently initiated a review of its accounting for stock option grants. Four and a half months later the company has still failed to file its 10Q for 3Q06 and has announced that it will require additional time to complete its 10K filing for 2006.
Weak financial controls have been compounded by continued poor guidance. During the 2Q06 conference call, management displayed optimism about the military business in 3Q06 and 4Q06, as the slower AMC business in 2Q would be offset with a pickup during the second half of 2006. “We are entering a busy second half, and have already experienced an increase in activity since the end of the second quarter,” said Randy Martinez in the September 5, 2006 press release. However, during the conference call on November 14, 2006, the company gave a considerably weaker outlook for 4Q06. The disappointment promptly sent shares from about $8.80 per share to below $7.40. Moreover, on December 27, 2006, the company revised downward its guidance for 4Q06.
Allocation of Shareholder Capital
While we view the recently completed Dutch tender offer as a step in the right direction, we believe shareholders would benefit if World Air Holdings were to adopt a more appropriate capital allocation policy going forward. More specifically, World Air Holding’s dividend policy should reflect the company’s strong recurring cash generation. The company has generated positive operating income in 17 of the last 19 quarters (the most recent shortfall due largely to the temporary penalty imposed by the military in 2Q06 which should not reoccur). Over this span, the company has reported $140 million in operating income and over $75 million in net income (even after debt issuance costs and non-recurring items) but has paid no dividends. After accounting for the share repurchase of approximately $40 million, the company currently has over $30 million in cash, representing $1.20 per share, and is debt-free. With no interest payment obligations, World Air Holdings should have no problem committing to an ongoing dividend. Such a commitment would demonstrate a clear plan to continue to return cash to shareholders and would signal confidence in the business going forward.
Board of Directors Lack of Oversight
The Board of Directors has failed to provide a level of oversight and diligence that would be expected of a public company and we think new members with a significant ownership stake can improve this record. The late filings and restatements that we mention above were partially blamed on the re-audit of historical accounting records at North American, an issue that was not acknowledged until well after the acquisition closed. The Board of Directors apparently did not fulfill its duties when they approved the North American acquisition, because it appears they failed to ensure there had been proper due diligence prior to the approval of the transaction. This is particularly alarming since a few of the Board members have private equity backgrounds. The cost of inattention to oversight has been huge: as stated in the company’s 10K, extra professional fees of $5.6 million were incurred from the failure or inability to identify these issues in advance. These unnecessary professional fees associated with the acquisition (which include closing costs, legal, audit/re-audit, and accounting) in addition to the $1.4 million in direct acquisition costs that were capitalized. Fees paid to the company’s auditor, KPMG, jumped to over $6.3 million in 2005, from below $1.1 million in 2004. Had there been more attention to the integrity of North American’s financial statements before committing $35 million in shareholder cash for the acquisition, the excessive professional fees could have been much more reasonable (specifically, $1.4 million total versus $7 million total ) or a lower price could have been negotiated. This is wasted shareholders’ money that the board should have focused on protecting. Stated another way, a $35 million transaction ended up costing $42 million (roughly a 15% increase in price) due to poor execution and oversight.
In addition, we are concerned that the Board and management did not conduct a thorough process in retaining Legacy Partners Group LLC to advise the newly appointed special committee on exploring strategic alternatives. At the time of retention, the Legacy Partners website showed that the firm had participated in only one deal within the transportation sector over the past four years. Our fund has been involved in overseeing numerous M&A transactions since we sit on the board of directors of several public companies. We believe that a Board that is serious about its duty to shareholders would have seriously considered using another firm. During the hiring process, we received calls from a few well-qualified investment banking firms informing us that they were not given an opportunity to be interviewed even after repeated phone calls to the company. This was even after we had called the company and suggested that they interview other firms in which we have had great success.
Shareholder Representatives on the Board
We would like to enter into immediate discussions with the Board about adding members with significant shareholder positions to the Board of Directors. We intend to assist the Board in aggressively pursuing strategic alternatives for the company, which we believe would be in the best interests of shareholders. In our view, the presence of large shareholders on the Board enhances oversight and financial discipline. Again, there are currently no significant shareholders on the Board. The largest beneficial owner on the Board is Randy Martinez, with 65,752 shares of stock plus 343,000 options with a weighted-average strike price of $3.70. Note that these shares were granted, not purchased like the rest of the shareholder base. The largest independent shareholder-director is Russell Ray, with 157,070 shares plus 20,000 options with a weighted average strike price of $2.22. Taken together, Mr. Ray’s ownership represents less than 1% of the shares outstanding. In short, since the majority of the Board of Directors does not own a meaningful amount of stock and to our knowledge have never purchased stock, we do not believe the Board has the sense of urgency felt by the shareholder base.
Finally, below we have highlighted a timeline of the constant mishaps over the past few years. As you will see, issues and problems have not been rare events. As one of your largest shareholders, we believe we speak for the rest of your shareholder base in demanding that the Board of Directors move more aggressively to address our concerns, the first step being to appoint significant shareholders to the Board of Directors.
Riley Investment Management LLC
John Ahn, Principal