FABRICE UPDATE TO FREE SUBSCRIBERSPresident's Club - REGULAR - update on LOY Loyalist Group (LOY.V) finally released its audited financial results for the year and fourth quarter ending 2014 as well as for the first quarter. The short-form recommendation is that unless you’re prepared to aggressively average down your position and be very patient and risk-tolerant you should sell and take the loss. Here's why: While many investors were braced for a restatement or fraud, as often happens when results are delayed, there were none. But there was far more bad news than good, and as an owner of hundreds of thousands of shares, I’m shocked at how quickly this business deteriorated. I think a fraud would have been easier to deal with. Let’s go back to the beginning of this year when we decided to get back into this name which, in the past, has made us a LOT of money. The latest financials available at that time were for the first nine months of last year, which should operating profits of $7.2 million on revenue of $52 million (which was more than twice as high as a year earlier.) That, combined with the prospect of student housing, looked like a good bet. It wasn’t. Why? A total failure of cost and liquidity management. While revenues and gross profit for 2014 were up more than 100%, the company posted an operating loss for the year of $4 million. Given that it had made $7.2 million in the first nine months, that implies an operating loss of $11 million in the fourth quarter alone. The net loss for the year was $19.5 million but that includes $15 million in write-offs for goodwill and intangibles, which are not that serious in this case.** Costs have simply spiralled out of control. Total overhead for the year was a staggering $26 million, including almost $10 million in head-office salaries and wages (more than tripling from 2013) and advertising and promotion expenses of $8.2 million (almost four times more than 2013). The sales and marketing expense is perplexing given that Loyalist paid agencies $15 million to send students to its schools. Why is it spending on advertising?? The company also spent $8 million on rent, which is astonishing, and as I understand it has never used a tenant representative, which likely would save $1 million a year or more. It’s clear that while the company made good acquisitions, there was simply zero cost discipline. By keeping operating costs in line with the prior year Loyalist would have earned about $7 million or more in operating income. Instead the company’s auditors have issued a going-concern clause, which casts doubt on its financial viability. Given a revenue decline and continued high costs in the first quarter, it’s clear Loyalist needs an emergency source of funds. I spoke to the new CEO, Shawn Klerer, and he said LOY's assets are good and could be nicely profitable but that he needs time and money to fix the problems, which include the bank. Loyalist owes $9 million and has breached its covenants so the bank will demand payment. It could do it now but will give the company some time. A raise is inevitable in the near-term, assuming there’s any demand, and that will be highly dilutive to existing shareholders. Unless insiders pony up a LARGE amount of money I don’t think it happens. I’m told they are prepared to do so. Former CEO Andrew Ryu has been replaced but stays on the board. Two other directors walked the plank. While I see the potential for signifiant cost cuts that would restore profitability, I’m leery about a couple of things. First, Q1 showed a drop in revenue year-over-year. This was the result of a loss of a contract with the Saudi Arabian government. The company says it can win this business back. But it makes me wonder what kind of top line the company can truly produce, especially if it cuts costs. Second, Mr. Ryu told us that the business was in good shape when LOY raised money a couple of months ago and that the financing was for an acquisition. The nine-month statement from last year supported that claim and Mr. Ryu bought stock in December ($50,000 worth). But the notes to the recently released financials show that he lent the company $1 million last year. If he’s lending the company emergency money how can he tell us that the company was in good shape? The money raised two months ago was used to pay for the out-of-control costs, not for an acquisition. That creates a massive credibility gap and partially explains why he’s no longer CEO (although still a large shareholder and director). The new CEO, Shawn Klerer, seems capable but it’s unrealistic to expect him to have a firm grasp on things at this early stage (he’s only been with the company about three months). He believes he can cut costs, and I believe that too because it’s obvious Mr. Ryu let them go. But there are risks on the top line that I don’t think are worth taking unless you are very risk-tolerant and very patient. Those in the recent private placement (I wrote the biggest cheque for that so believe me I share your pain) have no choice but to hold that stock until it’s free trading in a couple of months. The frustrating thing is that I saw the presentation for the student housing spinoff this weekend and it looks incredibly impressive (three months of research went into this plan, which is what really interested me about this investment. Shant Paladian has done a great job preparing it.). It may happen still, but it clearly relies on a healthy and viable Loyalist and that’s not the case at the moment so it’s clearly on hold for now. The important lesson for me here is that a small company that looks stable and seems to have a bright future can turn on you like a dime. Lesson learned, and we’ll make it back on the next one. **These assets arise during acquisitions and represent the difference between the fair value of the net assets acquired and the price paid. In a service-business acquisition one usually sees a significant goodwill asset created. I expected massive write-offs because when auditors delay financials for so long they need to show that there was a good reason for it. All it takes to create a massive write-off is to change the assumptions that underlie the value of an acquisition by one percentage point. The auditors increased the interest rate they use to discount future profits substantially. These write-offs don’t affect cash. Warmest regards, Fabrice Taylor, CFA | Publisher