The Shoes Begin To Drop At Gas Natural

Since our initial report on Gas Natural (EGAS), which warned that EGAS is not a "widows and orphans" utility company, the ensuing news flow has been foreboding. We cautioned investors that sticking around to collect a 5% dividend yield was like picking up pennies in front of a steamroller.

The subsequent events of the past four weeks reaffirm our view.

1. Auditor Resigns: The most ominous development of the past four weeks is the resignation of Gas Natural's auditor. On December 16th, EGAS received a notice of resignation from ParenteBeard LLC, the registered public accounting firm responsible for auditing the company's financial statements.

A change in auditor is never a good sign for a company. Often it calls into question the accuracy and reliability of a company's financial statements. The complexity of the EGAS business model, which combines regulated utility companies with unregulated subsidiaries, along with the pervasiveness of related-party transactions makes the EGAS financial statements inherently opaque.

Companies do occasionally switch auditors for valid reasons but it is very rare for an auditor to fire a company. Auditors for public companies simply don't resign for no reason. The competition for these types of clients is fierce and the resulting business is lucrative. Given how hard it is to win auditing business, it seems odd that ParenteBeard LLC would just walk away from the EGAS relationship without a reason. With Q4 coming to an end, we think the timing of the auditor's resignation suggests they are looking to avoid complicity in the upcoming annual 10-K filing. The annual report (10-K filing) is unique from the other financial filings because it contains a section called "Report of Independent Registered Public Accounting Firm" whereby the auditor attests to the accuracy and integrity of the financial statements. We surmise that ParenteBeard LLC resigned at this time of the year so that they could avoid attaching their name to the 2013 10-K.

The SEC requires companies to file a 10-K within 90 days after the end of the company's fiscal year. The fiscal year for EGAS ends on December 31st. EGAS is currently without an auditor and we believe there will be a steep learning curve for a new auditor to get up to speed on the disparate businesses. We think it is likely that EGAS will have to delay the filing of its 2013 10-K.

2. Federal Lawsuit: We think most investors are unaware that a lawsuit was filed against EGAS in federal court on December 10th (Wickham v. Osborne et al). EGAS has not disclosed this lawsuit as of the published date of our report. The lawsuit includes many of the complaints cited in the 2013 Order from the Public Utilities Commission of Ohio but it also contains new information from a former company insider, "Whistleblower 1." According to the lawsuit, Whistleblower 1 worked in the EGAS Controller's office providing accounting functions and working with the Company's auditors in preparation of its annual audits. When questions were raised about EGAS practices, employees were terminated, including Whistleblower 1.

Just like the PUCO Order, we think this document should be read in its entirety by everyone considering an investment in EGAS.

Here are the most significant excerpts:

"The Board has acquiesced to Defendant R. Osborne and his self dealing, even permitting the issuance of false and misleading financial statements that did not accurately portray these self dealing transactions between the Company and the private entities controlled by Defendant R. Osborne.

For example, according to WHISTLEBLOWER 1, in connection with the Company's financial audit for 2012 fiscal year end, the Company's purported independent auditor (ParenteBeard LLC) raised an issue with respect to hundreds of thousands of dollars of outstanding receivables owed to the Company by private companies controlled by Defendant R. Osborne.

The audit committee, which is customarily charged with discussing issues raised by the auditors in connection with the audit, permitted the Company to effectively forgive these amounts via adjusting journal entries designed to basically manufacture payment. According to WHISTLEBLOWER 1, Defendant R. Osborne and the Company orchestrated a scheme whereby Northeast and Orwell wired money to EGAS's Montana subsidiaries, Northeast and Orwell were then issued credit memos by Defendant R. Osborne's private companies, and then EGAS went to great lengths to find ways it could claim that it had previously overpaid these private entities."

"Moreover, the Company would engage in various schemes to overlook the obligations of these entities to EGAS' various subsidiaries. As described above, auditors declared that the Company would have to write off receivables from these entities. Defendant R. Osborne initially instructed Ms. Howell to fire the auditors, however this wasn't a realistic option with the Company's 2012 annual SEC filing due in such a short time frame. Thus, a scheme was orchestrated whereby the receivables were covered by Northeast and Orwell and then the private entities issued credit memos. The credit memos effectively were a method of forgiving the debts owed. According to WHISTLEBLOWER 1, Ms. Howell, then began to examine ways to offset the credit memos by seeing if more gas had been sold then had been charged for and even suggesting the billing method for these entities could be changed to incrementally increase the revenue going to them.

The Company's auditors indicated that they would test whether the credit memos described above were properly applied. Although he was told he would get whatever he wanted done, Defendant R. Osborne was cautioned with respect to the payment of future invoices he requested where credits were used to offset them would be given enhanced scrutiny by the Company's auditors."

3. CFO Resigns: The Chief Financial Officer of EGAS, Thomas Smith, announced his resignation less than two weeks after our initial report. As we pointed out in our initial report, Mr. Smith sold 87% of his stock in November.

4. President & COO Resigns: President and COO, Kevin Degenstein, resigned from EGAS on November 21st. Mr. Degenstein had held these titles for the past 5 years and was a 31 year veteran of the energy/utility industry. The new President & COO is Gregory Osborne (age 34) who is the son of Richard Osborne.

The CFO and President/COO are two of the top three most-senior level executives at EGAS which means that EGAS has lost 2/3 of its senior management team since our initial report. Following these departures, Richard Osborne (CEO) is the only remaining senior executive.

5. New Related Party Transactions: Given all of the recent turmoil and scrutiny regarding the related party transactions at EGAS, it stands to reason that EGAS would lay low for a while. Amazingly, EGAS continues to enter into new related party transactions. EGAS filed an 8-k after the market closed on Christmas Eve that disclosed the company entered into a 25 month lease for a warehouse owned by Cobra Pipeline Co. LLC, an entity that is controlled and owned by Richard Osborne (the CEO). The lease calls for EGAS to rent a 2,400 square foot warehouse for $2,000 per month. This equates to $24k per year or $10 per square foot per year. We analyzed other available warehouse properties in the area and found the average asking lease rate to be $2.00 - $3.50 per square foot per year. In other words, EGAS is paying 3x the market rate to lease a building that is owned by an entity controlled and owned by Mr. Osborne. The dollar figures are small in this transaction but the action speaks volumes. The level of defiance (or obliviousness) is staggering and suggests that EGAS management has no intention to clean up the corporate governance issues.

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Conclusion:

Each of these developments may have an innocent explanation but, taken in aggregate, suggest trouble ahead. The unfortunate reality is that these sorts of events are often harbingers to bigger, messier situations. The occurrence of massive insider selling, executive turnover, and auditor uncertainty are almost always precursors to corporate calamities, including this well-known Texas utility. We are not claiming that EGAS is the next Enron, but we do see a high probability that EGAS will have to restate its financial statements once a new auditor is in place. We think the stock has material downside risk due to potential PUCO regulatory action, financial statement/auditor uncertainty, and executive management turnover. Sadly, we view EGAS as "un-investable" until a new auditor has blessed the financial statements and the PUCO investigation concludes.

Source: The Shoes Begin To Drop At Gas Natural

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

Additional disclosure: The author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be accurate as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information. This article represents best efforts to convey a fact-based opinion. Our conclusions may be incorrect. This is not a recommendation to buy or sell any securities. This document does not in any way constitute an offer or solicitation of an offer to buy or sell any investment, security, or commodity discussed herein or of any of the affiliates of the Author.

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