UK Portfolio 2014

The Premise

This is what I tell myself:

If, in the medium- to long-term, the prices of financial assets gravitate toward their underlying values it is because active investors identify mis-priced securities and buy them. Stock-pickers, in other words, are the invisible hand. 

And, within the set of stock-pickers, private investors enjoy important advantages over professional fund managers: (1) we have a wider range of equities to choose from; (2) we have the option to concentrate on our best ideas and to exclude our worst ideas; (3) we can refrain from buying stocks that we simply don't understand; (4) we can weight the components of the portfolio on a risk/reward basis (with special attention to risk) rather than on a volatility (or tracking error) basis; and (5) we can choose a time horizon of our liking without fear of the sack if we under-perform in the short-run; (6) we can invest according to any so-called "style" -- asset based, GARP, distressed, arbitrage, etc. And, most importantly, (7) we can't afford to blow up whereas, in many cases, they can.

If the above differences are indeed advantages, it follows that the success in investing comes from exploiting them to the extent that one can:  Don't blow up, ever (rule #1). Look everywhere, size-wise and geographically. Don't be a prisoner of a particular "style" of investing if you don't have to. Concentrate on your best ideas and weight them according to safety first (see rule #1) and potential reward second. Don't buy anything whose downside you haven't fully grasped. Choose an investing horizon that suits you and ignore volatility and tracking error in the interim. 

Grasping the whole story and the extent of the downside is, I think, a matter of practice and of effort, the rest is a matter of acting responsibly. 

Review of 2013

In line with the reasoning above, last December I constructed a model UK portfolio that I thought would outperform the FTSE 350 by at least 20% over this past year -- ~20% outperformance being, I think, reasonable compensation for exploiting the advantages listed above.

This was the outcome of the experiment in its first year:

There are a couple of errors of judgment in those picks and, if I had to do it over again, I would leave out the cyclicals (Dewhurst and Creston) and stick with the five "either-way" picks. (Or, if I were to include cyclicals I should have gone all the way --i.e. very cyclical and levered, like the construction companies.)

2014

In this the second season of the great British bake-off, I've constructed a model portfolio that looks like this:


Again, I hope for (and expect!) year ahead returns that are at least 20% higher than the performance of the FTSE 350 and, to repeat what I soothsayed last year,  two-year returns that comfortably exceed that of any statistical strategy tracked by Stockopedia. 

I have previously written about Lombard Risk, Howden Joinery and Lamprell. I was introduced to Quarto by Lewis and to International Greetings by Richard. Senior is a wonderful business (moat, return on capital, long term secular growth, visibility, safety) that is obviously undervalued at 16x trailing earnings. And Creston is (still) in the portfolio because I'm being stubborn. 

They're all mis-priced in one way or another. One way of looking at Quarto, for example, is as follows:

And from that perspective, a market cap of £33 million may be too low for what is, after all, a stable, profitable and growing business. And, if you believe that Quarto has begun a serious effort to de-lever its balance sheet then you may be able to envisage £10 million in annual reductions in debt plus $2.5 million in dividends that, together, return ~38% to Quarto's shareholders each year, without a re-rating of the multiple.   

Please remember to do your own research and use your own judgment. It is entirely possible that I have no idea what I'm doing.

Disclosure: I own shares of Lombard Risk and I have sold out of Northgate

Judges Scientific II

I wrote about Judges Scientific last year.  The stock is up quite a bit, yes, but is still a bit misunderestimated

It is trading at ~13x its underlying earnings even though the company has been reinvesting most its retained earnings at  37% rates of return.



The acquisition of Scientifica doesn't show up in the last interim financials. That could be why.

Disclosure: No position

Republic Airways Holdings - Contract Airline

There are few mysteries to this idea. RJET was once an entity operating two different businesses, (1) a nascent, branded low-cost airline, and (2) a contract carrier. The branded airline ("Frontier") was bleeding cash, has since healed, and is in any case to be sold in this quarter.  The price has more or less been agreed and, after all is said and done, the sale will add ~$75 million in net cash to the parent's balance sheet.

What will remain of RJET - the "Republic" segment - transports passengers on behalf of the legacies under contracts that see it compensated by departure. Fuel is a pass-through cost and Republic gets paid the same irrespective of how empty or full the flight.

The Republic segment's profile looks like this:

  
There are a couple of uncertainties: the American/USair merger may decrease demand (i.e. departures) slightly as the number of hubs is reduced, and the outcome of the labor agreement negotiations with its pilots may knock two percentage points off current run-rate EBIT.

So, at the low end, one might reasonably expect run-rate EBIT of ~$180 million less interest expense of $110 million for earnings of $70 million on a market cap of $500 million. (There are a billion dollars or so of useable NOLs, so RJET won't be paying taxes for a while).

The company will also have ~$270 million in cash at the end of the year, after the sale of Frontier and, given the strong cash flow generation from the business, it seems to me not unlikely that, say, $50m to $100m of that is paid out in the form of dividends.

Disclosure: I'm long RJET

Mayur Uniquoters - Artificial Leather

Mayur Uniquoters (“Mayur”) is an Indian manufacturer of (PU and PVC) synthetic leather.

Belts, shoes, wallets, jackets, handbags, sofas, motorcycle seats, steering wheel covers – leather and its substitutes have a long list of applications. 

Leather itself, however, is expensive, in short supply, pollutive, and in any case subject to some ambivalence in a majority Hindu country. If one has been to India, however, one knows that there’s nevertheless plenty of leather about. It is only recently that synthetic (polyurethane) leather has been able to mimic the real thing well enough to have gained acceptance as a substitute for it in the range of consumer products listed above.

The synthetic leather industry in India is, as one would expect, largely fragmented. The so-called “informal” sector accounts for half the market and the “formal” sector consists principally of Jasch Industries, Fenoplast, Manish Vinyl, V.K. Polycoats, HR Polycoats, Polynova Industries, and Mayur itself.  Jasch and Fenoplast are listed; V.K, HR, and Polynova are private, and Mayur is by some distance the largest of them all.

This is how the listed companies compare:

It is not hard to see, then, why Mayur has done well over the years. It makes more synthetic leather, faster and cheaper than its competitors. It can undercut them on price and it can deliver in greater quantities. It has the broadest client vase, the lowest cost of capital, and the cleanest balance sheet, and is therefore positioned as the most reliable supplier to the major consumer goods manufacturers up the value chain. 

Big orders mean greater capacity utilization, lower average cost, a larger and more diversified customer base, faster lead times, bigger orders, even faster asset turns, even lower costs and so on -- the classic hallmarks of scale economies. 

Once Mayur had reached a tipping point (in 2008-2009 as it happens), it was always going to take yet more market share. 

No wonder, then, that Mayur’s last ten years of performance look like this.

Figures are in 2003 Rupees, i.e. adjusted for inflation

Its share price is up 30-fold since 2009. (Nobody wanted it then, even at a dividend yield of 25%).

Figures are in nominal rupees.

As it stands today, half of Mayur’s revenues are attributable to footwear. The Indian footwear industry is the world’s second largest and the Indian footwear market is the world’s third largest. The “formal” sector accounts for nearly 25% of the domestic market and consists of a handful of large players – Bata India, Relaxo Footwears, Liberty Shoes, Action, Paragon Footwear, and the VKC Group (all of which are Mayur customers and the first three of which are listed). 

Let's focus on Bata because it is the largest, because its production is entirely directed toward domestic consumption, and because it sources 75% of its synthetic leather from Mayur. 

This is Bata:

Figures are in 2003 Rupees, i.e. adjusted for inflation

Bata India trades at 35x earnings on the sensible assumptions that (a) the formal footwear industry will increasingly displace the informal manufacturing sector; (b) India's economic growth rate over the next twenty years will exceed that of the mature economies; and (3) Bata's competitive position (branding, experience, distribution network) will see it share in this bounty.

Auto

Motor vehicles of one kind or another -- scooters, passenger cars, SUVs, tractors -- contributed to 35% of Mayur's 2013 revenue. It is the number #1 (and very occasionally #2) supplier of artificial leather to each of the above. It is likely that there will be more motor vehicles in India ten years from now and that Mayur will profitably capture a healthy share of that growth. This year and next it will add GM, Mercedes and BMW to its roster of significant customers, thereby venturing further into the global market.

The last two years has seen Mayur investing in capacity to address this future demand. It has increased its production capacity, of course, but it has also taken steps toward backward integration, allowing it to control the availability of good quality knitten fabric (from which artificial leather is manufactured), thereby reducing the rejections rate and increasing gross margins. 

Mayur pays out every rupee of earnings not reinvested for growth, and its growth investments are repaid within two years. It is 75% family- and insider-owned and has always treated minority shareholders fairly.

One doesn't have to rely on the consensus projections of 20% per year growth in Indian artificial leather demand to suspect that Mayur is good value at a 10% enterprise yield.

This is a high conviction, long-term position and I've sized it accordingly.

Disclosure: I own this one.

(November 17th 2013. Note: I started drafting this at the end of August. The share price has advanced a little since then. It wouldn't be out of the question that the taper, whenever it comes, could provide a (perhaps much) more attractive entry point. The headache is in setting up a brokerage account in India and how to do that is googleable).

An Update on Emeco Holdings

Some news from Emeco this evening/morning:

"Emeco Holdings Limited (ASX: EHL) ('Emeco' or 'the Company') today announced the amendment of two financial covenants under the A$450m Senior Debt Facility, (the "Bank Debt Facility").

Emeco remains in full compliance with its current covenants. Amendments to the Gearing Ratio (Gross Debt: EBITDA) and Interest Cover Ratio (EBITDA: Net Interest) covenants were sought to provide the Company with additional flexibility and headroom and to provide balance sheet certainty while it pursues the debt reduction strategy in FY14.

Amendments will apply for the period to 30 June 2014 at which point the covenants will revert to current levels under the Bank Debt Facility. As previously announced to market, Emeco will not pay dividends or pursue other capital management initiatives prior to 30 June 2014, and has extended this commitment to providers of the Bank Debt Facility during the period to 30 June 2014.

Current and amended ratios are as follows:

	Current Covenants	Amended Covenants3
Gearing (Gross Debt : EBITDA1)	<3.0x	<3.5x
Interest Cover (EBITDA : Net Interest Expense2)	>4.0x	>3.5x

1 - Rolling 12 month trailing Operating EBITDA

2 - Rolling 12 month trailing Net Interest Expense

3 - Amended Covenants apply to the USPP Notes

Other key terms of the Bank Debt Facility, including pricing, remain unchanged and Emeco retains full access to the Bank Debt Facility. Emeco did not incur any fees or charges from providers of the Bank Debt Facility in connection with the amendment.

Emeco is focused on reducing debt and continues to generate strong cash flow with net debt reducing by
$25m in the first quarter from $415m at 30 June 2013 to $390m at quarter end. Through the combination
of further cash flow generation, working capital release, asset disposals and lower capex, Emeco will deliver further reductions in debt through FY14.

Stephen Gobby, Chief Financial Officer, said "We have been pleased with the cash flow performance of the business this year despite the tough operating environment. Our focus remains on maintaining strong cash flow over the balance of FY14 in order to further reduce debt and ensure that the balance sheet of the Company remains robust."

-----

This is a cash flow story: a bad business environment means Emeco sells off its inventory to generate cash flows; a good business environment means it rents out its inventory to generate cash flows. Emeco's rental fleet is best understood as inventory, which means that Emeco is, among other things, a "net-net".

Addendum November 20th:

An update and clarification of sorts. There's a post on this name at Alpha Vulture and the company has very recently guided between $90 and $105 million in EBITDA for FY 2014. Given that Chile and Canada account for $45 to $50 million of EBITDA, $90m in consolidated EBITDA means that Australian utilization rates have fallen off a cliff, to a third of 2012's figures and a sixth of 2011 figures. 

Alright, so this is where margin of safety comes in to play. 
--> Emeco needs to keep debt below 3.5x trailing consolidated EBITDA.
--> 90 million in EBITDA implies 40% to 45% utilization of its 813 machines
--> which means that it can sell off some of those machines 
--> so the question is, at what discount to book it will offload them.

Here's a sensitivity table relating cash flows from operations, net disposals, and discounts to carrying value on the one hand, to Debt/EBITDA ratios on the other:

Projected DEBT/EBITDA Ratios:

assumptions: operating cash flows = $90m EBITDA minus $30m capex mins $29m interest.

Can Emeco sell 2 machines a week at 40% discount to book? I think it can. And if it can, then you may consider that at the end of 2014 liquidation value will look like this:

That's why I'm long the stock. This is not Caterpillar. I should say that I'm a true believer at this point and I suspect that the conversation at Alpha Vulture would be more nuanced than anything I have to add.

Disclosure: I own shares in Emeco

The Dolan Company - Law Services

It turns out that The Dolan Co. has been written up a number of times since I bought it so there's likely no reason to repeat what has been said here and here.

In brief, Dolan's a cross between The Daily Journal and Epiq Systems, but levered. It has mostly disposed of its unattractive operating units and is now in a position to generate somewhere between $23 and $25 million in free cash flow. There are covenant issues and management is in the process of negotiating these with its lenders.

Disclosure: I own a piece of DM

Update: November 8, 2013

I'm out of DM. This development adds an element of risk that I'm not comfortable with. (I no longer feel as though I have grasped the entirety of the narrative; that's the worst kind of risk to take on). There are other, clearer opportunities with similar upsides. Next week's quarterly conference call should provide clarity on the company's plans for raising the $50m.

Lombard Risk Management - Enterprise Software

Lombard Risk Management (“LRM”) develops risk management and regulatory compliance software and licenses this software to financial institutions. 

Risk Management

The risk management business is long established and consists mainly of COLLINE, a collateral management product, and OBERON, an institutional trading software product. 

When banks and businesses lend to each other some kind of collateral is often required in order to reduce counter-party risk exposure. The types and varieties of collateral have become ever more complex over time. “COLLINE”, Lombard Risk’s 10 year old collateral management product, helps lenders keep track of these. COLLINE is licensed to about 50 financial institutions – including Northern Trust and Société Générale – and is probably the leading product in its niche. 

OBERON is software for processing, valuation and risk management of trades involving interest rate and inflation derivatives, currencies, and money market and fixed income securities. Its pedigree is longer than COLLINE's and dates back to 1996, is accordingly well-established. Mature enterprise software products tend to be characterized by stable revenue streams and high margins, and management reports that OBERON enjoys just that.

In any case, the Risk Management segment looks like this:

Regulatory Compliance

Regulatory Compliance is the segment that presents LRM with strong, sustained growth opportunities as the regulatory directives such as COREP & FINREP, Dodd-Frank, EMIR, Basel III's CRD IV and CRR, and so on, take hold in the immediate and medium terms. 

Needless to say, reporting requirements are about to become a great deal more complex and comprehensive than they were, and Excel and scratch paper will no longer cut it.

COREP: 10x times the data

LRM, already the leading provider of compliance and regulatory reporting software in the United Kingdom (and among foreign banks in the US), stands to benefit. 

That it stood to benefit was not so obvious in years past, at least to me: the very complexity of the reporting requirements may have led one to reasonably suspect that financial institutions would call in the Accentures and the Moody's Analytics of this world who would then sell their partners' or their own software solutions, leaving LRM out in the cold. It hasn't turned out that way: LRM is taking share and is signing up new clients at a fast clip. 

This is what the Compliance segment looks like:

Looks measly doesn't it? That's where the opportunity comes from.

LRM (along with most enterprise software companies) reports revenue on a percentage of completion basis and the finalization of the COREP/FINREP regulations was delayed by 9 months to January 1st 2014. Lombard Risk's fiscal year runs from March to March, so the revenue recognition from the clients won thus far will be mostly recognized in the second half of the year. 

The Big Picture

There is, at the same time, a great deal of operating leverage at work: ~75% of the company's current costs are fixed meaning that incremental revenue above, say, 9.5 to 10 million largely drops to the bottom line. This is what the operating leverage looks like on a consolidated basis: 

and this is what the consolidated income statement should more or less look like:

We know that the company is more than half way through its major software development program, so we can deduce that capitalized development expenditure will look like this:

and free cash flow will look something like this:

Management

It is clear that LRM's sweet spot is at the junction of risk and compliance and management is therefore in a tricky, game-theoretic spot. It would like to see itself as a consolidator in that specialty and is evidently averse to debt. It would therefore like a strong share price as  currency for so-called "tuck-in" acquisitions and it is perhaps this that has led them to talk up the value of the company -- not quite to the point of vulgarity but not far from it, either. 

In any case, I don't doubt that, in the final analysis, they could sell the company for two or three times its current valuation if they chose. (IDOX, after all, was spun out from LRM; they are no strangers to the M&A market). 

Value

LRM is worth more than its current market cap. Given its growth profile, 5 year contracts, and 95% client retention rate, 10x 2016 EBIT is probably at the low end of fair value, giving the shares a reasonable 100% to 150% upside.

Disclosure: I own some shares in LRM

Unitek Global Services - II

So now we have a clean set of updated numbers:

The company has generated positive FCF of 7 million in the TTM which may or may not reverse in the second half of the year: it may need 150 days of working capital in Q3 which would translate into an extra $7-1$10 million in additional cash required to fund the quarter, or it may have improved its cash conversion cycle so that the additional working capital requirement is negligible.

If it doesn't make it through to the next 10-K, the bankruptcy case may look something like this:

Assuming that Apollo would prefer 49% of $89.8 million to 25% of $3 million in the absence of the NOLs, the bankruptcy put may be ~$45 million to the common.

If it does make it through, then we're most likely looking at $20 million in cash earnings that grow over time -- through refinancing, debt paydown, organic growth, and a possible clawback.

This is an aggressive conservative investment and it's important to rely on your own research and intelligence rather than on my judgment.

Addendum: October 17th

Someone much smarter than I sent me a note that pointed out that (1) the value of the NOLs would likely be severely impaired in a BK because the company would have undergone a change of control, and (2) the EBITDA multiple envisaged for the enterprise might be too conservative because

(a) this is a line of work in which relationships and revenues are recurring and stable -- that is, attractive in its own right; 

(b) competitors could strip out a great deal of the administrative costs in the event of a takeover; and

(b) rivals may vie not to let the other guy achieve scale on the cheap.

I've amended the base case scenario accordingly to show the range of possibilities:

I do still think that a BK filing is an improbable outcome. As my correspondent noted, the service disruption that may result -- customers not getting their DTV connected in the busy season -- may have prompted Unitek's customer(s) to prepay some of the accounts receivable to make that scenario less likely. That may be where the improved cash conversion came from.

In any case, as with most distressed situations, there's a lot to think about and hitting on the most plausible narrative is the main thing. 

Portfolio Update

Over the last two weeks, I have sold out of Conrad Industries, doubled my Emeco position, and bought stakes in Mayur Uniquoters, Alaska Communication Systems, Republic Airways Holdings, and The Dolan Company. I have also converted about half of my position in Hawaiian Holdings into $5 and $6 call options expiring at various dates between September and April.

 In addition, I had been accumulating a stake in Axia NetMedia but my ambitions were cut down when the company unexpectedly sold its crown jewel for a pittance. I sold the shares I had bought just a few days earlier for a ~10% gain.

It’s been a long, long time since I’ve held so many different names. It feels like chaos.

Dart Group: Looking back & looking forward

When I looked at Dart Group last year it was undervalued: it could have easily generated unencumbered cash sufficient to pay off its liabilities to its creditors and to cash out its shareholders at the value of its market capitalization. In other words, it was a pretty good cigar butt at least and maybe more – one didn’t have to think too much beyond that. 

Since then, as everyone knows, the share price has almost quadrupled. A nice trade that I missed out on because I was thumb-sucking over the 10p that I’d have to pay for the airline (I valued Fowler Welch at ~60p and I wanted Jet2 for free).

At the current market cap, however, more scrutiny is required. Jet2 is a low cost airline. Or rather, Jet2 competes with low cost carriers. Now, in that particular market, what matters is unit cost: people will fly with you if you’re cheap and they won’t if you’re not.

 Jet2's route map. 50% of its traffic is to Spain.

To date, competition has been muted: Ryanair and Easyjet have been busy frying other fish. So Jet2 has been filling its planes, earning profits on ancillaries, and funding its growth via 0% interest bearing loans from its customers in the form of deferred income. This has added up to a high ROIC.

But a high ROIC is not evidence of competitive advantage. Sometimes a high ROIC is built 

into the nature of the sector (every advertising company and recruitment consultant has a high ROIC) and sometimes it is a function of the fact that the competition hasn’t come for you yet.

So, as I say, what matters in price competition is unit cost. And unit costs in the airline business are denominated in “cost per available seat kilometer” (CASK) in Europe, and “cost per available seat mile” (CASM) in the United States. 

This is how Jet2’s CASK compares with the two low cost carriers that are most likely to compete with it in the future:

Consider now that Jet2’s loss of the one quarter of the Royal Mail business will raise its CASK further. Consider also that Ryanair and Easyjet fly much shorter routes than Jet2 does (it costs a great deal more per kilometer to fly short routes than long ones).

Suddenly, there’s cause for concern: if Ryanair, say, decides that it wants to fly holidaymakers from Bradford to Alicante, it can price the flight much lower than Jet2, Jet2's bookings will fall, deferred income will fall, cost per passenger will go up, Jet2 ticket prices will have to go up,  and the negative spiral will be firmly  in place. 

What was a high ROIC operation frolicking in a Jacuzzi of cash can very quickly become a low ROIC business suffering from liquidity problems as the legacy airlines have long since discovered.

A note on the figures:
1. I have taken average stage length of each airline from a source I know to have been reliable:
http://centreforaviation.com/analysis/jet2com-strong-fy2013-profit-growth-hides-major-challenges-120030

2. Royal Mail flights are 10% of Jet2's departures and Royal Mail flights have numbered 16 per weeknight, implying that total annual departures for Jet2 = 16 x 5 x 52 x 10 = 41,600 flights per year.   

3. We know the composition of Jet2's fleet (and Ryanair's and easyjet's) so that we can use the maximum seat configuration to arrive at a figure for average number of seats per departure.

4. Together, these give us available seat kilometers (average stage length x annual departures x average number of seats per departure).

5. Short flights are more expensive per kilometer than long flights; they are more taxing on passenger, luggage, and aircraft handling, airport fees, etc. In order to adjust for this, industry convention uses the following formula: a multiplier  -- (average stage length of airline X/ average stage length of all airlines)^(1/2) -- is applied to the CASK of each competing airline to arrive at a cost per equivalent seat mile. If one wants to know how the cost structures of Jet2 and Ryanair would compare on the same route, the cost per equivalent seat mile is what one wants to know.

6. Applying the cost per equivalent seat mile to the distance between two airports (Leeds-Bradford ("Bradford") and Alicante results in a cost figure that can be used to compare the cost structure of two airlines. Small differences (10% or less) don't matter too much but large differences matter a great deal. In this case, it appears that Ryanair could price the flight at a 10% mark up and still charge half Jet2's fare.

7. That may explain why Jet2 is so keen to generate revenues from ancillaries: the more it earns from in-flight extras, the more competitive it can make its ticket prices. One can see that tickets are already priced at below cost. Can such a strategy survive the future attentions of Ryanair or easyjet? Each person must judge that for him/herself but I, for one, doubt it.

This post was corrected, amended & extended on August 21st

Disclosure: No position in Dart Group

Unitek Global Services

Unitek Global Services, listed on the Nasdaq, is a contractor with two business lines: (1) it installs and maintains home satellite and cable connections on behalf of DirecTV and Comcast (the “fulfillment” segment); and (2) it performs network engineering, design, construction and project management for the wireless and cable broadband industry (the “E&C” segment).

The fulfillment segment is Unitek’s bread and butter. It earns its revenues under long-term, fixed-fee master service agreements and therefore enjoys high revenue and gross profit visibility and those modest competitive advantages that accrue to regional scale.  Small, independent contractors are losing business (and/or selling themselves) to larger regional players like Unitek and MasTec. Fulfillment’s revenue growth, therefore, has mostly come from acquired and organic market share gains. The benefits from DirecTV’s own market share gains and the benefits from increased subscription churn have been lesser tailwinds. 

The E&C segment, on the other hand, is Unitek’s growth business: increasing demand for broadband wireless has meant increasing infrastructure capex by the major wireless service providers, and Unitek’s E&C segment has benefitted from its association with AT&T in particular. These are trends and relationships that will more likely than not continue over the medium term although, in competing with the likes of General Dynamics, Bechtel, Quanta, and Dycom, its gross margins in this segment will necessarily remain modest.  

Regional scale economies and some modest customer stickiness ought to translate into a reasonably profitable business earning low-to-mid teen returns on capital and, after shedding itself of unprofitable geographies where it had no scale Unitek’s underlying performance conforms to those expectations: 

Unitek's footprint, by segment

The strategic use of the word “underlying”, however, and the fact that Unitek’s market cap is $30 million, lets us know that there is more to this story.

First, and least interesting, is that with amortizations of debt discounts and acquired (non-operating) intangibles, noncash impairments, transaction costs, and all the rest of it, the difference between GAAP earnings and underlying earnings is comically substantial:

Second, in taking on a substantial amount of debt to fund its acquisitions, Unitek was inviting a near-fatal accident. And, when it acquired Pinnacle Wireless in 2011, that invitation was accepted: a year and a half later, an investigation by the Board’s audit committee discovered fraudulent revenue recognition practices at Pinnacle; the CFO, Controller, and division president were terminated; and the company was unable to file its 10-K and, later, its 10-Q’s, on time. It received a notice of suspension from Nasdaq, of course, but more important for our purposes, its inability to file financial statements triggered a default under the terms of its borrowings.

At this point, its lenders could have taken it to Ch. 11, wiped out the equity and brought it back under their ownership. (Between December and April, the share price fell by a quarter and holders of the common fingered their worry beads; between April and June, the market cap was cut in half as even the devout fled).

That the lenders (and Cerberus, especially) did not do so ironically reflects the value of the business. (I think we can all agree that a business that generates $25 million  of free cash flows to equity is worth more than $30 or $60 or even $90 million). In a Ch. 11 process, transaction prices would have been high, the administrative fees as extravagant as usual, and the implied returns to the acquirer therefore low. And besides, DirecTV had served Unitek with a 180 day notice of termination which meant that time was tight.

The lenders’ alternative option – one that promised higher returns – was to add penalties (warrants for 20% of the equity, please!) and higher interest charges on the debt. And that, in the end, was the outcome.   

So, Unitek’s future, under highly conservative growth and margin assumptions, looks something like this:

Apply a conservative multiple to 2016 earnings, discount back to the present, subtract the inevitable cash costs related to the forensic audit, the refinancing, and any litigation costs that may arise from the alleged fraud at Pinnacle Wireless, and Unitek’s value is likely two, three or four times its current market cap, even with the 20% dilution. At the other extreme, as Unitek de-levers and grows, MasTec will be an imperfect, but good enough, comp and MasTec trades at 22x.

Disclosure: I am long Unitek Global Services