Sunday, July 28, 2013

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  

18 comments:

  1. Excellent post.

    Here are some more articles about UNTK with a humorous twist:

    http://bit.ly/16FB9CZ
    http://bit.ly/16kvRij
    http://bit.ly/16kvUuq

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    1. Well done on getting in early. I enjoyed those posts.

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    2. Hi,

      I am the owner of the EngineeredReality blog and the writer of the above articles about UNTK (but no the person who posted the link here!)

      I appreciate that you enjoyed the articles.

      There is, of course, a number of different ways to analyze the data, but so far the company's equity has come back strong from the $1.25 that I once upon a time computed as the bottom, and I, for one, look forward to where it will max out. Certainly, all else aside, this does not look like a $30 million company.

      In the (very) short term the issue will be the impact of the restatement on the per share price (the lawsuit against the current CEO and the company is, to quote my uncle, a fart in a stiff wind,) and if the company can now FINALLY stay out of the mad-mad-mad acquisitions I think there may be some serious possibilities over the next years.

      In the short term there may be a set-back with the restatement (which will be severe,) but to my mind this is amply offset by the two bounces to the $2 (or so) range that we have seen.

      We will see, I guess.




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    3. I agree & and I think that the acquisition frenzy is now over for a long while.

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  2. Interesting situation, thanks for the writeup. After taking a look, I found a few issues not included in your analysis that for me are enough to make the company a pass.
    You seem to be basing your projections of future revenue and earnings on the 12 months to September 2012 numbers, but the company is in the process of restating every financial statement filed during that period. The company filed an 8K on June 14, 2013 with a brief update on their financial results, and estimates FY2012 revenues of $437 – 441 M. This is already $60 M less than your starting point for future projections. Subtracting the $60 M shortfall from the 12 months to September 2012 E&C revenues leaves the segment with revenue of $137 M for 2012. You can double check this by using the numbers from the 8K and making one or two fairly straightforward assumptions based on historical financial information. I get an estimated 2012 E&C revenue of $135 M. Pretty damn close.
    Looking past 2012, the company acquired DirectSat in September 2012 which will add ~$30 M of fulfillment revenue to your 2013 estimate at ~25% gross margin, but the company also disposed of their wireline operations which will have a large impact on E&C revenue. According to the 8K filed January 4, 2013, wireline accounted for $70 M of revenue in 2011, $48 M in 2010, and $40 M in 2009. Wireline only did $40 M of revenue in the first 3 quarters of 2012 and the division was written down and sold. It was low margin revenue (~8% gross margin), but that’s a significant chunk of E&C revenue gone. Wireline was only disposed of at the end of 2012, so the loss of revenue will only show up in 2013. Using the E&C revenue estimate of $135 M above and subtracting an estimated $50 M revenue for the full 12 months of 2012, you’re left with only $85 M of E&C revenue for 2013, just over a third of your projection.
    I also think your estimate of interest payments on the term loan is low. The amendment detailed in the 8K filed July 31, 2013 adjusts the interest rate up 2% to LIBOR (with a 1.5% floor) + 9.5%, so 11% interest. That makes annual interest payments ~$2.6 M higher than your calculation. Add in interest from the revolver and annual interest payments are something like $20 M.
    Adding up everything above, I get cash earnings of ~$5 M in 2013, improving modestly thereafter. With the amount of debt the company carries, a market cap of $30 M doesn't seem far off the mark to me.
    Like I said, thanks for the writeup, I really enjoy the blog. I’m curious to hear your thoughts on the above points.

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    1. Interest on the term loan incurs 4% of PIK on top of the 11% interest, so it's really 15%.

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    2. Thanks for taking the time to comment. I've started from the June 14 guidance and come up with the following as a lowball estimate of forward underlying EBITDA.
      https://docs.google.com/spreadsheet/ccc?key=0AoCLhoPnjQDgdEFTT1pEdnhVSVhadnU4MmZ4YV9YSmc#gid=8

      I can't see the debt not being refinanced at lower rates. I should have made that clear in the post. I see the term loans costing 8.5% in cash interest going forward.

      Zooming back a little, the equity is worth at least 5x EBITDA less debt, so something like 60 now and 100 down the road. There are what it's probably fetch at auction. So the question is whether UNTK can service its debt well enough to stay out of trouble for 3 or 4 years. I think it can.

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    3. Regarding the re-fi of debt: What if rates increase in 6 months or 1 year? Is there sufficient margin of safety to accommodate such an increase or is the situation too leveraged?

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    4. The way I see it, it's unlikely that rates will increase so much, in such a short period of time, that refinancing at less than 11% is not an option. Stil, at rates currently in force, I see cash earnings of approx 17 million and increasing as debt is paid down.

      The margin of safety is an interesting issue in this context.

      We've seen already that it is not so easy to take the company private via a quick Ch 11. The company's primary asset is the Master Service Agreement with DTV and DTV will file a 180 day termination notice as soon as there is a default.

      Now, the lenders own 20% of the equity via the warrants so, from their perspective, a 180 day shot clock and bk fees and the likelihood of higher bids is not attractive. In their shoes I'd prefer a 20% stake of a healthy company that I can sell on later at 3 or 4 times its current face value than risk losing it all in a process they likely won't be able control.

      But, of course, anything can happen and everyone will see the risks differently.

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  3. How funny that the fired CEO Ron Lejman used to work for Cerberus Capital Management.

    http://www.linkedin.com/pub/ron-lejman/7/818/515

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  4. AT&T accounts for 17% of UNTK's revenue and according to the filing:

    "Company was recently advised that AT&T had significantly lowered the estimated amount of services relating to tower modification that it would be requesting from the Company. It is expected that the impact of the AT&T reduction will be approximately $21 million in revenue."

    How does this affect your estimates?

    A very leveraged situation here but I do understand that lenders don't wish to see it die (in bankruptcy).

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    1. The way I see it, AT&T accounted for 1% of sales in 2011 but 17% in 2012. Gross margins in E&C are ~14%. Assuming that AT&T work sports better gross margins than E&C average, say 20%, then that represents a loss of $4m in gross profit and ~1m.

      Is this reduction in work an AT&T issue, or an issue relating to AT&T's relationship with UNTK? We don't know.

      As I see it, the investment case relies almost entirely on UNTK's ability to refinance its debt: if it doesn't, the stock stays at these levels; if it does, the stock at least doubles.

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  5. leveraged to the hilt and 75% of revenues from 3 customers. that's the investment case. you lose one, you cough up another 20% in warrants.

    also by skimming the latest K, it appears to me the fraud resolution was just to shift the acquisitions earnout payments one year later? so these guys were buying contracts with their rollups, but their legacy biz started shrinking too fast, and they cant stop now, or they'll mess up your forecasts :)

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  6. I was following along until I got to " but their legacy biz started shrinking too fast".

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  7. Yeah, it just shows that skimming can be a dangerous thing....

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  8. Excuse my ignorance if my accounting knowledge is not up to scratch, but Im confused why your figures don't take account of the depreciation and amortisation at all.

    E.g. for 2012 it was $26,469(000) and a couple $m less for 2011.

    From what I can see the vast majority of this is a genuine cost of doing business i.e. the cost of the property and equipment needed to do the work. This is not something that can be removed for the purposes of calculated earnings (its basically a cost of revenue). I would expect a similar level of D&A in subsequent years, which wipes out any potential profit and means the company is struggling to break-even.

    What have I missed?

    Kevin

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  9. Hi Kevin,

    I've assumed that actual cash capital expenditure ("capex") is more representative of the maintenance capex required to keep the business running.

    The D&A figure has lots of items in it that do not, in my opinion, represent reserves for future capital expenditure.

    I should point here out that since I posted this, Unitek has released an amended annual report with updated figures. When it releases the 2 quarterly reports that it hasn't yet filed, I'll update the above and reassess where we are.

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