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  

Portfolio Update

I have taken a small position in Unitek Global Services. It's messy, this one. I'll write it up over the weekend.

The Forest for the Trees

Note 1:

Note 2:
Technology & content expense = 2/3 maintenance, 1/3 growth

So:

6.6% normal margin x Revenue of $61,093 Revenue = $4,032 normalized profit

Amazon's grown at 33% over the last ten years and 40% over the last five years. If Amazon grows at 10% for next ten years, the stock is worth $375.

Tell me this isn't a Buffett stock.

The Power of Float

This is Amazon.

Assumptions: 10 Year forward growth at half the trailing 10-year growth rate. 8% cost of capital, in line with Walmart.

Northgate Plc -- Vehicle Rentals

Northgate buys vehicles (vans, overwhelmingly) and rents them out, on a monthly and yearly basis, to small and mid-sized businesses in the UK and Spain. 

Fleet management is done centrally, and sales are generated through a network of local offices.  

The advantage of this kind of operational structure is that (1) rental pricing, based as it is on intimate, local knowledge of the customer base, tends to be sensitive to demand, ensuring a high fleet utilization rate (90%) with very little variation.; and (2) fleet size and distribution across locations can be optimized with very little trouble – it is not hard to reduce the size of the fleet (the market for used white vans is liquid and robust) and it is not hard to move  vehicles from one rental location to another .

Add to this (3) the purchasing power derived from buying tens of thousands of identical vehicles from the same manufacturer (Ford, in this case), and (4) the benefit to credit risk management from local knowledge of the customer base, and one can anticipate that Northgate earns returns on its operating capital that are some 3 or 4 percentage points above its cost of capital – perhaps 13% as against a cost of capital of 9%.

In fact, the profit spread is a little higher, an almost 8 and a 1/2 point spread – 17.5% against a cost of capital of 9%.

The extra, unanticipated value is derived from the tax benefits of the excess depreciation that Northgate is able to record.   Northgate reports depreciation of its vehicles that is some 37% higher than its actual maintenance capex requirement. The tax benefit of this over depreciation amounts to an extra 1.8% return on invested capital.

  

So, Northgate can be expected to earn 17.5% returns on operating assets of 780 million. Discounting at a cost of capital of 9%, this places the value of the business at 1,514 million, and subtracting the non-operating items leaves us with equity that has an intrinsic value of 892p per share. Which means that Northgate is trading at almost a 1/3 of its value.

One would think that Northgate is an attractive acquisition candidate – it could be bought by either a private equity firm or by one of the large vehicle rental companies at a price halfway between price and value (say 575p) and satisfy both parties. The Times reports on rumors of just such a possible purchase, but at a price of 400p. It seems to me that this is the worst case scenario.

The Northgate writeup at Expecting Value and at Share Sleuth  are well worth your time.

Disclosure: No Position 

Postscript: 

I calculate maintenance capex as follows (follow along in the 2nd graphic, above):
The average dollar cost of fixed assets required to support a dollar of sales is $1.68

Sales have risen from 338 to 646 million over the last 10 years, which therefore implies that growth capex is approx (1.86 * (646 - 338)) = 687 million

Since total actual capex in that time period is 1,735, it follows that maintenance capex is total capex less growth capex = 1,735 - 687 = 1,048 million.

Now this 1,048 million in maintenance capex is substantially less -- almost half -- than the 1,985 million reported as depreciation over the same time period. 

I therefore adjust annual depreciation expenses downward by 52.7% in order to arrive at a more accurate maintenance capex and annual profit figures.

These adjustments get us much closer to the true economics of the business. I credit the company for tax shield from the excess depreciation that it is able to record because it is a permanent feature of its strategy.

FreightCar America -- Railcars

FreightCarAmerica (“RAIL”) makes and sells 80% of the coal cars in the United States. Its customers are railways, power companies, and leasing firms. 

RAIL has a couple of competitive strengths: 

• many railcar purchasers prefer to maintain a standardized fleet of railcars, making RAIL, the incumbent, the preferred supplier of coal cars; and 
• it has the capacity to manufacture 15,000 units a year in its plants at Danville and Roanoke, meaning that, in most years, it operates below capacity. 

Competition based on design is therefore as unlikely as competition based on cost.  And, given the high cost of transporting railcars across the ocean, competition from provenances with low cost labor is not a concern  

Looking back

The business has generated an average of ~$34 million per year in operating profit on average operating assets of $96 million, for an average return on invested capital of 35% -- a fair reflection of its competitive position

18% of this operating profit was used to close down a unionized plant, a nonrecurring expense, and 45% was paid out to owners. 15% of the operating profit was reinvested for growth.

The story in railcar units:

Looking forward

Core business – replacement coal cars

There are currently 270,000 coal cars in operation in the US and 3.7% of them – 9,950  – have needed to be to be replaced in an average year, 7,950 of which have been manufactured by RAIL.

At an average selling price $75,000 and an average gross margin of 11.75%, this recurring, though lumpy, business of replacing old coal cars has generated $590 million in gross profit since 2005. 

The coming business cycle calls for approx. 79,000 coal cars – those aged 30 or more years old today – to be replaced. Moreover, the coal cars to be replaced are made of steel and need to be exchanged for the more efficient aluminum cars which are RAIL’s specialty. The average replacement rate, therefore, is going to be comparable to the past eight years: 9,875 cars per year, perhaps 85% of which will be supplied by RAIL at an average price of $80,000 per unit. 

After overhead expenses and taxes (net of the NOL carryforward), the average annual operating profit from this core business is therefore going to approximate $36 million a year. 

Leasing

In order, it says, to smooth revenues across the business cycle, RAIL entered into the railcar leasing business in 2008. Setting aside the long-term wisdom of competing with its customers, the minimum revenue schedule over the next few years from this segment is knowable – about $5 million per year. 

Services

RAIL has also, via acquisitions, strengthened its commitment to providing railcar maintenance services in the busiest rail traffic corridors in the US. We can expect this segment to contribute another $4 million per year in after-tax profit.

RAIL’s total minimum earning capacity over the next business cycle, is therefore, about $45 million per year ($3.78 per share). Bearing in mind that RAIL pays out what it doesn’t reinvest for growth, we can project that, in the absence of the an incident like the closing of the Johnstown plant, it will pay out its excess cash and at least 75% of its operating profit, for an average of $3.10 per share per year, which is not bad for a stock priced at $18 and change. 

More conventionally:

It's a wildly cyclical stock, so everyone tries to time it. Some brokers even have a sell rating on it. The only real risk with this stock -- the only one that I can see --  is that it might be acquired at $25 or so by an outfit like Berkshire. The concerns over the near-term death of coal are founded more on hope than fact. 

Disclosure: No position 

Edited for typos on Oct 19th

Instem Plc

Instem provides software applications to the early development drug and chemical R&D market. Its clients use these applications to collect, analyze and report complex scientific data; comply with regulatory reporting requirements; improve quality, consistency and efficiency of information reporting; and to reduce the time of critical path R&D activities.

 

Provantis

Its principal product is Provantis, a suites of modules for managing and recording Early Development Safety Assessment (EDSA)  studies, from receipt of the compound through to the automated assembly of statistical analyses and final reports, allowing scientists to collect, analyze and share data, whether at one central site or remotely. Provantis promises to make their work easier, faster, and less prone to error. Remote deployment of Provantis is made possible by secure centralized data centers in Shanghai and the US;  Instem has partners that maintain the system 24 hours a day, 365 days a year.

The EDSA market is a modestly-sized, and Instem has been, for more than ten years now, the market leading provider of information solutions for that market. Half of the world's pre-clinical drug safety data has been collected over the last 20 years via its software; it has over 9,500 users of its solutions and supplies over 130 customers, including sixteen of the world’s top twenty pharmaceutical and biopharmaceutical companies. It has two competitors – Xybion Medical Systems and Pathology Data Systems in the European and North American markets – but Instem’s user base is approximately double the size of these two combined.It has an average client relationship exceeding 10 years and a 95% customer retention rate. Approximately 65% of its  revenues are recurring.  

In any case, Instem has also been increasing its penetration in the established Japanese market as well as in emerging other-Asian markets, particularly China. Instem reports that it won the overwhelming majority of new EDSA business placed worldwide in 2011 and that it has secured a record evel of new customers for Provantis. The most recent upgrade of the Provantis offering, in 2012, places Instem in a position to capture an even greater share of the EDSA market and to expand into other, closely related, markets such as safety pharmacology studies, drug metabolism and pharmacokinetics studies.

Centrus

Its other main product line is Centrus,  an application which grabs legacy scientific research data, transforms it into an easy-to-use format, facilitates communication between the "discovery" & "clinical" functions in a drug development value-chain; and produces SEND datasets in a few simple steps (SEND is the regulatory standard for the transmission of research data). The Centrus offering was strengthened in 2011 by Instem's acquisition of  BioWisdom, an app for extracting intelligence from R&D related healthcare data. As it stands, Centrus is like CRM software, only for raw scientific data.

Centrus is making its market -- there were no competing products when it was launched some 5 years or so ago,  and there are none today. Instem "spotted a gap in the market", as Alan Sugar would say, and they have developed the product and the market from scratch.

In any case, one can, from the above, more or less divine what the numbers are going to look like: 

 

As laboratory working practices change -- the growing prominence of multi-site working and outsourcing to contract research organizations and so on, as well as the adoption of new standards – Provantis and Centrus are likely to benefit.

Instem is a good business with a 7% CAGR since its AIM listing. It shouldn't be yielding 15%. Still, there is some cyclicality to this business, especially in the awarding of new business, and a conservative 9% hurdle rate is probably called for, easily placing the value of its shares at more than 2x the current price.

Disclosure: No position

PS: The trick to valuing this stock is to normalize properly. It is a cyclical business, so taking the average NOPAT margin of 17.84% and applying it to this year's revenue will come close to specifying the current earning capacity of the business, £1.93 million. Discounting at 9% (or applying an 11x multiple) gets you to a no growth earning power value of £21.39  million. Screens can't easily capture this: to them it looks like Instem is currently trading at 11x earnings, as it should be.