A change of pace — against the windPosted: June 6, 2013
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Taking a position in Unitek Global Services was not entirely consistent with my investment paradigm, which generally involves avoiding debt ridden companies, since, in my view, debt, however small, constitutes a landmine ready to cause havoc on the shareholders at any time.
In fact, at the time of my investment in its equity, Unitek Global Services had substantial debt and associated nasty covenants, and, moreover — and much to my dismay, the company markedly increased its debt after my investment. However, at the time of my initial investment, the fundamentals — sans debt — looked very appealing and I noted that the debt had a very late maturity date, leaving ample time to refinance or repay.
Moreover, for once I actually had no significant issue with the increase of debt, since the company used this debt to trade out an existing division with an acquisition that had a lower revenue, but higher net income profile than the divested division.
All these considerations, however, were sidelined when the company terminated its CFO, its Controller, the principal from one of its divisions, Pinnacle, and several other employees on the tail-end of the uncovering of revenue fraud related to the the Pinnacle division.
Although the direct impact of the fraud is relatively limited and apparently well understood, the market’s reaction was adverse and immediate — dropping the per share price of UNTK to $1, or so, giving the company a market capitalization of less than $20 million for a company with close to $500 million in revenues — a large part of it anchored with DirectTV.
This drop and the resulting market capitalization fundamentally changed the prospects for investors in UNTK.
In my view, Objective Zero, the overall corporate objective prior to the announcement of fraud and the grotesque overreaction by the market, was to grow the company’s operations so as to pay down debt, causing an increase in the per share price, ultimately reaching a point where the per share price was sufficiently high to allow for an equity issue to allow the retirement of the debt, after which the corporation would begin to generate serious amounts of free cash.
This objective was timely (the company had several years to achieve it) and aligned very well with a fundamentals based investment, where the realization of a return could wait for a long period, but — in return — would be solid and significant. Naturally, the basis for this long term investment was the per share price of $3 to $4 which was very low relative to the company’s fundamentals and the limited risk of default as underscored by a recent S&P upgrade.
As I saw it, while the company’s objective remains the same (with, of course, the added complication that the company needs to manage the risk that has emerged from the covenants, the customer fallout, and the usual predatory law-firm stimulated securities fraud law suits,) a clear short term opportunity had presented itself in the form of an asymmetric risk/reward proposition, with the per share price falling to $1, or so, completely out of proportion to the fundamentals and with limited risk that the per share price would fall further.
Moreover, my expectation was that, once the fall is arrested, then, absent fraud being detected in other divisions, a complete failure in renegotiating the covenants, or the locking down of the customer base, the share price could only go up — and it would do so very quickly. In fact, I was expecting at least two doubles… first a double from $1 to $2, quite rapidly, and then a second, slower, double from $2 to $4.
Accordingly, I doubled my position….
Fortunately I was right — at least for now. As the company struggled through the management of the covenants, renegotiating the covenants without incurring too severe penalties, and was assaulted by three law suits (more about this in a separate posting,) the per share price grew from a low of $0.95 on April 15th, 2013, to a high of $2.17 on May 28th — an easy double.
The per share price has since then retreated slightly, reflecting the market-jitter of the last days and a pull-push from interactions with DirectTV, which has raised a demand that the company refinance at least a part of the loan. Fortunately, the current loan holders appear to be very cooperative, and a meeting has been agreed-to between the three parties.
At a $2 level, I could push out, but I think that there is potential for a quickish run to $4 once the refinancing is complete and announced. Moreover, after the refinancing, there should, if I read the filings and a recent agreement with DirectTV correct, be a confirmation of the relationship by DirectTV, which could simulate a run, and, effectively, bring us back on track to achieve Objective Zero.
So, once we get back on track, all focus should be on operations and the tedious slow-grind, defense against the lawsuits filed by three small-time retail investors, rather than fancy and risky M&A measures and debt management minutia, leaving the company with a backlog of $500 million, an annual revenue line bumping towards $500 million, strong income from operations, and strong cash-flow. With a little luck, this will allow for a third double, from $4 to $8, in the medium term.
I can’t wait to see what tomorrow will bring….
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