Ockham’s razorPosted: August 2, 2013
As it is the case for all postings in this blog, my standard disclaimers apply for this posting. However, since this posting discusses investments, I urge you to review the disclaimers laid out in the About section with extra diligence. Moreover, even if you have already reviewed these disclaimers in the past, you need to review them again, as they are subject to change without notice. Do it now, and remember that whatever I say in this blog posting is simply my opinion — it is not science, it is not advice, and it is not an attempt to make you act in any way whatsoever.
As I was watching A Chorus Line yesterday, somewhat spaced out because I find this particular musical dull and really only had agreed to watch it so that I can take in the rather heavy-handed lesson of discrimination against over-qualification that is handed out two-thirds through the show and for the two renditions of One, which — finally! — are served to the audience at the very end of the show, I was reflecting on my last posting about Unitek Global Services (here.)
In my posting, I wrote about a posting by another blogger, Red, blogging on the red corner blog (here,) noting that the posting was worthy of mention because of the analysis made by Red:
… his analysis is refreshingly substantial in scope and because he apparently backs his analysis up with investment of capital.
The posting on the red corner blog concludes, of course, that UNTK is a bargain — a finding that is not particularly interesting, since we all knew this to be true (well, at least I did!) ….
When I made my first investment in UNTK, Unitek Global Services’ equity, I did so based on a quite thorough analysis of value and fundamentals and a basic ceteris paribus assumption. However, as it is now clear this was not a situation where all else was equal, and when Unitek Global Services announced that it had discovered revenue recognition fraud in one of its divisions UNTK’s per share price was razed to the ground, bottoming out between $1 and $1.25.
The bottoming out forced me to review the fundamentals again and, in particular, weigh the investment against the (relatively small!) revenue impact of the fraud, and my review concluded that UNTK was still a good investment, albeit with a higher risk profile than during my first review. In fact, ironically, the dumping of the per share price as the market fled the equity elevated the investment opportunity from excellent to stellar.
The risk of bankruptcy or bankruptcy protection triggered by demands by the company’s lenders was at the core of the flight of the market, and could, in some ways be justified. However, what the market failed to understand is that the risk of destruction was one shared jointly by the company’s stakeholders and its lenders, and, so, bankruptcy or bankruptcy protection was never really an option. As Red quite succinctly put it:
…[the company’s] 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.
Being a newcomer to Unitek Global Services and UNTK, Red sees all this with the advantage of hindsight. However, already as the situation was unfolding, it was fairly easy for anyone who engaged with the company from as investment standpoint to understand that the scenario facing the company’s stakeholders and its lenders was not one of conquest and pillage, but, rather, one of mutually assured destruction, which, once it became evident to the lenders, would effectively cause them to take their fingers of the trigger (although, of course, they did exert their pound of flesh.)
Moreover, since there was no real issue of total loss of value (assuming, of course, that everyone would act rationally — introduce a Pol Pot character into the mix and all bets are off,) I could turn my eyes toward the opportunity part of the situation. And, oh boy!, did I see opportunities, in particular short to medium term opportunities capitalizing on the market stupidity (read about this here.)
I was, of course, an an aggressive buyer during the period where the company worked through its issues, and my buying spree has already paid off and, importantly, appears to have the potential for paying off much more over the coming period — although I am bracing myself for a temporary setback related to the anticipated publication of the earnings and balance sheet restatements (although, at this stage, the restatements should have been factored into the per share price of UNTK, I have concluded that you can never underestimate the market’s ability to poop in its pants in face of headlines (read more about this here))
Anyway… Getting to the point…
Before and immediately after the meltdown of UNTK, I spent a huge amount of hours reviewing filings and investor presentations, cranking numbers, and performing analysis, and I ultimately concluded that there was excellent potential for gain from investing in Unitek Global Services. And now, as other analysts and investors are doing the same, countless hours are being spent combing through SEC filings and cranking out Excel sheets modeling price and earnings, all in the search of a rationale for buying.
But here is the thing that occurred to me as Mike Costa tapped across the stage: It ain’t that complicated anymore.
Further, it is superfluous to suppose that what can be accounted for
by a few principles has been produced by many.
But it seems that everything we see in the world can be accounted for
by other principles,supposing God did not exist.
For all natural things can be reduced to one principle which is nature; and all voluntary
things can be reduced to one principle which is human reason, or will.
Therefore there is no need to suppose God’s existence.
– Thomas Aquinas’ application of Ockham’s razor in Summa Theologica
In a nutshell, the drop in the per share price was caused by a fear of bankruptcy or bankruptcy protection on the tail-end of the uncovered revenue fraud. With this fear now proven as being unwarranted, the per share price will quite automatically appreciate from its current low level.
So, res ipsa loquitur. Simply put, since the revenue fraud did not impact upon the operations of Unitek Global Services in a way that was proportional to the drop in the per share price of UNTK, no further analysis is needed, and, thus, Ockham’s razor prevails again.
There is, of course, a cost to the debacle, most markedly in the form of a future dilution related to the lenders’ warranties, but in the larger scope of things and compared to the enormous loss of market capitalization that the company underwent in the early market-induced panic days, these costs are negligible (it is interesting to note that in an ideal world these costs would be apportioned out to the individuals that committed the fraud that caused the problem and the investors who joined in predatory class action lawsuits, effectively shooting themselves in the foot — but that is, of course, another story.)
There is a substantial learning lesson here. Perhaps this is, in fact, not an application of Ockham’s razor, but, rather, an application of Hanlon’s razor, with the majority of the drop in market capitalization not being attributable to a crime by insiders, but, rather, to good old fashioned stupidity by investors:
Never attribute to malice that which is adequately explained by stupidity
— Robert J. Hanlon
As usual, if you found this posting useful or entertaining — or if it saved you time, you can express your appreciation through donation via PayPal right now. For this type of posting an on-going donation of $75 per three months or a one-off donation of $50 is suggested.