Fabergé egg in the rubble (Partial Version)Posted: September 10, 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.
Why I am buying a lot of UNTK — right now
This posting discusses UNTK, the equity of Unitek Global Services, and, in particular, explains why I have recently been increasing my investment in Unitek Global Services based on certain information that I gleaned from the company’s recent 10K restatement filing for its 2011 fiscal year and for the interim periods ended March 31st, 2012, June 30th, 2012 and September 29th, 2012.
By way of background, I have gone through several rounds of investments in Unitek Global Services over the last year, and I have laid out my rationale for each of these rounds in a number of postings, and, so, I will not detail my pre-10K rationale for investing in Unitek Global Services, but, rather, refer the reader to my postings, perhaps starting with this one. Alternatively, if you are somewhat lazy (you shouldn’t be, but odds are that you are,) you can read a recent summary by another blogger, Red, blogging on the red corner blog (here.)
Overall, my earlier investments in Unitek Global Services have been predicated on the market’s consistent and repeated overreactions to negative news coming out of Unitek Global Services, primarily originating with a relatively minor revenue recognition and accounting fraud that the company uncovered in its Pinnacle division, and my assumption has been that these overreactions would allow for several opportunities for twofers around UNTK.
So far I have been entirely correct in my assessment of the market’s overreactions and the associated opportunities, and I have been able to profit from the predictability of the market. However, up until the date of the recently released 10K filing, my assumption has been that any gains would be relatively slow, and not explosive, with the practical limit being twofers.
With the 10K filing my assumption has changed, and I now see an opportunity for far higher gains in a very short time.
This opportunity is the subject of this posting. Before you proceed to reading about the opportunity, however, I want to repeat the disclaimer that I laid out in the above and emphasize that the operative word is opportunity, implying chance, guess, and risk. So, before you read on, you need to recognize that: (1) 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, and (2) that based on the 10K filing and my past experience I have formed an opinion about UNTK and Unitek Global Services, which has caused me to invest, but this decision is based on guesses and assumptions, which may be 100% wrong and, in fact, every dollar that I have invested and will invest in Unitek Global Services is at risk, including the risk of a complete loss.
It is estimated that at Stunde Null, the time of the capitulation of the Nazi government on May 8th, 1945, Berlin contained 75 million tons of rubble or 39 cubic yards of rubble for every inhabitant in the city.
The survival of the population of Berlin, estimated to be 2.8 million people, during the immediate post-war period, battling diseases and hunger, and, later on, battling an exceptionally cold winter, is a testament to German tenacity and Russian practicality.
The Russian military occupied all of Berlin at the time of surrender and would not hand the American, British and French sectors to the American and British Forces before July of 1945. To manage the acute logistical and humanitarian crisis that it had on its hands, the Russian occupying force instituted a rationing system linked to a rubble-clearing compensation scheme, which solved the problems of logistics and humanitarian help with one stroke, but also created an extensive underground economy based on Hamstern, the act of recovering goods from the rubble and traveling into the countryside in order to exchange these possessions for food. Mostly, the goods from the rubble would be small items, such as watches, rugs, and pillows, but, once in a while, the rubble work would turn up extremely valuable objects.
I was reminded of Hamstern when I recently read the newly published 10K restatement filing from Unitek Global Services.
On the surface, the 10K filing was loaded with rubble related to the restatement necessitated by the recently uncovered fraud, clearly indicative of the fact that the company, in the midst of securities litigation, is being extremely cautious about how it presents information. However, if you were able to move a few layer of brick, you would uncover several pleasant surprises, including nice top-line growth, nice operational performance, a nicely controlled litigation picture, and — surprisingly — a restatement that was much smaller that I, for one, had expected.
So, here, for the record, is an excerpt from the company’s earnings release discussing the 10K filing:
Revenues increased 24.5% to $437.6 million for the year ended December 31, 2012, from $351.5 million in 2011. This increase in revenues was primarily from organic revenue growth in the Company’s wireless business, growth in the cable portion of the Fulfillment segment from market share gains and the acquisitions completed in 2012, as well as the asset acquisition of Skylink Ltd. in September 2012.
Revenues from the Company’s Fulfillment segment increased 6.5% in 2012, to $305.3 million, from $286.7 million in 2011. Revenues from the Company’s Engineering and Construction segment totaled $132.3 million in 2012, an increase of 104.4% from $64.7 million in 2011.
Adjusted EBITDA increased 22.6% to $39.6 million for the year ended December 31, 2012, compared to $32.3 million for 2011. The year-over-year increase in adjusted EBITDA was primarily related to higher revenue and margins in the Company’s Engineering and Construction segment, partially offset by increased selling, general and administrative expenses related to a full year impact of the Pinnacle acquisition, which occurred in April 2011.
The Company also recorded a non-cash impairment charge of $14.9 million in the fourth quarter of 2012 related to the goodwill of its wireless reporting unit (including Pinnacle) in connection with its annual impairment testing.
Loss from continuing operations was ($39.5) million, or $(2.18) per diluted share in 2012, compared with $(7.3) million, or $(0.46) per diluted share in 2011.
Net loss for 2012 was $(77.7) million, or $(4.28) per diluted share, compared with $(9.1) million, or $(0.57) per diluted share in 2011. The increase in net loss and loss from continuing operations in 2012 was primarily related to the $14.9 million goodwill impairment charge, the impairment charges from discontinued operations of $35.2 million related to the Company’s wireline assets which were sold in 2012, an expense related to contingent consideration of $10.1 million compared to income of $8.5 million in 2011, and restructuring charges totaling $8.0 million.
These are, of course, big numbers, so it is probably prudent to explain that very large portions of the numbers are made up of charges related to the sale of one of the company’s divisions in 2012. This transaction, which was linked to the near-simultaneous acquisition of another, more profitable business unit, is expected to be a good thing, materially adding to the bottom line on the overall business going forward. Also,it is worth noting that a large charge was related to company performing its regular, annual impairment test in the fourth quarter of 2012. As the 10K filing says:
During the third quarter of 2012, we committed to a plan to sell the net assets of our wireline telecommunications business unit (the “Wireline Group”) which resulted in the performance of interim tests of impairment. As a result of those tests, we impaired property and equipment by $2.2 million and goodwill by $33.0 million.
We performed our most recent annual goodwill impairment test as of September 30, 2012, the first day of our fourth fiscal quarter. When we performed our annual goodwill impairment test, we determined that the fair value of the wireless reporting unit exceeded the carrying value. Accordingly, we performed the second step in the analysis and determined that the carrying amount of our goodwill exceeded its implied fair value, and we recognized an impairment loss in an amount equal to that excess. In the fourth quarter of 2012, the carrying value of goodwill for the wireless reporting unit exceeded its implied fair value and we recorded a non-cash, pre-tax impairment charge of $14.9 million.
So business as usual and — critically — related only to what I call funny money.
Funny money are non-cash income or expenses, an oddity born out of a somewhat broken accounting system that allows for non-tangible items, such as goodwill and customer relationships, to be considered assets and liabilities with peculiar effects on net earnings when they, at some point in the company’s life-cycle, are corrected — as they inevitably must be — through adjustments to earnings.
Don’t get me wrong. Funny money do matter. However, they do not matter for the fundamentals of the business, which, frankly, is dominated by cash collection, the benefits of tangible assets, and the inherent risks in tangible liabilities. Rather, they matter for the way that the make the — generally ill-informed and uneducated — market participants react when they are adjusted.
Here, for instance, $33 million in goodwill may have moved, but $33 million dollars in cash were not lost by the company, which, of course, is clear to anyone who cares to read the company’s cash flow statement.
Unfortunately, however, as no-one cares to read anything except headlines, the market equates a $33 million goodwill adjustment to a $33 loss of cash, causing an unsubstantiated depression of the per share price for the company’s equity.
We will talk more about funny money and their effect on the earnings later when we uncover our Fabergé egg from the rubble.
For now, on the point of the 10K filing, it is simply worth noting that the net loss for fiscal year 2012 may have been in excess of $75 million, but these were mostly funny money of little or no interest to value or fundamentals investors who routinely eliminate non-tangible assets and liabilities from their value calculations.
When all this is said, the important thing about the 10K filing, is not, in fact, the magnitude of the net loss for the year, but, rather, the diminutive size of the restatement, as detailed in the filing:
The aggregate impact of the Pinnacle revenue and related adjustments for the year ended December 31, 2011 decreased revenues and cost of revenues by $7.2 million and $1.4 million, respectively … These revenue and related adjustments also (decreased) increased accounts receivable, net, inventories, accounts payable and other liabilities at December 31, 2011 by $(7.2) million, $0.5 million, $(1.2) million, and $0.2 million, respectively…
It is worth noting that the adjustment’s decrease of revenues by $7.2 million is completely out of balance with the market’s reaction to the company’s announcement of the discovery of relatively minor accounting fraud in one of its many division, which wiped out between $50 and $65 million in market capitalization.
Remember this next time someone tells you that the market is always right.
So, in summary: Significant funny money loss, very limited restatement, and colossal over-reaction by the market.
However, it is not what is on or immediately below the surface that concern us…. Rather it is what you can find if you dig into the rubble.
Digging further down in the rubble, here is the extremely valuable item that I found, which immediately prompted me to buy more UNTK: …
The full posting is now generally available here.