My post on hard drive makers wasn't the most novel thing to grace these pages, but I find it interesting to muse over. A smaller example that I just remembered is a company worth looking at that is several years ahead of hard drive makers in facing its obsolescence with consolidating, cost cutting, and returning money to shareholders. USA Mobility (USMO), a stock that is a perpetual Magic Formula Stock, is in the declining beeper business. Yes. Beepers. There's still a decent sized market that is profitable for beepers. It is instructive of the risks as well as the rewards of these situations, as well as the extreme sensitivity to price paid in getting a good return on your investment. In a declining business, you need to be precise and accurate in determining the value. USA Mobility is interesting in that it was essentially in long term runoff mode up until about a month ago, when it announced an acquisition. Looking at the pre-acquisition scenario highlights the rewards of these declining industry cash flow machines, but the post-acquisition reality highlights some of the risks.
USMO is a roll up of beeper companies, many of which had gone bankrupt in the past. The industry has rationalized and USMO is solidly profitable. The market for beepers is focused mainly on healthcare and emergency services because the reception is more consistent than other technologies, so the company has had a core of customers that has been slow to change. Further driving profitability is a huge tax loss carry forward, with $370m unencumbered NOLs still to be realized. From the period of 2005-2011, the company has gone from $28/share to $6/share and is now at $15/share. Sometimes Mr. Market has been pleased with the company’s strategy and sometimes he hasn’t. Tilson described his Seagate investment as a tricky one only for nimble investors, and USMO is a pretty good example of how true his words are for a company in this type of situation.
USMO has been a cash flow machine as it has kept ahead of declining revenue by cutting expenses faster. From 2006-2010, revenue dropped from $497m to $233m, but EBIT has been pretty steady only dropping from $67m to $57m over the same period. Net income is not as smooth due to the accounting for the tax treatment of the NOLs, but the company has returned $366m to shareholders over the past 6 years while remaining debt free. They also executed a well-timed buyback in 2008-2009, purchasing $50m in shares in the $9/share range. I’d consider this a rare and impressive example of a disciplined management team that is genuinely looking to maximize shareholder returns. Check out Vaxgen for an example of a really shitty outcome for shareholders when management acts in the exact opposite way (slightly different situation, but I think more indicative of the confidence one should place in management of most companies).
Depending on your purchase price, the outcome of an investment in USMO has ranged from a minor loss to a huge gain. Even if you purchased the stock in 2005 when they first began declaring large dividends and executing intelligently on their runoff, the stock is down about 50%, but you would be about break even based on dividends. Not a desirable outcome, but it shows that done properly, a declining business will not guarantee a loss of capital. If you bought it in 2008-2009 (when the company was buying back shares as well, so I'm not just cherry picking the stock and overall market lows) you've made out pretty smartly on the share price and dividends. That doesn’t make it a good investment right now necessarily, but it does demonstrate that a declining business doesn’t necessarily translate into a wipe out of your investment, assuming management focuses on returning remaining cash flow to shareholder’s.
The investment thesis behind USMO grapples with the business being in perpetual decline on one hand, but still generating tons of cash on the other. The company is increasingly approaching the inflection point where revenue will decrease at a faster pace than expenses. The company’s guidance for 2011 is a revenue range of $182-192m and expenses (excluding depreciation) of $132-136m. Even using the most optimistic scenarios given, expenses as a % of revenue are creeping up now. This doesn’t preclude it from being a good investment though. There seems to be a floor in the decline, as hospitals/healthcare is a huge and sticky contributor to revenue (~60%) and it has only been declining at a low single digit rate compared to other revenue sources declining at much faster rates.
To shift into a discussion of whether or not USMO makes an interesting investment currently, it has become more complicated. Whether to take advantage of the tax loss carryforwards or to continue receiving a generous paycheck (management owns practically no shares), the company decided to turn a debt-free, cash rich position of $130m into a net debt of about $30m. While the debt load will be manageable and get paid off, it significantly raises the hurdle on the investment by removing a cash position that was 30% of the company’s market cap. The language being used to justify the acquisition is also something that requires close reading.
The company is paying $163m for Amcon Software. From the conference call discussing the acquisition:
Amcom is a leader in providing comprehensive and creative software and critical communications systems to our target market segments in Healthcare, Government and Large Enterprise. This is a company with over 40% of its revenue in recurring maintenance with a 99% renewal rate. This best in class statistic only serves to underscore the fantastic stickiness of their software solutions. Amcom has been and will continue to be led by an experienced management team.
This may sound like a nice business, but the company only had $51m in sales in 2010 and $12m in EBITDA in 2010, so the price wasn't very nice from USMO's perspective. It’s a growing company and USMO believe that they can use their existing relationships to cross sell products. You don’t have to be frugal to acknowledge that this is a pricey acquisition. The company hosted a conference call to discuss the acquisition and why it is a good fit. The transparency is commendable, but now investors are forced to understand the future to a greater degree. Now instead of trying to approximate a figure of future cash flows the beeper business will generate and add that to the previous cash pile to get a value, investors are left trying to figure out the value of the beeper business with no margin of safety and trying to figure out what this software company is really going to contribute over the long term. Management would argue that this is prolonging the cash flow from beepers as the software will allow them to provide additional value with their current offerings, but this is a much more uncertain outcome than $130m in cash.
None of this is to say that Western Digital or Seagate’s next few years will follow the same path as USMO. You shouldn’t let this bias how you view Western Digital or Seagate, because they could pursue wholly different paths in the face of decline. You should let it inform your view of them in as much as you could trick yourself into giving credence that their recent moves will translate into shareholder value. They very well may. With all the benefits of having a strong position in a consolidating but declining industry, it is important not to lose site of the risks that the benefits might not accrue to shareholders.
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