Key takeaways
- UniTek Global Services (UNTK) trades at a discount to its peer group as well as a recent deal multiple due to recent significant challenges that have since been resolved.
- Moreover, the improving financials are being masked by numerous non-recurring expenses and charges.
- However, the slow re-pricing of the stock provides an opportunity for patient, value oriented investors willing to wait for multiple catalysts to play out over the intermediate term.
Company overview
UNTK is a full-service provider of outsourced infrastructure services to the wireless, satellite TV and cable industries in the U.S. and Canada. UNTK operates in two segments:
The fulfillment segment provides installation and fulfillment services to customers in the satellite TV and cable industries.
The engineering and construction (E&C) segment provides infrastructure services, systems integration for public safety applications as well as construction and project management services for wireless customers.
The rear view mirror is smaller than the windshield for a reason
The past year has been challenging to say the least. However the successful resolution of these challenges (in bold below) and rebound in the stock since the latest earnings announcement supports the thesis that UNTK is on the road to recovery.
Financial restatement. In April 2013, an internal investigation revealed that several employees engaged in fraudulent activities that resulted in improper revenue recognition. As a result, the previously issued financial statements could no longer be relied upon and have since been restated. UNTK received a notice of termination from its largest customer DIRECTV (which was automatically withdrawn after the refinancing). There are two key takeaways. First, the expenses relating to the restatement should significantly decrease as a majority of the work has been completed. Second, management took multiple steps to correct the problem including appointing Grant Thornton as the new auditor, replacing finance and accounting staff as well as implementing new internal controls and procedures.
Lawsuit. A class action lawsuit was filed earlier this year relating to the restatement. This suit was settled for $1.6 million in October. However insurance paid for a vast majority of this amount while UNTK is only responsible for the $250,000 deductible. There are two key takeaways. First, this settlement removes uncertainty, which in and of itself is a positive development. Second, the actual cost to UNTK is significantly less than expected.
Possible delisting. In August 2013, UNTK received a letter from NASDAQ regarding its inability to file financial reports in a timely manner. However in October UNTK regained compliance with listing requirements after filing its quarterly reports.
High debt load. This was the single greatest concern for investors and remains the largest contributing factor to the low valuation. In July 2013, UNTK refinanced with a new revolving credit facility and amended term loan. There are five key takeaways. First, the high borrowing fees (including warrants) and higher interest rates (e.g. term facility increased by 600 basis points and revolving facility increased by 675 basis points) is actually a fair trade for the increased liquidity given the situation. Second, revolving debt should decline by ~$24 million once this amount is transferred to the new lenders (currently held on the balance sheet as restricted cash to collateralize letters of credit). Third, rising cash flow driven by lower levels of capex should allow for more rapid debt repayment. Fourth, management said on the most recent conference call that it expects to refinance again by mid-2014. This last point deserves extra attention as it represents one of the greatest catalysts given the interest savings. Fifth, although the coverage ratio recently declined as shown in the chart below, it is still sufficiently high and should rebound as an increasing proportion of cash flow is used to repay debt (e.g. capital lease obligations declined ~$5 million YTD).
Recent "messy" results mask improving financials
The combination of asset impairments, restructuring charges, restatement expenses, refinancing fees and acquisition earn-outs results in "messy" financial results that mask an improving financial picture as shown in the chart below.
Going forward the financials should be much "cleaner", which should help lift the valuation ceiling as investors will have an easier time understanding the underlying fundamentals. The following five factors should result in more consistent results.
First, operating cash flow (use of only $0.7 million YTD compared to $4.8 million in the year ago period) and working capital (increased by $11.7 million driven by reduction in receivables and inventory) continue to show significant improvements. Moreover, the potential reversal of the long term rise in receivables and inventories (shown in the charts below) represents "low hanging fruit" and should act as a significant (and largely overlooked) cash flow driver going forward given the renewed focus by management on improving working capital.
Furthermore, the already low capex rate (at just 0.60% of ttm revenue) is running 44% below the 2012 level with future spending allocated to the highest priority projects such as safety and productivity.
Second, the recurring revenue generated by the core fulfillment segment provides much needed visibility given the high debt load.
Third, although the effort to diversify the concentrated customer base is a longer term story, there are signs of progress as shown in the chart below. Its largest customer (DIRECTV) "only" accounts for 42% of revenue compared to 55% in 2010 as a result of gaining new large contracts (including a deal with ViaSat (VSAT)), a focus on the more profitable urban market (due to its higher density) and geographic expansion as a result of several small, bolt-on acquisitions.
Fourth, UNTK should continue to benefit from rising demand for wireless and cable/satellite services (e.g. 4G networks, HDTV, DVRs, VoD), expected vendor consolidation as it is one of the few fully-integrated service providers as well as increased infrastructure spending on public safety and municipal wireless systems that are critical for first responders.
Moreover, UNTK is able to grow even if the number of end users remains the same through higher market share as well as a focus on larger and longer term prime vendor wireless contracts. Furthermore, winning the initial E&C work provides the opportunity to deliver ongoing maintenance and optimization services.
Fifth, margins should continue to expand driven by lower expected labor/material costs, a lack of cable start-up costs following an expansion into the Southeast as well as the sale of its wireline business and closing of certain broadband cable fulfillment and wireless service locations due to a focus on the core fulfillment and wireless segments.
Moreover, in the mrq UNTK would have earned a net profit of ~$2.4 million excluding restructuring, restatement and impairment charges. If the current positive top and bottom line results continue, any future net income will be effectively shielded by the ~$86.6 million of federal NOLs that begin to expire in 2014 and fully expire in 2032. Obviously given the recent losses and near term expiration, there is a significant valuation allowance ($79.7 million) against these deferred tax assets. However these NOLs are considered worthless by the market until they're not. Within the next 12 months, the combination of a potential refinancing that lowers interest rates and continued operational improvements may result in a decrease in the allowance. Even a small decrease could act as a significant catalyst given the low market cap.
Valuation
The market still appears to question UNTK as a "going concern" despite the previously mentioned miraculous recovery over the past year. As shown in the chart below, the modestly lower margin is more than offset by an EBITDA multiple 1.5-2.5x turns lower. The twin catalysts of an expected refinancing and continued margin expansion should result in a narrowing of the valuation gap.
The strategic interest in the industry supports the argument for a higher multiple (at least for UNTK). For example, in August 2013 Goodman Networks completed its acquisition of competitor Multiband and paid ~7.4x EBITDA. The recent acquisition of an entire company at a higher yet reasonable multiple is encouraging given that it is based on actual demand rather than investor assumptions.
Risks
The primary risks to the investment thesis, in order of magnitude, are the following:
Despite the recent increase in financial flexibility, UNTK still has a high debt load at a high interest rate.
Although UNTK continues to diversify, its three largest customers accounted for 42%, 20% and 12% of revenue in the most recent nine month period.
Telecom spending (especially for E&C and wireless projects) remains cyclical and dependent on favorable economic growth as well as company specific spending decisions. For example, reduced wireless construction work from AT&T is expected to reduce revenue by $21 million.
Conclusion
The target price is based on a modest 0.25x turn increase in the multiple (high debt load = high leverage), which is still a discount to the two closest publicly traded and pure play peers as well as the Multiband deal.
A tight stop loss should be placed below the 200 DMA, which is substantially the same as the current price. The time frame is 12-18 months given the expected timeframe for a refinancing and overall longer term growth thesis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)
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