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Sitestar (SYTE): a bargain, but some lingering questions
Posted by: whopper investments (IP Logged)
Date: September 10, 2012 09:07AM
I mentioned in my post on Syms (SYMSQ) that one of my favorite blogs to read / steal ideas from is ragnarisapirate. In addition to our interest in SYMS, we share investments in SODI, PRXI, and MPAD (or at least I do, and he does last I heard from him!). He’s recently been all over Sitestar (SYTE) with some great scuttlebutt (he even filed a 13-D), so with that in mind I decided to take a look.
And I found a lot to like…. but also some lingering questions that are holding me back from investing.
So here’s what I’m going to do.
First, I’m going to go through my review of SYTE and why I think they’re so interesting.
Then, I’m going to post my lingering questions. If you have thoughts that can clear them up (good or bad) please post them in the comments!
Sitestar has two divisions.
Their first division is the legacy dial up internet division. This division is declining incredibly rapidly (revenues down ~25% year over year) but provides tremendous cash flow.
The second division is the new real estate division. This was literally just started (started investing late 2010) but is proving an incredible source of value. Consider this- at the end of 2010, real estate assets totaled just over $550k. At the end of 2011, real estate totaled just under $2.5m. That means average investment in real estate was ~$1.5m for the entire year.
With that, they generated net income of ~$190k. That’s a return on equity of ~13% for the year…. and it dramatically understates just how much value the company created from their real estate operations for several reasons.
1) We’ve assumed the real estate is financed completely w/ equity. While it is right now, these types of quick housing flips should be financed with mortgages and leverage- at least an LTV of 50%. If they did that, they’d be generating at least 25% ROE.
2) This is a business that grew assets ~500% in one year. I assumed average assets from year beginning and end. If you do the math on a quarterly basis for a company growing this fast, average assets would actually be much lower, resulting in a higher ROE.
3) On a related note, it takes 6-9 months to sell these things. Given how fast the company is growing, that means the majority of the assets were actually unproductive for most of the year. If you think this through, it means that ROE will be much, much higher once the asset growth levels out. For example, if the company buys $500k in real estate at the beginning of the year, sells them in June for $700k (a $200k gain) and then buys $1m in real estate, their ROE would come out to $200k/$750k (750k being the average of 500k and 1m) = 27%…. but it would actually be much better than if that if the company simply hadn’t grown!!!
So it’s clear the real estate division is creating tons of value. With that in mind, let’s start talking about valuation
The internet division is rapidly declining- 25% year over year, and it may be accelerating. However, it does provide nice cash flow, and the company does have tons of deferred tax assets to keep the majority of those tax assets. Most of the estimates I’ve seen for businesses declining this rapidly (AOL, Earthlink, USA Mobility (a pager provider) estimate value for businesses declining this rapidly at 2-4x TTM EBITDA. The internet’s divisions ebitda (after including corporate expenses inside it) comes out to $800k, which would place the value between $1.6-3.2m.
We could then add the book value of real estate (~2.7m) to get an enterprise value of $4.3-5.9m. They’ve got a little bit of cash and some notes payable due to a stockholder, but it’s fair to assume those net out.
However, they do have $900k in notes payable due stemming from an acquisition. As we’ll discuss later, I’m not positive how to treat this $900k (if it’s worth full value, or if the NPV is 66% of that). However, at some point it has to be a liability- so we’ll end up with a range from $3.4-5.3m. W/ 74.1m shares outstanding, that results in a price per share of $0.0459 – $0.715- a huge jump from their last price of $0.0325.
However, this might be too conservative- we used book value of real estate, and given how profitable their real estate division is (and the time it takes to sell the real estate), there’s almost no way it’s still worth book. If you assume they’ve appreciated by ~10%, it would be worth another $0.004 per share- which may seem insiginficant, but is actually more than >10% of today’s share price!
So, with the bottom end of my range ~50% above today’s price, I clearly think there’s a lot of value here. And the great thing is there could be a long runway of profitable growth here- if they can keep finding value in real estate, it’s not like they’re going to start cornering the market if they double or triple the size of their real estate holdings from today’s $2.6m levels!!!!
But then… there are my questions.
The big fundamental question is a basic one- all of the future value is going to come from their real estate division, right? But how long can they continue generating these types of returns? If you read through ragnar’s interview with their CEO, he mentions their current strategy is basically flipping low value (<$90k) distressed properties. They buy them in short sales, fix them up, and sell for big profits. But that’s not a permenant growth strategy- they’re already reaching the point where continuing to flip properties this small will be just a drop in the bucket. So what comes next? Do they go to bigger residential properties (apartment buildings, perhaps?)? The CEO mentions he wants to get into commercial real estate. The CEO seems to be very good at flipping small houses… but does he have the skills to manage bigger properties or lease commercial buildings??? He seems competent, but that’s a big risk going forward.
Then we come to some red flags that are really bothering me.
First, and most importantly, there’s the resignation of their auditor in 2010. This is really strange- the company first said they dismissed the auditor. But a month later they revised their filing and said the auditor submitted an immediate resignation. And the resignation cause SYTE to file their 10-k over 2 months late that year. Did they file their statements late because of the resignation, or did the auditor resign because they were filing their statements late? I don’t know… but that’s awfully strange.
There’s also this (and this, admittedly, is a bit nit-picky)- the company filed a press release stating they were buying back 10m shares… only the headline said they were buying back 1.5m shares. Given the importance of announcing a share buyback of >10% of your shares outstanding, how does that mistake happen? Are internal controls just running crazy of there? Are they sloppy? It just seems strange.
Maybe all of this craziness is happening because their CFO makes just $45k a year. Look, I’m normally a fan of companies that pay their C-suite execs “token” type salaries… except that normally comes w/ large shareholdings. In other words, the insiders are trading high salaries for share price appreciation. But the CFO owns 133k shares… that’s ~$3k worth of shares. Why does he even bother working for the company???? He could make more as an entry level accountant!!!! (The CEO, in fairness, makes less…. but he also owns 33% of shares out. That makes sense to me!)
Some other strange things pop up in a closer reading of the 10-k. For example, if you look under legal proceedings, you get this quote
Quote:However, if you read the 2008 10-k, you would get this quote
And if you read the 10-ks in between these two, you would get a completely different quote that didn’t mention the settlement or the share cancellation. So… What happened to that settlement? Why are they cancelling shares? Is this a good thing? Does it result in shares outstanding being returned to the company and cancelled? Or is it simply a cancellation of shares authorized but not issued?
Finally, there’s something strange going on with their USA Telephone acquisition. Here’s the acquisition info from their 2008 10-k
2007 revenues actually came in at ~$6.6m with 2 months worth of revenue from United Systems. Given those pro-forma statements, we can imply United was doing ~4.4m in revenue per year. By 2011, Syte’s entire internet division was doing under $3.7m in revenue. Now, I know this is a declining industry, and EBITDA margins were about 40% at the time, so they acquired United for a pretty low multiple. But, given how poorly the whole internet division has gone, this looks like a pretty poor use of money. I know this is a tough industry to invest in, the financial crisis probably accelerated people “cutting” dial up, and hindsight is 20/20 in deal making (I don’t hold DWA’s share buybacks at higher prices against them. Shares were worth more before the DVD business collapsed)- but shouldn’t SYTE have been able to foresee this big of a decline before making the deal???? I mean, the entire company is now trading for less than the value of this one acquisition! And a big piece of argument for investing SYTE is they’ll do a good job investing in real estate. With capital allocation like that / a deal this poor, how can we trust them to do a better job going forward?
Speaking of capital allocation, the company is doing a huge share buyback. But they used almost half of the share buyback in Feb 2009 (the depths of the financial crisis) at prices significantly higher than the than share price because of a put obligation related to this share issuance agreement- isn’t this a really strange transaction to agree to? Again, it makes me question capital allocation decisions.
Finally, going back to the United purchase, they have a $900k notes payable due from the purchase. Here’s what it looks like from Syte’s 10-k.
Here’s what it looked like the year before
Isn’t that strange? Why is this note not amortizing? Why does it keep getting pushed back a year in “due” terms? This may seem insignificant… but remember, we are talking about a company w/ ~160k in cash and a market cap of $2.6m- the value of this note is HUGE to this company. What is going on with the note??? If it is truly a current liability, shouldn’t the company have the “going concern” flag raised??? (Note that this doesn’t mean there would be no value here- it just means they’re facing serious liquidity issues!) If not, shouldn’t the note be reclassified?
So those are the red flags that are bothering. And thus, I ask you, dear reader: am I seeing red flags where there’s nothing to be seen? Am I making mountains out of molehills??? Do you have explanations for some of these issues??? Any color, whether positive, negative, or neutral, you can provide is appreciated.
I do think there’s a lot of upside here, but I also think these questions need to be answered!