Monday, January 9, 2012

Can a cheap company in a bad industry be a good investment?

LICT (LICT.Pinks)

Price: $2055 (1/9/2012)

Is it worth buying a dollar for fifty cents if next year that dollar will only be worth ninety cents?  I keep thinking about this and a few other questions as I've been looking at LICT corporation.  I'm sure most readers have never heard of LICT but I'm guessing most have heard of LICT's Chairman and CEO, Mario Gabelli the CEO of Gamco funds.

So what is LICT?  LICT is a holding company filled with a set of regionally diverse RLECs (Rural Local Exchange Carrier), in other words small local telecom companies.  The company owns fourteen different rural telecom subsidiaries that range in size from 800 lines to 7500 lines.  These are small companies in places like the Upper Peninsula Michigan, or Central Scott Iowa, let's not forget Bretton Woods NH.  In 2010 the company serviced 45,680 telephone lines and 17,599 DSL lines.  It seems that the closest companies are a few hundred miles apart from each other and none share the same infrastructure.  This means LICT essentially holds fourteen independent rural telecom companies.

So what's the good news?  I was attracted to this stock for a reason.  There are a few things that caught my eye, the first is that this company is serving an important niche market, when you live in the boonies there aren't exactly a lot of communication options to choose from.  Often cell service is spotty and high speed internet is non-existant.  Besides the somewhat sheltered business model there were a few financial highlights that caught my eye:

  • The company spent close to $300m building their network, they now trade for $56m quite a discount to a theoretical replacement cost. (theoretical because it has been replaced, see Verizon/ATT cell network buildout costs.)
  • LICT earned $450 per share in 2010, TTM they earned $409/sh for a P/E of 5
  • The company has $330 of FCF in the TTM for a P/FCF of 6.23
  • Book value of $70m meaning the shares trade at 20% discount to book.
  • The company is looking to restructure it's hodge-podge of debt.
  • A well known value investor as CEO who is determined to increase shareholder value.
If LICT wasn't in the rural telecom business these stats would make me think that LICT was a Chinese RTO fraud, P/E of 5, P/FCF of 6, trading below book, a catalyst.  All of the raw metrics, and financial figures make LICT seem like an absolute slam dunk investment.  The problem is that as I look at them I can't get the feeling out of my mind that I'm staring down a value trap.

This is a company that is clearly cheap, their main problem is they're resident in a declining industry.  In the past two chairman letters Gabelli states the industry is going the way of the horse and carriage, something I don't disagree with.  LICT has been experiencing modest residential line terminations which have been offset with a slight uptick in DSL, but if we're honest DSL isn't exactly the latest model technology either.  This is like jumping from a horse to a Model T in the age of Ferraris.

The question I mentioned in my first line is the crux to an investment like this.  Is there a big enough discount to a declining value so that LICT can be a good investment?  In one scenario maybe the company will just pay the free cash flow back to shareholders realizing further network investment is pointless.  If the declining free cash is greater than the price paid this could do well.  In another scenario the company could continue to invest yet come to the same terminal point with shareholders wishing for a turnaround the entire way down.

I don't really see any options for this business besides managing the assets they currently have.  It's unlikely that a buyer will emerge and want a bunch of rural telecom companies with a declining user base.   Yet at the same time management realizes the predicament they are in and have been doing all the right things, asset sales, spin offs, special dividends.

At the end of the day I want a margin of safety in my investments, a real actual margin of safety not a facade of safety.  It seems my lack of comfort with LICT is that I can't readily identify their margin of safety.  This is a plain cheap company, but not a safe and cheap company.  I just don't know if LICT will be able to outrun their industry's decline, I sure hope so for their investors sake, but I'm just not so sure myself.

I'd love to hear your thoughts, leave a comment below or email me by clicking the following link.

Talk to Nate about LICT

Disclosure: No position

8 comments:

  1. It could be better than you think. It really depends on the towns that they service. In my hometown, there is no cell service and DSL is the best that you can get. It doesn't matter that it is old technology; larger companies are not going to want to invest in an area that has only a few widely dispersed customers.

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  2. "This is a plain cheap company, but not a safe and cheap company." If you are saying that it is trading cheap to fair value then your statement is a contradiction. It is cheap precisely because it is not safe. There is obviously a sizeable and legitimate downside risk to owning this stock, something that has and should press valuation lower.

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  3. Anon,

    To clarify I consider a safe and cheap company one trading with a margin of safety. Consider a net-net where if the company was liquidated the shareholder would realize a return, that's safe, and if the company is marginally profitable it's cheap as well.

    I think often investors consider some big stalwart company safe because it's big and well known. I tend to consider safe being an investment with limited downside.

    The point with LICT is that even though it appears to be cheap it could be for a very good reason. The wireline business is going the way of dinosaurs and LICT is trying to outrun the decline. If they fail shareholders lose.

    Nate

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  4. Nate, Here are my thoughts...
    I frequently short companies in dying industries, especially those with valuations based on earnings. This is not something I would buy or sell.

    The things that usually bury a company in a dying industry:
    1. Bad Capital allocation/reinvesting in the dying business. Since the company is in cash cow mode it's intensely important what they do with their cash flow. LICT is good here with Gabelli at the helm.
    2. Leverage: Obviously LICT has a lot of debt, but I think the more important (and underrated) thing is operating leverage. LICT's fixed costs aren't that high. They have pretty fat margins, although their operating costs are rising. Book stores are an example of a dying business with high fixed costs. Their margins are already slim, so they are doomed.
    3. Ability to refinance assuming the company has leverage.
    4. Stickiness of products: What is the rate of decline? LICT's is orderly and predictable. The opposite is someone like PALM, who sees their products become unpopular and immediately is irrelevant. LICT still has some value to society.

    I think LICT still has some value, the problem is the debt is a risk, and they aren't that cheap. EV/EBIT is a more appropriate valuation metric in my opinion for high debt companies. On 2010 numbers they are at a multiple over 8. This is pretax so that's not that cheap.

    Of course, since they are a declining business their D&A (a historic number) will be higher than capex (a future number), so there is an adjustment to be made with that. I think you could add $3 million to income because of this adjustment. It probably would bring the EV/EBIT multiple down to 7 on 2010 numbers. Assuming a 35% tax rate you get about a 9% unlevered earnings
    yield on a declining asset.

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  5. As an update, this came out yesterday the company sold some wireless licenses for $7.7m or $325 a share:

    http://lictcorp.com/press/01_12.pdf

    So management is working on monetizing. Hopefully they pay down the debt with the cash.

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  6. Hester,

    Great comment, thanks for the input. I agree with you about some of the dynamics often seen in a dying industry.

    I don't mind wading into these sorts of situations where there is limited risk, in the case of LICT the debt is a big issue as you point out. As of now wirelines are rolling off in the 1-2% a year range, but this could easily accelerate if cell service is extended to any of the markets on a competitive basis. A rapid drop in subs could easily put the company at risk in terms of interest payments.

    In looking at this stock it really made me think about industry dynamics a bit more than I usually do which is a good thing. For a dying industry two things need to be in place to really protect shareholders, the first is management that realizes the game is up and is working for shareholders (this is extremely rare), and secondly a solid balance sheet with valuable liquid assets and little to no debt. LICT has some of this, but there are really too many question marks for me to invest.

    Nate

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    Replies
    1. I think you make a fair point on the risk of wireline decline accelerating. Last year I would of told you that was wrong, the cell services have already penetrated 97% of the US population, that extra 3% won't add much for them. But ATT's obsessive quest to take over T-Mobile (which failed of course) proves the cell companies want more rural presence.

      I wish the debt was publicly traded. I would snap up senior debt if it had a double digit yield and was at a discount to par in a second. The company is still extremely profitable on an EBIT basis, especially when you add back some D&A. Even if the cell carriers move in they will still have plenty of cash cow years ahead of them. It's going to take a lot of revenue decline before operating profit goes negative.

      This stuff takes a lot of time. It's not like RIMM or PALM or Blockbuster. The switching costs are higher. I know many rural parts of Montana that have just gotten electricity in the last 20 years... Seriously. Dial-up has been obsolete for a long time but AOL keeps squeezing cash out.

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  7. Nate, great post! There is a universe of declining businesses that appear statistically cheap but are most likely to be value traps. I imagine some will turn out to be great investments but it's a hard area of the market to play in.

    Have you ever taken a look at Aastra Technologies (AAH-T)? I'd love to hear your thoughts on this. It's similar in many respects to LICT. The company is well run by entrepreneurial founders who have a significant equity stake. The business has a strong free cash flow profile (limited capex required) and the company is sitting on net cash. There is also a lot of consolidation in their sector with many of Aastra's major competitors owned by P/E firms.

    The major risk seems to be figuring out a reasonable decline rate for the business. Aastra sells a legacy product that their customers might not replace in the future.

    Any thoughts on how to analyze this business?

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