DynTek and the problem with earnings

Investors in public markets love certainty, steady earnings, steady dividends, steady interest, steady growth, a market darling.  When something fits on a nice linear path the market goes nuts, a company that earns a steady $1 per year is valued higher than a company that earns $.50 one year and $1.50 the next.

Certainty is an interesting thing, of course no one knows the future, yet most market participants act like they have a hint as to what the future might be.  My favorite are CEO's who announce that they will earn some amount per share, and it will grow steadily at 15-20% forever.  Unless the company's customers have signed contracts locking themselves into those numbers it's foolish for anyone to announce something so uncertain with certainty.  Unfortunately the market's reward for certainty gives rise to the temptation for management to game earnings, which in the short term makes everyone happy, but ends in a trail of tears for investors and potentially (but not often enough) a visit to Club Fed for management.

I have written in the past how I prefer to value companies based on assets, because I believe the certainty of assets is greater than the certainty of earnings.  A company's book value rarely fluctuates dramatically from year to year, and the value of what they own is usually drifting upwards or downwards on a nice glide path.  Earnings on the other hand rarely are steady.  They might be down due to a recession, and then come back strongly during the recovery.  An investor who uses the trough earnings undervalues the company, whereas an investor who uses recovery earnings might overvalue them.  Many investors go through a complex ritual where they adjust and tweak all sorts of numbers and term their ending creation "normalized earnings".  If I decide to normalize earnings I will average a company's last seven years worth of earnings to create my value.  Unfortunately normalized earnings don't mean much if the companies earnings are highly irregular.  When a company's earnings are extremely volatile the market places a low multiple on their shares, one such company is DynTek (DYNE).

DynTek is a IT services and vendor business.  The company offers IT consulting services, and resells software from Microsoft, among other names.  For readers who are unaware of how the IT consulting industry works there are two types of tech consulting firms, software solutions, and implementation solutions.

A company that specializes in software solutions would visit a client, understand their needs and build a solution from the ground up using Java, C#, or the language du jour.  Accenture, and Ernst & Young are two large names that come to mind when I think of this space.

The second type of company is an implementation company, which is what DynTek is.  DynTek will install a Microsoft Sharepoint site at a client, configure a data center, or offer help desk services.  They install and configure software and hardware created by others, whereas a software solutions company will build a custom solution tailored to the client's needs.

The difference is material, it's the difference between hiring a plumber and an architect.  You don't hire a plumber to design the piping for a new building.  The architect designs the plumbing, while the plumber installs it.  The difference in roles appears in the rates they charge, implementation services charges much lower rates.

DynTek has had a few different corporate iterations, the company started in 1989 as Universal Self Care Inc.  They then changed to Tadeo Holdings, followed by TekInsight, and finally DynTek in 2001.  The company began life distributing diabetes drugs and related medical devices.  Then in the heat of the dot-com boom the company decided they wanted to become a tech company, sold their existing assets and purchased a software design company.

I bring up the company's history to show that their path to the present has been anything but predictable.  I could have done a post entirely on their history I dug up in old SEC filings.  As shown in the chart below, DynTek has never performed consistently:

As I mentioned above, for most companies, their book value is slowly changing, not for DynTek.  They found a way to destroy enough shareholder value to go from having $13m in equity to a negative $8.3m in equity.  Then almost as suddenly, they doubled book value from negative $5m to a positive $6.4m

Earnings have taken a similar roller coaster ride, from $.10 in 2010 to $2.92 in 2011, and back to $1.17 in 2012.  The company appears to be having another year like 2011, but given their track record it's impossible to predict anything.

I was initially attracted to the company due to their low P/E, they're trading with a P/E of 5x or so.  They're selling for roughly 2x book value, but given how quickly they're growing book this might not be much of a problem in the future.  But an alternate scenario exists as well, the company begins to falter again and earnings decline to a new lower permanent state along with book value.

The issue is there's almost no way to know by reading the financial statements.  Almost 50% of the company's revenue comes from government contracts, maybe that's good steady work set to grow.  Or maybe it is about to fall off a cliff.

DynTek seems like an interesting company, their growth is fascinating, and their business is simple to understand.  If they can continue to execute as they have in the past this might be an incredibly cheap stock.  Yet this isn't really knowable just from the financial statements, a little scuttlebutt is required on this company.

At this price I don't see a margin of safety, this company is another added to the discard pile.  I know that I have many readers who are looking for cheap growers, or successful turnarounds, and this company surly qualifies for a further look.

Disclosure: No position

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