Sitestar shows anything is possible

How many investors have found themselves in an idle moment thinking "If I were the boss at the company I'd do things a lot differently."  My guess is if one invests in struggling companies this thought occurs more often.

The difference between thinking something and taking action is a wide gulf crossed by few.  In the case of Sitestar (SYTE) a group of investors crossed the chasm and took control of an undervalued asset in a way that most investors can only dream of.  Their conquest makes for a great story, and since I'm a sucker for great stories I want to re-tell it, even if there aren't any take-away lessons.

The company came into being during the dot-com boom as an ISP (internet service provider).  They provide service to rural areas where major providers ignore because distances between homes are too far, or there isn't enough density to service profitably.  Markets like these are littered with small companies that somehow find ways to make a profit where large companies can't.

From the start Sitestar had profitability issues.  They earned $200k in revenue in 1999 but spend $3.5m to earn it.  Eventually they found their formula for success and revenue peaked in 2008 at $8.8m with $1.2m in earnings.  It was around this time that their customers discovered they could access the internet from their pocket at speeds that walloped their dial up modems and subscriber numbers began to quickly fall.  In response to the "dying" business the company's management decided that rather than re-invest in dial-up they'd go on a shopping spree and purchase real estate, rehab it and flip for a profit.

I've always been suspicious of public companies that change from one business to something completely different.  It is disjointed and almost reckless.  Yet, if I meet a private entrepreneur who has a number of unrelated businesses under their control I think "what a savvy individual."  But the truth to this is entrepreneurs are always experimenting, always throwing things at walls to see what sticks.  The good ones focus on what has stuck, and if something's stuck they focus on it.  Sitestar found something with potential but failed to execute on it.

Throughout the years the company acquired a real estate portfolio of properties they intended to rent, or renovate.  The key to making money when flipping a house is to buy at low prices, renovate and sell quickly.  There are carrying costs associated with owning a house and each month a house remains unsold the carry costs eat into the potential profit.  If a house remains unsold for too long the potential for any profit disappears.

Fast forward to 2013.  Real estate investor and investment blogger Jeff Moore discovers that the company is trading at a significant discount to it's liquidation value.  He purchases a 7% stake, files a form 13 SEC notice and talks to the CEO about joining the board.  While I said there probably weren't any lessons to be learned this could potentially be one.  From time to time readers will ask me "how do I join a Board?"  Jeff's method is as reasonable as any out there, buy a sizable stake in the company then ask the CEO.  Don't wait to be asked, but be proactive and ask.

All was not butterflies and roses with the Board position for Jeff.  This is where things got interesting.  Jeff as a new Board member had grand plans for the company.  He wanted to do things like determine the cost basis for the properties and sell ones that needed to be sold.  He also requested financials that the company should have easily been able to produce, especially for a Director.  He wanted to get his hands dirty and take action on the renovations, after all this was his area of professional expertise.

Instead he was met with resistance and diversion.  Battling the company's roadblocks led to a trip with fellow shareholder Steve Kiel to Lynchburg, VA (where the company is located) in 2014 to discuss these issues in person.

Jeff and Steve arrived at Sitestar and requested to speak to Dan Judd, the CFO.  One of the company's employees stated he'd come to meet them.  Jeff and Steve waited for hours before the same employee came back and announced she was heading to lunch and locking up.  Jeff and Steve decided to go across the street during the lock-up and at this time the CFO snuck out the back door and drove away.  I can only imagine the CFO peeking out the window all morning wondering "when will they leave?"  I think it speaks volumes as to the character of the CFO.

Based on this experience Jeff and Steve took a more activist approach and engaged in a proxy battle to gain additional seats on the Board.  Jeff and Steve proposed a full slate of new Directors and the company negotiated a settlement where Steve and Jeff would be on the Board.  If at this point the duo worked to fix the company from the inside this would be a very typical activist saves investment story.  But Sitestar is anything but typical.

All was quiet on the Western Virginia front for months until suddenly there was a press release that the CEO, Frank Erhartic, a 30% shareholder had been fired.  Under what circumstances could a significant shareholder who is CEO be fired?  Under suspicious ones.  Kiel and Moore discovered that the CEO had made a series of improper loans from himself and his mother, charged the company rent for a building he likely didn't own, as well as other potential securities violations.  The problems were so bad that this tiny company with a market cap of $5m aroused the interest of the SEC.  The fact that the SEC is spending any time on Sitestar indicates this isn't a simple issue like Steve Jobs accidentally putting a historical and wrong date on his stock options that could be quickly swept under the rug.  No, this appeared to be real fraud, the type of stuff so brazen as to seem unbelievable.  I can almost imagine the exchange an exchange between Frank and his mother.

Frank's Mom: "Honey, this Sitestar piggy bank you own seems quite lucrative, any way I can make some money on it as well?"

Frank: "Well Ma, you can buy shares in the market, but we're just a penny stock and you might never see a return.  Instead why don't you smooth me a check for $50k and I will pay you an above market interest rate on the loan.  You'll get some quick cash that's risk free."

As a result of Erhartic's firing Steve Kiel was appointed interim-CEO.  After the company metaphorically peed in the pool they were swimming in Steve decided it was time to clean things up.  He hired a new audit team and began the process of correcting financial statements and verifying all of their accounts.  If you're a one-person sole proprietorship doing some work on the side it might be alright to handle accounting on a wing and a prayer with only a faint knowledge of what's in your bank account.  But if you're a company with millions in revenue and a public exchange listing the standards are much higher.  You need processes and procedures that are repeatable and auditable, something Sitestar didn't have.

Sitestar's new auditors unsurprisingly found a number of issues.  It turned out no one really knew how many shares were outstanding, an interesting problem itself.  The company also discovered that they were paying $50k in rent a year for space in an office building the CEO claimed to own.  Except it's unclear whether he actually owns it, regardless he still took the rent payments.  There are dozens of other accounting fixes from goodwill impairments to the resolution of an outstanding $900k loan for $90k that had to be taken care of as well.  

While engaged in the audit Kiel and Moore went through the real estate portfolio with a fine toothed comb.  They realized that carrying costs had eaten into most of the potential profits and that the best course of action was to hire contractors and sell the properties as fast as possible.  This was the course of action the company should have taken from the start.  Kiel and Moore also discovered that the internet operations weren't as bad as they thought.  Through some cost cutting and creative growth strategies the ISP holds potential, not a ton, but it holds potential.

The company is still hauling around some of the baggage from their past life.  The company's CFO, Dan Judd was fired and asked to resign from the Board.  He has since refused to resign and dug in his heels.  Kiel and Moore plan on replacing him in the next proxy context, but until then the dead weight is still hanging around.

With the influx of cash from the real estate sales and money saved from cost cutting the new management team invested in an HVAC roll-up fund.  The stated goal of the HVAC fund is to purchase small HVAC operations, implement centralized operations and sweep the additional profit back into the fund.  This is a fund that is being run by a fellow value investor manager who Kiel has known for years.  Sitestar will reap the economic rewards of the situation without having to actively manage the partnership.  Additionally the manager will only earn a salary if they can execute profitably, it's in everyones interest to make this work. 

The company just released their 10-K from last year as well as Kiel's CEO letter.  So what are shareholders left with at this point?  Sitestar has morphed from an ISP with an undervalued real estate portfolio to an ISP with a liquidating real estate portfolio and an investment in an HVAC roll-up fund with management that is intent on creating value for shareholders.  The company is an interesting investment at these levels.  Think of it as cash and an ISP with optionality.  As properties are sold cash will accumulate on the balance sheet and management can put it to work.  What sweetens the deal is Kiel's track record as a hedge fund manager is above average, and shareholders are getting his skills 'for free'.

I love the story of Sitestar because it shows that determined investors can gain control of a mis-managed company and turn things around.  I don't know the legal costs involved in the proxy battle, but my guess is they aren't substantial.  The biggest thing that Moore and Kiel had was patience, conviction and determination to see the battle through.

Is Sitestar the exception?  Probably not, there are probably a dozen Sitestar's out there on the pink sheets.  I hope there are other determined investors with the resolve to clean those companies up as well.

Disclosure: No position

Don't let these companies hide in the dark!

Imagine for a minute that you had a brilliant idea for a product and needed some capital.  To launch your company with this masterpiece product you need capital, so you find some partners who believe in you and they contribute equity to the new venture.  The product does well, there's growth and everything is going well as you work to build the company.  Years pass, the original investors move on happy with their returns.  New investors come along, ones you don't know as well, but they're happy to collect their dividend checks and talk at the annual meeting.  Eventually these investors even stop coming to the meetings or calling, you are running the company on your own.

Slowly you start to become somewhat resentful of your faceless investors.  They are cashing their dividend checks derived from your hard work, but they aren't involved in the business at all.  They don't even seem to care what's happening with the business.  You adapt to their disinterest and start to release news less often.  Eventually you don't file financial statements as often because you don't think the investors care all that much.  They continue to receive dividends in exchange for no effort, so why should you give them any extra?

This relationship disintegrates to a point where eventually you actively hide information from your investors and pay yourself richly.  You're doing all the work, the investors aren't doing anything, plus they get dividends and don't make a fuss.

Does this story seem right?  Or when you read it does it seem wrong?  Does it make you made or angry?  It should and unfortunately it's not just a story, it's something that is happening throughout the market with companies both large and small, but primarily small.  

Shareholders are the rightful and legal owners of companies they are invested in.  As shareholders they're entitled to returns from the company, either dividends or the assets in a liquidation.  But there is a strange twist to shareholding, outside shareholders contribute nothing towards the success of the company yet reap the rewards.  After a company's initial capital has been contributed outside shareholders are simply trading ownership interests between each other.  It's easy to see how a company's management, or employees could see this as a negative.  The company's management and employees work hard every day to put money in someone else's pocket.  It's also not hard to see how some employees might think "I should take just a little extra for myself and department, we work hard and shareholders will hardly notice."

In financial textbooks shareholders should have power over their ownership interest by virtue of their voting rights for the Board of Director.  Shareholders elect the Board, and the Board makes sure the company is managed in the interest of the shareholders.  The problem is this scenario is only true in textbooks.  Boards consist of people who interact monthly/weekly/daily with management teams, and with that level of interaction it's hard to not become colleagues or friends with management.  It's much harder for the Board to stand up for faceless and nameless shareholders who own 100 shares with the certificates stuffed in savings deposit boxes in Dubuque, Iowa.

The idea that the Board is on friendly terms with management and neutral at best or usually on adversarial terms with shareholders isn't new. This relationship has been well known by investors for at least 100 years.  In theory the Securities Exchange Commission (SEC) was created to combat this problem as well as further promote transparency and fairness in the markets.

Unfortunately the SEC is swamped with leads, both real and imagined and they don't have the staff or inclination to pursue most of them.  A second confounding problem is that the SEC is staffed by people for whom the SEC is a career.  These SEC employees have families, friends and hobbies and earning a paycheck and a promotion is only a portion of how they spend their day.  SEC employees (rightfully so from their perspective) are focused on bagging the biggest cases because high profile or political cases can result in promotions, which means a nicer car, or a better boss, or a window office, or a bigger house in the DC-burbs, or really anything else career related.  But none of those things are "upholding the fairness of the markets". And who could blame SEC employees?  How many employees at any company show up to work each day and while passing the mission statement in the hallway think "I'm going to make the customer #1 and provide value in all aspects of my job today!!"  Most people are thinking about where they want to go to lunch, or about some difficult project, or socializing with work friends.  That work gets done is incidental to the experience.

The area of the market where the lack of a visible regulator or Boards that care about shareholders is most apparent is in small stocks that have "gone dark."  These companies were at one point SEC filing companies that used a loophole in the SEC regulations as a way to cease filing financial reports.  To cease updating shareholders with details about THEIR company.  And to hide in the dark.

The SEC claims that any company with less than 300 registered shareholders (more for a bank) can cease filing financial statements and escape regulatory burdens.  This is called "going dark."  The theory is that a company this small should be considered privately held.  I don't disagree with the SEC's logic, except for one area, the type of shares the SEC counts as 'shareholders'. The SEC believes that only registered shares count as true ownership interests.  A registered share are shares held in certificate form.  These are the fancy certificates that are held in safe deposit boxes and need to be mailed to to sold.  The three day settlement period is an artifact of when everyone owned paper certificates.  Three days gave investors enough time to mail their certificate to their broker after instructing a sale.

Since the markets have modernized most shareholders keep shares in street name at their broker.  The brokerage has a giant digital lookup with each holder's name and the number of shares they own, which is called a beneficial interest.  There is a substantial amount of case law confirming that beneficial holders, investors with street name holdings have the exact same legal standing as a registered shareholding.  And it's because of this that beneficial shares receive dividends just like registered shares.

The problem is these dark companies get to have their cake and eat it too.  They can pay dividends to beneficial shareholders but then hide behind their dark non-filing designation and claim they don't need to provide legally required information to shareholders.  

Companies go dark for a variety of reasons.  For some it's to save costs.  The cost of being public can be onerous to a small company.  Companies that go public for cost reasons often continue to update shareholders with news and their financial condition through the mail and on their website.  The cost savers are the exception.  The majority of dark companies are literally hiding in the dark.  Either management is hiding nefarious dealings with themselves and at times outright theft from shareholders, to other management hiding just how good the company is doing from shareholders.  In both cases management is lurking in the dark and escaping through an SEC loophole.

I own shares in a number of dark companies, they range from the cost savers mentioned above who are good stewards of shareholder capital to a number of cockroaches hoping shareholders never realize they exist.  One company I own, Kopp Glass, decided this year that as a beneficial shareholder I have ceased to exist.  It's almost a comical dance, the company claims I'm not a shareholder and have never been.  Which is ironic because I've been to two annual meetings, and at one the CEO told me he'd looked to see how many shares I owned.  It's worth noting that I have continued to receive my dividends quarterly just like I should.  But if I ask for an annual report I'm "not a shareholder according to our records."  The CEO acknowledged in the past I was an owner, but suddenly I'm not. At a dark company hiding in the shadows away from the SEC they can bend rules to fit whatever they want.

Kopp Glass isn't an exception either, they're just one of many companies that play this game.  The problem is the game is illegal.  In Pennsylvania (where Kopp is incorporated, but this rule also stands in Delaware and other states) it's illegal to grant different rights to shareholders of the same share class.  This means you can't pay dividends to only some of the company's shareholders and not others if they all own the same class of shares.  This also applies to information, a company can't distribute material financial information to a few shareholders and not everyone.  While doing so is illegal it could also be construed as to giving certain shareholders an inside advantage.  In the dark market these sort of occurrences seem normal, but they shouldn't be.  The public would be outraged to find out that GM executives were mailing out pre-released financial figures to a select group of their friends, those executives would probably end up in jail.  Yet with dark companies the SEC has implicitly approved the distribution of material information to whomever a company wants, not everyone by failing to act and take action against this blatantly wrong behavior.

Going dark doesn't mean a company can do anything they want.  It just means they aren't burdened with quarterly SEC filings.  To make an analogy a company that goes dark is acting like a person who moves from a city with zoning and a full time police force to a rural area without zoning and a local sheriff.  Moving out of a city doesn't mean the person can start to distribute drugs, sell weapons, open a brothel and do anything they want because there isn't a full time police force anymore.  They just moved from one form of structure to a different form, but the person would need to abide by the law of the land in both places.  Unfortunately dark companies have decided that they are above the law and since the SEC has failed to enforce the law these companies are getting away with it.

We now have an area of the marke that's lawless and a complete mess.  This is the breeding ground for pump and dump operations, unethical managers and anyone else who wants to hide in the dark.  Is it any surprise that pink sheet and non-SEC filing companies are universally derided as scams and dangerous to investors?

As investors there isn't much we can do to change this.  I have made it a point to write about companies that flaunt their dark status as a ticket to steal from shareholders, but writing can only do so much.  At some point the SEC needs to step in and enforce their own rules.

Investors have a very unique opportunity in that right now the SEC has an open comments period on financial information requests.  I know some investors who have let the SEC know their thoughts on dark companies, and I plan to as well.  I hope you will also write a letter, no matter how long or short telling the SEC that companies need to treat beneficial shareholders the same as registered shareholders in doing dark transactions.  The SEC should also ensure that going dark isn't a license to steal from shareholder pockets either directly or by giving out inside information to select parties.