Monday, August 1, 2011

Sitestar: The Cigar Butt That Isn't.

When Warren Buffett describes cigar butts, he describes them with the following:

“If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible. I call this the ”cigar butt” approach to investing. A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.”

This is a description that is given to a company that is dying and has no real prospects for changing... Sitestar is an evolving company; one that is able to juice cash flows out of the future of it's historical technology business. Using these cash flows, it is re-allocating funds into real estate, it's own undervalued common stock. As a result, the company may look like a cigar butt, but, in all actuality, could not be much further away from that!

Is It Really An Internet Company?

Sitestar, while having an internet service business that may be dying, is a company that is super cheap. I say this, because the while revenues on the technology side of things are getting gradually lower, the company is nimble in it's ability to reduce expenses. Looking at this document, we can see that as a % of revenue, costs remain pretty steady, despite a huge drop off in revenues. Really, the company can continue having it's revenue drop, which has slowed considerably, and still do quite well... Regardless, looking at the sheet, we see that things are not nearly as dire at the share price reflects.

The Misleading Income Statement...

Basically, even at the recently run up price of 2.5 cents/share, Sitestar is trading around 2x the previous year's earnings.

"But WAIT!" You say... that can't happen! I looked at the income statement, and they have lost money for a while.

Yeah, that's right, but, when we look at the cash flow and balance sheets, we see that those accounting losses are just that: accounting losses, that are not indicative of the real earnings of the business. In actuality, these losses are due to amortization and such; a lot of their business is intangible (customer lists) which lose accounting value on the balance sheet very rapidly and in turn, make earnings look a lot worse than they actually are (and, essentially, shield the company from paying taxes on some gains). When looking at this, it is important to determine if the reduction in the book value of the previous acquisition is offset by that of the earning power of the acquired business. Certainly, given how much Sitestar has earned in the past 2 quarters, it seems that is the case...

How long can this last? Well, I will be frank with you: I have no idea. But, I am confident that the company will be able to generate owner earnings for a decent period of time from the internet business due to it's nimble nature (which is pretty well reflected in the sheet that I linked to above. Furthermore, as the company acquires other customer lists and other internet companies, operational efficiencies will take place.

A potential forgiveness of debt...

One thing that I noticed with the company, is that they have a ~$900K note payable to USA Telephone, which, if you look at the original purchase agreement, was supposed to be paid off in 36 monthly installments. Yet, there has been very little paid on it in the past few years (see Note 6 and Note 6). It seems that this is due to USA Telephone not delivering on all that they said they would in the purchase agreement (you can read about the original purchase in this filing, and some others). I view it as being quite likely that a lot of this debt will be written off of the books, if not all of it... This would greatly increase the company's book value and financial footing.

Moving To Real Estate...

What I do know, is this: the company is moving it's cash flows into an asset that I generally love- residential real estate (I am, after all, a small time landlord). Lets take a look at the language used in the last 10K:

Pursuant to the approval of the board of directors, the Company’s management believes that it is in the best interests of the Corporation to implement a program to purchase (“Purchase Program”), as investments, real estate with the Company’s surplus cash flows. Any real estate purchased pursuant to the Purchase Program will be held as investment until such time or times as the Board of Directors, in its discretion, may deem advisable to sell or otherwise dispose of the property.

The current real estate market presents the unique opportunity to acquire properties at deep discounts from assessments with the potential for substantial profits. Management evaluates property as it becomes available with respect to the market value versus what it can be acquired for, in addition to other conditions that could affect the resale value. Renovations are made as needed to maximize the market appeal and value prior to listing for sale.

Management believes that there is sustainable cash flow potential for the near future in real estate and is actively pursuing the program. As of the balance sheet date, December 31, 2010, the Company has invested approximately $515,000 in surplus funds and is continuing the investing process. Management has determined that the Purchase Program will not impair the Company’s capital, cash flows or operations.
Since that point, the company has been allocating money into real estate like crazy. At the close of the quarter before last, they owned $1.378 million in real estate, at the close of last quarter, they owned $1.695 million in real estate all of which, appear to be unencumbered by looking at their SEC filings. Additionally, it appears to be a mix of commercial and residential properties located in various parts of Central Virginia... While it isn't disclosed in the company's financials, I was able to track down a good bit of the real estate, and find out what Sitestar paid for it.

Here are some addresses with various property info: I cannot stress enough that I am not sure if this is what the company owns... there is a possibility that there have been other businesses set up which use the name that these properties show up under. Sitestar may have bought their properties under a different name... I do not know for sure. As a result, no assurance can be given to the reliability of this information in any regard towards Sitestar: simply put, I don't have access to the company's books and have not looked at the deeds!

Roanoke County (a screen shot of the info below):

3606 Bunker Hill Dr
Assessed at: $139K
Date Purchased: 2/24/2011
Bought for: $139K

5306 Dresdin Cr
Assessed at: $172.9K
Date Purchased: 4/4/2011
Bought for: $173K

2818 GBoldreggin Dr.
Assessed at: $187.4K
Date Purchased: 3/14/2011
Bought for: $187.5K

3719 Janney Ln.
Assessed at: $155.5K
Date Purchased: 1/26/2011
Bought for: $155.5K

5460 Clearwood Dr.
Assessed at: $172.9K
Date Purchased: 4/4/2011
Bought for: $173K

10271 Ivy Ridge Rd.
Assessed at: $219K
Date Purchased: 2/11/2011
Bought for: $218.8K

4812 Moore Rd.
Assessed at: $151K
Date Purchased: 2/3/2011
Bought for: $151K

City of Roanoke

Assessed at: $210.7K
Date Purchased: 4/28/2011
Bought for: $0- it appears that it was some sort of a transfer or property exchange, where Sitestar took it back with a lender or traded property for it? Without looking at the deed, it will be hard to get an idea. It is on the government pages as being co-owned with BKC Properties, whatever that entity is...

Assessed at: $134.8K
Date Purchased: 2/17/2011 (again, co-owned with BKC Properties)
Bought for: $85.7K

Assessed at: $232.7K
Date Purchased: 11/19/2010
Bought for: $231K

1510 Rivermont Ave.
Assessed at: $224.9K
Date Purchased: 4/28/2011
Bought for: $64K

Total Amount Spent (with adding in nothing for the Cove Rd property): ~$1.58 million dollars. So, that leads me to think that they spent roughly $100K on the Cove Rd property, or, that they have some sort of reduced % ownership of the properties that they own with the entity known as "BKC Properties". While this may be a Sitestar entity, I simply don't know.

Additionally, in regard to the amounts paid for the properties, I have not looked at the deeds, but, they may have been purchased at lower prices, when considering a number of factors: they could have been short sales, the company could have received cash at closing from the seller, to get the sale price up, but, keep out of pocket expenses down, the company could have made a stipulation in the contract that the seller made a lot of repairs to the property, the list of possibilities could go on and on.

A lot of times, people try to keep the assessed values of properties kept higher than they paid for them, so as they are not reassessed at a lower value, since prospective buyers have a bias against paying more than something is assessed at. Additionally, when making it look like you paid more for a property on government tax records, it makes prospective buyers think they are getting a better deal than they actually are... adding a tag line of "being sold under county assessment makes a buyer feel good. Plus, if a buyer sees that you paid 1/2 what you listed it for, they are likely going to low ball you. Furthermore, Julie Erhartic, is on the board of directors, wife of the CEO, and a Realtor, is likely doing a good job of acquiring assets and navigating the straights of game theory real estate negotiation for the company. Furthermore, it isn't like the Erhartics don't have experience with real estate, they own several pieces in the area (some are in Roanoke), here are just 3 of the ones that they own in Lynchburg. One of which, is actually Sitestar's headquarters, which they lease to the company.

In regards to any money that they have spent on fixing up the properties, it is hard to tell by looking at the companies financials if it would have been accounted for as an expense, or, added to the cost basis- as based on when the property is put into use, and the nature of the repair, it should be added to the cost basis or expensed. Again, without actually looking at the company's books or actually seeing the progression of the properties, it is hard to get a feel for.

One thing that I am pretty sure of, especially when considering how the company has historically allocated capital, is that the properties will at a minimum tread water for the company/have been purchased at a fair value, but will ultimatly likely do well for them.

Share Repurchases!

In other capital allocation related news, the company repurchased 500K shares of stock last quarter and another 150K shares the quarter before that (see note 3). When you look at their history for stock repurchases, they have done so in an aggressive manner... Basically, in the past 6 months, the company has repurchased just a hair under 1% of their own common stock.

If that isn't enough for you, we see here that over the past 3 years, they have repurchased a glut of their own stock. AND, they repurchased it at prices that were significantly higher than where shares are presently trading at. While it is obviously preferential to buy shares at a lower price, this gives us an idea as to the willingness of the company to continue and expand it's repurchase program. Arguably, the company did a good thing by repurchasing shares even when they were trading north of 10 cents each, as they were not exorbitantly priced at the time; in addition to the fact that management had no way of knowing the stock would trade down.

In conclusion...

So, here is a company that is trading not only below book value, but, for less than tangible book value, and is has been earning a nice chunk of money relative to it's market cap. Furthermore, it appears that their internet business, while losing revenue, is very nimble in it's ability to reduce expenses as revenues decrease. With a significant amount of the company's expenses able to be covered by rents on real estate (which, seems to be a worse case scenario) we get the future of the technology business for free, which still has a lot of intangibles and goodwill to burn through, which gives us some preferential tax treatment...

Sitestar, even despite the recent run up in price, appears to basically selling for it's liquidation value, if you value all of the internet business at absolutely nothing and discount the real estate, which they seemed to get a fair market price on (and I would assume have been investing money in improving the condition of). Furthermore, you get all the future cash flows of the internet business and the appreciation of real estate for free...

Disclosure: I am long shares of SYTE.OB. This is a small and relatively ill-liquid security, so, it is likely to be considered risky. This is not advice of any kind. This is not a recommendation of any kind. Always do a ton of your own research in regard to anything that I say, do, write, or so much as even think about.


Chris said...

Why do I want the management of an internet company speculating on residential real estate? If management can't find a productive use for the cash it should be returned to the shareholder.

jeff said...

Because if they do it well, which, it appears they have the ability to do, it can in benefit shareholders more than returning it to shareholders.

It's all about capital allocation, at present, even if they allocate it badly, it looks like shareholders will do well, especially when considering what the stock is trading at. A better question to ask, is why would an insurance company like Berkshire Hathaway allocate funds to buying a boot company (like Justin Boots)...

Anonymous said...

Do you have any worries that management will mishandle the cash and company value in the long term to their benefit? Since their is no real BOD or corporate governance, what's to stop them from increasing the salaries and cashing out at the shareholders expense?

jeff said...

Not really, they have historically cut costs and run a pretty lean operation. Furthermore, they have no history of being unscrupulous, so, I doubt they would change all of a sudden. Frank is in charge of selling all the real estate, and I am under the impression that it is part of his job as CEO. He seems to work really hard.

Anonymous said...

I agree with all of your logic, but I still can't pull the trigger, namely because I don't feel that others will attest to the value of Sitestar. I do not want to be a bagholder waiting (years) for others to realize the value of Sitestar.

It's one thing that the volume is tremendously low. That's never a dealbreaker.

My primary concern is that other potential individual investors will look at a declining internet company purchasing real estate, scratch their heads, and think "that's weird", and then move on to the next potentially undervalued stock.

As an investor I look not just for value, but for clarity in the eyes of other future investors, namely those who will help drive up the price to its rightful value. With Sitestar, I don't see that public clarity.

I could be wrong here, as the price seems to have picked up in recent months. I'm just stating my concerns.

Anonymous said...

I just found your website and seen this post but is it just me or is it not too wise to invest a company that has had free cash flow of:

2008 ~ ~2.5 M
2009 - ~2.0 M
2010 - ~0.5 M
2011 - ~- 1.0 M

On top of a share price that has gone no where for 10 years which is usually at least relatively close to intrinsic value changes over such a long time period since the market is no where near 100% inefficient.

jeff said...

Thanks for reading, anon.

I don't care about historical price fluctuations, as they have nothing to do with the intrinsic value of the stock... While often stock prices do follow, IV, I don't believe this to be the case with SYTE. After having seen the properties that they are investing in, I am very confident in the future of the company.