Saturday, September 1, 2012

Portrait Of A CEO: Frank Erhartic

Frank Erhartic: One of the few CEOs who isn't afraid to get his hands dirty.

When I first went to Virginia to do scuttlebutt on my investment in Sitestar (which grew considerably after said trip) I thought that I had a pretty good feel for the company. On my second trip, I quickly realized that while I had a decent idea of what was going on, I didn't have a full appreciation for the situation at hand. For example, Frank Erhartic, the CEO of Sitestar is willing to do what most investment bankers would consider grunt work and actually work on a house when needed- this continues the tradition set by Roger Griffin at International Baler, where CEOs that I have a high opinion of are willing to do work that is far less glamorous than sitting in an office- Griffin as an example, landscaped the HQ of IBAL his first weekend on the job (on his dollar) and would even occasionally step into the line to weld balers to boost moral.

When talking to Frank in advance, I had told him several times that I would pay for lunch or dinner at whatever place he wanted, which was an open invitation for him to gouge me by going to a nice steakhouse or something. Where did he pick? A Chinese Buffet where the total bill (after a healthy tip for the 2 refills of the water that we drank) came to 19 bucks. I kid you not- while on this trip, I spent more money on a single bar tab/dinner in Charlottesville OR on all my highway tolls and the 2 trips I made to McDonald's, than I did on that lunch.

To describe the place we went, I will reference you to Yelp!: Larger cities like New York, Washington DC, Chicago celebrate culture with museum openings, art exhibitions, and galas.  Roanoke celebrates culture with Asian buffet openings.

Now, onto more serious matters.

Executive Compensation: It's obvious that this guy's idea of dining out is less than mine, which is saying something. I just hoped that this transferred over to his running of the business, which I already kind of expected given his cost containment in the executive suite: as CEO, Erhartic made $13K last year and the CFO of the company made well under $50K. While eating, I asked him about his low salary. He said rather than take a big salary, he would rather make money on the increase in the worth of the company (he owns about 1/3 of the shares) and that he was able to live off of other investments he had made- verifying what I had previously thought. His thoughts on salary and common stock ownership seem to mirror my own.

This was backed up with how he has gone about buying properties for himself and the company; it seems that the only properties that he has personally bought since Sitestar started their real estate acquisitions were ones that he wanted to personally live in. 

Moving To Roanoke: When asked about commuting between Lynchburg and Roanoke, he responded "I moved here (Roanoke) because this is where the deals are." The sense of trying to get a better deal all the time was showing as a common theme for him. Hell, when I was talking to him about 10% discount cards to Lowes (which you can also use at Home Depot) that you can get in the moving packets at the post office, he was way ahead of me. Erhartic talked of how he used to buy them on Ebay. Basically, if you pay a high price for them on Ebay and spend more than $30 bucks at the retailer, you break even. On a purchase of $1K, which is pretty typical at Lowe's and Home Depot (which will honor Lowes coupons) you save a decent amount of cash. Personally, I give my tenants a discount in rent if they to go to the post office for the moving packets and give me the cards. At a buck per card, it can save them some serious money on their rent and I come out way a head if I spend more than $10 bucks at the store; something that I can probably count the number of times that has happened on 2 hands. In fact, just 2 nights ago, I saved over $300 dollars by using one!

The Internet Business: While it is obvious that the internet business is losing steam, it has managed to remain profitable and cash flowing. Erhartic credited that in large part to efficiencies that had been created from the get go. For example, he made a lot of the costs (like capacity) variable so that while they paid a little bit more by not having a fixed contract initially when things were growing, they wouldn't be saddled with burdensome contracts when revenues eventually fell. At some point in the near future, he was going to be flying to Washington state to work on some more efficiencies for the internet business. 

Erhartic also spoke of how email had traditionally been one of the most troublesome items for them, which is why they always wanted to outsource it to other firms that could handle the job not only better than they could. I would think that if people are not constantly having problems with their email, that they would be less likely to change internet providers. In turn this should keep revenue from declining as fast and ensure nice margins. While I have no idea how long the internet business will last, I am comforted by the fact that it's costs are pretty scalable. Erhartic still gets offers to buy ISPs and such, but weighs their prices against the real estate that he can buy from Sitestar's filings, it's pretty obvious where he has been directing our company's capital.

Software: At lunch, I asked Frank how he found all the properties that he had bought. After grinning, he pulled out a sheet of paper from his pocket and unfolded it. It had pictures of properties, property info/specs of the houses, and some hand written notes on it. He explained to me in detail, how he had created a computer program to scour the internet for various sales to find properties in the area with all the specs and various values that had been assigned to them by different people. He pointed to one on the page and said something to the effect of "I know the guy that lent the money on this... He generally only lends 1/2 the value of the house." Erhartic also pointed out that sometimes, auctions for houses only go up for a few hours one day and get taken down, but still occur. This program apparently accounts for that when he prints out his sheet of results- giving him not only more, but better information than most people are able to get.

He also developed a website with software that is great for the managing of properties and there may even be an app in the works. At various points when I would ask how much he had paid for a property versus what it was worth he would just pull up the data on his phone and say something like "well, I bought this 6 months ago for $55K, when finished I'll probably be able to sell it for $90K. This is for a house that in my estimation only needed about $5-6K in work. It was kind of spooky, because probably 90% of the time, he would say something to me about what needed to be done to the house or the cost of fixing the house it was almost exactly the same as what I was thinking. At times, I felt like the guy was in my head.

The Economics Of Flipping: One might ask why there is such a large discrepancy as to why a house can be bought so cheaply (say, $55K), such a little amount of capital be put in it maybe $10K), then sold for a premium (around $100K). In my own experience, it is rare that a person looks to take on a project house to live in. Bankers and especially the government, don't like to or won't lend to owner occupants for houses like that, which eliminates the majority of home buyers... A lot of real estate investors are in a situation where they are either over levered or are real estate rich and cash poor, which eliminates even more buyers. Then, there are the investors that simply don't want to fool with residential real estate and want to use larger amounts of capital on bigger deals. As an example of a deal killing amount of work, the bathroom on the right turned out to be a great development for Sitestar. All that it really needs is a new light, mirror, faucet, and vanity. After that, a coat of paint and thorough cleaning which would have been done to the whole house any way, and it will look like $100,000 bucks. Total cost for the bathroom upgrade? Well under $500 dollars (even if you use nice stuff) and a day's worth of work.

Once the house is fixed up, first time home buyers are still able to get into a house that is in good shape with next to no money out of pocket through federally subsidized loans. The last house I sold was for just a touch more than $65K and was REALLY nice. It was actually nice enough that there were no comps in the neighborhood for the sale price. Anyway, the buyer got me to pay closing costs and such, rolled that amount into his loan, and as I recall, walked away from the closing table only having about $550 dollars of his own money in the deal... That's less than the security deposit I would have charged if I had rented the house out. Literally, is was far cheaper for him to buy the house from me, than for him to rent one in far worse shape! This types of artificial demand that the government discourages and then encourages likely won't be going away and can really play into Sitestar's hand. 

The company is also selling options to buy to renters of some of the houses as well; yet again, a great way to get money for shareholders and to help people on the path to home ownership. The house pictured to the left is one of them.

Networking At The Courthouse Steps: 
While at lunch, Frank said something about needing not having much time since he needed to get to an auction that was taking place. Being interested, I suggested that we both go- a request that he quickly obliged. We left the buffet in his standard Audi TT (which was a few years old) that had tools and supplies in the trunk. There were a few kids toys in the car as well, so I figured that this is a guy who likes his kids and works a lot. What started as a simple auction turned into a days worth of driving, looking at houses, co-ordinating workers, and conversation.

We arrived at the courthouse steps a bit early and talked about how we each got started in real estate. His start was relatively similar to mine- while in college, he bought a 6 plex that was fully occupied. If I remember correctly, he said that within a few weeks of closing, he lost 4 of the tenants and the heat went out. At that point, he was kind of like "Well, what am I going to do now?" The answer came pretty quickly and was exactly what I did, years after he: he was going to work his way out of the mess. Erhartic grew from there, learning along the way.

There were 2 scheduled auctions, one of which was canceled. In the picture above and to the left, you see everybody that was there (less me). Frank and the gentleman in the red shirt were the only 2 that were interested in bidding on the house (which from our previous conversation, seemed like a decent deal to me)... This gave me a pretty good idea as to why Sitestar is able to get the buys that they do on houses- there is very little competition in the area!

While standing around waiting for the auction to happen, Frank started talking to the older gentleman on the far left. It came out that he had some property in the area and that he was looking to buy more, just not on that day. Frank immediately seized the moment to network with him by inviting him to a local real estate investor gathering (where he is the Chief Technology Officer of the group). He also talked to him about potentially selling some of the properties that Sitestar owns.

The auctioneer needed to verify funds from the interested parties, but when she came to Frank, she skipped over him, saying something to the effect of "I know you're good" as they joked and had a quick conversation about the bidding. Ultimately, there was a bidder that was on the phone who purchased the property (I think via the attorney that was doing the auction, but, I am unfamiliar with the process in Virginia). Frank and I left, both thinking that there was money to be made on the house as either a rental or flip, but not so much that it was a stupendous deal for Sitestar.

Rentals Vs Flips & Leverage: As I believe prudent to do in my own business, Sitestar is not a one trick pony that only does flips or only does rentals. Frank told me that looks at ways to generate the highest return on investment. Naturally, I wanted to know when he was going to implement the use of leverage as it is a superb way to boost returns on real estate, especially when interest rates are low, Sitestar in in fantastic financial condition, and they have properties that will generate margins that are significantly in the double digits. While not boxing the company in to one way of doing things (flexibility is always nice), it seems as if the company will be getting some more rentals and then come to a point to where they can take on a million or so in leverage, using those cash flowing houses as collateral.

This led to a conversation where I asked what the ideal amount of money for the company to have when it comes to real estate. Frank said that he would really like to have $10 or so million to throw around on deals. He spoke of a nearby Gold's Gym that had recently sold for around $3 million, when it was probably worth north of $4 million, with an assessment just below of $3.75 million. When briefly going over the return on a cash investment in the place relative to the rents on the appraised price, you would be looking at percent that was solidly in the teens, in the first year without allowing for any growth in the price of the property... Pretty impressive.

Quality Of The Houses: An item that I noticed and was continually impressed by was the overall quality that most of the houses in Virginia were constructed with. I can't express enough just how shocked I actually was. Very few of them had any problems with setteling- in Central KY, this is a fact of life that we deal with. Personally, I have (much to the chagrin of my realtor) probably walked away from or given lowball offers on 50 houses simply because they had basement walls that were letting in water and have significant bows. Almost all of the houses in Virginia had copper piping that was in tact. Again, a rarity here. Frank generally checks the houses out before buying them, but as far as good bones go there seems to be little need. From what saw, he either does a great job with screening, or builders are a lot better in Virginia and people are more honest when it comes to stealing copper for drug money than they are here in Kentucky. I tend to lean to the former of those scenarios. Regardless, I was quite impressed with the 15 or so houses we sa.

Getting Tenants To Pay More:
Another great way to make money that Frank had copied from another landlord, was to get tenants to essentially pay for upgrades to houses. As an example, he can go to his tenants every year or 2 and say something to the effect of "Hey, due to the costs associated with doing business and rising prices in the rental market, I have to raise your rent by $25 a month. However, I can do an upgrade to your house. New counter tops, carpet in a few bedrooms, or something like that." This works out really well, as it gives the tenant something tangible in exchange for the upgrade, so it makes them feel like they aren't getting screwed. It can also keep workers busy if they don't have much going on. It's a win win for everyone involved.

While driving around, I even got to take a look at the lease and the rental application that the company uses. Both were very similar to my own. In both instances, Erhartic did just as I had; compiling useful info from a host of others that he had read, taking the good, forgetting the bad, and coming up with a very good and concise document that should hold up well in court in the unfortunate event of an eviction.

A Potential New Line Of Business? Erhartic has been thinking of even more ways to ensure profitability for the company and made mention of the potential for Sitestar to get into property management or even to start something along the lines of a partnership where they can raise outside capital to buy properties with where Sitestar would be a general partner. The software that he is developing would aid greatly in this and as most of you readers know, money management (which is essentially what Sitestar could get into) is something that generates incredible returns on invested capital. Will this eventually happen? It's hard to tell, but there seems like there are a lot of deals out there (say, the previously mentioned Gold's Gym) that this would be perfect for. With everyone and their brother wanting to make some sort of investment in real estate, this would be a great way for the company to offer a service to people that don't like getting dirty but want to own some real estate. Again, a win win for everybody.

Juicing Value Out Of Houses:
One thing that Erhartic does in every house he buys with a basement, is finish it. It is an easy, quick, and relatively cheap way to really raise the value of a place. When he does so, his crews don't do a poor job either. Notice in the picture to the right and how the lumber on the floor has a different color than that of the studs going vertically? That's because when framing in the wall, he makes sure to use treated lumber for the bottom plate. It costs a few dollars more per 2x4 maybe adding $35 or $50 dollars to the cost of every house, but makes for a really nice job since the lumber on the floor is resistant to water, condensation, and a host of other things that aren't good.

To see further evidence of the quality of work that the company does, check out this video I took the first time I was in one of the houses (I was let in by one of the workers on site), and compare it to the following pictures of the same house about 6 months later. Keep in mind, this isn't the only house that the company did a lot of work to!

Problems That Come With Growth: Whenever a person or company grows a new line of business quickly, there will inevitably be growing pains. This is something that is a constant worry with real estate, as contractors and laborers are often very skittish and retention of quality workers who work all the time and are honest is difficult. Frank combats this a little bit by refusing to hire smokers, as they often bring down an entire work crew by taking smoke breaks. He has had issues with various workers not showing up on certain days, but is working to improve the situation through a few different means. We threw back and forth some ideas on the matter, and hopefully they will be beneficial.

Additionally, when there are so many houses that need a little bit of work and are available at distressed prices, focus needs to be on buying the properties and striking while the iron is hot. When a company grows an operation of this nature from nothing in June of 2010 to  well over $2.6 million in real estate at the end of last quarter, with the properties carried at cost, there will be houses that don't get fixed up for a while. While I would prefer things to go quicker, fixing up houses is something that you have to keep a close eye on. Since the company doesn't have any debt against the ones that are not rented, they can afford to wait. In the meantime, they have the ability to sell them off to a "do-it yourselfer" or another investor. It doesn't strike me as a bad spot to be in.

As a side note, you can get abetter idea for the houses the company has for sale here and the ones that are for rent here.

Me Swinging The Hammer: The last day that I was in Virginia, I met Erhartic at one of the houses that a crew was in the process of finishing out. As some of the workers weren't there (it was a Saturday) I figured that I could take a little bit of time to lend a helping hand. As such, I hung a basement's worth of electrical boxes and bore holes through studs and joists for wires to be run through. It was re-assuring to me that Frank was at the house working, just as he said he would be when he dropped me off at my car the previous night (somewhere around 10 PM).

A while ago, I learned a trick from my brother, who picked it up from our great uncle that comes in handy when hanging electrical boxes, that I wanted to share with Frank. You can get a uniform height on them by essentially using your hammer as a measuring tape. Simply put your hammer, head down on the floor, and hold the electrical box on top of your hammer to place it before you nail it into the stud. It's a trick that a lot of people never really think of, so I told him about it. He just grinned and said "Yeah, I do that too."

At that point, I chuckled, thought to myself "of course you do..." and went about my merry way. Also, you might notice that I was hitting the nails in the box with the side of my (well actually, Sitestar's) hammer. For a free piece of home improvement advice: when hitting nails at a weird angle, I like to use the side to set the nail as it is bigger than the head. You are able to get the nail set straighter, use less force, and won't ever hit your hand. After a few blows, flip it and hit away as you normally would.

After a few hours, Erhartic, his daughter (who was hanging out with her dad while he worked), and I all went to Burger King to grap a quick bit to eat before I ventured back to Kentucky. We talked about the business some more, he educated me on "subject to" sales of real estate, and we even talked about the need to re-establish the company having annual meetings in the near future. In parting, I asked him what I always ask a CEO, roughly: "Is there anything else that you like to say about what's going on for any write up I might do?"

His response? "Just be honest."

On my drive home, despite thinking that there was some room for various improvements, I was pretty impressed with what I saw. It takes a unique type of person that can literally smell a crawl space and have a decent idea of what will be wrong with a house. If one can do that, run an organization, and understand capital allocation, there is the potential for a real winner.

EDIT (9/3/12): A reader asked me if I talked to Erhartic about the USA Telephone related debt that hasn't been paid for sometime. When talking to him, he said basically what I heard from the CFO a long time ago. "Look, we pay people what we owe..." was his response. When asking about the time frame for it coming off the books, Erhartic basically said that he was in the game for the long run and wanted to focus on buying properties rather than negotiate out of something that they don't owe now, or ever for that matter. Understandably, he seemed to be in no rush, 

Disclosure/Disclaimer: I, various members of my family through accounts that I manage, and our family investment club are long shares of Sitestar. As is public, we make up a group that has a 13D filed with the SEC in relation to our investment in the company. I have not bought or sold any shares of the company since the last amendment to the 13D was made, but reserve the right to change our position at any time. I assume that all I say is accurate, however, I am human and do screw up- as such, you should always do a ton of your own research before even contemplating anything that I say, do, write, or so much as think about.

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