About Me

My photo
Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Monday, March 26, 2018

"The Past is History, Tomorrow's a Mystery": On Paying Backup Prices for Starting Talent (CTEK, PSSR)

In a post-game interview after beating the Giants in a January 2007 playoff game, Jeff Garcia, then QB for my Philadelphia Eagles, said: "The past is history, tomorrow's a mystery, today's a gift" (sadly he didn't complete the aphorism: "that's why they call it the present.")

The premise of the comment was to "live in the moment" and it was made in response to a question about Garcia's unlikely rise from backup to playoff hero, a role I might add that was reprised and expanded on even more heroically by Nick Foles, 11 years later.

Investors, like athletes, should as much as possible "live in the moment" by putting their heads into their work of reading, learning and analyzing, and then making most of opportunities when offered by the occasionally mis-priced market.

Athletes are "talent" but investors are "talent evaluators". We look for managers and executives at a company, who themselves need to allocate their assets optimally. It is capital allocators all the way down.

And where a professional athlete's drive and focus directs them to only one outcome (with a focus on winning) the investor's world is by nature much more probabilistic. We need to consider the range of potential outcomes from success to failure, the inputs to those outcomes, and weigh the likelihood of each.

In our role as a "talent evaluator," I (and I'm sure many others) place a lot of emphasis on historical results as a reference for understanding what worked and why, and how in our assessment of future outcomes, these same managers are likely to behave given a set of changing circumstances.

But sometimes the near and / or distant past offers little guidance, b/c the product or company is new, or has an unremarkable - or even tarnished past - so the future opportunities aren't immediately apparent on form or financial statement. And since most people tend to repeat their behaviors, for better or worse, something significant needs to have changed for the trajectory to change, or one need be aware of the factors that lead to poor historical results. Getting back to the sports analogy, most viewed Foles' history with the Rams as sufficient to dismiss him as a potential starter, but they may not have understood how capable Jeff Fisher was at ruining QB's.

Companies with unremarkable histories are inherently lonely trades b/c understanding the opportunity requires some knowledge of what's changed / is changing, or requires some digging and / or comprehension of accounting, or simply requires the kind of patience that is unusual on Wall Street. And it usually takes time for these changes to filter through.

A simple example that comes to mind is PSSR, which I've written about previously and which I've patiently been accumulating even as the near history shows profits turning to losses, negative cash flow and evaporating BVPS.

This negative change of recent history is primarily a result of SG&A growth +21% CAGR 1Q15 to 1Q18 TTM while over the same period, revenues growth of +7% CAGR. The slowdown in sales growth was primarily due to a single customer not renewing a contract in 2017. (PSSR is a tiny $18M EV company; investors should consider the risks / consequences given the impact a single contract can have on the P&L.)

If you stopped at this unprofitable inversion, you'd miss the potential conclusion of that spend. When the "S" of SG&A is spent wisely and consistently, that "S"elling effort should result in a resumption of sales growth. It is the job of every investor under any scenario to assess for themselves the reasonableness and probability of "should" and where "should" elevates to opportunity.

This isn't an ideological "should" ("We should have ice cream for dinner every night") but one based on causality and reasonableness ("if you study hard you should do well on the test"). As a caveat, I warn those away from ever investing on the thesis of what Congress "should" do, b/c in my experience at least, it never does.

The nice thing in the case of PSSR (and other subscription-based companies like them), is that the balance sheet offers a peek into the future via deferred revenues, which has grown to new highs, indicating some traction (at long last) that "S"elling is converting into sales.

Therefore, there is a reasonable probability that revenues over the next 12-months should grow to new highs (back of the envelope assumes +$16M in 2018). This would infer some re-normalization of revenue growth > expense growth and a return to profitability.



And this is potentially just the start. Given the growth in demand for air travel concurrent with capacity constraints at airports, et al., one may anticipate that the airline industry should continue to want (and perhaps even rely upon) even in an ADS-B world, the type of technology solutions that PSSR offers (surface management, diversion management, fee management, etc), and that spending for that offering could be sustained by the strong positive economics experienced by the airline industry (provided fuel costs remain stable).

That PSSR has access to permanent capital sourced from their Chairman who is 76 years old, owns 55% of the company and has a long history of operating with an eye towards wise & capital allocation further aids my view. That his age creates a form of impatience makes it even more interesting b/c in a sale, this I believe could go for multiples of the current public market valuation.



Nobody knows the future ("tomorrow's a mystery") but with PSSR the probabilities seem attractive, at least to me.

All that said, it is actually not my endeavor here to write about PSSR but about another opportunity that seems like a lonely trade, where one can pay backup prices for starting talent, and where the past seems unremarkable but the future potentially rewarding.

In this case, I refer to Cynergistek (ticker: CTEK), which at the current price of $4.75 has a roughly $45M market cap company and by virtue of nearly $17M in net debt outstanding, an EV of $62M. At 8x EBITDA, and with foreseeable growth in its high margin cybersecurity business, it seems like an opportunity. And as we discuss later, the filings actually show some championship style historical financial statements, but an investor would need to dig to find them, an endeavor that would require more effort than trying to find pretty much any athletic statistic at the minor league, college or CFL level.



CTEK provides two niche service - cybersecurity and managed print services - to one niche type of customer - hospitals and healthcare institutions. 

About these services, in brief ...

1. Cybersecurity. This is the prize of the company. It is a consulting / staffing business, with low revenues, high margins and high cash flow. It is a service that utilizes highly skilled, trained, personable, customer service oriented folks with advanced knowledge of IT. The contact point with the customer tends to be the CIO or CTO.

2. Managed print services (MPS). This is a cash generator but an otherwise unattractive, low growth, low margin service for managing the purchases of printer supplies (toner / paper) and equipment (printers / copiers). It tends towards high and lumpy but low margin revenues (based on the timing of pass through equipment purchases). Traditionally it utilizes low skilled, personable customer service oriented folks with basic knowledge of IT. The contact with the client is the purchasing office.

... the company itself is the result of an acquisition where publicly traded pure play MPS company "Auxilio" acquired privately held cybersecurity company "Cynergistek", and then changed its name to Cynergistek.

I'll discuss more about this acquisition in a moment, but for now, here's a slide from their investor deck showing services offered. These are primarily consulting type offerings with some staffing and some MPS.


Why in brief this investment works ...
  • This is primarily a services business that makes money (broadly speaking) on the bill / pay spread of a utilized employee or contractor. 
  • The company has access to talent though a strong military connection that helps provide a quality labor supply, which is often a constraint in services businesses. More importantly, it is a constraint for customers who cannot otherwise access this talent.  
  • The company also owns technology that can be utilized for remote / automated engagements, which enables some scaling.
  • The risks of a cybersecurity breach means spending on it should no longer be discretionary. 
  • Customer spending supports growth in contracts = Grow sales. Leverage O/H. Generate cash. Pay off the debt. Value accrues to shareholders + potential multiple expansion.
  • Publicly traded staffing comps trade 10-15x FORWARD EBITDA. This is trading at 8x trailing.   
Why in brief this investment fails ... 
  • Customers don't have fat wallets. Post ACA, healthcare institutions have fragile income statements. That means long sales cycles and competition. 
  • A corollary to stressed financials is that it can lead to consolidation, which would shrink CTEK's market. 
The optionality of end market expansion beyond the thin-walleted healthcare market into education and academia offsets what I believe to be the biggest risks of the investment.

Since the company recently reported 4Q17 results, let's look at the present through this brief peak into the financials ...


... the contribution of the lower revenue / higher margin cybersecurity business means OpInc + EBITDA growth much faster than revenue growth. Investors who just look at topline growth are missing the picture entirely.

My view is that over time, mix shift towards faster growth / higher margin cybersecurity business justifies a higher multiple even if overall revenue growth slows. If this plays out over time, I'd say at current prices, the present really is a gift to investors.

"The Past is History" (ie a brief look at how we got here)

Going back to early 2000's, Auxilio (as this publicly traded company was previously known) was a pure play MPS business. It was managed capably under prior CEO Joe Flynn, except for the period '06-'09 when he left to pursue other opportunities and the company was incapably managed by someone else (Flynn returned in 2009).

Like everyone, Flynn has positive and negatives. One of this strengths was anticipating that the MPS business wouldn't offer enough growth or profitability for the long term so as far back as 2014, he started pursuing a cybersecurity offering.

He made two small acquisitions to implement the change: Delphiis for $2.7M in mid-2014 and RedSpin for $2.6M in early '15. His weakness however was making / integrating acquisitions. By the end of '16, the goodwill on both those deals was written down.

Then in January 2017, he cracked open his wallet to acquire Cynergistek for $34M. That acquisition cost $27M upfront, consisting of ...

$15M in cash (borrowed from a bank)
$2.8M in stock (1.2M shares valued at $2.40 / share)
and $9M seller's note

... with the potential earnout of an additional $7.5M to the two founders of Cynergistek, Michael "Mac" McMillan and Dr. Michael Mathews. (All the proceeds of the deal went to them).

At the time of the deal, core Auxilio was a $3M EBITDA company. As per deal press release: "CynergisTek generated approximately $15 million in revenues and $5.0 million of EBITDA in 2016." Thus, the acquisition was valued at 7x EBITDA fully loaded.

The two entities together offered a company with 2017 EBITDA of $3M + $5M = $8M, though by the end of this year, despite some cancelled contracts, it got pretty darn close.

Early into the acquisition, the company did a few things that had been anticipated ...

changed its name from Auxilio to Cynergistek to reflect the emphasis on CyberSecurity
moved its state domicile from NV to DE, a shareholder friendly move

... BUT financial results for 1H17 did not set the trajectory of an $8M EBITDA company.

Turns out, both the acquired company and the core company were experiencing contract churn + delays to new contracts. This Q/A b/t Jeff Bash (an investment analyst) and Paul Anthony (CFO) on the 2Q17 conference call sums up the issue ...


... the two key issues with the 1H EBITDA shortfall were ...

1. negative surprises aren't welcome in the investment world.
2. the difficulty the company could have funding the debt, with about 60% owed to a bank and 40% owed to the prior owners of Cynergistek

... then, more surprises post the deal ...

In October 2017, Flynn left, replaced by "Mac" McMillan, founder of the original Cynergistek. (Flynn went to a small private MPS business).
In March 2018, the COO of Cynergistek left, took his earnout with him, and the company refinanced the debt in order to pay off the bank and prior Cynergistek management ahead of schedule

... obviously, not everything went according to plan. It's a bit screwy and a bit weird and for investors who acquired this at the time of the acquisition, a bit frustrating. But, "the past is history" and at the end of all these changes, Michael "Mac" McMillan is like a QB that catches their own pass; he sold his company, pocketed $15M and now runs the company again along with it much larger acquirer.

It's a small sample size and not the easiest data point to find, but the filings from the acquisition show financial information for then privately held Cynergistek that perhaps indicates "major league" talent.

From 2014 to 2016, McMillan's company generated topline growth, margin expansion and strong cash flow generation ...



... that the cash on the b/s doesn't grow is simply a function of an annual "draw" by the business owners of $2M, $4M and $7M in 2014-2016. Even before the acquisitions, this business created a lot of wealth for its owners. Over the two year period, adding back the "draw" they grew BV +80% CAGR

That's where tomorrow's mystery comes in. Is it reasonable that he can continue to create value for owners today? Certainly there are reasons to consider either way.

One can blame prior management for overpaying for Cynergistek (and other acquisitions), for not doing enough due diligence to see that core and acquired contracts were at risk, that perhaps levering up in the near term might create risk.

One could argue, (as I do) that we should see more insider buying by the board and by the newly enriched management team of much more stock at current prices. (I'd also like to see more alignment of incentives towards lower DSO's for line managers and cash earnings for upper mgmt.)

The company has recently cleaned up its debt situation, but one should acknowledge that "putting the pieces into place" is not equal to value creation; rather its the performance of those pieces that creates value for shareholders. They need to continue to show results.

But even as the company digests these changes, it has transformed into a higher value business, though its not necessarily evident right off the bat. You won't see incredible topline growth with the cybersecurity business but rather margins and cash flow generation. And to see evidence that they've done this before, you'd have to dig to find it.

For the patient investor, with the past as history, and today's valuation a gift, tomorrow's mystery does not need to be a complete thriller to experience the opportunity. It could actually be boring, and investors can still win. Just the way I like it.

-- END --

ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE, WHICH I MAY OWN.