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This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Sunday, August 18, 2019

this shitty week in small caps, 2Q19 ($CTEK)

This might be a particularly urban experience, but do you ever order in from a restaurant where you've never actually eaten, then you drive by it and see a hole in the wall with dirty floors and it looks gross? I wonder how it changes the perspective of the food. If it's good, maybe you stick with it? Maybe it tastes worse next time? Or maybe nothing changes b/c it's good for what it does.

There's something about that perspective shift that resonates to me as an investing experience, especially after a tough week like this for so many small caps for myself and many of my peers also focused on this wee end of the market cap.

Cynergistek (CTEK) is a large holding of ours that debuted its new CEO, Caleb Barlow, on its recent 2Q19 earnings call.

When Mr Barlow's hiring was announced in July, the stock was at $4.80. Already declining going into the quarter on "rumors that a closing fund was liquidating" the stock fell out of bed during the earnings call when the retiring CEO Mac McMillan indicated that due to tough comps and delayed client contracts, sales in the back half would be down y/y.

The press release, filed the prior day, said nothing of this guidance as management chose instead to surprise investors ("surprise!") on the mid-day conf call. Now as of this writing it's at ~$3.05 trading for not much more than Book Value Less Goodwill & Intangibles.

Investors furthermore have no idea what last year's comps even look like. Earlier this year, in March, the company sold its large "Managed Print Services" division, a ~$60M sales per year business, leaving behind a smaller pure play IT svcs / cyber security consulting company with only $20M in sales. However, the company has still not filed pro-forma segment financials for this standalone pure play IT svcs company.

They've really thrown this new CEO into the fire! It's an unenviable environment I think brought on by amateur-hour preparation for the quarter and amateur hour thinking about capital markets messaging.

Or is this actually a gross restaurant? It's time to double down on research, (but it's also natural to rationalize).

CTEK has two lines of business ...

"Managed services" is a "relationship based" multi year services / consulting business to audit, manage and implement network or internet security procedures, mostly at healthcare institutions. This business has been slowly growing and is expected to continue to grow, sequentially and y/y. It is close to a recurring revenue and I think the company's primary focus.

According to the most recent 10Q this segment has $25M in backlog, up from $24M last year.

The second is "professional svcs" more simply a staffing company for IT security people, which is in a tight labor market. This is a lumpier business.

... the culprit for the quarter was the staffing business, which had a robust 2H18 that will not repeat in 2H19. Are customers taking their remediation work elsewhere? Has something changed with access to labor? Is it really just hard comps and management did a poor job messaging it? The contract business is growing.

I'm looking for answers - there's definitely a ton of competition in the space - but I believe a culprit is poor messaging during an interstitial handoff to the next CEO.

This is a sub $50M mkt cap company trading at 1.5x sales. It's on track to do ~$20M in sales this year. At ~40% gross profit margins equals $8M in annual opinc. The overhead is too large, with cash OpEx (S&M plus G&A) running at about $12M per. So they're losing close to $1M per quarter and have $10M in cash, no debt.

If they can grow and scale the cash OpEx, we win. They do this by delighting customers and offering hard to find employees interesting projects to work on.

If not, and they don't royally mess up, I think this could sell for $8 in a private transaction, assuming 15x multiple on $4M per year in EBITDA (after stripping out pubco costs and much of the G&A). But that assumes they're growing. I hear the new CEO is a "good guy" who knows how to solve problems.

But if they're really messing up, this cheap investment can always get cheaper still. And the thing is, the company has a long pattern of messing things up.

Going back five years, the company was named Auxilio and it was a standalone managed print services business to hospitals. Auxilio tried to expand into IT svcs with acquisitions in '14 and '15, spending about $5M in total. On both acquisitions, there was little realized growth and goodwill was written down within a year.

An activist Chairman got involved in 2016 to help it further and in January '17 it acquired Cynergistek, Mac McMillan's IT services / cyber security consulting firm, for ~$28M (1.2M shares of stock, a $9M seller's note and $15M cash funded by debt). A valuation of ~7x forward EBITDA of $5M, which never materialized.

The combined company changed its name to Cynergistek. The Auxilio CEO, who was expected to stay on, bolted to build a PE financed roll up in the managed print services space.

Mr McMillan, Cynergistek's founder who'd just sold his company and had eyes on retiring took over to run the company. In that process, he recognized that the two lines of business - MPS and IT security - brought together by the activist Chairman and touted as a winning pair, were actually way too much for this small levered company to manage.

In 2019, with urging at least from this shareholder, the company sold the MPS business back to its former CEO for $28M, enough to pay off the debt associated with the initial Cynergistek purchase.

... so in a way, Mr McMillan had his own private IPO sponsored by legacy Auxilio shareholders. Meanwhile, those legacy shareholders (if any have stuck around) own at roughly the same EV a smaller unprofitable IT services company instead of a larger low margin MPS business.

That history, I realize, offers ample reason to stay away. We all should want to avoid brain damage. But I also think knowing why people stay away is sometimes part of the reason to own it at the right price.

To be clear, some of that reason is that as a standalone they're not (even close) to as profitable as expected. This is doing 40% GP margins and still losing money on excess overhead. But at Book Value excluding Goodwill and Intangibles, for a company in a high demand space with low fixed costs, it could be a great price b/c IF they're getting the business right and satisfying customers, it can generate significant FCF.

It's still too soon to tell but I think the odds are favorable. In talking with folks who work in healthcare IT, I hear that demand is very high for the services they offer, though competition is also very tight.

As a small company investor, I buy when the ingredients are still in the kitchen and I think the chefs have know how, knowledge and time to bake the cake and still throw a good party somewhere down the line. That approach has to be based on due diligence to offer solid evidence of management capabilities. I've done some of this, it's always on going, and have heard independent positives about Mr Barlow. Not an empty suit at IBM. Understands the industry.

I've also worked in enough kitchens and prepped for enough parties to know that there are often points when you think "this is never coming together." And while the stock makes it look that way, certainly it makes it look like I've made an investment mistake, I think the mistake here is around transparency and disclosure, and I hope it's only made once. A lot of this could have been avoided if the company had just published the pro forma #'s calling out y/y comps offering more visibility rather than a surprise.

Beyond that, there were no surprises - little new information on the call - the core business remains too small relative to the overhead. They want to grow into big shoes. They have $10M in cash and so about two years to turn profitable. McMillan supposedly isn't selling his stock. If the operations are right and the new guy can grow, this is a steal.

Or this could be a terrible investment. The new CEO has zero pubco experience and running a tiny division at a large corporate is very different than running a tiny business. The activist Chairman is a poor look for a company that needs capital market and industry savvy. (This is the same person btw who once tried to open a business in California with someone who was barred from doing business in California, how's that for judgement). I can go on with the things that worry me about CTEK.

I'm reminded here momentarily - and apologize for closing on this tangent - of the time I thought it wise to write down all the things that worried me about my kids, just to get it out of my head. When I got to seven single space pages, I decided maybe it wasn't the best use of my time. The fact is, in life and in investing, there are always more ways by volume to go wrong than to go right.

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