Monday, February 25, 2013

USA Mobility: Cheap, But For How Long?

Though the market has risen considerably over the last few months, not every stock has been lifted by the tide. Shares of cash-cow USA Mobility (USMO) have flat-lined. As cash has continued to accrue, the valuation has become more compelling. USA Mobility now appears on the Magic Formula screener, both because it is cheap (P/E of 6), and because it generates strong returns on capital (2011 ROE of 40%).

But looking under the hood reveals that there is more to the story than these superficial numbers tell by themselves. First, the company's main business line, from which almost all of the profits come, is in rapid decline. Paging services do have their applications (particularly in health care), but that market is shrinking quickly. To give you an idea of just how fast erosion is taking place, management called its last reporting period a "fantastic quarter" with "significant improvement", as the annual rate of unit declines hit a record low of *only* 10.2%.

But if it's cheap enough, a declining business can still generate returns for shareholders when that cash is put to good use. Warren Buffett's Berkshire Hathaway, for example, is littered with dying businesses (including its namesake), but the capital those dying businesses produced was put to productive use.

In USA Mobility's case, the company's capital allocation policy appears to be harming shareholders. Rather than return the bulk of the company's cash and cash flow to shareholders, management appears hell-bent on acquisitions that will grow revenues. But the company's last acquisition looks like a giant overpay at this point: two years ago, USA Mobility paid over $160 million (note that this is almost two-thirds of USA Mobility's current market cap!) for a company that is not even breaking even right now.

Despite this, USMO CEO Vincent Kelly is unabated. He stated recently that "[W]e expect to allocate a significant portion of our retained capital to pursue software acquisitions and other related growth opportunities in the software space."

When pressed about his dismal acquisition track record on the company's latest conference call, he betrayed overconfidence and a lack of objectivity. Here's what the caller had to say:

"I would just like to go review the Amcom purchase and to see what you've learned from it and what sort of faith existing shareholders can have in the company in determining the appropriate use of their cash. Since the purchase, your stock price is down approximately 45%. Based on the most current quarter, when annualizing EBITDA, it looks like the Amcom purchase was approximately 27x cash flow. What confidence should your shareholders have that the cash that you're generating from your balance sheet is appropriately being used to purchase new companies instead of returning that cash to the shareholders?"

CEO Kelly's reponse was as follows:

"The company has actually done extremely well in terms of total return to shareholders. We looked at it since the last time we changed our dividend, going back to the beginning of May in 2008, and we're up about 146%...That's point number one. Point number two, you should not be looking at Amcom as a multiple on cash flow because we bought Amcom to transition a declining paging business into a growing software business."

First of all, it's not clear why Kelly chose to pick some day in 2008 as a starting point from which to measure shareholder return. Because that's when the dividend was changed? Ridiculous! So every time a CEO wants to obliterate his track record, he just has to change the company's dividend policy and ignore everything that happened prior? Kelly has been CEO of USA Mobility since 2004, and over that period, shares are down over 70%! But hey, since some arbitrary date that just happens to coincide with the worst financial meltdown in a generation, USMO is up big! Why aren't shareholders happy?

The second point Kelly makes really gets to the heart of the matter. Kelly has no interest in returning cash to shareholders, because he's not a shareholder of any significance! Though he has been CEO since 2004, he has accumulated a whopping $1 million worth of shares. His salary and bonuses, on the other hand, have seen him rake in $7.5 million in compensation in the last three years alone. He has little incentive to allocate capital in a shareholder-friendly manner, and every incentive to plow capital into "growth" businesses that secure his position. Clearly, shareholder and management interests are not aligned at this company.

Finally, it's worth noting that recent profits are overstated relative to the company's true earnings power. The company has been able to reverse tax valuation allowances that have propped up net income, but this is not sustainable. While operating income last year came in at $60 million, net income was almost $90 million. Be sure to take a reasonable tax rate into account should you choose to value this yourself!

USA Mobility appears cheap on every metric. Unfortunately, this company's stewards appear likely to ensure that it is management and not shareholders that benefit from this company's cash cow pager operations. Buyer beware!

Disclosure: No position


Paul said...

Who are these Braeside Investments guys? They own about 9% shares o/s. You think they could force the hands on these guys.

Anonymous said...

Excellent post Saj!

Many investors ignore capital allocation decisions and suffer the losses on companies with favorable looking valuations.

You highlight an obvious lesson that investors, and in particular cigar butt investors need to learn: What managers do with cash matters, and in a dead industry, they should be returning cash to shareholders.

Unfortunately, human nature being the way it is, managers rarely return the capital to shareholders, and instead pursue wild turnaround attempts and overpriced takeovers. Be aware of these situations as they rarely turn out well.