Zunicom (ZNCM): Relative Value Arbitrage Opportunity???
Zunicom conducts all of its operations through AlphaNet Hospitality Systems, a provider of computer access to hotel guests. This business is in serious decline as contracts expire and marketing efforts cease. According to Zunicom’s most recent 10-Q, AlphaNet lost nearly $600,000 in the first nine months of 2007.
Zunicom has one other major source of revenue. In December 2006, Universal Power Group (a former wholly-owned subsidiary) sold 2 million shares via an initial public offering. Zunicom sold 1 million shares, and continues to retain 2 million—for a minority interest of 40%. This portion of UPG’s market value goes on Zunicom’s balance sheet as an “investment in unconsolidated investee.” Additionally, Zunicom reports 40% of UPG’s income as “equity in earnings of investee.” If we add this figure (for the first three quarters of 2007) to AlphaNet’s loss, the result is a profit of about $116,000. Zunicom also earns interest income on unsecured promissory notes from UPG. Adding this income to $116,000 gives us $466,000.
Judging solely by the current market price, one would assume that Zunicom is unprofitable. Subtracting property, equipment, inventory and deferred stock compensation leaves “true” net asset value of $9.6 million. (This includes the current market value of the UPG shares and the principal balance on UPG promissory notes.) Zunicom’s market capitalization of $6.4 million is clearly too low—only unprofitable businesses sell below asset value as so adjusted.
Perhaps the market does not believe that Zunicom is truly profitable, since it does not receive cash from the 40% of UPG’s earnings it reports as earnings. However, I believe that the equity method of accounting is appropriate in this instance. On page 186 of Security Analysis 4th edition, Benjamin Graham argues:
“Where a company does not own a majority of the voting stock of an affiliate, it is standard procedure to include in the accounts only the dividends received from it. This theory is contrary to actual fact, since in most cases there is a common or interlocking directorate and also business relationships of considerable importance. The analyst should make allowance for the full equity in affiliates where the amounts involved are significant.”
With an ownership interest of 40%, Zunicom would probably be able dictate UPG’s dividend policy and pay itself at will. Hence the reported undistributed earnings should be considered economically substantial.
There is an apparent arbitrage opportunity in UPG and Zunicom shares. Because earnings are split on a 60:40 basis, UPG’s market cap should be 1.5 times greater than Zunicom’s. Theoretical parity looks like this:
(.6)(Zunicom market cap) = 1
(.4)(UPG market cap)
At current prices, the relationship is actually:
$3.6 million = .45
$8.0 million
This large deviation from parity has two obvious culprits: AlphaNet’s operating losses and Zunicom’s SG&A expenses. A third complication is hidden on the balance sheet. According to John Rudy (CFO), liquidating AlphaNet would result in an IRS recapture penalty of about $3.8 million. The adjusted price relationship should be:
$7.4 million = .925
$8.0 million
The deviation from parity is not as large as I originally thought. Furthermore, management intends to enter new businesses instead of distributing UPG shares to shareholders.
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[...] arbitrage is profitable except under very unlikely contingencies. I have identified one current opportunity; however, it is not suitable for passive minority [...]
In your parity you forgot to account for ZNCM’s net cash position and also their NOL. Also, who says that AlphaNet has to be liquidated? They can run it off for $0 penalty and build up their NOL while doing so.
There is only about half a million dollars in cash, and that will certainly erode with AlphaNet’s operating losses. In addition, management will probably continue to destroy shareholder value on dumb acquisitions.
um, they have the note receivable from UPG. Keep in mind that should they make an acquisition the headline multiple will be deceiving (assuming the acquisition is profitable) as they will be able to utilize their NOLs. Tax losses are something most people overlook and in this case are significant. To the original author: I suggest you rethink your valuation methodology.
Nicole, I should point out that they will start to receive their quarterly principal pmts on the notes starting Sept. 2008. To the author: You can’t simply take 40% of UPG’s earnings and add those to ZNCM’s…earnings is not CF.
Spreadsheet,
Undistributed earnings of an investee do not count as cash flow under general accounting rules. However, they tend to be fully as beneficial to the owner as if they had been distributed; the earnings result in a higher price for the investee’s shares. This would be ideal for Zunicom shareholders, since management may sell the 40% UPG stake.
Whether you are correct in buying ZNCM will depend at bottom on the intelligence of management. I have spoken to several company executives (surprisingly, most work as part-time subcontractors) and none of them seems motivated to act intelligently. They are lucky that UPG will begin principal repayments soon, but this is only a temporary solution.
Zunicom is similar to a SPAC at this point, except investors are not guaranteed to have their money returned if an acquisition fails to take place. There are two obvious hindrances to your plan. First, how will Zunicom be able to arrange financing under the current state of credit? And second, how likely will management find a profitable acquisition?
As an outside passive minority investor, your destiny depends too much on luck. In order to realize the large asset value that has been withheld from shareholders, you should take a control position (although William Tan’s 30% stake may make this impossible). The advantage of Graham, Buffett, Icahn, Lampert, etc., over the ubiquitous “value investor” has been their ability to control investee policies. Without this element, the traditional “value approach” is incomplete and invariably leads to poor results.
I disagree on many of your points. My point about undistributed earnings was to clarify the author’s statement of the idea of GAAP earnings vs. free cash flow (although his formulas don’t require either, per se, he does allude to GAAP earnings in the writeup). GAAP earnings are meaningless. Don’t believe me? Compare reported net income to OCF-Capex (by definition net income is a proxy, although a poor one, for fcf). Compare GAAP taxes to cash taxes paid. Compare D&A to capex. See my point? So, basing any argument or using net income as a basis of your thinking is highly misleading. Besides, the author is only considering UPG’s current earnings and ZNCM’s cost structure to come up with the valuation. What happens when UPG starts paying off the debt they owe ZNCM? ZNCM will get a disproportionate share of UPG’s cash flow.
All of this talk is fine and dandy but hard to put into practice if you use the method the author lays out. This was my main point. A much easier way is to come up with ZNCM’s asset value by adding the 40% of UPG stock they own (at current price) + net cash + value of the debt owed them by UPG (discounted or undiscounted, however you want). Now, that will get you a minimum value that ZNCM is worth. What to do with the NOL’s? You can be reasonably assured they will make an acquisition, which would increase the probability they will use the NOLs. Can they utilize ALL of them? I dunno, but the size of the NOL in comparison to their EV is substantial so it can’t be ignored.
This is not a SPAC. Financing the acquisition? It would be great if they didn’t get financed for an acquisition, which would increase the likelihood they return cash to shareholders. If anything, this could actually work in our favor: a bad acquisition will have a harder time getting financed. If its a good acquisition the financing will make it.
I also disagree with how you layout the control aspect. Of course it would be better to have control. What’s you’re point?
In the great majority of instances where large realizable assets are withheld from shareholders, management has not acted appropriately. It is a mistake to pay attention to what can be counted—the theoretical value of Zunicom—and to ignore what cannot be counted—human actions that will affect true value. I recommend that you visit The Deal Sleuth (http://thedealsleuth.wordpress.com/) to examine the base rate of outcomes for similar situations. Whenever management is complacent, shareholders invariably suffer.
It seems that you have owned ZNCM since well before my writeup. I am curious to know how you came across this situation.