Sitestar shows anything is possible

How many investors have found themselves in an idle moment thinking "If I were the boss at the company I'd do things a lot differently."  My guess is if one invests in struggling companies this thought occurs more often.

The difference between thinking something and taking action is a wide gulf crossed by few.  In the case of Sitestar (SYTE) a group of investors crossed the chasm and took control of an undervalued asset in a way that most investors can only dream of.  Their conquest makes for a great story, and since I'm a sucker for great stories I want to re-tell it, even if there aren't any take-away lessons.

The company came into being during the dot-com boom as an ISP (internet service provider).  They provide service to rural areas where major providers ignore because distances between homes are too far, or there isn't enough density to service profitably.  Markets like these are littered with small companies that somehow find ways to make a profit where large companies can't.

From the start Sitestar had profitability issues.  They earned $200k in revenue in 1999 but spend $3.5m to earn it.  Eventually they found their formula for success and revenue peaked in 2008 at $8.8m with $1.2m in earnings.  It was around this time that their customers discovered they could access the internet from their pocket at speeds that walloped their dial up modems and subscriber numbers began to quickly fall.  In response to the "dying" business the company's management decided that rather than re-invest in dial-up they'd go on a shopping spree and purchase real estate, rehab it and flip for a profit.

I've always been suspicious of public companies that change from one business to something completely different.  It is disjointed and almost reckless.  Yet, if I meet a private entrepreneur who has a number of unrelated businesses under their control I think "what a savvy individual."  But the truth to this is entrepreneurs are always experimenting, always throwing things at walls to see what sticks.  The good ones focus on what has stuck, and if something's stuck they focus on it.  Sitestar found something with potential but failed to execute on it.

Throughout the years the company acquired a real estate portfolio of properties they intended to rent, or renovate.  The key to making money when flipping a house is to buy at low prices, renovate and sell quickly.  There are carrying costs associated with owning a house and each month a house remains unsold the carry costs eat into the potential profit.  If a house remains unsold for too long the potential for any profit disappears.

Fast forward to 2013.  Real estate investor and investment blogger Jeff Moore discovers that the company is trading at a significant discount to it's liquidation value.  He purchases a 7% stake, files a form 13 SEC notice and talks to the CEO about joining the board.  While I said there probably weren't any lessons to be learned this could potentially be one.  From time to time readers will ask me "how do I join a Board?"  Jeff's method is as reasonable as any out there, buy a sizable stake in the company then ask the CEO.  Don't wait to be asked, but be proactive and ask.

All was not butterflies and roses with the Board position for Jeff.  This is where things got interesting.  Jeff as a new Board member had grand plans for the company.  He wanted to do things like determine the cost basis for the properties and sell ones that needed to be sold.  He also requested financials that the company should have easily been able to produce, especially for a Director.  He wanted to get his hands dirty and take action on the renovations, after all this was his area of professional expertise.

Instead he was met with resistance and diversion.  Battling the company's roadblocks led to a trip with fellow shareholder Steve Kiel to Lynchburg, VA (where the company is located) in 2014 to discuss these issues in person.

Jeff and Steve arrived at Sitestar and requested to speak to Dan Judd, the CFO.  One of the company's employees stated he'd come to meet them.  Jeff and Steve waited for hours before the same employee came back and announced she was heading to lunch and locking up.  Jeff and Steve decided to go across the street during the lock-up and at this time the CFO snuck out the back door and drove away.  I can only imagine the CFO peeking out the window all morning wondering "when will they leave?"  I think it speaks volumes as to the character of the CFO.

Based on this experience Jeff and Steve took a more activist approach and engaged in a proxy battle to gain additional seats on the Board.  Jeff and Steve proposed a full slate of new Directors and the company negotiated a settlement where Steve and Jeff would be on the Board.  If at this point the duo worked to fix the company from the inside this would be a very typical activist saves investment story.  But Sitestar is anything but typical.

All was quiet on the Western Virginia front for months until suddenly there was a press release that the CEO, Frank Erhartic, a 30% shareholder had been fired.  Under what circumstances could a significant shareholder who is CEO be fired?  Under suspicious ones.  Kiel and Moore discovered that the CEO had made a series of improper loans from himself and his mother, charged the company rent for a building he likely didn't own, as well as other potential securities violations.  The problems were so bad that this tiny company with a market cap of $5m aroused the interest of the SEC.  The fact that the SEC is spending any time on Sitestar indicates this isn't a simple issue like Steve Jobs accidentally putting a historical and wrong date on his stock options that could be quickly swept under the rug.  No, this appeared to be real fraud, the type of stuff so brazen as to seem unbelievable.  I can almost imagine the exchange an exchange between Frank and his mother.

Frank's Mom: "Honey, this Sitestar piggy bank you own seems quite lucrative, any way I can make some money on it as well?"

Frank: "Well Ma, you can buy shares in the market, but we're just a penny stock and you might never see a return.  Instead why don't you smooth me a check for $50k and I will pay you an above market interest rate on the loan.  You'll get some quick cash that's risk free."

As a result of Erhartic's firing Steve Kiel was appointed interim-CEO.  After the company metaphorically peed in the pool they were swimming in Steve decided it was time to clean things up.  He hired a new audit team and began the process of correcting financial statements and verifying all of their accounts.  If you're a one-person sole proprietorship doing some work on the side it might be alright to handle accounting on a wing and a prayer with only a faint knowledge of what's in your bank account.  But if you're a company with millions in revenue and a public exchange listing the standards are much higher.  You need processes and procedures that are repeatable and auditable, something Sitestar didn't have.

Sitestar's new auditors unsurprisingly found a number of issues.  It turned out no one really knew how many shares were outstanding, an interesting problem itself.  The company also discovered that they were paying $50k in rent a year for space in an office building the CEO claimed to own.  Except it's unclear whether he actually owns it, regardless he still took the rent payments.  There are dozens of other accounting fixes from goodwill impairments to the resolution of an outstanding $900k loan for $90k that had to be taken care of as well.  

While engaged in the audit Kiel and Moore went through the real estate portfolio with a fine toothed comb.  They realized that carrying costs had eaten into most of the potential profits and that the best course of action was to hire contractors and sell the properties as fast as possible.  This was the course of action the company should have taken from the start.  Kiel and Moore also discovered that the internet operations weren't as bad as they thought.  Through some cost cutting and creative growth strategies the ISP holds potential, not a ton, but it holds potential.

The company is still hauling around some of the baggage from their past life.  The company's CFO, Dan Judd was fired and asked to resign from the Board.  He has since refused to resign and dug in his heels.  Kiel and Moore plan on replacing him in the next proxy context, but until then the dead weight is still hanging around.

With the influx of cash from the real estate sales and money saved from cost cutting the new management team invested in an HVAC roll-up fund.  The stated goal of the HVAC fund is to purchase small HVAC operations, implement centralized operations and sweep the additional profit back into the fund.  This is a fund that is being run by a fellow value investor manager who Kiel has known for years.  Sitestar will reap the economic rewards of the situation without having to actively manage the partnership.  Additionally the manager will only earn a salary if they can execute profitably, it's in everyones interest to make this work. 

The company just released their 10-K from last year as well as Kiel's CEO letter.  So what are shareholders left with at this point?  Sitestar has morphed from an ISP with an undervalued real estate portfolio to an ISP with a liquidating real estate portfolio and an investment in an HVAC roll-up fund with management that is intent on creating value for shareholders.  The company is an interesting investment at these levels.  Think of it as cash and an ISP with optionality.  As properties are sold cash will accumulate on the balance sheet and management can put it to work.  What sweetens the deal is Kiel's track record as a hedge fund manager is above average, and shareholders are getting his skills 'for free'.

I love the story of Sitestar because it shows that determined investors can gain control of a mis-managed company and turn things around.  I don't know the legal costs involved in the proxy battle, but my guess is they aren't substantial.  The biggest thing that Moore and Kiel had was patience, conviction and determination to see the battle through.

Is Sitestar the exception?  Probably not, there are probably a dozen Sitestar's out there on the pink sheets.  I hope there are other determined investors with the resolve to clean those companies up as well.

Disclosure: No position