Description

A thoughtful investor once told me: “Good investments are only obvious in hindsight”. While I agree with this statment, shorting SPOK at >$20 might be as simple / straightforward a short as it gets. Bottom line is SPOK is an obviously dying business trading at >17x 2016 cash flow. Sales and cash flow have declined steadily for the last 15 years and you can be fairly sure they will do so for the next 15.  From 2011 to the mid-point of this year’s guidance sales have declined at a CAGR of -6.5% and cash flow has decline at a rate of -23.5% While there is no “catalyst” as such, if the price stays the same, the falling cash flow will eventually make shares trade a crazy multiple.

Bulls point to the growth in the software business and a significant amount of net cash and NOLs.  While the software business is indeed growing, this is a much lower margin business and the growth is not nearly enough to offset the decline in the paging segment. Furthermore, my research suggests that SPOK’s software division was helped in the last couple of years by government’s Electronic Health Records (EHR) mandate (as were many other healthcare focused software companies) and as such growth as begun to decelerate (software revenue actually fell in Q1).

While SPOK does indeed have a significant amount of net cash (about $105mm) and NOLs, this cash has sat on the balance sheet for some time. Management sitting on cash might actually not be a bad thing for shareholders since the company’s last big acquisition has not created value for shareholders and the current market for deals is much richer than when SPOK previously made acquisitions.

Business Overview

SPOK was written up in January 2015 by jhu2000 so pls refer to that memo for a better discussion of the company’s history and business. However to simplify things, SPOK is best thought of as two businesses:

Paging – SPOK is the largest provider of pager services. Pager signals are up to 40x stronger than cellular signals and thus are viewed as a highly reliable form of mobile communication.  As such, customers tend to be those who need to respond to emergencies such as doctors or government personnel.  This segment is 63% of total sales and approximately 71% of sales are to the healthcare sector.

Software – SPOK entered the software business in 2011 with the purchase of Amcom Software.  Amcom's products facilitate communications for hospitals while ensuring security and legal compliance.  These systems are used to automate call centers and both emergency and routine contacts with doctors, patients and government agencies. Approximately 62% of sales are to the healthcare sector.

Rapidly Dying Business Trading at 17x Cash Flow

The paging business accounts for  63% of sales and a much larger percentage of SPOK’s profits. It should not be surprising to anybody that this business is dying due to the increase in availability and reliability of alternative moblie communications. In the just the last four years ending 2015 total EBITDA has decreased by 45% despite the improving global economy.  This business declines every year and I am nearly 100% certain it will continue to decline every year from now on.  Despite this, SPOK trades at 17x cash flow which is generally regarded as an appropraite multiple for a slowly growing buisiness.

Figure 1: SPOK Trades at 10x Cash Flow

Margins in the Software Business Appear Challenged

While there is no debate that the pager business is dying, bulls point to the rapid growth of the software segment as reason for optimism. Indeed, software revenue grew at a CAGR of 5.6% from 2011-2015 and are forecasted to grow at a similar rate in 2016. However, profitability in this business appears challenged and growth will likely slow.

SPOK stoped provding expenses / margins by segment in 2013 and now only provides revenue.  Given the change in reporting, it’s not possible to know the exact margins in the two segments after 2013. However, by making some reasonable assumptions we can see that profitability in the software business is challenged.  As shown in Figure 2, as sales in the pager business have declined segment profits have declined at a slower rate as cost reductions have offset some of the sales declines.  Over the years, the opportunity for cost reductions has decreased and thus the percentage of incremental sales declines that have fallen to the bottom line has increased. While we don’t know what these incremental margins were after 2013, I believe its reasonable to assume they were higher than the 52% seen in 2013. If we assume incremental margins were between 60% and 75% in 2014 and 2015 this implies at best a minimal increase in profits for the software business and low incremental margins.

Figure 2: Margins in the Software Business Are Challenged

Software Growth to Slow

After growing mid-single digits for the last several years, in the last quarter software revenue declined 1.3% while bookings declined 14.8% (!). Management blames a reorganization of the sales force. While this may be partially true, it is likely not the whole story. By the end of 2015, the federal government required healthcare providers to use electronic health records or else face reimbursement penalties.  This caused a surge in software spending and many of the hospitals SPOK targets as customers underwent a complete IT overhaul. While SPOK’s software does not directly address EHR issues, when hospitals are undergoing a core software change it is easier for SPOK to sell their solution as part of a larger IT switch. Now that this is mostly over, software sales growth should slow.

Acquisition Track Record is Poor

I first looked at this company many years ago (when it was known as USA Mobility). Initially, I simplistically thought that a pager business could never survive for very long.  However, for nearly a decade after the company was formed out of bankruptcy this was a case study of how to run a dying business.  Management ruthlessly cut costs (way more than I thought they could) and returned cash to shareholders (the dividend yield used to be much higher).  However, even if this is the right thing to do for shareholders, the problem with running a business in this manner is that management is ultimately left without a job. As always seems to be the case, SPOK eventually decided to cut the divided and use the cash flow to make acquisitions. 

To be fair, SPOK has a far greater amount of NOLs than will ever be used by the pager business.  As such, management has decided to make acquisitions in order to generate profits that can be offset by NOLs. Theoretically, this makes sense since presumably whoever is selling a business to SPOK would have to pay taxes on the earnings of that business whereas SPOK would not. As such, acquisition targets could be worth more to SPOK than to a seller and SPOK should be able to capture that difference in value. This was the rational given for the Amcom acquisition and for management’s stated intention to make future acquisitions.

In practice however, the Amcom deal was a disaster.  SPOK paid $141.6mm for a business that has likely never generated more than $8mm in EBITDA.  There is no reason to think that future acquisitions will be any better, especially since business valuations today are much higher than they were in 2011 when SPOK purchased Amcom. 

What’s the Stock Worth?

What multiple should we put on a declining cash flow stream like this? Well, it is probably reasonable to assume cash flow doesn’t continue to fall >20% per year.  Double digit declines for the foreseeable future are reasonable however.  If you assume cash flow declines 12%/yr for 5 years and 6% for the next 5, at a 9% cost of capital plus the full value of the cash on the books shares are worth $11. Admittedly this is a very crude valuation and can be argued with for any number of reasons. However, so long as you believe cash flow will continue to fall steadily (which is almost certain) then $20+/share is way too expensive anyway you look at it.

On an SOP basis I think it would be generous to assume the software biz is worth what SPOK paid for it in 2011. This assumes that someone is willing to pay >17x EBITDA for a business growing at 5% (with growth slowing) and little ability to improve margins. Even at this value with a run off of the pager segment plus the full value of cash still only gets you to about $15/share.

Risks

Good Acquisition – It is possible management is able to make an acquisition that creates meaningful value for shareholders. However, given the track record and current valuation levels for potential targets, I view a value destroying acquisition as a more likely outcome.

Slower-than-Expected Decline of the Paging Business – The precise rate of decline for the pager business is difficult to estimate. Indeed, healthcare customers have proven more resilient than other segments and as these customers come to represent a larger portion of the overall business, it seems reasonable to conclude that sales declines could be slower than they’ve been in the past. However, management has also discussed how there are now fewer opportunities for cost cuts then in the past.  In any case, we can be highly certain that cash flows will continue to decline by a meaningful amount every year. As such, even if the rate of decline slows, at 17x cash flow SPOK is still overvalued.

Catalyst

Lower earnings / cash flow forever