Yesterday GTSI Corp (NASDAQ: GTSI) reported its earnings. It was a busy period for the company which included the resolution of the Eyaktek subsidiary issues, the purchase of Information Systems Consulting Group, Inc (InSysCo) and the authorization of a share repurchase program. With the sale of Eyaktek, the company’s revenues declined quite dramatically.
The quarterly conference call became quite heated, with three different investors demanding to know why the company is still operating and what is being done to improve shareholder value. More than half of the Q&A section was devoted to these questions, which is far more than I have encountered in any other conference call (you can listen to the call at the link above; unfortunately no transcripts exist). The second caller, an elderly gentleman who apparently has held onto the company since its IPO in the 1980s, raked management over the coals for a variety of issues and then demanded that the company dissolve. The third caller (who has held since the 1990s) echoed this sentiment. The fifth caller noted that dissolution would entail significant costs (legal, severance, asset sale commissions, etc.) and so a better solution might be to do a tender offer or large special dividend. All were in agreement that something has to happen and quickly.
There are a few issues at hand. First, the company is trading at ~3/4 of the value of the cash on hand (the company has no debt), and ~45% of book value (which is largely tangible). The market is essentially saying that the business is worth more dead than alive. Second, despite the large share repurchase program authorization, the company is unable to make much use of it due to restrictions on the percentage of daily average volume that a company can repurchase. So, despite the large authorization announcement, this will be ineffective in resolving the discount. Shareholders (myself included) had hoped to see much more use of this authorization throughout the quarter, and so understandably there is frustration that this has not occurred.
So when should a company throw in the towel and admit defeat, returning capital to shareholders for reallocation elsewhere?
For starters, if a company is unable to earn its cost of capital, then further operation will destroy shareholder value. Since companies exist for the sole purpose of increasing shareholder value (and doing so at a rate sufficient to at least meet the risk-adjusted opportunity cost of that capital), the failure to earn the cost of capital suggests the firm should be liquidated. This is basic finance theory, but the devil is in the details: the assessment of whether the company will in the future be able to earn the cost of capital is where disagreements arise.
We know that firms aren’t liquidated after the first quarter in which they fail to earn their cost of capital. Shareholders should and do give managements a substantial amount of leeway. As the fifth caller noted, the costs of dissolution are great, and so in a world with significant transaction costs to starting and closing businesses, we are left to balance the cost of closing down with the ongoing value destruction. At some point however, the destruction has to end.
Where does GTSI stand? Looking back at the last sixteen years, the company has earned average returns on equity of 1.3% and returns on assets of approximately zero. Lest you think this is accrual accounting trickery, the company’s free cash flows have been excessively weak and net out to negative $52 million over the period. Moreover, on pretty much any metric you look at, the company has failed to perform on a level other than that which would be described as below par.
So should the company be wound up? Again, this depends on how you forecast its future performance. The company does have opportunities to right this ship. The InSysCo acquisition enjoys greater gross margins and should go a long way toward achieving management’s desire to transition into a higher margin services business. Additionally, in the aftermath of last year’s SBA problems, several senior managers departed and we now have a fresh management team that appears to be focused on shareholder returns.
From my perspective, these changes have bought the company some time. However, if the recent conference call is any indication, shareholders are growing restless and will begin to agitate for change. Given the company’s excessively low valuation, one would expect activist investors to be sniffing around. Luckily insiders are feeling the pain as well, with directors and executive officers as a group holding nearly 1/4 of the company’s shares. Management also noted on the conference call that the Board is, at each meeting, discussing alternatives for improving shareholder value. They mention that every suggestion offered by the callers noted above had been discussed and is actively being considered.
From my perspective, the company’s cash balance alone should provide a limited downside to the share price, and based on the current valuation, the market has such low expectations that even a small improvement in performance can have a big impact. As long as they don’t start burning through that cash, I am willing to give them a bit more leeway as the new management attempts its strategy. However, the leash is short.
What do you think of GTSI?
Disclosure: Long GTSI