Description

The fast growing cash cow hidden in Warwick Valley has not gone unnoticed by the activist community, and management now finds itself forced to defend its value-destroying ways. I can’t say with certainty if/when value will be unlocked here, but the activist has a good case which grows stronger every quarter. Meanwhile, you are protected by the value of the hidden asset (probably worth the more than the current quote by itself), a 3.2% dividend yield, and a net-debt-free balance sheet.

Warwick Valley is a 101-year old RLEC (rural local exchange carrier) nestled in some primarily rural communities just north of the NY metro area in upstate NY and NJ. Like the wireline telecom industry in general, it now finds its formerly sleepy franchise challenged by LD price competition, wireless & email substitution, etc. As a rural provider Warwick is somewhat insulated from these issues vs. the RBOCs and other mega-telcos, but the sledding has been a bit rough all the same.

As luck would have it, Warwick entered into a JV with NYNEX (now Verizon) back in the late ‘80s to offer this newfangled service called wireless. The JV was structured as a limited partnership where the partners contributed capex for licenses and infrastructure, then essentially rent the network wholesale to retail mobile phone providers who then do all the “work” (advertising, activation, billing, customer care, etc.). Verizon is the GP and purchases 90+% of the wholesale minutes. Warwick owns a 7.5% LP interest, which basically entitles it to a similar percentage of the free cash flow.

When I call this a cash cow, I’m talking about an entity with returns on equity north of 100% and zero need for outside capital. The numbers are impressive:

Year Revenue Net income Distribution per share
1999 35,512 26,417 $ 0.36
2000 57,678 44,901 $ 0.60
2001 81,952 67,220 $ 0.92
2002 114,591 97,369 $ 1.40
2003E 121,711 $ 1.75


Management loves these distributions because they fund the capex for new telecom projects with questionable returns on capital such as broadcasting cable TV via Warwick’s copper pipe. They also love the distributions because they have allowed management to up the dividend every year (now at 3%), which has the effect of placating the largest shareholder – an elderly widow who lives in Warwick, NY. I’ve heard that this stock represents substantially all her savings, but I can’t confirm that.

Last year an activist investor (Philip Goldstein of Santa Monica Partners) started agitating for a spinoff or sale of the LP interest. (By the way, I am not affiliated with Santa Monica.) Among Mr. Goldstein’s more interesting tactics is a lawsuit he filed claiming that Warwick should be classified as an investment company. If Warwick were to be classified as such, management’s grip on the company would be severely weakened. Section 3(a)(1)(C) of the Investment Company Act of 1940 stipulates that a company which isn’t primarily engaged in the business of investing in securities might nevertheless be an investment company, if the fair value of its investment securities equal 40% or more of its total assets. Management originally filed for an exemption under Section 3(b)(2) of the Act, which put a stay on the litigation. But after Warwick’s 3rd party valuation advisors concluded the 40% threshold hadn’t been breached, Warwick withdrew the filing, and now the litigation is back on the burner.

In their filing to the SEC, management claimed that the original POTS (plain old telephone service) business is worth $90M. This is actually a reasonable claim, provided that current management isn’t running it. Currently, the POTS business simply does not have the economies of scale to justify that valuation, but it probably would if it were sold. The rational thing to do would be to stop chasing the unattractive new revenue streams and sell the business to one of the neighboring providers (CZN, VZ or FON), who could then eliminate a lot of needless costs. Importantly, industry competition would likely force the company to do both these things if it were to be cut off from the prodigious cash flow coming from the LP.

Ticker Related rev Access lines Related rev/ line Adj. EV Adj EV/ line
AT 2,986 3.10 $ 963 11,603 3,743
CTL 1,970 2.40 $ 821 8,421 3,509
CZN 2,238 2.40 $ 1,112 7,994 3,331
TDS 801 1.00 $ 801 3,777 3,777
CTCO 319 0.46 $ 686 883 1,901

WWVY 28 0.03 $ 917

Based on the RLEC comparables in the table above, I’d say Warwick deserves about a $3,000 per line EV in a change of control scenario. Warwick’s revenue per line is significantly higher than that of CTCO, but it doesn’t have nearly the scale of the other comps. 30,200 lines at $3K/line gets you to $90M.

(Note that the “related revenue” figures strip out revenue corresponding to business lines that are dissimilar to the Warwick POTS operations (e.g. wireless). The “adjusted EV” figures strip out the values of dissimilar business lines. Also note that CZN is one of the three POTS providers whose territory borders on Warwick’s. The other two are VZ and FON.)

Management also claimed that the LP interest has a fair value of $22M. I must confess that I don’t know how they arrived at this conclusion, but it strikes me as patently absurd under any valuation methodology. $22M implies a trailing 2 ½ X multiple. It’s worth noting that management cited increased competition at the wireless business in the latest 10K, and that YOY net income growth has slowed to 25%. Still, 25% bottom line growth with no capex is nothing to sneeze at, and the $22M valuation is a lowball sneeze if I ever saw one.

By separating the LP from Warwick, one could eliminate the needless extra layer of taxation at the corporate level. I’m not exactly sure what multiple you put on capex-free 25% growth, but it’s probably not less than a 15X trailing P/E. Sure, this is wireless, but that’s equivalent to a roughly 12X forward multiple. Again, look at the growth.) With 5.4M shares out, LP distribution per share for ’03 will be about $1.75. So that gets you about $26 per share for the LP, which is above where the shares are at today. As outlined above, the POTS adds another $17 or so in value. Subtract $0.75 for the pension plan and you arrive at just over $42 per share. Plus there’s a 3%-and-growing dividend while you wait.

I don’t know the exact odds that the SEC will buy management’s claim that the LP is less than 40% of the value here. But bear in mind that that LP income is rapidly growing, whereas POTS income is not growing at all, so it’s becoming increasingly clear that the LP makes up the bulk of the value. Thus, outside shareholders have time on their side.

Catalyst

1)Potentially favorable SEC ruling
2)The passage of time - the LP is the largest contributor to net income (70%+) and this percentage grows meaningfully with each passing quarter, which strengthens the activist shareholder's case.