Showdown in Warwick Valley

You know, at one time there must've been dozens of companies making buggy whips. And I'll bet the last company around was the one that made the best [expletive] buggy whip you ever saw. Now how would you have liked to have been a stockholder in that company? -- Danny DeVito in Other People's Money

For more than three years, hedge fund manger Lawrence Goldstein of Santa Monica Partners (SMP) has been writing letters to Warwick Valley Telephone's (Nasdaq: WWVY  ) management and board of directors. So far, Goldstein's letters have been ignored, but at some point the piper has to be paid, and a showdown may be in store. Some say hell hath no fury like an activist hedge fund scorned, and given that Warwick's valuation is at a significant discount to its peers (which Goldstein outlined for me in his investment thesis) -- something's gotta give.

Dead or alive?
Often, hedge funds are branded as vultures, willing to send workers to the unemployment line to fatten their pockets. When Goldstein suggested Warwick sell itself, raise its dividend, or spin off a profitable division, he was called a scavenger, a vulture trying to eat off the livelihood of a small-town company.

Resistance is futile?
Warwick is a small-town company in New York run by local folks. As a telecom company serving an estimated population of 50,000, Warwick has a long and proud history. Historically, it had a monopoly in its small market and was master of its domain. However, in 2004, thanks to deregulation, Cablevision (NYSE: CVC  ) and Time Warner (NYSE: TWX  ) entered Warwick's market. Cablevision's 3 million cable television subscribers outnumber Warwick's 24,000 landline telecom subscribers by more than a hundredfold, and subscribers are increasingly demanding voice, video, and Internet in one nice and neat package. Furthermore, telecom is a capital-intensive business, and fixed costs need to be spread over a huge number of subscribers.

In other words, Warwick's competitive advantage was gone. It couldn't offer the broad array of services that Cablevision could at the same price, and it suffered from a severe disadvantage in terms of economies of scale. When the winds of consolidation stir, most managers sell out to a bigger fish in exchange for a nice severance package and a buyout premium for shareholders. They usually don't need any prodding, because the writing's on the wall -- if they don't sell out, they'll go out of business and lose their jobs anyway, so they might as well take the money.

Garbage in, garbage out
However, Warwick Valley management has a trump card to play. Decades earlier, it had invested in Orange County/Poughkeepsie Partnership (O-P), which provided wholesale cellular services to Verizon (NYSE: VZ  ) . As cell phones became prevalent, O-P became wildly profitable and Warwick's 7.5% ownership provided it with a steady stream of growing dividends. This was almost like free money -- Warwick didn't have to do anything, it just got a bigger and bigger check from the partnership every year.

The question was, what should the company do with this cash? Goldstein, through his 13-D filings, argued that the cash belonged to the shareholders, and that it should be returned in a dividend, spun off, or monetized in some way. Warwick's management, however, committed the cardinal sin of capital allocation and threw buckets of bad money after good by reinvesting O-P's dividends into new areas such as voice over Internet protocol, video on demand, digital TV, and high-speed Internet.

The numbers tell the story. From the end of fiscal 2003 to 2005, Warwick Valley lost 3,187 landline access subscribers and 6,839 dial-up Internet subscribers, but only gained 1,228 additional high-speed Internet and 836 additional digital TV subscribers. Warwick Valley (not including O-P) earned $3.1 million in operating income in 2003; by 2005 it was losing $2.9 million. Meanwhile, its share of O-P's earnings increased to $10.9 million from $8.8 million in this time frame. Because Warwick's plain old telephone service operations were more valuable when they were profitable and had more subscribers, management's ill-advised diversification resulted in a significant loss of shareholder value -- since 2003, the stock price has been cut nearly in half.

I recently spoke with Goldstein to hear his side of the story. It seems Warwick has worked harder at thwarting Goldstein than increasing shareholder value. When Goldstein tried to nominate two representatives to the board of directors to replace two who were up for election but had resigned a month before the annual meeting, Warwick told him nominations had been closed six months earlier. Obviously, it would have been impossible for Goldstein to predict six months prior to the meeting that the board members would quit five months later. Goldstein sued and won, but the court decision was two days before the shareholder vote, which wasn't enough time to garner support for his cause.

Empire strikes back?
It's been more than three years, and Goldstein still fights for shareholder value. He's outlasted Warwick's management -- recently, the CFO resigned and the former CEO abruptly announced his retirement.

Warwick's operations are bleeding red ink and subscribers, and for the first time ever, O-P has slowed down -- its expenses have increased while sales have decreased. However, there still may be something left to salvage.

If good things come to those who wait, Goldstein may be vindicated after all. Historically, O-P has grown at a rapid pace, so if results turn around, the company will be a huge beneficiary. After all, on a sum-of-the-parts basis (see below), Warwick's stock looks to be undervalued.

Undervalued stock
As I write this, some significant developments have occurred. Warwick has hired an interim CEO, Thomas Gray. It's too early to tell what his stance is on current matters (although Mr. Gray's contract runs for only three to six months and his $8,333 weekly salary, on an annualized basis, is more than double the salary of the former CEO). Furthermore, Fairpoint Communications (NYSE: FRP  ) recently absorbed some assets from Verizon in a deal that sent Fairpoint's stock up 15%. In the process, Fairpoint sold its 7.5% O-P ownership (Warwick and Fairpoint each owned 7.5% of O-P, Verizon owns the rest) back to Verizon for $55 million. Goldstein indicated to me that, based on the Fairpoint transaction and industry comparables, he thinks Warwick is worth at least $85 million, and possibly as much as $200 million.

His thinking goes like this: Warwick's O-P investment is worth at least $55 million, or what Fairpoint sold its stake for. However, if the telephone operating business were spun off or sold, leaving O-P (and other passive investments), the company could register as an investment company (income would not be taxed at the corporate level but passed through to shareholders, similar to a REIT).

O-P's $8 million of run-rate earnings (extrapolating the most recent quarter), or $10 million in trailing-12-month earnings -- which convert to cash and could be returned to shareholders as dividends -- capitalized at 7% to 10% (the yield investors would likely demand) would be worth $80 million to $140 million. (Warwick's current market cap is $93 million.) If we value the rest of Warwick at $2,000 to $3,500 per access line subscriber (Warwick has 24,000 subscribers remaining), which is the level at which competitors such as Embarq (NYSE: EQ  ) trade, then that's an additional $48 million to $84 million in value. Put it all together, and it's clear that Warwick's shares are trading at a significant discount to its peers, and hopefully Warwick's new management will take steps toward closing that discount.

To check out an interview with another hedge fund manager:

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. Time Warner is a Stock Advisor pick. The Motley Fool has a disclosure policy.


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