Harry Long of Contrarian Industries has a great guest post on SureWest Communications (SURW). Harry is the Managing Partner of Contrarian Industries, LLC and can be reached at firstname.lastname@example.org (mailto:email@example.com):
SureWest Communications (SURW) is a fascinating study in capital allocation, which is the most important strategic imperative in an industry with stagnant growth. For the past 3 years, SureWest has averaged a little over $60 million in cash flow from operations, yet amazingly, trades at a $91 million market cap, giving it a Price to Cash flow ratio of less than 1.50X.
Why is the stock so cheap? The answer is simple. The company does not pay a dividend, and cash flow has been pretty steady for many years. In addition, SureWest has plowed back much of its cash flow into capital expenditures, upgrading its network to compete in the broadband space, as traditional phone service revenue has declined.
I would argue that even though broadband revenue growth has kept overall revenue and cash flows stable, that now is the time to reward stockholders. At the beginning of 2000, SureWest’s stock sold at $32.88 a share. On September 27th, the stock closed at $6.54 a share. Over a decade, shareholders have been clobbered. They deserve the very best form of shareholder value after such punishment and such a long wait—a dividend check in the mail every quarter!
On September 27th, I spoke to SureWest CEO Steven Oldham. He was clear that maintenance capex, calculated conservatively, was $15 million per year. In my opinion, that means SureWest could comfortably dividend out almost $45 million a share per year, which would equate to a dividend of $3.20 per share annually.
Dividend yields on telecommunications companies top out at around 10%. If SureWest instituted a $0.80 per share dividend paid quarterly, I believe its stock would quickly shoot to $32.00, giving it a 10% yield, which would be comparable to the upper end of the dividend yield range for other Telcos.
On September 23rd, SureWest announced that the board increased its share repurchase authorization, “which increases the total amount previously available for repurchase under the program from approximately 253,000 shares to approximately 1,253,000 shares.”
Since then, the stock has jumped. This is a fair start to build on. However, it is not nearly enough. The best increase in shareholder value comes from a dividend check in the mail. A repurchase authorization is just that—an authorization. It does not force the company to buy back stock. The type of dramatic increase in shareholder value, which shareholders deserve after suffering heavily for over a decade, is a fat dividend of $3.20 per share annually.
The reality is that fiber-based telcos have not grown quickly for years. Competition in the telecommunications industry is intense. Pricing competition is intense. You can be a brilliant operator, but competitors are likely to match any move to either lower pricing, or offer more services. Hence, the customer benefits, but shareholders rarely earn substantial returns without scale. The Comcasts of the world have scale, and some moderate advantages. They can squeeze a smaller competitor. They can afford to spend more. SureWest cannot, in my opinion, outspend a large competitor. Therefore, they need to dividend out their cash flow, improve shareholder value, and/or negotiate a sale to a larger competitor.
Executives, as fiduciaries, are stewards of capital. It is very tempting to have the mentality that the job of a Telco executive is to grow the company, even if vast amounts of capital have to be sunk into it at very low returns on capital. However, growth at low returns on capital can be destructive to shareholder value, because the capital could best be deployed elsewhere. The real test of character is whether executives love the business of buying vast amounts of equipment which earn low returns on capital, or whether they love their shareholders. If SureWest executives truly want to behave as first-class fiduciaries, I would argue that their duty is to shovel money back to shareholders, who can find better returns in other industries on their own.
As Warren Buffett said, “When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Recognizing that truth is imperative for SureWest’s executives, even if they have brilliant plans that they believe will allow the company to grow. For a reality check, revenue at SureWest last quarter decreased by almost 1% from a year ago. When it comes to growth, “show” means much more than “tell.”
CEOs are intensely competitive and do not lack in confidence. As such, they systematically over-estimate their ability to extract shareholder value from intensely competitive industries. They often truly delude themselves in to thinking that they will be special, that they will not suffer the fate of the other small players in the industry. But they are almost invariably wrong.
We do not need to be prophets to reasonably predict what will happen if all cash flows are continually sunk back into the company. We need to look at the past. In 2000, SureWest’s stock sold at $32.88 a share. Since then, hundreds of millions have been sunk into capex. On September 27th, SureWest’s stock sold at $6.54 per share. Most Telco mangers are human. They love running and growing Telcos. It is more an engineer’s perspective than a business perspective. SureWest shareholders, however, have suffered from this perspective, in my opinion, with a very cheap stock price and decimated shareholder value. Shareholders deserve a radical change in strategy.
Charlie Munger and Warren Buffett have often pointed out that the best managers are excellent capital allocators. SureWest is at a classic capital allocation fork in the road. I predict that if SureWest does not change their capital allocation strategy, that shrewd acquirers and activists will become involved. They will either see the company as a great potential vehicle, like the original Berkshire Hathaway (BRK.A), or will turn the company into a dividend machine themselves, if management refuses to.
Even if activists or financial acquirers do not make a run at the company, SureWest would be in a far better negotiating position with a potential strategic acquirer, such as Comcast, with a higher stock price. A stock price of $32 per share would be a great touchstone for negotiations. In every mature industry, management often says a version of “Trust us. Next year will be better. If we just plow a little more money into it, we’ll see a return.”
As Charlie Munger has pointed out, people are easy to fool, and the easiest people to fool are ourselves. Confirmation bias rules the day. Any dis-confirming evidence is likely to be ignored. For years, the auto industry said the same thing to shareholders. We all know how that ended. As Buffett has often pointed out, “A girl in a convertible is worth five in the phonebook.” Shareholders can have dividends today which will increase shareholder value if they are declared by the board now. Dividends today are far more valuable than promises of rosier days ahead for Telcos.
In 2009, CEO Steven Oldham received $1,361,140 in total compensation. I do not begrudge him such compensation, so long as he does not begrudge stockholders a large dividend. Everyone deserves to be treated fairly—especially shareholders. Shareholders need to be put first—capex should be at the back of the line.
SureWest would make a fantastic vehicle. Cash flow could be redeployed to many other industries, to great advantage. Buffett and Munger have seen this playbook before. After all, they wrote it!
If CEO Steven Oldham sees the light and starts supporting huge dividends, he will become a hero to shareholders in this industry. However, if he does not, the board should replace him with someone who wants to reward shareholders now. After all, shareholders have waited for the rewards of ownership for 10 years. They should not have to wait any longer.
Disclosure: Author is long SURW