As Warren Buffett reminds us, dividends are neither good nor bad in themselves. Ideally, companies should only pay dividends if they can't get a satisfactory return through re-investments in their business, smart acquisitions, or well-timed share buybacks. Despite this fact, stocks often drop enormously on dividend cuts. I think there are probably two reasons for this. One, many investors in dividend-paying companies bought shares specifically for the dividend income. Without the dividend, they sell -- regardless of the company's true intrinsic value. Two, dividend cuts can sometimes signal financial distress.
These facts mean sometimes stocks can become mispriced when managements rationally decide to change capital allocation policies and cut dividends to capture growth opportunities. I believe such a mispricing is currently occurring with Alteva (ALTV). Founded in 1902 as the Warwick Valley Telephone Company, Alteva has in recent years transformed itself from a quiet traditional telephone provider into a unified communications company, changing its name to Alteva in May 2013. In 2012,Alteva was the ninth largest UC provider in the United States, according to Frost and Sullivan. Unified communications is a growth industry, expected to expand at a continued annual growth rate of around 25% between 2012 and 2016.
As investors can see in Alteva's most recent 10-Q, second-quarter results announced on Aug.12 were very good and show a company poised to capitalize on growth in the UC market. UC revenues increased 21% over the last 12 months. Gross profit increased 23% from the prior year. The company returned to profitability, and adjusted EBITDA increased 54% from the prior year. In the first six months of 2013, Alteva added more than 30% of the installed UC base of users that had been accumulated over the past eight years.
So, why has the stock dropped 27% over the last five days? You guessed it: They cut their dividend. They're not a sleepy telephone company anymore. They can deploy cash for high returns on capital in a growth industry. David Cuthbert, Alteva's CEO, said in the Q2 press release:
As we continue to increase revenues and improve our operating performance, increases in cash flow will be used to strengthen the balance sheet and best position the company for continued growth. Supporting these objectives, after the end of the quarter, the company's board of directors approved the discontinuation of common stock dividend payments. We believe our operational performance improvements and the difficult corporate decisions we have made affecting our workforce and our shareholders in the near-term will deliver substantial returns for all of our stakeholders in the long-term.
Analyst Jason Revland from Blue Capital Management kicked off the Aug. 12 earnings call Q&A by applauding the move:
First, a comment. As a relatively newer growth investor, I think we can appreciate how difficult the decision that was to eliminate the dividend, but we applaud that decision and think it was the right thing for long term shareholder value creation which is more in line with your current business strategy. So we think that was your decision. I'm sure it wasn't an easy one. And a general question, I'd like to first of all applaud you on the execution. I think all growth metrics look pretty solid this quarter.
Now the best part of this investment thesis isn't that market participants are selling the stock without regard to intrinsic value because the dividend was cut. The best part is that (as of Aug.15) Alteva's market capitalization is around $45 million dollars. If you look at its balance sheet, it has total assets of around $41 million against liabilities of around $30 million. However, Alteva also has a legacy partnership with Verizon Wireless worth at least $50 million dollars pretax. That's right. With your guaranteed $50 million, you're almost buying a growth business in Unified Communications for free.
The most recent 10-K can explain:
The 4G Agreement also gives us the right (the 'Put') to require one of the O-P's limited partners to purchase all of our ownership interest in the O-P during April 2013 or April 2014 for an amount equal to the greater of (a) $50.0 million or (b) the product of five times 0.081081 times the O-P's EBITDA, as defined in the 4G Agreement for the calendar year preceded by the Put.
We will continue to monitor the results of the O-P. Without the benefit of our guaranteed payments, after 2013, under the 4G Agreement our O-P distributions will likely decrease. However, as the 4G and successor cellular technologies develop and customer usage increases, the O-P retail business model could improve. The Put grants us an ability to decide whether the prospect of improvement is significant enough for us to remain a limited partner of the O-P.
CEO Cuthbert explains it in English on the Aug. 12 call:
I'd now like to update everyone on the O-P partnership. The O-P is our partnership with Verizon Wireless. Our share of the earnings of the O-P was $1.8 million for the second quarter of 2013. But we received a cash distribution of $3.25 million due to the guarantees in the O-P agreement. We're also guaranteed to receive that same amount for each of the remaining two quarters of this year. We also have a put option for the sale of our stake in the partnership back to the general partners from an amount equal to the greater of $50 million or 5 times our ownership stake in the partnership multiplied by the partnership's EBITDA for the calendar year preceding the exercise of the put. Our option to exercise the put will come due in April 2014.
CEO Cuthbert is a United States Naval Academy graduate and a former Naval Special Operations Officer. He led underwater and land bomb disposal teams domestically and abroad. Irrational selling due to the dividend cut, the Verizon "Put," optionality on a high-growth business, and a really cool CEO all make Alteva a buy.