The Contrarian, Episode I: SureWest Telecommunications

| About: SureWest Communications (SURW)

SureWest Telecommunications (NASDAQ:SURW) is perhaps the best potential activist/acquisition target in the United States. It has a traditional copper-based telephone system in Roseville, California which is a declining cash cow, and a growing fiber-based Internet/TV/Voice service which is offsetting declines in traditional telephony, creating a stable to slightly growing revenue situation.

In the last 12 months, it has thrown off a little over $65 million in cash flow and sells for a market cap of $163 million. CEO Steven Oldham has stated that the maintenance capital expenditures necessary to maintain SureWest's network are only $15 million annually. Therefore, free cash flow is potentially $50 million if an activist fund or acquirer slashed growth capex. The growth capex, in my view, has a poor to mediocre return on capital.

Here is my back of the envelope ratio analysis for SureWest:

  • Market Cap / Cash Flow = 2.5X
  • Enterprise Value / EBITDA = 4.76X
  • Market Cap / Free Cash Flow = 3.26X

The company is stunningly cheap, in my opinion. What is the catalyst here? As I originally wrote:

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.

That radical change in strategy would be re-instituting a large dividend, and/or selling the company to a larger competitor. It's very hard for smaller Telcos to earn more than moderate returns on capital expenditures. They simply don't have the scale, and this is a scale industry. However, the company would make a great Berkshire Hathaway-like vehicle for someone who wanted to deploy the capital elsewhere, or it could be a strong dividend play.

A generous dividend would be the most straightforward way to create shareholder value. With $50 million in potential free cash flow, SureWest could dividend out $3.20 per share annually. Teleco's trade on yield, and yields typically top out at 10% for Telcos, so a $32.00 share price would be very possible—with the right strategy.

In the movie which follows, I take an in-depth look at the numbers:

What's my take-away? SURW is not a suitable investment for a retail investor, but only for investment firms with the wherewithal, determination, and staying power to push for a dividend and/or sale of the company. In other words, this is a stock which needs a catalyst, and as such, is most suitable for firms which will push for substantial strategic change.

Since CEO Steven Oldham cut the company's dividend, I believe an activist, or an acquirer, would receive a very warm welcome from shareholders who have suffered a substantial decline in the value of their SURW holdings over many years.

Disclosure: I am long SURW.