Warwick Valley Telephone Company
Duane W. Albro
TWST: Let's start with an introduction to WVT Communications Group.
Mr. Albro: The company began in 1902 as essentially a rural local exchange carrier, what's called an RLEC. It was a regional local exchange carrier for many years, then the company did an IPO in 1998, and it's now traded on Nasdaq. Because of cable competition and wireless substitution for landline service, the company began having some difficulties in the mid-2000s. I joined in 2007 to look at the difficulties and see how we could turn the company around. I had spent considerable time in the telecom sector, not just with telephone companies, regulated companies or incumbent carriers, but also spent some time with what's called a competitive local exchange carrier. These are companies that compete with the incumbents, such as Verizon and AT&T, primarily for business customers. I had also spent some time at a cable company. So when I came into WVT, our focus was to sort through the process of replacing the declining revenue stream.
In a company like Warwick Valley Telephon (WWVY)e, our regulated, landline ILEC business, which operates in the semirural area northwest of New York City, there is not a lot of growth on a demographic basis. So you probably are not going to see a lot of line growth, and in fact, you are likely to see access line decline due to both cable competition and wireless substitution. We determined that our growth would likely not come from this region, and instead began selling outside our regulated region into contiguous areas in the mid-Hudson area in 2007 and 2008. Warwick is in Orange County, N.Y., and so we began selling in regions contiguous to this area.
In 2008, we purchased what was one of the early versions of a hosted communications platform and began selling hosted voice over IP in the mid-Hudson region. We had some success, albeit limited, because we were essentially using former ILEC salespeople to sell this new product. By late 2008, we were already starting to look at companies that we might acquire. Fortuitously, in early 2009, a company that we had been having negotiations with to acquire filed Chapter 11. That company was USA Datanet in Syracuse, and we acquired the company, which had $4.5 million in revenue, for $1.5 million.
So that was a good move for us in a couple of ways. One was that we acquired an additional platform identical to the platform we had in Warwick upon which to sell these hosted voice over IP products. That gave us redundancy, and we also picked up a global network and a nice customer base in the upstate area with customers in Syracuse, Rochester and Binghamton. It diversified our customer base roughly contiguous to areas that we were already selling in. We began seeing some improved sales performance as a result of that acquisition, but not robust sales progress in the way that we had hoped and projected we would get. In some measure, we felt we needed more expertise, and in some measure we felt perhaps we needed to add some territory. In 2010, we began looking for other acquisitions.
Now, let me digress for a second. One of the reasons we could do acquisitions was that many years ago, back in 1983, we invested in a wireless partnership with a company called NYNEX, which, of course, is a predecessor to Verizon. At the time, WVT had a 7.5% partnership interest in this wireless partnership. Over time, that grew to be a fairly significant cash stream for us. In recent years - those being 2007, 2008, 2009 and 2010 - the cash payouts we received as a result of our investment in the wireless partnership have been classified on our income statement as "other income." In 2010, that amount was about $12.5 million. The cash payouts are used in part to pay our dividend. Therefore, the average investor, who looks at our net income and tries to determine our ability to pay a dividend on that basis, would see a good portion of our net income had come from other income, which was the distribution from the wireless partnership. But these cash distributions have been so significant in recent years that it also gave us cash to build a war chest to make acquisitions.
By 2010, we had a fairly sizeable war chest that we could use to acquire companies. We have a very clean balance sheet. Virtually, we have no long-term debt and some short-term debt, and so we were in a very strong position to make an acquisition. In 2010, we began looking for the right acquisition target - one that would complement our existing business communications services using Internet protocol, and more importantly, that would position us to take a leading role in this large and fast-growing market. We looked at a wide range and a large number of companies.
Then, in late 2010, we began having discussions with Alteva's CEO David Cuthbert, who's on this call right now. In our early conversations it was rather astounding how similar our viewpoints are and that we have a similar mindset and a similar culture about our companies. But most importantly, they had demonstrated enormous success in terms of results in their sales processes associated with what is now called unified communications or UC. UC is more than hosted voice over IP because now it's literally cloud communications. We are hosting more than the voice in the cloud. Alteva not only hosted voice over IP, but they hosted Microsoft applications, and they had done an extraordinary job of integrating Microsoft with their telephony platform, which really intrigued us. They averaged 60% annual growth in sales for three years, and that was pretty astounding. What's not to like about 60% average annual growth? They had a team of people who were just amazing at how well they worked together, how well they collaborated and the decisions they made. As we talked more and more, we realized that this was a match made in heaven. I liked David and his team so much and was so impressed with the work they had done that we literally gave our unified communications business to them to run and it was almost a reverse merger, where we acquired them and gave them primary responsibilities for that aspect of the company. In fact, David became Chief Operating Officer with responsibilities for all day-to-day operations in our consolidated company.
We accomplished an extraordinary merger. We literally did our definitive agreement on July 14, and we closed on August 5, which is incredibly fast. What's even better is that David and I collaborated with our senior team, and we fully integrated the entire company by September 25. So within a little over a month, we had all of the company fully integrated with people functioning in their jobs. That's pretty astounding.
When you think of the normal time from definitive agreement to close, it could take as much as six months, and generally it could take a year to complete the integration and transition. It gives an indication of two things: one, how well our companies fit together; and two, how great our people are to step up to accomplishing those things - certainly David gets an enormous amount of credit for the leadership that he has shown in doing this.
That brings us to today, with the exception of one thing. I didn't really talk about our local telephone company. We had seen back in 2007, when I arrived, significant erosion of our residential access lines due to competition from a cable TV provider, who is our primary competitor in our franchise telephone area. By 2008 and 2009, we were seeing wireless substitution, and in fact, by 2011, we had essentially achieved duopoly status with our cable TV competitor on the residential access-line business. They had acquired about half of our residential telephone lines although not half of our broadband or video. So on the residential access line, we aren't generally losing access lines to cable anymore. We're losing them primarily to wireless substitution.
In 2010, we saw some other things happening. Our broadband network was starting to get choked, and customers were complaining that they couldn't get downloads. They were trying to download streaming video, Netflix movies, YouTube movies, large files, game files, and our network was unable to accommodate it. One of the first things we did was to significantly increase our backbone bandwidth capacity to alleviate that choke point. We found that our local transport from the node to the customer was also getting choked in some cases. So when we looked at the type of content that was using the bandwidth, it was in large part from customer use of Hulu, Vudu, Netflix, YouTube and the like. And this over-the-top programming was becoming preeminent in our local broadband facility. At the same, we had a landline video product.We had our own headend and offered a robust set of channels. But that was consuming bandwidth from our broadband customers.
So in 2009, we engaged with DIRECTV and stopped offering landline video. We began offering DIRECTV as the video portion of our triple play. That was very advantageous to us for a couple of reasons. It freed up bandwidth, but the other thing was that the content costs in having your own headend were becoming exorbitant. So for example, in 2011, HGTV, which is a package with Food Network, notified us they were going to have an 83% rate increase. And that was not unusual. We got the same types of notices from the History Channel and A&E. In the triple play, which is typically $29.95 each for each of the three pieces, video was costing us about $59. So we said, "Wow! We are losing money," yet we had to have a triple play to be competitive. If your primary competitor has a triple play, you have to have a triple play. But to lose that much money, to have such negative margin in one of those three critical products meant the other two products were picking up the slack and covering the margin. If we went to DIRECTV, we didn't get a big gross margin. It's fairly minimal gross margin, but at least it is positive. So we switched to DIRECTV, stopped offering landline video and have slowly been moving people out of the landline video to DIRECTV. We've been dropping channels as they notified us of rate increases. Our local video franchises expire in June of this year, and we will be completely out of the landline video after that.
Today, 100% of our customers can get five-megabit broadband service, and 60% can actually get 15 megabit, and for a premium, they can get 30 megabit, which is pretty competitive. The 30 megabit is actually better than the offering from our cable competitor.
We have really three key aspects to our business. The first is our cloud communications business, which has evolved from what we call unified communications. Then we've got this investment in a Verizon Wireless partnership, which gives us cash, and then we have this ILEC that was significantly unprofitable and is now evolving to being profitable as we transform it into a broadband company. Ultimately, in the future there are going to be no residential access lines as we know them, as these customers will either have a wireless cell phone or they will be using their broadband for telephony services. So essentially, the ILEC becomes a broadband company.
We also continue to grow unified communications, with Alteva now running that major sector of our business. And we continue to maintain the Verizon Wireless partnership. So that brings me to today.
TWST: You talked about how the company is evolving. Is that going to include additional acquisitions?
Mr. Albro: Most likely, but probably not territorial per se, and here's why. When we acquired Alteva, we acquired a tremendous sales engine. We kept all of the employees including all of the senior leadership team with the exception of the Founder, who is now a Consultant to us on a multiyear contract. We now have all of our team in place, so to acquire another unified communications company immediately fosters the question: "What do you do with their senior team?" Secondly, to acquire customers by buying a company, unless you can get that company at a discount, can sometimes not be done with the best economics, especially with unified communications companies being such a hot industry right now - they are all looking for significant multiples. Thirdly, in this cloud communications world, although you may have your first contact with a customer in Philly or Syracuse or Rochester or the Hudson Valley, in large measure, these businesses represent multistate, multicountry, multisite customers. As an example, we have a real estate management customer in Rochester, and they have real estate management offices across the country, some in Mississippi, Alabama, Texas, some in New Mexico, Arizona, Oregon, California, Virginia and Maryland. We say they are a Rochester customer, but they are really a national customer. So when you think of this cloud communications world, not to use a trite word, but our customers aren't tethered to any particular geographic location, so now that we have made this major step with the merger with Alteva, it changes how we look at things.
Future acquisitions would most likely be more to fill in areas, perhaps with applications we want to offer our customers or perhaps some aspect of the business where we might want to expand or be more robust. I don't foresee another major acquisition like Alteva, but we will continue to opportunistically look at opportunities. We've done that.
TWST: You announced the company's third-quarter results in December. What were the highlights for the quarter and what were the reasons for the quarterly numbers?
Mr. Albro: Well, certainly revenue growth as a result of the Alteva acquisition was a highlight. But we had some lowlights too. One lowlight is that it used to be when you acquired a company that you capitalized not only the acquisition cost, but all of the closing and transition costs. That changed a couple of years ago, and so in our third quarter, we managed to bang ourselves really hard with a lot of acquisition costs. So the cost of acquiring Alteva banged us pretty heavy in the third quarter. That's a one-time anomaly.
The other thing that happened is that we changed our relationship with the Verizon wireless partnership, so that affected our net income. It's a rather complicated arrangement, but I'll see if I can make it as easy to understand as possible. Our partnership going back to 1983 with Verizon was a wholesale partnership. What that meant was our partnership had no sales centers, no retail stores, no marketing costs. We just provided a network to Verizon Wireless retail. As a result, we got fairly sizable gross margins. We're talking significant gross margins, because none of those sales and marketing costs are loaded into the partnership. Interestingly, we were the only wholesale partnership in all of Verizon Wireless domestic territory. Nobody really remembers back to 1983 why it was built as a wholesale partnership, but they had always wanted to convert it to a retail arrangement for alignment. We said that if they wanted to convert it, they would have to give us a big chunk of cash because our partnership distribution will certainly decline from significant gross margins down to what the wireless industry more typically gets, which is 30% to 40% gross margin at retail, and that would result in a lower cash distribution for us.
Along came 4G, and Verizon formally notified us with the proverbial shot across the bow, saying they were not going to introduce 4G to the partnership. That led to more conversations and more discussions, and as a result of those conversations we entered into an agreement and changed the partnership to be a retail partnership. So the $12 million to $13 million we were getting each year was going to be diminished, arguably by nearly half, and so Verizon made some accommodation. They said they would guarantee our payout for three years at the same level of cash payout that we had enjoyed as a wholesale partnership, and then in the fourth year, they provided us with a put option, where we can force them to buy our interest for $50 million or five times EBITDA, or as an alternative to exercising the put option, we could continue with the retail partnership at our discretion.
Those are great agreements, arguably worth almost $80 million, but in the short term, the accounting for the partnership, the difference between the retail distribution and the wholesale, does not get shown as income. It goes directly to our balance sheet. So if you read our quarterly report, you're going to trip over about as many times as we could stuff into that 10-Q an explanation that when you look at our net income you're going to see "other income" declining, which may happen for about another several quarters, which is going to have diminished net income for accounting reasons. But cash is going to hit the balance sheet, not the income statement. At some point in the future, cash distributions in their entirety will come back to hitting the income statement again. When you look at our 10-Q, there are so many qualifiers to those results between the acquisition, the change of the Verizon Wireless agreement, that it's not clear what we have earned and what cash has been received.
That was a very long answer to your question, and so to come back to your question, I'm actually thrilled with the performance of Alteva for the quarter, although it's masked by all those reasons that I just shared with you.
TWST: Would you please tell us about your background, and then tell us about the rest of the management team as well?
Mr. Albro: Sure. My history is in the telephone company world. I started in what was New York Telephone and worked up to the ranks through NYNEX and Bell Atlantic to the officer level running New York. At the time that NYNEX and GTE merged, I opted out with what's called a retention and severance package that enabled me to pursue other interests. After a noncompete period, I moved into the CLEC world and was Chief Operating Officer at a company in northern Virginia. That company was acquired, and then I worked for a cable company in the New York-metro area as Operations Vice President. From there, I started doing strategic consulting for investment banks and private equity funds, and then ran a cell-phone refurbishing company in Fort Worth, Texas. After that company, I came to WVT Communications Group. I've been around the telecom world in both the large incumbent carrier to CLEC, then in the cable world, then in the cell-phone world.
David Cuthbert, who is our Chief Operating Officer, is a Naval Academy graduate and spent just shy of 10 years in active duty service in the Navy. David was in the special-ops area of the Navy. He got out of the Navy, and began working with Alteva and rose to be CEO of Alteva. Our Chief Sales Officer has been in the CLEC and unified communications sales world, has worked for ATX, Alteva and then spent a short period of time as a Consultant before heading Alteva's sales. Mark Marquez, who is our Chief Network Officer, came to us from Alteva, and he has spent considerable time and has a lot of experience in what I would call the IP network world. The Chief Technology Officer for our company, Jay Mercer, came to us from USA Datanet and has extensive experience in the telephony network world and IP world, particularly with Global Crossing. Our CFO has extensive financial experience working for a major regional media company. He had also worked for Frontier Communications and he knows telephony accounting, and so he's got considerable experience. So I'd say collectively we probably have about 200 years or so of aggregate experience in relevant communications and technology areas.
TWST: WWVY is publicly traded. Is it a dividend-generating company?
Mr. Albro: Yes, we are. Our company has been paying a dividend for 104 years, so 416 consecutive quarters of dividends. Since 2008, our dividend has grown an average of nearly 10% per year. We've increased our dividend for one primary reason: to reassure our shareholders that we are transforming our business from a declining local exchange carrier to a growth company. And in doing so, we want our shareholders to stick with us, so we've taken cash from this wireless partnership and essentially passed it through to shareholders as a commitment to them and a demonstration of appreciation for them sticking with us. We have a fairly robust dividend, and we are the only publicly traded cloud communications company that gives such a dividend - that gives any dividend for that matter. So I think that kind of sets us apart.
TWST: Thank you. (LMR)
Duane W. Albro
President & CEO
Warwick Valley Telephone Company
47 Main St.
P.O. Box 592
Warwick, NY 10990
(845) 986-6699 - FAX