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Monday, April 23

Otelco: An Ugly Stock with an Interesting Story

This morning, Otelco (OTT) was down more than 40% after announcing Friday evening they are losing their biggest source of revenue.  I made a purchase this morning at an average cost of $7.00 in one account and $6.88 in an account I oversee.

Shares of OTT are unique in that they are an IDS.  In laymen's terms, each share of OTT represents one share of stock and one share of a bond.  The bond is valued at $7.50 and yields 13%.  It is callable in 2012 but does not mature until 2019.

The company announced Friday night that Time Warner will not be renewing its network access contract with Otelco when it expires 12/31/12.  There will be a transition period in 2013 when they stop doing business with Otelco.  In response, Otelco suspended the dividend on the stock portion of the IDS.  In my opinion, suspending the dividend is great news and the only option the company has.

Here's what we know:

  • At some point in early 2013, 11.7% of their revenues vanish (the Time Warner portion).  This is bad.  Really bad.  Based on 2011 revenues, it's a $12.1MM annual loss in revenue.
  • We also know they just dropped the dividend, and frankly that ain't coming back.  They spend $8.9MM per year on the dividend portion of their quarterly payout.
  • This leaves a gap of $3.2MM per year ($12.1MM minus $8.9MM).  BUT, we won't actually see this revenue loss until next year, so the $8.9MM in savings from cutting the dividend in 2012 will shore up the balance sheet some through 2012.  
  • The company spent $5.4MM for to acquire another telephone company,Shoreham, in October last year.  Otelco's cash balance dropped to $12.4MM at the end of 2011 as a result.
  • The business was already generating $5MM+ cash per year.  Add to that the $8.9MM they won't be paying out.  That's nearly $14MM in cash they will be able to add to the balance sheet, giving them in my estimation about $26.3MM at 12/31/12.

This is when it gets ugly.  Not only will they contend with the loss of Time Warner, but their Senior Subordinated debt owed to Wells Fargo comes due October 31, 2013.  They can't pay it off, so it will have to be refinanced.  Fortunately, the company has been chipping away at this debt over the last few years.  It has declined from a high of $173.5MM to its current $162.4MM balance.  These prepayments were completely voluntary.  As a lender, Wells Fargo likes to see a company demonstrate an ability (and desire) to prepay debt.

Otelco has way too much debt.  That's the biggest risk with this company.  In fact, roughly $.25 of every dollar they take in goes towards interest payments.  It's downright scary.  One option the company has this year is to call their subordinated notes (these are the ones yielding 13%).  The Senior notes from Wells Fargo yield 4%.  If they could work out terms with Wells Fargo to roll up all their debt into a single instrument, they could potentially lower their debt service.  A bonus to the investor is that if the notes are called in 2012, Otelco will pay you a 6.5% premium (so you would receive $7.9875/bond instead of $7.50/bond).

For the individual investor, you could buy shares of Otelco under $7.50 if you believe they will not go bankrupt.  Sure, the company could defer interest on the subordinated note, but as long as they don't declare bankruptcy, your biggest risk is the deferral of interest on your notes.  To mitigate risk further, you might purchase shares now, and sell them at the end of 2012 if they haven't been called.  What you don't want to happen is to see October 31, 2013 roll around without the company having reached new terms on their senior debt.  That's the trigger that could bring this company into bankruptcy.

I'm not a professional, and I benefit if this company's stock goes up.  Do your own research before considering a purchase of Otelco.

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