Cincinnati Bell (CBB) will celebrate 140 years since its founding this July. It has long provided phone and data communications to residents and businesses in Ohio, Kentucky and Indiana. We have been invested in them for the tiniest sliver of their history, and today endured our very first quarterly earnings release. We were lambs to the slaughter.

The bull case on CBB is that they own a data center (Cyrusone; NYSE:CONE) which represents an undervalued asset. Although their fixed line business is in decline, they have been investing in the data center and in January sold 31% of the company in an IPO. The 69% of CONE that CBB retains is itself worth $975MM, more than the market cap of CBB itself.

The genius in the CONE IPO was that it relieved CBB of the need to continue funding CONE’s CAPEX allowing CBB to pay out excess cash flow as dividends while raising enough capital for the independent datastorage business to self fund growth.  The $390MM of EBITDA that CBB expects to generate in 2013 should need to cover even less capex than 2012 for its legacy business and even after interest and pension fund contributions ought to provide for $100MM to be distributed to shareholders. Since CBB doesn’t pay a dividend, even a $0.25 cent annual dividend ($50MM) on a $4.25 stock would provide almost a 6% yield and draw in dividend investors to drive the stock higher. The once ophan stock of the legacy telco that pays no dividend while investing in datastorage becomes appealing to income seeking investors while their investment in CONE is rewarded in the market by REIT investors seeking growth.

But instead, the company disclosed in its earnings release that it projects 2013 capex at $180-190MM for the non-CONE businesses. The equivalent number in 2012 was $140MM, so they’re increasing their investment into a declining business. The value creation they promised with one hand through the CONE IPO is being hijacked by management with the other. In addition to which, they’re paying certain employees $40-50MM in “IPO success payments”. So far, those are the only people who have made any money out of the IPO.

Fortunately we were not bold and our investment was very small (indeed, smaller after today’s rout). The good news is that the equity in CBB’s remaining business excluding the 69% of CONE they retain is valued at negative $320MM. That’s how the market assesses their decision to quicken the pace of fiber-optic investments and the odds that they’ll generate a return above their cost of capital.

So now it’s over to the activists to impose a taste of corporate democracy on a management team that’s lost the plot. As of December 31 holders included Marcato Capital Management, Gabelli and Lonestar Capital Management. Assuming they retain an investment they can’t be happy with today’s developments. The IPO Success Fee especially grates. We’re holding our small position in the knowledge that more value exists than the company’s current valuation implies while we await a 13-D filing. It might well be an interesting story to follow.

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