All values in $CAD
The Yellow Pages are going the way of buggy whips and encyclopedias. For many, many years The Yellow Pages was a fantastic business with near monopoly-like margins and stability. Today those profitable characteristics still exist but the business is shrinking and will eventually be gone. Already, there are many people under 20 who don’t know what The Yellow Pages are. However, it isn’t like the internet is a new thing. People have been able to more conveniently find what they are looking for online for many years now, yet The Yellow Pages will still make big money this year, just not as much as they made last year.
Because the YP business’ cash flows have been so strong and steady historically, the participating companies were able to operate with large debt loads. YP companies all over the world leveraged their balance sheets up and generated healthy returns on equity. Even for many years after the internet began rendering the YP business obsolete, the economics were favorable enough to service a large amount of debt. But the dwindling revenues finally caught up, and every YP company in the world that I am aware of has had to negotiate these huge debts. Many have refinanced their debt, filed for bankruptcy, recapitalized, or merged with another YP provider to eliminate some costs and slow their decline.
Most of these YP companies have begun utilizing their long standing customer relationships to give them a bit of a jump start in creating a business services and digital media replacement similar to Yelp. So far this strategy has been more successful than I would have expected.
In the US there are multiple YP providers and some competition, but in Canada there is virtually only one provider. Competition isn’t likely to increase in the print business; there are no entrepreneurs coming out of business school and saying “I’m going into the Yellow Pages business!” This makes for a more predictable stream of cash flows.
In Canada, Yellow Media is essentially the only game in town. If you want to advertise your law or dental practice in the YP, you have to call them up, and if you don’t call them up, one of their 3,400 employees are likely to call you. Today they won’t only offer you an ad in the print directory, they will also try and sell you on their digital advertising options consisting of website listings, website construction and design, mobile app ads, web page search engine optimization, and google ads. In a short period of time Yellow Media has become one of Canada’s largest internet-media companies, and they are growing their digital business by about 10% per year (although much of this growth is the print customers transitioning to digital).
Unfortunately, primarily due to competition, the digital business isn’t the cash cow that the print business was in its prime. Companies like Yelp and Angie’s List take some of the business. It is easy to get started helping small businesses design websites. There are many businesses going into online advertising, and this competition takes a toll on profitability. Yellow Media’s margins have been declining for years as they transition to their digital offerings.
Reviews for most of their digital products are good, but not great, and Yellow Media currently sports healthy customer retention rates, likely due to an informational advantage from having been face-to-face with all of these businesses for many, many years.
With that background, let’s look at the investment thesis. I will discuss the economics of the print and digital businesses, and then we will put it all together and play with some assumptions to see what the risk/reward is at these levels.
The Print Business
Make sure there aren’t any children reading this because this information may be disturbing to some viewers. The Yellow Media print business is declining at roughly 20% per year. Most of the YP print users are fifty years or older according to Yellow Media. According to Yellow Media, most Canadians use print directories at least sometimes during the year. 90% of Canadians use the internet. My guess is that the rate of decline will slow as the vast majority of the population that is willing to adopt internet searching and smart phones makes the transition leaving only the fur trappers and curmudgeonly hermits who will die never having heard of YouTube. It is kind of a low-hanging fruit principle; nearly all 40-year-olds will adopt online searching, but there are a number of older people who have lived their lives without the internet and they are still ok without it. Again, the internet has been around in full force since the mid-90s and Yellow Media still managed to generate about $225m in EBITDA from their print business in 2013, although that was 23% lower than what they generated in 2012. The only thing I can see that would cause the decline in print to accelerate would be an environmental activist push claiming that the print directories are wasteful. My guess is that this is unlikely due to the fact that the print directories are already becoming irrelevant at a fast rate without any help.
The Digital Business
The digital business is more promising (feel free to let the kids back in) but not as predictable. The digital business primarily helps small businesses promote themselves online. According to Yellow Media, there is widespread adoption of the digital platforms by previous print customers. Digital is cheaper, and obviously the wave of the future. Nearly 50% of print customers have already made the transition. There is good news and bad news in this information. There are still many print customers to bring to digital, and they are about halfway through the easy converts. We will likely see continued growth in the digital business for a few years and then a leveling off or a decline. As of now, it appears that Yellow Media has a respected and recognized brand and a popular mobile app that focuses on local businesses, but I don’t think the digital business is likely to be any kind of a growth business, and I doubt Yellow Media has any lasting competitive advantages.
The Recapitalization and New Management
In 2012, due to pressure from debt holders (some of them value-oriented investors and funds), Yellow Media recapitalized to reduce debt. They paid off the debt holders with equity and wiped out the previous equity holders, kind of like what can happen in a U.S. bankruptcy. It was a controversial move given that Yellow Media was still able to service its massive debt load and looked to be able to continue to do so. Some of the lenders protested in vain. It’s possible that some of the value-oriented bond holders saw the opportunity to acquire equity ownership at a very low price and that is why they pushed for the recapitalization.
In the end, debt was reduced by a huge amount and the previous debt holders wound up owning 80% of the company. In addition, Yellow Media committed to a mandatory 75% excess cash sweep to pay down debt. This prevents management from taking the excess cash and blowing it on value destroying acquisitions or Hail Mary-like projects. The mandatory debt repayment has been increasing equity and decreasing interest expenses.
In early 2014, they brought in a new CEO. The old CEO wasn’t terrible, but the new one is pretty good. He managed a successful transition from print to digital at a YP company in France. Additionally, as a new CEO, he is less-likely to suffer from confirmation bias and sunk cost fallacies because he has no emotional attachment to the old ways. It is a challenge to manage a melting ice cube, and I think it is wise to bring in someone who has had success. The move was applauded by debt and equity holders alike.
While the recapitalization reduced debt by about $1.5B, it created a very confused and unnatural shareholder base. Many of these funds are fixed income-only funds, so they are required to sell their stock regardless of price, and others are likely to sell as soon as they see a good opening, like a significant move in the stock price. This selling pressure creates quite an entry point, and it is part of the reason the bargain exists. It could also explain the recent slide in the share price.
Bringing it all together
So, we have a print business declining at 20% per year, and a digital business growing at 10% per year (for now). Digital comprises almost 50% of current revenues. The overall decline looks like this:
Since 2007, overall revenues have declined by 8% per year, while operating income has fallen by 10% per year.
Since the recapitalization at the end of 2012, Yellow Media has reduced long-term debt from $788 to $637 (19%), which has reduced interest expense, and the decline in interest expense will accelerate as Yellow Media’s balance sheet improves. Last year, Yellow Media had interest expenses of $74m and Operating Income of $320m (4.32x interest coverage).
Using a simple single stage DCF model with no terminal or sale value (out of conservatism given that DCFs overestimate the value of declining companies) and a 15% discount rate, this seems more than fair given that their senior notes pay 9.25%. I have created three possible scenarios.
The Good Scenario
We will assume that the digital transition is a success, and the print business continues to slowly decline. This makes the overall earnings decline only 5% for the next 15 years. This would mean that the current value of the stock is $46.
The Just OK Scenario
Here, we will assume that what has been happening continues. Revenues and earnings both fall at about 11% per year for the next 15 years. This would put a value on the current stock of about $33.
The Bad Scenario
Let’s say that print declines don’t slow up, they accelerate. Also let’s assume that digital levels off, or maybe even declines. Overall earnings fall at 20% per year (a 100% increase over the previous 5 years’ rate) for the next 10 years after which there is almost nothing left, and the company throws in the towel (this would mean that they are still earning $30m per year when they call it quits in year 10). That would put a current fair value at about $22.
Another way to look at the valuation is to put a multiple on estimated earnings a few years out. If earnings decline at 15% per year for the next three years, they will be at roughly $175m. Newspaper companies trade at about 6 to 7 times earnings (because they are in a similar situation as Yellow Media), and a growing company will trade at 10 times or more. If we decided that Yellow Media should trade at five times, we have a fair value (($175m x 5)/28m shares outstanding) of $31.25.
There is also a possibility that the digital business becomes the main focus as it begins to generate the majority of revenues. If the digital business is growing at all it will trade in line with other advertising and business services companies. This would mean at least 10 times earnings of perhaps $100m, or a share price of $36 or more, and this is with no value given to the cash provided by the print business.
It is difficult to peg an exact value on a business like this, but it is safe to say that the company is cheap, although it might be a bumpy ride.
Risks
Because the investment is made in Canadian dollars, there is some currency risk.
Declines could accelerate much faster than expected.
Hopefully the share price appreciates before the intrinsic value falls to meet it.
Disclosure: Long Y.TO
