Projecting Yellow Media

Because of my work situation I am faced with a limited amount of time to analyze my investments.This precipitates the need for efficiency and a focus on the questions that matter most.

Thus I spend a good deal of time thinking before I spend any time analyzing. This is particularly true when I am just introducing myself to an opportunity. I think about how I can distill it down to one or two questions that I can focus on. Rather than taking the approach that I need to understand every aspect of the company (something that I simply don’t have the time to do) I look for the lynch pins and focus on understanding their mechanics in great detail.

To give a few examples; this was my strategy for the mortgage insurers, where I focused strictly on whether or not they would pushed into run-off or bankruptcy by the regulators. With Arkansas Best I focused on what the upside might be if the company negotiates a union contract similar to that of YRC Worldwide. With YRC Worldwide I focused on their leverage to the upside. When I initially bought PHH I focused strictly on the value of Fleet, which allowed me to view the mortgage operations as an upside option.

With Yellow Media, I narrowed it down to two questions. They are:

1. When and at what level is the online business going to grow enough to offset the declines in the print business.
2. What assumptions should be used to answer question 1

First the Assumptions

The second question must be answered first. Assumptions must be made about future growth, future margins, tax, interest and capital expenditures.

Extrapolating the future growth in the on-line business is tricky because of the divestitures that Yellow Media has made in an attempt to bring the debt down. Thus I have excluded the impact of CanPages, LesPAC, Deal of the Day and YPG USA in the estimates below.

The company said year over year growth in on-line revenue was 15.7% in 2012 though I’m not sure how they calculated that.  I calculate 6%.

The company has been growing on-line revenues by converting its print advertising base, and in my opinion success going forward will be determined by how effectively they can continue to do this. If you look at the increasing penetration of print subscribers who are subscribing to on-line or mobile placement, you can see that they are having success so far.

Additionally, the company has been getting more advertisers to increase spending (presumably increases are occurring via the on-line business, not print) while advertisers that have decreased spending has flat-lined (though, as I will describe below, the 18% are likely key customers).  This is a sign that existing advertisers are finding value in the products.

As for the print business, it is in terminal decline. However it does appear to be in a fairly stable and predictable decline. The chart below illustrates the year over year fall in revenue.

The fall in revenue is due to some advertisers choosing not to renew.  Only 86-87% of print subscribers have renewed over the last two years.

Based on the above and on the color provided by management, I think that I can put together some conservative assumptions about how growth may look in the future. My rough, baseline estimate is to assume that on-line revenues grow at 6% per year while print revenues decline at 21% per year.  This is consistent with on-line growth over 2012 and compares conservatively with the decline of 19% for the print business.

There are a couple of potential positives that could help boost both the print and on-line businesses.  Consider the following:

• On the first quarter conference call management pointed out that approximately 82% of their advertisers were exhibiting either stable or increasing spending trends.  Only 18% of the advertisers were lowering spending.  However those 18% of advertisers were skewed towards large companies whose spending made up about 40% of Yellow Media’s revenue.  It was only in 2011 that Yellow Media began to address the deficiencies in their product offerings and focus their sales towards these clients.  Its possible that success could slow the revenue declines in print.
• According to comments on the Q3 conference call, in the last year the company put very little investment into their brand prior to the restructuring.  It was only post-restructuring that they began to make a more concerted effort to re-establish their brand and relevance in the market.  The lull, and the restructuring, has likely had a negative impact on the perception of advertisers and stabilizing that perception would help mitigate revenue declines.

As for gross margins, management has guided that they will decline as the print business declines and is replaced by the on-line business. Guidance is that gross margins will trend to 40% (from its current level of above 50%). I would expect this to occur over the next couple of years and have allowed for this in my model below.

I came up with an interest expense by tallying up the cost of each of the new notes. They add up as follows:

• $800mm of 9.25% senior notes would be $74mm per year
• $100mm of 8% subordinated debentures would be $8mm per year
• $7.5mm of exchangeable debentures, presumably at 8% would be $0.6mm per year

Summing these items up, total interest would be $82.6mm per year.  Note that this compares to interest costs of $148mm per year before the restructuring.

I didn’t put a lot of effort into coming up with a depreciation and amortization number because I am mostly concerned with cash earnings. I just went with $100 million each year going forward, which is around the same level it was on 2012.

As for taxes, the company says that they expect to pay $60 million in cash taxes in 2013 and $80 million in 2014. Subsequent to that it doesn’t appear that there is a significant deferred tax asset so I have assumed 27% tax rate after 2014.

When is the on-line business going to begin to stabilize overall operations?

With those assumptions at hand, I came up with a rough model that projects how earnings and cash flow would develop over time. This is shown below.

The results are a bit ridiculous when looked at on a per share basis. There are about 28 million shares outstanding. I am estimating pro-forma free cash flow of $243 million for 2013, which is about $8.60 per share. I would expect them to have fully paid off their senior debt (of around $800 million) sometime in 2017. By 2018 growth in the online business is offsetting declines from the print business and free cash flow of around $4 per share.

If anything approaching this scenario plays out, I don’t really see how this stock stays at these levels.

Now I understand that there are many risks to this model. Margins may end up being below 40%, the online business may fail, or the print business declines may accelerate. All of those things need to be watched closely for as this certainly isn’t the sort of business where you rest easy and wait for your assumptions to play out. But there is also a lot of room for error when your estimate is calculating free cash flow as a per share basis that exceeds the current share price.

One thing I will say is that I am not entirely sold on their product line.  I’ve spent some time playing with the websites (I have not downloaded the mobile apps yet) and in my opinion is that they are ok.  I can see the value in Redflagdeals.com, the forums on the site seem busy enough, and the flyers section is handy, but I didn’t see a lot of local businesses advertising deals, it was mostly chains.   The flagship Yellowpages.ca site is solid (I’ve used that site to find local businesses for years now) and provides the basic business search that you expect from a yellow pages offering.  I found the Canpages.ca site a bit difficult to navigate (it kept setting my location to Toronto, which is not where I live), and the success I had finding a business really seemed to depend what I was looking for; some topics seem well populated while others are sparse.  The one thing that would make the CanPages site more useful would be reviews, and that seems to be where gigpark.com comes in, but unfortunately, while actually pretty functional, didn’t produce very many recent recommendations.

So it appears they have more work to do.  But it may also be that I am not the target audience; I am not a shopper and apart from my investment research I spend very little time on-line (I don’t own a smartphone, which is why I haven’t used the mobile app yet).  I would welcome other informed opinions about their product lines.

I originally bought Yellow Media at $7.50 in the middle of February, becoming aware of it after @FamilyOfficeGur piqued my interest with his numerous #phonebook tweets.  I thank him for directing me towards the idea.  I have continued to add to that position through this week, at as high as $9.25. While I understand the risks, and I understand that this is perhaps not the best business, I have to think it is worth more than the stock is trading for, even now. I also have to wonder whether a private equity firm interested in milking the free cash of the business might become interested in it, or whether a competitor looking for a stronger Canada presence might find it an interesting take-over candidate (it would most certainly be accreditive to earnings for most anyone). At any rate, the potential reward seems to more than offset the risks, and so I have been willing to roll the dice on this one.