Can I interest you in buying an overleveraged, dying business whose profits could easily go to zero over time, which was very publicly pitched by a big-name investor over a year ago so that many value investors believe they are already familiar with it, and whose stock has languished 25-70% lower since then as the business has struggled?

No?  Then how about a stock trading at 0.5x cash flow, which has obvious ten-bagger upside and whose downside risk has fallen significantly over the last six months – fallen so much that we recently stopped trading around for profit and now intend to hold all our shares for the big ride up?

They are, of course, the same stock.  We currently estimate this stock has a roughly 75% chance of 400-900% upside and 25% chance of 100% downside, for weighted expected return of 300-650% over perhaps two-three years.  We believe now is a good time to buy a small position (in case it does go to zero), for three reasons:

1. The business struggled during 2013 due to merger upheaval but already showed in its 1Q results that the struggle is over and better times are here.  Thus, the risk of worse-than-expected structural decline has lessened materially.  The company’s debt prices have already risen far more than the relative rise in the stock price.
2. The risk of a new recession within the next two years has dropped to its lowest level in years.
3. The company has two potential upside catalysts that were not in sight when the year began.

Dex Media (DXM) was created on April 30, 2013 in the prepackaged bankruptcy/merger of Dex One and SuperMedia, which are straightforward yellow pages businesses.  Dex One and SuperMedia were new names for old yellow pages businesses that had gone bankrupt during the financial crisis and re-emerged for a few years before this new bankruptcy filing.  When is the last year that you opened up a physical yellow pages book to find a business or even a phone number?  There may not be a more clearly dying business in the world.  However, they also sell online marketing solutions to small businesses, and those revenues are growing.  Kyle Bass pitched DXM at the Ira Sohn conference a week after the merger.

DXM currently has $2970m of debt on its books, $244m of cash, and $185m of equity market cap.  That makes its net debt 94% of the enterprise value and the equity 6%.  Even these numbers understate the amount of debt because a big chunk of it is carried on the books at less than par value.  By the terms of its debt agreements, DXM is run largely for the benefit of the debt holders; the equity is a tiny stub that is merely along for the ride.

In the face of all those negatives, the business is generating roughly $400m of free cash flow per year, more than double the equity market cap.  DXM uses all the free cash flow to pay down the debt and will keep doing so for years.

The investment decision here is conceptually simple:  DXM is in a race against time.  If its revenues and earnings decline slowly enough, it can pay down enough debt and reduce its interest expense enough such that it can more than cover interest payments in later years even with greatly reduced cash flow.  If the business declines too quickly, though, unlevered cash flow will sink below interest expense and the business will go bankrupt for a third time in ten years.  Two different paths could lead to a bankruptcy: either a faster structural decline, or a recession that comes sooner rather than later.  (Like most advertising/marketing businesses, yellow pages are highly cyclical.)

Given the debt load and valuation, the possible outcomes are as binary as they come.  If DXM loses the race, the equity is a genuine zero, because shareholders will not receive a dime of cash flow until much more debt is paid down.  But if DXM wins the race, the equity is a multi-bagger, because DXM will throw off mountains of cash to shareholders even assuming the business keeps declining forever and profits eventually go to zero.

THE BUSINESS

DXM is an old-line yellow-pages provider that serves as a marketing channel for small businesses.  73% of its revenue still comes from printed yellow pages books.  The other 27% is from online services, both simple listings in the online version of its yellow pages and serving as a small business’s aggregator channel for online marketing.  See pp. 6-12 of their 1Q earnings deck for detail on their digital offerings.  Their typical digital bundle includes “reputation monitoring, Google+ Business page, internet yellow pages, local [website] listing claiming, call tracking & reporting, professional website, mobile website, and social media.”  Many customers buy packages of both printed and online exposure, with 36% of total customers currently buying a digital service.

As one might expect, the print business is steadily declining at ~20% per year.  The digital business, however, has enjoyed mid-single-digits growth over the last year and mid-teens growth in the preceding year.  DXM has reported only four quarters of results so far, and it has not provided the dollar split of print and online revenue numbers.  It has, however, provided pro forma total sales numbers going back to 1Q12 and provided the percentage revenue declines for print, online, and total.  With those inputs, we can employ high school algebra to derive the revenues for each segment.  ($m, hard inputs in blue):

In the 1Q results, management gave 27% rather than 25% as the current digital mix.  Our numbers calculate the mix as of early 2012 and then work forward from there.  The 2% discrepancy in the most current numbers is small enough that we can ignore it, and a slightly higher digital mix is a slight positive.

When we first looked at DXM, we were skeptical that a yellow pages company could create a durable digital marketing business, i.e., one that would not itself start declining within a few years.  We assume that, relative to Silicon Valley or Seattle, DXM has virtually no ability to innovate online and probably has some modest disadvantage in online operations as well.  We gained comfort over time that the online business should be able to, at worst, limp along with only modest declines, and at best, grow at long-term rates that are positive but still less than those for the online marketing industry.  DXM’s core customer is a small local business.  A yellow pages business still has far greater penetration of sales relationships into that segment than any online-only business.  Also, very small businesses are perfectly suited to a one-stop-shop type offering such as DXM can provide; we see the value from outsourcing their online marketing function to someone whose core competency is small-business account management and customer service.

THE DEBT – AMOUNTS AND PAYDOWN TERMS

Investing in DXM’s equity requires a detailed understanding of its debt.  DXM encompasses the yellow pages operations of four distinct geographic regions, each of which had its own senior bank debt and continues to have its own debt even after the recent merger/bankruptcy.  The four debt silos are SuperMedia, R.H. Donnelly, Dex Media East, and Dex Media West.  The senior debt all matures on 12/31/2016 and all carries a floating rate of (to simplify a bit) LIBOR-plus, with a LIBOR floor of 3.0%.  With 30-day LIBOR currently at 0.15%, that means DXM’s interest rates will not rise until short term rates rise 285bps from here, which will not occur (a) for more than two years and (b) unless the economy is doing well enough that DXM’s business should be doing well.

DXM also has senior subordinated notes with interest that must be paid ½ in cash and ½ in-kind (PIK), with a rate of 12% on the cash and 14% on the PIK amounts.

The outstanding debt on the balance sheet and its interest rates as of 3/31/2014 were:

$931m – SuperMedia, 11.6%

$670m – R.H. Donnelly, 9.75%

$403m – Dex Media West, 6.0%

$378m – Dex Media East, 8.0%

$244m – senior subordinated notes, 13%

$2,626 total

There is a twist, though.  In the bankruptcy, the SuperMedia debt (35% of total debt) was marked down to 75% of par, so the par value is 33% higher than what is on the books.  As of 3/31/2014, the SuperMedia par value was $1,241m, and the total debt par value was $2,936.  The total blended interest rate was 11.3% of book value, compared to 10.1% of par value.  In DXM’s P&L, the excess par value gets amortized as an additional interest expense (so the GAAP interest expense exceeds the cash expense by more than just the PIK amount).

The company pays down debt in four ways (see p.44 of the 10K for more details):

1. Amortization
2. Mandatory prepayments, at par, in amounts equal to 50-70% of each silo’s “excess cash flow”
3. Voluntary prepayments at the company’s discretion using the rest of the cash flow, at specified discounts to par ranging from 12.5% to 30% for different silos

Before moving to #4, note that, because the SuperMedia debt is booked 25% below par, the mandatory prepayments reduce the stated outstanding debt by less than the payment amounts.  However, the voluntary prepayment discounts to par are substantial enough such that they reduce debt by more than the payment amounts.  Because 30-50% of cash flow can go to voluntary prepayments, the company is in fact using all its cash flow for prepayments, and the voluntary payment discounts apply to 100% of the debt while the SuperMedia excess applies to only 35% of the debt, the combined prepayments are reducing the debt’s par value by roughly the amounts paid.

The fourth pay-down method is the best: The company has twice made successful open-market tender offers to repurchase debt from all four silos at substantial discounts to par.  In November, when reported quarterly results were at their worst and the debt and stock were both trading at their lows, DXM repurchased $80m of SuperMedia debt –the best debt to repurchase given its more onerous interest rate and terms – at 72.5% of par and another $21m of the other senior debt at 63.5-78.5% of par.  Compared to official prepayments of the same total face value, half mandatory (at par) and half voluntary (at the usual discounts), this tender created $21m of value for equity holders, at a time when the entire equity market cap was only $65m.  The second tender was in June, for $54m, at 82.2-92.5% of par, and created $5m of value.

THE SURVIVAL ANALYSIS

Our core investment thesis a year ago was, and today remains, that DXM will survive and throw off plenty of cash to shareholders even assuming a perpetual 21% decline in the print business, modest declines in the online business, substantial margin declines, and resulting large declines in free cash flow.  Our analysis from a year ago, tweaked only slightly since then, is as follows (inputs in blue):

Here are the key assumptions and some comments on them:

• Print revenues fall 21% per year, forever.  This assumption is likely too pessimistic, based on our experience with AOL’s dial-up customers and several other dying businesses:  The customers who are most prone to leave do so in the early years, and those who are left are the very-high-inertia customers who are more prone to stay until they literally die (for consumers) or shut down (for small businesses).  The percentage declines thus decelerate.
• Digital revenues initially grow modestly but then turn negative.  This assumption may also be too pessimistic, as discussed earlier.  Also note that a -4% nominal decline implies a -6% real decline if inflation averages 2%.
• There are two components of the revenue (and margin) lines that we know are highly unrealistic but cut in opposite directions.  First, printed yellow pages may not survive for nine more years.  We would not be surprised if DXM, as have several newspapers, eliminates the print edition and forces all customers to either cancel or go entirely digital.  Obviously DXM would not do this unless and until it becomes financially advantageous to do so.  Going all-digital would cost some customers, but it would substantially reduce operating expenses and improve margins.
• On the other side, we have not modelled in a recession.  Yellow pages revenues are highly cyclical, most costs are fixed, and if a recession comes in the next two years, DXM is probably dead.  We well remember that all the yellow pages businesses sported single-digit cash flow multiples in early 2008 and were effectively wiped out by October.  A recession that is more than two years away, however, looks survivable given the interim debt pay-downs, especially if it is the usual brief/shallow kind rather than the deep/extended credit-collapse kind.
• EBITDA margins initially rise from 39% to 41% and then steadily fall to 33% in year 9.  With heavy fixed costs, the revenue declines cause significant deleveraging.  However, the business should be able to cut some fixed costs over time.  Also, digital margins are lower than print, so mix shift will drag down the total over time.  Countering that effect will be a likely improvement in digital margins with more scale.  More importantly, management has guided to $150-175m of merger cost savings by next year, which on $1,618m of 2015 revenue would theoretically add a whopping 10 percentage points to margins.  In early 2013, when print’s percentage declines were higher and print was a higher portion of the mix (so its deleveraging affected the total margin more), margins were shrinking by ~200bps.  We are assuming only a 200bps rise from all the merger savings and then a 100bps decline in the later years.  We suspect that we are being too conservative with assumed margins in the near years but that, if so, that margins would then fall more in the out-years.  Even a temporary boost to our assumed margins would be a huge boost to survivability.
• Interest expense at the current effective rate.  PIK interest is included in the cash flow calculations despite being non-cash because all cash flow is used to pay down debt, so the PIK additions to the debt balance are equivalent to having paid cash interest.  We do not model in interest rates rising enough boost DXM’s rates past their floors.  If rates do rise that far, we would expect inflation and GDP growth to have picked up and boost DXM’s EBITDA enough to cover the added interest cost.
• Taxes starting at zero and growing to 15% of EBITDA.  DXM’s GAAP earnings are currently negative and will remain so for years despite strong cash flows.  (E.g., 1Q14 D&A was $161m while capex was $3m; net working capital will be a continuous source of untaxed cash flow.)  It is possible that cash taxes will remain zero throughout; I have not done a detailed analysis.
• Capex at 0.9% of sales, based on actuals/guidance.  This may be too optimistic in later years if they have to invest in digital and if any major print equipment hits end-of-life before they eliminate print.
• Net working capital benefit equal to 22.8% of their reduced revenue, based on actual levels of NWC/sales
• Debt levels at book value rather than par – because they can effectively pay down at book value rather than par, as explained above
• All FCF used for debt pay-downs

The result: on assumptions that will of course diverge from reality but that we believe are conservative overall, net debt to EBITDA will be 3x this year and fall to zero by 2021.  Digital revenues will exceed print revenues at the end of 2017.  If digital revenues actually grow or are even flat rather than shrinking, or if the merger cost savings outweigh cost deleveraging more than we have assumed, this business will gush money, relative to its current market cap.

WHY BUY NOW – THE STORY OVER THE PAST YEAR

We have been following and trading DXM for a full year, adding lower and trimming higher multiple times.  We stopped trimming after 1Q results and expect to hold all our shares, for three reasons:

1. The business has already turned the corner. 

We expected 2013 to be a rough period for the business, and it was.  Management was clear up-front that the merger integration would cause a lot of operational and marketing upheaval and hurt revenues in the short term, while the merger’s revenue benefits wouldn’t start coming through until 2014 and much of the cost benefits until 2015.  In 2Q, print declines stayed in their recent 22% range, but digital revenue growth, which had been 14-28% for the preceding four quarters, fell to 6%.  Margins also fell by 229bps.  3Q was even worse: Print fell 21%, digital had 0% growth, and margins fell 119bps.

A rough patch had been expected, but not zero digital growth.  That really freaked out investors – too much, in our opinion.  When Kyle Bass pitched the stock in May, he pushed the price from $14 to $24 within a few weeks.  The stock fell all the way to $4 just after the 3Q results, which is when management astutely launched its debt tender offer.

That offer marked the bottom for both the debt and the stock.  With 4Q results, digital growth was back to 5% and the margin decline was down to 43bps.  Even with the slightly-worse-than-expected rough patch, the actual 2013 results came in very close to the estimates we had made in July.  (See red numbers in the survival model above.)  In 1Q, digital growth was 8.5%, the EBITDA margin rose 16bps; print decline, digital growth, and margin all came in materially ahead of our assumptions in the survival model.  Management also gave three hugely positive updates on the call: The print business was contracting less than they had expected, merger cost-cutting is ahead of schedule, and the merger cost savings will be greater than expected.

In response to the better fundamentals, the senior debt has climbed higher, with each silo 13-14 points off its lows, three of the four silos near or above their all-time highs from last May, and the weighted average price at all-time highs.  As someone has been pointing out on Seeking Alpha, the last time the debt prices were here, the stock was at $24 versus $11.40 today.  That simple comparison fails to give credit for last May’s temporary stock boost from Kyle Bass, but the stock is still too cheap even relative to where it has already been and far, far too cheap relative to its risk-adjusted intrinsic value.

2. The risk of a new recession within the next two years has dropped to its lowest level in years.

DXM’s primary risk is a recession that comes earlier rather than later.  We are not going to devote much space trying to persuade you of our macroeconomic views, but we believe the risk of recession is unusually low, despite the horrid 1Q GDP and retail sales data.  Consensus is for GDP growth to accelerate from its five-year average of ~2% to more than 3% in each of the next several quarters.  The consensus has forecast an acceleration in each of the last several years.  We thought those earlier forecasts were wrong, and they were, but we believe the current one is finally right, for a simple reason:  The labor market is finally tightening enough to reach a tipping point.  The number of unemployed and underemployed people is falling low enough that employers will need to increase compensation for the first time in years.  Average real wages will finally rise after years of falling, which will increase consumer spending and therefore aggregate demand. 

3. The company has two potential upside catalysts that were not in sight when the year began.

In March, DXM peer YP announced a new co-marketing deal with Yelp.  Such a deal makes good sense for both sides: Yelp gets better access to YP’s tens (or hundreds?) of thousands of customer relationships, while YP benefits from Yelp’s much more robust reviews inventory, its much higher growth rate, and its perception as a next-generation business rather than a dying one.  It would also make good sense for Yelp to strike a similar deal with DXM, because DXM and YP operate in distinct geographies.  A Yelp deal would be very helpful to DXM because its digital revenue growth rate is probably both the most important and most uncertain success factor.

DXM could also refinance its debt at better terms.  With the current debt sporting a blended 10% stated yield and 12% effective yield, while 10-year Treasuries are still at 2.5% and credit spreads are low, the opportunity for improvement is tremendous. By 4Q the company will be in a much better position than it was during the bankruptcy/merger, because its operational rough patch will be behind it, merger cost savings will be ahead of schedule and larger than planned, and (we believe) the economy will be on better footing.  Merely consolidating the debt from the silo level to the parent level will eliminate some credit risk and reduce the required risk premium.  We can imagine a second refinancing perhaps two-three years later when debt levels and the remaining credit risk are lower again.  Our survival model ignores this upside.

VALUATION

If DXM survives, the upside numbers are so high and so unknowable that setting a precise price target is unnecessary.  The key number to estimate is the odds of survival, which is also necessarily fuzzy. 

We frame the upside as follows:  In a few years the cash flow will probably have fallen materially, but the risk will have fallen even more and the forward rate of cash flow declines will have fallen as well.  At that point, the cash flow should get a multiple that is mid-single-digits if digital revenues are shrinking and 10x if digital revenues are growing.  To use some precise numbers, if our survival model improbably turns out to be precisely correct, in three years cash flow will be $329m and the stock might receive a 7x multiple, for a target market cap of $2.3 billion.  That is a 13-bagger.  If you think a 7x multiple is 40% too high and it should only be 5x, that would make the stock a 9-bagger.  Even a 3x multiple makes for a 5-bagger.

You must discount that upside by the odds of a bankruptcy and subtract a 100% equity loss in the case of bankruptcy.  We think about everything discussed above and choose bankruptcy odds of 25% as our base case.  These inputs produce silly-large weighted average expected returns of roughly 500% at a 5x multiple and 1200% at a 10x multiple.  If you believe our odds of survival are too high, you can cut them dramatically and still arrive at large expected numbers.  At a 50% odds of survival, 900% upside and 100% downside, the weighted average expected return is still +400%.  At 50% odds, 500% upside and 100% downside, you get +200%. 

Turning the analysis around, for the stock to be fairly valued, you must believe that the equity has only a tiny chance of survival, or that the equity will survive but the business will later decline so much that its cash flow will never merit more than a tiny multiple, or some combination of the two. 

We can encompass all of the above in a sensitivity table.  The only inputs are our very rough estimate of $329m for 2017 cash flow and the current equity market cap.  The table shows the weighted-average expected investment returns at each combination of 2017 cash flow multiple and odds of success (avoiding bankruptcy).  As you can see from the colors, the assumptions required make the equity an expected loser (red) are draconian, and the assumptions required to expect triple-digit returns (green) are undemanding.  (The yellow cells have returns of nearly 100%, which is much better than spotting nearly one camel.)

THREE TIDBITS FOR THE TECHNICALS- AND TRADING-MINDED

2Q results should both improve sequentially and enjoy an easier comp.  3Q will improve more sequentially and have an even easier comp.

The stock chart looks very, very nice.

The short interest is 5.5m shares, which is 36% of total shares and, depending on where you look, 42% to 66% of the float.  Much of the shorting may be debt holders shorting the stock against their debt investment, but that doesn't mean they won't eventually need to cover.

• Each of the next 10 earnings releases.  Unlike for most stocks, when the core investment issue is survival, even very modestly improving results are significant. 
• More debt tenders or a debt refinancing
• Yelp deal