Description

I will preface this write-up by saying that the equity of Dex One Corporation (DEX) is a small, speculative investment for us.  In our view the equity is trading at a valuation that assumes the company's declining top-line will almost certainly continue to decline indefinitely, eventually eliminating free cash flow, and/or rendering the company unable to refinance its term loan debt which comes due in October 2014.  Under either of these scenarios the equity will eventually be worthless; however, if management is able to attain their goal of arresting the top-line decline and achieve their stated goal of top-line growth in the second half of 2012, the equity has tremendous upside.  We view the equity as a significantly undervalued, long-dated option on the business' potential stabilization. 

Description

Dex One Corp. (DEX) is an advertising and marketing agency that provides a range of advertising solutions to small and medium sized businesses through various channels for its customers to advertise, most notably in print directories (a.k.a. "yellow pages") and DexKnows.com. Dex One focuses primarily on small and medium businesses.

DEX, formerly known as R.H. Donnelley, filed for chapter 11 bankruptcy in May 2009.  DEX emerged from bankruptcy in January 2010 after eliminating $6.1 billion of debt.  The company emerged with a term loan at each of the company's subsidiaries and Senior Subordinated Notes at the parent.  Free cash flow generated since bankruptcy has been used to reduce debt.  Today the company has $2.35 billion of senior debt in the form of term loans and $300 million of Senior Subordinated Notes.  The weighted average interest rate on the company's debt as of 3/31/2011 was 7.2%.

The following table shows the different tranches of debt in the DEX's capital structure:

The following table shows the company's key financials as well as the company's guidance for 2011:

The company and industry for that matter face secular shifts towards more digital and online advertising, which has caused significant top-line erosion in the company's core channels.  The management has undertaken several initiatives to arrest the decline of advertising revenue in print directories and offset this with their digital initiative.  These initiatives include a focus on new technology platforms and solutions such as applications for iPads (Dex Mobile, Dex City Central), bundling of different products and services to be a one-stop solution for a local business' advertising needs and implementing a unique pricing mechanism in certain markets which guarantees a minimum number of customers to an advertiser for a fixed price. Management has guided to a revenue decline of 16% for 2011, but expects to mitigate the top-line declines and begin growing the top-line in the second half of 2012.  Implicit in this guidance is a negative single-digit decline in print, offset by mid-teens growth in digital. 

In addition management continues to cut costs to offset the impact that declining print advertising has on EBITDA.  In 2011 they expect cost savings of $140 million, the bulk of which comes from reducing SG&A and selling expenses.

Management

The company's CEO Al Mockett, has been at DEX since September 2010.  His prior experience includes running the Yellow Pages business of BT, being the CEO of American Management Systems and the CEO of Motive Inc.  Under his leadership at American Management Systems (AMS) his main task was to cut costs and flatten the management structure.  AMS's stock price doubled during his time there, and the company was eventually acquired by CGI Group.  At Motive Inc., Mockett was responsible for focusing the company's revenue opportunities with the areas of highest profit potential.  Motive was acquired by Alcatel-Lucent 2 ½ years into its turnaround.

Management has been buying shares in the open market, which demonstrates their confidence in turning around the business.  In early March, Mockett purchased 200,000 shares at $4.20 per share.  Around the same time the company's new Chief Technology Officer purchased 10,000 shares at $4.35 per share.  More recently, EVP of Sales and Marketing, Richard Hanna bought 50,000 shares at $2.13 per share on May 26.

Conclusion

While the turnaround does have significant execution risk, should revenue stabilization occur in line with management's anticipated timeframe, EBITDA should stabilize above $550 million, at which point the company would be generating over $6.00 per share in free cash flow per annum.  This includes the benefit from the company's sizeable NOL, which doesn't start expiring for another 14 years.  While one can debate what multiple of free cash flow would be appropriate once revenues stabilize, it is certainly significantly higher than today's 0.3x.  The leverage to the upside is extraordinary if they don't need to restructure the debt.  As an example, at 5x "stable" EBITDA of $550m, down from $808m last year, we can make a double before debt reduction... but at 6x EBITDA (or lower multiple combined with higher stable EBITDA) we can make a >7x return. 

Risks

Continued weakness in DEX's top-line, resulting in revenue declines continuing at a 15 - 20% rate, eventually leading to the company running at an EBITDA loss and/or being unable to refinance their debt... at which point the stock would be worthless.

Catalysts

Any sign of stabilization in the company's revenues. 

Catalyst