Description

I am recommending a long position in the common stock of The Dun & Bradstreet Corporation (DNB). I liked the stock better last week when it was trading in the $69 range, but I still feel that at $72.68 the risk/reward is compelling. Although it is only up +5% from its recent low, with the strong move upward in the last 3 trading days it seems a few people have noticed the cheapness already. These days stocks don't seem to stay very cheap for long. There might be reason to wait until the next quarter, around the end of April, as management commentary has indicated that 1Q10 will still be weak, and 2 out of the last 3 quarters have seen big selloffs. But I could also see the stock trading into the low-$80s by then as well just based on valuation.

Investment Highlights

Stable business with barriers to entry and a wide economic moat-global database of information on 150 million businesses is an asset that is nearly impossible to replicate. This provides a high barrier to entry. In addition, no customer accounts for as much as 10% of total revenues, making it difficult for any single customer loss to significantly damage the value of the company.

High return on capital, high free cash flow production, and a healthy balance sheet-due to large share buybacks over the past decade the company has negative shareholder equity, and with low net debt/EBITDA of about 1.4x, returns on capital are in the triple digits. Free cash flow margin peaked at 25% in 2008, and capital needs have averaged $10 million per year the last 5 years.

All-time low valuation-multiples are 20-34% below historical medians, depending on the metric, and near all-time lows. In addition, the stock is cheap on an absolute basis, trading below a market multiple of earnings and at a 9% FCF yield excluding extraordinary capital expenditures.

Management focused on shareholder return-total shareholder return is a central principle of DNB's business philosophy, and management has increased EPS growth by 6% per year through consistent and predictable share buybacks over the past decade, using nearly 100% of cash flows from operations for share buybacks and reducing S/O by 36% over the past 10 years. Allocation of capital has been disciplined and cumulative acquisitions net of divestitures since 2001 have been about $265 million, only 10% of cumulative cash flows from operations, an indication that management does not stray from its core business.

Strong International growth and stable U.S. position as dominant player.-DNB will benefit from a pickup in U.S. business activity as most operations require some type of credit and DNB is the premier provider of information on counterparties for those types of decisions. Meanwhile their International business is growing revenues at double-digit rates.

Near-term catalyst of non-farm payroll numbers-the next three monthly non-farm payroll numbers should provide a catalyst for economically sensitive businesses as the numbers will be positive, large, and growing due to Census hiring.

Business Description

2009 Revenues: $1.687 billion, operating income $465 million.

DNB has three divisions:

Risk Management Solutions (64% of Revenues, $1.07 billion in 2009)-The core of DNB's business is its global database on 150 million businesses. DNB gathers data from over 20,000 global sources, including trade data, banking information, court and legal filings, newspapers, company financial statements, and interviews, and manages this information in its database to which it provides access for its customers. Risk Management Solutions consists of reports from DNB's database used primarily for making decisions about new credit applications (75% of segment revenues), scoring and integrated software solutions (25%), and tools to help companies better understand the financial risk of their supply chain (5%). Risk Management Solutions are generally sold under fixed price subscription contracts that allow customers unlimited access to risk information. Risk information is also sold using monthly or annual contracts that allow customers to purchase information up to the contract amount based on an agreed price list. Once the contract amount is fully used, additional risk information can be purchased at per-item prices which may be different than those in the original contract.

Competitors: Equifax (EFX), Experian (EXPN LN), Transunion, the three large credit rating agencies. Traditionally these companies only provided consumer credit information but they now offer consumer and business information combined to help customers make credit decisions with respect to small businesses.

Sales and Marketing Solutions (28% of Revenues, $475 million in 2009)-consists of marketing lists, labels and customized data files used by customers in their direct mail and marketing activities (40% of segment revenues), decision-making and customer information management solutions (60%). Sales & Marketing Solutions which provide continuous access to marketing information and business reference databases include access or hosting fees which are sold on an annual subscription basis. Alternatively, data files of marketing information are also sold to customers, sometimes with periodic updates.

Competitors: EXPN LN, infoGroup (IUSA). DNB likely competes with many other marketing firms such as ADS's Epsilon unit, Acxiom (ACXM), Harte-Hanks (HHS), and others. DNB reportedly bid on IUSA in the recent auction and lost out to CCMP.

Internet Solutions (7% of Revenues, $119 million in 2009)-Hoover's and First Research are subscription-based websites providing information on businesses. AllBusiness.com provides online media and e-commerce products that give advertisers the ability to target small business customers.

DNB's global database has records on 150 million + businesses, 100 million of which are active businesses and 50 million of which are no longer active. The database had records on 58 million businesses in 2000, so the growth rate over this period has been 10-11% per year. The geographic breakdown of the active businesses is as follows:

Africa                           1,402,073

Asia Pacific                  17,997,859

Europe                         41,612,627

Middle East                  581,621

Latin America               12,196,890

North America 26,046,764

Grand Total                  99,837,834

DNB's business is managed in two segments: North America, which consists of Canada and the United States, and International. North America produced $1.31 billion in revenues, 78% of the total, and $483mm in operating income, 86% of the total ex-corporate expense. International revenues were $355mm in 2009, 22% of the total, up from 21% and 19% in 2008 and 2007. International operating income was $81mm, 14% of total ex-corporate. International core revenues grew +18% in 2008 and +13% in 2009 excluding changes in F/X (after F/X revenues grew 23% in 2009, 14% of this was due to acquisitions), versus +6% and -4% growth for North America revenues. International operating income grew 31% and 14% in 2008 and 2009. Total company organic revenue fell -2% in 2009, and acquisitions added +3% to growth, for core revenue growth of 1% excluding the effects of F/X. North America margins and return on assets are both significantly better than International margins and ROA.

Over the past 5 years the company has transitioned the business model from predominantly transactional to predominantly subscription-based. At the end of 2004, 12% of Risk Management Solutions revenues were subscription-based versus about 45% in 2008 and 64% today. For DNB I believe subscription-based revenues are superior to transaction-based revenues and should be valued at higher multiples because they are more predictable and probably stickier.

Management

Management has created value for shareholders through share repurchases

Sara Mathew became CEO in January 2010; she had been the CFO at DNB since 2001.

Management has returned significant value to shareholders by large and consistent share repurchases since becoming a public company. Since the spin-off in September 2000, the company has repurchased 43.7mm shares for $2.69 billion, or about 55% of the shares originally outstanding (although the share count has only been reduced by 36% due to share issuance for stock-based compensation). Discretionary repurchases are activated by annual $100mm or $200mm repurchase authorizations form the board of directors. These repurchases have increased EPS growth from about 10% per year without the buybacks to about 16% per year since the spin-off. This has been accomplished with annual revenue growth of 2-4% since that time.

On the first day as a newly publicly traded company, September 18, 2000, the stock closed at $17.25; the 9.5-year CAGR to a recent price of $72.68 is 16%, without including the $3.91 in cumulative dividends paid over the last 3 years. This despite the stock being down -32% from its high of $106.63 reached on 7/16/07.

Management has created value through increased efficiencies which have improved operating margins

Operating margins have improved from 17% in 2001 to 27.5% in 2009 despite minimal revenue growth:

2010 Guidance

Core revenue growth excluding F/X of +1-3%

International revenue growth in the mid-teens, 2/3 of that is organic growth

Operating income growth of -2% to +2%, excluding extraordinary technology expense

Diluted EPS growth of +1-6%, also excluding technology expense

FCF of $240-270mm. DNB defines FCF as CFFO less CapEx and additions to computer software and other intangibles. By this measure FCF was $296mm in 2009, and $352mm in 2008.

"Capital expenditures" which includes both traditional CapEx and additions to software and other intangibles expected to be about 5% of revenues, or $85mm.

Share repurchases "up to $150mm".

Why is the stock mispriced?

-2 out of 6 sell-side analysts are projecting $4.80 and $4.73 for 2010 EPS versus $5.61 guidance, which lowers the consensus number to $5.29. Excluding those two analysts consensus is $5.55. The two low estimates include the full one-time technology expenses (although they are still far below guidance), while guidance and the other estimates exclude them. This creates some confusion. The technology expenses of about $72mm over the next two years (~$1 in EPS) obscures the true profitability of the business if investors only look at GAAP numbers.

-Disappointing guidance given for 2010 in February. 2009 guidance cut dramatically in July 2009. New CEO on January 1^st, and while she has been the CFO since 2001 and therefore the transition should be smooth, this is an additional reason why management credibility might be low at the moment. Rumors of additional management turnover might scare investors as well.

-the payoff for the $120mm in technology spending appears to be a long way off as the benefits will only begin to appear in late 2011 and 2012. However, given that DNB's competitive advantage is its data quality, it is paramount that customers be able to access that data in the most efficient and flexible ways possible. These investments seem to be the right thing to do now in order to protect and enhance DNB's competitive advantage.

-Since DNB cut guidance in mid-2009 as many companies more levered to an economic recovery were raising guidance, there could be the perception that DNB won't benefit very much from better global economic growth. I believe they will benefit, but that due to their increasingly subscription-based model there is a lag in their revenue growth. As management has stated they should begin seeing improvements in 2Q10.

Strong Free cash flow generation and growth

FCF (here defined as cash flow from operations less capital expenditures) margin increased from 15% in 2001 to 25% in 2008, fell to 21% in 2009, and is expected to fall back to 18% in 2010 due to higher than usual technology capital expenditures. DNB instituted a quarterly dividend in 2007 at 25c per share, raised it 20% to 30c in 2008, raised it 13% in 2009 to 34c, and recently raised it 3% to 35c in 2010 for a current 1.9% dividend yield. Dividends will cost about $71mm in 2010, so the allocation of about $340mm in FCF available will be 21% for dividends, 25% for CapEx and additions to software, and the rest for stock buybacks. Of the $2.7 billion in cumulative cash flow from operations produced from 2001 through 2009, 4% went to CapEx, 10% to acquisitions net of divestitures, 12% to additions to software and other intangibles, and 98% to share buybacks, indicating an increase in leverage over that period of 24% of CFFO, or about $650mm. Dividend payout ratio in 2007 was 20%, 21% in 2008, 22% in 2009, and based on guidance and 51mm S/O 25% in 2010.

Balance Sheet

Debt consists of the following:

$300mm 5.5% senior unsecured note due 3/15/11, trading at 0.8% YTM

$400mm 6% senior unsecured note due 4/1/13, trading at 3.2% YTM

$259mm outstanding on a $650mm revolver, interest rate 0.47%

$223mm in cash

$736mm in Net Debt

TTM Net Debt/EBITDA = 1.4x

Valuation

Since its spin-off from Moody's in September 2000, DNB has traded at a median LTM P/E of 19.5x. Currently the multiple is 13.4x, within reach of its all-time low of 12.75x recorded on 11/20/08. On at EV/EBIT basis the 10-year median multiple is 11.5x versus 9.3x now, near its all-time low of 8.6x reached in 2001. On a FCF yield basis the stock has averaged 6.5% over its nearly 10-year life, versus 9% currently. 2009 FCF was $360mm, down -15% from peak 2008 FCF of $425mm. On peak FCF the yield would be 11.6%. FCF has fallen a lot more than EBIT and EBITDA from peak levels, -15% versus only -6%. Peak TTM EBIT fell from $512mm to $481 or -$31mm while FCF fell from $425mm to $360mm or -$65mm. $10mm of the difference can be explained by lower amortization of software due to an increase in estimated useful life for back-end software from 3-5 years to 5-8 years. The remaining $14mm difference can be explained mainly by increases in working capital I believe.

Return to median multiples would yield a stock price of $103 (P/E), $89 (EBIT), and $97 (FCF, excluding $20mm non-recurring technology CapEx), a median of $96, or +32% from the current price.

Relative to the TTM P/E of the S&P 500 the stock is also near an all-time low: historically it has averaged a 1.3 multiple premium to the index whereas now it is trading at 5.2 turn discount, 1.8 standard deviations below the median spread. Until mid-2009 it hadn't traded at a discount to the S&P since early 2004, and during those 5.5 years the median multiple premium was 2.7. Granted the TTM S&P earnings are more depressed than are those for DNB-but that is kind of the point, this is a very stable company and as a result it deserves a higher multiple than 13x.

12-month return forecasts and estimated probabilities:

Base case: $83, + 14% on $5.60 guidance + 2% dividend yield = 16% total return, 50% probability.

Upside: $97, + 34% from a takeout or improved growth outlook and return to historical multiples, 25% probability.

Downside: $64, -11%, based on -10% earnings downside to $5 and all-time low multiple of 12.75x, 25% probability. Incidentally, since the end of 2005, the stock has only spent about 7% of the time below $70, the vast majority of those days being in mid-2006. Over these 4+ years the stock has bounced off the $70 level and risen to at least $80 within 3 months on 5 separate occasions. It appears to be doing this again after closing below $70 on six consecutive days over the past two weeks.

Expected Value = $83, +14%

Base / Downside: 1.5 to 1

Upside / Downside: 3 to 1

Risks

• Weak U.S. economy persists: General economic activity remains at the current depressed level for years.
• Competitive losses due to lower pricing pressures revenues and margins: competitors with lower market share will try to win business by pricing 50% below DNB's prices.
• Underfunded pension plan: pension plan is underfunded by $450mm. Expected contribution in 2010 is $31mm, and expected payment to postretirement benefit plan is an additional $7mm. Pension is 65% equities and has an expected annual return of 8.25%. Should equities underperform this could become a drag on cash flow and reported earnings.
• Potential tax liability of $129mm: 1990s tax actions created a potential liability. I don't know the likelihood of a required payment, although this issue has been mentioned in each of the last 3 10-Ks and each time the filing states that the company does not expect anticipate payments within the next twelve months.
• Longer-term competitive threats to the business: from the 10-K, "We also face significant competition from the in-house operations of the businesses we seek as customers, other general and specialized credit reporting and business information services, and credit insurers. For example, in certain International markets, such as Europe, some credit insurers have identified the provision of credit information as an additional revenue stream. In addition, business information solutions and services are becoming more readily available, principally due to the expansion of the Internet, greater availability of public data and the emergence of new providers of business information solutions and services." This could be a large risk.
• Risk due to technology upgrade: from the 10-K, "In February 2010, we announced an approximately two-year strategic technology initiative to be implemented at an aggregate cost of approximately $110 million to $130 million. We will rely in part on third-party providers to implement a new data supply chain and update our technology infrastructure and to thereafter run such operations both within D&B and from their own remote locations." Large-scale technology changes are risky because they can cause service disruptions as well as lower employee productivity in the near-term as time is required to learn how to use the new tools. Service disruptions can scare away prospective and existing customers. The cost estimate might be too low, which will likely reduce FCF available for stock buybacks; as 6% of long-term EPS growth has resulted from buybacks in the past this could significantly reduce near-term EPS growth, which will dissuade investors from paying an above-market multiple as they have in the past.

Catalyst

• Non-farm payroll data will improve significantly in the coming months: Jobs numbers improve meaningfully in the coming months. According to the SBA 64% of jobs are created by small businesses, and I believe that as non-farm payrolls increase the demand for lending and other credit-based activities will increase demand for DNB's services. Regardless of whether you believe that the current economic rebound is self-sustaining or not, the Census hiring will boost the payroll numbers by 635,000 jobs in April and May according to the Department of Commerce. After nearly two years of job losses, the market will most likely react very positively to job gains, especially large ones, even it everyone knows that the numbers are boosted by temporary hiring. April 2, May 7, and June 4 are the next three releases of non-farm payrolls data.
• DNB is a private equity takeout candidate: due to the stable cash flows and barriers to entry this is the type of business that private equity funds would be interested in buying. It is quite similar to IMS Health (RX), and in fact DNB owned RX between 1988 and 1996. TPG and the Canadian Pension Plan fund bought RX last month for about 9.1x LTM EBITDA, 12.2x LTM EBIT, and a L5Y average FCF yield on the equity of 9.4% (I use L5Y for RX because 2009 FCF was inflated). Those multiples applied to DNB translate into takeout prices of $81, $99, and $71, averaging to a 15% premium to the current stock price. I would argue that DNB deserves higher multiples than RX due to the lack of regulatory risk associated with its core business information directory, which should dictate a lower discount rate. On the other hand RX's 2009 EBITDA and EBIT declined much more from their 2008 peak than they did for DNB, which might justify a lower multiple for DNB assuming TPG et al. paid a price with some assumption of a return to 2008 numbers. A DNB transaction would be of similar size to RX, in the $5-6B range, which is an amount that PE firms appear capable of executing these days based on improvements in the credit markets.
• Investor day to be held in the next few months, likely in May: first investor day in 2 years, first non-earnings call presentation in at least 2 years I think. This should raise company's visibility for investors and serve as a positive catalyst.
• Sell-side is bearish on the stock: only 2 out of 8 analysts covering DNB have a BUY rating, but the four best known firms (Stifel, JP Morgan, Baird, and Stephens) have all either initiated at HOLD or downgraded to HOLD within the past year. As a result there is room for upgrades if the stock falls below $70 again or if economic conditions improve.