Description

R.H. Donnelley (RHD) is an independent marketer of yellow pages advertising, growing earnings at 30% this year while trading at only 12x EPS (2001). After its recent restructuring, the company continues to employ free cash flow towards its aggressive stock buyback program and debt paydown.

RHD has been in operation since 1886, has key partnerships with telecommunications giants Ameritech/SBC and Sprint, and currently is the publisher or sales agent for approximately 175 directories with a total circulation of over 15 million. RHD has a diversified customer base of approximately 200,000 businesses, many of which rely on yellow pages
directories as their principal or sole form of advertising. RHD completed its separation from The Dun & Bradstreet Corporation as part of a spin-off effective July, 1998.

Investment Highlights

Improving financial performance: After implementing its restructuring plan last year, the company increased operating income 10% and earnings per share over 17% in 2000 (on a pro-forma basis) and should generate 30% EPS growth in 2001. While management has publicly committed to $2.40 in 2001 EPS (27% growth), this figure excludes the accretive effect of
ongoing share repurchases.

Business model historically “recession resistant”: Yellow pages are a stable and reliable form of advertising, representing a $24 billion industry worldwide and approximately 12% of U.S. local advertising expenditures in 2000. With the low-cost, annual placement, and ongoing reference benefits of yellow pages, businesses are typically reluctant
to reduce their expenditures on this form of advertising in the short-run, which leads to consistently high renewal rates among advertisers.

Focused corporate strategy: RHD is now focusing exclusively on its profitable yellow pages advertising business. By selling its relatively low-performing New York contract to Bell Atlantic and extending its contract with Sprint to 2010, RHD has moved to emphasize its most profitable regions – including fast-growing areas such as Las Vegas and Central Florida. Also, this past December, RHD shut down its money-losing internet marketing services experiment, Get Digital Smart (GDS). Furthermore, RHD’s investment in its Asian JV, ChinaBig.com has been completed and its ownership stake diluted, thereby moving the operating losses at the affiliate off RHD’s income statement. Any additional investments would likely take the form of acquisitions of additional yellow pages businesses divested by telecommunications players.

Management focused on shareholder returns: After being approached by a third party about a potential sale of the company in 2000, management diligently began a formal sale process until weakening capital markets made a sale virtually impossible for the buyer. As a relatively recent spin-off with management owning more then 3.5% of the stock, RHD has
committed to employing its excess cash flow toward enhanced returns for shareholders. RHD announced a $100 million share repurchase program last December and has retired over $35 million of stock, representing about 5% of shares outstanding.

Attractive valuation: While RHD has no true comparable public companies, related advertising services and marketing companies (including ADVO, Acxiom, Catalina, and Valassis) are trading at 10x to 30x EPS in 2001, compared to RHD at only 12x. Management is committed to buying up the undervalued shares in the open market and has publicly reiterated
its openness to a sale of the company.


Investment Risks

Economic sensitivity: While yellow pages advertising is less economically sensitive than other forms of advertising, a recession could lower the rate of increase in yellow pages advertising expenditures which would in turn moderate the projected EPS growth over then next couple years. As of the first quarter of 2001, management has reported no discernible effect of an economic slowdown on the yellow pages advertising business.

Dependence on telecommunications partnerships: RHD has recently expanded and solidified its relationships with Ameritech/SBC and Sprint, while ending its relationship with Bell Atlantic. In particular, the SBC partnership takes the form of the 50/50 DonTech joint-venture, which represents over 80% of RHD’s operating income.

Billing and collection issues at DonTech partnership: In the latter part of 1999 and all of 2000, calendar sales at DonTech were adversely affected by issues related to the administration of billing and collection functions at Ameritech, resulting in a loss of customers who were significantly delinquent and withdrawn from directories. Management reports progress on this front so far in 2001.

Impact of Internet on advertising: The Internet could potentially change the value proposition of yellow pages advertising, but RHD's own digital experiments have not proven profitable while the physical book continues to be valued by advertisers.

Catalyst

Buyout/takeover: With RHD's stable cash flows, low valuation and willingness to entertain buyout offers, there exists the real possibility that a third party could close the valuation gap for shareholders. Indeed, after being approached last year, management has publicly committed to exploring actively any and all takeover proposals.

Share repurchase: The ongoing share repurchase program is significant and accretive even at higher levels. Management has also indicated that a Dutch tender or leveraged recapitalization are being actively considered.

Restructuring: Operating results should continue to improve as recent restructuring takes full effect.

Wall Street sponsorship: Currently only one small firm follows RHD (CJS Securities).