Description

RH Donnelley

RH Donnelley is a mature, unexciting business that is being priced as if it were about to disappear from the planet. At the current price, the shares have a 20% 2008 FCF Yield and a 5.5% 2008 dividend yield.  Recent fears about a possible recession and the threat of the internet have driven the stock down 39% this year.  What the market is missing is RHD’s historic strength during recessions, unique local customer niche, more than $14 per share in tax shields, and the per share FCF growth created by debt pay-down, regardless of flat revenue/EBITDA.

The Business

What’s more, the yellow pages business is recession resistant.  With over 600,000 advertisers in 500 different markets and across hundreds of industries, RHD does not have considerable exposure to any one region or industry.  RHD’s largest advertiser accounts for less than 1% of revenue and no single industry accounts for more than 9% of revenue. 

At the low end of the advertising ad spend spectrum, the yellow pages weathers economic downturns quite well.  Over the last two major recessions (1999 and 2001) yellow page directories  were able to maintain a low, single digit growth rate while media such as TV, newspapers, radio and magazines experienced between 4% and 9% declines.  Recently, RHD has seen some weakness in a few individual markets, for example Florida real estate brokers, but its business as a whole remains stable and on track because of its diversified nature.  (Housing related businesses only account for 5.2% of revenue)

Concerns over online competition seem to be weighing on the stock.  Internet advertising is clearly capturing a larger percentage of advertising spend, but this doesn’t necessarily make RHD obsolete.  RHD customer representatives manage relationships with over 600,000 small, local businesses.  (think mom & pop dry cleaner or local pizza shop).  Only 55% of small businesses advertise, and over half of those choose to advertise in the yellow pages.  Small businesses spend a large portion of their advertising budget on yellow page ads to reach local customers in an affordable way.  Many of these simple businesses don’t have the time, budget or scope to develop and manage an online advertising strategy.   

For those customers who are interested in developing an online ad strategy, this is where RHD’s new Triple Play strategy steps in.  RHD is now offering Search Engine Optimization (SEO) and Search Engine Marketing (SMO) in addition to online versions of its print directory.  These services help customers bid on Google or Yahoo ad space and develop a cost conscious online advertising strategy.  RHD’s recent purchase of Business.com has sped up its roll out of an online strategy and is expected to help fuel growth over the next few years. While Google and Yahoo certainly have the capital to recreate the yellow pages, they don’t have the local advertiser relationships and it is doubtful if it is economically in their interest to pursue these highly localized, low advertising budget businesses.  This leaves RHD with a unique niche in the local market.  While I believe the big growth days for RHD are in the past, I think its position as affordable and effective advertising media for local businesses will ensure RHD business remains in place for years to come.

NOLs and Tax Shield

Over the past few years, through acquisitions and mergers, RHD has amassed over $10bn of asset “step up.” I understand this step up be basically an amortization tax shield associated with large acquisition the company made.  RHD can save up to $250m in cash taxes a year by using these step-ups.  The tax shield rolls over and there is no expiration date.  According to management this tax shield won’t run out until about 2017.  As the company pays down debt over the next few years, cash taxes would normally increase, but with this tax shield RHD will continue to pay very little in taxes for the next 10 years.  In addition, RHD has about $400m of federal NOLs which will not be fully utilized until 2012.  RHD estimates cash taxes will remain below $10m a year until 2012.

The company’s filings and documents are vague regarding the details of these tax shields, particularly the “step up”.  It wasn’t until talking to management that I could grasp the true value of these assets.  There is one slide in a company presentation that is particularly helpful in understanding these assets. (12/3/2007 UBS Global Media & Communications Conference slide #33 can be found on the company’s website).  On this slide, management uses a NPV calculation to value its cash tax benefits from both the “step up” and NOL at $1.9bn using an 8% discount rate.  Say the assets are only worth 50% of that and you still have about $1bn in tax assets or about $14 per share.

At $14 per share these tax shields account for about 35% of the company’s current equity value.  I believe the current stock price is significantly discounting the true value of these tax shields. 

Dividend and Debt Repayment

Free cash flow can grow 5 – 6% a year with absolutely no growth in revenue or EBITDA due to debt repayment.   In 2007, RHD used $100m of its $600m FCF to buy back shares and $500m to pay down debt.  In 2008, they plan to use $155m to pay a dividend and the rest (~$465m) to buy back shares and pay down debt.  Paying down $500,000 in debt a year will decrease interest expense by $35 - $40m a year.  90% of this will fall to the bottom line because of their tax shields.  Dividends and share repurchases will be increased over time as debt continues to come down.

RHD has historically never offered a dividend.  With FCF currently in excess of  $8 a share, investors have been pushing for the company to begin returning more value to shareholders.  In November 2007, RHD finally announced a long anticipated dividend plan to distribute 25% of FCF annually beginning in Q1 08.  Although this is a solid 5.5% dividend yield, the 25% FCF payout is on the conservative side (some analysts expected closer to 40%) and leaves considerable room for the company to boost its dividend even if there is no growth in FCF.  (RHD’s closest competitor, Idearc, has a 43% dividend payout ratio of FCF)

Comps

RH Donnelley’s closest public competitor is Idearc (IAR).  Idearc operates superpages.com and prints the Verizon Yellow pages in 35 states with 3,000 ad reps and 850,000 customers.  IAR has a more national presence in larger cities compared to the smaller, second tier cities targeted by RHD.  A smaller market focus results in less competition from other directories and other advertising medias for RHD.  

This regional difference is evidenced by 5% decline in IAR’s print revenue in 2006 and 2.4% decline in the first 9 months of 2007 compared to flat RHD net directory revenue in 2006 and 0.5% decline in the first 9 months of 2007.  IAR sees print revenues continuing to drop going forward while RHD expects 0 to 2% annual growth in print revenues on average over the next few years.  (RHD guided to flat revenue in 2008).  RHD’s EBITDA margins are also higher.  Adjusted for stock options expense and one times charges, RHD’s EBITDA margin for 2007 is 54% compared to 48% for IAR and 2008 estimated adjusted EBITDA margin for RHD is expected to be 53% compared to 45% for IAR.

Given the better regional focus and strong margins, RHD should be trading at a slight premium to IAR, as opposed to a discount.  IAR is currently trading at a 19% 2008 cash flow yield compared to RHD’s 30% 2008 fully taxed cash flow yield.  Even if you attribute no value to the NOLs, RHD is trading at a 22% 2008 FCF  yield compared to 18% for IAR.

With a dividend yield of  7.7% for IAR compared to 5.4% for RHD, IAR may appear to be a better investment, but at a similar FCF payout ratio of 43%, RHD would have a dividend yield of 9.3% compared to IAR’s 7.7%.  

At a 22% cash flow yield the market is expecting RHD to fall off a cliff next year.  Given the company’s market position and high recurring revenue this seems unlikely. While RHD is not a fast growth business, it is simply too cheap at these prices to ignore.

Catalyst