Yellow Media (TSE:Y) Update

I believe buying Yellow Media(Y), either in the common shares or warrants, is an attractive investment today. Although the company was written up before, I thought I would expand my commentary.

The company has completed their recapitalization. Debt maturity was extended to 2018 and total debt was reduced by 54%. This will result in $45M less interest paid each year. The company is still generating significant free cash flow and even though the main business is dying there may be an overreaction by Mr. Market.

Effects of the Recapitalization

Overall the recap lowered debt by $1.5 billion. The company now has $800M (9.25%) senior secured notes and $107.5M of senior convertibles (8% per year or PIK 12%). All together they will pay $82.6M in interest per year.

Interest expense should drop though because the company has forced debt repayment. As mentioned in their filings, there is a bi-annual cash sweep that will be used to pay down debt. The minimum payment is $100M in 2013, $75M in 2014, and  $50M in 2015 for a minimum payment of $225M over the next three years in some fashion. So it should look something like this:

Interest expense is simply for senior notes. Total interest expense would add back $8.6M each year for the converts.

According to the covenants, this minimum will get paid as long as there's at least $75M in cash on the books. At the end of Q4 2012 they had $106.8M of cash on their books.

It has been mentioned twice (covenants and in the Q3 2012 Call) that there is a 75% excess cash sweep. So the real question is how much cash can the business generate?

Business Analysis

The business is divided into two segments, Print and Online. Obviously Print is not doing so well and is seeing double digit declines on an annual basis. It's tough to peg a firm number on decline rate. I'll try to estimate 2013 free cash flows.

1. In 2012 online revenues were $367.3M, up from $346.1M in 2011 or a 6% increase. Management has guided for growth of roughly 11% per year. It seems reasonable to conclude that with increased focus on the business the company can grow online revenues at least 4% and perhaps 11%.

Scenario 1(low): Revenue in this segment grows 4%. $367M*1.04 = $381.9M
Scenario 2(high): Revenue in this segment grows 11%. $367M*1.11 = $407.3M

2. Print. Ah print. This segment was declined considerably. In 2010 the print segment was doing $1,184M in revenue and it dropped to $740.7M of revenue in 2012. That's a drop of roughly 20% per year. Year over year I calculate that print dropped 24.5%(2011 had print revenues of $982M, this declined $241.3M). As another reference point, a decline of 20% per year is also what DEXO and SPMD forecast (Slide 13).

Scenario 1: Print declines by 35% next year(40% higher than this years decline): $740.7M *65% = $481.5M
Scenario 2: Print declines the same as it did this year (~25%) in the past two years. $740.7M*75%= $555.5M

3. Print revenues are expected to be 50% of total revenues by 2014, according to the Q2 2012 conference call. EBITDA margins are right around 50% and management expects this to go down into the 40's as they transition to online but they do not give a bottom figure. In the 2011 Annual Report (pg 29) Y states "most of our new online placement products contribute margins similar to those of our print products in our local markets."

I think EBITDA will go down but end up being somewhere between 40%-50%. In 2010 and 2009 online revenues were about 30% of revenues and EBITDA was over 54%. It seems reasonable that EBITDA margins will not drop much lower than 40%.

Scenario 1: EBITDA margins plummet to 40%
Scenario 2: EBITDA margins only drop 2% from 2012's average of 51% and end up being 49%.

Therefore in those two scenarios EBITDA will be...

Scenario 1: $381.9M + $481.5M = $863.4M*40% = $345.3M
Scenario 2: $407.3M + $555.5M = $962.8M*49% = $471.7M

(Both of these revenue and EBITDA calculations are below 2013 consensus. My hope is to come up with an independent assessment)

I think EBITDA will be between $345M-$471M. This is compared to a company that has $106M of cash and we know has $800M of long term debt and $87M of outstanding debentures. Enterprise value (assuming a market cap of ~$200M) is right around $1.0B. This implies a forward EV/EBITDA multiple of 2.8X-2.0X.

CapEx was $42.5M for 2012, and $68.8M for 2011.In the Supplemental Disclosure management breaks down CapEx. If we believe that 2012 is accurate due to the closure of Canpages, than CapEx could be around $45M in 2013(rounding up).

Interest is straight forward. They will pay up to $74M on the senior notes per year and $8.6M on the convertibles. Therefore Interest is at most $82.6M and will be less depending on the amount of debt paid off.

Taxes were guided to be $60M in 2013 and $80M in 2014 in the Q4 Supplementary Disclosure.

So cash available to pay down debt is:

Scenario 1: $345.3M-$45M-$82.6M-$60M = $157.7M

Scenario 2: $471.7M-$45M-$82.6M-$60M = $284.1M

75% of the excess cash is well above the minimum $100M required to pay off. Based on Scenario 1, I estimate that by Sept 2013(the second date of debt repayment) total LT debt should be less than $700M, reducing interest expense by $9M per year.

It's cheap, but so what?

The main reason one avoids a dying business is a lack of flexibility and inevitable squandering of capital by management to pursue "growth opportunities." The later is not as much of an issue because the new covenants force management to pay down debt and prevent management from taking on new debt. This should help prevent any large acquisitions. Good thing, if we use the Canpages acquisition as a template, management has proven to be poor capital allocators.

Discussions with IR indicate that there is more flexibility than one would think. Yellow Media does not own printing presses nor is it bound to them (see DEXO). Therefore if a business segment (say Montreal Yellow Pages print distribution) becomes unprofitable, management can shut it down and focus on segments that are still making money.

While there will be a slight lag (and thus a slight drop in EBITDA margins), management has shuttered unprofitable segments. I think the proof of this can be seen in the lower decline in EBITDA margins compared to print revenue declines. 

Downside

It would be sloppy to not address the potential downside here. I think the easiest way to imagine downside is to send the print business to zero and let online growth simply stay the same. I'll have to make a few vague assumptions here but my point doesn't change too much.

If print goes zero and online revenues stay the same, the result is revenues will be ~$360M. Management has told me there are few hard fixed costs. So I will assume that EBITDA margins come in at 40%. Even that is draconian compared to margins that have largely stayed the same.

So EBITDA is $360M*40% = $144M.

Interest would be $74M because the Senior Convertibles have a PIK toggle. If the print business goes to zero I'm willing to bet management would "toggle on."

CapEx would probably be cut to only "Sustaining Capital Expenditures" of ~$20M (this is just the annualized rate of sustaining Capital Expenditures on page 4 of the Supplementary Disclosure for Q3 2012).

So earnings before taxes would be $144M-$17.5M-$74M = $52.5M.  I can't imagine that much of any taxes would be paid. Either way it doesn't matter.

If this happens in the next three years they most likely default because they can't pay the mandatory minimum payments of $100M, $75M, and possibly $50M in 2013, 2014, 2015 respectively. Remember, they need to keep a minimum of $75M of cash in the bank. They've got $106M right now. So if print goes to zero TODAY they may survive for one year, but probably not two, and definitely not three.

Conclusion

It seems unlikely that the print business will go to zero over the next 3-12 months. Given the large number of subscribers (309,000) it's likely that the current rate of attrition can be extrapolated forward. I can only base this on what has happened the past couple of years and what similar companies (DEXO/SPMD) are predicting. Businesses can and often do fail faster than expected.

The million dollar question is: Will online revenues grow enough to transform a dying business with a small online segment into an online advertiser with a small dying print segment? I believe Q4 showed that print is going to die a slow death, one that hopefully can be milked. The company deserves a discount because cash flows may be squandered. At this price my models and research lead me to believe that Yellow Media is very undervalued.

I've also started to dig into DEXO/SPMD. The new company could offer an interesting hedge and/or investment I hope to dig deeper into the newly combined company over the next couple of months.