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Valassis Communications, Inc. (NYSE:VCI)

Q3 2008 Earnings Call Transcript

November 6, 2008, 11:00 am ET

Executives

Alan Schultz – Chairman, President and CEO

Bob Recchia – EVP and CFO

Analysts

Townsend Buckles – JPMorgan

Alex Bisson – FTN Midwest Research

Matt Chesler – Deutsche Bank

Troy Mastin – William Blair & Company

Daniel Leben – Robert W. Baird

Dan Salmon – BMO Capital Markets

Edward Atorino – Benchmark Company

Todd Morgan – Oppenheimer & Company

Hal Holden – Barclays Capital

Stuart Brown [ph] – EBAF & Associates [ph]

Michael Clancy [ph] – Credit Suisse

Adam Spielman – PPM America

Patrick Duran [ph] – Mountain Capital Advisors [ph]

Operator

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Valassis Communications Third Quarter 2008 Earnings Conference Call. During today’s presentation all parties will be in a listen-only mode. Following the presentation the conference will be opened for questions. (Operator instructions) Please refer to the Safe Harbor language on the earnings documents released this morning. This call will be governed by the language stated thereon. This conference is being recorded Thursday, November 6th, 2008.

I would now like to turn the conference over to Alan Schultz, Chairman, President and Chief Executive Officer of Valassis. Please go ahead, sir.

Alan Schultz

Thank you, Eric. I'd like to welcome everyone to the call today. I have with me Bob Recchia, our Chief Financial Officer.

As everyone knows, our world and the world around us changed very dramatically in September. We did not anticipate the severity of the U.S. economic decline or the extent of its immediate effect on our clients' budgets or our business. This morning I will share with you details of our third quarter performance, our assumptions for how the current economic conditions will continue to impact our business and our plan to do something about it.

The most direct answer I can give you to what happened in the third quarter is -September happening. In the middle of September we closed our books for the month of August. At that time, revenue for the two-month period, July and August, was up 4.5% versus the previous year. This was very consistent with our plan for low- to mid-single digit revenue growth in the second half of 2008.

By the time we closed the books for the third quarter, a lot had changed. Obviously, September results fell off dramatically. The best description of today's economic and business environment I heard came from a large consumer packaged goods client. At a recent meeting they introduced me to an acronym called VUCA – Volatile, Uncertain, Complex, and Ambiguous.

As business leaders in this VUCA once-in-a-century economic environment, we've got two choices. One, we can throw up our hands in the air and say, “There's no way we can accurately predict what's going to happen, so let's just batten down the hatches and wait out the storm.” Or, two, we can proactively make some assumptions about the economic environment, how it will affect us and for how long. We can then use these assumptions to build a plan that allows us to fight our way through this economic storm.

We have chosen the second option. Right now, based on the knowledge we have today, we believe our revenue for the second half of 2008 will be down 6% to 7% versus the second half of 2007. This contrasts with our original plan of up low- to mid-single digits in the second half of 2008. Based on our current assumptions and forecasts, we have calculated our full year 2008 adjusted EBITDA to be approximately $219 million.

During the last earnings call, based on a deteriorating economic environment, we discussed an anticipated decline in our existing business base for the second half of 2008. At the time, we believed we had a hole of about $35 million to fill and our plan was to fill that hole with new client acquisition and cross-selling strategies.

We now believe that the revenue hole in our base business is nearly $100 million in the second half of 2008 and we have been less successful from a new client acquisition and cross-selling perspective in this quarter.

Not surprisingly, the small business environment has been a challenging one. Local market client base – our local market client base – has been hit especially hard by the slowing economy and decline in consumer spending. Prior to this quarter, we were on track to surpass our goal of 4,000 new local market clients for the year.

Sales activity, including sales calls and proposals, has increased. However, our conversion rate to contract dropped off significantly. We only generated 828 new clients in the third quarter versus our 1,025 per quarter average in the first half of 2008, a 19% decline. In addition, the average new client value for our local market client base dropped from 25,000 to 20,500 and our retention rate of new clients has fallen from 50% to approximately 40%.

Cross-selling also became more difficult. Where we were successful at cross-selling, revenue for these clients did increase. However, we simply have not executed our plan to ramp up cross-selling across our client base as well as we had anticipated. Confronted with this economic environment we asked ourselves two questions. The first question being, "When do we believe the current economic climate will improve?" We are looking at the same consumer trends you are. Consumer spending declined 3.1% in the third quarter, the biggest decline since 1980. And last week the Conference Board announced the U.S. consumer confidence index fell to an all-time low in October.

Based on consumer and client trends, our assumption is that the current economic storm will persist throughout calendar year 2009. As such, we are making the assumption that our revenue will be down 6% to 7% in the first half of 2009 versus the first half of 2008. And the assumption that the second half of 2009 revenue will be flat to slightly down due to easier comps from the back half of 2008. In essence, we have assumed that things will not get any worse, but they also will not get any better throughout 2009.

We are making the best assumptions we can based on the best information we have available. I expect all of you will evaluate these assumptions for yourself. We recognize that there are many events outside of our control as I don't believe any of us anticipated the events of the last eight weeks.

Historically, media dollars typically follow consumer usage. And we know consumers are more focused than ever on seeking value. With that said, however, we have not assumed we will be the beneficiary of any shift to value-oriented media. To date, I'm aware of only two strategic clients that have moved quickly to increase their spending with us in order to address the current environment and their need to deliver more value to consumers. One client booked approximately 20% more business with us in the fourth quarter than they had originally planned. The other client recently placed $500,000 in incremental business.

We know that other clients are having similar discussions but we have yet to see concrete programs or contracts. Until we see more clients book incremental business, we will stick with the above revenue assumptions.

After making these assumptions, we asked ourselves the second question, "Based on these revenue assumptions, what do we need to do from a cost perspective to provide a comfortable, covenant cushion throughout 2009?" We went to work on a plan. This 2009 Profit Maximization Plan includes reductions in SG&A and cost of goods sold as well as improvements and production efficiencies. In addition, we are reducing planned capital expenditures and scaling back on investments and innovation. This plan narrows our innovation investment to two areas – in-store and interactive. It also sets limits on what we deem acceptable startup losses for both.

On Tuesday, our Board of Directors approved this Profit Maximization Plan designed to generate cost savings between $50 million and $60 million in 2009. Bob Recchia will take you through the details of this plan shortly.

Taking into consideration our current revenue assumptions, plus if we take the middle of the $50 million to $60 million cost savings range or using $55 million of cost savings in 2009, and you run this through our model, it yields an approximate adjusted EBITDA of $215 million in 2009. Our goal in providing you this guidance at this time is to be as transparent as possible during the current volatile economic environment.

Before I turn it over to Bob, I'd like to share with you some additional details on some of our individual business segments.

Cancellations and order reductions were a major factor in the Shared Mail segment and put pressure on the operating leverage of this business. The Shared Mail wrap, the four-pager that goes around the contents of our Shared Mail package, revenue from this wrap was down $6.1 million in September, which comes right off the bottom line. This decline was due primarily to a change in client mix. Previously, the wrap was dominated by the franchise food category, which experienced significant decline in Q3.

Earlier in the year we were able to fill the wrap with a growing local customer base, but we were not able to do so in September. So the wrap was purchased primarily by clients within lower paying customer verticals. In addition, wrap sell-through percentage fell from 89% in the third quarter of last year to 83% this year.

During this economic downturn, most companies are planning for increased bad debt. We are too. However, we take a different approach for our smaller local customer base. We do not extend credit. They pay cash upfront or use a credit card. So while protecting us from increased bad debt from these smaller businesses, it does not put us in a competitive advantage position. In fact, it puts us at a competitive disadvantage to other media companies who will extend credit to that customer base.

Profit from our Neighborhood Targeted business was down $14.8 million, or over 74% for the quarter. This was driven primarily by our ROP business which experienced a shift in customer mix to lower margin clients. In addition, as newspaper circulations continue to drop, we have continued to shift newspaper preprint business from newspaper distribution to shared mail distribution. This shift represented approximately $11.8 million in revenue from the Neighborhood Targeted business in the third quarter that shifted into the Shared Mail business.

Profit from our FSI business was down $3.5 million, or 95% this quarter. The FSI story remains one of continued price pressure and increasing costs, especially paper costs, which increased 20% in the quarter versus year ago. The surprise, however, was the decline in industry pages of 5.2% in the quarter. Lower page counts, continuing price pressure and higher costs resulted in a profit decline in this business.

On a positive note, based on currently booked programs we do expect low-single digit growth in our FSI business page volume in the fourth quarter of 2008, which should result in a small revenue increase in Q4 along with an increase in segment profit versus Q4 of 2007.

At this time, I'd like to turn the call over to Bob Recchia to provide more details and numbers associated with our Profit Maximization Plan, estimated cost savings, and debt covenant cushion. In addition, Bob will give you more details on our International, Digital Media and Services segment.

Bob Recchia

Thanks, Al, and good morning to everyone on the call. As Al mentioned, I'm going to provide you with some of the specifics of our 2009 Profit Maximization Plan. Before doing so I wanted to share some of the thought process and considerations taken into account to develop the plan.

First, I think we all realize we're in an uncertain economic climate and forecasting what customers will do is very difficult. Secondly, while we are very pleased with the results of the acquisition of ADVO some 18 months ago, the debt incurred at that time poses certain complexities that must be considered. And lastly, we do not want to leave the organization void of the talent and products that we are developing, which we expect to be a significant part of our growth in the future. So taking these points into consideration, we've developed the 2009 Profit Maximization Plan, which we believe will allow us to navigate through what looks to be an uncertain economic climate throughout 2009.

Our Profit Maximization Plan encompasses those things that we can control or at least influence, namely, SG&A, production and distribution cost inefficiencies, underperforming businesses or products, and capital spending. The plan should result in a total cost savings of between $50 million and $60 million in 2009 and a one-time cost to achieve of approximately $4 million, which we expect to recognize in the fourth quarter.

Much like we have done in the past as we have tracked our progress against the cost synergies associated with the acquisition of ADVO, we intend to report progress against these objectives that we hope will give you comfort and confidence in our ability to reach or exceed these targets.

In the area of SG&A we expect savings of approximately $25 million coming from a combination of headcount reduction, reduced IT infrastructure and operational costs, reduced travel and entertainment expenses and lower spending levels across the remaining expense items. We will accomplish these spend reductions through a combination of the elimination of certain discretionary items and negotiation of lower costs in cases where expenditures cannot be fully eliminated.

In the production area we have opportunities to significantly reduce costs primarily relating to the FSI and Shared Mail businesses. These costs include paper, delivery, and production and will be realized through a combination of negotiation with suppliers, changes in the delivery of the products and a modest headcount reduction. We expect to realize savings in 2009 of approximately $26 million in the production area.

We have also taken a hard look at many of the businesses and products that have been in development and evaluated their impact on our long-term growth strategy as well as their current financial performance. NCH clearing both domestically and internationally is performing well and our 2009 outlook is for improved performance. Other than reductions in SG&A, we are not proposing any changes at this time. We do expect to phase out NCH International Media over the next two quarters, which we estimate will result in a year-over-year savings of approximately $1.5 million.

We expect no changes in our Valassis of Canada business with the exception of lower SG&A costs. We are negotiating to sell our One-to-One Services business to the current non-affiliate management of that business. These negotiations are expected to conclude in the fourth quarter. Losses are expected to total approximately $2 million in 2008 for this business.

Our RedPlum interactive business is key to our future growth and therefore we have decided to continue to invest in its development. We expect reduced expense levels and improved revenue in 2009 resulting in a $2.5 million improvement in the year-over-year results.

We plan to discontinue Valassis of China in the fourth quarter resulting in an additional $500,000 a year savings.

All-in-all, our plan breaks down as follows. SG&A reductions will be $25 million, about 60% of which is headcount and the remaining is other spend items. Production costs are $26 million and driven primarily by paper but we also will find savings in delivery and other materials as well as some additional Shared Mail optimization. And then lastly, the underperforming businesses that I outlined that we are either selling or exiting will yield $6.5 million in annualized savings.

This estimated $57.5 million reduction in costs includes the planned improvement and cost synergies from 2008 to 2009 of $11 million as detailed in our Form 8-K filed in late September updating our investor presentation. All savings are in addition to the plan cost synergies of $38 million in 2008 and will be additive to 2009 EBITDA. We expect capital spending of between $15 million and $20 million in 2009, a significant reduction versus the forecasted 2008 expenditures of $26 million.

Taking into account the 2009 revenue assumptions provided in our press release and the cost savings detailed here, we have projected our adjusted EBITDA for 2009 to be approximately $215 million. This level of adjusted EBITDA should provide us with a minimum cushion of 20%, rising to near 30% by December 31, 2009 on our bank covenants.

In addition to the cost improvements planned for 2009, sales compensation plans, cross-selling opportunities, new customer acquisition, and many revenue generating and profit improvement ideas are being implemented. We expect the combined effects of these sales efforts to have a positive effect on our results, but due to the high degree of economic uncertainty and the difficulty in quantifying the results of these efforts, we have not specifically reflected them in our revenue guidance.

At this time, we will open up the lines for questions.

Question-and-Answer Session

Operator

Thank you, sir. (Operator instructions) Our first question comes from Alexia Quadrani with JP Morgan. Please go ahead.

Townsend Buckles – JPMorgan

Thanks. This is Townsend Buckles for Alexia with a few questions. First, can you clarify what level of adjusted EBITDA you need to achieve in Q4 to satisfy your leverage covenant and can you give kind of a confidence level into hitting that number or at least that number?

Bob Recchia

Well we have given you a Q4 EBITDA number. That number will yield about a 15% cushion with the current debt situation that we have. However, we do have a lot of cash on hand. If we were to get tight on that we would simply pay down some debt. So Q4 should not be an issue for us.

Townsend Buckles – JPMorgan

Okay. And many of the newspaper companies have recently amended their credit agreements or are in the process of doing so. Are you having discussions with your banks or are you planning to do that?

Bob Recchia

No. We're not. We feel like we've got adequate cushion throughout 2009.

Townsend Buckles – JPMorgan

Okay. And then finally are you considering any other asset sales to pay down debt such as selling NCH?

Alan Schultz

I think the approach we're going to take is that if we can get fair value for our shareholders, certainly we would consider a variety of different options. In this environment, getting fair value for your shareholders is a difficult thing to do, but I think it all would come down to what a potential purchase price would be.

Townsend Buckles – JPMorgan

Okay. Thanks.

Operator

Our next question comes from Alex Bisson with FTN Midwest. Please go ahead.

Alex Bisson – FTN Midwest Research

Good morning, everyone.

Bob Recchia

Good morning.

Alex Bisson – FTN Midwest Research

A couple questions for you guys. You noted in the press release that customers are pulling out or canceling on the Shared Mail product. How quickly can someone do that? Can they do that with a couple days notice or how does that process work?

Alan Schultz

Yes, the way it works from – the most likely problem we'll run into is what we would call a light-weighting problem and in that particular situation what would happen is a client perhaps commits to run a 12-page program and then they don't ship us a 12-page program; they ship us an 8-page program. We would find that out literally two weeks before we actually dropped it in the marketplace and so in that situation that would take our revenue down. The way that our contracts are written today is we don't necessarily have any recourse against the customer in those situations, which is something that we're looking at right now in terms of a process improvement change.

As it relates to cancellations, we do have some of our contracts that provide for some cancellation fees if a client should do an outright cancellation, but not all of our contracts provide for cancellation fees. So I think clearly one of the things we're looking to do is tighten up our contracts and our processes a little bit about – revolving around light-weighting and cancellations.

Alex Bisson – FTN Midwest Research

Okay. You discussed in the Shared Mail business you're seeing some weakness with the restaurants. Are there any pockets of strength within the different client verticals?

Alan Schultz

When you look at our total customer base right now, as we've mentioned, the CPG client base which primarily makes up our FSI business it was soft in the third quarter, but we definitely know that there are a number of CPG clients today that are having conversations about the importance of providing more value to consumers. There's a lot of research out there on this subject right now. Consumers are having a tendency to move more towards private-label products versus the branded products. And right now, as I mentioned, we've had a couple of clients who acted very quickly to distribute more value-oriented content, increase coupon values, et cetera, in the fourth quarter. I think others are still reviewing that possibility and haven't locked in any plans yet.

The other thing that we have seen is the grocery industry has actually grown for us and the drug industry has increased their spending with us. The other area that we've seen that's seen positive is in entertainment, primarily television related, satellite, cable TV, et cetera, has also been another growth area for us.

Interestingly enough, we've seen some pickup in the furniture category, which is obviously in a very difficult situation these days based on the slowdown in housing, but they seem to have taken the approach that they need to increase their spending to try to drive consumers to the store and increase their revenue. So we have seen some growth in the furniture category also.

Alex Bisson – FTN Midwest Research

Okay. As you look at the $4 million of cost you expect to incur in the fourth quarter, is that all cash or will some of it be non-cash?

Bob Recchia

That will all be cash. It's mostly severance.

Alex Bisson – FTN Midwest Research

Okay. And then I guess, finally, could you provide an update on shifting the FSI booklet into Shared Mail? I know you've been doing that with Stop & Shop and in some other markets. Could you give us an update on how you see that progressing?

Alan Schultz

Yes. In 2008 here we're distributing about 5.7 million circ through Shared Mail. We're now – right now, planning on two market list changes for 2009. We'll do a February 1st change, which will kick it up to – by about another 0.5 million circ, take it up to 6.2 million-6.3 million circulation. And then we're planning a July 1st change –market list change, which will take it up over 10 million circ distributed through Shared mail. So that's currently the plan, as we speak.

Alex Bisson – FTN Midwest Research

Alright. But it sounds like both you and your clients are pretty pleased with how that's going?

Alan Schultz

Yes. The research has been very positive in terms of incremental product movement, so we're very optimistic about it. The other thing we've seen is we've been tracking consumer awareness that the coupon booklet is in the Shared Mail package and we've seen some pretty dramatic increases in consumer awareness. When we started out a few months into it consumer awareness in Providence was in the 60s – I think 65%, 68%. Now we're well into the 80s. So consumers know to look for that coupon booklet in the Shared Mail package.

Alex Bisson – FTN Midwest Research

Excellent. Thank you very much.

Alan Schultz

Thank you.

Operator

Our next question comes from Matt Chesler with Deutsche Bank. Please go ahead.

Matt Chesler – Deutsche Bank

Good morning. Thanks for taking my call. Can you comment on how much of revenue are you going to be walking away from as a result of discontinuing some of those businesses you mentioned and is that revenue – well, also you're voluntarily walking away from included within your revenue guidance assumptions? Or revenue guidance ranges you've given us?

Bob Recchia

Yes, I don't have all the numbers in front of me, but the European media’s biggest portion of that was the French business, which we sold last quarter. So there's not a tremendous amount of European media after that. There's not a lot of revenue coming out of China. So I'm thinking it's sub-$20 million. I'm looking at a number here – sub-$20 million – all up somewhere around there.

Matt Chesler – Deutsche Bank

And that includes the one-to-one business?

Bob Recchia

Yes. The one-to-one business is around $10 million. And I'd tell you that it looks like International – that we're – maybe $15 million.

Matt Chesler – Deutsche Bank

Is your down 6% to 7% guidance range a pro forma number or would that reflect the $20 million less–?

Bob Recchia

That would reflect that.

Matt Chesler – Deutsche Bank

So if you hadn't disposed of it your range would be better or –?

Alan Schultz

It would be a little better. Yes.

Matt Chesler – Deutsche Bank

Okay. Just a follow-up on the covenants that you have and your agreements. Are there any further step-downs beyond the ones that take place at year-end 2008?

Bob Recchia

Yes. There's two covenants, the senior secured leverage ratio goes to 3.75 at December 31st and then down to 3.5 at December 31st of '09. I believe it stays there thereafter. The interest coverage ratio steps to 1.75 at December 31st of '08 and then to 2.0 at December 31st of '09.

Matt Chesler – Deutsche Bank

Okay. And then finally, in this environment can you give us any thoughts on how to think about cash flow and working capital usage over the next 12 months?

Bob Recchia

Yes. I would tell you we're managing that very closely right now. We're looking into different ways to generate some working capital. Typically, we would guide toward a flat working capital number year-on-year. I would still guide toward that but we are looking at every way we can to see if we can improve our working capital position going into next year. But I would tell you we haven't baked any of that into any assumptions at this point. I think you're safe to assume it's flat.

Matt Chesler – Deutsche Bank

And then finally just a follow-up on your progress in migrating shared – newspaper delivered products through Shared Mail. Have you had any more discussions with retailers such as Stop & Shop to expand the program to them or have you expanded your Stop & Shop program beyond Providence?

Alan Schultz

We have had some discussion with other retailers. Most of the focus has been on the drug category to bring in some additional drug players out of newspaper into Shared Mail.

Matt Chesler – Deutsche Bank

Can you comment on any sort of the (inaudible)? It's been a number of months – is there any – or what's the nature of the – I presume that there has been some feedback or there's been – the reason why you haven't made more progress on that front. Can you comment on these or what any objections might be or anything you need to overcome in order to expand that at a faster rate?

Alan Schultz

From what I'm aware of with the conversations with the drug players is you have buyers who have been buying newspaper for a long, long, long time, are very comfortable with newspaper, like newspaper, and it's just getting them to shift their mindset. Obviously, as newspaper circulations continue to decline and newspaper penetration levels of their marketplace and the saturation level around their stores continues to decline, I think it becomes more difficult for people to ignore the shift to Shared Mail. But right now I'd say it has more to do with buyer mindset. There are also – some of these companies have got annual contracts with the newspapers that require certain frequency levels. So if they are to pull out of the newspaper and distribute a lower frequency, they have some short rate potential. So that's an issue, also.

Matt Chesler – Deutsche Bank

One final question if I can sneak in. In terms of RedPlum, one of the hold-ups has been the – digitizing your content. Can you update us on your progress in getting all your robust local content up onto RedPlum to can start driving traffic towards that website?

Alan Schultz

Yes. I think we're making progress more in terms of a strategy than anything else at this point in time. We basically have been looking at two solutions. One is a technology solution and the other is kind of a manual solution and right now we're trying to cost those out and figure out what's the most efficient way. Is it manual or is it the technology?

We have been focused on the top 34 DMAs and trying to get the content up in just those top 34 DMAs. So I would tell you we've made some progress to date. Most of the progress we've made to date is on a manual basis and we'll have to see what the cost of the technology solution is before we move forward with that.

Matt Chesler – Deutsche Bank

Alright. Thank you.

Operator

Our next question comes from Troy Mastin with William Blair and Company. Please go ahead.

Troy Mastin – William Blair & Company

Good morning. Thank you. I want to get a little more color on what you said happened through the quarter. You said you were up 4.5% in July and August. I'm assuming that's the entire Company. Correct me if I'm wrong there. And then can you give a little more detail by segment. Specifically, I'm most interested in how Shared Mail performed through the quarter.

Alan Schultz

Yes. When I talked about the up 4.5% through July and August I was talking about the Company as a whole. I wasn't talking about any particular segment. I would tell you when you look at the month of September, clearly the biggest fall-off was in the Shared Mail business. I think that was more of the surprise than anywhere else. I think the rest of the businesses came in about where we had anticipated them to be, but Shared Mail was really the issue.

Troy Mastin – William Blair & Company

And can you give some idea how the growth rates looked for Shared Mail through the quarter?

Alan Schultz

Yes. They actually were pretty much there too at that kind of low- to mid-single digit level before we hit September, so they were pretty consistent with the rest of the Company.

Troy Mastin – William Blair & Company

And September, I believe, is the biggest month for Shared Mail in the quarter. Is that correct?

Alan Schultz

I think our biggest month of the year is December as a whole – the Company as a whole. But September I think, depending on what year you look at, is either the number one or number two month in terms of just the Shared Mail business.

Troy Mastin – William Blair & Company

Okay. And roughly in the quarter, is it 40% or 45% of revenue for Shared Mail typically? Help us understand how much it decelerated?

Alan Schultz

I don't know that one off the top of my head, Troy. Bob–?

Bob Recchia

Yes. I've got quarterly numbers. I don't have the monthly in front of me. We'd have to dig that up. It is clearly the biggest month. I don't think it's that big, but it's clearly the biggest month from a profitability standpoint, as well. So we'll have to get you that.

Troy Mastin – William Blair & Company

And thinking about what your likely results will be this year or thinking more into the third quarter and fourth quarter, you had revenue down 7.2% this quarter. And your guidance is for minus 6% to minus 7% for next quarter or for the back half of the year, I think. So the implication would be that you will have a less bad fourth quarter than third quarter and I'm trying to get some context on this number because of third quarter having relatively healthy July and August. I would assume if you took the September run rate and ran that out through the fourth quarter you'd actually see the fourth quarter down more than the third quarter. This might be a mix situation where you've got some visibility into the FSI business. Just what can you tell me to help me understand your confidence in the fourth quarter numbers a little bit more?

Alan Schultz

Yes, good question, Troy. I would – I think you sort of explained it the way you assumed it which is, as we look at October and November right now, we have pretty good numbers and the numbers that we're looking at look nothing like September. So the risk does become December, though, when we look at the non-Shared Mail businesses, we think we have a pretty good handle on December and the quarter as a whole at this point in time.

As you know, in the FSI business we get things booked pretty well in advance, so the FSI business we've got a pretty good handle on here now for the quarter. There will be very few changes in it at this particular point in time for the rest of the year and based on a lot of the conversations that are taking place at the CPGs, I would just assume that if it was going to get better – if it was going to change in any way, it would get better versus worse. So I think we feel pretty good about that. So if there's any risk in our fourth quarter at this point in time, the risk becomes in the month of December and the risks would be related to cancellations or people light-weighting or something along those lines. We certainly got our sales organization watching this one very closely, looking at weekly bookings, looking at forecasts regularly. And at this point in time, barring some unforeseen, unexpected events, we're pretty comfortable.

Troy Mastin – William Blair & Company

And you said you've got a handle on October and November. What does that mean for the Shared Mail business? What have you seen post the end of the quarter for Shared Mail–?

Alan Schultz

Yes. Shared Mail business in October, November, is basically down in the 4% to 5% range.

Troy Mastin – William Blair & Company

And that sounds less bad than, obviously, than what you saw in September–?

Alan Schultz

Yes, yes. By a lot.

Troy Mastin – William Blair & Company

Okay. And that – I guess if you look across your business, your customer types – small, medium, large, if you put them in those buckets – it sounds like smaller clients have been more of the issue. And do you have a sense for if that's due to liquidity with the tightening of credit in September, which is appearing to loosen up a little bit. If they made very short-term decisions to make payroll and things like that do you have any color on kind of what's going through the smaller clients' minds, if that is where the weakness is?

Alan Schultz

Yes, I think, and again, I think you hit the nail on the head there. I think small businesses right now are really getting caught up in this credit crunch and they clearly view marketing spending as a discretionary item. And, obviously, in the month of September they decided that they weren't going to spend and so we definitely saw a pull-back from a small business perspective in the month of September. And I would say that we still haven't seen a return in the fourth quarter to kind of the activity level we saw from local customers in the first half of the year. And right now, our sales organization has pretty significantly kicked up the number of proposals that they are making, the number of calls that they are making, and we're not necessarily seeing conversion of the contract as a result of that. And then when you look at some of the bigger clients, I talked about the fact that grocery and drug we've actually been doing pretty well in but the mass merchandisers have been a bit slow for us also.

Troy Mastin – William Blair & Company

Okay, good. Thanks. And then a question on your debt. If you could just remind us how the bank definition for EBITDA varies versus your definition when you provided in guidance?

Bob Recchia

There's a couple of items that we don't get credit for in the bank. One of them had to do with restructuring costs. So, for example, the one-time restructuring cost that we'll take in the fourth quarter here for severance, we would not get to add that back for bank purposes. That's the biggest and the only significant one at this point.

Alan Schultz

Bob, there's some other add-backs that we have to get from EBITDA to a higher adjusted bank number, which the add-backs are stock-based comp, 123R and–

Bob Recchia

Right. That's the same for both, though. He was looking for just the ones that didn't count and that's primarily restructuring.

Alan Schultz

Yes.

Troy Mastin – William Blair & Company

Okay. So if we look at that 215 number for 2009, that would be comparable with what the banks would be looking at?

Bob Recchia

Yes.

Troy Mastin – William Blair & Company

Okay. And based on your current business mix, I know you don't know how business is going to play out or at least the mix you're planning on for 2009. How much wiggle room do you have in revenue in terms of not tripping your covenants? So would revenue, if it declined 1% or 2% more than you are expecting in 2009, would you then be at risk of tripping those covenants and if you saw a scenario like that unfolding, what else do you see in the business that you can do in order to stay clear of that trigger?

Alan Schultz

Yes, what we did, Troy, was we took those – the original revenue assumptions that we gave you here. We took the cost savings assumptions, the $55 million and then we stress tested the model. And basically what we were trying to see was how much of a revenue decline could we tolerate. And so the current model we laid out for you would show revenue down 3.5%, 4% versus 2008 so then 2009 would be down for the full year 3.5%, 4%. We could actually tolerate over an 8% decline in revenue with the $55 million cost savings goal in place. And we could, if we went for more cost savings, if we needed to, we could potentially get to a cost savings number higher and we could, in that situation, tolerate a revenue decline up to about 11% and still be able to pass our covenant test. So we have done the stress testing of the model at this point in time and we're pretty comfortable.

Troy Mastin – William Blair & Company

Okay, thank you.

Operator

Our next question comes from Dan Leben with Robert W. Baird. Please go ahead.

Daniel Leben – Robert W. Baird

Great, thanks, good morning. Just first on the senior secured debt, it wasn't in the press release. Could you give us where that stood at the end of September?

Bob Recchia

It should be at 7 – hold on for a second, 7.12.

Daniel Leben – Robert W. Baird

And then could you just talk a little bit about with the assumptions, talking about getting the cushion up closer to that 30%, what assumptions have you built in for paying that down in 2009 to get to that level?

Bob Recchia

The assumption is we'd take free cash that's generated during the year and pay it down. I think if you run the numbers with $20 million of EBITDA – I'm sorry, $215 million of EBITDA and $20 million in CapEx, you're going to get about $80 million available for debt reduction.

Alan Schultz

And then, of course, we've got $100 million due January '09 that we would pull out of cash and so we'd reduce debt by $100 million in January and then we would apply our free cash to debt reduction throughout the year.

Daniel Leben – Robert W. Baird

Okay, great. And then during the quarter we had some bankruptcies in the retail world. Did you have exposure to any of those customers?

Bob Recchia

I'm not which ones you're referring to.

Alan Schultz

I think we had some exposure to Wickes, but I don't think it was anything significant. And our plan right now is to increase our bad debt by about $2 million to $3 million next year, which is a 25%, 30% increase in bad debt for next year as we kind of build our model out for 2009.

Daniel Leben – Robert W. Baird

Okay, great. And then on the ADVO synergies, just could you just talk a little bit about where you are seeing the additional synergy from?

Bob Recchia

Yes. And these are not necessarily just ADVO synergies. Okay? These are cost savings across the entire organization at this point. As I mentioned in the area of SG&A, there are going to be coming – about 60% of that is headcount. A big portion of the rest is IT infrastructure, IT consultant spend. You do recall that we built a data center. That was designed to save us about $4.5 million a year. That's baked into this. That savings will be here. On the production side, it's going to be paper. We are seeing that market start to turn. We feel like we can save some dollars there. We've got savings planned for media rates for newspapers, moving FSI into Shared Mail, and further newspaper alliances that are slated to be negotiated in 2009. So you've got about $26 million there and I think that that could be a conservative number. We should be able to – and then the underperforming businesses that we've outlined about $6.5 million by selling or exiting.

Daniel Leben – Robert W. Baird

Okay. So the way to read that is just it's coming out of all those other pieces. Alright. That makes sense.

Bob Recchia

Yes. The synergy number, and I want to be clear on this, we had $38 million we've been tracking against that this year. We said that would go to $49 million next year. So that improvement of $11 million is within my $57.5 million. Don't double count them.

Daniel Leben – Robert W. Baird

Okay. Great. And then just you mentioned that October and November had ticked up in terms of growth rates from September. You said it wasn't really in the small businesses. Could you give us an idea of areas where you have seen some improvements in October and then looking into November?

Alan Schultz

Yes, I think it's in the kind of the same categories that we talked about earlier – drug, grocery, entertainment, satellite, cable TV, furniture and then CPG, the consumer packaged goods. Those are the client verticals that we've seen some improvement in.

Daniel Leben – Robert W. Baird

Okay. And then last question just in terms of the CapEx you're cutting, is this down to what you would consider a maintenance level or are there still some other projects going on?

Bob Recchia

No. At $20 million, we can do some projects. It's not what we did this year because we had some big IT projects. But we'll still be able to accomplish some things. I've been telling you guys for about two years, it doesn't take a tremendous amount of capital to run the printing and the inserting operations of the combined businesses and I think you're seeing that.

Daniel Leben – Robert W. Baird

Okay, great. Thanks guys.

Operator

Our next question comes from Dan Salmon with BMO Capital Markets. Please go ahead.

Dan Salmon – BMO Capital Markets

Thanks guys. Most of my questions have been covered so maybe just a couple of clarifications. Bob, the $4 million in one-time costs expected in the fourth quarter that is also included in the $219 million of guidance. Is that correct?

Bob Recchia

No. That's not. So you're $65 million does not include that in Q4.

Dan Salmon – BMO Capital Markets

Okay, okay, thank you. And then any change in course in terms of the litigation going forward at News Corp. in light of the new environment?

Alan Schultz

No. I think we're still in the same place. We're scheduled for our tort case in Wayne County Circuit Court here in Michigan in kind of mid-January and we've got Federal Court here in Michigan for the anti-trust claims in April and then we've got August in California, which has the Cartwright Law associated with it, which is more favorable in terms of kind of predatory pricing. So those are all still on track.

Dan Salmon – BMO Capital Markets

Okay. And then one last one, Al, if you could maybe update us a little bit on how your presentations to strategic clients of the new targeting system, the IMO system, is progressing so far,

Alan Schultz

Yes. We've done a good job. We're up over 60 clients that we've presented it to. I think it's been very positively received. I will tell you this, though, in the environment that we're in today clients are a little shell-shocked, so it's hard to get them to react and respond as quickly as we would like them to because they are constantly sort of reviewing their budgets and their plans and revising their budgets and their plans based on instructions from their senior management in this environment. So I've been, quite frankly, disappointed with the level of cross-selling revenue that we achieved in the third quarter. So one of the things I talk about is, there's good marketing meetings where you have a great discussion with the client and it's intellectually stimulating and everybody loves the new targeting system and then there's the sales meeting where you walk out with a contract and my sense of things right now is we're having more marketing meetings than we're having sales meetings. And we're working on a variety of ways to address that here and there are some changes that are going to be made in terms of our focus on cross-selling and trying to really nail it down to our big four products because those are the ones that are really going to drive revenue for us and we're going to try to put some more financial incentives in place for sales people to cross-sell effectively. And then we're going to get – kind of restructure the sales organization in a couple of small areas to make sure that we've got a group that’s clearly focused on sales meetings and converting contracts.

Dan Salmon – BMO Capital Markets

Okay. Thank you.

Operator

Our next question comes from Edward Atorino with Benchmark. Please go ahead.

Edward Atorino – Benchmark Company

Yes, just, again, a clarification everything under the world's been – on the SG&A, is all of that '09 or will there be a drop-off in the 4Q of '08 this $24 million, $25 million decline?

Alan Schultz

Yes, good question, Ed. I think we will see some declines in SG&A in the fourth quarter of '08. A lot of that is going to be related to incentive based comp and those kind of things. But you will see SG&A declines starting in the fourth quarter and then –

Edward Atorino – Benchmark Company

Is that around $90 million maybe or so? Secondly, what is your current debt, as defined, current debt-to-cash flow ratio and remind me again what the bank limit is again both the nine month–

Bob Recchia

As of September 30th we would have calculated it at 3.18 times. The covenant test level is at 4.

Edward Atorino – Benchmark Company

Okay, good. And actually the same question about the – all of the cost cuttings you mentioned, that's all '09? Just only little bit on the fourth quarter? Or will some of this stuff show up in the fourth quarter to get to your $13 million net earnings number?

Alan Schultz

I don't think we're assuming a lot of the other costs stuff other than some SG&A in the fourth quarter savings, but the rest will really flow through in '09, ED, like paper and that sort of thing and we clearly think that paper is at a cyclical peak here from a pricing perspective and energy costs are down and currencies have gotten much more favorable for the paper companies and demand is down pretty significantly for paper. So it's hard for us to imagine how they can continue to hold on to the current pricing levels in this environment.

Edward Atorino – Benchmark Company

Got you. One last thing, you said FSI revenues maybe up in the fourth quarter or was that just pages?

Alan Schultz

Well, I think we'll see some page growth and some revenue growth, both. I don't think we'll see a lot but I think we will see some, and I think–

Edward Atorino – Benchmark Company

That would imply a pretty different pricing environment unless you got a whole lot of page growth. Or is there an extra week in the fourth quarter there, an extra mailing?

Alan Schultz

No. I don't think so, but you're right in the sense that the pricing environment in the fourth quarter is not quite as onerous as what we saw earlier on.

Edward Atorino – Benchmark Company

Okay. Thanks very much.

Alan Schultz

Okay.

Operator

Our next question comes from Todd Morgan with Oppenheimer. Please go ahead.

Todd Morgan – Oppenheimer & Company

Yes, thank you. Two quick questions on the debt. I guess can I assume that you are going to use the current cash balances to repay the 6 5/8, and I think roughly $80 million or so cash flow next year to reduce secured debt. And I think that that would put your secured debt around $530 million at the end of next year excluding anything you might repay in the fourth quarter of this year. And I guess I'm trying to reconcile what looks like a reasonably large cushion between that implied secured leverage at around 2.5 times and the 3.5 times covenant. I think you'd said at the same time that you think you have about a 20% cushion. Are those the right kind of numbers and can you help me understand if that's – the 20% cushion comment is really referring to that?

Alan Schultz

Yes, your assumptions are correct in terms of using cash to pay down the 6 5/8 due in '09. And your assumption is correct that we would apply free cash flow against debt reduction. What Bob did say was that the covenant cushion as we calculate it through the year in '09 never falls below 20% but as you get to the end of the year and increases it’s up near 30% or more. So the covenant cushion should increase as the year goes on. So I think your assumptions are all correct.

Todd Morgan – Oppenheimer & Company

And then just secondly, I don't know if you've talked with the rating agencies since these numbers have come out or about these third quarter results and what you do expect for the next 18 months or so?

Alan Schultz

We have not yet but certainly that is part of the plan and, in fact, I think there's going to be a conversation scheduled for later on this afternoon and – because we know the rating agencies are looking certainly at least a year out into the future and we know that they too, like us, are watching covenant cushions very closely.

Todd Morgan – Oppenheimer & Company

Great. Thank you, then.

Alan Schultz

Thank you.

Operator

Our next question comes from Hal Holden with Barclays Capital. Please go ahead.

Hal Holden – Barclays Capital

Yes, just a very quick one. Your debt is trading at a pretty significant discount. Is there any thoughts to make an open market purchases to help you de-lever faster?

Alan Schultz

I don't think we have any comments on that at this point.

Hal Holden – Barclays Capital

Okay. Thank you.

Operator

Our next question comes from with Stuart Brown [ph] with EBAF & Associates [ph]. Please go ahead.

Stuart Brown – EBAF & Associates

Yes, my questions have all been answered. Thank you.

Operator

Our next question comes from Michael Clancy [ph], Credit Suisse. Please go ahead.

Michael Clancy – Credit Suisse

My questions have also been answered. Thank you.

Operator

Our next question comes from Adam Spielman with PPM America. Please go ahead.

Adam Spielman – PPM America

Questions have been answered. Thank you.

Operator

And our next question comes from Patrick Duran [ph] with Mountain Capital Advisors [ph]. Please go ahead.

Patrick Duran – Mountain Capital Advisors

Yes, thanks. I was just hoping you can give me an approximation of what percent of your cost of goods sold is variable versus fixed?

Bob Recchia

Off the top of my head I probably can't.

Alan Schultz

It's hard for us to do, Patrick, because we really measure everything kind of by business segment and the percentages vary quite a bit by business segment and I don't think we've gone through the math to roll it all up to get an overall average.

Bob Recchia

I'm not sure an overall average would be meaningful.

Patrick Duran – Mountain Capital Advisors

Okay. Well, I guess I'm just trying to get a handle on why your cost of goods sold has been decreased more with your revenue in the quarter compared–

Bob Recchia

Well, part of it I can tell you is that in the Shared Mail business your postage cost doesn't necessarily go down as your revenue goes down. It's a high fixed-cost business. That's the operating leverage that we talked about. So if you look at the quarter, we basically had flat distribution expense even though our revenues were down. So that one is not going to move nearly as much in either direction. So when revenues grow 5% or 6%, you will leverage that fixed postage cost. When they shrink, unfortunately, it eats the margin up pretty quickly.

Alan Schultz

Yes, and then, of course, as we've mentioned the FSI Business paper cost in the third quarter was up about 20% versus the third quarter of last year. So you had a big price increase there. The paper companies, as I said, have been ramping prices up over the last year and it's our belief they've kind of hit the cyclical high now.

Patrick Duran – Mountain Capital Advisors

Thank you.

Operator

Our next question comes as a follow-up from Edward Atorino. Please go ahead.

Edward Atorino – Benchmark Company

Since you addressed the pricing in the fourth quarter, any visibility on pricing in the FSI business going into '09? Is it also less onerous?

Alan Schultz

Ed, I think at some point in the future when we refine our model a little bit more and get Board approval on our detailed 2009 plan we might provide some additional detail in the future but I don't think we're prepared to do so at this time.

Edward Atorino – Benchmark Company

Okay, thanks.

Operator

And this does conclude our question-and-answer session. I'd like to turn the call back over the management for any concluding remarks they may have.

Alan Schultz

I'd just like to thank everybody for their attendance here today. Obviously this is the most challenging environment any of us have seen or worked through in our entire lifetime. So I think one of the things we've always said about our business is it tends to be one of the last areas where clients cut their spending. I think what's kind of unique about this situation is, is we've now got kind of a print media ads recession that's been going on for five or six quarters now. And what we've typically seen in the past during these advertising recessions is that you might see two, three, maybe maximum four quarters of decline in terms of client spend. In the past, we were always coming out of the recession, advertising recession, before we as a Company ever really got our spending cut. This one has gone on long enough where I think clients have finally gotten down to cutting our type of spending.

With all that said, clearly there's a lot of incentive right now and desire from a consumer perspective and I think that does create some opportunity for us in the future. So we appreciate your understanding and I assure you that we're doing everything we can that is within our control to address this issue and we're looking forward to the days where we can start growing revenue and profits again.

So, thank you and have a great day.

Operator

Ladies and gentlemen, this concludes the Valassis Communications third quarter 2008 earnings conference call. You may now disconnect and we thank you for using ACT Conferencing.

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