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Dolan Media Company (NYSE:DM)

Q3 2008 Earnings Call

November 6, 2008 10:00 am ET

Executives

Haug Scharnowski – Director, Investor Relations

James P. Dolan – Chairman of the Board, President, Chief Executive Officer

Scott J. Pollei – Executive Vice President, Chief Financial Officer

Analysts

Bob Evans - Craig-Hallum Capital

Randy Hugen - Piper Jaffray

Jim Goss - Barrington Research

Operator

Good morning, ladies and gentlemen and welcome to the Dolan Media Company third quarter 2008 conference call. (Operator Instructions) I will now turn the call over to Mr. Haug Scharnowski. Mr. Scharnowski, you may begin.

Haug Scharnowski

Thank you. Good morning ladies and gentlemen and welcome to Dolan Media Company’s third quarter 2008 conference call. On the call today from the company are Jim Dolan, Chairman, Chief Executive Officer and President and Scott Pollei, Executive Vice President and Chief Financial Officer.

By now, everyone should have had access to our third quarter 2008 earnings release which went out today at approximately 6 am Central Time. In case you have not seen our release, you may find it on the Investor Relations section on Dolan Media Company’s website at www.dolanmedia.com. In addition, a slide presentation supplementing this conference call is also available on our website. This call is being webcast and the replay and slide presentation will be available on the company’s website for a period of 21 days.

Before we begin, we’d like to remind everyone of the safe harbor statement under the Private Securities Litigation Reform Act of 1995. Today’s prepared remarks contain forward-looking statements and management may make additional forward-looking statements in response to your questions. The words “expect,” “believe,” “anticipate,” “estimate,” “continue,” “plans,” “will,” “outlook,” and similar expressions are intended to identify forward-looking statements. These forward-looking statements are based on information currently available to us and are subject to a number of risks and uncertainties and other factors that may cause our actual results, performance, prospects or opportunities to be materially different from those expressed in or implied by these forward-looking statements.

For a more detailed discussion on the factors that could cause actual results to differ materially from those projected in any forward-looking statements, we refer you to the risk factors contained in Dolan Media Company’s annual report on Form 10-K filed with the Securities and Exchange Commission on March 28, 2008. We also refer you to Item 1A of the company’s quarterly report on Form 10-Q filed May 8, 2008 and August 11, 2008 and the company’s quarterly report on Form 10-Q filed in the next few days, as well as pages 2-7 of the company’s prospectus filed on October 3. Except as required by federal securities laws, Dolan Media Company assumes no obligation to revise or update any forward-looking statements that may be made in today’s release or call.

Please note that on today’s call, in addition to discussing GAAP financial results, the company will discuss various non-GAAP financial measures. Today’s earnings release contains the non-GAAP financial measures discussed in today’s call as well as an explanation of Dolan Media’s use of these non-GAAP financial measures. It also contains reconciliation between GAAP and non-GAAP measures required by SEC Regulation G. The non-GAAP information does not substitute for any performance measure derived in accordance with GAAP. The use of non-GAAP measures also has limitations which are described in more detail in the company’s earnings release.

With that, I would now like to turn the call over to Jim Dolan.

James P. Dolan

Thank you, Haug and thank you all for joining us today. This has been an interesting and challenging environment for us as lenders, politicians, and regulators address the growing mortgage crisis. We’ve been paying close attention on a daily basis as efforts continue to mitigate foreclosures.

Let’s talk first about the national situation. Our views on the growing foreclosure volumes have not changed. Absent government actions, there would be very high growth rates in foreclosures for several years to come. But of course, there are government actions. Over the past few months, federal, state and local governments have proposed and in some cases, acted on legislation that may affect the number of total mortgages in foreclosure. Until now, most of this legislation has focused on lengthening the foreclosure process by adding waiting periods or notice requirements toward the beginning of the process. These waiting periods are intended to give the lender and the homeowner extra time to determine if they can refinance, restructure the existing loan, or otherwise avoid foreclosure. For example, Maryland passed a law this April that requires lenders to wait at least 90 days after default before they commence on action to foreclose a mortgage. We’ve seen similar legislation pass in California.

Other mitigation programs have been announced including the Hope for Homeowners Act of 2008 which went into effect on October 1, the Federal Emergency Economic Stabilization Act also known as the $700 billion bailout and Bank of America’s Nationwide Home Ownership Retention Program for former Countrywide mortgage customers which is the result of a settlement with attorneys general from ten states.

More recently, there have been discussions about another government program that would guarantee some percentage of each refinanced mortgage of the Federal Deposit Insurance Corporation. Just last Friday, J.P. Morgan-Chase announced a 90-day moratorium on foreclosures related to mortgages that it owns. Overall, it isn’t clear how many mortgages would be affected by these many, varied and sometimes overlapping efforts.

On occasion there have been discussions and proposals to impose further foreclosure moratoriums. These discussions and proposals have lacked specific details contributing to the difficulty and determining the potential effect on foreclosure volumes. Even if a national moratorium were enacted, we would not anticipate a 100% stoppage in foreclosure filings. Some mortgages simply cannot be refinanced due to job loss, significant equity that’s negative, or other issues affecting the homeowner.

Although the foreclosure avoidance efforts will have some success, we continue to believe that there will be many foreclosures in the future. At moratorium’s end, we would expect a surge of foreclosures. In fact there are several drivers of future foreclosure growth. We believe foreclosure volumes will continue to be affected by a weakening economy, higher unemployment rates and the greater number of “underwater” homes with negative equity and the growing number of seriously delinquent mortgages.

Reports issued last week estimated that between 7.5-10 million homeowners have negative equity in their homes. According to the Mortgage Bankers Association’s National Delinquency survey, the number of seriously delinquent borrowers, that are borrowers who are 90 days or more behind in their mortgage payments, continues to grow. Seriously delinquent home rates have historically been a leading indicator of future foreclosure volumes. In the most recent delinquency survey which was for the second quarter of 2008, the percentage of loans that were seriously delinquent was 4.5%. That was 47 basis points higher than the first quarter of 2008 and 203 basis points higher than the second quarter of 2007.

Though the number of seriously delinquent homes continues to rise, so far we have not seen a corresponding rise in the number of foreclosure starts. This indicates a widespread delay in moving delinquent mortgages into the foreclosure process.

We believe this buildup in seriously delinquent loans is partially caused by lenders and loan servicers focusing their efforts on loss mitigation, loan modifications and similar programs adding time before a foreclosure is commenced. Our direct conversations with mortgage servicers have confirmed the growth of a delinquency backlog.

Now let’s talk about Dolan Media. As you might have imagined, the last couple of months have been turbulent in this business sector with many new ideas, approaches or programs being raised and many competing points of view. Program details are extremely vague. As a result, we cannot evaluate with any level of certainty what effect these programs will have on the number of foreclosure files referred to American Processing Company for processing or the number of foreclosure public notice advertisements placed in our publications.

So at this time, we are temporarily suspending all of our guidance. To be clear, we will provide guidance in the future. We are suspending guidance now solely because of the environmental uncertainty.

That being said, I would like to put out that we run a very good business with solid performance in the third quarter. We experienced 24.9% year-over-year growth in our total revenues primarily resulting from businesses we acquired in 2008 including in September, National Default Exchange or NDEx. Our year-over-year total revenue growth also benefitted from an increase in public notice revenues in our existing businesses.

We continue to be excited about the NDEx acquisition and have focused our attention on integrating NDEx with APC. We are evaluating ways we can achieve synergies, cost savings, market share increases, and revenue growth as we work to combine these businesses. Given the current economic and regulatory environment, we are accelerating some of our integration plans and strategies so we can realize these synergies and cost savings more quickly positioning us to continue to respond proactively to changes facing the foreclosure industry.

Though there may be challenges ahead, we are very well-positioned in all parts of our company. Members of our senior management team have significant industry experience and deep knowledge of our target communities and markets. They have responded quickly to changes in the communities where we operate, helping Scott and me manage our company through these uncertain times.

In addition to monitoring this changing business environment, we are focusing our attention on the cost side of the business. We have developed a number of cost containment programs across all divisions to respond to the changes in the business environment. We have started decreasing discretionary spending in all units and we are making staff reductions through attrition. We will implement our other cost containment plans as necessary in the future.

We continue to see solid cash flow and adjusted EBITDA in the third quarter. During the quarter, we made our regularly scheduled term loan payment of $1.2 million and in addition, we paid $3.5 million on our revolver in October. At this time, we have nearly $30 million available under our revolving line of credit.

The state of the housing and foreclosure crisis continues to be severe and we anticipate significant foreclosure file volumes in the future. In addition, we continue to look for opportunities to expand and grow the business information and professional services divisions. We are expanding our service offerings to include loss mitigation support and we are working hard to identify new relationships and to expand our existing relationships with law firms and mortgage servicers. We also will, of course, expand geographically.

We talk mostly here about our professional services division but let me say a few words about our business information division. Our management team there is hard at work developing revenue growth even as we contain costs. More of our work is moving from print to online media and we continue to work on developing new products and services to serve our existing markets. We also have an active acquisition pipeline.

Before handing the discussion over to Scott, let me insure you we continue to run the company with an eye toward increasing long-term value. The challenges we face now are short-term and we must manage as we had in the past. We will continue to run this company by being opportunistic and innovative, beating our competitors and providing superior client and customer service.

Now Scott Pollei will provide a view of our third quarter 2008 financial results.

Scott J. Pollei

Thank you, Jim.

During the third quarter of 2008, our revenues increased $9.6 million or 24.9% to $47.9 million compared to the third quarter of 2007. $8.5 million or 23% of the total increase is attributable to acquisitions while approximately $1 million or 2.7% was from organic growth primarily public notice and appellate services revenues. Remember, we define organic growth to also include fold-in acquisitions.

The professional services division which consists of American Processing Company and Counsel Press through its revenues achieved 47.9% year-over-year. Acquired revenue growth was 45.6% and represented the majority of the division revenue growth while organic growth was 2.3%, all of which came from Counsel Press. Within the division, APC achieved year-over-year revenue growth of 54.7%. All of the growth at APC is attributed to the previously announced acquisition of Wilford & Geske’s mortgage default processing services business and NDEx. Our Michigan and Indiana operations saw a year-over-year decline in revenue based on fewer mortgage default processing files deferred to us from our law firm partners.

During the quarter APC serviced 52,900 case files for our law firm clients, 20,100 were referred to us by Wilford & Geske and the Barrett Law Firm and other customers of NDEx. This represented an increase of 52.4% from the 34,700 case files we serviced in the third quarter of 2007. Excluding the files contributed by NDEx and Wilford & Geske, case files declined approximately 1,900 files or 5% in the September quarter compared to the same quarter last year. We believe these declines are attributed to the lender actions and response to the various regulatory efforts in Michigan and Indiana which are at a more mature phase of the foreclosure cycle.

Because the NDEx operations are relatively new to the company, we acquired them on September 2. Let’s talk about the growth in the NDEx file. NDEx processed 40% more mortgage default files in Texas during the third quarter of 2008 versus last year. In California, mortgage default files processed by NDEx grew 194% over the same period. California is early in the foreclosure cycle and Texas benefitted from an expansion in loss mitigation work.

At Counsel Press, revenue increased $800,000 or 22.3% during the quarter. The increase in appellate services revenue resulted from an 8% increase in appellate files processed as well as the number of larger case files processed in the third quarter of 2008 as compared to the same period last year. About half of the increase during the quarter is the result of our expansion into the Chicago market.

In our business information division, revenues increased to $22.2 million, up 6% compared to the third quarter last year. Revenue growth in the division was driven by a 20.1% increase in public notice revenue. Public notice revenue from a February 2008 acquisition of the assets of Legal and Business Publishers in Charlotte, North Carolina offset a decrease in public notice revenues in The Daily Record in Maryland. As Jim indicated earlier, the decrease in public notice revenues in Maryland was the result of the change in law there in April 2008. This law delayed the timing of when foreclosure notices were placed in our paper for publication. We are beginning now to see public notice placements pick up in Maryland.

Circulation revenue increased 4.6% year-over-year primarily as a result of increased newsstand sales and the average price of paid subscriptions. Display and classified advertising decreased 3.2% in the third quarter. This was due to a decrease in the number of ads placed in our publications. We expect our display and classified advertising revenue to continue to decline as our customers tighten discretionary spending in light of local economic conditions in the market we serve. This is a typical recessionary pattern that we’ve experienced in previous economic downturns.

Our consolidated operating expenses for the quarter were $41.4 million, an increase of 30.9%, $31.6 million last year. Expenses for the quarter represented 86.5% of total revenue. For the same quarter last year, it was 82.5%.

Let me explain the drivers between the operating expense increases. First, our direct operating expenses were up 33.7% or $4.5 million. Direct operating expense as a percentage of revenue in the third quarter increased 37.4% compared to 34.9% for the same period last year. The increase in direct operating expenses is mainly attributed to the direct operating expenses index and the processing operations we acquired from Wilford & Geske earlier this year. As a result, the professional services division had a $3.9 million increase in direct operating expenses. The business information division reported a $600,000 increase in direct operating expenses resulting from higher production-related costs such as printing, additional editorial staff, event costs and operating costs related to the Legal and Business Publishers acquisition.

During the quarter, we also had a $3.8 million or 24.9% year-over-year increase in selling, general & administrative expenses. The business information division SG&A increased $1.2 million or 13.9% year-over-year. This was primarily related to a $400,000 increase in information technology costs related to maintaining and improving our publication websites, $200,000 of additional bad debt expense, and $200,000 of operating expenses from the acquired business of Legal and Business Publishers. Our professional services division SG&A increased $2.6 million or 63.9% year-over-year. This increase was primarily related to the increased costs of operating acquired businesses and increased personnel costs at APC.

In the third quarter, we also had a $200,000 year-over-year increase in the stock-based compensation expense and a $400,000 increase in the expenses associated with being a public company. We also expensed $400,000 of legal accounting and other due diligence costs related to acquisitions we are no longer pursuing. We expect our SG&A expenses to increase for the remainder of 2008 by at least $600,000 as a result of being a public company including costs that we expect to incur if we were to comply with the Sarbanes-Oxley Act. The increase in expenses which included $400,000 in professional fees we wrote off this quarter in connection with the potential acquisition that we are no longer pursuing was partially offset to reduce bonus accruals which amounted to $600,000 of expense in the third quarter of 2007.

Finally, operating expenses increased due to added depreciation and amortization expense. Depreciation increased $300,000 and is primarily associated with the acquisition of NDEx. Amortization expense increased $1.2 million due to the amortization of Finite Life and Tangible Assets acquired in 2008 as well as the repurchase of interests in APC from our minority members in 2007.

Operating income for the third quarter 2008 was $7.8 million compared to $8.3 million for the same period last year. During the third quarter, we took a $1.5 million expense related to a terminated acquisition. We reported this expense as a non-operating break-up fee consolidating statements of operations. Adjusted EBITDA for the third quarter was $12.9 million, an increase of 11.1% from $11.6 million in the prior year period. Our adjusted EBITDA margin decreased 3.3% year-over-year to 26.8%. The decrease in margin can be partly attributed to the addition of NDEx operations which has a higher mix of direct operating expenses to revenue than our historical profession services division. It can also be attributed to higher direct operating expense and SG&A expenses in the business information division. Some of this increase was due to the decreased profitability of the Maryland operations during the foreclosure notice delay that Jim discussed earlier.

For a reconciliation of adjusted EBITDA to GAAP net income or loss, please refer to today’s earnings release. Please note that we have also excluded the impact of the non-operating break-up fee from our adjusted EBITDA calculations since we have not previously incurred and do not anticipate incurring such expenses in the future.

Net interest expenses for the quarter was $1.9 million and $171.7 million of total debt compared to $3.2 million of net interest expense for the prior year period. The prior year period included $700,000 of interest expense in connection with our interest rate swap and a $1 million expense related to the amortization of deferred financing fees.

GAAP net income for the third quarter was $2.5 million or $0.09 per diluted share on 28.1 million weighted average diluted shares outstanding. Net income excluding the break-up fee was $3.4 million or $0.12 per diluted share. GAAP net loss for the third quarter was $7.5 million or a loss of $0.38 per share, on 190.7 million weighted average diluted shares outstanding in the third quarter of 2007. Net loss for the third quarter of 2007 included non-cash interest expense of $9.9 million related to our redeemable preferred stock. This stock was redeemed on August 7, 2007 in connection with our initial public offering and we have not recorded this non-cash interest expense since that time.

Last quarter, we introduced cash earnings per diluted share to our regularly non-GAAP disclosures. Our cash earnings in the third quarter of 2008 were $4.6 million. This translates to cash EPS of $0.16. Cash earnings excluding the break-up fee for the quarter was $5.5 million. Cash earnings excluding the break-up fee per diluted share was $0.19 for the quarter.

We have included reconciliations of these non-GAAP measures to GAAP measures as required by Regulation G in today’s earnings release.

Now, I would like to transition to our balance sheet and comment on the company’s cash flow characteristics. At the end of the quarter, we have $2 million in cash, down from $4 million at the end of the same period last year. Increases in our accounts payable and accounts receivable are primarily related to the NDEx acquisition.

Total debt at quarter’s end was $171.7 million compared to $53.2 million in September 30, 2007. We added $99 million to debt related to the September 2 acquisition of NDEx. At the end of the quarter, the company had total debt to EBITDA ratio of 2.7X, well below the senior leverage ratio debt covenant of 3.5X. The company also continues to be well-positioned on its other financial covenant of fixed charge coverage ratio which was 3.7X at quarter-end and well above the minimum set of 1.2X.

At quarter’s end, the company used $99 million on its revolving credit facility and $71 million on its term loan. Subsequent to quarter’s end, we converted $85 million of the outstanding revolver to a new-term loan triage. In addition, as Jim indicated, we paid the revolver down by $3.5 million. Today, the outstanding balance in the revolving credit facility is $10.5 million and we have $29.5 million available.

For the three months ended September 30, 2008, we reported cash flow from operations of $6.6 million and free cash flow of $5 million. With that, we will open up the call for questions and answers.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from Bob Evans from Craig-Hallum Capital. Please go ahead.

Bob Evans - Craig-Hallum Capital

First, can you comment on the Maryland impact on a revenue standpoint? How much public lost revenue are we talking about?

James P. Dolan

Bob, we estimate it was somewhere between $750,000-$1 million of revenue.

Bob Evans - Craig-Hallum Capital

Jim, can you comment as it relates to, you suspended guidance. How should we take that? If you could give us some sense in terms of how your business has done thus far in Q4 are you seeing continued trends in growth and give us some logic as it relates to suspending guidance because I think you know we’ve seen some fear in the market as it relates to that.

James P. Dolan

I’m not going to comment with too much regularity on that but so far, we’re fine. It’s starting out to be a good quarter. We have a solid business. We are controlling the costs which we of course can control. The sole reason for the guidance suspension is because there are so many revenue drivers that are up in the air right now, it didn’t seem responsible for us to even pretend to know what the new administration is going to do or what some of the other private factors may do in the next couple of months. We do look forward to resuming guidance when we can, when things stabilize but not right now.

Bob Evans - Craig-Hallum Capital

Given what’s out there and what you know right now and what you referenced before in terms of a bigger and growing pot of delinquencies, do you expect 2009 to be a growth year for foreclosures from an industry standpoint nationally?

James P. Dolan

I can give you a partial answer. If you ignore all the attempts to mitigate losses and to restructure and that sort of thing, there is a huge accumulation of delinquencies waiting to go to foreclosure. That’s even increasing because of recessionary trends. So if you want to call it gathering storm clouds or whatever you might want to choose, that’s still large and growing, and that’s really not changing. Now what’s being done to mitigate, that’s the wild card. After that, we would see a very strong growth year for ’09 and even beyond ’09 too.

Bob Evans - Craig-Hallum Capital

Even the situation that you referenced before, the moratorium, my understanding is, it’s died a little bit, is that how it would be for banks that are getting federal money and it would be for first mortgage owners, so Thanksgiving, federal money, foreclosure, not a number of potential foreclosures impacted by at least 50% and then first mortgages would knock that number down further yet. I guess I am trying to put it into perspective that it could have some impact but it’s not like the entire faucet is turning off or am I missing something?

James P. Dolan

No, I think you’re getting it right. We obviously are reading tea leaves here. We’re trying to parcel what politicians say in the microphones and then see what policies might come from that. I can’t envision or has there anyone to my knowledge suggested a complete moratorium on foreclosures. I don’t think it’s in the cards. I don’t even think it’s possible.

Bob Evans - Craig-Hallum Capital

I know there is some legal challenges to that as well as it relates to the loan secure ties, is that correct?

James P. Dolan

That’s correct, yes.

Bob Evans - Craig-Hallum Capital

From a cash standpoint, Scott, how much of your APC business is variable cost?

Scott J. Pollei

I guess it depends on how you define variable. The vast majority of our expenses on the APC business were personnel. It’s people and rent to the extent that there’s a volume drop or something. I guess ultimately those costs become variable and we are developing several different contingency plans ranging from growth with more volume coming and what you do with staffing there to if there’s a political thing that moves the volume down in a short-term basis, we’re developing plans there as well.

Bob Evans - Craig-Hallum Capital

The vast majority, are you saying 70%, 80%?

Scott J. Pollei

It’s about 70%.

Bob Evans - Craig-Hallum Capital

Jim, as it relates to the market, I guess maybe what you can attribute from a media standpoint, regardless of political or what happens on the political side, would you expect to grow share next year and should we expect you to get into new states?

James P. Dolan

I would say yes to both, very much so, yes.

Bob Evans - Craig-Hallum Capital

What states would you look to bring the most share in?

James P. Dolan

Do you mean which single state would you get the most share in?

Bob Evans - Craig-Hallum Capital

If we look at next year, which states would you gain from as dollar standpoint the most share in and what would you expect to?

James P. Dolan

Well, we’ve not gone to that level of granularity in our predictions but I think it’s a safe bet to say that California is a very fertile territory for growth. It’s so big and there’s just so much more market share there, but we are trying everywhere. We are coordinating our efforts so that we don’t have a single state by state effort but we have a centralized effort to grow across all of our states.

Bob Evans - Craig-Hallum Capital

As it relates to, you mentioned California and Texas growth rate, can you give us some sense of what Minnesota may have looked like in the third quarter, ballpark, on the APC business?

James P. Dolan

I know it’s growing but I’m not sure that we have that particular statistic in front of us. I think we can get back to you on that.

Bob Evans - Craig-Hallum Capital

Also as it relates to Michigan and Indiana, you said that files are down about 5%. Can you elaborate a little bit more there because the Realty Trac numbers have Michigan flat or split, can you just talk about why that is and if there’s something specific to those states and do you still think you’re maintaining share there?

James P. Dolan

Well, we are maintaining share there. We track this very carefully. We have a team of people who focus on this. This is their primary job. I’m glad you brought up Realty Trac because that’s something we hear a fair amount about. We talk directly with our clients or the law firms talk with our clients. We have very good data that is; I guess you would call it primary research. We are not losing market share in either state and we know exactly how many files have been referred statewide and exactly how many we get. So we’re very confident in our data and it shows that that data is showing and I think it will continue to show that we are not losing market share. We are slowly gaining market share, I believe. I know this is in contrast to some Realty Trac data that might show something different. We continue to not believe Realty Trac’s data. When we compare the primary research numbers we have with what Realty Trac is reporting, it doesn’t match up. We can’t make sense out of their methodology.

Bob Evans - Craig-Hallum Capital

As it relates to an industry standpoint, you’re just saying that it’s slowing in those states as it relates to foreclosures or temporary pause?

James P. Dolan

I think you have sort of a long-term cycle that’s taking place here. They’ve been in a foreclosure crisis in Michigan for 28 years and counting, Indiana is a little bit less than that. You got a long rise in foreclosures from where we are now. I think that is peaking. It’s a gentle peak. The uncertainty, the wild card in this is what the recession will do. Will that worsen it yet for another few quarters or a year? You also have additional uncertainty in Michigan in what happens if GM and Chrysler merge. Would that drive additional economic pain for that state? That’s a wild card too. Absent those things though, I think that you would not see very much growth in those two states going forward because a lot of things have already been imposed upon them.

Bob Evans - Craig-Hallum Capital

You mentioned loan modification, you had growth in Texas. Are you looking at doing more loan modification work for the servicers in other regions, can you discuss that business?

James P. Dolan

Yes, we are. We’re doing it as a line of business in Texas and we’re taking that to our other jurisdictions as well. It’s something that the clients had asked the law firms to work on. In fact, company-wide we have something like a dozen and a half pilot projects in loss mitigation underway. There’s no single accepted way to do loss mitigation because it pretty much didn’t exist even a couple of years ago. So clients suggest we try things, when it becomes a standard process, then it is part of our fee structure and part of the services that we provide. There’s obviously a lot of loss mitigation interest and a fair amount of activity now. That’s one of the lines of growth we expect for our business.

Bob Evans - Craig-Hallum Capital

Final question, margins on the professional services are down sequentially. Is some of that related to acquisition integration or can you give us your thoughts as it relates to the professional services post-margin and what we should expect?

Scott J. Pollei

Part of it, Bob, as we said before, the NDEx acquisition, that business operates at a lower margin than does the historical APC business. So just blending that in by itself. Now we only had one month of it. It didn’t have quite as big an impact as it will for a full year. Just blending that in by itself brings the margin down. It’s not that the professional services business is worsening or anything, it’s just when you blend those together, you get that. There were not significant acquisition integration costs in September. That really was not impacted by that.

Bob Evans - Craig-Hallum Capital

And the EBITDA margins for NDEx relative to your previous APC business prior to that, how do they compare?

James P. Dolan

Likewise with the operating margin there, they are lower. As you recall, there’s a couple of reasons for that. NDEx has a title operation that operates at a significantly lower margin. It’s profitable so it’s a good business to have but it operates at a lower margin than the regular foreclosure processor. In addition to that, because in California, we don’t operate with a law firm partner, we deal directly in California with the mortgage servicers or the banks. On their behalf, we advance funds to cover some costs. Some of these costs are included or are reported net and some of these costs are reported on a gross basis. There is some specific accounting literature that governs how we do that. For those items that are on a gross basis, it adds to revenue, it adds to the direct operating expense which has the end result of dropping that margin a little bit.

Bob Evans - Craig-Hallum Capital

Is NDEx on track as to integration and revenue trends that you were expecting?

James P. Dolan

Yes.

Operator

The next question comes from Randy Hugen from Piper Jaffray. Please go ahead.

Randy Hugen - Piper Jaffray

Can you give us a little more detail on the break-up fee? What kind of company were you looking at and when in the quarter were you looking at the acquisition?

James P. Dolan

It was a company that serves the legal profession. It was an expansion from the current platforms we have so it wasn’t an extension. It would have been a new component or special services division. We were pursuing it at the same time we were working on the NDEx transaction. Toward the end of the quarter, I believe Scott, wasn’t it when we stopped?

Scott J. Pollei

Yes.

James P. Dolan

It was a matter of our own discipline in choosing that the NDEx deal was more important so we did that and we also had financing available but we didn’t like the pricing. So we chose not to do it.

Randy Hugen - Piper Jaffray

Is this something that you might come back to and revisit later on after NDEx is more fully integrated?

James P. Dolan

Absolutely. We still think very highly of the company under the management team. The strategy was right, it’s just the timing has to change.

Randy Hugen - Piper Jaffray

Where do you see display and classified and circulation revenues going from here?

James P. Dolan

Display and classified continue to drop gently. There’s not a lot of steep falloff there. We’ve been drifting down for, I guess, 18 months now. We don’t see growth in the near-term. This is a recessionary cycle we’re in. It’s not a horrible drop. We are holding our core advertisers at this point. Many of them find us still the best way to reach the audiences and they have few to no alternatives. So we feel pretty good about that but it is still dropping.

Circulation in units is dropping a little bit but because of pricing ability, we have pricing power so we are able to generate revenue growth there. I don’t see that changing. In this kind of economic condition, in all of our customer segments, they really need the content we have and the services we have way more than ever.

Randy Hugen - Piper Jaffray

Trying to dig into the foreclosure filing volumes that you saw, can you give some commentary on how things trended during the quarter, whether you exited the quarter at higher or lower run rate than you started? Anything that you can give us a little bit more visibility into where things might move from here.

James P. Dolan

Let’s start with Michigan and Indiana. I’m not going to give you the monthly volume statistics but it was not a sequential decline. It goes up and down from month to month. If you were drawing it on a graph, we sort of hit a U-shaped pattern, where it was up slightly and then down and then back up by the end of the quarter. In Texas and in California, we saw significant year-over-year growth. Now we didn’t own NDEx last year, but if you looked at the industry-wide statistics for California, they were up significantly last quarter. If you look through what NDEx processed as a business last year before we owned and compared it to what it processed this quarter, as we reported here it was up 190%. Texas was up 30%. We do see across the whole APC business, if you will. We saw sector-wide growth.

Just anecdotally toward the end of the quarter, we were hearing from some clients that they were setting aside a few of the loans in preparation for the Hope for Homeowners program kicking in October 1. We didn’t see numbers reducing below our expectations but we did hear and have conversations with lenders that indicated that was happening.

Randy Hugen - Piper Jaffray

On some of the private modifications and legal settlements, can you discuss maybe how some of those will impact you or possibly not be as impactful based on your specific exposure?

James P. Dolan

The Countrywide settlement will impact us in a few states. I don’t want to be real specific but I can tell you that we don’t do much Countrywide work in California. That settlement there will not have much effect since we don’t do that work, there’s nothing to take away there. I’m not sure about other programs at this point. There are no other specific programs that will have significant impact.

Randy Hugen - Piper Jaffray

Finally, you mentioned that you’ve done some scenario analysis on where expenses and staffing levels will trend in some different situations. If there were to be a 90-day moratorium for a quarter, decreased foreclosure filings by let’s say 50%, what’s the worst case scenario for your margins for a quarter like that?

James P. Dolan

I really don’t want to discuss specific scenarios because we don’t really know which will happen. I will tell you we got many, many plans. We got a plan for almost any possible scenario. We know how to maintain our profits going forward. It would be irresponsible for me to pretend one is the most likely and given answer and to be precise like that. To quote Mike Barrett who is our new friend of the NDEx in Texas, this isn’t our first rodeo. We’ve been through downturns before so we have plans ready for almost anything that comes up.

Randy Hugen - Piper Jaffray

Is it reasonable to think that you could temporarily reduce your staffing levels significantly and then ramp them back up by 90 days later?

James P. Dolan

I guess anything’s possible theoretically. I won’t comment on whether we have plans to do something like that but I suppose that it’s possible.

Operator

The next question comes from Jim Goss from Barrington Research. Please go ahead.

Jim Goss - Barrington Research

I guess you have talked a lot about the mortgage foreclosure issue. Maybe I will shift to a couple of other things. One, you mentioned that you are shifting some of your print publications online. I was wondering, have you done it in a total shift rather than just a complementary online product in any place? If so, I was wondering what sort of economic model impact you’d be seeing from that sort of development?

James P. Dolan

In a few cases, we’ve done a total shift. We’ve always had tandem, print and online and then a few cases, we’ve gone completely online. Of course, costs go down. You don’t have printed mail things so the production costs tend to be much better from a business model standpoint. The challenge is on the revenue side. We know how to sell print ads all day long and we are doing pretty well at selling online ads but the fact is, revenue from online ads tend to be smaller. We’re still balancing the model to make sure that these things work and so far, so good.

Jim Goss - Barrington Research

That’s generally the problem in print, if you go online, you can’t replace the dollars. The cost cuts aren’t balanced out even if the revenues are down; you’re still not getting the same profitability. That’s what you are seeing so far?

James P. Dolan

I don’t know. I think there are some nuances we should explore a little bit here. We have found ways and a lot of other people have found ways to have an online model that is profitable. Even on a margin basis you can come pretty close. The problem is everything is smaller. The top and bottom line in dollars is smaller. That’s the challenge. We’re not here to shrink our business even though we hold margins. The alternative we are exploring is do we take one product and fragment that or do we do a number of things online, so we replace one print thing with several companion things online. We’re looking at revenue streams and we’re exploring on how to keep growth in actual dollars.

Jim Goss - Barrington Research

If you can solve that problem, the print industry will love you. The break-up fee issue suggests that you have been thinking more importantly about the potential shift and focus on some other legal silos. Do you think that process will intensify given the challenges in pretty much your core business right now?

James P. Dolan

I wouldn’t say shifting. We’ve always been looking for other growth areas in all parts of our business including professional services. I mentioned the pipeline, we do have a pipeline of opportunities. We’re in active conversations with a number of dual parties, pretty much all of the time. Our long-term and short-term interests in doing something more for attorneys is there.

I should mention by the way, we’ve never paid a break-up fee before. It’s not part of our model. This was for us, I believe a one-time thing, right Scott, never in 15 years have we done this before.

Jim Goss - Barrington Research

The other thing in the foreclosure area, you talked about organic growth versus acquisitions. You’re including fold-in acquisitions in the organic growth which is maybe not exactly what I think of as organic growth. With NDEx, you have an opportunity to move into markets on an organic basis if you will now that they have been acquired, versus acquiring properties in that market. Can you describe how those processes differ and some key metrics that might measure your success, and talk about how it can affect your economics?

James P. Dolan

I’ll start and Scott will probably want to chime in with some more detail. In general, it starts with the clients and the law firms because it’s the clients’ needs and demands that we would intend to satisfy within the expansion move. We are in conversations with clients on a continuing basis. We have a very clear sense from them on where their problems are, what states they would like somebody to come in to solve their problems. We are well versed in these states, we look at them all of the time. It’s an interactive thing because they say we have a problem with state X and if we think we’d like to go there, we talk with them directly saying all right, we can go there. Can we count on business from you if we go there? You don’t get contracts signed; it’s not that kind of a thing. You get a pretty clear indication from them on when our needs and hopes are synchronized. When we decide that the state is right, then we can very quickly build out our technology bridge from what we have today to what that state needs. Every state is different so there’s always something out of us that’s needed. At the same time, we are developing a local law firm relationship so that we have a law firm or an attorney on the ground in that state because that’s necessary too. In a matter of months or a couple of quarters, maybe at the worst case, we’re ready to start up. The client sends us some files on a test basis. If we do well, then the file volume grows and there we are.

So that’s how it works in an operational sense. Economically speaking, it’s anywhere from $1.5 million to $3 million to launch into a new state. The variables that we look at are is this state similar in its legal system to a state that we are already doing business. So it’s a simple adaptation or is it very different. Judicial versus non-judicial is a factor. Those are the variables from $1.5 million to $3 million.

Operator

The next question is a follow-up from Bob Evans from Craig-Hallum Capital. Please go ahead.

Bob Evans - Craig-Hallum Capital

As it relates to the moratorium scenario, do you believe you can manage your business and profitability in that scenario if it were to occur where you would be okay as it relates to your debt and your debt covenants?

James P. Dolan

Absolutely.

Bob Evans - Craig-Hallum Capital

So you believe you can adjust your expenses and maintain that free cash flow and profitability?

James P. Dolan

Well, we couldn’t maintain necessarily what our run rate is this summer, but we believe that we have the ability to manage our costs so that they are appropriate for our revenues. We have plenty of head-room with our covenant now and this is of course part of a model and part of our planning.

Operator

Thank you ladies and gentlemen. This concludes today’s question and answer session. Mr. Scharnowski, do you have any concluding comments?

Haug Scharnowski

No, I think we’re done here. Thank you, everybody.

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Source: Dolan Media Company Q3 2008 (Qtr End 09/30/08) Earnings Call Transcript
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