As I have written about previously, one of the main ways I make money as an investor is by shorting the stocks of what I call "dead-companies-walking," businesses on their way to bankruptcy. Some dead-companies-walking emerge from bankruptcy in better shape. They take advantage of the reorganization process to restructure their debt loads or streamline their business models and they go on to become successful concerns. Others, however, merely use bankruptcy to postpone inevitable ruin. Like zombies in a B-movie, they rise briefly from the grave, only to fall back into it again a short while later.
Two weeks ago, I shorted one of these "zombie" businesses: Dex Media (DXM), a newly formed company created from the merger of two bankrupt producers of Yellow Pages (Dex One and Supermedia). I believe DXM will likely give me the unique opportunity to profit on a rare hat trick in the corporate world, the dreaded "Chapter 33"--three bankruptcies for the same company.
The main reason I was so eager to short DXM is obvious: the company derives most of its revenue from a product that is on the verge of obsolescence. At this point, Yellow Pages are the buggy whips of the advertising world. I have three kids in their teens and twenties. They've never even heard of Yellow Pages. If I asked them, or any of their friends, what Yellow Pages were, they would probably think I was talking about a coloring book.
Of course, DXM's management says all of the right things about transitioning its 665,000 mostly small, local business subscribers to its web portal, superpages.com. But I find it mystifying that anyone would believe that this platform will ever be able to compete with deep-pocketed, firmly established online titans like Google (GOOG), Yahoo (YHOO), Yelp (YELP), and Bing (MSFT). Why would consumers abandon the brands they already use every day to go through the additional step of logging onto superpages.com and then typing in a search query for a pizza place, muffler shop, or plumber? Moreover, other competitors like daily newspapers are already muscling into superpages.com's market share. In Dex Media's own hometown, The Dallas Morning News, with a daily circulation of 430,000, reported that its digital advertising revenue grew over 30 percent in the June 2013 quarter.
Despite these issues, DXM--like so many dead-companies-walking before it--continues to find bulls willing to believe it can return to glory. Earlier this month, a prominent writer for the Wall Street Journal penned a glowing recommendation of its stock. To be fair, as the writer pointed out, Dex still brings in a fair amount of free cash flow, over $300 million last year. Because of this, it is currently generating positive EBITDA, and is paying down some of its crushing debt load, which stands north of $3 billion. At first blush, these are both positive signs--until you look closely at the company's most recent quarterly results.
Revenues from print advertising shrank 21.8 percent in the June 2013 quarter, while digital revenues rose a paltry 6.2 percent compared to 14.5 percent the year before. This was the largest decline for print ad revenues in years, and--contrary to the claims of DXM's management--there is very little chance the slide will decelerate, let alone reverse. The company estimates free cash flow of $352 million in 2013 and $474 million in 2014. I am confident that these numbers are vastly overstated. Why would print revenues rebound or increase for a product fewer and fewer people are using? And how can shrinking digital revenues ever make up for this shortfall, especially given DXM's onerous debt obligations and the brutal competitive environment superpages.com faces? The answer, of course, is that they can't. It's little wonder Moody's just added DXM to its list of companies with negative outlooks and credit ratings at or below B3.
I've seen this pattern repeatedly over the years. As industries unwind and go obsolete, overly optimistic boosters have a hard time facing reality and they predict that revenue declines will slow or at least "stabilize." I heard these rosy predictions from investors and managers in video rental chains in the mid-2000s and from paging company executives in the late-1990s. But secular shifts don't "stabilize," they accelerate--and bankruptcies that arise from those shifts come swiftly, not slowly. As a character in Ernest Hemingway's novel The Sun Also Rises says, there are two ways to go broke, "Gradually, then suddenly."
Perhaps the most puzzling thing about DXM's defenders is that the company has already gone through this exact process not once, but twice in the last five years. To borrow another literary saying, "past is prologue," and a quick look back at DXM's predecessors shows that they, too, managed to look good on paper for brief periods before rapidly imploding.
In 2008, I let positive EBITDA numbers scare me away from shorting DXM's forebear, Idearc. Revenues for the company were falling back then, too. But as the CEO at the time explained to me when I met with him, management was cutting costs aggressively and--just like DXM today--paying down its enormous debt load (which topped $9 billion at one point). Less than six months after that meeting, Idearc was in bankruptcy court and I was upset with myself for missing out on such a prime short opportunity.
Supermedia, the company that emerged from those proceedings, also enjoyed positive EBITDA, thanks again to aggressive cost-cutting and debt repayment and restructuring. As a result, to my astonishment, Supermedia became one of the hottest stocks in the market for a time in 2010, soaring to almost $50 a share. We all know how that movie ended, though. Revenues continued to drop, debts continued to weigh the company down, and pretty soon, it was back in bankruptcy court. The only difference that time was that I didn't make the same mistake twice. Just like I'm doing with DXM now, I shorted Supermedia and I made a nice return when they merged with Dex One.
The plain fact of the matter is that a business can't cut its way to revenue growth. Investors would be wise to remember that when they hear about the "cost synergies" Dex Media will achieve by combining the operations of Supermedia and Dex One. Reducing costs and retiring debt might spruce up balance sheets long enough to lure in a few new credulous investors. But unless this new company magically finds a way to convince more customers to pay for an outdated service that fewer and fewer of them have even heard of, bankruptcy will close the book on DXM yet again.