It is fairly rare that MagicDiligence has an unabashed negative opinion towards a Magic Formula stock. Joel Greenblatt's strategy is mechanically designed to find what should be good companies that are trading at cheap valuations. A number of provisions are made in the mechanical formulas to prevent poor stocks from making it in. For example, companies with a lot of debt and little cash are penalized by using enterprise value instead of market capitalization. While there are certainly bad stocks in MFI, the truth is that a solid majority of the stocks filtered by the official screen are "OK" to "great" potential investments.
That said, SuperMedia (SPMD) is just a bad Magic Formula stock. The company is the post Chapter 11 re-spawn of Idearc (formerly IAR), a stock so bad that it was one of the reasons for starting MagicDiligence in the first place. After reorganizing in bankruptcy court, SuperMedia's balance sheet is better - but still pretty ugly. Moreover, the business itself has basically not changed at all. Let's take a look.
The company is a publisher of telephone directories in the U.S., the 2nd largest in the country. Some publications include the White Pages for residential listings, Yellow Pages for business, an online presence with Superpages.com, SuperpagesDirect direct mailers, and Superpages Mobile for cell phones. The company earns money through selling advertising. Traditionally the Yellow Pages are an excellent source for local businesses to acquire customer leads. Idearc was spun off from Verizon (NYSE:VZ) in 2006, filed for bankruptcy protection in March 2009, and re-emerged with the new moniker at the start of this year.
SuperMedia does have a key competitive advantage: it uses the Verizon name on its directories in locales where Verizon provides local phone service. Since many people naturally trust what looks like the official directory (the one with the Verizon logo) over competitors, it allows SuperMedia to charge more than non-official publishers like competitor Yellowbook (YELL).
From a big-picture perspective, though, there is little growth potential in SuperMedia. The company has posted revenue declines every year since being spun off, and in 2009 sales fell 16%... 19% in the final quarter of the year. Competition is everywhere. In the publishing space, Yellowbook has been a thorn in the side, competing aggressively in nearly all of SuperMedia's markets and driving down ad rates. In the online space, SuperPages.com is at a major disadvantage to the big search engines like Google (NASDAQ:GOOG), which already incorporate locale when serving search ads. Location-based services have been pushed heavily in many mobile device applications, further eroding any advantages SuperMedia may have had. In all likelihood, SuperMedia's revenues will continue their long, steady decline.
This is unfortunate, because even after reorganization the balance sheet is still pretty ugly. The firm was able to whittle down debt obligations from over $9 billion (yes, with a "b") to a still very high $2.7 billion, due in 2015. Interest on this debt is obviously junk rate, at 8% over LIBOR with a minimum of 11%. Considering how low LIBOR rates currently are (less than 1%) compared to historical averages (4-5%), it is conceivable that this could increase to as much as 14% during the term of the loan. Even at 11%, I calculate operating earnings covering interest at no more than 3 times, which is just too low (MagicDiligence likes 5 times over at the absolute minimum). With declining sales, that ratio will tighten.
Also, I don't think SuperMedia will have the cash flow left over to pay down the debt by maturity. The balance sheet shows about $212 million in cash, and annual free cash flow around $400 million. That's almost 7 years to repay, and that's also assuming the company can maintain those kinds of cash flows, which is unlikely given the competitive picture. Also, you can forget about share buybacks or a dividend here. All of these things will contribute to a consistently low valuation.
The stock is certainly cheap with an earnings yield of 23%, but this is justified in my view. Magic Formula investors may have noticed an anomaly where the screen was calculating the market cap at $6 billion instead of the proper $630 million. This was due to using the old Idearc float of 147 million shares, instead of the "new" SuperMedia float of 15 million shares.
In short, SuperMedia is lipstick on the pig that was Idearc. It's still a pig, and still a bad Magic Formula stock. Avoid it.
Disclosure: Steve owns no position in any stocks discussed in this article.