The Long and Short of Idearc

Idearc, Inc. (IAR) was spunoff from Verizon Communications (VZ) on November 17th, 2006. Idearc initially struck us as being a very attractive spinoff. As a result, we conducted some research and crunched the numbers to determine if this was a good investment opportunity. Our findings and analysis follow:

The Case for Idearc

We found IAR to be a promising spinoff because of its:

* 1 to 20 distribution ratio: Many people will have few shares and will likely sell them, depressing the price
* Different [and unattractive] business: Shareholders of VZ [telecom] would probably like to get far away from yellow pages, which would depress the stock price
* $9.1 billion in debt: With a market cap of just $3 billion, IAR’s share price could appreciate extremely quickly if debt was paid down
* Dividend yield of 4.89%: Management "expect[s] to pay dividends at an annual rate of approximately $1.37 per share" - Form 10-12B/A
* Impressive operating margins of around 45%
* Leading online yellow pages site at SuperPages.com

The Case against Idearc

Our biggest concern with Idearc is the industry in which it competes, and its massive debt load:

* Shares are currently $27.98 while debt per share is about $62
* Idearc operates in a very competitive industry of declining yellow pages advertising revenues - declining revenues alone will hinder IAR’s ability to repay debt
* The industry is evolving to compete with online advertising and IAR must be able to react quickly to its competitive environment. We believe the debtsignificantly hinders IAR’s ability to do so
* The cash situation is so tight that IAR may not be able to invest in SuperPages.com, even if it is the right long term investment

Valuation

Firstly, we value stocks as if they were companies that we must own forever. This is not the only approach, but is the one we have chosen to use here. We feel the best representation of IAR's value is its cash flow generation capabilities.

If one could buy the entire company, it would cost about $13 billion [Enterprise Value = Debt + Market Capitalization, or $9B + $4B]. Because one person just bought all of company [including debt], this person would be entitled to all of the interest and dividend payments. So, if you owned all of Idearc, you would receive $900M in cash, annually [$700M + $200M]. Idearc would pay for itself in 15 years [$13B / $900]. If we could be sure of this scenario, then we would definitely purchase shares of IAR.

At The Mercy of the Industry

IAR is at the mercy of the industry because the debt will hinder its ability to adapt and evolve. We are currently seeing battles fought over pricing and territories and we would not be surprised by a period of consolidation. The debt should hinder IAR's ability to be meaningfully acquisitive. However, if the industry does well we would expect IAR to do well because it is one of the largest players. We cannot be sure of how this industry will develop; consequently, we are not going to invest in a company as highly leveraged as IAR.

Summary

If IAR is able to stem revenue declines, maintain operating margins, and prudently invest in the business, then this investment opportunity could be truly remarkable. This is because highly leveraged spinoffs provide significant upside for the many reasons previously discussed.

However, should operating difficulties arise, IAR will find itself unable to make interest and/or dividend payments because the cash is so tight. So a potential investor must weigh the upside potential with the risks. For IAR, the upside and downside are extreme.

We will continue to look at IAR and see how this situation develops. To be clear, we are not saying IAR is a good or bad investment. We are only saying that there are significant uncertainties that prevent us from passing a judgment one way or the other. We hope that our analysis has provided you with some additional insight. And, although we don't have a recommendation on IAR, there are a few other spinoffs that we do like quite a bit.

IAR 1-month chart

Comments

[kkin365:]

Unexpectedly, we received our allotment of IAR (that shows how unattentive we have been with our holdings). The key issue, which the above story did not address, is the impact of on-line search engines and map services. omooc

2006 Dec 04 10:45 AM

[jbs:]

David,
The shift towards online search engines and map services is absolutely the most significant threat facing the industry. I guess I assumed that people were aware of this.

I feel that the industry is going to have to deal with online competition. I don't know how it will unfold, how dramatic the shift will occur, but it will be important. If IAR was in better financial shape I would feel much more confident in its ability to address this competition.

So the point here wasn't so much to say that the industry has issues, but instead to point out that IAR may be too risky because the debt severely hinders its ability to adapt to what we expect will be a changing industry. More concretely, they won't be in a good position to buy their competitors, and they may not be able to invest in SuperPages.com as much as they may like.




Jordan
Think Intrinsic

2006 Dec 04 01:17 PM

[glendokid:]

The comment that the $900M cash flow will pay for the company in 15 years overlooks the fact that the cash flow is rapidly declining! - look at the old Q's. In five years my guess is that the cash flow will be $400M. then it'll take 25 more years to pay for the company IF IT DOESN'T KEEP DECLINING.

Folks are also overlooking the following issues with the online business:

A. It is still a small part of revenue and income
B. It's growth rate is declining: 26.0%, 9.2% increases in revenue (YoY) in 2005, 2006 respectively. Twas growing at 80% per year in 2002.
C. Cost cutting has already been done in the on line search area, so there may not be saving to be had there.
D. There are major competitors to their on line search. Who do you think of when one says, "on line search" ?

The leverage is attractive, but this sure looks like the newspaper business to me.

2006 Dec 07 05:38 PM

[Chris Ripley:]

As a small business owner I can tell you Yellow Page advertising will be with us for many years to come. I simply could not run my business without a yellow pages ad (several of them in fact). Search based advertising is certainly an attractive venue for advertisement, but it is not the only one nor will it become the only one any time soon. The advantage a yellow page directory has is that it serves a small local market rather than a nationwide market which makes it less vulnerable to the online threat. I'm not arguing that Idearc will experience huge growth, but I don't think revenues are as vulnerable as some may assume.

2006 Dec 11 09:14 PM