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
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.
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