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The share price of directories publisher SuperMedia (SPMD), formerly known as Idearc, is down nearly 90% since it re-listed on Nasdaq following the exit from bankruptcy in January 2010. At the recent price of about $6.00 per share, the company has a market value of less than $100 million and an enterprise value of $2.3 billion.

Our thesis is that deleveraging will transfer significant value from debt to equity holders as the enterprise value trades at only 3.3x 3Q10 annualized EBITDA (with EBITDA up sequentially in every quarter of 2010 despite declining revenue), the debt does not mature until yearend 2015, and 3Q10 annualized FCF represents 20% of recent net debt — and nearly 5x recent equity market value!

Key reasons why SuperMedia may be undervalued include: 1) emergence from bankruptcy at year-end 2009; 2) “fresh-start” accounting quirks which result in low GAAP revenue and net losses (not reflecting the true economics of the business); and 3) a general “out-of-favor status” of traditional advertising providers.

While there is a possibility that equity holders lose again as a result of another bankruptcy or dilutive share issue, the market appears too pessimistic regarding the company’s prospects. This sets up an upside potential in the equity that is large enough to warrant closer examination, despite the lack of downside protection. The key risk is that the underlying business deteriorates so quickly and substantially that cost-cutting cannot be done at a pace and scale necessary to preserve recent free cash flow generation.

SUPERMEDIA: FRAMING THE EQUITY UPSIDE POTENTIAL

($ in millions) Conservative Base Case Aggressive
Valuation Methodology1 5x normalized EBITDA-capex

(assumes revenue at 90% of 3Q10 annualized net ad sales, 3Q10 actual EBITDA margin and capex at 2% of revenue)

5x normalized EBITDA-capex

(assumes revenue at 100% of 3Q10 annualized net ad sales, 3Q10 actual EBITDA margin and capex at 2% of revenue)

5x normalized EBITDA-capex

(assumes revenue at 100% of trailing net ad sales, 3Q10 actual EBITDA margin and capex at 2% of revenue)

Normalized revenue $1,422 $1,580 $1,919
Estimated EBITDA margin2 35% 35% 35%
Normalized EBITDA $500 $556 $675
Less: Capex3 (28) (32) (38)
Normalized EBITDA less capex4 $472 $524 $637
Fair value multiple5 5.0x 5.0x 5.0x
Estimated Enterprise Value $2,359 $2,621 $3,183
Less: Net debt at 9/30/10 (2,165) (2,165) (2,165)
Estimated fair value of the equity of SPMD6 $194 million $456 million $1,018 million
$12 per share $29 per share $66 per share
Implied 3Q10 annualized FCF yield 223% 95% 42%
Implied 1Q10-3Q10 annualized FCF yield 257% 109% 49%
Implied EV-to-3Q10 annualized ad sales 1.5x 1.7x 2.0x
Implied EV-to-3Q10 annualized revenue 1.2x 1.3x 1.6x
Implied EV-to-3Q10 annualized EBITDA less capex 3.6x 4.0x 4.9x

  1. Our three valuation cases differ solely with respect to the "normalized" revenue assumption, which we think is the key value driver. Given the highly leveraged balance sheet, equity value changes dramatically based on small changes in assumptions. Therefore, our estimate of the fair value range should be viewed in that context: SuperMedia has significant upside potential if revenue can be stabilized at recent levels of advertising sales. Downside protection, however, is low given that there are no tangible assets and the fact that revenue and cash flow could decline dramatically if ad sales decline materially from the 3Q10 level of $395 million.
  2. EBITDA margin is assumed stable at the 3Q10 actual level for all three valuation cases. This implies an assumption that costs could be reduced on lower revenue relative to the "aggressive" case (revenue in the "aggressive" case approximates the revenue achieved in 3Q10 on an annualized basis). The company grew EBITDA margin from 31% in 1Q10 to 35% in 3Q10 despite revenue declining from $533 million in 1Q10 to $489 million in 3Q10.
  3. Assumes capex is 2.0% of revenue in each valuation case. This is in-line with the 2005-09 average. YTD through September 2010 capex is also 2.0% of revenue.
  4. EBITDA less capex was $162 million in 3Q10. On an annualized basis, this implies EBITDA less capex of $648 million, roughly approximating our figure used in the aggressive case.
  5. For reference purposes, competitor Dex One Corporation (DEXO) has recently traded at an approximate EV-to-EBITDA less capex multiple of 4x based on 3Q10 annualized EBITDA less capex.
  6. Based on 15.5 million shares outstanding.

What the market seems to be focused on:

  1. Declining net advertising sales: Net advertising sales, which drive future revenue, have been on a relentless downward trend (down 15% y-y in 3Q10) due to the secular decline in print advertising versus other ad platforms such as the Internet. The weak U.S. economy, and especially the difficult situation of small-and medium-sized businesses, has been another drag since 2008.
  2. GAAP net losses: The GAAP net loss is $252 million YTD through September on a GAAP revenue decline of 60+% y-y to $750 million (see below discussion on why this is misleading).
  3. High level of debt: Despite reducing debt by about $6+ billion since the bankruptcy filing in 2009, recent net debt to 3Q10 annualized EBITDA is 3.1x. With negative tangible shareholders’ equity, shares offer no downside protection.
  4. CEO uncertainty: In October, SuperMedia announced the sudden resignation of CEO Klein, who has led the company through the bankruptcy process. The company hired Peter McDonald, an industry veteran and former COO of Dex One, as interim CEO. The sudden departure of Klein and lack of a permanent CEO are not confidence boosters at a time when the company needs strong leadership.

What the market seems to be missing:

  1. Yes, net ad sales are declining…but EBITDA has grown every quarter in 2010 as the company is reducing costs. EBITDA is up from $163 million in 1Q10 (31% margin) to $165 million in 2Q10 (32% margin) and $172 million in 3Q10 (35% margin). With 5,000+ employees versus Dex One’s ~3,500 employees on a similar revenue base, the potential for further cost reduction appears significant.
  2. GAAP revenue and net income do not reflect the true economics of the business and are therefore misleading. As a result of fresh-start accounting following the exit from bankruptcy, deferred revenue and deferred directory costs were adjusted to their “fair value” of zero at year-end 2009. This means that $846 million of deferred revenue and $215 million of deferred directory costs are not recognized in the 2010 income statement. SuperMedia’s “true” revenue is not declining at the 60+% rate the GAAP figures imply. The company remains highly cash-generative despite reporting GAAP net losses. Free cash flow is $373 million YTD through September, including $108 million in 3Q10.
  3. Yes, debt is high…but it is manageable and forces discipline, which benefits equity holders. SuperMedia exited bankruptcy with $2,750 million of senior secured term loans and $212 million of cash at yearend 2009. Net debt is down by $373 million since then to $2.2 billion at September 30, 2010, as a result of the company’s free cash flow generation in the period. SuperMedia is in compliance with all of the debt covenants, which also stipulate mandatory debt principal payments (67.5% of any increase in the company’s available cash) each quarter through debt maturity at yearend 2015. This cash sweep provision results in automatic deleveraging and capital discipline which should, over time, lead to a significant value transfer from debt to equity holders. With no debt maturities before 2015, and 3Q10 annualized free cash flow representing 20% of recent net debt, SuperMedia should be able to manage its debt load without the need to raise new equity.
  4. The CEO change may be a positive as former CEO Klein appears not to have had the support of the company’s employees and board. The press release announcing the change did not thank Klein for his service or mention any of his accomplishments.
  5. Potential for value-creating industry consolidation. The lack of a permanent CEO at SuperMedia may open the door for potential M&A. Given that the traditional directory publishing industry faces secular revenue declines, industry consolidation may offer one way to more drastically reduce operating costs and preserve profitability. For example, a merger between Yell Group’s U.S. business or Dex One with SuperMedia may create significant cost synergies relative to the recent market value of SuperMedia shares. It is worth noting that funds controlled by “superinvestor” John Paulson own 17% of SuperMedia and 7% of Dex One as of June 30, 2010.
  6. What about the “growing part” of SuperMedia’s business? The company’s Internet-based advertising platform, Superpages.com, is one of the leading websites in the U.S. (Alexa ranks it #289 in the U.S. based on traffic). While SuperMedia no longer discloses revenue by ad platform, 10% of 2008 company revenue (equating to ~$300 million) was Internet-based, per the latest available data. This part of SuperMedia’s business is growing and deserves a much higher multiple than the traditional, print-based advertising business. Assuming Internet-based revenue of $400 million in 2011 and a 3x revenue multiple, the implied enterprise value of the print-based business is less than 1.0x 2011E revenue (assuming a y-y revenue decline of ~20%). This appears too low given 30+% EBITDA margins and minimal capex requirements.

Some background information on SuperMedia:

SuperMedia provides advertising services to small-and medium-sized businesses in the U.S. The company, which comprises Verizon’s (NYSE:VZ) former U.S. print and Internet yellow pages directory operations, was spun off from Verizon in 2006. It continues to be one of the largest U.S. publishers of directories, based on revenue. While revenue by ad platform is no longer disclosed, 80-90% of it likely comes from SuperYellowPages print directories and direct mail, while the rest is derived online at Superpages.com. A source of competitive advantage comes from an exclusive publisher deal with Verizon through 2036 in the markets in which Verizon is currently the incumbent local exchange carrier.

SuperMedia competes against different advertising media, including newspapers, radio, television, the Internet, billboards, direct mail, telemarketing and other yellow pages directory publishers. The latter include Yellowbook (the U.S. business of Yell Group), with which SuperMedia competes in the majority of its markets. To a lesser extent, SuperMedia competes against other directory publishers, including AT&T’s (NYSE:T) YellowPages.com, Dex One (DEXO) and Local Insight Media.

Disclosure: No positions

Source: SuperMedia: Priced as Though Bankruptcy Is a Foregone Conclusion