Yellow Pages vs. Internet Ads: The Long Case for R.H. Donnelly

| About: RH Donnelley (RHDC)

John Osterweis, Osterweis CapitalNewsletter Value Investor Insight carried an interview January 31st with John Osterweis, who's equity fund has returned 15.3% annually over the past 10 years, versus 8.4% for the S&P 500, according to Value Investor Insight. Here's the excerpt from the interview (also with analysts Matthew Berler, Michael Hughes and Sasha Kovriga) in which they discuss R.H. Donnelley (RHD), which was trading at $66.50 at the time of the interview (current price here):

What interests you about telephonedirectory company R.H. Donnelley (RHD)?

Matthew Berler: Publishing YellowPages remains an excellent business, primarily because the return on the advertising dollar for local businesses remains among the highest of any option they have. Even as the Internet has grown, Donnelley’s customer renewal rates are still higher than 90% and – with minimal capital spending necessary to remain competitive – EBITDA margins are still above 50%.

Donnelley has a product advantage because they’ve assembled the directory businesses of the regional Bell operating companies in several southeastern and mountain states, as well as in Chicago. These so-called “incumbent” directories typically have more comprehensive listings, broader reach, large and more established sales forces and can command premium prices compared to the upstart competition in each market. It’s surprising the Internet hasn’t been more of a threat.

MB: Donnelley essentially makes its listings available to the Yahoos and Googles of the world for free and then upsells to current clients services that enhance their web marketing capabilities and how they appear in the online listings. We view the Internet as another form of distribution for companies like RHD, which are gathering immense amounts of listing information. They have to keep the information fresh and updated, and have thousands of salespeople making sure the information is current. Our bet is that any competitive damage from the Internet is not going to happen nearly as quickly as the stock market seems to expect. We just don’t think it’s that plausible for Google and Yahoo to try to replicate what the directory companies do.

JO: While the company’s valuation might indicate the market views this as an overleveraged, dying business, whenever a directory business comes up for sale, there’s a feeding frenzy on the part of private- equity buyers. They’re seeing something different, which is a business with extremely low capital spending and extremely high cash flow. We’re attracted to the cash flow. Donnelley is paying down debt very rapidly and we expect them to be able to start buying back stock hand over fist as early as next year.

Are you counting on any growth?

MB: Management insists it can deliver 2- 4% revenue growth per year. We’re not that optimistic, but see no reason they can’t grow 1-2% annually from continuing to roll out new directories and from online upsells. There is plenty of leverage in free cash flow, though, which we expect to grow from $9.40 per share this year to more than $11.50 in 2008. Much of that comes from lower costs, from declining interest expense, reduced merger-related expenses after the recent acquisition of Dex Media, and the winding down of upfront spending to build their online capabilities.

With a recent share price of $66.50, how are you looking at valuation?

MB: We look at it in a couple of ways. Based on free cash flow, the stock is very cheap, trading at a 14% free-cash-flow yield on 2007 numbers and a 17% yield on next year’s numbers. If you believe, as we do, that the company can deliver some top-line growth, continue to deliver great free cash flow and pay down debt so that the general risk profile improves, it’s not unreasonable that in 12-18 months the market would re-rate this to a 10% free-cash-flow yield. That would result in a $115 share price.

Looking at it another way, over the next five years we expect Donnelley to generate free cash flow with a discounted present value of $60 per share. That’s almost the current stock price, and what you get in addition to that is what we think will still be a very substantial operating company five years from now.

What’s the biggest risk?

MB: The biggest risk is that we’re wrong about the extent to which the Internet impacts the directory business. But we keep coming back to the fact that these companies provide very valuable content to both advertisers and users, which is not at all easy to replicate. As long as they continue to do that, we expect this to be a very profitable business for a long time.