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Executives

Gregory W. Freiberg - Chief Financial Officer and Executive Vice President

Alfred T. Mockett - Chief Executive Officer, President and Director

Tyler D. Gronbach - Senior Vice President of Communications

Analysts

Todd Morgan -

Shagun Singh Chadha - CRT Capital Group LLC, Research Division

Shachar Minkove - JP Morgan Chase & Co, Research Division

Dex One (DEXO) Q3 2011 Earnings Call November 3, 2011 8:30 AM ET

Operator

Good morning, and welcome to Dex One Corporation's Third Quarter 2011 Results Conference Call. [Operator Instructions] Please note that today's call is being recorded, as well as webcast live over the company's website at www.dexone.com. I would now like to turn the call over to Mr. Tyler Gronbach. Sir, you may begin.

Tyler D. Gronbach

Thank you, Theresa. Good morning and thank you for joining us this morning. We will begin with comments from Dex One's CEO, Alfred Mockett; and CFO, Greg Freiberg. Following their comments, we will then have time for some of your questions.

I would like to quickly remind everyone, certain statements made today may be forward-looking as defined by the Private Securities Litigation Reform Act. We call your attention to our news release for the quarter ended September 30, 2011 and the company's Form 8-K furnished to the SEC this morning. These documents discuss third quarter 2011 results, as well as forward-looking guidance. The 8-K also includes the third quarter results package, which provides additional information pertaining to the quarter.

We encourage you to review these materials and the company's other periodic filings with the SEC, which is set forth the important risks and other factors that could cause actual results to differ materially from those contained in, or suggested by any forward-looking statements.

Electronic versions of Dex One's SEC filings can be obtained by contacting the company, visiting dexone.com, or the SEC's website at sec.gov. Copies of the news release and third quarter results package can also be found under the Investor Relations tab at our website.

Commencing on February 1, 2010, the company adopted fresh start accounting as required under GAAP, which had a significant impact on the reported results of operations in that year. These reported results were not indicative of our underlying operating and financial performance and are not comparable to any prior or subsequent period presentation.

During the call today, we will refer to certain adjusted figures that are non-GAAP financial measures. In the current period, such items include expenses, EBITDA, free cash flow and net debt. Some of these figures exclude stock-based compensation and long-term incentive program expenses, fair value adjustment and other items. Additional information about non-GAAP financial measures as well as a reconciliation between these items and the comparable GAAP measures, can be found in the press release and related 8-K furnished to the SEC.

One final reminder. This call is the property of Dex One Corporation, and any retransmission or broadcast without the expressed consent of the company is strictly prohibited. With that, now I'd like to turn the call over to Alfred.

Alfred T. Mockett

Thank you, Tyler, and good morning. Since our last conversation, we have continued to deliver on our strategic plan, drive operating results and position the company to capture a greater share of clients' digital marketing investment. In the quarter, we posted 15% growth in digital sales, which now represent 16% of total ad sales, increased sales and customer retention from bundles, and delivered quarterly ad sales that marginally overachieved our guidance range, and financial performance that keeps us on track to achieve our full year guidance.

Just under a year ago, I held my first Dex One quarterly call. This morning, I'll take a look at our progress so far, review third quarter sales performance, and provide our [ph] sales outlook for the fourth quarter. Then I will ask our new CFO, Greg Freiberg, to provide a financial overview of the quarter, following which we will take your questions. Greg joins us from Savvis, where over the course of 2.5 years, he helped create nearly $2 billion of equity value by navigating their business' transformation and return to growth. Since joining us in September, Greg has spent a considerable time on the financials, taking a deeper dive into the business and evaluating our strategic alternatives. We are very pleased to have Greg on the leadership team.

Over the past 12 months, we have focused on 3 critical areas: people, partnerships and packages. We focused on the strategy that puts the best people selling the broadest set of marketing solutions, by partnering with the leading digital players to build simple and effective packages. Looking beyond this year, in the view in part supported by an assumption that the economic headwinds would turn to tailwinds during 2011, we had anticipated that by the end of 2012, we would return to growth and have digital ad sales in excess of 30%. This will not happen for 2 reasons. First, local business has not participated in the recovery to the extent the recovery existed. The prevailing view is that at best, we are in a very slow recovery or potentially heading to a double-dip recession. Local business is seeing little to no new business formation, no job creation, no injection of new capital. Our customers are exercising extreme caution and restraint in spending.

Second, the secular shift to digital is happening faster than anticipated, resulting in a relatively steady rate of decline of print. Now while this is a disappointment, this is an exciting time for the digital business. Search engine marketing sold via our proprietary Dex Net engine is up 30% compared to the third quarter of 2010. This underscores that customers are willing to buy digital services bundles. We are rapidly expanding our digital offerings, and we have opportunities to increase our penetration rate and share of wallet.

We continue to work towards having a full complement of digital services by the end of the first quarter of 2012. This will help us to continue to close the gap, offsetting print losses, which we expect to decline at double-digit rates over several years with digital gains increasing at a faster pace than market. We are driving towards the inflection point where digital growth can overcome print decline. Along the way, we will expect strong cash flow from print while we capitalize on digital opportunities.

Although we continue to make significant advances in the critical areas of people, partnerships and packages, we do not have enough visibility into external factors to be specific about when we will return to growth. Now looking at the progress we have made against initiatives outlined for the year. First from a people perspective, we've assembled a leadership team that possesses a wealth of experience leading companies through transformation across a number of industries. So far, we have reduced headcount by 1,300 people, but in a skills refresh, we've recruited 700 professionals primarily in sales, digital development and marketing. We have therefore reduced our staffing by over 600 employees or 17%.

We're differentiating ourselves by building a high-energy, digital-savvy sales organization that is committed to winning in the marketplace. We established the Dex One Sales Academy to increase the effectiveness of marketing consultants and launched the continuous learning curriculum that leverages computer-based training. In addition, we've supplied marketing consultants with iPad loaded with customized sales apps, giving them digital web-based conferencing and will shortly provide them with a new customer relationships management platform from salesforce.com.

We have also improved our portfolio of digital services and solutions by partnering with leading digital players. As Google recently announced, we are one of approximately a dozen U.S. companies that were invited to participate in their premium SMB partner program. As a top-tier partner, we are authorized to conduct joint promotions, have access to additional technical tools from Google, have access to Google's technical and engineering support, have visibility into Google's product pipeline, and finally can benefit from financial incentive program.

In addition, we have signed agreements with 11 leading digital companies over the past year including Yahoo!, Bing, and Yelp to increase our speed to market, improve the breadth of our digital services, and help deliver more high-quality leads. This represents significant progress. In fact, I believe we've completed one of the largest single-year service upgrades in our industry, though there is more to do. In the coming months, we intend to introduce digital display on additional platforms, social media and search engine optimization services.

Finally from a packaging perspective, customers are responding favorably to the introduction of new service bundles. In fact, we have sold more than 20,000 bundles since we started in June. 10% of these are the ultimate bundle, Dex Guaranteed Actions, which is a bundle combined with a performance guarantee. We've created these integrated service packages that combine our most effective solutions at our best prices end easy to buy yet customizable sets. They deliver the right amount of valuable leads to customers and help them manage their digital presence.

During the quarter, 30% of ad sales were generated from bundles, and customers who purchased them spent over 10% more this year compared to last year. More than half of the bundles incorporate at least 4 services. By increasing the number of marketing services that customers purchase from us, bundles are expected to increase retention rates. They are also helping us to generate approximately twice as much spend from new customers compared to those new customers who are buying solutions à la cart.

Turning to the third quarter sales results. Ad sales and bookings declined approximately 40%. As anticipated, major metro performance declines in the print product, and a digital solutions set that is still expanding, all weighed on results. Continuing introduction of new digital solutions, together with a rollout of bundles, are expected to help mitigate declines in our major metro areas. Continued improvements in digital performance from existing solutions, adoption rates for bundles and increased sales efficiency, contributed to a 2% year-over-year moderation of ad sales trends.

Bundles are working. Digital sales are improving, and our customer contact center is helping us to increase the number of customer touch points without increasing the number of marketing consultants. In fact, we have planned to open additional customer contact centers in 2012 to enhance our ability to service local business. This efficiency is creating additional sales capacity that we are redirecting to digital specialists. We have a limited number of these specialists today, but we anticipate increasing their ranks as we migrate from being a digitally light to offering the best whole suite of services within our market. Looking forward, we expect ad sales trends to continue to moderate in the fourth quarter. We anticipate the year-over-year decline to be between 12.5% and 13.5%.

So in summary, we have made substantial operational progress since last year. While ad sales results are slightly better than guidance, we recognize that we need to continue to improve. We believe the next several quarters will remain challenging, but we anticipate getting closer to growth over time. And with that, I'll turn it over to Greg.

Gregory W. Freiberg

Thank you, Alfred, and good morning, everyone. I'm excited to join Dex One as CFO, and I'm pleased to have this opportunity to discuss our progress. I've spent the last 2 months meeting and listening to employees, clients and partners as they share their ideas and passion about helping local business and consumers connect. I get it, and I'm just as passionate to be here.

As way of background, I come to Dex One with significant experience in helping companies transform. I've worked in small, rapidly growing technology companies; large, balance sheet constrained companies, and firms that were transitioning their business model. The common thread across all of these is the determination to improve the operating model and create additional shareholder value.

I was attracted to Dex One for several reasons, including my strong preference to work for companies that are underestimated by competitors. We have the scale of 400,000 clients and significant free cash flow to assist our transition to digital. I admire Alfred in what he's achieved throughout his career, and I thoroughly agree with the vision and strategy he has established. I am focused on assisting the team as we transform the business and return to growth.

So let's dig into the quarter. During the third quarter, we prudently managed expenses. We took steps that are expected to help us improve our capital structure, and we continue to generate robust EBITDA and free cash flow.

Starting with ad sales. Declines were primarily driven by a net client loss of 9% and a decline in average sales per customer of approximately 5%. Looked at from another viewpoint, we saw a loss on sales through existing clients of 18% partially mitigated by a 4% gain from new customers.

Ad sales trends moderated, thanks in large part due to digital sales. Digital sales grew 15% this quarter compared to the prior year, driven by the launch of new products at the end of the second quarter as well as solid performance of our existing digital suite. Digital growth rates have been accelerating, which we expect to continue.

Turning to the financials. Revenue, our deferred and amortized view of top line results was $360 million, down 17% compared to the third quarter of 2010. Bad debt was 4.2% of revenue, a 1 point increase from last year but within the normal range. Total expenses were $214 million including $4 million of restructuring charges. When including restructuring, expenses were down $21 million or 10% from 2010. Primary areas of savings were headcount, more focused digital operations, and lower print-related costs.

We remain on track to achieve our full year target of approximately $125 million of net expense reductions. EBITDA was $146 million, representing a 41% margin. Cash interest was $59 million. CapEx was $4 million, and working capital and other was a use of cash of $5 million. This resulted in free cash flow of $78 million for the quarter. We ended the quarter with $195 million of cash on the balance sheet.

We continue to reduce our debt and look for ways to increase balance sheet flexibility. During the quarter, we repaid $52 million of mandatory debt obligations and increased our cash reserves. At the end of the quarter, net debt was $2.4 billion and leverage was 3.6x. We maintained our significant tax attributes that will help us generate strong cash flow conversion for many years.

During the quarter, we elected the PIK option on our $300 million of subordinated bond for the semiannual coupon that is due March 2012. This will result in interest being paid half in cash and half in PIK. This has no cash impact in 2011. We are constantly monitoring and evaluating options that can create value for Dex One. We see that our debt instruments are trading at attractive prices, and our goal is to obtain amendments to our credit agreements to allow us to repurchase debt below par.

Finally, our 2011 guidance remains unchanged, although we expect to be at the low end of the range for revenue and EBITDA. Free cash flow should be closer to the midpoint, and net debt will be under $2.35 billion. In addition, we are confirming that the restructuring program we announced a year ago is still expected to have an aggregate expense and cash cost of up to $50 million. The current cumulative expense and cash cost are $38 million and $27 million respectively. Additional expense will be incurred prior to the end of this year, although the cash cost will linger into the first half of 2012.

So to wrap it up, we delivered solid EBITDA and free cash flow as we continue to take costs out of the system and work to improve our capital structure. Operator, we are now ready to take questions.

Question-and-Answer Session

Operator

[Operator Instructions] Shagun Singh of CRT Capital Group, you may ask your question.

Shagun Singh Chadha - CRT Capital Group LLC, Research Division

I was wondering if you could talk about EBITDA trends by markets, and where you're seeing disproportionate strength versus weakness? And then I have a follow-up question.

Alfred T. Mockett

Well, we can't provide that level of specificity on EBITDA. But what I can tell you in terms of market trends, about 40% of our revenue comes from the major markets. We have 9 major market in major metro areas, and 60% of the business is in Tier 2, Tier 3, and rural communities. What we see is the major metros underperforming the market, the average, by about 5 points, and the Tier 2, Tier 3, and rural overperforming the average by about 3 points, and that's how we get the mix.

Shagun Singh Chadha - CRT Capital Group LLC, Research Division

Okay, that's helpful. And I just was wondering if you could talk a little bit more about the ad market and what you're expecting in the fourth quarter? Are you expecting more of a deceleration from here and into 2012, just also as it relates to digital ad sales guidance that you just provided?

Alfred T. Mockett

Okay well, first of all, let's deal with the baseline of the print decline. The latest data I looked at, actually that's the last 4 years, the average decline in print through [ph] other industry is about 19.5%. Now we, traditionally, we have been able to outperform that print decline by 2 or 3 points, and we're confident that we can continue to do that with the introduction of bundles and DGA. And so that's one side of the equation. On the digital side of the business, of that estimate are that the digital market that we're addressing, our addressable market is growing of the order of maybe 20% a year or so. And we believe -- in fact we're quite confident that we can outperform that market going forward.

Operator

Todd Morgan of Oppenheimer.

Todd Morgan -

There's a slide -- in the -- during the slide deck, that talks about a 9% year-over-year customer decline. I think that's sort of gradually getting smaller with time. Is there any way you could sort of conceptually split that number up? I imagine there's a couple of buckets where there's probably a natural turnover level, just probably a percentage of those customers, who are actually going elsewhere. And there's probably a group that's just simply not able to participate, because of credit or business closure reasons. I don't know if you have any sense of what that split might look like.

Gregory W. Freiberg

It's Greg. About 40% of the customers who leave are involuntary. And so that would be that people with their business has been distressed and they are no longer in business, or they've not met our credit profile. So just under half.

Todd Morgan -

Okay and so then are there customers who are simply exiting and taking their spend elsewhere? And what part might that look like? Would you have any sense of that?

Alfred T. Mockett

Yes, that is close to the balance. That is the secular shift from print to digital. And coming into this year, we were quite frankly product-stocked. We didn't have a full suite of digital services. We rapidly expanded that digital suite, and we will round it out in the first quarter, with the release of high-end SEM digital display and social media products. At that point, we feel confident we're in a position to capture the migration of that spend.

Gregory W. Freiberg

I think you quite see that overall change improving on the slide.

Todd Morgan -

In the same vein, I think on a different side, you talked about the 4% sort of new customer revenues. Can you generalize about what that revenue spend looks like, digital versus print? Or are there other ways to characterize that versus your...

Alfred T. Mockett

Yes, in terms of our new revenue, we are finding that at least 40% of the new revenue is coming from the digital portfolio.

Operator

[Operator Instructions] Our last question comes from Shachar Minkove of JPMorgan.

Shachar Minkove - JP Morgan Chase & Co, Research Division

I wanted to -- nice to see the cash building on the balance sheet. Wondering if you can just give us a little bit of visibility into how the cash splits up between the different entities, east, west and RHDI?

Gregory W. Freiberg

I don't have that in front of me. I think we can follow up on that.

Alfred T. Mockett

Well, thank you, for your interest and your questions. We have made a lot of progress on our transformation in only a year, but there is much more left for us to accomplish. Our top priorities are to leverage our sales channel that provides unique access to and influence over local business, expand our digital partnerships and service bundles, and package our services of simple and effective bundles. Thank you for joining us today. I look forward to providing updates on our progress and achievements on our next call.

Operator

This concludes today's conference call. Thank you for your participation.

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