Look For Significant Improvement In Dex One's Balance Sheet And Valuation Metrics

Mar.23.12 | About: Dex Media (DXM)

Dex One's (DEXO) problems are not operational. The business continues to throw significant cash and while the print portion of the business is on the decline, the company is working on its cost structure to eliminate $120 m in cost this year to offset the EPS decline from the print. The digital segment, I expect will continue its growth on the top line at a 30% clip, while at the same time we could see some margin improvements now that the company is done recruiting and training its digital sales force and they will be fully productive.

The problem has always been financial. The capital structure it inherited coming out of the RH Donnelley bankruptcy is onerous. The stock trades at these levels not due to doubts about its cash producing and profit generating capabilities. The stock trades so low because the investors are understandably worried about the capital structure.

In this light, it is now a good time to review the recent moves by the company to address the debt and the effect it is likely to have on the balance sheet and the income statement.

2011 FY Ending Consolidated Balance Sheet

Dex One ended FY 2011 with an equity balance of -9.9 million, a cash balance of $257.9 million and total outstanding debt of $2.5 Billion. The company has 50.2 million shares outstanding.

Sub Par Debt Repurchase

The company recently concluded its first installment of debt repurchase under par. In this transaction the company bought back $142 million in face value of debt of its various subsidiaries for $70 million. This transaction was concluded in the Q1, 2012 and will materially impact the Q1 balance sheet.

The company has another tender of debt repurchase outstanding for its Dex One Senior notes (maturing 2017) where it wishes to utilize $26 million in cash to purchase debt at between 27% and 30% of the par value. The tender is open till Apr 19, 2012, which will fall into Q2 2012.

Effect on the Balance Sheet Q1 and Beyond

The Q1 debt repurchase creates $142 -$70 = $72 million in additional equity. Assuming the Q1 net income is positive, the equity line on the Q1 balance sheet will be at least $62 million ($72 in new equity - $10 million in Q4 equity balance).

Q1 is also traditionally the strongest quarter for Dex and the various signals from the company do indicate that the business is performing at or a little above expectations. For example, the face value estimate of the debt to be repurchased this year started at $200 million, then it was increased to $400 million and now again increased to $500 million. I do take it as a signal from the management that they are increasingly comfortable with how Q1 is shaping up in terms of earnings and cash flow.

Depending on how the repurchase of $300 million Dex One Senior notes go, it can potentially add another $55 million in equity to Dex One's consolidated balance sheet in Q2. If everything goes according to the plan, it would not be surprising to see Dex One end 2012 with $250 m+ equity on its balance sheet from debt repurchases alone. Profitable operation will of course increase this value.

As a reference, for investors who look at Price to Book ratio as a valuation metric, the market value of the company as of today (Mar 22, 2012) is $59 m, which is below the expected Q1 Book Value.

Impact on the EPS

I do not expect this debt repurchase to have a material impact on the Q1 EPS. However, Q2 will show a reduction in interest expense on the portion of the debt that has been retired as follows

Note Amount Repurchased Weighted Interest Rate (as of Dec 31, 2011) Annual Interest savings
RHDI $92m 9% $8.28m
Dex East $23.6 m 3% $0.71m
Dex West $26.6m 7.2% $1.92m
Total $142.2m 7.67% (weighted) $10.91m
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$10.91 m in annual interest savings adds 0.22/share in eps annually, or 0.055/share per quarter.

The Dex One Senior note debt repurchase when completed, will retire approximately $81 million (estimated) in debt at a interest rate of 12% (14% for PIKs). This should generate additional $9.72 million in annual interest savings. This translates to 19.4 cents/share in additional eps improvement annually, or 4.8 cents/share quarterly (debt is payable semi-annually, but needs to be accrued).

According to my model, the eps gains through interest savings, cost reductions, and growth in the digital segment completely offsets the eps losses due to the print decline in 2012. As a result, barring any one off or extraordinary charges and any tax related adjustments, I expect the 2012 EPS for Dex One to come in at $1.8/share or better. This does not include any further debt repurchases below par that the company may engage in this year.

It is also worth noting that starting Q2, 2012, the goodwill charge will be off the ttm eps number for Dex One and should result in much cleaner and more representative earnings figure.

Impact on the Cash Flow and Going Concern Fears

The going concern fears largely rest upon the ability of the corporate entity to service the Dex One Senior Subordinated note (2012). This is reflected in the substantial discount at which the Dex One Senior trades in the debt market. The subsidiaries, while their debt matures earlier, do not have the same immediate cash flow concerns. The consummation of the $26 m debt repurchase at the corporate level substantially below par results in a decline of about $10 million a year in cash flow requirements for interest payments (more if you consider principal payments). Additionally, improved cash flows at the subsidiaries also increase their ability to upstream cash to the corporate. As a result, the Going Concern fears around the corporate entity should ease. If additional Dex One Senior debt is repurchased this year, than this issue might very well be moot by the end of 2012.

At the subsidiary level, barring any significant changes in the industry dynamics, I expect these businesses to continue to generate cash, service and reduce their debt and be in a position to refinance successfully in Oct 2014.

From my perspective, the risk/reward equation in DEXO stock is attractive. The management is taking all the right steps to strengthen the balance sheet and improve their capital structure. The stock, however, will continue to be volatile until more pieces fall into place. Do your own due diligence and stay within your risk tolerance.

Disclosure: I am long DEXO.