Starting Point - Valuations are Crazy
Two companies earn a dollar. As I write this, the dollar earned through a state of the art professional network on the Internet is valued at 2480x the same dollar earned through the distribution of yellow pages directories and custom digital advertising solutions.
How can this be true?
To buy $1 of LinkedIn earnings, it costs you $893.
To buy $1 of Dex One earnings, it costs you $0.36.
These are called earnings multiples. The implications are basic.
$1 earned by LinkedIn is worth $2480 dollars earned by Dex One.
$1 earned by Dex One is worth $0.0004 dollars earned by LinkedIn.
It begs the question. Is a LinkedIn (LNKD) dollar really intrinsically worth 2480x that of a Dex One dollar? The point of this illustration is not to argue that LinkedIn owners are clueless, but that Dex One owners are truly owners of a situation that is priced for Bankruptcy. For those of you familiar with the Altman Z-Score, it is true that both Dex One and SuperMedia are in the Grey Zone.
Introducing a Non-Bankruptcy Bankruptcy
Dex One (DEXO) and SuperMedia (SPMD) are planning on merging to form Dex Media. The merger is subject to the negotiation of acceptable credit agreement amendments with both of the companies' lenders. More recently, SuperMedia outlined in their latest form 425 and Dex One discussed on their conference call that they are considering the use of a pre-pack Chapter 11 bankruptcy in order to implement the terms of the merger agreement whereby the equity interests remain intact. This bankruptcy as they talk about it is really a refinancing in disguise. The only difference is the means to the end. The end result of a refinancing is the exact same as the end result of what is being proposed. The reason that Chapter 11 is being used is because the companies are having difficulty getting 100% of their creditors on board. As such, through the use of a pre-pack Chapter 11, they only need 66% of their creditors on board and a judge's approval.
This is a situation where the company is not defaulting on their equity obligations. This is a pre-pack Chapter 11 that I support.
Introducing a Bankruptcy Non-Bankruptcy
The Companies' Creditor Arrangement Act (CCAA) is frequently considered Canada's version of Chapter 11. For companies in less financial trouble, the Canada Business Corporations Act (CBCA) is, in theory, is preferable for shareholders to CCAA.
In theory, one would expect that if you have two companies with more or less the same financial metrics and one of them is pursuing CBCA in Canada and the other one is pursuing Chapter 11 in the USA, the one that we should expect to retain the most value for shareholders should be the one filing CBCA because it is an agreement that both the shareholders and the creditors support. Given that I just outlined a Chapter 11 that is really a refinancing in disguise, I am going to do the opposite and introduce an agreement between shareholders and creditors that is really a forced bankruptcy in disguise.
Yellow Media (YLWPF.PK)in Canada is looking to recapitalize when it is my opinion that they should be looking to do exactly what SuperMedia and Dex One are doing. Yellow Media is less leveraged and has higher margins.
That said, Yellow Media is choosing to write down their debt at an EXTRAORDINARY price after announcing Second-Quarter 2012 Financial Results that beat analyst expectations by a wide margin.
Common shareholders are going to end up getting around 7% of the recapitalized company. As a common shareholder, if you owned $250M of FCF of a company with $1426M of net debt, you are now going to end up owning around $20M of FCF of a company with $820M of net debt.
Would you trade the income differential of $230M/year for around $600M of debt forgiveness? Me neither. This is effectively a bankruptcy where the equity interests are left with next to nothing.
I have learned through this process that things are not as they seem. Bankruptcies are not always bankruptcies as we know them where shareholders get wiped and creditors take over. Agreements between shareholders and creditors are sometimes more like bankruptcies than bankruptcies themselves. In the cases illustrated above, American Chapter 11 is less of a bankruptcy than Canadian CBCA.
The differential is easy to identify. In the American Chapter 11, management is acting in line with their fiduciary duty. In the Canadian CBCA, management is defaulting on their equity obligations. It begs the question, is management being forced to default on their equity obligations as they claim to be? Perhaps.
It is my understanding that the group of creditors that Yellow Media is negotiating with are hostile and looking to takeover the company. Compare that to the group of creditors that SuperMedia and Dex One are working with that sound more open to the idea of working with the companies to effectively refinance. Perhaps this differential in creditor types and their understanding of the situation is related to the prior bankruptcies of Idearc (SuperMedia) and R H Donnelley (Dex One).
While Yellow Media looked like it was going to be a multi-bagger (10x return or more), this effective bankruptcy reduces the return I expect on my invested capital to around 5x from where we sit today. Meanwhile, Dex One and SuperMedia appear to be refinancing and in that case I think that the upside from today's market price is around 25x my money --- if not more.
The Bottom Line
If you are a shareholder and you don't own enough shares to takeover the company and remove management, you need to take into consideration the ability and willingness of management to represent your interests especially in situations where the company needs to refinance, because this need can be taken advantage of by creditors who may want to take over your company and leave you out to dry. If you want to take advantage of the American Chapter 11, buy SuperMedia and join me while we make over 10x our money.
Disclosure: I am long SPMD, DEXO, YLWPF.PK.
Additional disclosure: I do not own LinkedIn and recommend that anyone that does re-consider their investment hypothesis if their goal of ownership is to make money.