Dex Media (DXM), one of the nation's largest local marketing firms for small and medium businesses, may one of the best risk/reward small-cap equities, with upside of 100% near-term and as much as 15X in 18 months. Two key things seem to not be recognized by investors today-(I) Dex Media is a business generating fundamental momentum and high profit-margins, and (ii) an extraordinarily low valuation of 0.5X P/FCF is not consistent with the strong prices of its bank debt which trade at 52-week highs (FYI, media stocks trade at 10X P/FCF, not 0.5X). There are skeptics for this story, grounded on misperceptions about its capital structure and about the durability of its business model (transitions away from print). We highlight 6 reasons supporting our positive thesis on DXM:
- #1. High EBITDA/FCF margin business (41%/19%, respectively) with digital EBITDA margins of 15%-24% and growing. Dex Media operates a very profitable business and with a forecasted $1.9b of sales in 2014E, the company's free cash flow, after paying off interest, capex and taxes, is $370mm, or $21 per DXM share (19% of sales)- how many companies have that high a FCF margin?
- #2. Digital momentum has recovered (as new programs gain traction) and aided by easier comps throughout 2014…The stock suffered heavily last year as digital growth slowed sharply (due mainly to disruptions of marketing focus after the merger was completed) but growth has improved in the two most recent quarters, seeing digital growth of 5.1%/8.5% in 4Q13/1Q14, respectively. The company's start-smart and flex bundles are resonating with customers, and leading to re-invigorated digital growth. Moreover, digital comparisons get easier throughout 2014. As a result, we believe the company can generate 10% or better growth starting in 2Q14.
- #3. The recovery in the company's bank debt to 52-week highs and moving towards Par (price=100) means the stock will catch up, perhaps doubling in the near-term. One rule we have always followed in our 20-plus years following markets, is that bonds always lead stocks. DXM's bank paper have soared from below 70 in November 2013 to 82 or so today-a 52-week high. The last time the bank paper traded here, the stock was $24, meaning we should see a sharp move in the equity, likely if the company reports strong 2Q results (we expect that to be the case). The improved financial performance is behind the recovery of the bank paper and we believe it is only a matter of time before the bank debt recovers to par (price = 100). That would obviously support a much more dramatic re-rate of the stock's P/FCF multiple
- #4. We believe DXM will potentially do a global refinance of its existing bank debt in late-2014, with timing dependent on delivering continued digital growth (2H14?). The remains a major catalyst-CCC bonds yield 6% vs DXM's current 10% overall cost of debt-the 400bp incremental savings is $100mm annually, or $6 per DXM and also opens the door for the company to start buying back equity. Recall, the company is constrained today as its debt is structured by geographic silos of each operating unit.
- #5. Short interest is at an all-time high of 5.5mm shares, or 33% of the float, contrasting with the recovery in the bank debt. There are some who say this is due to buyers of bank paper shorting the common. This does not make sense. The total gross value of debt is $2.8b while the common market cap is $170mm. There asymmetry of this does not make sense. Moreover, short interest has been rising ever since the company reported slowing digital growth in middle of 2013. In fact, from November 2013 (right after the terrible 3Q13 results were reported), short interest soared from 3.5mm shares to 5.3mm within a month.
- #6. We believe Dex Media will ultimately strike a strategic partnership with a digital marketing partner [ala YELP (ticker: YELP-NASDAQ), etc], to improve their "value proposition" to customers and also to burnish their own reputation (most customers do not realized Dex Media is a Google premiere partner). This likely will validate the legitimacy of the company's market position and remind investors that with its $500mm of digital sales, it is one of the largest local digital advertising players.
- What could go wrong? There is considerable risk here, but we argue it is reflected in the valuation-after all, at 0.5X P/FCF, investors clearly are not paying for more than 6 months of operations. The greatest risk is digital momentum is not sustained and we see weak growth in digital-this does not seem to be the company's view and during their 1Q conference call, they noted that growth momentum will continue. Moreover, the company is targeting its existing installed base of 550,000 customers to upsell/bundle digital products. Each 5% increase in penetration from 36% represents 28,000 new digital customers or 15% growth.
THE UPSIDE CASE: A Re-rate to a more normal 6X P/FCF multiples means this stock is a 15X bagger…
As noted above, there are risks to the story, but we argue the positives significantly outweigh the negatives. To understand the upside case for Dex Media, it may help to take a look at the 4-year price chart for DXM below (log scale). The stock was $150 in 2010 and even after recovering from its lows of 2011, is still more than 90% off its highs.
- Note how applying round multiples of FCF result in the stock retracing much of its decline. If the stock holds $12, which we expect, it will seek $24, the 2013 high. That is 1X P/FCF multiple. The next key level is $47 which it saw in late 2010, or 2X P/FCF. And if it succeeds, it will seek $153, or 6X P/FCF. By the way, 6X is below the average media multiple (this implies a 17% FCF yield).
- We are using an 18-month time frame and assume DXM will trade using metrics applied to other media stocks. The most common metric is free cash flow multiples--media trades at around 10X-20X P/FCF but we believe DXM will trade at a discount to those others, because of the lingering skepticism. The 18-month timeframe is used because this allows the company time to execute its digital strategy and realize cost synergies (the bulk of the $175mm annually are realized in 2015).
- At 6X, the stock is valued at $153, or 15X bagger higher than today's prices.
#1: The core business model of local advertising is high-EBITDA and FCF margin
Dex Media operates a very profitable business, in terms of EBITDA and FCF margin, 41% and 21%, respectively. The company has a $1.4b NOL (NPV is $400mm) and therefore will not be paying cash taxes for at least 3 years. Take a look at the chart below.
- Note that of the $1.9b of sales in 2014E, the company's free cash flow, after paying off interest, capex and taxes, is $370mm, or $21 per DXM share. This works out to 19% of sales-think about that, how many companies have a 40% EBITDA margin and a 19% FCF margin? This highlights how much scale DXM enjoys as one of the largest advertisers for small and medium business.
Source: investagainstcrowd estimates
There are some investors who might say these high margins are only attributable to the legacy print directory business, and not their growing digital platform. That is simply not true-the company on several conference calls has noted that digital is profitable today.
Source: investagainstthecrowdguy estimates
- We did a composition analysis of their EBITDA margins. Backing out legacy print EBITDA, by applying a 45%-48% EBITDA margin (historical margin levels) to get the "implied" digital EBITDA margins.
- As shown, even after backing out higher print EBITDA margins, the implied EBITDA margin for their $528mm digital business is 15%-24%. And this margin is growing. There is a certain level of scale with the business. As the company has noted in the past, digital margins are going to be lower over time, because of the higher cost of distributing digital vs print-but it does not mean the business lacks scale.
- Additionally, we think Print will be around much longer than investors realize. After all, certain verticals such as contractors, services industries, construction, still see a lot of value in print. Moreover, rural and suburban areas are still users of directory, as well as older Americans. DXM noted that yellow pages shrank a decade ago from the major metropolitan areas. And the renewal rate remains a still impressive 80% for yellow pages.
#2: Comparisons getting easier on Digital…which was weak in the second half of 2013…
One of the reasons DXM stock fell sharply in 2013, was the rapid deceleration seen in their digital advertising revenues. As shown on the chart below, growth fell from 13.5% in 1Q13 to 0% by 3Q13. During that time, the equity fell from $24 to $4 and has since recovered to $11.
- One of the principal drivers in this loss of digital growth were the integration issues associated with a merger which closed in May 2013. We provide greater detail below, but given the sheer size of the merger (2 equal sized businesses) and the differences in existing go to market strategies (legacy Supermedia versus Dexone) meant significant disruption.
- Fortunately, digital growth in the two most recent quarters (4Q13/1Q14) show considerable progress, moving to 5.1%/8.5%, respectively. And we believe this could reach double-digits as we move through 2014.
- One driver is simply easier comparisons. Take a look below, we get easier comparisons throughout 2014 (vs year ago) as growth rates in 2013 slowed to 0% by 3Q13. By contrast, digital growth rates were double-digit throughout 2012.
Source: investagainstcrowdguy estimates and company reports for historicals.
Merger headwinds are turning into tailwinds as well…
Many of the headwinds created by the closing of the merger last year, are behind the company. (the merger closed in May 2013). That is, because of the scale of the merger, the differences in existing strategies, and the large footprint of each of the businesses, meant the merger would need to follow a timeline before synergies could be realized, as shown below:
Source: investagainstcrowdguy estimates
- In fact, the marketing of the combined businesses did not offer new plans until the end of 2013. And it was at that time, that digital growth began to improve. We believe the company will build on this momentum throughout 2014 and beyond.
- But it is more than just marketing plans. Note how there were multiple challenges facing the company throughout 2013 after completion of the merger. The company in recent conference calls noted that their salesforce again seems motivated with products they can sell. And that they can offer their customers a differentiated offering. A complete solution of digital marketing along with exposure to print products. And the added benefit bundles and flexible offerings.
#3: Bank debt is at 52-week highs and heading towards par (price if a bond=100), which means the stock needs to massively catch up…
One rule we have always followed in our 20-plus years following markets, is that bonds always lead stocks. And the bearish case for DXM grew in 2013 as it bank paper fell in price from the 80s (in early 2013) to below 70.
- But since those lows in late-2013, DXM bank debt has seen a remarkable recovery in price. Recently, the composite price of its bank loans hit 52-week and all-time highs as shown below. The recovery in prices has followed the improved fundamental performance of Dex Media financial results-in other words, as digital growth has recovered and EBITDA margins have been steady, the probability for a full recovery in the bank debt has similarly risen.
- The bank debt continues to advance and we believe it is possible it could trade to par by the end of 2014. We base this on our expectations for digital growth to continue to accelerate to double-digits and also on the expectation that cost savings of $100mm will be realized in 2H14 (from the merger).
- This is a positive signal for the stock that needs to be reflected in the equity. Take a look at that chart carefully. Note how the bank debt is at levels seen a year ago. This implies the stock should be trading closer to its price seen a year ago as well. That is $24. In other words, simply relying on the relative price argument of the stock follows the bonds, the stock should double from here.
#4: Global refinance is on the horizon…every silo of bank debt is now trading above 70…
We ultimately expect the company to refinance its debt (due at the end of 2016) but pursuing some type of global refinance of debt. That is, do a large debt deal and replace its silo bank debt with longer term term debt, with timing of such a transaction dependent on delivering continued digital growth (2H14?). The remains the mother of all catalysts-CCC bonds yield 6% vs DXM's current 10% overall cost of debt-the 400bp incremental savings is $100mm annually, or $6 per DXM share and also opens the door for the company to start buying back equity.
- We have shown the daily price history of DXM bank debt (4 silos) below. Note the strong recovery in each tranche. What is more notable, is the timing of the recovery of the tranches. Supermedia and Dex Media West traded well since late 2013. The Dex Media East since the February 2014. And most recently, RH Donnelly strong since May. The latter being key, as it contains the tax asset and is a double-beta reflection of overall fundamentals. But the takeaway is that improving prices of bank paper facilitate the ability to do a global refi (at par, it is even easier).
- Additionally, if the company were to do a global refinance, this would eliminate many of the restrictive covenants seen in their silo debt structure today. For instance, the company could, post-refinance, use excess free cash flow to buy back common stock. With annual free cash flow of $375mm, and a stock market cap of only $170mm, they could buy back the entire float with less than 2 quarters of cash flow.
- A pre-condition to executing a global refinance (presumably a multi-billion term debt deal via high-yield and perhaps some bank debt) is producing fundamental performance that is seen as adequate and sustainable by investors. We viewed this as being 3 quarters of good digital results, and more specifically, a progression of improvement that is seen as sustainable. If 2Q14 results are solid (which we expect), with digital growth reaching low double-digits, the company is arguably in a position to do a global refi.
- We get the sense the company wants to pursue a global refinance deal sometime in late 2014 or early 2015. The cost of debt benefit, as noted above, is substantial, saving the company at least $100mm annually. In all likelihood, the company needs to work with existing debt holders. Why? A new deal would be substantial, $2.7b-plus, and it is logical to target existing holders of the paper for the new placement.
#5: Record 5.5mm shares are sold short, or 33% of the float.
Short interest is now 5.5mm shares and the stock is $12. Basically, 2.0mm shares shorted at $4 are underwater by $8. Is this a stubborn short? We believe this is the case.
- We do not believe these are not due to position hedging by bank-debt holders. Short interest has been rising ever since the company reported slowing digital growth in middle of 2013. In fact, from November 2013 (right after the terrible 3Q13 results were reported), short interest soared from 3.5mm shares to 5.3mm within a month.
- Moreover, there is a sizing issue. The total outstanding bank debt is $2.9b and was over $3.5b when the merger closed in May 2013. The stock market cap is only $170mm. Thus, there is an asymmetry here. Moreover, the short interest soared after missing 3Q (see bullet above), not due to holder positioning.
- We believe a massive short-covering will happen after 2Q14 is reported. IT could lift shares to $30 or higher…
#6: Interest in seeking a strategic deal with Yelp or a major digital player will be done
We believe Dex Media will ultimately strike a strategic partnership with a digital marketing partner (ala YELP, etc), to improve their "value proposition" to customers and also to burnish their own reputation (most customers do not realized Dex Media is a Google premiere partner).
- We realize that in past conference calls, management stated several times that a strategic partner is not needed to generate sales or fill a product hole. In fact, as a Google-premiere partner, Google actually refers inquiries for local advertising to Dex Media (among others as well). In fact, at $500mm in digital sales, DXM is probably the largest or second largest local digital advertiser (YP.com is the other). The point being, they have scale in digital already.
- But, a digital partner gains them a "cool" factor which they acknowledge is helpful in improving perspectives for prospective customers. For instance, during the 1Q14 earnings conference call, management made several references to the fact that alliances are being created in the industry and Dex Media has interest in being involved in these discussions.
Disclosure: The author is long DXM. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.