Description

Investment Thesis:  Independence from a parent milking its cashflow should lead Idearc to improved revenue and cash flow trends.  Valuation is compelling even without EBITDA expansion, providing a 5% dividend yield and an 11.5% free cash flow yield.

 

Idearc is the directory business of Verizon.  It was levered up with $9.1 billion in debt and spun-off effective 11/17/06 after a failed sales attempt.  The company was not included in the S&P 500 and the distribution ratio was a highly geared 1:20.  All these elements point to a high likelihood of a technically driven sell-off.

 

In past years, Idearc was managed for the good of its parent company.  For instance, Verizon offered an early retirement package which sapped Idearc of over 50% of its salesforce at the end of 2003.  In another example, Verizon sold its Hawaii properties, which contributed $24 million in revenue at around a 75% margin.  Needless to say, proceeds bypassed Idearc.

 

Idearc began rebuilding its salesforce, but given a 12-18 month ramp to productivity, a 6 month sales cycle, and accounting which amortizes revenues over the 12 months after a directory has been published, the loss of the salesforce negatively impacted results for the following 2+ years, and the benefits of a reinvigorated sales force should become increasingly apparent going forward.

 

Indeed, year over year sales declines, which had been running down 5%+ earlier in the year, should narrow to less than 1% in Q4.  2007 should be flat, and revenues should grow from there.

 

Idearc is in three businesses:  incumbent markets, independent markets, and internet yellow pages.  Incumbent markets, representing around 90% of revenues, are the legacy markets in which Verizon was the ILEC and its yellow page directories had the dominant market share.  This business is akin to RHD.  Independent markets, about 3% of revenues, are ones in which there is another ILEC (eg BellSouth), and Verizon is publishing a competitive directory, similar to Yellow Book’s business.  Finally, Idearc owns superpages.com, the leading internet yellow pages, with an approximate 23% share of local search.  The internet business contributes roughly 6% of revenues.  The other print yellow page publishers are also providing internet solutions, but Idearc appears well ahead.

 

Incumbent markets are expected to decline at about a 1.7% CAGR industry wide over the next five years, driven by incursions from independent competitors and a slow migration to the internet.  Idearc, with #2 market share, has underperformed the industry with 5% revenue declines in each of the last three years.  Post spin, Idearc will resume advertising its services, planning to spend about an industry average 1% of revenues, versus close to zero under Verizon.  This incremental spend, incidentally, is fully funded from lower standalone costs compared with the costs allocated by Verizon.  This investment, combined with a rehabilitated sales force, should allow Idearc to close the gap to industry growth rates.  Indeed, published revenues (sales generated but not yet amortized) are set to decline only 2.5% for 2006, versus closer to 6% in prior periods.  Given weak H1 results, Q4 should look even better. 

 

Independent markets are the growth driver of the industry.  Idearc and the industry should grow at a low-teens CAGR.  Internet growth should be even higher at around 20%.  It should be noted that advertising is often bundled between print and online, so that the allocation of revenue has some discretion, and growth rates may not be pure and comparable across competitors.

 

Over the next five years, incumbent revenue share should decline from around 90% to around 80% of total, with independent and internet driving LSD revenue increases in 2008 and beyond.

 

It is not surprising that the margin structure of these businesses is quite different.  Incumbent markets, with the network effect of dominant market share, have stronger pricing and greater density to lever fixed costs.  I’d estimate EBITDA margins for Idearc in this line of business at around 51%.  RHD is running closer to 55%.  The independent businesses have lower pricing and less density, so margins are lower, though likely still a respectable 18%.  Finally, the internet business contributes roughly a 25% margin.

 

Idearc has made a few comments on margins.  First, they attribute about 400 basis points in margin differential to RHD to their mix of independent and internet businesses.  While RHD is looking at 55% margins, Idearc projects ’06 EBITDA margins at 48%.  Secondly, they mentioned that they thought incumbent margins could hit mid 50%, independent markets could reach mid 20%, and the internet could reach high 30% margins.  They have also stated that their independent corporate costs are lower than the allocated costs under Verizon, and that this will fully fund their increased outlays for advertising.  Let’s assume Idearc is able to grow its EBITDA margins on the incumbent business by 400 basis points bringing it inline with RHD, while there is no improvement in the other businesses’ margins.  This improvement would be enough to offset the negative mix shift from the 10 point higher revenue contribution from the lower margin businesses.  Should the growth businesses actually achieve their targeted margins, there would be reasonable margin upside.

 

It is important to note that Idearc has said that they anticipated their margins may decline by a point to a point and a half, given the negative mix shift.  Looking at the margins on a segment by segment basis, however, suggests that this guidance may prove overly conservative.  The company conceded this point.  It is also encouraging that, even officially, Idearc thought that even if margins declined, EBITDA dollars should still increase.

 

It is important to note that management has not yet struck options.  It would not surprise me to see conservative guidance put out on 2007 early next year.

 

This business is not capital intensive, and starting with a base level of EBITDA around $1.5 billion, I’d expect around $485 million in free cash flow, of which $200 million will go to paying a dividend.  Idearc plans to delever by around $1 billion over the next 5 years.  Assuming $200 million in delevering annually, earnings would improve by 6 cents per year and cash flow by $8.7 million dollars.

 

Even after delevering there should be incremental free cash flow which could go towards increased dividends over time.

 

Summary Valuation and Estimates:

Price	$      27.60
Shares	146
Market cap	4,030
Total debt	9,100
Cash	123
TEV	13,007
		2006	2007	2008
TEV/Sales		4.0 x	4.0 x	4.0 x
TEV/EBITDA		8.4 x	8.2 x	8.1 x
TEV/EBIT		9.2 x	8.7 x	8.6 x
P/E, fully taxed			8.6 x	8.1 x
P/FCF			8.7 x	8.2 x
Dividend yield		5%
Net revenues		3,236	3,252	3,275
EBITDA		1,552	1,578	1,608
Operating income		1,417	1,488	1,518
EPS			3.20	3.40
Dividend		1.37
FCF/Share			3.16	3.37

 

 

 

Valuation:

 

If Idearc is unable to grow EBITDA meaningfully, I believe it should trade at about $32 (10x FCF) to $34 (4% dividend yield), my near-term target.

 

There is an embedded call option on improving fundamentals, however.  If revenue can grow modestly and EBITDA margins firm, cash flow could improve to $550-$600 million in 3-4 years.  Applying the same 10x FCF multiple would yield a stock price in the $37-$40 range, achievable in 2 years.  In this scenario, the dividend could have grown to around $2 a share.

 

In terms of downside, I would expect there to be good support at $24, maybe $22, should there be massive selling pressure on the spin technicals.  For the stock to trade lower would require the market to believe that revenues and EBITDA will continue to slide.

 

 

Risks:

• Revenues do not stabilize:  Reinvestment in salesforce and advertising is not the prescription to Idearc’s revenue declines.
• EBITDA margins decline:  Idearc is unable to run its businesses more effectively, despite independence and despite newly acquired salespeople maturing to full productivity. Revenue mix issues overwhelm and drive margins lower.
• Internet competition:  Despite enjoying leadership in local search share, the internet is highly competitive and superpages could lose its momentum.

 

Key Dates:

No specific dates yet, but would expect Q4 earnings release to be accompanied by some high level color on 2007 in early Q107.  Also expect management to strike stock options in the coming weeks or months.

 

Related Securities:

• RHD.
• Captive yellow pages units of T and BLS.

YELL LN  UK-parent of Yellow Book, a major independent publisher.

Catalyst

Catalysts:
• Sales turn positive: As Idearc is managed for its own benefit and as the reinvestment in salesforce and advertising shows its effect, sales should go stabilize in Q4 and 2007 and grow from there.
• EBITDA margin: While company is saying that adverse mix shift will hit margins to the tune of a 1 point or more, my analysis suggest margins could stay flat to possibly improve, despite the mix shift.
• Free cash flow: Idearc has more than sufficient free cash flow to pay its current dividend and delever. Should EBITDA grow, the incremental opportunity becomes that much larger.
• Dividend yield: Idearc plans to pay out 40-45% in dividends. As the company grows EBITDA and delevers, this should translate into respectable earnings (and dividend growth).