Yellow Media has had an exceptional 2013, rising 222%. However, the equity still presents as an attractively asymmetric reward-to-risk opportunity with hard catalysts for value realization over the next two years.

The underlying thesis is straightforward. Yellow is comprised of two businesses: the dying high free cash flow print business and the growing digital media business. I believe the equity value is a fair representation of the current value of the digital business, leaving the cash flow of the print business to cover the manageable debt outstanding. Contractual debt paydowns over the next two years should virtually eliminate the debt balances, thereby transferring a minimum of CAD 3.68 per share from debtholders to shareholders representing a 17% return on the current price. Excess cash paydowns could transfer an additional CAD 5.32 from debtholders to shareholders, representing an additional 25% return on the current stock price.

Yellow has two debt issues outstanding. The secured first lien notes maturing in 2018 were issued in conjunction with the restructuring in December 2012. There is a contractual paydown of CAD 100MM in 2013, 75MM in 2014 and 50MM in 2015. In addition, there is a 75% excess cash flow sweep that has to be directed towards debt paydowns. In 2013, Yellow paid down CAD 153.4MM of principal on the notes, leaving CAD 646.6MM outstanding. The debt currently trades at 105 indicating the debt market’s comfort with this credit.

The second debt issue is an unsecured convertible bond maturing in 2022. CAD 107.5MM was issued and remains outstanding. The conversion price is CAD 19.04. With the equity currently trading at CAD 21.13, the call option is in the money. Yellow cannot address the convertible until the first lien notes remain outstanding, but it is increasingly likely that will have to pay cash interest on the converts, they will likely settle them for 6MM of new shares of equity rather than settle for cash. This 21% dilution is unfortunate, but removing a need to settle the bonds for cash significantly de-risks the equity. This unsecured debt is trading at 119 indicating the debt market’s comfort with the credit and the fact that the option is in-the-money.

Yellow’s digital media business helps small businesses build and manage their online presence. This is a decent, but not exceptional business. However, it has achieved some scale (CAD 444MM estimated revenues for 2013) with EBITDA margins estimated at 25%. The business throws of CAD 100MM in EBITDA and after a capital investment of CAD 30MM (10MM maintenance and 20MM growth), is growing revenues at 10% and pre-tax discretionary cash flow (EBITDA – CAPEX) at 16%. My research indicates that Yellow has an advantage operating in a smaller, somewhat closed market like Canada relative to operators like Dex Media (DXM) which operate in the highly competitive US market. Assuming a conservative evaluation of 7x – 8x EBITDA yields a CAD 700MM – 800MM valuation for this business or roughly CAD 20.59 – 23.53 per fully diluted share, roughly equivalent to the current share price.

Yellow’s print business is a near monopoly provider of printed yellow pages directories. Yellow does not own or operate the physical printing plants. It’s only legacy liabilities relate to pensions and this liability is shrinking as interest rates rise. The print business generates an estimated CAD 562MM in revenues for 2013 and is shrinking roughly 20-25% per year. Costs are highly variable and Yellow has been able to maintain roughly 55-57% EBITDA margins in spite of the shrinking revenues. With an estimated maintenance capital investment of CAD 5MM per year, the print business is throwing off CAD 245MM in pre-tax free cash flow in 2013 – which should easily cover the CAD 646.6MM of first lien debt which is only 2.5x pre-tax free cash flow. Valuing this stream of declining cash flow at a conservative 25% pre-tax yield arrives at an estimated value of CAD 980MM, less the 646.6MM of debt yields and incremental CAD 9.81/share of value – a 46% return on the current price in addition to the CAD 4-9/share in contractual transfers occurring over the next two years for a combined 89% return over the current price.

Yellow hired a new CEO from Solocal, the French equivalent of Yellow, where he was responsible for their digital business. He will assume his position on January 1, 2014 and could offer a free option with his ability to accelerate growth of the digital business – which has not been reflected in my assumptions.

While Yellow does not offer the extremely asymmetric reward-to-risk profile that existed earlier in 2013, I believe it is still a very attractive opportunity since even though there may be less upside remaining, the downside exposure has been curtailed given the debt paydowns and the likely settling of the converts for shares rather than for cash. There should still be 50% - 90% upside in the stock with limited downside with hard contractual catalysts to value transfer from debtholders to shareholders and a free option on accelerated growth of the digital business under new leadership.