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Hi all,

I went through RH Donnelley's numbers back when they announced they were buying Sprint's publishing and advertising businesses. Since then the merger has gone through. I wrote this up in my notes but didn't get a chance to post it. As usual do your own research and check my numbers. At the time of this post I do not own RHD.

Recap: What do they do?
They are the leading marketer of yellow pages. They are the exclusive sales agent for 175 telephone directories across the country. With the purchase of Sprint's publishing and advertising business RHD will have more than 260 yellow pages directories distributed to 18 million members in 18 states.

What's Attractive About RHD?
$630 million in yellow pages advertising in 2001.
Minimal investments in working capital
Free Cash Flow of $70 million per year (90% of net income)

Uses for cash
· Invest in growth (sprint)
· Buy back stock
· Pay down debt

Earnings growth rates
· Last 5 years 8%
· Median Analyst estimates for next 5 years 14%
· Attractive valuation current P/E of 9.9

Walk the Walk
In 2001 they bought back $56 million in stock and retired $65 million of debt. Looks like they are acting on their promises. They similarly bought back stock and paid down debt in 2000 and 1999. In those 3 years they bought back $125 million in stock and paid down approximately $180 million in debt. Option dilution isn't an issue in 2001 they issued 682k options which result in maximal dilution of 2.2% of their outstanding 29.7 million shares.

I estimate you could earn an acceptable 11% return by purchasing RHD for less than $26.56 per share today. It was priced at at $25.49 back when I wrote this up. My valuation assumes an 8% growth in EPS and a future P/E of 15 at the end of the next 10 years.

What Makes RHD Interesting?

1) Brand Simply put, everyone has heard of the yellow pages. They are ubiquitous. 9 out of 10 adults use the yellow pages. 97% of households have it.
2) Proven/Attractive business model This is a fairly lean business model. After all it's advertising. Capital expenditures are very small clocking in around $4 million per year while free cash flow comes in around $70 million per year. Free cash flow is an impressive 90% of net income. Predictablilty makes valuation much easier.
3) Stable Revenue They have a relatively stable stream of revenues. Even with the poor economy their business has held much better than most companies who rely on advertising.
4) Margins Their gross margins are in the neighborhood of 30-40%. Not too shabby.
5) Valuation When I first looked their P/E was around 15. It's now around 18, still less than the S & P average.

Words of Caution
1) Debt As of 6/30/02 they had $241 in long term debt. As a rule, I just don't like debt. However, with their consistent and strong cash flow this debt isn't very concerning. From 1998 to 2001 they consistently paid down their long term debt from 464 million to 241. This will increase by a whopping $2.23 billion after the Sprint acquisition!
2) Big Acquisiton Oh yeah that Sprint thing. They basically doubled the size of their company by acquiring Sprint's publishing and advertising business. Sprint needed the cash to help shore up their balance sheet. Was this a fire sale? From an initial glance it doesn't appear that Donnelley made a bad deal. I estimate they paid about 10 times earnings for that business while their business is currently fetching about 15 times earnings. That's an estimate based on what I could find in Sprints statements. In my opintion that's pretty cheap for a business like that.

Sprint adds 1,000 employees and $560 million in annual revenues. However, Sprint has been a partner RHD and I've got to believe they understand the business and its potential value. One could argue this in this depressed advertising market it's the perfect time to make such an acquisition. Not to mention the historically low interest rates. It's probably not a bad time to acquire an advertising business especially when you can get cheap money.

But, however you slice it this is a big pill for RHD to swallow and assimilate. As Charlie Munger says, 75% of all mergers or buyouts are bad deals for the acquirers. This is a huge purchase for RHD and its success is tied to the performance of this stock from here on out. Many might want to wait until a few quarters after the merger to decide on this as investment. For those who are comfortable with the risk you might be rewarded with some nice investment gains. I tend to believe that the advertising market is on the upswing.

One last look at sprint. Their unit generates approximately $560 million in annual revenue. Assuming similar margins to RHD (40%) that would mean they paid about 10 times earnings for this business. To me that doesn't seem excessive it's actually a discount to what RHD is currently trading for (and they've been buying back their own stock by the bucket-fulls over the last 3 years).

4th Qtr and Full Year Earnings
Donnelly will report their 4th qtr and full year results after the market close on Feb 25th 2003. You can get the release here

I would love to hear any of your thoughts.

Fool on!

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