Bankruptcy May Yield Surprising Opportunities

In a recent issue of the Morningstar Opportunistic Investor newsletter, we wrote about how surprising opportunities may be uncovered when companies restructure via bankruptcy. It's a dicey field to play in because companies that go bankrupt tend to be weak competitively, and sometimes emerge from Chapter 11 still heavily laden with debt. Nevertheless, because few people pay attention to these "ugly ducklings," sometimes there are great deals to be had.

We bring you such a deal today--SuperMedia . To be sure, SuperMedia is a dog of a company with extremely unfavorable long-term headwinds. But a crappy company doesn't automatically lead to a crappy investment. In this case, the valuation may just be too compelling to ignore.

Road to Bankruptcy
SuperMedia's business is simple: It publishes phone books, mostly yellow pages. Almost all of its revenue comes from advertising in the books. If a lawyer wants bold font on his listing, it costs money. If a roofer wants a fancy logo next to theirs, it costs a lot more money. Historically, the phone book business was very lucrative, generating EBITDA margins north of 50% in some cases. Often, it might be a small business's primary source of advertising. Moreover, competition was limited--generally, the telecom incumbent dominated whichever territory they are serving.

These conditions persisted for decades, generating massive free cash flows for phone book publishers and their parent companies--the fixed line telecom operators. SuperMedia was actually a division of  Verizon (VZ).

Then came the Internet and more importantly,  Google  (GOOG), and things began to come unglued. This is a familiar story for most forms of "traditional media." As yellow book usage declined, local businesses felt less of a need to advertise. Between 2002 and 2006, SuperMedia's revenues fell on average 3.7% each year. Although painful, margins generally remained high and the company produced operating income of $1.3 to $1.7 billion per year.

In 2006, Verizon decided to get rid of the declining but still profitable division through a spin-off. This was all well and good, but Verizon also decided to load the company up with over $9 billion of debt. The idea was that although the business was clearly declining, the pace was relatively predictable and manageable. Also, SuperMedia had a small and rapidly growing Internet advertising operation. By shrinking gracefully and by growing the Internet division, SuperMedia would generate enough cash flows to pay off the debt and end up as a much smaller, but profitable and growing company in the far future.

All these plans came to naught when the economy turned and credit dried up. The phone book business has tremendous operating leverage--even if nobody buys advertising, they still have to print and distribute the books. SuperMedia declared bankruptcy in March 2009, when it failed to meet a looming debt maturity. In 2009, revenues fell 15.5%, following a 6.8% decline in 2008. Operating income fell from $1.3 billion in 2007 to merely $741 million in 2009. These were the darkest days on record for the industry.

Climbing Out of the Recycling Bin
In a surprisingly short amount of time, SuperMedia restructured itself in bankruptcy court. The business was cash flow rich and had no tangible assets, so liquidating it would have been counterproductive. The restructuring was relatively clean and simple:

• The unsecured creditors received 15% of the new common stock and a small cash settlement.
• The senior secured creditors received $2.75 billion of new debt and 85% of the new common stock.
• The old common equity holders were wiped out entirely.

SPMD stock began trading in January. There are 15 million shares of stock outstanding, producing a market cap of $630 million at current prices. There are no warrants or convertible securities outstanding. About 1.5 million shares are reserved for management incentives, should they beat their (very low) targets.

What We See
First, I really don't like the company. I doubt the Internet business line will save the company in the far future. The best we can hope for is a long and slow decline.

However, I think the stock is interesting: it looks incredibly cheap.

In 2009, which was a terrible advertising environment, SuperMedia earned $2.5 billion of revenues. The company suffered terribly from negative operating leverage, with EBITDA margins falling a full 10 points to 32%. Still, despite all this, after backing out bankruptcy related costs and adjustments, and figuring in interest costs from the new debt, SuperMedia earned roughly $290 million in net income, $810 million in EBITDA, and $305 million in free cash flows.

If you are good at math, you should see that the stock is trading at roughly 2.2x earnings and a 48% free cash flow yield. This is a very, very distressed price.

Moreover, we think there's some upside to earnings, if the economy improves in 2010. 2009 was a strange year, littered with a variety of restructuring costs and accounting adjustments, which were lumped into general & administration expenses. These totaled roughly $43 million, which should disappear in 2010. Next, SuperMedia was hit by a barrage of bad debt expenses during the year--these soared to an astronomical 9.1% of revenues, compared to a "normal" level of 5-6%. Getting this amount under control, which should be much easier when your clients aren't going bankrupt, should boost operating margins by 3%. Lastly, the firm took many staff cuts in 2009, and some of the savings should begin to roll through this year.

All told, if revenues merely remain flat in 2010, we think the company can earn $360 million, or over $24 per share. If we get lucky and revenues rebound 2-3%, and SuperMedia benefits from positive operating leverage, that earnings number can easily run above $400 million, or $27 per share.

Lastly, SuperMedia still generates lots of free cash flows. Almost all of this cash flow will be directed towards repaying the senior secured debt, which bears interest at a minimum of 11% per year. In 2009, it generated pro-forma free cash of $305 million. If we are right about earnings improvement in 2010, that number can rise to around $400 million. Just by paying back the debt and avoiding the high interest expense, earnings can rise about $2 per share each year.

Risk-Reward Proposition
Even though SuperMedia is a very cheap company, there is a significant level of risk involved.

The reason is simple: the company will continue to decline, probably for the foreseeable future. This makes it easy for investors to fall into a "value trap," where earnings perpetually decline and the stock price perpetually disappoints.

In light of this risk, our bet is simple. The market is valuing the company at a very distressed level: perhaps it will go into bankruptcy again in a few years' time, wiping out shareholders anew.

We on the other hand, are betting on a more gradual decline, on the order of 5-6% per year, as opposed to 10-15%. If this were to happen, I would expect the equity to appreciate considerably, especially if we see a short cyclical rebound in 2010 or 2011. Intuitively, if SuperMedia earns $27 per share and the market comes around to our view, I think the stock should trade at something more like 5x earnings, producing a stock price of $135, more than triple the current levels. We don't think this outcome requires a big leap of the imagination.

If we buy the stock, we plan to keep it on a very tight leash. If we don't get stabilization in the revenue trend in the next year or two, we would consider our thesis busted. Profits will keep falling and the stock may get stuck at 2x earnings. We don't plan to stick around in this case, even if it means taking a capital loss on the order of 50%.

All in all, I would classify SuperMedia as a High Risk / Very High Reward investment. Though we generally hate secularly declining businesses, I think the odds are on our side here.

The Opportunistic Investor purchased shares of SPMD on March 5 at about $41 per share.

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