A Potential 20-Bagger Stock

Dex One (Nasdaq: DEXO) is a turnaround story. As we have seen so many times, the market punishes out of favor stocks to the extreme but as the turnaround starts taking hold, the stock responds. In this case, the company is now beginning to tackle its biggest issue – debt – head on. And since the company is profitable and generates excellent free cash flow, DEXO represents one of the few opportunities in the stock market to get in the early stages of a major bull run in the stock.

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Dex One Overview

In January 2010, RH Donnelley reorganized under bankruptcy protection and started afresh as Dex One. Essentially, Dex One is a publisher of yellow pages, mostly for AT&T (T) and Century Link. It publishes its directories in 28 states in the US. In addition to its print business, Dex One also operates a local business directory and search site called DexKnows. In addition, it operates a Pay per click ad network called Dex Net.

The co mpany describes itself as a marketing company that helps local businesses with their marketing programs across multiple platforms in generating leads.

The company operated 3 separate subsidiaries under the Dex One umbrella – Dex One Media East, Dex One Media West and RH Donnelley Inc. The company has been restructuring and reorganizing itself since 4Q 2010 and at the end of Sep 2011, it is now organized as RH Donnelley Corp, RH Donnelley Inc, Dex One Media, Dex One Digital (formerly known as Business.com, Dex One no longer owns business.com website) and Dex One Service.

The company is currently focused on growing its digital line of business and away from printed directories with good success.

The Current State of the Company

The company closed out Q3 2011 with a net income of $0.44/share and expects the next quarter to perform roughly in line with Q3. The trailing revenues and earnings are as follows:

click to enlarge

Rev enues figures are in millions

In Q2 2011, the company took a massive $801 million write down on impaired goodwill which is clearly a one-time event (or since the company is restructuring it will have quite a few of these one-time events). There were other write downs in 2010. As part of the restructuring, the company is on track to realize $125 million in cost savings in 2011. To come to the adjusted EPS, I have backed out the one time events along with their estimated tax consequences to get a good picture of their ongoing business.

As of Nov 17 2011 market close, the company shares are worth

  • Price: $0.97/share
  • Market Value: $48.67 million

Which gives it the following profit ratios

  • Price to Earnings, ttm adjusted: 0.65
  • Price to Earnings, next 12 month (estimated): 0.55
  • Price to sales, ttm: 0.03

To summarize, Dex One’s core busines s is profitable and can be bought at a PE ratio of 0.65. Put it another way, a mere 2 quarters of Dex One’s profits can buy out the entire company in the market.

So why does the market treat the stock as if the company will not last another 6 months?

Ugly Balance Sheet

On the surface, the debt level is too high. And the book value is non-existent.

Summarized Balance Sheet

Period Ending

Sep-30-2011

Cash

195.424

Goodwill

0

Intangibles

2234.978

LTD (curr & long term )

2551.736

Tot Curr Assets

1045.65

Tot Curr Liab

1080.502

Total Equity of the company is $6.563 million. At the end of Jun 30, 2010, the company had equity of $940.05 million. Since then, the company has written down $1.345 Billion in goodwill, down to 0, that it still carried after the bankruptcy reorganization of RH Donnelley. A quick calculation shows that the company created $411 in equity in the last 5 quarters (=6.563 – (1345-940)), or around $80 million/quarter.

Without the write downs, the equity of the company would have been around $1.35 Billion today.

Market sees the following picture:

  • Revenue (ttm): $1.486 Billion
  • Debt: $2.552 Billion
  • Reported EPS (loss): (10.87)/share
  • Equity: $0.006 Billion

And promptly believes that the debt level is too high and drives the market value down to less than $50 million.

Compare the above to the following:

  • Revenue (ttm): $1.486 Billion
  • Debt: $2.552 Billion
  • Adjusted EPS (loss): 1.50/share
  • Equity: $1.35 Billion

- and it is easy to see that a $50 million market value is quite ridiculous.

These two pictures are essentially identical, except for writing off of the Goodwill, which is a non-cash and non-operating charge and has no effect on the actual business going forward. It just had the effect of altering the EPS line and the Shareholder’s Equity line.

But the debt is really high, isn’t it?

The debt is quite high, no doubt. However, Dex One is currently generating about $400 million in Free Cash Flow/year (which is after debt payments). This means that it can pay the debt off in roughly 6 years if it directs all its FCF towards debt repayment. Its current $195 million cash cushion (which is itself $3.89/share – compared to the share price of $0.97/share) should be enough working capital for the next 6 years.

This is the worst case scenario. In the best case scenario, the debt can be paid back much faster. Here is the breakdown of Dex One’s total long term debt:

Debt Schedule

Nominal Value

Interest

Discounted Value

Discount%

Maturity

Interest/Q

DME Line

$ 677.40

2.80%

$ 375.97

44%

24-Oct-14

$ 4.74

DMW Line

$ 618.90

7%

$ 411.95

33%

24-Oct-14

$ 10.83

Dex One Senior

$ 300.00

12%

$ 57.00

81%

29-Jan-17

$ 9.00

RHDI Senior

$ 955.40

9%

$ 427.90

55%

24-Oct-14

$ 21.50

Total

$ 2,551.70

7.22%

$ 1,272.82

50%

$ 46.07

Except for the $300 million note, all other debt matures in Oct 2014. I want to draw your attention to the Discounted Value column. This column shows the current market value of the corresponding debt. So, for example, The RHDI senior note is currently selling in the market at 55 cents on the dollar.

Dex One is currently in the process of negotiating with their lenders to get approval to allow them to buy back part of their debt at below par. If they are able to come to an agreement, we will start seeing “write ups” on the income statement and the balance sheet and it will also be favorable to th e cash flow. This will be a major catalyst in moving the stock price appreciably higher.

Estimating Intrinsic Value for DEXO

In 3 years’ time, when the bulk of the debt matures, in a no growth scenario Dex One will likely add another $80x3x4 = $0.96 Billion in Equity. This will bring Debt to Equity ratio to almost 1. If Dex One is able to retire some of the debt at a discount, debt/equity ratio will decline even further.

Currently Local.com trades at a 0.73 P/S and 1.02 P/B, despite making losses. A similar valuation will put Dex One at $1B in market value in 2014. This is not unreasonable for a company with $1.5 Billion in annual revenues. With approx. 50 million shares outstanding, this puts Dex One’s price 3 years from now at $20/share. It is worth noting that coming out of bankruptcy, Dex One shares traded at over $30/share in Feb 2010. The company values itself at $2.275 Billion ($45/share) assuming current cash flow for next 4.5 years a nd then a terminal growth rate of (1%) using a discount rate of 13.5%, so my estimate is definitely much more conservative than the company’s.

Here we have a stock that can be worth $20 in 3 years. If you demand a 15% return on your investment, you should be willing to pay up to $13 for the stock today. Add another 50% margin of safety and any price under $6.5 should be a great purchase. Of course, the stock is right now available for $1 so it is especially attractive.

No wonder Paulson & Company now own 7% of the outstanding stock.

Disclosure: I am long DEXO.

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