Dex Media: A Stronger Buy, After The Successful Debt Tender

DXM: A stronger buy, after the successful debt tender

A few weeks ago, we discussed why we saw positive asymmetric risk/reward with Dex Media (DXM) with a roadmap to becoming a multi-bagger. It was an ideal combination of a company making an operational transition (from print to a multi-platform strategy) and a very compelling capital structure story (substantial fcf, major deleveraging, equity prices cheap vs debt, etc). There is obviously significant execution risk here.

The notion of a radically undervalued stock happens with surprising frequency. In our decade-plus of long and short investing in TMT, we have seen this take place with numerous situations: the Sprint PCS affiliates, the rural cellular stocks, the towers, the radio and TV stocks, the cable names, post reorgs of many sorts, etc. The key is to be patient capital and to be willing to ignore the noise and consensus negativity.

We wanted to provide an update on our views, as there have been a few positive developments recently, and also highlight the significant relative value discrepancy between Dex's equity and debt:

1. DXM's recently completed debt tender creates $10-$11 per share of equity value. DXM recently completed its announced debt tender, retiring $138mm of par value of debt for a consideration of $101mm (a discount of $37mm to par). There is a direct transfer of value to equity holders via two mechanisms: 1) $2.11 due to the discount to par ($37mm, or $2.11 per DXM share) and 2) $8.47 per share via the NPV of annual interest savings, by applying a 10x multiple to the $15mm in realized lower annualized interest expense ($0.85 per share x 10). In other words, beyond cutting debt by 4% with this tender, there is an immediate benefit to the equity holder.
   


2. The recent surge in short interest to 4.1mm shares, or 60% of tradeable float, argues the "crowded trade" is being short, which could lead to a considerable rise from short covering. The latest NASDAQ data (11/15) shows short interest surged to 4.1mm shares (up 607k). Why do we think the short trade is the crowded and consensus trade? Two reasons: 1) the rise in short interest is a contrast to the patience and concentration of the top holders of equity-the top 10 holders control 10.6mm shares (61% of shares outstanding) and our analysis shows that the increase in short position seems to be primary selling pressure itself-each 500k shares sold short has pushed the stock down roughly $3.25(E). 2) At 60% of the company's tradeable float (we define tradeable as excluding those shares held by the top 10 investors), it looks unsustainably high, particularly considering the relative stability of the company's bonds. If short interest decreases by 1.5mm shares (to levels of a few months ago), we estimate the stock would rise about $10 per share from short covering alone.
   


3. The debt yields 14.26% and the equity FCF yield approximates 337% on our estimates (yes, 20x greater equity FCF yield versus debt yield). Consider that the weighted average cost of debt for DXM is 10.08% and the effective credit yields 14.26% (weighted credit price is $71)-these are hardly the costs of debt associated with a business in deep distress, yet the stock remains under selling pressure. A more reasonable relative value (between equity and credits) would suggest the equity FCF yield should be 20%-30%, which implies a stock price of $75-$122 (using an equity FCF per share over the latest 12 months of $24.49).
   


4. The stock is pricing in a 95% chance of bankruptcy by 2016 while the debt is pricing in a 20% probability. By nature, the equity of any company is a "call" option on the future of the enterprise. And in the case of highly leveraged companies, like DXM, the equity has a significant embedded call premium (as the value of the enterprise changes, there is a leveraged benefit to the equity). The value of DXM equity can be derived by looking at scenarios. Using a scenario analysis, the stock's current price implies a 95% chance the company is bankrupt in 2016-three years from now. The debt, using the same scenario analysis, implies a 20% probability. Does it make sense that the debt markets see a meaningfully lower chance of bankruptcy 3 years from now? We do not think so, and thus, we believe the stock remains more attractive on a relative basis.
   


5. We continue to expect the "breakout" quarter to be seen in 1H14. Under our scenario, digital growth is achieved by: 1) expanding its penetration of multi-platforms to its current customers; and 2) expanding its base of customers. Without a doubt, the company has to execute a transition to a multi-platform strategy leading to revenue stabilization. In our view, the first "breakout" quarter could be seen in 1H14, when digital growth recovers (we stress that we would not be surprised to see negative growth in 4Q13). We believe merger integration and related "noise" impacted the productivity and effectiveness of its 2,000 Google-certified sales consultants. Notably, generating growth does not require major improvements in productivity. For instance, to achieve 2% digital growth in 1H14, DXM needs to boost its penetration of digital by less than 1% of its 600,000 base of customers (already 34% penetrated) or by 4,000. That is 2 sales per existing sales consultant. These consultants already generate 300 sales per year. With "smart bundles" and other new products, we believe this is achievable. And they have the benefit of an 80%-85% retention rate of its existing customers. After growing double-digit in digital for several years, growth slowed right after the merger. Doesn't it make sense that merger distractions played a major role?

#1: Debt tender is a transfer of equity value. Latest tender of $138mm, creates $10-$11 of equity value.

We received a few queries asking how a debt tender actually creates equity value. We have shown the calculations below. There is a direct transfer of value to equity holders via two mechanisms:

1. The debt tender retired $138mm of par value of debt for a consideration of $101mm, a discount of $37mm to par. The $37mm discount, is a benefit of $2.11 per DXM share. That is, the company retired a larger dollar value of debt compared to the cash consideration paid.
   


2. Additionally, consider the NPV of the interest expense saved. As shown below, we estimate this be to $8.47 per DXM share. We apply a 10x multiple to the $15mm annual interest expense savings ($0.85 per share x 10). We are not applying any taxes as the company has a $1.6B NOL which it will utilize in these interest expense savings.

Source: Company reports, Wavelength calculations.

Taking a step back, the company is doing an impressive job of de-leveraging. Look at the chart below. For 2013, the company is on track to retire over $550mm in debt ($410mm from free cash flow sweeps and $138mm from this debt tender). That works out to a 16% reduction in gross debt in 2013. FCF calculation and supporting exhibits from company quarterly presentation on back pages.

Source: Company reports Wavelength calculations.

#2: We think short interest at 4.1mm shares, or 60% of tradeable float, is setting up for potentially disconcerting upside.

It is apparent to us that the "crowded" trade is to be short DXM. Short interest has surged to 4.1mm shares (the most recent period shows the largest two-week increase ever at 607k) and about 60% of tradeable float. (As stated previously, we calculated tradeable float excluding the 10.6mm shares held by the top 10 shareholders, or a float of 7.0mm.)

• This sizable short interest is a major contrast to the concentrated and patient capital of the shareholders of DXM. Based on the latest filings, the top 4 shareholders own 35% of the shares (and Hayman added in the most recent quarter). The 17 page 1 holders control a total 12.1mm shares, or 69% of the shares outstanding. Keep in mind that this does not include a few additional stable shareholders, who have not filed their holdings. Typically, a small cap stock's page 1 holders represent 25% of the shares outstanding.

(click to enlarge)

Source: SEC filings.

So why would this imply the potential for a big "short cover" rally? Take a look at the figure below.

• As the share price has fallen, the short interest has soared-meaning, as the stock has fallen, short sellers have increased conviction. By contrast, the core shareholders referenced above have been stable and have added 1.2mm shares in the past quarter. Granted, we did see two large sellers in the past quarter, but they have been entirely offset by these new buyers.

• In other words, one can argue much of the decline is a proportionate result of the rise in short-selling interest itself. After all, since the summer, short interest has risen by 2.0m shares, equivalent to Paulson or Franklin nearly liquidating their stake. Is it any wonder the stock has been under so much pressure?

Source: SEC filings and Wavelength.

Using a simple chart highlights how the rise in short interest has been linear to the decline in the share price.

• In fact, the regression slope is -6.5755, meaning for each 1.0mm increase in short interest, the stock has fallen $6.5755.

• We see this dynamic eventually reversing itself. Meaning, when short interest declines, we expect to see a sharp rise in the equity price.

Source: Bloomberg and Wavelength.

#3: Does it make sense the credit yield is 14% and the equity FCF yield is 337%? We argue the equity is too cheap relative to DXM credit prices.

The weighted average cost of debt for DXM is 10.08% and an effective credit yield of 14.26% (weighted credit price is $71). DXM has 5 sets of bank paper outstanding, which we list below, comprising total debt of $3.2B (gross). Of this, the weighted average price is $71 (the various classes trade between $57 to $80).

Source: Wavelength calculations.

DXM debt is rated CCC, and as a consequence, is not owned by traditional credit funds. Further, because of the company's speculative debt rating, the debt has equity-like characteristics. (At a net debt/EBITDA ratio of 3.5x, DXM is really not heavily levered for a media company, but as long as the visibility of EBITDA is not strong, its debts will trade at a discount to par.)

• As a CCC-rated issuer, the credit will have equity-like characteristics. Three key points here: 1) the debts, given their equity-like nature, do not have to trade at Par (100) for the equity to have value; 2) the value of the debts and the stock should both move directionally; and 3) more importantly, there should be a relative value relationship between the debt and stock-that is, an investment opportunity is created when the stock trades cheap relative to the price of the debt.

• Naturally, the yield of the debt and the yield of the equity should be related. After all, it is the same issuer generating cash for both. If debt holders require a 14.26% yield, they do see the company as risky. However, a 14.26% yield hardly implies bankruptcy.

• Last year, there were many times when the debt yielded close to 30%. Thus, we argue that the 14% yield implies a more sanguine view of the company today.

#4: The stock price implies at 95% chance of bankruptcy by 2016, while the debt implies a 20% chance by 2016.

As we mentioned earlier, the equity of any company is a "call" option on the future of the enterprise. And in the case of highly leveraged companies, like DXM, the equity has significant embedded call premium. (As the value of the enterprise changes, there is a leveraged benefit to the equity.)

We can thus look at what the potential future value of DXM looks like under various scenarios. We use three scenarios below:

• The scenarios are: 1) base case: company stabilizes revenues by 2016 and thus, could very easily trade at 5x P/FCF; 2) reach case: company becomes a modest growth business and trades at a multiple significantly higher than 5x P/FCF; and 3) adverse/negative case: company goes bankrupt in 2016. Note: The FCF projections we incorporate into our view are LTM and are less than those projected by DXM in their lender's presentation.

• By assigning various probabilities to each scenario, we can derive a "weighted average value" and thus, price the equity accordingly.

• As shown below, the stock price at $6.63 basically assumes a 95% probability of bankruptcy in 3 years.

• Using even a 50% chance of bankruptcy, we derive a much higher value. Why? If there is a 50% chance the stock trades for $125 in 3 years, the present value today is not zero, nor is it $6.63.

Source: Wavelength calculations.

Again, by using the same scenarios for debt prices, we can derive that the debt is implying a 20% probability that DXM is bankrupt in 2016. Hence, we get to the relative value question. Does it make sense that the equity is considerably and materially more pessimistic about the outcome of DXM? (Note that while we see material upside in our reach scenario, we don't believe it is appropriate to consider using a healthy media peer multiple as part of our reach scenario here. As a result we are conservatively using a 5x multiple for illustration purposes, despite the potential for DXM's multiple to reach a significantly higher level.)

• Incidentally, if we applied a 20% probability of bankruptcy to DXM, we derive a weighted average value today of $100 per share. In other words, the stock is still massively undervalued. Given the low probably we assign to our reach scenario, the weighted average value would not be materially higher using a healthy media peer multiple.

#5: 1H14 should dispel misconceptions about the company's transition to a multi-platform strategy (not just digital vs. print) and should placate investor impatience on digital.

The slowdown in the past two quarters on digital growth has been disappointing, but as we noted in our previous commentary, we believe the merger integration and associated challenges were a major factor, given the realities around the integration.

• DXM has been focused on getting people in place first, next products and solutions, followed by market strategies and processes. They have made progress with synergies and stated publicly that they now have the right team in place. The company is in the process of finalizing its go-to-market strategies for leveraging new products such as "smart bundles" and other product suites (rolling out in the next few months).

• As a reminder, we would not be surprised to see digital growth actually dip to negative in 4Q13. The company has provided no guidance. That said, we anticipate seeing the positive inflection sometime in 1H14. Execution risk for the merger is down dramatically (as discussed below) and we believe 4Q13 is really the first quarter that the company can move forward with execution. Even as of 3Q13, overall declines in sales are actually improving (see below) to a -15% decline vs. -17% in 4Q12 and -16% in 1H13. And by the end of 2014, we expect overall revenue declines to slow to mid-single digits

Source: Wavelength Projections.

The key for DXM is ultimately execution. We believe DXM's management is focused on creating a long-term sustainable and profitable business serving the advertising needs of the small/medium business.

• As a reminder, the company is one of the largest digital media players today with $540mm in digital media revenues (9-month annualized), 2.5x the size of YELP and larger than Yellow Media in Canada. But again, Dex's approach to its customers is to offer a multi-platform strategy with print still a highly profitable and useful resource for its customers.

Source: company reports.

#6: The technical picture has become bullish.

We are cognizant of the fact that not every investor is "patient" capital and thus, the technicals make a difference. But as the stock has fallen from the mid-$20s to the current range, the consolidation at these levels has produced a much more constructive technical picture. Again, we want to emphasize that our positive case for DXM is predicated on fundamentals, however, in the short-term, we see a very positive risk/reward on the technical picture.

Naturally, one positive technical signal does not carry as much significance as multiple positive signals. Hence, we want to highlight 4 positive developments in the technicals of DXM:

1. The weekly RSI has turned up after troughing at under 30. The previous 3 instances of this saw the stock rise by 400%-800% over the next few months (late-2011, summer-2012, and Dec-2012.);


2. The weekly MACD is about to inflect positive. The 3 prior instances saw a 300%-800% subsequent rise in the equity;


3. The stock recently closed above its 50-day moving average (with a rising 20D) and prior instances saw the stock double within a few weeks;


4. There are a constellation of positive Japanese candlestick patterns which we have not seen since February 2013, when the stock moved from $7 to $23.

Weekly RSI is oversold and curling up….

Take a look at the weekly RSI below (RSI, or relative strength index, measures the internal momentum of the stock. In the case of a weekly interval, we are using a 14 week interval). The stock recently bounced from an oversold reading of 29 on the weekly RSI-reaching a 30 on the weekly RSI historically is associated with a stock seeing heavy selling over several weeks.

• As highlighted below, this low weekly RSI reading was seen in late-2011, mid-2012, and late-2012.


• As we highlight below, in each precedent instance, the stock subsequently rose 400%-800% within the next few months.


• Basically, when the weekly RSI gets oversold and turns up, it is a sign of a stock that has been under heavy selling pressure-and as we noted, this does not surprise us given the surge in short-interest.

The weekly RSI gives us a sense for the internal momentum of stock. And if it moves from a weekly oversold (falling towards 30) and recovers, this is a meaningful positive technical signal, with a lot of information value.

FIGURE: WEEKLY RSI WAS OVERSOLD AND NOW TURNING UP…

Source: Bloomberg and Wavelength.

The weekly MACD line has turned positive, a harbinger to strengthening momentum…

The MACD, or moving average convergence/divergence, is another measure of a stock's momentum. There are three signal lines: MACD line, signal line (AVG) and the difference (MACD bars). We look at the MACD bars and the directional moves in the signal and MACD lines. Take a look at how the stock reacts when the MACD weekly bars turn positive?

There are three precedent instances of the swing of the weekly MACD from negative to positive:

1. In the Summer of 2012, the weekly MACD swung to positive and the stock rose 400% in a few months;


2. In December 2012, weekly MACD similarly swung to positive and the stock staged a 400% rally in a few months;


3. More recently, in the Spring of 2013, the weekly MACD turned positive and the stock rose 300% within a few months;

The MACD weekly bars are converging on zero. And the MACD line itself is moving up, suggesting we could see a move to a positive MACD swing within a few weeks.

FIGURE: WEEKLY MACD HAS TURNED POSITIVE...3 PRIOR INSTANCES SAW STOCK GAIN 300%-400%....

Source: Bloomberg and Wavelength.

The stock closed above its 50-day moving average while the 20-day is moving up…

Take a look below, notice how the stock recently closed above its 50-day moving average while the 20-day moving average ($5.675) is moving up? This pattern has happened twice recently.

1. In June 2012, when the stock was $5 and within three months, was over $11;


2. In Dec 2012, the stock moved to $5 (a move above its 50-day) and subsequently surged to $10 before making its way to $20.

Why does this pattern matter? In our view, it reflects where the congestion or selling of a stock takes place-in other words, it highlights where the "battlegrounds" exist-if a stock can move and hold its move above the 50-day, we see this as very constructive from a technical perspective.

FIGURE: DXM CLOSED UP ITS 50-DAY MOVING AVERAGE AND 20-DAY IS MOVING UP…

Source: Bloomberg and Wavelength.

The cluster of positive Candlestick patterns are pointing to a positive swing…

Finally, take note of the recent cluster of positive signals using Japanese candlestick patterns. The concept behind candlesticks is to view the open, close, highs and lows of the day as signs of supply/demand and resulting behavior of buyers.

• As shown below, in the past month, we have seen a cluster of 4 positive candlestick patterns: (I) tweezer bottom in early Nov.; (ii) an inverted hammer in early Nov.; (III) another tweezer bottom in mid-Nov.; and (iv) engulfing line in late-Nov.


• The last time we saw a cluster of positive candlestick patterns was February 2013. Then, we saw a cluster of 4 positive candlestick patterns when the stock was $7. Within 3 months, the stock was in the $20s.

Again, past is not a prologue to the future.

CONSTELLATION OF POSITIVE CANDLESTICK PATTERNS IS REMINISCENT OF FEB 2013…PRIOR TO 300% RISE IN EQUITY…

Source: Bloomberg and Wavelength.

BOTTOM LINE: We remain constructive and our thesis hasn't changed. In our view, the stock's current valuation simply does not make any sense.

We believe the stock has tremendous upside potential and we see 1H14 as the period when the "breakout" quarter could happen-that is, we think the combination of solid digital improvements and overall improvements in the company's revenue profile could materialize. As we noted previously, Wavelength is very cognizant to focus on worst-case scenarios as much as we are focused on the long-case. In that vein, we would argue that the shorts may win if this company cannot turn itself around in time. However, given the major discrepancy of relative value of debt vs. equity, the upside remains substantial.

Source: Dex Media: A Stronger Buy, After The Successful Debt Tender

Disclosure: I am long DXM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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