Yellow tale

Scott Klein of Idearc Inc. isn't entirely kidding when he attributes 97.3% of the fall in his company's stock price over the past year to Wall Street ignorance. "The people who work there never leave home without a hand-held device," contends the CEO of the country's second-largest publisher of Yellow Page directories. "They're folks for whom the thought of getting on a plane without a laptop makes them break out in a cold sweat. You may even have noticed they reach for their cell phones at the slightest pause in any conversation."

That's quite an indictment, considering the 52-week decline in Idearc's stock price clocks in at 97.4%. But Klein, who offered his assessment of the investment community right before Idearc entered into a quiet period to review capital-structure alternatives, isn't the only one who blames Wall Street insularity for dragging down his company and his industry. Also in the chorus of critics is Klein's counterpart at the country's third-largest directory publisher. Wall Street analysts are "the worst demographic for Yellow Pages usage," David Swanson, the chairman and CEO of R.H. Donnelley Inc., asserted in an interview with Barron's a couple of months ago. "Just because they don't use it, they assume nobody is."

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Some consider Swanson's vitriol more understandable than Klein's -- and not just because the 52-week implosion in R.H. Donnelley's stock, down 98.1%, is even greater than Idearc's. When it comes to value destruction, Swanson, a 23-year company veteran, presided over the entire $4.1 billion that shareholders of Cary, N.C.-based R.H. Donnelley saw disappear in the past 52 weeks. But by the time Klein left private equity firm Symphony Technology Group LLC to join Dallas-based Idearc in June, the stock market had already smoked $3.7 billion of the $4.2 billion in equity value vaporized from that company over the course of a year.

Going forward, though, the two CEOs and their companies face identical challenges. They must convince Wall Street that their print Yellow Page directories, which 87% of the U.S. population continues to use at least once a year, maintain relevance. They must lead increasing numbers of these print users and advertisers across the digital divide into so-called IYP (an acronym for Interactive Yellow Pages) without losing them to Google Inc. and other masters of search-engine optimization. They must compete with other offline and online directory publishers -- independents as well as industry leader AT&T Real Yellow Pages, which remains safely ensconced inside its Ma Bell parent -- while dealing with a customer base that's counting on cost reductions to see it through the recession. And they must do all this while saddled with crushing loads of debt.

Idearc's debt of $9.04 billion actually exceeds an enterprise value of $9.03 billion, meaning its cash on hand is worth more than the market value of its common stock. It's the same at R.H. Donnelley, whose $9.90 billion in debt tops an enterprise value of $9.88 billion. To service this debt, fortunately, both companies have enviable cash flows: For the trailing 12 months, each claims Ebitda of nearly $1.4 billion. Still, cash flow notwithstanding, Idearc's debt represents 6.6 times trailing Ebitda. At R.H. Donnelley, it's 7.1 times.

How each company got so leveraged has its own provenance: Idearc received its $9 billion in November 2006, when parent company Verizon Communications Inc. spun off what had been its in-house directories division; R.H. Donnelley accumulated all but $300 million of its $9.9 billion during a debt-fueled acquisition spree, which began in 2002 and transformed the one-time Yellow Page sales agent into an industry leader with asset additions from Business.com Inc., Dex Media Inc., LocalLaunch Inc., SBC Communications Inc. and Sprint Nextel Corp.

Today, with lending practices euphemistically characterized as covenant-tight, the balance sheets of both companies recall the no-longer-tolerable excesses of covenant-lite. Interest coverage in the most recent quarter -- 1.8 times for Idearc and 1.7 times for R.H. Donnelley -- would suggest extreme vulnerability in light of declining sales. Third-quarter revenue fell 7.1% at Idearc and 3.5% at R.H. Donnelley. Idearc has responded by retaining Merrill Lynch & Co. and Moelis & Co. to come up with a capital structure that can support what CEO Klein calls "our strategic business objectives," while R.H. Donnelley has just had its outlook revised downward to "negative from stable" by both Fitch Ratings and Standard & Poor's Ratings Services.

The challenge of keeping cash flow generation ahead of debt obligations strikes many as too close to call. "Will they make it?" asks an analyst who covers Idearc and R.H. Donnelley. "Who knows?" Then, after reflecting, he says, "I'd at least like to think their core business isn't going to disappear as quickly as the stock market thinks it will."

An uncertain future for the Yellow Page industry stands in stark contrast to its past. Since 1883, when a printer in Wyoming ran out of white paper for the directory he was publishing and serendipitously discovered black ink on yellow paper was easier to read, the business has posted either solid growth or solid profits. For many of the intervening years, it racked up both. In July 1990, Sales & Marketing Management reported that U.S. Yellow Page revenue grew from $2.9 billion to $8.3 billion during the 1980s, "outpacing the growth of advertising expenditures in all media by roughly one-third." Few took notice, S&MM continued, as the least flashy of media "moved slowly into the top ranks of advertising, quietly edging out first outdoor, then magazines and now radio."

Revenue growth slowed in the 1990s, dropping to 48% between 1991 and 2001 after increasing 186% the preceding decade. By then, however, the medium's resilience more than compensated for the slower growth trajectory. As American Demographics noted in a November 2002 article: "Between 2000 and 2001, [the U.S. Yellow Page industry] posted an estimated ad revenue gain of 3 percent, whereas almost all other media saw losses. For example, broadcast TV, the Internet and consumer magazines fell 13 percent, 12 percent and 10 percent, respectively." The buoyancy of Yellow Pages was such that an Advertising Research Foundation executive hailed the medium as "almost recession-proof."

That's hardly the case today, even without the complications posed by a surfeit of debt. Veronis Suhler Stevenson LLC projected in August that domestic spending on Yellow Pages would produce a 0.7% compound annual growth rate between 2007 and 2012. Only newspapers -- with a CAGR of negative 2.4% -- were accorded a worse outlook. And that's from a total of 20 media segments for which the New York-based merchant bank made forecasts.

Greater growth is being projected for the medium by the Kelsey Group, an industry researcher and analyst in Princeton, N.J. But the 2.8% CAGR it forecasts for the same 2007-to-2012 period encompasses all of "directional advertising" -- a term that, in addition to print Yellow Pages, includes IYP and local search. (The latter refers to the use of search engines by computer users who add a geographical designation, such as "Manhattan florist," to whatever service or information they are seeking.) Overall, the Kelsey Group expects domestic directional advertising to rise from $16.4 billion in 2007 to $18.8 billion in 2012, with a negative CAGR of 2.9% for advertising in print Yellow Pages more than offset by positive CAGRs of 23.7% and 25.8%, respectively, for IYP and local search.

Nobody knows better than the CEOs of Idearc and R.H. Donnelley that their companies' survival depends on their ability to contain usage and revenue erosion in their core print products, which last year accounted for 87% of industry sales, while staying ahead of interlopers and competitors in the fast-growing IYP and local-search segments. R.H. Donnelley's Swanson has even incorporated this three-part mandate into his company's "Triple Play" -- a strategy introduced a month after the acquisition of LocalLaunch in September 2006 and trademarked, literally, by July 2007.

LocalLaunch, a Chicago-based consulting firm specializing in local-search marketing, gave R.H. Donnelley "scalable in-house expertise to efficiently and effectively bring search-engine marketing solutions to Main Street business," Swanson said at an investment conference shortly after announcing the Triple Play strategy. But it wasn't just an ability to bid on keywords that the acquisition delivered. Rather, the CEO explained: "This is about a team of people that also know exactly how to index and improve rankings of an advertiser's Web page. They understand how the major search engines' algorithms work and what combinations of terms can most effectively be used to get our advertisers the most effective results in both paid and free search results."

Then, using a dentist in Colorado Springs as his example, Swanson quantified the contribution of individual Triple Play elements. About 127,000 residents in Colorado's second-most-populous city obtain dental services each year, he said, and 25,000 of those choose their provider after consulting with print Yellow Pages. Yet another 3,000 rely on IYP, and an additional 11,000 make up their minds after visiting some sort of Web site or using an online search engine. So the Triple Play, if used by the dentist, would have exposed his business to 56% more potential customers than the Yellow Pages did by themselves. (This percentage increase has been ratcheting upward, no doubt, since Swanson first came up with this example two years ago.)

The trickiest part of the Triple Play strategy -- already the business model for the entire industry -- is its search-engine-optimization, or SEO, component. For this is where AT&T, Idearc, R.H. Donnelley and Yellow Book USA, which collectively command more than 80% of the online-offline directory market, intersect with such search engines as Google, Microsoft Corp.'s MSN and Yahoo! Inc. Relationships between these two groups are still so primitive that Yellow Page companies often do little more than feed Google and other SEOs a limited view of their database, with no money changing hands, in the interest of increasing exposure for Yellow Page advertisers. Never mind that the dynamics of these relationships are still emerging; Wall Street has convinced itself that Google will emerge invincible.

This outcome is by no means assured, however, as a simple Google search on "carpenter Teaneck" reveals. The search returns 10 business names, ranging from "Mr. Handyman" to "Anne Carpenter Inc.," as well as a phone number for each. Below that, though, is a link to an encyclopedia.com entry about Mr. Edward Carpenter of Teaneck, who's further identified as a New York City school administrator. So much more clutter follows that, after several downward scrolls, even early adopters can be forgiven for missing the Yellow Pages they used to peruse as kids.

Those pages not only presented local carpenters in an easily digestible format but frequently included an illustration of several who, in display ads, informed directory users that they and their families had been "serving the community for 50 years," considered "no job too small" and could also "Hablo Español." The pages were also likely to serve up similar tidbits about competitors whose businesses might even be nearer. Not to put too fine a point on it, but SEO does not yet render information as succinctly or completely as even those old directories did.

IYP isn't there either, although it's definitely still a contender. For the industry's IYP mission, AT&T has the best address: www.yellowpages.com. Idearc isn't far behind with its superpages.com, to which it added Switchboard.com through a $225 million acquisition last year. Similarly, R.H. Donnelley enhanced its DexKnows.com with the $345 million purchase of business-to-business vertical Business.com a year ago.

An industry expert who requests anonymity expects the continuing quest for a "better mousetrap" to inspire incremental improvements in IYP and SEO. But some day, he says, an IYP or SEO competitor will come out with a real game changer -- something that does for the directory business "what the iPod did for digital music." And though it's impossible to know who'll create this metaphorically superior mousetrap, its basic look and general features are foregone conclusions. "As soon as they come up with a screen interface that replicates a real Yellow Page," the expert explains, "the print version is dead."

There's no denying a first-mover advantage, to any owner, IYP or SEO, of the Yellow Page industry's online game changer. But the issue then will be how best to sell it. By the feet-on-the-street model employed by traditional Yellow Page publishers? Or by the fill-in-the-form model preferred by SEOs like Google?

Charles Laughlin, a senior vice president and program director at the Kelsey Group, acknowledges "a big sales force may not always be a barrier to competition." But it is today, he says, considering how few of the country's 12.5 million small and medium-size businesses, or SMBs, would market themselves through SEO, IYP or even the Yellow Pages without a sales representative walking them through the process. This SMB mindset does more than favor traditional Yellow Page players like Idearc, with a sales force of 3,000, and R.H. Donnelley, with one of 1,900. It also gives SEO competitors pause.

Google, with its cash pile of $14.4 billion, could acquire Idearc or R.H. Donnelley without even taking a loan. Doing so, of course, would give it the feet-on-the street sales force so critical to closing advertising deals with SMBs. But the acquisition would also raise questions about corporate vision and mission: Does Google want the nurturing and managing of a sales organization to become a core competency? Could the combined staffs -- Google's 17,000, with either Idearc's 7,000 or R.H. Donnelley's 5,000 -- ever be effectively integrated? And how might investors respond to Google's sudden immersion in an industry with growth prospects in the low single digits?

At Idearc, meanwhile, newcomer CEO Klein immediately identified his sales force's established relationships with 800,000 clients as the company's greatest asset. "SMBs really need to reach out and touch outside resources that can help drive their businesses," he says. "Our premise reps really act as media consultants to them." So rather than take reps out of the field to achieve SEO-like efficiencies, Idearc is not only keeping them there but training them to add direct-marketing services to their product line.

Klein, who spent his early career as a marketer for Procter & Gamble Co. and PepsiCo Inc., considers the addition a natural extension for a company whose legacy business isn't really getting SMBs to advertise in the Yellow Pages but, rather, generating leads for them. These leads may have originally come from printed Yellow Page ads, where independent studies show a return on investment of $52 for each $1 spent, or more recently from IYP ads, with an ROI of $55 for each $1 spent. (These ROIs, by the way, still compare favorably with an $11 return on television commercials and $8 for radio advertising.) But now the leads are starting to come from Idearc-initiated direct-mail campaigns, too.

Dave Lewis, an Idearc regional vice president of sales who has sold Yellow Pages for 19 years, already reports good feedback from the field. "At point of sale, our clients love our new product set," he says. "These folks need someone they trust to be their one-stop shop for getting things like postcards -- designed with a strong offer, printed on high-quality paper -- mailed to folks who are likely to need that service. It also helps our other product sales, as we're able to bundle all of our products and really help that business crank up advertising at a minute's notice or crank it down if they are getting too much business."

The upshot is that it's not just the $14.7 billion printed Yellow Page business anymore. That's still the core, but the future is getting even deeper into the $12.7 billion (and rapidly expanding) Internet-advertising market. Ramesh Lakshmi-Ratan, executive vice president and COO of the Direct Marketing Association, believes expansion into direct marketing shows promise, too. "If you own a pizza shop or a laundromat or the neighborhood store," he says, "you don't have a lot of time to get sophisticated about things like advertising and marketing. And so the person who walks in the door and talks to you face to face becomes very important in terms of giving you new ideas and showing you a mix of things that can improve sales."

Moreover, Ratan credits IYP and SEO with embarking Yellow Page sales reps on a continuing education program that puts mastery of direct marketing within their reach. "They're already offering and combining reasonably intricate and sophisticated products," he says. "It makes absolute sense" not only to expand the product line but, by doing so, position the Yellow Pages for a slice of the $174 billion spent annually on domestic direct-marketing campaigns. It's the sort of makeover that could compel even Wall Street to reconsider its abandonment of directory-driven businesses -- provided these businesses can make a convincing case they'll be able to manage their debt as well as their operations.

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