In New Zealand there has been considerable debate about the increasing impact of private equity funds investing in the economy.  The recent acquisition of Telecom New Zealand’s Yellow Pages business by CCMP and the Ontario Teachers Pension Plan for NZ$2.24 billion is the most recent high profile example.

The common characteristic of these acquisitions is the use of significant amounts of very cheap debt.  The ability to obtain this debt has been a key factor in the valuations that private equity funds have been able to pay for acquisitions.

This increased private equity activity has only appeared in New Zealand over the last six to twelve months.

Just over twelve months ago there was a very high-profile transaction in the New Zealand market where the Australian media company Fairfax purchased on-line auction site Trade Me (Trade Me is New Zealand’s version of eBay) for NZ$700 million.  This price was generally greeted by the media with amazement – we thought the price looked more than reasonable.

The Trade Me sale was to an established media company while the recent acquisition of Yellow Pages was by a pure financial buyer using cheap debt.

What would a private equity buyer have potentially paid for Trade Me?

Private equity funds like certain characteristics in the businesses that they buy.  Private equity funds like: large businesses, dominant market positions, strong management teams and strong cash flows (to pay back the debt).  Yellow Pages have all of these characteristics – but so does Trade Me.

The question has been asked – does 1 Yellow Pages = 3.2x Trade Me?

We thought that was a great question – and decided to have a closer look.

This is what we did:

We took our previous valuation of Trade Me and made some amendments.  We assumed that EBITDA forecasts for the current year of NZ$45 million were met.  We then projected EBITDA at NZ$65 million for the current (2007) rising to NZ$100 million in 2009.  We then projected EBITDA growth for 10% in the next two years falling to a 3% long-term growth rate – this equals a 4% long-term growth rate in the Valuecruncher model.  We lowered our equity discount rate to 12% from the 15% we had previously used.  The Yellow Pages transaction was based on raising debt equal to 10x the forecast EBITDA ($157 million of EBITDA) for approximately NZ$1.6 billion.  For Trade Me we assumed that NZ$600 million of debt could be raised for a private equity transaction.  We assumed a cost of debt of 7.5% and a 12% cost of equity on a 50:50 debt to equity ratio (assuming a NZ$580 million debt capability – 8.9x NZ$65 million EBITDA) for a WACC of 9.75%, which we rounded up to 10%.  This WACC is probably conservative.  We used 8% in valuing the private equity transaction for Yellow Pages.

Our answer was a current valuation of Trade Me to a private equity buyer of NZ$1.16 billion.

Trade Me - Private Equity Valuation

We are not saying that Trade Me should have waited and not done the deal with Fairfax.  Decisions are made with the information that is available at the time – the potential impact of private equity on valuations of businesses such as Trade Me could not have been foreseen at the time of the transaction.  However, we do not believe that you can compare the two transactions without making the adjustments that we have.

Based on the raw numbers 1 Yellow Pages = 3.2x Trade Me.  Based on our adjusted analysis 1 Yellow Pages = 1.9x Trade Me.

Yellow Pages is a great business.  However, we see a significant number of challenges for the business moving forward.  Telecom New Zealand had an asset with significant potential on-line with Yellow Pages.  At Valuecruncher we believe that Telecom New Zealand would have struggled to achieve that potential had they retained ownership.  Telecom New Zealand probably did the right thing exiting the business – for a very good price.  We believe that on-line competition (from multiple current and potential sources) will potentially significantly disrupt the Yellow Pages business.  CCMP (one of the acquirers of Yellow Pages) brought the Singapore Yellow Pages equivalent in 2003.  Yellow Pages have announced some strategic measures it is implementing post the separation from Telecom New Zealand.  These include a revamp of the Yellow Pages website and a new physical DIY publication for the Auckland market.  We presume these activities are based on the successes that CCMP had with similar acquisitions – such as the 2003 Singapore acquisition.

Valuecruncher believes that the environment that Yellow Pages operates in is now dramatically different to 2003.  12 months ago 1 Yellow Pages might have equalled 3.2x Trade Me and today 1 Yellow Pages might equal 1.9x Trade Me.  Our bet is in 12 months time that ratio will have moved again – and not in Yellow Pages favour.  Especially if physical publications continue to be a cornerstone of the Yellow Pages strategy – the Yellow Pages acquisition requires a very good on-line strategy and flawless execution.

This week Telecom announced the sale of its directory business Yellow Pages to private equity company CCMP and the Ontario Teachers Pension Plan for $2.24 billion. Both parties have a history of investing in the asset class, CCMP invested in Singapore Yellow Pages in 2003 and the Otario Teachers Pension Plan took a 30% stake in the Canadian Yellow Pages in 2002. 

Valuecruncher has followed the sale process with interest and made a number of posts discussing the valuation. The sale price was within the expected range of analysts and consistent with the last Valuecruncher valuation posted. Valuecruncher believes the price is an excellent result for Telecom and its shareholders.  

Much has been made of the excellent margins Yellow Pages achieves (EBITDA margin ~ 60%) compared to international comparables (Yell Group (UK) 27% and Yellow Pages Singapore 43%) and this appears to have been fully factored into the price. The Yellow Pages transaction implies an EV-EBITDA multiple of 14.3, this is higher than the 7.8 to 12.9 range observed in acquisitions of European directory services. The ability of the Yellow Pages to maintain these margins as a stand alone entity remains uncertain with it interesting to note that Telecom will continue to provide information database services and billing services (via Gen-i). 

The focus now shifts to the future of Yellow Pages and directory services in New Zealand. The time horizon of CCMP (3-5 years) and the level of debt to be utilised (75%) mean that the success or failure of the investment will primarily be determined by the value obtained at exit. There is currently a significant amount of uncertainty around the future of directory services as they are expected to migrate from a print medium to an online service. The speed of this transition and the ability of Yellow Pages to adapt and compete with rivals including APN will be interesting to observe. APN has launched apnfinda a combination of UBD, Wises and finda with a combined database of nearly 250,000 businesses to focus on gaining a significant share of the online directories market. It is interesting to note that the transaction included a clause restricting Telecom from competing in print or online directories for the next 10 years. This clause does not apply to Yahoo!Xtra and follows Telecom CEO Theresa Gattung’s comments that directories are moving online and the market would be dominated by major players such as Google and Yahoo!.     

We have written about the Yellow pages here and here.  Some of our commentary has been picked up by leading New Zealand business publications.

NBR Yellow Pages Sale

But it appears our valuation was wrong.  The rumours in the market were that it took NZ$2.1 billion to make the short-list and the four finalists are all private equity players.  Our valuation was NZ$1.1 billion – that is a long way short of NZ$2.1 billion.

Here at Valuecruncher we back our analysis – and when we are that far out we want to know why.

Our valuation was based on Yellow Pages Group as a standalone entity – normal valuation procedure.  Often in a sale process an acquirer in the same industry can come in and extract synergies (either revenue and/or costs) and be able to pay a higher price than outsiders by paying away some of these synergies in the process.  We discussed this in a post about 42 Below.  In the Yellow Pages example the logical party with the ability to exploit synergies in the directories business in the Australasia region is Telstra with the Sensis business.  Then Telstra came out with an amazing statement when they did not make the final short-list saying in-effect that the price was too high and the bidders are paying too much.  So we can take it that the synergies were not enough to secure the asset.

Are the remaining private equity players paying too much – as Telstra suggest?  The remaining bidders are a very successful group that have a track record of generating wealth in the private equity business.  How can these funds pay this amount (with the expectations of significant returns) when the typical logic says it is too high?

This has been bugging me – I don’t like being this far out on valuations.  I like to think it isn’t typical.

Two things drive value – cash flows and the discount rate applied to those cash flows.

I started by looking at the cash flows of the business.  Do the private equity funds provide the expertise for the Yellow Pages Group to increase the cash generated by the business.  I concluded no – the EBIT margins of 50% are at the top of the international comparator range.  Private equity funds have brought in operational expertise over the last couple of years but this isn’t likely to bring insights on new strategies for Yellow Pages Group – private equity funds like Clayton Dubilier & Rice have Jack Welch (ex-GE CEO)  where what the Yellow Pages Group buyers need is a Sam Morgan.  I don’t believe that Sam Morgan is going to start work for the ultimate acquirer of the Yellow Pages Group – but it is the only way that cash flows are likely to be increased.  I stick with my conclusion – no; the cash flows are not the answer.

The discount rate – has to be here somewhere and if it isn’t the cash flows…  This is where things get interesting.  In my prior analysis I started with a 15% discount rate and moved to a 12% rate.  Then I found this.  For those that can’t be bothered following the link – it is a Bloomberg piece about the rates private equity funds are able to borrow at and the amounts of debt available.  The numbers are crazy – private equity funds are able to borrow startling amounts of cash for each transaction at very low rates.  The Bloomberg piece states 2.25% above LIBOR (London Inter-Bank Offer Rate – basically the rate banks will lend to each other).  The LIBOR rate today is 5.30%.  2.25% above that is 7.55% and the borrowers will be able to take the tax benefit (at say 33%) to give a post-tax borrowing rate of 5.1%.  If we assume the equity portion of the discount rate is 15% – reflecting the variability of the cash flows of the asset (rough estimate rather than science – but probably pretty close).  If we then assume a 75:25 debt equity split (5.1%x75% + 15%x25%) we have a weighted average cost of capital (WACC) for the private equity buyers of 7.6% – we will round it up to 8%.  If we put that into the Valuecruncher valuation model from last time – all cash flow assumptions remain constant and we simply substitute 8% for the 12% discount rate we used.  We come up with a valuation of NZ$2.47 billion.

Yellow Pages Valuation - Private Equity

Telstra’s WACC is 10%.  Placing Telstra’s WACC into the model produces a valuation of NZ$1.78 billion – NZ$690 million short of the private equity valuation.  Potential synergies extracted from the Yellow Pages Group by Telstra obviously would not close that gap.  That is why Telstra exited.  Others could pay more.

The ultimate reason the price has gone so high is that there is an unprecedented amount of cheap debt available to fund these types of private equity acquisitions.  Is this cheap debt a sustainable on-going condition? Too hard to call – but if a big private equity transaction goes bad and some big lenders lose significant capital things may change.  For now private equity buyers can finance certain acquisitions (Yellow Pages Group is an example – a combination of size and stable cash flows) with very cheap debt.  This gives them a big advantage over potential strategic acquirers (i.e. Telstra’s Sensis with Yellow Pages Group).

What does this all suggest about the final price paid by one of the remaining buyers?  Hard to say – my valuation is based on some broad estimates.  The specifics of the funding arrangements available to each private equity fund will be different.  It will probably come down to the group that decides they really want the asset and are prepared to go the distance to get it.  The individuals involved are pretty competitive types – so that could be interesting.

That said – this is a deal about leveraging the existing cash flows.  I would not expect the ultimate owner of these assets to be investing significantly in new services – i.e. developing an effective on-line strategy for Yellow Pages Group.  Expect more of the same in regards service from the Yellow Pages in the New Zealand market over the next few years.

There are certainly questions about the strategic wisdom of Telecom selling the Yellow Pages Group.  But the choice of timing – with the cheap debt available to private equity funds – means that the result to Telecom will be a good one financially.

And that is how in my opinion private equity buyers can pay in the region of NZ$2.1+ billion for the Yellow Pages Group.

We have had a lot of discussion around the valuation we did of Telecom New Zealand’s Yellow Pages Group (Yellow Pages).  Based on some of this discussion we have decided to revisit some of the assumptions and see where we come out - see if there is a change.

Key assumptions

In our valuation we have used a 15% discount rate – basically we ignored the ability of Yellow Pages to assume debt.  This is probably an oversight.  Yellow Pages produces a lot of cash.  Any owner could use this cash flow to repay substantial debt – which would lower the WACC (discount rate) we have used.  15% is probably too high and around 10% (Telecom New Zealand’s WACC) is probably too low – we have used 12%.

In our valuation we used 20% growth – based on the compound annual growth rate Yell has achieved over the last five years.  Yell has achieved this growth primarily through acquisitions.  Acquisitions are probably not available to Yellow Pages.  Any acquisition probably isn’t going to deliver the 20% annual growth that Yell achieved by entering the United States then Spanish markets.  We hear that Yellow Pages will hit the NZ$300 million revenue mark this year (NZ$250 million last year) and then a figure of 5-8% annual growth is more realistic.  We have used NZ$300 million for 2007 and then 7% growth to 2009 and kept the 3% terminal growth.

EBIT margins – how much revenue is pre-tax cash?  Several parties have suggested that the Sensis EBIT margins are a better reflection of Yellow Pages margins than Yell.  The opinion is that 50% EBIT margins are closer to the mark than the 28% achieved at Yell and the 35% we used.  I struggle on this one – 50% EBIT margins are achievable, but that is an exceptional business.  Yell has achieved 30% EBIT margins and is, we believe, a very good case study for Yellow Pages.  To see how it plays out however we have used 50% EBIT margins.

Making those changes produces a Valuecruncher valuation for Yellow Pages of NZ$1.38 billion with a range NZ$1.11 to NZ$1.66 billion – based on sensitivities around revenue growth and EBIT margins.  This is 11.0x 2006 EBIT (assuming 50% EBIT margins).

Revised Valuecruncher Yellow Pages Valuation

This is where the NZ$1.5+ billion figure has come from.  To get above this level requires removing significant costs or new revenue streams (potentially on-line).  We still believe NZ$2.2 billion is fantasy – but we can see where NZ$1.4-1.6 billion comes from.

At Valuecruncher we don’t believe 50% EBIT margins are achievable – for a standalone Yellow Pages business.  The highest that we feel comfortable with is 40%.  Yell is at 28% - Ebay has ~40% margins.  At 40% EBIT margins the Valuecruncher result is – NZ$1.10 billion with a range NZ$867 million to NZ$1.36 billion – based on sensitivities around revenue growth and EBIT margins.  This is 11.0x 2006 EBIT (assuming 40% EBIT margins).

Our previous valuation of NZ$897 million may be low.  We can see how the NZ$1.5+ billion figure has been obtained.  However – we can’t get to 50% EBIT margins required by these numbers.  At Valuecruncher the best we will assume is 40%.  At 40% with the various amendments the valuation is NZ$1.10 billion.

Valuecruncher Valuation – NZ$1.10 billion with a range of NZ$867 million to NZ$1.36 billion.  If Telecom New Zealand can get above that – they will have done well.

On 3 November Telecom New Zealand announced their first quarter result and that they would be running a competitive process for selling their directory business – Yellow Pages Group (Yellow Pages).

Analysts have placed values on the Yellow Pages business of between NZ$1.5 billion and NZ$2.2 billion.

We decided to have a look and see what sort of valuation we would place on Yellow Pages.

Yell Group

Before we get to Yellow Pages here in New Zealand – it is worth having a quick look at Yell Group (Yell) in the UK.  Yell was the directories business owned by BT (British Telecom) that was sold to private equity firms in 2001 and then listed on the London Stock Exchange (LSE) in 2003.  This is a pretty good case study of what might happen with Yellow Pages here in New Zealand.

Some details:

BT sold the business in 2001 for GBP2.14 billion – that year the business had EBIT of approximately GBP220 million (normalised EBITDA of GBP245 million for the year ended 31 March 2002 and we have assumed GBP25 million of depreciation and amortisation – 31 March 2006 EBITDA of GBP503 million with GBP54 million of depreciation and amortisation).  This equates to an Enterprise Value (EV)/EBIT multiple of 9.7x.  At the time of the sale the business was operating 25% EBIT margins – revenues of GBP865 million and EBIT of approximately GBP220 million.

Over the next five years to 31 March 2006 Yell increased revenues at a compound annual growth rate of 17% and adjusted EBITDA (for abnormal items) at 20%.  For the year ended 31 March 2006 Yell had revenues of GBP1.62 billion and EBIT of GBP449 million – 28% EBIT margin.  96% of these revenues in 2006 were derived from selling advertising in printed classified directories.

It is worth noting that Australian Telco Telstra’s wholly owned directories business – Sensis – has EBIT margins approaching 50%.  Sensis is however not an independent company.

Significant parts of Yell’s growth had been achieved by acquisitions in the United States (now reptresenting over half the 2006 EBIT).  In July 2006 Yell completed the acquisition of Spain’s primary directory business (not included in any of the financial or staff numbers used in this analysis - but incorporated in the current share price).

Yell had 11,500 employees at 31 March 2006 so derived GBP141,000 of revenue per employee.  This converts to NZ$403,000 at 0.35.

Today Yell trades on an EV/EBIT multiple of 13.8x.

Yellow Pages in New Zealand

This is what we know:

Yellow Pages last year had approximately NZ$250 million of revenues with approximately 600 people.  For the first three months of the current financial year revenues grew by 11.3% against the prior period last year to NZ$69 million.  This equates on a run rate basis to approximately NZ$276 million this year of revenues.

Our valuation approach

We started with the NZ$250 million of revenues for last year.  We have assumed that there is scope for considerable growth over the next three years and used 20% annual growth from 2007-9.  The current period has growth of 11.3% so far – we are saying that Yellow Pages can do better than that over the next three years.  We don’t specifically value growth options (i.e. new electronic services) – remember 96% of Yell’s revenues are still print based advertising.  But this growth rate implies some new revenue streams – the same large acquisitions made by Yell internationally are not available to Yellow Pages (in our opinion).  We use a 3% terminal growth rate post-2009.

We have looked at Yell’s 28% EBIT margin and Sensis’s nearly 50% margin and used 35% as an EBIT margin.  We think Yellow Pages can do better than Yell but that Sensis’s EBIT margins are inflated by not being a fully independent company.

With 600 employees – Yellow Pages derives NZ$458,000 of revenues per employee.  This is comparable with Yell’s NZ$403,000 per employee and further justifies our slightly higher EBIT margin.

Our answer

A copy of our valuation is included below.  We produce a mid-point valuation of NZ$897 million – well below the NZ$1.5-2.2 billion being suggested.  We come out at an historic EV/EBIT multiple of 10.3x – compared to Yell’s 9.7x when the business was originally sold and 13.8x today.  It should also be noted the Yell share price has risen 19% since late June 2006 on the successful acquisition of the Spanish directory assets – the market views Yell as a higher value owner of the assets.  This has inflated the current multiple – prior to the acquisition the multiple was 11.9x.  We have used the 13.8x multiple in our analysis – but it does include expected growth in the newly acquired Spanish assets.

To get to the NZ$1.5 billion valuation with our assumptions requires 45% compound annual growth to 2009.  Which will be very hard without major innovation or significant acquisitions – where will the acquisitions come from?  This is a 17.5x historic EV/EBIT multiple and a 14.3x forecast EV/EBIT multiple (assuming 35% EBIT margins and 20% revenue growth this year).  To get to NZ$2.2 billion is 65% compound annual growth and 25.4x historic EV/EBIT multiple and 21.0x forecast EV/EBIT multiple.  TradeMe was bought by Fairfax for 26.9x historic EV/EBIT and 15.6x forecast EV/EBIT.

I believe these numbers (NZ$1.5-2.2 billion) are fantasy.  The top of our valuation – based on sensitivities – is NZ1.1 billion.  Using the current 13.8x Yell multiple gives a valuation of NZ$1.21 billion.

There are some serious strategic questions about actually selling Yellow Pages – BT ultimately stared another directories business after selling Yell.  BT originally sold Yell because of severe debt issues after buying 3G mobile spectrum – Telecom New Zealand has no such pressures.

At Valuecruncher we don’t believe that Telecom New Zealand will achieve the sale price currently being discussed in the market – NZ$1.5 billion+.  An acquirer paying NZ$1.5 billion+ would need to extract some significant synergies and be prepared to pay for them in the sale process.  Our number is around NZ$900 million.  We will watch the process with great interest.

TEL Yellow Pages Group Valuation