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Directories: Industry Perspectives from the Point of View of Financial Investors

Introduction by Kimberli Lewis

Since this time last year, the dynamic telephone directory acquisition market has seen at least nine major acquisitions, many involving private equity firms, either directly or indirectly.  Veronis Suhler Stevenson is one of the most active such firms.  What makes our industry interesting to companies like Veronis Suhler Stevenson?  Are there more acquisitions and exits on the horizon?  Morgan Callagy, Managing Director of Veronis Suhler Stevenson, is an expert in this area. 

Morgan graduated from Georgetown University in Washington DC, joining the company in 1996.  Veronis Suhler Stevenson manages private equity funds from offices in New York and London, focusing exclusively on media communications and information industries. 

Morgan was involved in Veronis Suhler’s acquisition of Yellow Book USA and its disposal to British Telecom Yellow Pages in 1999.  He moved to London to set up the office there in April 2000, since playing leading roles in Veronis Suhler’s joint investments with 3i in the European directories sector.  Veronis Suhler acquired Fonecta from the Finnish company, Telefoongids from Dutch operator KPN, and recently, Verizon’s European directory portfolio, comprising operations in Austria, the Czech Republic, Slovakia, Poland, Hungary and Gibraltar. 

 Morgan Callagy

Managing Director, Veronis Suhler Stevenson, UK

I.                  Overview of Veronis Suhler Stevenson

After spending many years in publishing, John Veronis and John Suhler founded the company in 1981 in New York.  In 2000, we opened our European headquarters in London.  The firm has two activities: advisory work, in the directory space, we recently advised California‑based National Directory Company (NDC), which was acquired by Yell; and private equity activities, with more than $1 billion under management, we are the largest private equity group dedicated to media industries.  We are active in both the US and European directory sectors through our fund activities. 

II.               Directory Publishing Activities

1.                  Yellow Book

In 1997 we invested in independent directory publisher, Yellow Book.  It published predominantly print directories in four states with $60 million in revenue.  A strong management team pursued a buy and build strategy, resulting in four separate acquisitions, one of which doubled the company’s size.  When we sold Yellow Book to British Telecom two years later, the company had become the largest independent publisher in the US.  Circulation increased by 260% to 18 million, revenues had increased by 250%, and it was publishing directories from Long Island to Florida. 

2.                  Fonecta

In 2002, alongside 3i, another European private equity fund, we acquired the directory publishing, directory assistance and electronic directory divisions of Sonera.  The company, renamed Fonecta, operates largely in Finland, with over 500 employees in France.  Fonecta is one of the leading directory companies, providing finder services across an integrated platform of products, including printed directories, enhanced directory assistance services and electronic and mobile directory applications.  There was a significant opportunity to grow top‑line revenue, currently just under €100 million, and to grow the bottom-line organically, through acquisitions and cost savings initiatives.  We liked the Nordic market, especially Finland, because it is ahead of the innovation cycle and a leader in new technologies, particularly on the mobile side. 

3.                  Telefoongids

In February 2003, we acquired KPN’s directory operations in The Netherlands with 3i.  Formerly known as TeleMedia, we renamed the business Telefoongids.  With $150 million in revenue, it has a strong market position and generates The Netherlands’ highest usage both in print and online.  We backed a strong management buy-in team to help refocus the business, orphaned under KPN’s ownership.  We will continue to build on the company’s strong White Pages and internet presence. 

4.                  Mediatel

In July this year, we completed the acquisition of MediaTel from Verizon, which consists of operations in six countries: Austria, the Czech Republic, Slovakia, Poland, Hungary and Gibraltar.  Although the reason behind the acquisition was the business in Gibraltar and the potential to move south into Africa, I think we will focus on Europe.  MediaTel has €160 million of revenue and each country is at a different development stage, in both print and electronic cycles.  Most of the businesses are incumbent in their markets and all are poised for exceptional growth, as many of the countries are scheduled to join the EU.  We brought in a seasoned CEO and CFO to complement a strong local management team and we intend to help the businesses work closely together. 

III.           Differences Between the US and European Markets

The US market is significantly larger than the European one, consisting until recently of predominantly telco‑owned businesses in the US and limited telco ownership in Europe with recent transactions.  In the US, there are no national print players, as there are no pan‑European players, although a few businesses have operations in several markets.  In the US, there are many competitive markets with three plus publishers and often three books.  In Europe, there are one to two publishers per market with strong incumbents. 

In the US market, publishers sponsor new launches, rare in Europe.  In the US, the internet presence of directory businesses has high competition from ISPs and portals, whereas in Europe, particularly in smaller markets, directory publishers have a stronger internet presence.  In the US, incumbents are a low growth and independents a high growth business; in Europe, incumbents represent high growth because of new media developments across the product portfolio. 

Stand‑alone directory businesses are a relatively new concept in Europe; most of them are previously managed divisions of telcos.  However, most telcos have been looking for ways to reduce high debt levels as a result of overspending on acquisitions or third generation licences, so have been selling off non‑core assets.  We have also seen the emergence of directories integrated with ISPs and the subsequent separation of the ISP business, for example the recent SEAT transaction.

IV.            Directory Sector Profile

In the last two years, many high profile directory transactions have attracted interest from investors.  Many such transactions have topped the charts in terms of size, the buyouts of QuestX in the US and SEAT in Europe being the largest ever buyouts in their respective markets. 

The directory sector’s public and private investor profile has consequently been raised.  Private equity has been involved in every European transaction in the last two years and there is a similar situation in the US and Canada.  Private equity has been fuelling M&A activity in the sector.  We will have to wait and see what is next but it looks like it will not be in Germany. 

Increased M&A activity in the directories sector has been driven by several factors, namely investor interest, debt reduction programmes by vendors, particularly telcos, and favourable banking markets and lending environment. 

V.               Investment Considerations

1.                  Overview

The first investment consideration is favourable cash flow and working capital dynamics.  Secondly, new revenue streams, driven by new, more integrated products and distribution platforms, for example, Fonecta in Finland and Eniro  in Sweden.  The low threat of new entrants creates high barriers to entry in the sector, a big positive, and the businesses are resilient to slowing economies.  M&A activity brought about by debt reduction programmes and favourable financing markets and leverage characteristics of the directory business are important for private equity, since we use leverage to drive our returns. 

The EBITDA margins of larger European players range from 20% to 50%, 20% being at the low end, breaking out Yell’s UK and US components.  Access to data is a fairly insignificant cost, with the largest single expense being the sales force, accounting for 30%, and production and distribution account for 10%.  Across the board, directory margins in Europe are about 35%, though companies like SEAT and VNU have exceeded 40%.  The VNU and Wanadoo margins are solely print margins.  Amazingly, Australian EBITDA margins are nearing the 60% level. 

2.                  Cash Flow and Working Capital Dynamics

In terms of cash flow and working capital dynamics, there is often good earnings visibility because canvasses, and therefore cash collection, begin well ahead of publication.  New media activities generate high cash flow margins due to less expensive production and distribution costs.  Capital expenditures are lower than 3% of revenue and cash conversion, EBITDA to free cash flow, is high, which is important when we look at returns models. 

3.                  New Revenue Streams

The directory sector has evolved in a relatively short space of time from print to CD‑Rom to online and now mobile and enhanced directory assistance services.  This migration allows publishers to deliver above‑average growth beyond core traditional print products.  In 1998, 3% of revenues were generated outside core print products.  Today, this figure exceeds 10% and is forecast to continue growing rapidly. 

New technologies allow directories to expand coverage of the transaction process.  New products and applications create new opportunities for customers and users, creating further upsides in both EBITDA and revenue improvements.  Technology is forcing the business model to evolve.  Growth is driven by new platforms, like online and mobile directory applications.  New platforms are developing as additional to, rather than a substitution for print revenues.  If they are sold properly, new media applications will be key drivers to future value creation in the sector. 

4.                  Barriers to Entry

Barriers to entry are high.  In major European markets, large publishers hold strong positions, with generally one other publisher in the market.  There are few examples in Europe of publishers launching successfully against an incumbent; in the US, we have had many successes.  Another characteristic that creates high barriers to entry is the importance of the size of the sales force.  Brand recognition makes it difficult for smaller players to establish themselves, and a high quality and flexible database allow the production of different products.

5.                  Resilience of the Business

Consumers have often made purchasing decisions when consulting directories, important to advertisers with low bargaining powers.  Directory advertising is crucial, the only option for small businesses.

6.                  M&A Activity

The more M&A activity in the sector, the more the profile is raised and investors’ interest is peaked.  In the recent SEAT auction, there were four consortiums bidding for the asset, within which there were about a dozen different groups – remarkable, given the size of the transaction.  Most transactions have involved private equity with in excess of $10 billion of proceeds in Europe, and over $15 billion in the last two years alone.  The heavy private equity involvement in the sector has mainly resulted from large strategic acquisitions having been sidelined. 

7.                  Financial Considerations

In the last four years valuations have been all over the map.  The rise in 2000 fuelled by the internet bubble brought valuations to new heights and directory publishers were often perceived as internet stocks.  Valuations have since come down, supported by stable core print products.  In the last two to three years, EBITDA multiples in Europe were slightly higher than the US, a product of the US tendency to higher margins; lower margins in Europe reflecting improvement potential.

In the public markets, directory publishers trade at between nine and 11 times EBITDA and the markets are strong believers in the defensive characteristics of the sector.  In private equity, directories have good financing capabilities, again due to high EBITDA and cash flow characteristics.  Lending institutions are comfortable lending to this sector, which has a good transaction history.  Banks like the incumbent status of European directory publishers.

Private equity sponsored transactions have included debt packages at about 5.5 to 6.5 times EBITDA.  With the inclusion of high yield instruments or other subordinated debt, those multiples can be pushed and in the SEAT transaction, they are setting a new precedent; although the debt multiple has not yet been announced, it is likely to be close to seven times EBITDA.

8.                  Leverage

While good financing packages are critical in a buyout, our overriding objective is to not over‑gear businesses, but to leverage them prudently, leaving room within the capital structure for follow‑on acquisitions.  The debt markets have recently been very favourable; the cost of borrowing is at an all‑time low, with interest rates nearing record levels and thin credit spreads.  This is reflective of the sector’s past performance.  Due to the size and credit characteristics of directory businesses, institutional financing packages are available for longer‑term subordinated capital.  High yield markets are attractive, with two new issues to follow: Cincinatti Bell in the US and Dex Media.  SEAT has not yet come to market.  Mezzanine financing in Europe is often available without warrants, which is important for us, as it allows prepayment without deluting equity returns. 

VI.            Sector Risk

We do however see risk in the sector.  The landscape is becoming highly competitive, especially in the US.  Technology is opening the market to new entrants.  We are all closely watching increased investment spending, new product development, and the growing presence of major players in the search market.  The re‑entrance of telcos like British Telecom in the UK market is highly pertinent. 

VII.        Conclusions and Trends

Consolidation will be a continued theme.  I expect further M&A activity in the sector and the possible emergence of more transatlantic companies.  I also think directory businesses will further expand in areas like directory assistance, like Eniro’s  acquisition of Response.  From the private equity perspective, directories are generally a very attractive sector with a proven formula for success, in which we will hopefully drive growth.

VIII.     Questions

Participant

Could you give us some ideas on the parameters for an exit strategy?

Morgan Callagy

We are very early in the cycle of our European investments, but execution of the plans is important.  Regarding exit strategies, we will see more IPOs in the sector, possibly some US companies looking for expansion opportunities in Europe.  We may even see companies looking towards Eastern Europe for expansion opportunities.  I think new technology developments within the product portfolio to help enhance business returns are going to be increasingly important. 

Participant

You mentioned your concern that telcos were re‑entering the market.  Have you seen much activity from the mobile operators?

Morgan Callagy

I have not seen any evidence of mobile operators entering the print side.  On the new media side, it is something that we need to be concerned about and watch.  In some of the smaller markets we are looking to form relationships with mobile operators and develop joint products.  Mobile operators can obviously benefit from our database and the types of enhanced data that we can offer in terms of new services.  Once media sales become an important part of mobile directory applications, I think that you will see more mobile operators co‑operating with directory publishers. 

Kimberli Lewis

What is your opinion of the situation in Germany with DeTeMedien?

Morgan Callagy

Many of us would like to see something happen in the German market, but until DeTeMedien ends up in the hands of somebody other than Deutsche Telekom, I do not think we will see a lot of M&A activity.  It is likely that if a transaction does happen, the business will end up in the hands of the publishers and following that, it becomes a very interesting market from our perspective.