Valuation of highly leveraged/distressed equities

Recently two articles were published on Seeking Alpha about Dex Media (DXM), one arguing that the stock could be a 30x bagger and one arguing that it will be a zero. Seeing both the bull and bear thesis for a stock is in my opinion always interesting, especially when there is a big divergence between the two viewpoints. If someone is wrong there might be an opportunity to make money! But in this case I think both authors are making a fundamental valuation mistake.

Dex Media is extremely leveraged: the market value of the equity is just $130 million while the company has $3 billion in debt with a market value of $2.1 billion. Shorts often use this statistic as an argument that the equity should be a zero, and the author of the Dex Media short case isn’t an exception:

But the intelligent investor needs to temper expectations of a multi-bagger opportunity in the equity with the plain fact that the debtors are willing to sell the debt at a discount to par, implying that the equity has no value whatsoever.

I would argue that this is not the right perspective. The equity is at this moment effectively an out of the money call option: there is zero intrinsic value, but it could still have plenty of extrinsic value. The debt doesn’t reach maturity until late 2016/early 2017, so what you have is an option with two years till expiry. The question you should be asking is: “what is the probability that the fundamentals change between now and then in such a way that the market value of the company changes from today’s $2.2 billion to >$3 billion?”. To be clear: I have no idea what the answer to that question is! But what I do know is that you can’t present a good argument for a long or short case without trying to answer this question.

Dex Media is one of the many dying yellow pages businesses worldwide that is trying to move online. At the moment the legacy business is quickly deteriorating while the online business isn’t great either, but I would argue that there is probably a large amount of fundamental uncertainty on how this company will look like in one or two years time. It’s not impossible that they can slow down the decline in the legacy businesses, or turn around the internet business. Maybe there is a ~10 percent probability that Dex Media is in two years time a company with a >$4 billion enterprise value. In that case both the equity and the debt could be priced correctly, even though the debt is currently trading at a big discount to par.

Options do have value when they are not in the money. The big – and in this case unanswered – question is how much value?

Disclosure

No position in DXM

7 thoughts on “Valuation of highly leveraged/distressed equities

  1. Packer

    This may be the case where the debt is good buy and the common stock a speculation. Francis Chou has a good thesis for the DexMedia debt purchased at the right price. The common is very risky because it is like buying an out of the money call option on a melting ice cube.

    Packer

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    1. Alpha Vulture Post author

      I don’t know if a melting ice cube is the best comparison. They do generate cash flow, but the question is more if it ever will be enough to repay the debt. The ice cube isn’t melting yet, but it might simply not be big enough.

      And yes, it’s certainly like buying an out of the money call option, and therefor risky. My point in merely that if you want to value an out of the money call option you have at the very least to be thinking about the probabilities of various scenario’s. If it’s like an option value it like an option!

      Reply
      1. Packer

        DXM’s revenue is declining on a 15%+ annualized basis and they are scrambling to reduce costs just as fast. The hope that digital would fill in the print decline rate has been dashed as its growth rate is down to 0%. I don’t see how this is not a shrinking value firm with the debt holders receiving the residual earnings until there is nothing left. (Note: you have to be careful with the GAAP numbers as they historically (last year) only include Dex Media and now include the merged Dex/SuperMedia. )

        Packer

        Reply
        1. Alpha Vulture Post author

          I basically agree with you 100% on DXM, it’s just that in my mind a melting ice cube is a bit different: a business that generates, for example: 10M, 8M, 6M, 4M, 0M in cash flow is simply a business that doesn’t have a lot of value, but it’s not what I would view as a melting ice cube. A business that has 10M in liquidation value today, but generates -1M in cash flow every year, that would be a melting ice cube that could have zero value after a couple of years.

          In the latter case there is value today (the ice cube), but that’s slowly melting away. In DXM’s case there is some amount of value, and I don’t think that value is destroyed, it’s just that it’s probably not enough to pay off the debt load.

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  2. Pingback: ~1000 days – $DXM $YLWDF timeline analysis – market has given up on dex – not so fast! | GlenBradford.com

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