Editor's Note: Donnelley is assuming $5.5 billion of Dex's debt, rather than $5.5 million as was originally reported.
Call it vintage, call it retro. Consumers are once again letting their fingers do the walking. Besieged by a lack of local listings and an overabundance of online paid advertising, consumers are saying sayonara to dot-com directory listings and dusting off their old yellow pages.
Advertising in the yellow pages is by no means sexy. Compared with online and TV advertising, it can be downright frumpy. But it has some unique characteristics and interesting strategies that make it eye-catching to the everyday investor. Remember how the friendly phone book was the tried and true before the Web was born? Versatility comes to mind when I think of how it doubled as a go-to source for everything from florists to physicians, and even served as a toddler booster seat in a pinch. (Whose rear never saw the business end of a telephone directory?)
In an industry presumed dead by some analysts and most consumers just four years ago, the stocks of directory publishers, such as BellSouth (NYSE: BLS ) and Verizon (NYSE: VZ ) , are poised to gain from the reincarnation of the yellow pages. And merging entities R.H Donnelley (NYSE: RHD ) and Dex Media (NYSE: DEX ) could get the biggest boost when they combine forces to dominate local markets from Minnesota to Florida, becoming the third-largest directory publisher, with a 19% market share.
Financial fervor: why investors should turn to the yellow pages
Both Donnelley and Dex Media have shown impressive financial results during the past two years. Dex's annual revenue nearly doubled in just a year, jumping from $883 million in 2003 to $1.6 billion in 2004. The company struggled with administrative costs during the same period; it was trying to stand on its own after spinning off from Qwest (NYSE: Q ) . That put a strain on earnings, so let's cut it some slack. But third-quarter profits rebounded this year, reaching $0.10 per share, up from a loss of $0.24 per share the same time last year. Donnelley's annual revenue skyrocketed from $80.3 million in 2001 to $603.1 million in 2004. Earnings per share during the same period were up to $1.19 from a loss of $3.53 in 2003.
And there's no sign of revenue waning. Advertising in the yellow pages is big business. Many top ads -- think color banners on book spines, pop-outs, or back covers -- go to businesses with seniority or to those who have advertised with the directories the longest. Many directories sell out of space months before the books go to print.
When it comes to advertising in the yellow pages, size matters. Next time you thumb through your yellow pages, take a close look at a small two-inch, non-color advertisement in alphabetical order. The owner of that scaled-down tombstone is probably paying between $250 and $300 per month for the listing. That's right, per month. Slightly bigger ads, those referred to as one-eighth of a page, run $500 to $700 per month, depending on market size. And a full-page color ad can run a business owner up to $4,000 per month. Aside from administrative and labor costs, most directory publishers cite paper and ink as their major expenses. Talk about minimal cost risk.
Still not convinced that directory advertising is big business? Consider this: Yellow pages advertising is the only form of advertising targeting consumers who are actively seeking specific information and are armed to purchase. And while directory advertising accounts for only 5% of advertising industry revenue, the business as whole brings in more than $250 billion annually.
Donnelley plans to acquire Dex for cash and stock valued at $4.2 billion. Approval is likely imminent. The companies crossed an antitrust hurdle last week when a waiting period for possible regulatory review passed, and shareholders are expected to approve of the merger.
Donnelley is assuming $5.5 billion of Dex's debt but is hoping to capitalize on Dex's large Internet presence and existing strategic relationships, including exclusive publishing rights for Qwest, which spun off Dex three years ago. The combined company, which will retain the Donnelley name and operate in Cary, N.C., will have a total circulation of approximately 73 million, serving more than 600,000 local and national advertisers.
Pre-merger Donnelley shares are more appealing than Dex shares. Donnelley touts a strong operating margin of 34%, promising return on equity of 33.7%, and is trading at 16.5 times forward earnings. It looks like a bargain compared with Dex's return on equity of 6.8% and forward P/E of 37.6. But I would advise a wait-and-see attitude if you're a long-term investor. With an estimated $50 million in after-tax synergies by the third year, post-merger numbers could be much more promising.
Watch for strong post-merger annual revenue to reach more than $2.7 billion and a consolidation of SG&A costs before 2007. If you prefer the quick bounce, consider purchasing Dex shares if they fall below $25 before shareholders approve the merger. Donnelley plans to purchase each Dex share for $12.30 in cash and 0.24 of a Donnelley share, which translates to roughly $28 per Dex share.
Location, location, location
Companies will benefit from each other's regional reach, boosting market share to 19%. Dex is the official publisher of the Yellow Pages and White Pages directories for Qwest in Arizona, Colorado, Idaho, Iowa, Minnesota, Montana, Nebraska, New Mexico, North Dakota, Oregon, South Dakota, Utah, Washington, and Wyoming. Donnelley publishes Sprint (NYSE: S ) directories in 18 states, with major markets including Las Vegas and Orlando. Donnelley also publishes directories for SBC (NYSE: SBC ) in Illinois and Northwest Indiana. Both directory publishers trail Verizon and SBC in market share. Verizon and SBC dominate with 27% market share each.
Don't call it a dot-com comeback
Not that the yellow pages were struggling by any means. In fact, the industry is one of the most stable, surviving the recession of the early 1990s and the dot-com burst. The first phone directory was published with 50 names and businesses in 1878. Advertising and customers skyrocketed over the next century. From 1997 to 2000, however, overall references to print yellow pages directories in the United States declined. But so did business for many print media outlets left in the wake of the dot-com storm. Overall references to print yellow pages directories remained relatively stable from 2000 through 2004.
Between 1990 and 2005, aggregate sales across the board have shown little decline. That's because directory publishers have been anything but passive. Unbeknownst to most consumers, Donnelley and Dex embraced the dot-com era. Donnelley began offering online city guides and search sites in all of its Sprint markets under the Best Red Yellow Pages brand and in the Chicagoland area at chicagolandyp.com. Dex's Internet-based directory, dexonline.com, which is bundled with Dexa's print product, provides clients with local advertising search options for a $99.95 flat fee. In February Dex partnered with Local Matters -- an online directory provider -- to gain a more local look and feel in an effort to compete with Citysearch.com and Zagat.com.
Sign of the times
Joining the Internet rat race aside, don't judge a yellow pages book by its cover. Just because it looks like it did last decade doesn't mean the listings are the same. A recent search in print yellow pages -- for research purposes only, mind you -- yielded such updated listings as cellular, laser hair removal, sex counseling, and e-mail services.
The five most frequently referenced headings, according to the Yellow Pages Association, are restaurants, physicians, automobile parts and repair, and pizza, reflecting little change in search needs over the past two decades.
Industry experts may concede that the Internet is a go-to directory source for many consumers, but according to a recent study by market research firm Harris Interactive, 33% of consumers actually prefer the print directory to the online version.
No one promises that the yellow pages' next century will be as easy as its first. But rest assured that the yellow pages won't see the same sad demise as its industry cousin, the rotary-dial phone.
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Fool contributor Amanda Tyler does not own shares in any of the companies mentioned in this article.