Memorandum To: From: Subject: Date:
Apax Partners and Hicks, Muse, Tate & Furst Eric Ma, Stephen Chan, Terence Chung, and Steve Aoki Valuing a Cross-Border LBO: Bidding on the Yell Group November 1, 2010
Yell currently has two well-established business lines that are competing in two different markets. While the environment is different in each market, Yell’s business lines achieve somewhat steady cash flows that are on pace with market growth, even with the forthcoming Office of Fair Trading (OFT) imposition to limit annual increases in advertising rates in the U.K. market. The projected EBITDA for both BT Yellow Pages in the U.K. and Yellow Pages USA combined are more than enough to cover the considerable interest expense. Furthermore, the capital intensity to expand in the market (i.e. through new market launches in the U.S.) is relatively low compared to other industries. With that being said, good buyout candidates also have a strong and defendable market position. This is true for both lines with BT Yellow Pages as a market-leader in the classified directory business and Yellow Pages USA as a market leader in the independent publisher of business directories. Finally, given that financial buyers are interested, these business lines are relatively easy to divest should the need arise. However, BT Yellow Pages and Yellow Book USA represent two very different businesses. The U.K. business is subject to heavy regulation which will restrict the price. Thus the only way to expand profits is through the advertisement volume. Unfortunately, the growth in the classified directories advertising market has been declining over the last few decades and will probably continue in this fashion even though the total advertising market has seen increasing growth. The saving grace for this business could be the additional divisions that BT Yellow Pages owned. While these divisions were in the start-up stages, the growth opportunities would be more significant than the core business. The U.S. market was significantly different as the independent directory providers represented an area of substantial growth potential. The regulatory framework did not inhibit the pricing although new product launches were naturally volatile in their success. In terms of the industry life cycle, BT Yellow Pages is most likely in the late maturity / early decline stage while Yellow Pages USA was still in the growth phase. These factors combined with the buyers’ investment horizon will influence their exit strategy.
Management provided Apax and Hicks Muse team with projections for both BT Yellow Pages and Yellow Book USA based on what a potential buyer should expect in the upcoming years. Since management is trying to sell the business, we have to be skeptical at the assumptions used to come up with these projections. As a financial buyer, you tend to leave the day-to-day operations with
management and thus would hope that they can meet their projections. These numbers should be viewed with a grain of salt, as management would want to make the company look as attractive as possible to potential buyers. For BT Yellow Pages, their growth is driven by two main factors – number of advertisements sold per year and advertisement prices. Thus, as a potential buyer, these areas need to be scrutinized and scrubbed to come up with a justifiable projection. The year-over-year advertisement volume from 2001 to 2006 is decreasing. For SME’s, BT Yellow Pages were considered a “must buy,” yet the volume projection is trending downward. Since economic cycles tend not to influence this industry, it is vital that we figure out why the trend is not positive. A potential reason could be reliance on online services vs. physical paper directories. Sensitivity analysis should be applied to see how a further decrease in volumes would affect the overall valuation. For advertisement prices, the trend is slightly increasing from 2001 to 2003 and flat thereafter. Management seems to be more optimistic here as the OFT is on the verge of placing a cap on advertising price growth. Since the cap is based on inflation and the fact that inflation is decreasing, the advertising prices should be adjusted to show a decreasing trend.
The year-over-year revenue growth for Yellow Book USA ranges from 10.0% to 15.0% with an average of 12.5% and a CAGR of 12.4%. Organic growth in the US market is 4-5% and so the additional growth for Yellow Book USA must be coming from new market launches as well as increasing market share as an independent publisher. The growth rates seem quite aggressive and so additional new market launches may be required in years 2005 and 2006, currently not projected, to ensure that there is a buffer to hit revenue projections. It may make sense to also decrease the revenue growth rate to portray a buyer’s more realistic base case and use management’s case as an upper limit case. Given that management combined total revenues, revenues would need to be broken out between organic and new market, as these result in different EBITDA margins. CAPEX and depreciation also need to be reviewed as they are interconnected – an increase in CAPEX usually means an increase in depreciation and vice versa. Overall, the numbers for both markets should be viewed with skepticism as these are management projections and may not reflect the buyer’s expectations in terms of the growth in the market.
This buyout is more suited to APV/CCF valuation. WACC is not applicable here because the calculation of WACC assumes constant debt-to-equity ratio. Based on the debt repayment schedule, it is unlikely
that the firm will be able to maintain a constant ratio. However, if the firm is committed to maintain a constant debt-to-equity ratio, it will have to engage in issuing/purchasing its own stocks and issuing/retiring its debts. As this is not the case, WACC should not be used in valuating this buyout. On the other hand, APV/CCF is ideal for this transaction because the debt repayment schedule is known in advance. APV/CCF separates the calculation into two parts: unlevered cash flow using unlevered cost of equity and tax shield using the cost of debt/unlevered cost of equity. The APV uses the cost of debt and it could be overvalued because the tax shield may be not applicable if the company suffers a net loss. On the other hand, CCF uses the unlevered cost of equity for the tax shield calculation. This makes the CCF calculation more conservative than APV. For our calculation, CCF is more suitable due to the known debt repayment schedule and the more conservative valuation.
Coming up with an accurate valuation becomes more complex when dealing with different denominations of cash flows from cross border assets. Yell’s two business line, BT Yellow Pages and Yellow Book USA, operates and generates revenue from their respective countries; therefore, we must look each asset as a separate entity. We could do a separate valuation on each asset based on the home country’s currency and financial projections. To determine a representative discount rate, we used betas and debt/EV ratios of comparable firms from each region. For example, for Yellow Book USA, we only used betas and debt/EV of comparable American firms and not European firms. We also had to take into account difference in risk-free rates by looking at country-specific yield on Treasury bills when calculating the cost of equity for each asset. Depending on the capital structure, each asset may benefit from tax savings from tax-deductible interest payments. The interest tax shield must be calculated using the local country’s corporate tax rate; therefore, each business line may have different cost of debt. However, this is not the case in the Yell LBO. At Yell, we used the U.K. tax rate of 30% because the acquired company is incorporated in the U.K. thus everything is consolidated in pound sterling.
When building a valuation model, we must consider the growth potential of each asset separately as well. We should take into account the firm’s local business strategy, competitors, and overall market potential to develop a representative perpetuity growth rate. Once we have a fair enterprise value for both assets, we can then use the spot rate to convert the enterprise values into a common denomination for comparison. An alternative to the above method is to convert all pro-formas into a common currency using currency futures before performing a valuation.
Whenever there are cross-border assets, firms are exposed to currency risk. Many of these risks can be hedge using the derivatives market such as the use of futures contract or options. All these factors play a vital role when forecasting revenue growth / free cash flows, determining the discount rate and eventually calculating a fair enterprise value for the firm. Using our base case assumptions outlined in Exhibit 5, a CCF valuation is £2.02 billion while an APV valuation is similar at £2.04 billion (shown in Exhibits 1 and 2, respectively). There is not much of a difference between the two valuations because the valuation from the tax shield is relatively small. So using a higher discount for the CCF valuation doesn’t yield a significant difference. The U.S. business is valued (in Exhibit 3) and converted to the pound sterling to reach a total valuation in pounds. These values include the 5% in transaction fees. Sensitivity is done on four major variables. The first variable is the terminal growth rate of the U.K. business since BT Yellow Pages represents a considerable chunk of the total valuation (see Exhibit 7 for the sensitivity of growth rate on BT Yellow Pages valuation). If the terminal growth rate is 5% (highly unlikely to happen), the total acquisition price with fees is £2.44 billion, compared to the £2.04 billion with the base case of 2% growth rate. The second variable is the terminal growth rate of Yellow Book USA (see Exhibit 6 for the sensitivity of that growth rate on Yellow Book USA’s valuation). This scenario analysis doesn’t affect the overall valuation much as the Yellow Book USA only accounts for a small fraction of the overall valuation. For the third variable, we reduced management projections of Yellow Book USA’s revenue growth to an 11% CAGR (derived from 5% organic growth and 6% growth of new product launches once they hit steady state) in order to create a downside scenario where revenue projections are not as optimistic as management believes. This scenario would yield a lower valuation of £1.9 billion as seen Exhibit 1. The last scenario analysis performed is the change in regulatory imposition. Currently the base case is that revenue decreases by the inflation subtracting 6% annually. The result is shown in Exhibit 8. When there is no regulatory imposition applied and the price grows with inflation, the acquisition price with fees is 3.39 billion. If they can negotiate with the UK government to reduce the rate to 5%, instead of 6%, the acquisition price with fees is 2.22 billion. It is highly sensitive to the change in regulatory imposition. This implies there is significant upside if the regulatory imposition is lower than 6%. Overall, we are confident that the bid would be somewhere between £1.9 billion to £2.2 billion.
Since this is a financial acquisition, the buyer is more opportunistic and thereby looking for value creation based on the assets itself. The acquired assets are less likely to create synergies. Financial buyers are also concerned about the winner’s curse as they may have overvalued the target firm and thus overbidding for the company. However, there are some characteristics that suggesting this is not strictly a financial acquisition. Both private equity firms, Apex Partners and Hicks, Muse Tate & Furst, are trying to leave a mark on the reputation of both firms. Additionally, both private equity firms are looking to expand its presence on the European continent.
Exhibit 1: CCF valuation of Yell Year BT Yellow Pages Revenues Direct Costs Discounts & Free ads Overhead Costs EBIT Tax Rate EBIT (1-t) Capex Depreciation Changes in WC FCF (from UK main business) Year Discount Factor PV of FCF Sum of FCF
Actual 31-Mar-00
521,133 180,479 42,402 102,530 195,722 30% 137,005 7,380 5,530 10,570 124,585
Actual Projected Projected Projected Projected Projected Projected Terminal 31-Mar-01 31-Mar-02 31-Mar-03 31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07
550,185 187,395 47,276 88,870 226,644 30% 158,651 9,760 5,370 12,772 141,489
593,385 201,742 86,585 77,137 227,921 30% 159,545 9,730 8,850 6,000 152,665 2 0.79 120,405
608,163 206,649 84,324 79,013 238,177 30% 166,724 9,230 8,400 8,497 157,397 3 0.70 110,243
621,361 211,278 86,615 80,783 242,685 30% 169,879 8,380 7,630 6,300 162,829 4 0.62 101,284
632,530 214,996 85,366 82,204 249,964 30% 174,975 8,000 8,000 4,375 170,600 5 0.55 94,241
637,743 216,716 86,049 82,862 252,116 30% 176,481 8,000 8,000 2,023 174,458 1,678,356 6 6 0.49 0.49 85,586 823,373
47,400 14,263 14,700 53,750 5,400 135,513 30% 40,654 0.89 36,104
47,400 14,263 14,700 53,750 5,400 135,513 30% 40,654 0.79 32,063
43,450 14,263 14,700 53,750 5,400 131,563 30% 39,469 0.70 27,645
37,525 14,263 14,700 53,750 5,400 125,638 30% 37,691 0.62 23,445
29,625 14,263 14,700 53,750 5,400 117,738 30% 35,321 0.55 19,512
19,750 14,263 14,700 53,750 5,400 107,863 30% 32,359 0.49 15,875
(11,226)
(6,497)
1,217
5,524
9,812
1,470,873
Debt Senior Term loan A Senior Term loan B Senior Term loan C High Yield bond Vendor Loan Total Interest Expense Tax rate Tax shield Discount Factor PV of tax shields Sum of tax shields
154,643
PV of U.K. businesses Sum of other U.K. businesses
94,175
Yellow Book USA (converted @ Spot rate)
576,390 195,972 78,180 74,930 227,308 30% 159,116 10,220 6,130 2,178 152,848 1 0.89 135,741
200,127
Total EV Less Debt Equity
1,919,819 1,450,000 469,819
Total Acquisition Price with Fees Total Acquisition Price with Fees (US Base revenue)
2,020,862 1,855,126
954
94,392
Exhibit 2: APV Valuation of Yell Year BT Yellow Pages Revenues Direct Costs Discounts & Free ads Overhead Costs EBIT Tax EBIT (1-t) Capex Depreciation Changes in WC FCF (from UK main business) Year Discount Factor PV of FCF Sum of FCF
Actual 31-Mar-00
521,133 180,479 42,402 102,530 195,722 30% 137,005 7,380 5,530 10,570 124,585
Actual Projected Projected Projected Projected Projected Projected 31-Mar-01 31-Mar-02 31-Mar-03 31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07
550,185 187,395 47,276 88,870 226,644 30% 158,651 9,760 5,370 12,772 141,489
53,906 Senior Term loan B 19,690 Senior Term loan C 20,142 High Yield bond 68,712 Vendor Loan 8,118
PV of U.K. businesses Sum of U.K. businesses Yellow Book USA (converted @ Spot rate)
Total EV Less Debt Equity Total Acquisition Price with Fees
593,385 201,742 86,585 77,137 227,921 30% 159,545 9,730 8,850 6,000 152,665 2 0.79 120,405
608,163 206,649 84,324 79,013 238,177 30% 166,724 9,230 8,400 8,497 157,397 3 0.70 110,243
621,361 211,278 86,615 80,783 242,685 30% 169,879 8,380 7,630 6,300 162,829 4 0.62 101,284
632,530 214,996 85,366 82,204 249,964 30% 174,975 8,000 8,000 4,375 170,600 5 0.55 94,241
637,743 216,716 86,049 82,862 252,116 30% 176,481 8,000 8,000 2,023 174,458 1,678,356 6 6 0.49 0.49 85,586 823,373
47,400 0.93 13,179 14,263 0.92 3,956 14,700 0.92 4,068 53,750 0.90 14,560 5,400 0.95 1,537
47,400 0.86 12,214 14,263 0.85 3,658 14,700 0.85 3,753 53,750 0.82 13,147 5,400 0.90 1,458
43,450 0.80 10,376 14,263 0.79 3,382 14,700 0.79 3,462 53,750 0.74 11,870 5,400 0.85 1,384
37,525 0.74 8,305 14,263 0.73 3,128 14,700 0.72 3,194 53,750 0.66 10,718 5,400 0.81 1,313
29,625 0.68 6,077 14,263 0.68 2,892 14,700 0.67 2,946 53,750 0.60 9,678 5,400 0.77 1,245
19,750 0.63 3,755 14,263 0.62 2,674 14,700 0.62 2,718 53,750 0.54 8,739 5,400 0.73 1,182
(11,226)
(6,497)
954
1,217
5,524
9,812
1,470,873
Debt Senior Term loan A
Sum of tax shields
576,390 195,972 78,180 74,930 227,308 30% 159,116 10,220 6,130 2,178 152,848 1 0.89 135,741
Terminal
Rate 7.9%
8.2%
8.4%
10.8%
5.4%
170,568
94,175 200,127
1,935,744 1,450,000 485,744 2,037,625
94,392
Exhibit 3: Valuation of Yellow Book USA – in US$ (US Dollars $000s) Year Revenue (from new launches) Organic Revenue EBITDA (organic) EBTIDA (new launch) for 1st year Total EBITDA EBIT Tax Rate EBIT (1-tax) + depreciation - Capex - changes in NWC Unlevered Free Cash Flow Time Discount factor PV of FCF Sum of PV of UCF
Actual 31-Mar-00
Actual Projected Projected Projected Projected Projected Projected Terminal 31-Mar-01 31-Mar-02 31-Mar-03 31-Mar-04 31-Mar-05 31-Mar-06 31-Mar-07 56,700 64,800 56,700 64,800 0 0 364,900 418,400 487,350 533,800 688,390 757,229 62,033 79,496 102,344 122,774 172,098 189,307 2,835 3,240 2,835 3,240 0 0 64,868 82,736 105,179 126,014 172,098 189,307 67,703 85,976 108,014 129,254 172,098 189,307 35% 35% 35% 35% 35% 35% 38,108 48,637 63,537 76,183 106,663 117,850 6,240 7,910 7,430 8,810 8,000 8,000 (10,600) (8,700) (8,170) (8,990) (8,000) (8,000) (46,376) (53,152) (59,846) (65,846) (75,723) (83,295) (12,628) (5,305) 2,951 10,157 30,940 34,555 492,011 1 2 3 4 5 6 6 0.90 0.81 0.73 0.65 0.59 0.53 0.53 (11,345) (4,282) 2,140 6,618 18,112 18,174 258,767 MGMT 288,183 Base@11% rev. growth 61,457
Exhibit 4: Discount rate calculations United States Beta Beta Equity (from comps) Average D / EV Average E / EV unlevered beta assuming Beta debt = 0 CAPM cost of unlevered equity UK Beta Beta Equity (from comps) Average D / EV Average E / EV unlevered beta assuming beta debt = 0 CAPM cost of unlevered equity
1.32 0.23 0.77 1.02 11%
1.35 0.05 0.95 1.28 13%
Exhibit 5: Assumptions -
BT Yellow Pages has its price adjusted for inflation as stated by the U.K. Office of Fair Trading The U.K. discount rate is calculated using the comps Telefonica Publicidad e Informacion and Enriro The U.S. discount rate is calculated using McLeodUSA and WorldPages The model assumes the debt is held in the U.K. and the U.S. business line will have its cash flows converted to U.K. denominated pounds at the spot rate For the base case, the terminal value growth rate of BT Yellow Pages is 2% which is a forecast of the nominal rate in the classified directories advertising market For the base case, the terminal value growth rate of Yellow Book USA is 4% which is the historical growth of the U.S. yellow pages market New launches in the U.S. are forecasted to return 5% EBITDA to Sales in the first year. This is a conservative estimate as actual sales can fluctuate between 5 – 11 million Once launched, the new markets are assumed to reach organic EBITDA margins in the following year
Exhibit 6: Sensitivity in Yellow Book USA to growth rate Growth Rate Sensitivity Growth Rate FCF 4% 288,183 1.0% 207,553 2.0% 228,652 3.0% 254,833 3.5% 270,440 4.5% 308,535 5.0% 332,114
Exhibit 7: Sensitivity in BT Yellow Pages to growth rate Growth Rate Sensitivity Growth Rate Acquisition Price with Fees 2% 2,020,862 1.0% 1,928,943 1.5% 1,972,832 2.5% 2,073,645 3.0% 2,131,926 4.0% 2,268,811 5.0% 2,441,707
Exhibit 8: Sensitivity in BT Yellow Pages to regulatory imposition Regulatory Imposition Sensitivity Regulatory Imposition Acquisition Price with Fees -6% 2,020,862 -5.0% 2,224,426 -4.0% 2,437,510 -3.0% 2,660,487 -2.0% 2,893,744 -1.0% 3,137,677 0.0% 3,392,695
