The following is a guest post by George Schultze, founder of Schultze AssetManagement LLC, an alternative investment firm founded in 1998 that manages $231 million in assets and specializes in distressed securities.  Mr. Schultze is author of The Art of Vulture Investing: Adventures in Distressed Securities Management (Wiley Finance, 2012).

Dex Media is an advertising company formed when the two main firms in the domestic yellow pages industry, SuperMedia (SPMD) and Dex One (DEXO), merged.  Although just recently listed under ticker symbol DXM, the company has a rich operating history – to wit, SPMD had been in business for over 125 years prior to the merger while DEXO is no spring chicken either (it was founded in 1841).  Dex Media a fantastic example of an extremely cheap value oriented stock with substantial upside potential.

Most people know that yellow page print advertising is a very mature business in light of today’s internet information flow available in nearly ubiquitous form.  Nevertheless, both of Dex Media’s operating companies had successfully started to transition their businesses – from traditional print-based yellow page advertising over to higher margin online and digital offerings.  In fact, even before their merger, each of these companies already considered themselves “premier partners” with Google on account of the huge amount of daily usage traffic they drove to that company’s website.  Going forward, their combination brings additional internet traffic synergies as well as important local business content to Google.

Pro forma for the merger, the combined company generated $460 MM in nicely growing digital revenues, out of $2.6 BN in total, during 2012.  Although the remaining print business is in a steady state of decline, the combined businesses generated good cash flow with attractive EBITDA margins of over 41% in the quarter ended March 31, 2013.  Additionally, this business requires very little capital investment – for the quarter just ended, the combined companies only spent $5.6 MM in capital expenditures.  This compared with over $239 MM in cash flow as measured by adjusted EBITDA.

As we’ve witnessed in other industries experiencing secular change (such as the newspaper industry and the plain old wire line phone industry), the primary challenge for DXM’s management is to continue transitioning the business as quickly as possible, while maintaining a sharp focus on reducing legacy operating costs.  Of course, managing change in an industry like this is never easy.  Even so, the merger of these two firms through joint bankruptcy proceedings gives the combined entity a major head start towards achieving these goals.

My history with this firm is as an activist investor.  My company became activist with SPMD in the summer of 2012 when we filed a Form 13D wherein we recommended that its board consider a merger with its largest competitor (DEXO.)  I was very pleased to see that within short time after our 13D filing the board agreed and ultimately signed a merger agreement.

In the fourth quarter of 2012, the management teams from both companies finalized the merger details which would ultimately be consummated as dual pre-packaged plans of reorganization.  The general merger terms provided that DEXO and SPMD shareholders would split the new entity’s common stock in a 60%/40% split, with shareholders of each company receiving stock in DXM in exchange for their old holdings.

Interestingly, the combination was also designed to preserve approximately $1.8 billion in net operating loss carryforwards (“NOLs) and other tax assets previously owned by DEXO.  As a result, the combined entity will see substantially-reduced corporate taxes going forward on account of these assets.  In fact, the tax asset owned by DEXO prior to the merger also helped justify the uneven 60%/40% equity split (instead of an even 50%/50% deal).

The companies also sought to significantly amend the terms of their syndicated loans in the merger.  However, in order to extend all bank debt maturities and achieve enhanced loan covenant relief they first required 100% consent from all lenders.  This voting threshold was lowered substantially by simply moving the merger into a bankruptcy court where two “pre-packaged” plans of reorganization were quickly approved by all interested parties.

Today, management projects that the new company (DXM) will achieve $150-175 MM in synergies by eliminating excess overhead, IT, sales, and digital/print costs.  In addition, it expects to benefit from a larger scale (through increased purchasing power/ad presence), increased offerings, tax benefits, and better cash flow/deleveraging opportunities going forward.

Based on today’s approximate $16.00 per share price for DXM, the market is valuing the company’s equity at just under $275 MM.  Add to that figure $3.4 BN face amount of debt and then deduct $490 MM in cash and tax assets it owns to get an adjusted total enterprise value of $3.2 BN.  This compares very favorably, at only 3.3x TEV/EBITDA, with the company’s last quarter’s annualized run rate of $960 MM in EBITDA.

Apparently, DXM’s cheap market valuation hasn’t gone unnoticed by other value investors.  This week, Kyle Bass from Hyman Capital highlighted the company as his best ideas at the Ira Sohn Hedge Fund Conference in New York City.  To quote Mr. Bass, the DXM stock “…will be worth 5 times today’s price in three years.”  We couldn’t agree more with Mr. Bass about the potential upside potential for this underfollowed company.