Can Cerberus beat Telstra's blunder?

Given the history of private equity purchases of directories businesses, the deal announced overnight in the US which will see Cerberus Capital Management acquire a majority interest in AT&T's Yellow Pages directories businesses for $US950 million will have more than a few people in the sector scratching their heads in bemusement.

Cerberus will pay $US750 million in cash and a $US200 million note for 53 per cent of AT&T Advertising Solutions and AT&T Interactive. Those businesses lost $US2.27 billion in 2011, although that was due to a $US2.9 billion non-cash writedown in their value.

Absent the impairment charges the businesses, which generated revenue of about $US3.3 billion last year, made about $US643 million. That, however, was 25 per cent less than they earned in 2010 and about half what they earned in 2009. And their revenue base is about 30 per cent smaller than it was in 2009.

That is a familiar story for most owners of directories businesses, including Telstra. Telstra's Sensis business had actually held up remarkably well until last year, when its revenues and earnings abruptly imploded, with revenue tumbling 24 per cent and earnings before interest, tax, depreciation and amortisation diving 55 per cent.

In France, the KKR-controlled PagesJaune suspended dividend payments earlier this year after a 19 per cent fall in earnings. The value of the company is down nearly 90 per cent since KKR paid 3.3 billion euros for France Telecom's 54 per cent shareholding in 2006.

In the UK Yell Group, which owns what used to be BT Group's directories, as well as businesses in the US, Spain and Latin America, has a market capitalisation of only about $US140 million and is in discussions with its lenders. When Hicks Muse Tate & Furst (now HM Capital) and Apax Partners bought the business in 2001 they paid about $US3 billion before subsequently floating it.

In 2007 CCMP, now Unitas Capital, and Canada's Teachers' Private Capital, paid $NZ2.24 billion for Telecom Corp of New Zealand's directories businesses in what has been described as the "high water mark" pre-GFC private equity transaction. Last year lenders to the business took control of it after writing off more than $NZ1 billion on their loans.

There are other examples of how badly private equity firms misjudged the rate at which cash flows from high-margin directories that had traditionally been very stable could evaporate as search and advertising migrated to the internet.

The firms were attracted to the businesses because the cash flows enabled them to be loaded up with debt – which explains why so many directories businesses have been smashed by the interaction between their leverage and their suddenly plummeting cash flows.

Yet Cerberus is still buying into AT&T's businesses. The explanation probably lies in the price, which values the businesses at only $US1.8 billion. Even if their revenues and earnings continue to fall, there still should be significant cash flows for at least the next few years. Like most directories businesses, the AT&T units are also pursuing a different kind of future online.

Just as Sensis is doing, they are all trying to reinvent themselves as digital marketing and advertising businesses, offering not just advertising in print and online but lead generation and technical support for their primarily SME customer bases.

So, within those old print businesses there are potentially quite different digital businesses with significant growth potential, albeit at lower margins and with very different – far lower – valuations than the old print directories once enjoyed.

Presumably Cerberus has developed a view about the rate at which the old cash flows will dry up and the new ones will grow.

Telstra, of course, had its views about how much its conversion to a New Age directories business would cost it as it pursued a careful transition over several years – and within months was shocked by the continuing acceleration in the rate of decline.

Maybe David Thodey should place a call to New York to see whether Cerberus' interest in directories is confined to the AT&T businesses or if it is interested in used directories businesses generally.