DBRS Downgrades Yellow Media to BBB and R-2 (high), Negative Trends

DBRS has today downgraded the ratings of Yellow Media Inc. (Yellow Media or the Company), including its Medium-Term Notes to BBB from BBB (high) and its Commercial Paper rating to R-2 (high) from R-1 (low), with Negative trends. The downgrade reflects DBRS’s concern that the business risk of Yellow Media continues to increase as it accelerates its transition from print to digital, even though there is an expectation of a strengthened financial risk profile going forward as a result of recent actions and the ongoing underlying free cash flow that the Company continues to generate.

DBRS believes that Yellow Media’s directories business, which is now its principal business since the recent sale of the automotive assets of Trader Corporation (Trader), will face heightening competitive challenges as it continues to transform its business from a print-placement and listing organization into an online digital media and marketing service provider. While DBRS notes that the Company continues to make steady progress on this transition, which DBRS believes is critical for its long-term success, Yellow Media now expects to have 50% digital revenue by the end of 2014 (slightly more than 25% at Q2 2011). With the acceleration of the transition, DBRS believes that the competitive landscape, the barriers to entry and the resulting pricing power will be more challenging for the Company as it transitions its small and medium-sized enterprise (SME) customers more toward digital services.

As a result, DBRS believes that the steady normalized EBITDA and cash flow from operations that the Company’s directories segment has generally exhibited to date will experience pressure going forward. Furthermore, depending on the success regarding further investments the Company is expected to make to support this transformation and to grow digital revenue, in conjunction with economic conditions, the Company’s digital revenue may not be able to compensate for the pressure on print revenue. Both of these factors are expected to suppress EBITDA margins in the near term. In this context, the Company anticipates that EBITDA margins should stabilize at approximately the 50% level by the end of 2014 (from historical levels that have been consistently in the upper 50% range) with new products and additional cost-saving initiatives.

DBRS notes that Yellow Media is undertaking a review of its strategic and operating plans in the context of accelerating this transition and has withdrawn its operating guidance for 2011. DBRS believes that the Company’s review will be focused on undertakings to support organic growth. This is expected to be centred on improving the customer experience, growing traffic and expanding its service offerings. Additionally, the Company indicated that the outcome of this review could lead to a non-cash writedown of its assets, which include a high level of goodwill and intangibles. DBRS notes this goodwill stemmed from the acquisition of a number of businesses to create its national directory platform and support its digital production initiatives. While not an irrelevant consideration, any goodwill writedown on its own would not affect the cash flow, EBITDA margins and coverage metrics that are key focuses in the ratings.

DBRS continues to believe that given the uncertainty regarding Yellow Media’s digital transition and the higher business risk associated with becoming more dependent on digital revenue, it remains prudent for Yellow Media to strengthen its financial risk profile. As such, DBRS notes that the proceeds from the recent close of the sale of Trader ($708 million net, closed July 28, 2011), along with the additional free cash flow from today’s substantial reduction in the Company’s dividend (more than $200 million per year after the dividend was reduced by 77% to $0.15 per share on an annual basis from the previous rate of $0.65 per share), should position the Company well to achieve a reduction of leverage, with debt-to-EBITDA of approximately 2.0 times (currently at the upper end of the 2.0 times to 3.0 times range), which is now a formalized target.

While this level of leverage was already DBRS’s expectation, with the proceeds from the sale of Trader and organic free cash flow both used for debt reduction, the Company will have further free cash flow to support greater investment in its digital transition and internally finance any maturities over the medium term.

DBRS believes that Yellow Media should be better positioned at the BBB level if it manages its digital transition while maintaining a financial risk profile that is stronger than it had been historically. However, the Negative trend reflects the risks associated with executing on the digital transition, generating reasonable levels of EBITDA and cash flow from operations and attaining additional financial flexibility. As such, DBRS will continue to monitor these items, including the Company’s plans and progress regarding its digital transition over the medium term. This will continue to require meaningful evidence that the additional challenges are being dealt with as the transition progresses. DBRS believes that the outcome of these risks could take longer than DBRS’s typical 12-month period within which trends are typically resolved.

Note:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating the Newspaper and Magazine Publishing Industry, which can be found on our website under Methodologies.