Yell Group Case
The purpose of this memorandum is to briefly introduce what the deal is about, how to determine the bid value with appropriate approach, how sensitive our final value is to relative factors and discuss the case questions.
Introduction
Macroeconomic Analysis
Based on the industry life cycle, Yellow Pages UK is most likely in the late maturity / early decline stage while Yellow Book USA is still in the growth phase. Although financing the acquisition of Yellow Pages will be a challenge due to the illiquid and lacking European high-yield markets, the recent reversal of high-yield spread coupled with major issuances indicate that investors’ risk appetites are growing and fuelling the growth of this European asset class. As more and more funds/private equities venture into the Europe market, exiting Yellow Pages will be more than viable.

Industry Analysis
Bargaining power of buyers is fairly high. In the US, there are no switching costs for buyers and they have the option of switching brands or utilize various means to obtain directories listing. However, in the UK, Yellow Pages have other businesses in addition to its core directory business to capture customers who prefer online/phone.
Threat of new entrants is very low in both UK and US. For instance, the position of incumbents in US is so strong that it is a common practice to offer advertisers a free year of advertisement which require an upfront sunk cost of $4million. Likewise in the UK, the barriers to entry are so high that the anti-competition bureau has to step in to enforce a second antitrust policy on Yellow Pages.
Intensity of competitive rivalry is fairly low. Yellow Pages enjoy a high market share of 85% and Yellow Books is the market-leading independent publisher and this market for independents is estimated to grow to $4.56 billion by 2005.
Bargaining power of suppliers is negligible as yellow-pages advertising is a “must-buy” for UK SMEs and 75% of US SMEs advertise in yellow pages due to the proximity-purchasing behavior of consumers. As such, margins are not likely to be pressured.
Threat of substitutes is medium. Although the cyclicality of such an industry is low where advertising expenditure in yellow pages does not fluctuate widely with economic cycles, there are other substitutes such as media advertising which resulted in a declining growth in the classified directories advertising market as opposed to an increasing growth in the overall advertising market.

Business Specific
With a 20% carried interest in portfolio investments, the risk-reward proposition for this deal has to be attractive. In this acquisition, there is a strong management team in place. APAX has relevant prior experience as they previously acquired Yell’s main competitor in the UK and sold it for EU 745 million within a year. Meanwhile, Hicks Muse is the largest private equity media owner and both PE have investment professionals/offices situated in both US and UK. Our valuation will also show how this proposition is financially viable.

Valuation
In terms of valuation method, WACC is not applicable in this case since it assumes constant debt ratio in its calculation. Additionally, we have detail information of the debt for the LBO, so it’s possible to calculate the tax shield under the APV/CCF method. Hence, APV/CCF method is the most suitable approach while valuing a LBO. The only difference for APV and CCF is the differences in discount factors, and we will give both of the results.
In terms of valuing a cross-border business, we decide to do a separate valuation for BT Yellow Page and Yellow Book USA in their own markets and then transfer all valuation into the same currency (pounds) according to the exchange rate.
BT Yellow Page
According to the management projections, the growth rate of volume in 2002 is about 9%, which we think is overestimated. We can see from TABLE A in the case that the average growth rate for directories advertising market is 6.6% with a dropping tendency, compared to that of 12% in previous years. So we make our own projection that the growth rate for volume will be 6.6% in 2002, and drops to 5% in 2007. Furthermore, the sponsors forecasted that a cap 6% under inflation rate will be put out, so the growth rate of price should be -3.6%, and -3.7% in 2003, and -4% thereafter. For CFC of other U.K. businesses, 20 million of CFC in 2007 is overestimated and we adjust it to 15M.
Based on the information provided in the case and extra research, we choose the interest rate of 30-year TB which is 4.52% as our risk free rate. We choose 7.5% as market premium.
When calculating the r0 for the company, we separate the operations of the firm into two parts, which are traditional directory publishing and other new business, and we choose different peer firms for them.
As BT Yellow Page is operating in Europe, peer firms should be chosen from European market. After considering the similarity of the main business activities, we choose Telefonica Pubilicdad e infomacion and Eniro as peer firms for traditional directory publishing business of the company.We first get unlevered Beta separately and then calculate the average number. So. β0=average(βs/(1+1-τ×BS))=1.35.And then we have r0=rf+β0×mkt premium=14.66%
For other business, we choose SEAT Pagine Glalle and Wanadoo as peer firms. So β0=average (βs/(1+1-τ×BS)=1.20. And then we have r0=rf+β0×mkt premium=13.53%
We also separate the operations of the firm into two parts when choosing the terminal growth rate. We use the average growth rate of CCF of traditional directory publishing business of BT Yellow Page from 2002 to 2007 as its terminal growth rate, which is 1.26%. And for other business, we choose the average growth rate of total advertising market in UK in the last three years, which is 8%. Details of valuation refers to Appendix 1.
Yellow Book USA
While valuing Yellow Book USA, the first thing we need to identify is that the revenue from new launches and organic operations should be valued separately due to their different EBITDA ratios. For new product launches, we assume the EBITDA ratio will be 7% in the first year, and then approach to that of organic operations since the second year. According to the case, the EBITDA ratio of organic operations rises from 17% in 2002 to 25% in 2007. Since the total revenues of a new launch gain (8.1M) are given, we can get total EBITDA.
In order to calculate the total free cash flow, we need to know the changes in net working capital (NWC). Usually, what affect the NWC the most are the accounts receivable and the accounts payable. In this case, account receivable and account payable turn over in a short period of time, thus, we assume that the cash, other current assets and other current liabilities stay constant in the coming years. Also, another assumption required to calculate the ΔNWC is that as a publishing company, the days inventory turnover is very small. So we can get that ΔNWC=Δ Revenues*(Days AR – Days AP)/365. Then we can get 46M increasing of NWC in 2001, which is consistent with the information given.
To calculate r0, we choose the interest rate of 30-year TB (5.61%) as risk free rate and 7.5% as market premium. Moreover, we choose WorldPages as peer firm to get the beta0, after taking the similarity of the main business activities into consideration. Then, we have β0=βs/(1+1-τ×BS)=0.74. So r0=rf+β0×mkt premium=11.13%.
According to the case, the growth rate of RBOCs is 4.3% in 2000, which is a benchmark for a matured firm in the US market. Hence, we take 4.3% as the terminal growth rate of Yellow Book USA. Finally, the total present value for Yellow Book USA is 895 million in US dollars, which are 621 million in pounds.
Details of valuation refers to Appendix 2.

PV of Tax Shield
Second part of the APV/CCF equation is the NPV of the financing side effect; it takes into account of the tax shield effects from the debt package offered by Merrill Lynch-CBIC World Markets.
APV is the valuation methodology that we use because it provides a reliable valuation in the context of LBO where leverage is high and capital structure is changing. Since the details of debt schedule and interest payment are given, when using cost of debt as the discount rate, it means the risk of tax shield is less risky than the firm but as risky as the debt itself. Total NPVF under APV is about £ 235millions, given that the LIBOR rate and UK Tax rate are 5.4% and 30% respectively. To get this figure, interest tax shield of each debt is calculated by multiplying interest expense and UK tax rate, then they are discounted by their corresponding cost of debt which is the interest rate of the corresponding debt instruments, and the present value of all discounted tax shield are summed up to get the NPVF. Details of the calculation are enclosed to Appendix 3.
We use CCF as a reference to the APV method. Discount rate of tax shield under CCF is all-equity cost of capital (R0), the intuition behind is that it assumes the interest tax shields are as risky as the firm. NPVF discounted from using R0 will be independent of the capital structure. Theoretically, the interest tax shields should be discounted by the corresponding R0 of the business that the debt financed; in this case, there is insufficient information about how the debt instruments are allocated to finance which of the line of business under Yell group. Therefore, a weighted average R0 is used as a proxy. From the previous calculations, we know that R0 of classified directory business in BT Yellow page is 14.66%; R0 of other UK business is 13.53%; R0 of Yellow Book USA is 11.13%. We believe that the weighting of R0 should be based on the significance of the cash flow generated from the operations of the business, therefore PV of NPVU from these 3 line of business are used as a value weighting for computing the weighted average R0. Total NPVF under CCF is about £ 202millions. To get this figure, interest tax shield of each debt is calculated by multiplying interest expense and UK tax rate, then they are all discounted by the weighted average R0 (13.15%), and the present value of all discounted tax shield are summed up to get the NPVF.
Details of valuation refers to Appendix 3.

Bid Price
NPVU from Yellow Book USA (US$895 million) is first converted to pounds using spot bid price (1.439$ per £), then NPVU from BT Yellow Page and NPVF discounted by cost of debt is added to that to give the APV of Yell Group, whereas adding NPVF discounted by R0 will give the CCF. Bid price net of transaction fee under APV is £ 2,149 million and that of CCF is £2,115 million, these are the valuations of the Yell Group.
Bid price would be the 5% transaction fees on top of the CCF or APV calculated. Therefore, bid price using APV valuation is £ 2,256 million while the bid price under CCF valuation is £ 2,221 million.
Details of total value refers to Appendix 4.

Sensitivity Analysis
In the sensitivity analysis, we have considered changes on 6 possible variables, which include changes on the growth rates of both BT Yellow Page and Yellow Book USA, changes on discount rate of FCF of each companies, changes on regulated price growth rate and also exchange rate fluctuations.
Variations on BT Yellow Page and Yellow Book USA’s terminal growth rates will influence the final transaction value significantly. Based on our calculation, when BT Yellow Page’s terminal value varies from 3.00% to 6.00%, the final value will change from £1.96 billion to £2.27 billion. (Appendix 5.1) When Yellow Book USA's terminal rate increases to 5.8%, the final transaction value will be £2.30 billion. (Appendix 5.2) In addition, the final value will be affected if discount rates used in UK and US business fluctuate because of the variation on market premium and beta. A 1% increase on r0 in one part of business will cause a £0.1-£0.2 billion deduction on final value. (Appendix 5.3-5.5) Government regulation on price ratio fluctuation also has an impact on the valuation. If the future regulation deducted a lower ratio of inflation, the final value will increased largely. (Appendix 5.6) As a cross border LBO case, exchange rate fluctuation will influence final value as well. In the range of £1.424-£1.457, final value will change from £2.16 billion to £2.14 billion. (Appendix 5.7)
Overall, based on the sensitivity analysis, we believe the final value should be in the range between £1.96 billion to £2.37 billion, and the transaction price (with 5% fees) should be £2.06 billion to £2.49 billion.
Details of sensitivity analysis refers to Appendix 5

Conclusion
In conclusion, Yell Group Limited is a good buyout candidate. Firstly, Yell group plays a leading role and experiences a relatively high growth rate in the directories advertising markets. Also, other U.K businesses of BT Yellow Page are still at their early stages and have some potential good opportunities in the future.
In terms of market position, both U.K. and U.S. business play a leading role in the industry. However, Yell’s U.K. business and U.S. business are quite different from each other from other perspectives. For example, U.S. business is relatively mature comparing to other businesses in UK. If we were Apax/Hicks Muse team, we would not trust the management projections in Exhibit 6 and Exhibit 7. Yell Group Limited is aimed at selling the company with maximized firm value; therefore, we make lots of adjustments in our valuation to ensure the final value is reasonable.
The cross-border nature of the Yell deal makes the valuation process tougher because we have to do BT Yellow Page’s and Yellow Book USA’s valuation separately based on their different financial markets. In addition, our valuation is sensitive to exchange rate and regulation when it is a cross border LBO.
By using APV valuation approach, BT Yellow Page worth £1,292 million and Yellow Book USA worth £621 million ($895 million). The tax shield is £235 million. Therefore, the firm value our group generates is £2,149 million plus additional 5% transaction fee, which is £2,257 million in total. According to Yell’s prospection, cash flow over £2 billion is welcomed. And this is lower than our valuation for the company. That means we still have room for bidding for a final price. Thus as an investor, we think it’s a good deal to make.

Appendix 1: Valuation for BT Yellow Page (pounds in thousands)

Appendix 2: Valuation for Yellow USA (US dollars in thousands)

Appendix 3A: PV of tax shield under APV

Appendix 3B: PV of tax shield under CCF

Appendix 3C: PV of tax shield

Appendix 4: Total Value (pounds in thousands)

Appendix 5: Sensitivity Analysis (pounds in thousands)
Sensitivity to BT Yellow Page Growth Rate（5.1） Growth rate | Total value | FV with 5% fees | | 2,149,376 | 2,256,844 | 3.00% | 1,958,832 | 2,056,773 | 3.50% | 2,000,757 | 2,100,795 | 4.00% | 2,046,188 | 2,148,497 | 4.50% | 2,095,558 | 2,200,336 | 5.00% | 2,149,376 | 2,256,844 | 5.50% | 2,208,243 | 2,318,655 | 6.00% | 2,272,876 | 2,386,520 |

Sensitivity to Yellow Book USA Growth Rate（5.2） Growth rate | Total value | FV with 5% fees | | 2,149,375 | 2,256,844 | 2.80% | 2,052,489 | 2,155,114 | 3.30% | 2,080,659 | 2,184,691 | 3.80% | 2,112,672 | 2,218,306 | 4.30% | 2,149,375 | 2,256,844 | 4.80% | 2,191,878 | 2,301,472 | 5.30% | 2,241,675 | 2,353,758 | 5.80% | 2,300,818 | 2,415,859 |

Sensitivity to r0 of BT Yellow Page and Business（5.3） Advertisement discount rate | Total value | FV with 5% fees | | 2,149,376 | 2,256,844 | 12.50% | 2,348,506 | 2,465,931 | 13.00% | 2,295,840 | 2,410,632 | 13.50% | 2,247,488 | 2,359,862 | 14.00% | 2,202,939 | 2,313,086 | 14.50% | 2,161,764 | 2,269,853 | 14.66% | 2,149,376 | 2,256,844 | 15.00% | 2,123,594 | 2,229,774 |

Appendix 5: Sensitivity Analysis
Sensitivity to r0 of BT Yellow Page and Other business（5.4） Other business discount rate | Total value | FV with 5% fees | | 2,149,376 | 2,256,844 | 11.50% | 2,246,627 | 2,358,958 | 12.00% | 2,213,317 | 2,323,983 | 12.50% | 2,187,502 | 2,296,877 | 13.00% | 2,166,931 | 2,275,278 | 13.53% | 2,149,376 | 2,256,844 | 14.00% | 2,136,272 | 2,243,085 | 14.50% | 2,124,568 | 2,230,796 |

Sensitivity to r0 of Yellow Book USA（5.5） Discount rate | Total value | FV with 5% fees | | 2,149,375 | 2,256,844 | 9.50% | 2,376,730 | 2,495,567 | 10.00% | 2,292,858 | 2,407,501 | 10.50% | 2,222,685 | 2,333,819 | 11.00% | 2,163,139 | 2,271,296 | 11.13% | 2,149,375 | 2,256,844 | 11.50% | 2,112,003 | 2,217,603 | 12.00% | 2,067,635 | 2,171,017 |

Sensitivity to Government Regulated Price Growth（5.6） Inflation deduction | Total value | FV with 5% fees | | 2,149,376 | 2,256,844 | -2% | 6,198,678 | 6,508,611 | -3% | 3,920,118 | 4,116,124 | -4% | 2,985,827 | 3,135,118 | -5% | 2,474,086 | 2,597,790 | -6% | 2,149,376 | 2,256,844 | -7% | 1,924,042 | 2,020,244 | -8% | 1,758,043 | 1,845,945 |

Appendix 5: Sensitivity Analysis
Sensitivity to Exchange Rate Fluctuations（5.7） Exchange rate($/£) | Total value | FV with 5% fees | | 2,149,375 | 2,256,844 | 1.4245 | 2,155,706 | 2,263,492 | 1.4299 | 2,153,326 | 2,260,993 | 1.4353 | 2,150,964 | 2,258,512 | 1.4390 | 2,149,375 | 2,256,844 | 1.4408 | 2,148,620 | 2,256,051 | 1.4462 | 2,146,293 | 2,253,608 | 1.4516 | 2,143,984 | 2,251,183 |