The Good Book
By Lawrence A. Armour

(FORTUNE Magazine) – I had this dream the other night. I'm interviewing Lou Gerstner. We're in his office in Manhattan, and he's in a good mood. Why not? He bailed out of IBM at the right time, and he's now chairman of Carlyle Group, a high-profile investment company where guys like George H.W. Bush, James Baker, Arthur Levitt, and John Major hang out.

In my dream Lou's smoking a cigar. He puts his feet on the desk, examines the ash, and says, "So what can I do for you, sonny?" (I'm older than Lou, but that never seems to bother him.)

"How are things?" I ask, starting with a trick question.

"Couldn't be better," he replies. "I'm in a great firm with very smart people."

That was the opening I was looking for. "They're so smart, why are they paying $7 billion for a Yellow Pages company?"

"Simple, kid. It's Thanksgiving. You're at the dinner table. Your cousin's 4-year-old kid can't see a thing. What do you stick under his butt? You could use a Think Pad, but the new ones are too thin. So you go to the kitchen and get the Yellow Pages."

I couldn't get the dream out of my head. Lou's one smart cookie but...$7 billion? For a Yellow Pages business? Right here in the Information Age?

Next day I call a friend, Mat Stover, who ran the Yellow Pages for one of the telcos when it was called Bell Atlantic. "The man we put on the moon didn't have a slide rule in his pocket," I begin. "How come we still have the Yellow Pages?"

"They work," says Mat, who chairs an investment firm called LKM Ventures. "Your sink leaks. You pick up the Yellow Pages, flip to the Ps, and there are ten guys within a three-mile radius who can fix it."

"Can't you use the Internet?" I ask.

"Sure. The RBOCs have online Yellow Pages. So do Yahoo, MSN, and your company, AOL, and you can always go to Google and search for a plumber. But until everyone has broadband and is sitting in front of a computer that doesn't crash, the Yellow Pages are going to be with us."

Makes sense, but still...seven big ones? I call another old friend, John Kelsey, who runs the Kelsey Group, a consulting firm that deals with the Yellow Pages community. "Is the Yellow Pages an exciting, high-tech business?" asks John, who is fond of rhetorical questions. "Of course not. It's a no-surprises, stable business with recurring revenue streams and large profit margins. How large? Some of these guys have Ebitdas of 55% or more."

Talk about your dirty little secrets. The old Ma Bell never talked about it, but Judge Harold Greene knew a cash cow when he saw one. In 1984, when the 22 Bell operating companies were spun out, AT&T begged to keep the Yellow Pages. The judge said no. The Yellow Pages were divvied up among the RBOCs, Judge Greene's thinking being that the kids would need the income from the directories to make a go of it.

Everything was cool until 1996, when Congress gave the local and long-distance telcos the okay to duke it out with broadcasters, cable companies, and Internet types. As one of the tradeoffs, the RBOCs were forced to share Yellow Pages data with outsiders. Independent Yellow Pages operators sprang up, and crude directories appeared on the Net.

Then came Armageddon. The stock market bubble burst, and the telcos, which had taken on huge debt to finance their adventures into cable, wireless, and even more nefarious activities, suddenly needed lots of cash. What better way to raise it then to sell the family jewels? And who better to sell them to than the private-equity firms, which adore no-surprise, high-margin operations that throw off the cash to pay for themselves?

Roll tape. In the past 18 months J.P. Morgan Partners Asia and CVC Asia Pacific paid $220 million for Singapore Telecommunications' Yellow Pages. Veronis Suhler Stevenson and Britain's 3i Group laid out $300 million--plus for Verizon's directories in Scandinavia and Europe. Hicks Muse and Apax Partners, the primary owners of Yell Group (publisher of British Telecom's Yellow Pages and Yellow Book USA), paid $600 million for McLeodUSA's directories. Kohlberg Kravis & Roberts and Teachers' Merchant Bank paid $1.9 billion for Bell Canada's Yellow Pages. R.H. Donnelley teamed up with Goldman Sachs Partners in a $2.2 billion purchase of Sprint's directory business. Last month KKR, Hicks Muse, Apax, Texas Pacific, Thomas H. Lee, Blackstone, and other long-ball hitters lost out to a European consortium's $6.7 billion bid for Telecom Italia's directories. And Carlyle Group, Lou Gerstner's new firm, is halfway through its $7 billion purchase of Qwest's Yellow Pages.

That's a lot of money for a company that can't even spell its name right, but here's the other part of that dirty little secret. Turns out U.S. businesses spend more on Yellow Pages advertising--$14 billion a year--than on ads in either magazines or local TV. It's like shooting fish in a barrel. As Steve Blondy, CFO of R.H. Donnelley, puts it, "You don't go to the Yellow Pages and look up pizza unless you're planning to order pizza."

And like Marian the Librarian, whose life went from dull to exciting when the right man came along, the Yellow Pages are poised to step out of the reference section and take a star turn. For 115 years the business has been run by telco engineers whose idea of creativity is plastering ads on the covers and spines. The new LBO owners see the Yellow Pages for what they are--the advertising vehicle small businesses can't live without--and everything suggests that Madison Avenue types will soon be pushing the MIT crowd out the door.

The LBOs will also spend money to mine the Internet. "Instead of just giving you a listing of bike shops in Brooklyn, we'll eventually provide a map that shows where they're located and tell you which ones are open Sunday, carry Trek, and take MasterCard," says Jim Atwood, a Carlyle Group partner.

Want a piece of the action? Word out of Toronto is that KKR is planning to tap the sizzling Canadian market for income trust units (think REITs) this summer by selling a small piece--best guess is 10% for $300 million--of the Yellow Pages it bought last September. If the offering flies, the Yellow Pages KKR continues to hold will be worth roughly twice what it paid less than a year ago. A spectacular return on investment, to be sure. But hey, we're talking Yellow Pages--the sexiest business alive.