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We were disappointed that Lee Enterprises' (NYSE:LEE) stabilizing results for Q4 2012 were offset by news that Berkshire Hathaway (NYSE:BRK.B) sold 2.1M of its 3.2M LEE shares it received when it acquired $85M of Lee's 2nd Lien Term Loans in April 2012. Berkshire had made this investment in Lee Enterprises last year as part of his highly-publicized spate of investments in the newspaper industry. In addition to Berkshire's purchase of $85M of Lee's 2nd Lien debt from Goldman Sachs (NYSE:GS), it also purchased all but one of Media General's (NYSE:MEG) newspaper operations for $142M plus a few other community newspaper publications from other sellers. Berkshire also lent Media General $400M and received penny warrants for 4.65M shares of Media General's stock. Berkshire exercised its warrants in September 2012 and now owns 16.6% of Media General's stock.

We believe that the combination of Berkshire Hathaway reducing its stake in Lee Enterprises as well as the closing of the Manassas News & Messenger publication (one of the Media General papers) helped contribute to LEE's share price declining from an intraday high of $1.75 before Lee released its Q4 2012 earnings to $1.24 after Berkshire announced the reduction of its share ownership. Lee's share price drifted down to a low of $1.10 on December 26th, 2012 but has steadily recovered to $1.33 as of January 25th, 2013 thanks to Lee's stabilizing operating income. As such, we believe that Berkshire shouldn't sell its remaining stake in Lee nor should anyone else for that matter.


(Click to enlarge) Source: Morningstar Direct

Lee most recent quarterly results are showing signs of stabilization. Lee's October to December fiscal quarter is Lee's first fiscal quarter in its fiscal year and it is Lee's most lucrative fiscal quarterly period due to the holiday season. The company generated free cash flows of $30.9M in the Q1 2012 period, which was an increase from the $28.65M in Q1 2012. Lee paid down $29M in its debt during the quarter due to the sale of the North County Times for $11.95M and it also increased its liquid cash position by $6.36M. Although Lee has to pay a sharply higher weighted average interest expense rate due to its debt refinancing last year, it no longer has to pay any debt financing and reorganization expenses in order to survive as an organization.

We hope that Lee would be able to execute the refinancing of its 2nd Lien Term Loans that carry a 15% interest expense coupon and a 2017 maturity but failure to execute such a deal would not have any additional negative impact on Lee as an investment opportunity.

Although Lee would have to pay $3.5M in refinancing costs if it refinanced this debt, we expect it to potentially reduce its interest expense by 2% if it can execute a deal. We expect Lee has been in discussion with its lenders about a potential deal in order to attempt to close a deal after January 30th, 2013 when it will be able to execute such a deal. We are expecting Lee to generate about $14M in free cash flows per quarter for Q2 2013 to Q4 2013 primarily due to the absence of additional mandatory debt financing and reorganization costs that were incurred in the comparable periods in 2012. This will result in Lee generating just under $75M in free cash flows during FY 2013, which will help enable Lee to potentially reduce the face value of its outstanding debt below $875M as of the end of the year.


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Source: Lee's 2012 Deutsche Bank Leveraged Finance Presentation and Our Estimates

Lee's adjusted revenue declined by 3.8% in Q1 2013 versus Q4 2012 and this was attributed to declines in its adjusted advertising revenues due to the weak economy. Operating Income increased by 1.2% as the revenue declines were offset by a 3.7% reduction in cash operating expenses and a $1.7M reduction in depreciation and amortization expenses. Lee's management expects its cash operating expenses to decline by 3.5%-4.5% in FY 2013. Interest Expense increased by $10M year-over-year, due to increased cost of debt associated with the bankruptcy reorganization. Compensation expenses decreased 4.9% due to a reduction in the average number of full-time equivalent employees of 8.1%. Newsprint and ink expense decreased 13.1% as a result of a reduction in newsprint volume of 12.6%. Other operating expenses decreased 0.6%.

Lee's pre-tax income in Q1 2013 of $22.9M was stable in comparison to Q1 2012 as Lee's $7M gain from the sale of investments and reduced debt financing and reorganization costs were offset by higher interest expenses. Lee's net income of $14.6M in Q1 2013 was stable with Q1 2012 as increased gains from discontinued operations were offset by higher tax expenses. Lee's EPS of $.20 from continuing operations exceeded the $.15 consensus estimates by the analyst community and we are expecting Lee's EPS to have bottomed out as its interest expense rate is not likely to increase further and Lee is steadily paying off its outstanding debt. Gatehouse Media (OTC:GHSE) is the community newspaper leader serving the New England region and we can see that although Lee and Gatehouse engaged in debt-funded deals-from-hell around the 2005-2007 buyout boom and bust, at least Lee is making progress in reducing its debt unlike Gatehouse.


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Source: Morningstar Direct

Lee is making steady, incremental progress in monetizing its digital properties. Lee's circulation revenue increased by 3.9% due to gains from paid content initiatives and a $.50 price increase on its flagship St. Louis Post-Dispatch newspaper publication. Lee's digital revenue in Q1 2013 was $16.3M and increased 4.8% from Q1 2012. Lee's digital revenue in Q1 2013 was 8.8% of its total revenue, up from 8.1% in 2011. The key driver of Lee's digital revenue growth was its mobile advertising revenue, which reached $1.3M in Q1 2013 and increased by 147% versus Q1 2012. This was achieved in addition to Lee's 150% increase in mobile advertising revenues in FY 2012. Digital subscriptions have introduced in nearly all of Lee's markets and Lee is planning to introduce the Google (NASDAQ:GOOG) Doubleclick advertising platform in Q2 2013. Combined print and digital advertising revenue decreased 6.3% to $128.7 million, with retail advertising down 3.8%, classified down 7.7% and national down 24.2%. Combined print and digital classified employment revenue decreased 8.9%, while automotive decreased 6.9%, real estate decreased 11.5% and other classified decreased 5.9%. Print advertising revenue on a stand-alone basis decreased 7.7%.

We are pleased to see that the NYSE has returned Lee to full compliance with its continued listing standards and is not likely to see its stock de-listed from the NYSE. We are more pleased with the recent news that it entered into agreement to sell The Garden Island newspaper and digital operations based in Lihue, HI to Oahu Publications, Inc. for $2 million. Oahu Publications owns the Honolulu Star-Advertiser and will consolidate The Garden Island's production, printing and distribution activities with the Star-Advertiser's printing, production and distribution operations. Although the $2 million sales price seems kind of puny, The Garden Island only generated $3.4M in revenue and $100K in operating cash flows over the last 12 months ending December 31st, 2012.

While this is less than the $11.95M from the sale of the North County Times in October, it is equal to the $2M in net proceeds that Media General salvaged from the sale of The Tampa Tribune in October. The Garden Island was one of Pulitzer Inc's 12 community newspaper publications published through its Pulitzer Newspapers, Inc. community newspaper subsidiary. Although The Garden Island's average daily paid circulation has actually increased under Lee's ownership, its tiny level of revenues ($3.4M in the TTM) and cash flows ($0.1M) have been a rounding error in relation to Lee Enterprises's consolidated revenues and cash flow levels.


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Source: Pulitzer Annual Reports 2000-2004 and Lee Annual Reports 2005-2012

In conclusion we're pleased to see Lee's share price stabilizing. Lee is most certainly not a blue-chip company and the glory days of the newspaper publishing business are most certainly over. However, we also believe that the worst for Lee is over and we don't expect it to buy any other newspaper chains at 25X TTM FCFs using debt like it did with Pulitzer in 2005. Lee has been able to keep its EBITDA stable since it bottomed out in 2009. Although Lee's revenue has been steadily sagging since 2006, it has been able to offset these headwinds with lower operating costs. Lee has also mitigated its print revenue declines with its revenue from its digital advertising and circulation programs.

One item that impressed us was Lee's rapid revenue growth from its mobile advertising program. Lee's mobile advertising revenue increased by 147% to $1.3M in Q1 2013 after it grew by 150% in FY 2012 and reached $2.7M for the year. Lee remains one year ahead of schedule with regards to reducing debt and it announced it will be selling another peripheral newspaper publication. After selling the North County Times to Papa Doug Manchester's MLIM Holdings LLC in October 2012, it is expecting to complete the sale of The Garden Island to Oahu Publications. Although Lee only salvaged $11.95M from selling the North County Times and is only expecting $2M from selling The Garden Island, it will enable it to reduce debt by almost $14M and save at least $1M in pre-tax interest expenses, as its 1st Lien Term Loan carries a 7.5% annualized interest rate and Lee has to make principal and interest payments on a quarterly basis.

Source: Lee Enterprises: Berkshire Shouldn't Sell Lee Nor Will We