The phrase "burning the furniture to heat the house," is meant to express the desperate measures that some people will take in order to stay warm and therefore alive. It also symbolizes actions that are ultimately futile - after all, once the furniture is burnt you have nothing left to burn to keep yourself warm. It's a stopgap measure that is ultimately both destructive and fails to obviate the final outcome - being left in the cold. We believe that Lee Enterprises (LEE) has been burning its furniture to stay alive by aggressively cutting costs in order to service its crushing debt load. While these actions have so far allowed the company to keep its EBITDA relatively stable, the current level of profitability looks unsustainable and additional cost savings are probably impossible. As we will explain in this article, the operations of LEE have been gutted and the result is an enterprise on the precipice of decline. Below we review the two major actions LEE has taken to maintain its profitability.
Action #1: Aggressively Fire People
Result #1: Product quality declines
Prognosis: Not repeatable and dangerous to the business
Since the beginning of 2010, Lee Enterprises has reduced its headcount from 6,304 people to 4,678, a decline of 26%. If you're wondering how this is possible, it's not from getting people to work smarter or harder. Firing 26% of the workforce was made possible by the company's decision to shrink its newspapers. Over the same time period, the volume of newsprint consumed by the company has declined by 30%. In case you think that the decline is simply due to fewer subscribers, the newsprint produced per subscriber has also declined by 14% over this period, which means not only that Lee has fewer subscribers, but also that each of Lee's subscribers is reading a smaller newspaper. They are selling into a shrinking consumer base that also consumes fewer newspapers. The end result of firing so much of its staff is that LEE now produces a substantially less robust product than it previously did. Here's how the headcount of LEE and the volume of newsprint consumed looks over the past two years:
Action #2: Increase Prices
Result #2: Subscribers Leave
Prognosis: Not repeatable and dangerous to the business
To combat the decline in the number of subscribers (which has declined 19% since the start of 2010) and the continued loss of advertising market share by newspapers, Lee Enterprises has raised its prices for subscribers. Over this period, the average subscription revenue per subscriber has increased from $29.11 to $34.87, an increase of 20% (or an increase of nearly 40% is you normalize for the size of the newspaper). In essence, LEE has decided to charge more for a product that is continually declining in value, as can be seen in the aforementioned decline in both the number of employees at LEE as well as the company's newsprint per subscriber. Below is a graphical representation of the average subscription revenue per subscriber, the number of subscribers at LEE, and the average newsprint volume per subscriber over the past two years:
An Overvalued Stock
As if the deteriorating fundamentals weren't enough, Lee Enterprises is also significantly overvalued based on recent transactions in the newspaper industry. We rely on transactions because there aren't many good comparable companies that trade because they often have significant other assets such as Internet properties [McClatchy - (MNI)], real estate [NY Times - (NYT)] or broadcasting assets [Gannett - (GCI)]. On the other hand, we can look at several recent transaction comps to see what newspapers may be worth. For instance, Berkshire Hathaway (BRK.A) (BRK.B) bought the newspaper division from Media General (MEG) for $142 million in May, 2012. In the prior year, the newspaper group had generated about $28 million in EBITDA so they were sold at a multiple of 5.1x. Likewise, Newcastle recently purchased the Dow Jones Local Media Group for 3.4x EBITDA and also restructured GateHouse at an implied valuation of 6.0x 2013E EBITDA. In contrast, Lee Enterprises is trading at 6.2x EBITDA. At the average transaction multiple of 4.8x, LEE's equity would actually be worthless due to the extreme financial leverage at the company. Even at the high-end multiple of 6.0x, LEE's equity would only be worth $2.85 or 18% below its last price of $3.49.
Furthermore, Lee's extreme leverage and dwindling business makes it a good candidate for a future bankruptcy or restructuring. There have been numerous bankruptcies in the space over the last 5 years, as can be seen here.
Due to declining industry fundamentals and the rash of bankruptcies in the space, transaction multiples have collapsed. Newcastle Investment Corp (NCT) says in their latest presentation that local newspaper businesses can be purchased at 2x-5x EBITDA, down from historical averages of 10x EBITDA (here). This supports our view of Lee's equity as being worthless.
Lee Enterprises has embarked on an unsustainable business model of destroying its product while raising prices in an effort to sustain its financial performance. In many ways, the company was forced down this road by its enormous leverage, which already caused the company to file for bankruptcy once before, in early 2012. While this strategy has been successful at stabilizing the business over the past few years, it is unlikely to be successful going forward. LEE's short-minded strategy of gutting its workforce (and therefore its product) while simultaneously increasing prices is doomed to fail. We believe the stock is worth at most $2.85 per share and is likely ultimately worthless based on industry average multiples and the high likelihood that LEE's financial performance will begin to deteriorate once consumers catch on to the much weaker product and the company runs out of cost cutting measures. We are short the stock and suggest shorting the stock.