Lee Enterprises (Ticker: LEE) owns a portfolio of newspapers in small towns and medium-sized cities. We're well aware of poor fundamentals in the newspaper industry, and we believe that digital media will continue to encroach on print's territory. That said, we're willing to make small investments in companies with debatable fundamentals if we think the risk-reward profile overwhelmingly favors us. Such is the case with LEE.
During the first half of 2011, LEE's stock declined more than 75% (from above $3 per share to below 80 cents) on fears that the company's creditors would force it to file for bankruptcy. LEE is heavily indebted, and the vast majority of the company's debt matures in April of 2012. Unless LEE can refinance its debt before this looming maturity, it will face bankruptcy.
Adding to the negative sentiment, the NYSE notified LEE last Friday that the company no longer meets the minimum stock price requirement for continued listing. LEE has 6 months to cure this deficiency.
Despite this risky profile, LEE has several important things going for it. First, the company has shown an impressive ability to cut costs as its revenues have fallen, so its cash flows have declined much more slowly than its sales. Relative to its cash flows, its current interest payments aren't very burdensome, and the company's leverage isn't excessive. For this reason, we think that its highly likely that the company will be able to refinance its debt and avert bankruptcy. Certainly, it will pay higher interest rates on its new debt than on its current credit facility, but the company can accommodate these higher rates.
Here's the math. Lee had about $1,026M in total debt as of the end of its Q2. Its TTM EBITDA is about $170M, meaning that the company's debt-to-EBITDA ratio is 6.0. Importantly, the company has been running at a $170M EBITDA run-rate for more than a year, up from $160M in 2009. Also, $170M is just shy of 2x the $90M in annual interest we think LEE will pay on its new debt. 6x EBITDA for total debt and 2x interest coverage are reasonable multiples. Generally, we're skeptical of investment rationales that make use of EBITDA, but since that's how prospective creditors will look at LEE, we find it useful in assessing the likelihood that the company will refinance its debt.
Seen this way, LEE's leverage, though substantial, isn't grossly excessive. Given that numerous companies of dubious financial standing have been able to issue debt this year, we think that LEE has a good shot to refinance its debt before maturity.
So what will the equity in the new-look LEE be worth? Let's say LEE issues $1B in debt to refinance its existing debt (it will generate considerable cash flow in the next few quarters, so its new debt will likely be of smaller principal value than its current debt). Let's also assume that this is broken down into a $750M credit facility with an average interest rate of 8% (more than 750 bps over LIBOR) and $250M of junk bonds yielding 12%. This comes out to $90M of average annual interest payments.
Let's assume the company has a $150M EBITDA run-rate going forward, down from the current $170M rate. Subtract from that our $90M interest figure, $20M for cap ex (up from $10M in 2010), and assume a 40% tax rate. Under these assumptions, we arrive at run-rate earnings of $24M. Give this earnings stream an 8x multiple, and we arrive at an equity valuation of $192M. Even if you assume 30% dilution from the company's refinancing, you still arrive at a share price north of $3.
Importantly, we believe that each of the assumptions above is an unfavorable for equity holders. LEE management thinks it can grow revenue and EBITDA in the future, and CEO Mary Junck has been steadfast in her assertion that the outcome of the refinancing will be satisfactory. We're more skeptical than the CEO about the future of the business, but even if EBITDA remains at its current level going forward and there is little or no equity dilution in the refinancing, the stock could easily trade to $6 or $8 per share. If LEE's business rebounds, it could go higher still. Finally, it's also conceivable that a bigger rival or opportunistic investor views this situation the same way we do and decides to acquire LEE, another outcome that would favor our investment.
Now, with a looming maturity of a large debt burden, it's entirely possible that LEE files for bankrupctcy and the stock ends up worthless. This is not an unlikely outcome, and it's one that investors must consider before buying LEE shares. However, at its current sub-$1 price, there's a lot more that can go right for LEE than can go wrong. We think there's a better than 50% chance that LEE will be able to refinance its debt. If this happens, we think the stock well make a beeline for $2 or $3, and could trade much higher than that if the future turns out favorably for the company.
LEE probably shouldn't be a huge holding in any portfolio, but we've made it a small part of our book, and we think that it could give us huge returns with a tightly-defined downside. After all, it can't go lower than $0, but it can go a lot higher than it is right now.