At the quarter ended June 26, 2011, Lee Enterprises (LEE) generated $134.3 million in free cash flow (which I'm defining as operating cash flows minus investing cash flows) over the trailing twelve months. As of the close of business on Monday, September 12, the entire company was for sale at only $34 million (which is the market cap after the upcoming dilution of 6.74 million shares, which I'll get to shortly.)
Last Thursday evening, Lee announced a monumental debt refinancing (pdf) that will prevent the company from going Chapter 11 and having the shareholders get wiped out. The market reaction on Friday was to move the stock from $0.60 a share all the way up to... $0.62. Then the following Monday it actually went down to $.615. So if any researcher believes markets are always efficient, that's an anomaly they'll definitely want to check out. Even though Lee had been priced as if its death were imminent, the big announcement that stockholders escaped the executioner's ax barely budged the stock price at all.
With its current free cash flow, Lee is priced at 0.25 times TTM free cash flow. No, that's not a typo. That means that if you bought $1,000 worth of Lee stock right now, the slice of Lee that you'd own could expect to make back that $1,000 in a few months.
Typically, stocks are priced that cheaply only because Wall Street expects the company to have a strong chance of dying. And indeed, that was the case with Lee up until last Thursday. If it had not been able to refinance the approximately $1 billion in debt it had coming due April 2012, then shareholders were going to be wiped out.
However, that threat is now virtually gone, as you can see in the CEO's letter to shareholders here (pdf). Lee has refinanced $864.5 million of the debt, and even if Lee cannot refinance the remaining $175 million coming due in April (the worst case scenario), it will file a prepackaged Chapter 11 filing that will not wipe out shareholders, but could involve having to issue a number of new shares in order to convert that debt into equity, which would improve Lee's balance sheet in exchange for diluting the current shareholders. However, Lee's stock is so ridiculously cheap right now that even if the number of shares was quadrupled, it would still mean you owned your shares at 1x TTM free cash flow.
Next we turn our attention to Lee's ability to service and pay down its debts. The metric to look at for this is not free cash flow, since that's an after-tax figure, but earnings before interest and taxes (EBIT), since interest on loans is paid with pre-tax dollars. The TTM figure for Lee was $159 million (which does not count writedowns and other non-cash expenses, of which Lee has had a lot), while the interest amount paid on the refinanced loans, which begins June 2012, will be $80 million. This results in an interest coverage ratio of about 2.0, which is a safe level.
There remains the $175 million in Pulitzer acquisition debt remaining to be refinanced, which is due in April 2012. For purposes of this exercise, let's assume Lee waits until February and refinances all of the debt rather than converting some or all of it into equity. As of the last 10Q, Lee had paid down $97.7 million of debt in the trailing twelve months, for a rate of $8.1 million a month.
Between now and the time it refinances the Pulitzer debt, it should have paid off about $55 million of that principal, since substantially all of its free cash flow will be directed at paying down that debt. So the amount it will need to refi will be $120 million, and even if it needs to pay 15% for that debt, it will mean $18 million in interest.
In short, the pre-tax cash flow I would expect it to have will be about $60 million per year considering the total amount of interest at the most pessimistic of assumptions. At a 38% tax rate, that means there will be about $37 million in free cash flow next year, which Lee will use to continue paying down principal on its tier 1 debt. Just as paying down principal on the mortgage of your house builds your equity (i.e., ownership) in your house, so too does a company paying down debt increase the amount of its assets owned by its shareholders. Plus as time goes on, interest payments will have less and less of a burden on Lee.
So the bottom line for equity holders is that Lee will be rising in value by about $37 million starting in April 2012 (and accelerating after that), while the entire company is currently on sale for $34 million.
The Moat Around Lee's Castle
Lee's qualitative story is quite interesting. As it says, "everyone knows" that newspapers are dying.
However, Lee Enterprises is much more of a small newspaper play, which makes its economics different. The average size of a Lee paper is a circulation of around 25,000. These often are towns without local TV stations, so other than the Internet and billboards, so if you own a car dealership, grocery store, or some other local business, the only game in town if you want to advertise to the largest group of people in your community, at the highest return on investment, is the local paper.
Here are the reasons Lee Enterprises has a competitive advantage with its papers:
1. Economies of scale
Local newspapers gravitate toward economies of scale. The winning paper makes money, and any competitors in the same town are pretty much going to struggle forever with higher per-unit costs than the winning paper. Not only are there economies of scale with distribution, but also with the reputation these papers have built in their local communities.
2. Demand based on customer captivity
Reading the newspaper becomes a habit, and it's a continual flow of information unlike, say, a typical book, which you buy only once.
Moreover, if you want news about your country or maybe even your state, you have multiple sources of information, and often they're free. But if you want in-depth information about your small town, the local newspaper is pretty much the only place for you to go.
3. Supply of information
Newspapers have established relationships with local institutions like the police and city hall, so the local reporters can pick up the phone and dial the digits and know their call will be answered. The local papers also have the inside scoop on all the stuff interesting to locals like the high school sports, the obituaries, births, and so on.
Obviously the overall franchises are not as good as they used to be. There's been a lot of information available online for free now including, unfortunately, the newspapers themselves that for some reason have thought they needed to offer everything for free online. However, as of this past summer, Lee has begun rolling out paywalls for its papers, so it's definitely solving this problem over time. (The new paywalls may also show a boost to Lee's revenues beginning this quarter, but that's another article entirely.)
There is a pervasive amount of pessimism about Lee Enterprises right now. It's on sale for about one year's worth of free cash flow even after the most pessimistic of the realistic dilution assumptions, so this means this business could have an extremely large margin of safety. Finally, however, it's important to take a long-term perspective as a shareholder of Lee. It may take days for Wall Street to realize the extraordinary value of this company, or it could take many years.
With the amount of free cash flow generated by LEE, combined with the fact that going to zero no longer looms thanks to last week's refinancing, this stock could very well be the buying opportunity of a lifetime.
Disclosure: I am long LEE.