New Media's Decline Is Accelerating, Not Slowing

Summary

• NEWM's rollup of declining local newspapers seems dangerous - and it is.
• Management is forecasting a return to overall revenue growth, but digital advertising is declining, and the company is reliant on price increases in circulation.
• A double-digit dividend makes shorting a bit more difficult, but a leveraged, declining business has more than enough downside to compensate.

The story at New Media (NYSE:NEWM) is one of the strangers in the markets. First, it's a roll-up of local newspapers, a seemingly odd target, given the obviously secular decline in the space. NEWM pays a double-digit dividend, for reasons that aren't entirely clear: after distributing nearly $100 million over seven quarters, while talking up extensive acquisition opportunities in the space, the company executed a $120 million stock offering in November. This came at the same time NEWM management was talking up its undervalued stock - even citing a $25 price target - and to its credit, put its money where its collective mouth was. And, again, it's a rollup of local newspapers and using a strategy that its predecessor GateHouse Media rode straight into Chapter 11.

The irony is that an investor unfamiliar with the NEWM story might assume that it was essentially a "cigar butt" type of play: local newspapers could add value if they're a) acquired cheap enough and b) can contribute enough cash flow (either through existing business and/or synergies/cost cuts) to repay the acquisition cost in a matter of years. But New Media's version of the story is that organic revenue trends will improve, as digital revenue growth offsets ever-shrinking legacy print business.

I'm highly skeptical on that point, and Q1 results last month support that skepticism. I regret not shorting NEWM at $16, when I was dissuaded both by the dividend and the potential for improvement in 2017. But even at a lower price, NEWM looks like it's in big trouble. And, at some point, that's going to mean more downside for the stock.

This Is Not Working

Source: author from NEWM presentations

The chart above uses New Media's own figures given after the end of each quarter, which are pro forma for any acquisitions completed and/or announced (usually) since the last report. The dip in 2015 came from the company's controversial and hugely profitable sale of the Las Vegas Review-Journal to Las Vegas Sands (LVS) CEO Sheldon Adelson. That aside, the trend is obviously negative, and consistently so.

In Q1, pro forma As Adjusted EBITDA, as New Media terms it, declined 10% year over year. But that doesn't show the depth of the decline. Over the four quarters, New Media spent another $68.1 million in acquisitions, which, at a targeted 3.5-4.5x multiple, implies roughly $17 million in incremental As Adjusted EBITDA.

That suggests that organic EBITDA declined something closer to 20% year over year, as the pro forma figure dropped from ~$171 million to $153 million between Q1 2016 and Q1 2017. Using similar math over recent quarters shows the underlying decline actually is accelerating, with post-LVR-J spending more than offset by erosion in legacy properties. Similarly, a 4% decline in free cash flow looks closer to 20% on an organic basis.

This is a declining business even on a reported pro forma basis, but the erosion in the underlying business is being hidden (somewhat) by M&A strategy. That fact alone seems to negate any real upside to the equity, barring either EBITDA multiple expansion or debt repayment. The former seems unlikely (at nearly 6x, NEWM already trades at a premium to the space), and the latter isn't really happening: debt decreased just $13 million over the past four quarters. Cash did increase, but it took a $120 million equity offering to increase that figure $56 million year over year. And, New Media seems intent on spending its cash on more acquisitions to execute the exact same strategy.

Is Growth On The Way?

So, there's little way to see New Media supporting a $690 million market cap and $910 million enterprise value based on the business as is. But New Media believes that the trajectory will improve. CEO Mike Reed has said in the past that the company is headed for organic revenue growth and, on the Q1 conference call, projected year-over-year increases in free cash flow starting in Q2. Cost cuts are expected to help margins, and further growth in the Propel digital marketing business should be a driver as well.

Reed did walk back guidance for revenue growth, however, saying that weaker-than-expected performance from print advertising caused "a slight delay by a couple of quarters" in getting to that point. But the company still laid out a potential scenario for that organic growth to arrive next year:

Source: New Media Q1 presentation

There's a couple of major problems with this scenario. For one, New Media broke out the $72 million increase as follows:

• $38 million from Propel, based on a 65.5% growth rate, the average of the last four quarters. But Propel growth was 56% in Q1, and growth rates tend to decelerate. The company has added 50 salespeople, but there's no guarantee that efficiency will accelerate revenue growth, as is modeled here.
• $4 million from Circulation, based on a 0.9% increase over the past few quarters. This is the core of the NEWM bull case, and it's where the bull case is the weakest. New Media has fought off volume declines in circulation by raising prices - Reed said on the Q1 call that price increases were close to 10%. There is no way that's a sustainable strategy over a multi-year basis. I argued in November that a circulation decline was a potential catalyst for a short. That figure sure looks like it's near reversing, and at 36% of revenue, that's an insurmountable problem for the positive revenue growth projection.
• $21 million in new Commercial Print wins. This seems to imply that the rest of the business will be flat, which appears to have been roughly the case in 2016 but may not hold going forward.
• $8 million from Events, where revenue is expected to double.
• $1 million from business-focused BridgeTower Media.

There's also something missing from the model: digital advertising. For all the hopes that digital advertising can replace print advertising (both at New Media and peers like McClatchy (MNI), New Media's digital advertising revenue actually is declining. It fell nearly 10% YOY in Q1 after a 9% decline in 2016, using figures from the 10-K.

So, when New Media says over half of revenue is stable...

Source: NEWM Q1 presentation

...that's not actually the case. Of the 53% that is supposedly stable or growing, 36 points (~68% of the total) is Circulation. Another 6 points come from digital advertising. To my eye, the growth areas are Propel (6% of revenue) and Events (a bit over 1%). The rest of the business might grow on an individual basis, but combined, the top-line trajectory seems highly likely to stay negative.

There's another problem here: margins. Organic revenue growth still seems to imply declining EBITDA. Profit margins already are declining, and trading a dollar of high-margin print advertising revenue for labor-intensive Propel sales likely implies further compression.

The story here simply doesn't make sense. A stable of local papers acquired at 4x EBITDA shouldn't be valued at 6x - there are synergies here, but not that many. Funding the dividend through equity and debt when the stock is supposedly undervalued is an odd choice, to say the least. Paying Fortress (now owned by SoftBank (OTCPK:SFTBY)) $32 million in fees last year, including $25 million in incentive compensation, much of it due to the equity offering, seems unnecessary. (To be fair, Fortress does pay Reed and CFO Greg Freiberg, who receive no compensation from New Media itself.)

But most importantly, this is a declining business, and there's no reason to see that reversing on an EBITDA basis. If New Media were acting as if that were the case, there might be some value to pull out. But it certainly sounds as if New Media is content with its M&A strategy, and even a 10.8% yield isn't going to compensate shareholders at current prices based on the current trajectory.

Valuation, Shorting, And Catalysts

The catch remains what to do even if the declines aren't going to reverse. New Media isn't hugely leveraged on a net basis; its net leverage ratio is just 1.4x (again, on a pro forma basis), while the maximum ratio under its credit agreement is 3.25x. That agreement doesn't mature until June 2020; even if New Media unwisely accelerates its M&A, runs into trouble, and heads to zero, shorts at $13 are paying out as much ~30% in dividends over those three years and, thus, only earning ~20% a year on a CAGR basis.

One way around, that problem is puts, which both negate the dividend payment and add some leverage to the trade. The October 12.5 is at $0.85/$0.95 and last traded at the midpoint; the October 15 looks attractive as well. Liquidity isn't great, but it's enough for individual investors and likely even smaller funds.

The fact is that this business isn't working, and I'm not sure that some investors quite realize that fact. There's certainly a 'yield trap' aspect to NEWM stock, but other investors might see the possibility of growth, or at least stable profits, going forward.

To be blunt, I see basically no evidence on that front. Any growth potential here essentially rests on Propel, which is a $60-70 million business, and maybe Events, which is targeting $15 million this year. That's not enough, or close. The stock offering makes the dividend greater as a portion of free cash flow (it's over $70 million against a pro forma $110 million); higher interest rates should increase the company's interest expense (which already has a weighted average rate over 7%). And, if the company has to walk back FCF and revenue growth projections again, as seems likely, the stock is going to fall. A 5x EV/EBITDA multiple sends NEWM back toward $10, and that's still a modest premium to peers.

The biggest risk to a short is if New Media decides to focus on deleveraging instead of extending its reach, but there's little evidence to see that occurring. Other than that, the risk is New Media getting to organic revenue growth with double-digit declines in print advertising through either stable circulation volumes or some sort of rebound in digital advertising. A short is basically a bet against those outcomes. And, at the moment, it looks like a very good bet.

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Disclosure: I am/we are short NEWM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.