A Concerning Quarter Undercuts The Bull Case For A.H. Belo

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About: A.H. Belo Corporation (AHC)
by: Vince Martin
Summary

AHC has been a classic small-cap value play, with cash and real estate creating potential upside on an SOTP basis.

But the question has been whether management will sell its last newspaper - the Dallas Morning News - or continue trying to build out its digital business.

A terrible Q1 performance raises risks surrounding the operating business, while a CEO change adds questions about the long-term strategy.

With paper value perhaps less impressive, and capital allocation uncertain, it might be time to take profits.

I've had an on-again, off-again interest in A.H. Belo (AHC). The owner of the Dallas Morning News has an attractive SOTP case, which led me to buy shares as AHC drifted below $5 last summer. $50 million-plus in cash on the balance sheet and potential proceeds from the sale of its former headquarters support much of the current equity value.

But the question - as is so often the case in the micro-cap value space - is what management plans to do with that cash. Two shareholders - outgoing CEO Jim Moroney and his second cousin, incoming CEO Robert Decherd - control the voting power, and combined own over 10% of shares outstanding. That skin in the game, and a history of special dividends using proceeds from past asset sales, has established some confidence that AHC would be careful stewards of the capital - and eventually drive some upside in the stock.

But AHC also has spent up to build out a digital marketing business, in an effort to offset declines in DMN circulation and advertising revenue. While shareholders like myself would prefer the company to sell the DMN - particularly given seemingly attractive sale prices of late - that may not be management's preferred strategy. And so the risk (which, again, is so common in this space) is that capital allocation may delay or erode the potential returns seen on paper.

From that standpoint, AHC's Q1 report on Wednesday is hugely concerning. The operating business had a truly abysmal quarter, with declines accelerating in print revenue and the digital business turning south as well. I'm not sure what the CEO change means in terms of strategy, and without some value in DMN the bull case here gets a bit weaker with the stock still above $5.

AHC sold off as the day went on - and I likely will head for the exits myself. I'm loath to overreact to a single quarter, but with the business declining and the strategy unclear, I'm not sure that selling the news here actually is an overreaction.

Q1 Earnings

AHC's first quarter results weren't quite as bad as headline numbers suggested - but they were ugly. Revenue dropped nearly 19% year-over-year, with adjusted operating loss (what other companies usually refer to as Adjusted EBITDA) nearly tripling.

On the top line, a change in accounting reduced revenue by $2.9 million (and was offset on the P&L by an equal reduction in operating expense). But that aside, the top line still dropped 13.7% year-over-year.

Meanwhile, the report was concerning across the board. Advertising revenue fell a whopping 27%, per the 10-Q. Backing out the accounting impact, the figure still dropped 20%. On the Q1 call, Moroney said a national grocer - the DMN's largest advertiser had pulled its preprint business from all newspapers. That aside, preprint revenue would have fallen 10.7% instead of 21.9%.

But that alone doesn't explain all of the weakness in print. AHC didn't break out preprint's contribution in Q1 or in 2017, but the last time it did (full-year 2016), it represented about 43% of total advertising revenue. If that's still roughly the case, that exit only accounted for about five points of the decline, with the December sale of the Denton Record-Chronicle adding a bit more than a point.

That still means a mid-double-digit decline in advertising overall - and an even higher rate of erosion for the print business. Coming off a Q4 report where declines were relatively modest (advertising revenue was off 4.1%), it represents a notable step down. Circulation revenue fell 6% excluding the accounting shift (7.4% as reported), another disappointing number. DMN has been able to offset most of its subscriber declines with pricing, as circulation sales were down just 3.4% last year. That strategy seems to be running out of room.

All told, the print business had a terrible quarter. On the call, DMN publisher Grant Moise attributed the weakness mostly to national advertisers - but that's not exactly comforting news. AHC was able to cut expenses sharply to mostly match the revenue declines - but much of the savings came from layoffs last year, and there is a point where AHC simply can't cut anymore.

The plan long-term is for the digital business to offset those declines. But I've long been skeptical that's achievable for any newspaper - and Q1 suggests it might be impossible for the DMN. Digital advertising appears to have declined, per the 10-Q, with the filing saying that "revenue decreased primarily" due to the accounting change. The use of "primarily" seems to imply that the decline was greater than that driven by the new standard; in other words, digital ad revenue still declined on an apples to apples basis.

Meanwhile, digital services revenue plummeted. Marketing Services revenue, per the Q, fell 27%. That business includes DMV and Your Speakeasy (two acquisitions used to build out that business), along with programmatic advertising and promotional merchandise sales through the company's MarketingFX unit. Backing out the accounting change, the drop was just 13% - but in the digital services business, the news was much worse. As reported, revenue fell 35%; less than half the decline was accounting-related.

Perhaps not coincidentally, A.H. Belo didn't break out DMV revenue, as it has in past quarters. But the trend quite clearly is terribly negative. Growth has steadily moderated, moving last year from 50%+ in Q2 to 20.3% in Q3 to 7.3% in Q4. DMV and Speakeasy combined then dropped in the high teens this quarter. Even with compensation relatively flat Y/Y, EBITDA in the segment dropped from $805K last year to $155K this year.

From the perspective of the operating business, it's really an awful quarter. And it dramatically changes models for future profitability in the business. Adjusted EBITDA last year was $11.7 million, actually up year-over-year (albeit by less than 1%). Guidance for ~$5 million in capex this year and $1 million-plus in cash taxes suggests free cash flow at that level of about $5.5 million.

But EBITDA profitability dropped $1.6 million in the quarter. On a run rate basis, that pretty much wipes out the ability of the combined operating business to generate any free cash. (To be fair, capex should drop off in 2019 - but a continued negative trend in EBITDA will offset that benefit.) And commentary from A.H. Belo at no point suggested that the weakness in the quarter was a one-off problem.

There's not going to be another national grocer who replaces that lost business. High-margin display and classified ad revenues aren't coming back. 10% annual compensation cuts aren't possible forever. And the decision by management to basically ignore the digital business in the release and on the call - and to not disclose DMV's sales figures - leaves investors to assume the worst. The operating business already was the weakest part of the bull case, with hopes for big upside based on a buyer paying more than cash flow numbers suggested. Q1 numbers raise real concerns.

The CEO Change

Last month, AHC announced that Moroney was stepping down as CEO after five years, to be replaced by Dechered. I've discussed the shift with two other investors involved with the stock - and truthfully haven't quite figured out what the move means for AHC's long-term strategy.

In the release, Moroney said his move was overdue, as he had committed to four years upon taking the job. And he cited a transition committee established last year that had set up a new management team (including a promotion at the DMN and a new head for the renamed Belo + Company, which includes the digital assets). And, initially, the hiring of Decherd seemed like good news for those shareholders hopeful that the DMN - and/or AHC itself - would be sold.

After all, Decherd is 67 - and a former CEO himself (he preceded Moroney). Decherd comes from the newspaper side - not the digital businesses, which were purchased after he ended his original tenure. Both Moroney and Decherd are incentivized to drive shareholder value, given their ownership, and one would think that if Belo's board was planning a multi-year effort to invest in the digital business, they would have brought on an outsider and/or a younger executive better-versed in that industry. The initial appearance was that Decherd was a hire by a board that believed the position of CEO of A.H. Belo wasn't going to exist a few years now.

But as another investor pointed out, Moroney is giving up a substantial ($4 million-plus) change in control benefit by retiring. That would seem to suggest that Belo isn't for sale any time soon. And the establishment of new heads on both sides of the business also supports the idea that Belo's board plans on staying independent.

It's still possible that the board may see the writing on the wall. Q1 performance could accelerate that process. But it seems at the moment that Belo isn't planning on selling DMN, or itself, in the immediate future.

Valuation

At Thursday's close of $5.35, AHC has a market cap of about $118 million. $54 million in cash at quarter-end and a previously estimated $25-$30 million in value from the company's old headquarters in downtown Dallas (whose proceeds should be shielded from taxes by NOLs, per past commentary) combine for nearly $4 per share.

And they leave a value on the operating business of under $40 million. There is a pension liability carried at $23 million, but a 50 bps increase in interest rates would reduce that liability to zero, per commentary on the Q2 call.

It's not hard to get over $40 million - on paper. The Austin American-Statesman just sold to New Media (NEWM) unit GateHouse Media for $47.5 million. The Palm Beach Post sold, also to GateHouse, for $49 million. The Los Angeles Times and San Diego Union-Tribune were acquired for $590 million, with a combined circulation 4-5x that of the DMN.

Those comps suggest as much as $100 million in value at the DMN, and even excluding the digital assets would value AHC above $8 (zeroing out the pension liability; AHC would be $7+ based on the carrying value of the pension liability). But Moroney specifically pointed out in response to a question on the Q1 call that GateHouse's purchase was based on taking out a lot of costs, and that company (whose stock continues to look like a screaming short, though it's held up so far) focuses more on small- to mid-sized papers (with Austin a bit of an outlier in its portfolio).

And so there's two problems with the value on paper (no pun intended) here, or expecting upside to $8-9 per share. The first is that DMN has increasingly little value if it's not sold (ideally as a trophy asset for some wealthy civic-minded Texan, a la Patrick Soon-Shiong with the Times or Jeff Bezos with the Washington Post), particularly if Q1 results are any guide. Even an acquirer like Gannett (GCI) who can take out some level of cost is going to blanch at buying a paper whose standalone FCF is close to zero. The second is that AHC still is considering another acquisition on the digital side - Moroney specifically cited the possibility of another purchase on the Q1 call, after saying in the past that the company was looking to build out that business - which after the quarter looks like a classic case of throwing good money after bad.

Again, the conflict between returns in theory and in practice is a common one in the small-/micro-cap space, particularly for controlled companies. Both Moroney and Decherd descend from the paper's first publisher (George Dealey, for whom Dealey Plaza was named) and may have priorities for the business beyond cold-blooded shareholder returns.

That's not necessarily a bad thing from a moral perspective. But after Q1, it's a significant concern for AHC shareholders. The newspaper business posted a disastrous quarter, and the digital business wasn't much better. If A.H. Belo isn't going to sell the Dallas Morning News, it has to turn it around. After Q1, that seems pretty much impossible. And it leaves shareholders reliant on the management team to make decisions it doesn't want to make. That's a very uncomfortable position in which to be.

Disclosure: I am/we are long AHC. 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.

Additional disclosure: As of this writing, I plan to exit my stake in AHC, but I reserve the right to keep all or a portion of my shares.