When a New York hedge fund launched a hostile $1.3 billion bid for Gannett (GCI), publisher of USA Today and over 100 local newspapers, it put 2019 on track to be the year of M&A in the newspaper world. Declining readership and money going to online advertising have CEOs hunting deals to find companies to buy before they themselves get bought. Survival of the fattest.
How can investors profit from this potential wave of newspaper dealmaking? I look at three factors to find the best target when an industry is consolidating: strategic position, quality, and cheapness. Those factors point me to Lee Enterprises (LEE) as the most likely to see its stock benefit from a newspaper M&A boom.
1. Strategic Position: Lee Enterprises is the fifth-largest newspaper chain in the U.S. with 49 newspapers that reach more than 3 million readers daily online and in print. Being No. 5 in the industry positions makes them an ideal size target to be acquired. It's has the scale to be meaningful for a larger rival like New Media Investment Group (NEWM) or Gannett (GCI), who could find buying Lee or other assets helpful in fending off its unwelcome hedge fund suitor. Typically in M&A, the bigger the target, the more the acquirer has to stretch to get financing to cut the deal.
Lee Enterprises's (LEE) mainly small-town papers are across the midwest with its most well-known being the St. Louis Post-Dispatch. These are markets adjacent to ones where Gannett (GCI) and Tribune Publishing (TPCO) operate. Driving industry consolidation is the potential synergies from combining back-office support functions for smaller papers and creating regional editing desks. Those cost-savings will help justify the premiums CEOs pay to cut a deal that allows the publishers to grow their empires. Acquisition premiums for most M&A deals tend to be 15% to 25% above their unaffected share price.
2. Quality: It's hard to get a better endorsement for the quality of Lee Enterprises (LEE) than the Oracle of Omaha, Warren Buffett. He had this to say in June: "Lee Enterprises’ growth in digital market share and revenue has outpaced the industry. Lee also has led the industry in overall innovation and performance, all while faithfully fulfilling its public trust as an indispensable source for local news, information and advertising."
Buffett had enough trust in the Lee Enterprises management team that he asked them to run most of Berkshire Hathaway's (BRK.B) own 30 papers for the next five years. Lee Enterprises (LEE) has maintained top in the industry operating margins of over 20% and generates $128 million of annual cash flow (EBITDA). Buffett is hoping Lee's cost-cutting playbook can make his papers financially healthier, while shielding him from criticism when newspaper reporters and paper deliverymen get laid off.
The biggest drag on Lee's quality is a $478 million debt burden it piled up when it went on an acquisition spree over a decade ago at lofty prices. It currently pays 10% annual interest on that debt. Fortunately, Lee's preparing to refinance that debt to lower the interest expense. On the most recent earnings conference call, CFO Tim Millage said: "[W]e are very actively discussing refinancing with our advisors and lenders. We are ready to enter the market as soon as we and our advisors believe the market is receptive to an opportunistic refinancing."
3. Cheapness: Despite the strategic positioning and business quality, Lee Enterprises's (LEE) stock is still really cheap. It trades at a forward P/E ratio of just 2.9x compared to New Media Group (NEWM)'s 17.1x and Gannett (GCI)'s 12.7x, according to Seeking Alpha data.
Why such a big valuation gap? Clearly Lee's $478m in debt gives investors pause and is worth discussing. When the upcoming refinancing lower the interest rate, it will allow Lee Enterprises (LEE) to repay its debt faster as more cash flow can go to paying off the debt's principal rather than servicing interest expense. For example, if Lee can reduce its interest rate from 10% to 8%, that will save nearly $10 million per year, which can be used to pay off more of the debt's principal, further reducing interest expense.
And even without the refinancing, none of Lee's debt comes due before 2022, making a liquidity crisis very unlikely.
It's pretty rare to find a high-quality business that also happens to be a dirt cheap stock with multiple near-term catalyst such as industry M&A and a positive debt refinancing to push its stock higher.
To be sure, the longer-term outlook for the newspaper industry isn't rosy and we should expect revenue to decline for the foreseeable future. If the economy slows, advertising is often one of the first items that companies reduce and it could disproportionately impact Lee Enterprises (LEE) and other newspapers.
However, there are also other factors contributing to Lee Enterprises (LEE) being overlooked by investors. Many young analysts are reluctant to look at industries with major headwinds, preferring to study the fast-growing industries like cloud computing and breakthrough technologies. Similarly, because Lee Enterprise is based in Iowa and its $155 million market cap doesn't attract much attention from big Wall Street investors, the major banks have given it limited sell-side coverage and most of the attention on the company has been on its high-yielding debt where a couple banks follow its debt.
In other words, we've caught a nice fish in a corner of the lake where others aren't fishing because its raining over here and the water's too shallow for the biggest boats to navigate over.
A Final Thought on Buybacks
In the latest earning call, we took note that the CFO Tim Millage spoke pretty frankly about the company working toward a new stock repurchase program after its refinancing. Millage wants the new loan package to "have less restrictive covenants than we have today for such things as stock buybacks." We agree and such a program would be the first major step to reward shareholders in a decade and be the most powerful driver for the stock absent a takeover.
For example, if Lee were to use just 15% of its $128m in EBITDA (~$20m) for a buyback program - it could repurchase a whopping 12.5% of its outstanding shares at current prices. That would be a powerful signal to the market that the shares are too cheap and Lee would still have firepower to reduce debt steadily and buyback more shares until the market revalues the stock to a more reasonable level in line with peers.
We see Lee Enterprises's (LEE) stock rising from $2.68 today to between $5 and $7 by the end of this year as newspaper M&A booms, Lee completes its debt refinancing, and the company rewards investors with a stock repurchase program.
Disclosure: I am/we are long LEE. 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: This article and associated research does not constitute investment advice.You should consult with your investment adviser and conduct your own research before making any investment decisions. We take no liability for any losses or fees you may incur from such investments. We may buy or sell securities related to or mentioned in this article at any time and will not update on those changes in position. Invest at your own risk and do your own work.
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