Lee Enterprises (LEE), which manages newspapers for Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) (BRK.B), reported an impressive quarterly results on Friday. An analysis of the results showed better-than-expected revenue trends and steady deleveraging that should draw investors to re-rate the stock to the top-end of industry peers.
Along with the revenue outperformance in its core news business, Lee Enterprises is also seeing strong results from TownNews, a lucrative venture that provides a digital platform for other news publishers and TV broadcasters to deliver content most effectively to readers on the web and mobile devices.
In addition, Lee Enterprises' five-year deal with Berkshire Hathaway to manage the bulk of its newspapers is bearing early fruit. LEE executives expect the deal to exceed their initial $10m annual revenue projection in its first year. This agreement generates profits for Lee without requiring any additional capex or investment, meaning the revenue earned from Berkshire flows directly to Lee's EBITDA, i.e. cash flow that can be then used to pay down debt faster or fund share buybacks.
These positive developments should fuel Lee Enterprises shares in the near term. It also sets the stage for a string of steps by Lee that could cause shares to soar above $6. These steps include:
1) Completing a favorable refinancing package for its $478m in debt that reduces interest expenses and extends debt maturities
2) Aggressively execute share repurchases up to $10m cap currently authorized
3) A spin-off of or outside minority investment in TownNews to highlight the hidden value of this attractive, growing asset
Can Lee Halt or Slow Revenue Declines?
Like all newspaper companies, Lee Enterprises faces revenue declines as advertisers shift spending online. However, Lee is doing better than peers in limiting revenue declines because of its loyal small-town readership, strategic focus on local over national advertisers, and investments in its digital platform TownNews.
LEE's 4% y-o-y revenue decline in the latest quarter compares with a 7.3% decline at Gannett (GCI), a 10.7% decline at McClatchy (MNI), a 5.7% decline at New Media Investment Group (NEWM), and 12.3% decline at Tribune Publishing (TPCO), according to company filings.
Overall, the newspaper industry may resemble a melting ice-cube on a summer's day, but Lee Enterprises' local retail advertisers' strategy, investments in publishing platform technology, and lean-cost operation are keeping its business cooler than the rest. The below chart illustrates how this strategy results in industry-leading performance on margins and preserved cash flow.
(Source: Q1 Lee Investor Presentation p 28)
Due to the Iowa-based newspaper media chain's rising stock price, the company recorded a small net loss in the latest quarter. As LEE's stock gets closer to the $4.19 strike price for its warrants, the company recorded a non-cash fair-value adjustment that turned net profit slightly negative.
Looking beyond the accounting treatment, we view the rising value of the warrants liability as a major positive for the company. If the 6m warrants are exercised, it would generate $25m of cash for Lee to pay debt that currently carries a 10% rate. Investors owning the stock today at $2.65 wouldn't complain about the dilution if the stock rises 58% triggering the $4.19 warrant strike price.
Debt Refinancing Frees Up Capital Allocation
The ongoing debt refinancing discussions should reduce Lee's hefty debt service expense, which cost Lee over $8m in the latest quarter alone. If the new debt package comes with an interest rate closer to 7%, down from the current 10%, it would save the company $14m annually in year one.
Saving $14m a year is no small matter for a company like LEE with a $150m market cap. Lee could spend that to buy back 10% of the company's shares or pursue strategic tuck-in acquisitions.
(Source: Q1 Lee Investor Presentation p 30)
Lee's CFO Timothy Millage said on the earnings call that they are having "productive refinancing conversations with our advisers and our lenders." In the quarter, LEE did take a bite out of its expensive 12% second-lien debt by paying $7.3 million of principal this month at par. That single payment will save the company $876,000 annually in debt service costs. It also reduces outstanding net debt to around $443 million or 3.5x Net Debt/EBITDA - closer to their ideal level of 2-3x Net Debt/EBITDA.
While Lee Enterprises appears to be on the right track toward creating value for its shareholders, there are still risks for LEE and its shareholders going forward.
The biggest long-term risk is the deterioration of online advertising rates as Google (NASDAQ:GOOG) (NASDAQ:GOOGL) and Apple (NASDAQ:AAPL) push deeper into the news distribution business. Google, which has a strong grip on online advertising rates, could squeeze the share of profit newspapers get from online advertising. Apple is also working on bundling news content on its own service and could cut into subscription revenue and captures valuable reader data for itself.
On an industry level, an economic downturn could crimp advertising budgets, which are usually one of the first cost cut steps taken by executives.
Lastly, LEE may not be able to secure attractive terms for a refinancing package if the high-yield lending market sours and investors demand a higher-than-expected interest rate.
The latest results from Lee Enterprises are encouraging for shareholders. If management can continue to execute and take further measures including those outlined above to create shareholder value, the rewards for investors in LEE could be dramatic. Our calculations suggest LEE's shares could rise from $2.65 today to over $6 by the end of this year if the company takes such steps to reward shareholders.
Disclosure: I am/we are long LEE, BRK.B. 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.
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