- Graham Holdings Q1 earnings and annual shareholders meeting shed important light on how the company has been impacted by the COVID-19 pandemic.
- While intrinsic value has certainly declined, full year operating cash flow is expected to be meaningfully positive for 2020.
- Further, current cash on hand is more than sufficient to cover all near term debt with long term debt not maturing until 2026.
- A conservative valuation still suggests that shares are attractive at $346 per share and even those demanding a greater margin of safety should keep an eye on shares for a potential bargain later in the year.
It was only two months ago that I last wrote about Graham Holdings Company (NYSE:GHC), but it feels like it may have been two years ago. On March 9th I modeled the company's worth at ~$680 per share using what I felt were conservative assumptions.
While the number of confirmed COVID-19 cases at the time was still low, the risk of large scale disruption was there and clearly not enough effort was made to analyze this risk and incorporate it into the modeled valuation.
Company logo. Source: Company.
First quarter earnings have also been released since I last wrote and the company also held its annual meeting on May 7th. Both provide important insight into specific COVID-19 impacts to the company's operating businesses and how the company's capital structure is being managed in response. I also posed three questions to CEO Tim O'Shaughnessy during the company's annual meeting. His answers were thoughtful and shed some light on how to think about the valuation of the company.
If forced to place a specific value on shares today it would be roughly $520 per share, a decline in intrinsic value from two months ago that is close to proportional to the share price decline. But, all of the company's businesses have been and continue to be impacted by COVID-19, and investors should consider that the range of possible outcomes for Graham Holdings and the economy continues to be wider than normal. As such, a larger than normal margin of safety may be demanded for the stock by many investors.
First Quarter Earnings and Initial COVID-19 Impacts
First quarter earnings were affected by the COVID-19 pandemic, but obviously not nearly to the extent that Q2 and Q3 earnings will be. It appears that prior to the disruption many subsidiaries were on a path towards a strong year.
Overall revenues at Kaplan declined by 4% in Q1, with International up 7%, Higher Education down 11%, Test Preparation down 30%, and Professional down 7%.
Higher Education should actually be helped by the pandemic and potentially see increased student enrollment from a weaker economy. But, the other three parts of Kaplan should see deterioration. The International business includes segments reliant on travel, such as the Pathways program and language learning. The Test Preparation business is seeing reported revenues erode from the deferral of some standardized testing and Kaplan Professional has similarly seen pressure in its CFA exam offerings.
Approximately 30% of Kaplan revenues come from offerings requiring students to travel to study and another 30% comes from preparing students to take exams around the world. Those businesses' revenues are not going to immediately go to zero, but they are going to be substantially reduced.
The television stations had a very good first quarter, with revenues up 7% and operating income up slightly. The increase was primarily because of political advertising, although the digital media group within the division continues to perform exceptionally well. Commercial advertising rates will certainly be lower throughout most of the remainder of the year and the summer Olympics are now moving out of this year and into 2021. There is a good chance that political advertising remains strong, however. Four of the company's six television stations are in Michigan, Virginia, and Florida, all of which should be battlegrounds in the fall. While income will be impaired, the broadcast group should still be solidly profitable this year.
Manufacturing revenue in Q1 was essentially flat to last year, but adjusted income was materially higher from some expenses at two of the businesses in the group last year in pursuit of expansion. These businesses continue to operate, but demand surely has been reduced and plants are not operating at full capacity. The company is putting a great deal of effort into containing expenses and it would appear that optimistically these businesses may be breakeven to slightly profitable for the remainder of the year.
Within the remaining businesses, the healthcare group is going to be materially impacted, although an acquisition boosted the top line by 22% in Q1 and will make reported results look better than underlying results for the rest of the year. Slate, Social Code, Clyde's Restaurants, and the automotive dealerships will all also be hit hard for the rest of the year. Two small businesses related to podcasting - Pinna and Megaphone - are doing huge amounts of business, but their relative size will prevent them from being much of an offset to the larger parts of the company.
The chart below summarizes Q1 results. Adjusted operating income is GAAP operating income plus intangible asset amortization and any impairment charges. The very strong revenue growth in both the healthcare and other groups are because of acquisitions that are not yet comparable.
Dollar amounts in millions. Source: Author, derived from Q1 10Q.
During the company's annual meeting, some very positive comments were made regarding the financial strength of the holding company as well as full year expectations. Graham Holding's CEO Tim O'Shaughnessy stated that the company expects to generate "meaningful" operating cash flow in the current year. Q1 saw positive cash flow, but not enough to be considered "meaningful" for the full year, which leads me to believe that the remainder of the year should also be cash flow positive. Remarks by O'Shaughnessy in response to a question on spinning off the broadcasting stations at least suggested that the group was going to play a large role in the overall group remaining cash flow positive.
Graham Holdings does not give regular guidance, so it seems extremely likely that their willingness to make this statement in regards to full year cash flows would indicate that the economic situation would need to materially worsen for there to be a cash burn in 2020.
Further, near term debt maturities are minor and are significantly less than cash on hand. The bulk of the company's debt does not come due until 2026. The securities position was also reduced by $48 million through sales in February and a further $46 million through April sales. The current value of the marketable securities is $420 million.
Annual Meeting Questions and Answers
Three of this year's questions from shareholders came from me and I think O'Shaughnessy's responses are worth paraphrasing and elaborating on somewhat.
My first question to O'Shaughnessy was how he thinks about the company's valuation, especially in regards to how he decides to repurchase shares, and whether he could comment on the value to shareholders of the overfunded pension plan. My second question was on ways that the pension plan could be put to use to increase shareholder value, which was somewhat related to the first question.
Although he did not use the exact phrasing, it is fair to say that he endorses some version of a sum-of-the-parts approach to valuation, by saying that he broadly sees four buckets of value for the company including the net cash position, marketable securities portfolio, the value of the operating businesses, and the overfunded pension plan. After summing these values, he discounts them using a 25%-30% margin of safety before he would be willing to repurchases shares.
He approaches the valuation of the operating businesses by asking what the company would pay to acquire those businesses in the open market. Many of the businesses now owned by Graham Holdings were acquired in private transactions, so this approach is indeed likely very useful for management. It is less likely to be useful to shareholders to think along those lines, but since the opportunity costs for shareholders are generally alternative public investments, it seems to be intellectually consistent to re-phrase this response and say that shareholders should think about the operating businesses by asking themselves what they would pay for those earnings at comparable businesses in the stock market. For example, if Kaplan or the broadcast group were independent companies, what earnings multiple would entice you to invest?
O'Shaugnessy also most definitely believes that the overfunded pension plan increases the value of the company and he clearly includes some portion of the overfunding in his own valuation, although he did not state how he does so with precision. Two important avenues of realizing value from the overfunded pension plan were also the two that I noted two months ago: a form of compensation to employees as well as a means to absorb pension liabilities of acquired companies. So, it is certainly a possibility that future acquisitions could take place that involves the assumption of pension liabilities as part of the consideration if a deal emerges that is a general fit for the company.
The last question I posed was whether the company would be willing to disclose the details behind its marketable securities portfolio, to which the response was that it was a good question and something that should be discussed within the company. So, shareholders should watch for potentially more disclosure in the future, although that is not guaranteed.
Final Thoughts on Current Valuation
The outlook for Graham Holdings for the remainder of this year is better in the aggregate than might have been assumed prior to the annual meeting. There are a couple of different material risks to companies due to the present uncertainty. One risk is that the pandemic lasts significantly longer than expected and causes a multi-year depression that would significantly reduce the value of most companies from current levels. That is a risk for Graham Holdings and its business mix is more vulnerable than average in that scenario.
The second important material risk for some companies is that they do not have the financial resources to survive a period of negative cash flow without either filing for bankruptcy or being forced to raise expensive debt or dilutive equity. That is not a risk for Graham Holdings presently as cash flow should stay positive and the company continues to maintain a very strong balance sheet.
The company seems to take a generally similar approach to valuation, although assumptions can vary greatly between two observers and someone else may arrive at a specific valuation quite different from mine. O'Shaughnessy certainly seems to suggest that some accounting for the overfunded pension plan is necessary, but that the value to shareholders is much less than the full value. I think the approach I have taken previously of including 20% of the overfunding in a valuation model is still reasonable.
If forced to place a value on shares today, I would estimate it to be ~$520 per share. That would be the result of a 20% haircut on the value of the operating businesses from two months ago and end of Q1 values for cash, the securities portfolio, debt, and the overfunding of the pension plan. A conglomerate discount is also determined by capitalizing the central costs of the company. These assumptions are summarized in the chart below.
Previous valuation and current valuation of Graham Holdings. All values are in per share amounts.
If a 25%-30% margin of safety was sought, as suggested by O'Shaughnessy, then it would imply a target purchase range of between ~$365 and ~$390 per share. Again, in no way would I suggest that the company endorses such a valuation or that others need to use the same assumptions that are presented here, but that seems to be a relatively conservative target for new investors or those looking to add to an existing position. The current price of $346 per share is just slightly discounted from the bottom of that zone, although the level of uncertainty that currently exists around the valuation of all businesses may also require a more demanding margin of safety for many investors.
But, given the history of the management team and its strong financial position heading into this period of economic disruption, this is a company that should not be overlooked as it often is. Graham Holdings should be seen as a great builder of businesses. The Kaplan subsidiary has been built through tremendous organic growth and many acquisitions over decades and the manufacturing group has similarly been grown from a single acquisition in 2013. The building of steady shareholder gains should continue and reward shareholders far into the future.
At a minimum, an eye should be kept on Graham Holdings and if another market sell-off or other forces push shares back down towards $300, even the most conservative of investors would be wise to not pass up the bargain.
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Analyst’s Disclosure: I am/we are long GHC. 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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