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Investment Thesis
The free cash flow conversion at Lee Enterprises (NASDAQ:LEE) is industry-leading and will enable the company to quickly de-risk its balance sheet, which will result in a rerating of the equity value of Lee. Lee appears to be undervalued at current prices.
Record low interest rates and a booming stock market are not ingredients for depressed equity valuations. Declining revenues and a product that some believe will be obsolete in the near future are. It is in this environment that profound misvaluation can lead to opportunities for investors willing to look beyond recent weaknesses.
Total newspaper circulation in the United States has gone from 60M copies a day in 2000 to about 30M copies today. The Wall Street Journal estimates that in the same period, total newspaper advertising revenue declined from $50B to about $11B. Newspaper agencies responded by going digital and redirecting their focus on online advertisement sales. This was however not enough to offset the lost revenue in print and what resulted was a steep overall revenue decline for the industry.
Brand value proved to be worth its weight in gold. The New York Times (NYT) proved especially efficient in converting its print readers into digital subscribers, and by 2015, it had more digital-only than print subscribers. The economical characteristics of a newspaper business change dramatically in a digital space. Local newspapers have been less successful and a great deal of them went out of business. The ones that remained could only do so by joining forces or by using reserves built in better times, the latter (especially) not being a sensible long-term strategy.
Lee Enterprises is the operator of a platform that owns some 70 local American newspapers, including the St. Louis Dispatch and the Buffalo News, read daily by approximately 1.5M people. It enjoys a near-monopoly on news generation in most of its markets and its 100-plus years of existence has resulted in a strong relationship with its communities. Readers turn to the local names of Lee as the main supplier of quality local news. Lee's main business comes from selling subscriptions to readers and advertisement space to local businesses. It also operates the digital advertisement agency Amplified that serves the digital needs of all the local newspapers attached to the Lee platform in areas such as web development, social media management, fulfillment, and search. Amplified has recently started to accept business from non-Lee papers as well.
The economic characteristics of its platform model favor scale as the marginal cost of adding a new name to the platform is significantly lower than the costs of operating that paper on a stand-alone basis. This has resulted in industry-leading operating margins comparable to those of the NYT despite the fact that 30% of its operating revenue is from digital versus the same being about 50% for the NYT. Operating margins are even higher when one adjusts the operating costs for the new digital reality. The digital strategy and its accompanying army of software developers find their way to the income account whereas the balance sheet still reflects the previous focus on print subscription and its printing presses and expensive real estate. Most of this equipment does not have to be replaced in a digital area, but accounting rules dictate the income account to reflect just the opposite. The consequence is that GAAP depreciation is four times larger than actual capital expenditure. If depreciation and thereby the operating costs reflected the actual future capital expenditure needs of the business, operating margins would be about double the number now stated in the income statement.
In 2020, Lee substantially increased its scale by acquiring the newspaper assets of Berkshire Hathaway (BRK.A, BRK.B). This transaction added 31 media operations and resulted in substantial cost synergies as these papers were added to the Lee platform. It also enabled Lee to refinance its debt on more favorable terms, a 25-year runway with no breakage costs or prepayment penalties, and transformed Berkshire Hathaway into the sole lender. According to Schedule 14A, the transaction was conducted on favorable terms as it valued the Berkshire assets at a relatively low 3.4 times EV/EBITDA. This reflects to a proposed 5.5 EV/EBITDA valuation of the announced takeover of Tribune Publishing by Alden Capital.
Lee is an attractive buy at current prices for two reasons: the ability to produce substantial free cash flow and the prospect for increased revenues if the digital strategy would prove to be successful. Lee is set to produce around $110 million of free cash flow in 2021, conservatively calculated, which will be almost exclusively used to pay down debt. This reflects to a current market capitalization of $180 million and an enterprise value of $650 million. It follows that the equity holder will receive a 60% return on its current investment in the form of obtaining a larger part of the total enterprise value of the firm. Paying down debt and thereby de-risking the equity component should at some point result in a rerating of the equity. So, not only is the interest of the equity investor in the business expected to increase over time, but also the value placed upon this interest by the market is expected to increase as it will reflect the de-risking of the balance sheet. The second reason reflects Lee's digital strategy. Lee currently has 286K digital-only subscribers which are about 69% more than last year. This compares to about 700K print-only subscribers. It is expected that somewhere between FY23 and FY25 the number of digital-only subscribers will exceed the number of print subscribers. This would translate into an overall growth of the subscription base as compared to the steep declines in more recent years. The economic characteristics of a digital-only newspaper are substantially better than a paper-based mostly on print revenue as:
- The business would be less capital extensive since a digital newspaper does not require the use of expensive printing machines,
- It would result in increased operating leverage as the marginal costs of adding another subscription to the existing subscription base will be close to zero (excluding marketing costs),
- It would result in increased operating leverage as the marginal costs of adding another newspaper to the platform will be substantially lower than the costs of operating that paper on a stand-alone basis.
Valuation
If one makes basic assumptions about the cost of capital (12% reflecting the riskiness of Lee's equity and the overall state of the newspaper industry) and the free cash flow growth rate (0%), the current fourth quarter annualized free cash flow of $110 million should translate into an EV of $910 million or an equity value of $430 million. Given the uncertain nature of the newspaper business, it is more appropriate to model several scenarios to come up with an average equity value reflecting the probabilities of the various scenarios. The most recent quarter (4) is used as a proxy for the remaining quarters which are then used to approximate FY21. This is appropriate for two reasons:
- Revenue in the three remaining quarters should be lower given the lack of political spend in those quarters
- Revenue in the three remaining quarters should be higher given the return to normality as the effect of COVID-19 normalizes.
These two effects are expected to cancel each other out, making it appropriate to annualize Q4. Moreover, the operating income of Q4 includes some impairments and losses on asset sales that the author deemed non-operational and that therefore have been excluded from the NOPLAT calculation.
The base scenario is assigned a probability of 50% and assumes a revenue decline of 5% up until 2025 and a terminal growth rate of 0%.
Source: Author, with data obtained from the Lee Enterprises 10K and 10Q
The negative scenario is assigned a probability of 25% and assumes a revenue decline of 10% up until 2025 and a terminal growth rate of 0%.
Source: Author, with data obtained from the Lee Enterprises 10K and 10Q
The positive scenario is assigned a probability of 25% and assumes stable revenues up until 2025 and a terminal growth rate of 0%.
Source: Author, with data obtained from the Lee Enterprises 10K and 10Q
Scenario one can be viewed as a continuation of current business practices in which an increase in digital-only subscriptions is not enough to offset the decline in advertising revenue, but where total revenue decline does slow down somewhat compared to the recent future. The negative scenario assumes a continuation of recent revenue declines and a digital subscription growth significantly lacking the expectations of management. Digital subscription growth in scenario three offsets the slight decline in advertisement revenue up to the point in which revenue doesn't increase nor decrease. This scenario is most aligned with management's views and expectations. The probability distribution is conservative and reflects the author's preference for setting low expectations: better to be approximately right than completely wrong.
Using a cost of capital of 12% and a terminal growth rate of 0% results in an equity value of $300 million. The calculated price per share should be viewed as an approximation but it is clear that the corresponding margin of safety is large enough to absorb possible mistakes in the assumptions made. The value of the equity investments in TNI Partners and Madison Newspapers is obtained from the 10-K.
Source: Source: Author's own calculations
Another way to approximate the value of Lee is to compare certain current valuation metrics to the valuation metrics of industry peers. The numbers in the following graph are based on Q4 2020 (again annualized).
Source: Author's own calculations
The free cash flow conversion rate of Lee is industry-leading owing to the previously-discussed discrepancy between the depreciation costs, capital expenditure, and the high overall operating margin attributable to its platform business. Lee is, however, valued as if it was the weakest operator in the industry as expressed by its relatively low EV/adj EBITDA. The reason for this is the relatively high debt both as an absolute number as well as a percentage of the total enterprise value. Compared to peers, Lee appears to be undervalued.
Risks
Lee is undergoing a digital transformation of which success is not guaranteed. Its highly leveraged balance sheet furthermore makes dividends and buybacks unlikely in the near future, and although a successful investment in Lee does not depend on the firm achieving revenue growth, a continuous trend of revenue declines will most likely result in a depressed equity valuation. And although Lee still appears to be undervalued, the substantial recent increase in its share price might signal that investors already priced in at least some future business improvement.
Conclusion
Equity investors rightly wonder what is left for them after all the free cash flow has been used to repay debt. The answer is a larger claim on the total enterprise value of the firm. But what is this claim worth in five years, equity investors ask themselves, in an industry that has sustained substantial revenue declines in the past and in where many observers predict the end of the newspaper business altogether. What investors need is not a rearview mirror, but an enhanced understanding of the economical characteristics of a newspaper in the digital area. The scenario analysis has shown that a potential appreciation in the value of Lee shares does not depend on any low-probability success event such as future revenue growth. If Lee continues to perform in the way it has been doing in recent quarters, equity investors still own a business with a strong ability to generate free cash flow and a good chance to repay all outstanding debt. If on the other hand the digital strategy somewhat succeeds and if management proves to be correct in their assumptions, then equity investors are in the possession of a firm with good prospects and growing free cash flows for years to come. Investors taking a position in Lee will find that the risk-reward proposition is clearly skewed to the right.
Update Q2
Digital-only subscriptions grew about 8% compared to the previous quarter, a continuation of the positive trend in subscription growth. Revenue came in at $192 million compared to $212 million in the previous quarter, reflecting the lack of political income in the current quarter. Lee managed to repay $25 million in debt, bringing the total net debt to $465 million. The author is neutral regarding the current quarter noting that free cash flow generation and digital-only subscription growth, the pillars of Lee's investment case, continue to improve and that although the revenue trend is not improving, COVID-19 reopenings should be beneficial to Lee going forward.
