August 20, 2017 - 11:26pm EST by
2017 2018
Price: 1.95 EPS .41 0
Shares Out. (in M): 59 P/E 4.8 0
Market Cap (in $M): 115 P/FCF 1.5 0
Net Debt (in $M): 554 EBIT 0 0
TEV ($): 670 TEV/EBIT 0 0

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"There are few assets so bad that they can't be a good investment when bought cheap enough."
- Howard Marks

I frequently find that you make way more money when things go from truly awful to merely bad than you do when things go from good to better.  That's why I currently own shares of Lee Enterprises, a business facing powerful secular headwinds with a leverage problem, to boot.

LEE is a newspaper publishing company operating primarily in the Midwest, Mountain West, and West regions of the United States.  LEE operates across 21 states and focuses on small/mid-size markets that are regional shopping hubs with established retail bases.  Note that LEE operates with a fiscal year ending in September.  jdr907 wrote up LEE a little over a year ago (marking LEE's first appearance on VIC) and does a nice job describing the business in more detail so I will not repeat all that here.  Since jdr907's write-up, things have gone from truly awful to merely bad, yet the stock price has not reflected that.

Most LEE markets are midsize, regional hubs where LEE's digital and print media are the dominant sources of local news, information and advertising with very little, if any, print competition.  In their markets, LEE has more reporters, photographers and sales people on the street than all of their competitors combined.  A competent management team has done a nice job managing costs, creating a company with margins that significantly outpace the industry average (by several hundred bps).

Positive developments over the past 1.5 years -

1) Increased cash cost cuts

Management first guided for 2017 cash cost takeouts in December of 2016.  In the three quarterly reports since the original 2017 guide, management has increased this guidance in every quarter.  Obviously this game can't go on forever, but management is very confident they can continue to take cost out of the business through 2018 and beyond, and will be giving formal guidance for further cost takeouts in 2018 on the next earnings call.

2) Accelerated repayment of most expensive debt

LEE is 3.7x levered and as such, does not pay a dividend, unlike most other public newspaper publishers.  Moreover, LEE's weighted average cost of debt is ~9%.  As a result, all of LEE's FCF is absorbed by interest payments / debt paydown.  Since 2011, LEE has paid down >$500m in debt (vs a market cap of $115m today).

The end of the March quarter marked a significant change that will accelerate the repayment of LEE's highest cost of capital, the 2nd Lien term loan, which carries an interest rate of 12%.  Beginning in April, 2nd Lien lenders no longer had the option to decline excess cash flow payments at par.  Going forward, management now has the ability to use Pulitzer excess cash flow to forcibly amortize their most expensive issue, which they are eager to do.  Given the high interest rate on this debt, these excess capital payments will accelerate interest savings in the future.  This acceleration in interest savings will contribute toward FCF stability even if the topline continues to be weak.  This is all part of a virtuous cycle in which debt reduction results in more interest expense savings, which are used to further reduce debt, gradually transferring value to the equity holders.  Finally, management announced on the Q3 conference call that they have begun evaluating the timing and economics of refinancing all or a portion of the company's long-term debt.  This is the first time management has made this announcement, which they left out of the press release.

The bulk of LEE's debt does not mature until 2022.  Cash plus availability under a revolving facility brings liquidity to just under $60m currently vs $32m of required payments over the next 12 months.

3) Subscription revenue returning to growth
While management does not provide specific guidance for subscription revenue, on the Q3 conference call they stated they are feeling quite good about it and expect it to be as good as 2016's figure.  Backing into what that implies for Lee's Q4 subscription revenue reveals management is expecting to report subscription revenue growth of 6% next quarter.  This will be quite welcome after three quarters of negative to flattish growth in this segment, which now comprises 35% of total revenue.

4) Monetization of real estate

Management currently has $17m worth of real estate listed for sale, most of which represents Pulitzer properties.  $7m is currently under contract, which is expected to close within the next 6 weeks.  There are several buyers currently looking at the remaining properties.  It is important to note that any cash proceeds from the sale of Pulitzer properties will be used to pay down the expensive 2nd lien term loan, so real estate sales closing in the next 6 weeks will free up additional cash to retire this expensive debt.

Management also revealed on the Q3 call that they are in the process of engaging a real estate adviser to evaluate the sale of additional real estate not currently listed.  The 10-K does not disclose much detail about LEE's real estate, other than to say that LEE owns virtually all of it.  Presumably the formal engagement of an adviser indicates they could be looking at divesting a material amount, which would further accelerate deleveraging.

5) Acquisition of Dispatch-Argus

During this most recent quarter, LEE agreed to acquire the Dispatch-Argus, a collection of newspaper assets in Illinois, for $7.2m.  The Dispatch-Argus is just across the Mississippi river from LEE's operations in Davenport and Muscatine, offering substantial synergies.  The deal will be immediately accretive to free cash flow and earnings.  Management has represented to me that the accretion from this deal more than offsets the opportunity cost associated with not paying down the expensive 2nd lien term loan.
Here's management when asked about the acquisition on the Q3 conference call:
Well, we have not disclosed what the multiple was, but to give you a sense of what it was, it was a very good multiple for us and much, much lower than what our current stock trading multiple is. So it was a very good value, and we're going to drive a lot of synergies and some good cash flow given the price we paid.

Note also that this transaction closed a couple days after the end of last quarter, so its impact will be observable for the first time next quarter.
6) Industry consolidation  / potential takeout
GCI's aggressive pursuit of TRNC in the Fall sent many newspaper stocks much higher on the prospect of more industry consolidation.  The GCI/TRNC deal ultimately fell apart over lender concerns about a deteriorating ad market for newspapers fueled by retail weakness and the seemingly endless migration of advertising dollars from print to digital.  
This weakness has led to multiple contraction across the industry.  LEE, for example, is now 50% off its high of $3.92/share.  But after a difficult March quarter print, LEE saw improving revenue trends during the June quarter, with subscription revenue basically flat after two consecutive quarters of negative growth.
Similarly, on Gannet's recent call, management called for improved print ad comps in the back of this year on account of cycling some major losses from some of the larger dept and big-box stores.
More interesting still was their commentary around their appetite for M&A:
"We have made it clear that we're still very interested in expanding local footprint where it can add to our clusters and is a good fit, proving we can very quickly find the centers to use those brands."

And later,

"But John and I have also been very open to markets that might be a little smaller but bring great benefit to us because we already have clusters. So we're kind of approaching things both ways at this point since that up with 109 markets today and the way USA TODAY NETWORK is growing. We're very happy there but, we certainly are going to stay open to those opportunities. But, we also are back looking at things where they may be smaller in nature but, can add some really immediate synergies. John and his team at Gannett Production Services have just demonstrated over the last couple of years that they can bring those into our fold very, very quickly."
I would not be surprised to see Gannet take an opportunistic pass at LEE now that the market appears to be pricing in unending retail weakness.  Gannet has traditionally bought newspapers in small or mid-size markets.  Given LEE's industry leading margins, Gannet's flexible balance sheet, and today's interest rate environment, Gannet would have to work very hard to pull off a deal that was anything other than highly accretive.
There are significant cost synergies in a roll up, and top line synergies are also important with the potential to cross sell between regional and national publications.
New Media is also open about its intention to consolidate the industry and would be a natural buyer for LEE, as New Media looks for dominant providers of local news in small/mid-size markets with an underinvested digital opportunity that allows it to plug in UpCurve, its digital marketing services business.
What is worrying the market?
The deteriorating trends that derailed the Gannet/Tronc deal have not dissipated and are not expected to reverse quickly.  Fears around poor retail results negatively impacting available retail advertising dollars have weighed on all the newspaper publishers, with particular concerns around the big-box retailers.  While of course LEE is not immune to this dynamic, the reality is that the big-box and mall-anchor retailers under the most pressure are typically not in LEE's small/mid-size markets to begin with.
Some investors were likely alarmed by the Dispatch-Argus acquisition.  This represented a departure from management's historical statements regarding every dollar of FCF being used to retire debt.  There was very little disclosure in the original press release but I am satisfied it was a good use of cash and do not believe management has become at all cavalier about their need to delever the balance sheet.
Finally, perhaps some didn't like that earlier this year Buffett sold the $200k worth of LEE shares he still had lying around.
This is a business in secular decline, so forecasting with reliability is difficult.  Investors will differ about what assumptions to use for future ad segment declines and digital/subscription revenue growth.  With limited cash taxes, no pension contributions this/next year, continued cost cutting, falling capex, and accelerated declines in interest expense, I think maintaining more or less stable FCF is not unrealistic.
Assume a small haircut to 2016's FCF of $80m for 2017.  Call it $78m or $1.32/share (but note LTM FCF after fiscal Q3 is $87m).  This is on a $115m market cap (68% yield).  Investors in a debt-laden business with secular headwinds and a healthy dose of unpredictability will naturally demand a high yield, but anything above 35% feels excessive here (implied $3.75 share price, and below where Lee's stock traded less than a year ago) and leaves substantial room for error.  Debt markets do not seem too concerned (Lee's bonds trade at a premium).


Lee is currently trading at less than 5x fwd Ebitda, right around the high end of what NEWM thinks is a good deal for tiny mom-pop newspapers that lack Lee's scale, margins, and attractive markets.  What's a fair multiple for Lee, then?  5.5x?  That's $3.70/share, up 90% from here.  With Lee, tiny changes in the multiple have a huge impact on the equity value.  LEE also has $115m in NOLs.

Ultimately, time is your enemy here, as this is not a great business.  But currently valuation I think is too compelling and more than compensates for the business risk.

- Retail ad market takes another leg down, driving revenue declines that cannot be offset by cost cuts.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


- continued debt paydown

- real estate monetization

- accelerating subscription revenue growth

- sector m&a

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