|Shares Out. (in M):||9||P/E||NM||NM|
|Market Cap (in $M):||3,000||P/FCF||NM||NM|
|Net Debt (in $M):||-250||EBIT||0||0|
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The recent uncertainty around the proposed tougher regulation of the for-profit higher education industry has caused fearful investors to flee (or short!) companies in that business, including The Washington Post Company (WPO), the parent of Kaplan, a major operator of for-profit colleges. I believe that regardless of the outcome of the proposed regulation, WPO is an attractive investment here, as the market is now giving Kaplan Higher Education a negative value. Once the market gets regulatory certainty in November (when the new rules must be finalized), I believe people will be more comfortable with owning education stocks, and the stock will recover.
A conservative valuation of WPO's assets excluding for-profit colleges comes to $380 per share, 16% higher than the current share price. This leaves shareholders with a free option on Kaplan Higher Education (KHE), which, based on current trading multiples of comparable companies, is worth an additional $165 per WPO share, bringing the potential upside to $550 per share, or 67%.
As a bonus, WPO generates significant free cash flow even excluding KHE, and carries a significant excess cash balance. Management has a history of buying back stock, and management has a history of being willing to make contrarian investments. WPO has annual free cash flow of well over $300 million, gross cash and available-for-sale securities (BRK stock) on their balance sheet of nearly $1 billion, and a public float (excluding BRK and family holdings) of only $2 billion. A significant buyback would be very accretive and a possible significant catalyst.
WPO has been written up twice on VIC before, and also in Barron's as recently as this April, so this is not an unknown story to value investors. I will seek to try to add some more value here by looking more closely at some of the assets that do not get talked about as much. The Cliff's Notes version is below; I go business-by-business afterward.
To keep matters simple, I assume a tax rate of 40% to get from operating income to net income for all divisions. Per share data is based on 9.2 million diluted shares outstanding at the end of Q2 2010.
Washington Post excluding Kaplan Higher Education
Net Cash & Securities $800 million ($87 per share)
Television Stations (8x 2010E Net Income) $550 million ($60 per share)
Cable (6x 2010E EBITDA) $1.75 billion ($192 per share)
Kaplan International (13x 2010E Net Income) $400 million ($44 per share)
Kaplan Test Prep $250 million ($27 per share)
Newspapers, Kaplan Ventures, etc. $0
Total value before Kaplan Higher Ed, Overhead $3.75 billion ($410 per share)
WPO Corporate Overhead ($20m after-tax, capitalized at 13x) -$275 million (-$30 per share)
Total value before KHE, after overhead $3.5 billion ($380 per share)
Upside from current price of $327 16%
Including Kaplan Higher Education
Kaplan Higher Education (7x 2010 Net Income) $1.75 billion ($191 per share)
Kaplan Corporate Overhead (7x 2010 Net Income) -$250 million (-$27 per share)
Total value of Kaplan Higher Education $1.5 billion ($165 per share)
Total value of WPO $5 billion ($545 per share)
Upside from current price of $327 67%
Net Cash & Securities ($750 million)
Simple and straightforward. We have three components: Net cash, Berkshire stock, and pension surplus.
Net Cash: $250 million. Net cash was $250 million as of the end of Q2, consisting of $650 million of cash and $400 million of debt. Note that the $400 million of 10 year debt was issued an unattractive rate (7.25%) in early 2009, when their last bond matured.
Berkshire Stock: $300 million. WPO owns 2,214 Class A shares and 425,000 Class B shares, worth $300 million at $120,000 per Class A share. The cost basis is fairly high; most of the stock was acquired at the time of the Gen Re acquisition in the late 90s, when BRK was trading at around $80,000 per share. Any tax liability is fairly small and can potentially be eliminated through a transaction with BRK down the road.
Pension Surplus: $250 million. The pre-tax surplus at year-end 2009 was $410 million ($250 million after-tax). It was at a similar level as of Q2 2010. The value of the pension fund was $1.4 billion, and the present value of the pension liability was $1 billion, so the value of the surplus is somewhat sensitive to market fluctuations. The pension is invested 75% in equities, substantially all of which is managed by Ruane, Cunniff & Goldfarb. The performance of the pension's equities should generally track the performance of their mutual fund, Sequoia (SEQUX).
It might be argued that a conservative valuation should exclude the pension surplus because it is not liquid (unless used for funding early retirements). However, any gain from the pension will ultimately revert to shareholders, so I believe it should be included.
Corinthian Stock: WPO also owns 7.7 million shares of Corinthian Colleges (COCO), worth about $40 million at current prices, but I believe this is more accurately thought of as part of the free option, since any legislation is likely to hit COCO harder than it hits KHE. I exclude this from cash and securities, though even in the worst-case scenario it would provide a meaningful tax deduction.
Television Stations ($550 million)
Revenue Operating Income
2006 $362 $161
2007 $340 $142
2008 $325 $123
2009 $273 $71
2010E $310 $110
1H 2008 $161 $56
1H 2010 $156 $51
For those unfamiliar with television broadcasting, note that political advertising and the Olympics have a meaningful impact on revenues and profits, so it is useful to compare even-numbered years with even-numbered years and odd with odd.
WPO owns 6 stations (Jacksonville, Orlando, Miami, Houston, San Antonio, and Detroit). WPO has long had one of the best-run station groups in the country, and they continue to have industry-leading margins, despite the challenging economic environment in their markets. However, there is no question that broadcast television faces secular challenges, and these challenges are likely to cause profitability to continue to deteriorate. The proliferation of other entertainment options continues to eat into the audience for broadcast television, and the adoption of DVRs has lessened the effectiveness of advertising. The growth of other revenue streams, such as retrains fees and internet advertising, has done little to offset these trends.
So far, the decline has been relatively measured, and management has done an excellent job in controlling costs in a difficult environment. The key challenge the industry faces is the relatively fixed nature of the cost base. Local news is the bread and butter of the industry, and the expense of newsgathering is relatively independent of the size of the audience and the rate advertisers pay. As revenues decline, it is likely margins will compress even further. Ultimately, the industry might be forced to consolidate, subject to the consent of regulators.
In light of these facts, I think it is best to value the television stations based on a conservative DCF. My DCF value works out to be 5.5x 2010E operating income, and 8x 2010E net income (the multiples are slightly higher if normalized for even/odd years). Though these multiples seem low, especially in relation to where these businesses have traded historically, if we account for the declining trajectory of the industry, the valuation is quite reasonable.
I would note that comparable publicly traded station groups trade at higher multiples. For example, Belo Corp (BLC), the largest comparable, trades at over 7x 2010 EBIT. In my opinion, this reflects the highly levered nature of these companies (BLC has $1 billion in net debt and a market cap of only $600 million, and it is probably the least levered of the bunch), which creates large enterprise valuations whenever a speculative wave sweeps over the group.
Cable ($1.75 billion)
Video Subs Data Subs Voice Subs
2006 693,550 289,010 2,925
2007 702,669 341,034 58,640
2008 699,469 372,887 93,520
2009 668,986 392,832 109,619
2010 (Q2) 654,228 406,900 120,588
Revenue EBITDA Margin Depreciation Capex FCF
2006 $578 $220 38.0% $104 $142 $31
2007 $626 $233 37.1% $108 $138 $45
2008 $719 $284 39.4% $121 $114 $104
2009 $750 $286 38.1% $124 $84 $137
2010E $771 $295 38.2% $124 $90 $136
WPO's cable operations (operating as Cable ONE) pass approximately 1.4 million homes in rural markets across the West and South. Cable ideas have been posted on VIC in the past, and the issues that face the cable industry as a whole are fairly well known. Like their publicly traded competitors, they have been very successful in adding data subscribers, but they have been losing video share to satellite.
Satellite will continue to be a difficult competitor on the video front, but cable has the technological advantage over telecom competitors when it comes to data. As consumers demand faster speeds, cable should continue to increase their share of data subscribers. Right now, Cable ONE provides video to 47% of homes passed, and data to only 29%.
Cable ONE differs somewhat from Comcast and Time Warner in that they have tried to stay at least one or two years behind the curve when making capital investments. They were late in rolling out voice and data, and as of last year, they have yet to start converting their system to all-digital. The advantage to this approach is that the equipment gets cheaper the longer you wait, and as a result they have achieved lower capital expenditures and a higher return on investment than their peers. In fact, they appear to have had positive free cash flow in every year of their existence but one, in marked contrast to their peers.
I conservatively value Cable ONE at 6x 2010E EBITDA, in line with Comcast and Time Warner. This is equivalent to 10x EBIT and 13x FCF, which represents good value for a steady, growing business. A strong argument can be made that Cable ONE actually deserves to trade at a higher multiple of EBITDA than its peers. First, Cable ONE has achieved a better return on invested capital than its peers, and it should continue to do so in the future. Second, because it is a year or two behind the curve, it has a longer runway for growth. It has better potential to increase its digital, data, and voice penetration, as well as its sales to business customers.
Kaplan Test Prep ($250 million)
(Financial results exclude restructuring charges, discontinued ops)
Revenue Operating Income
2005 $484 $98
2006 $507 $94
2007 $499 $81
2008 $478 $58
2009 $434 $25
2010E $411 $8
1H 2009 $224 $17
1H 2010 $212 $0
In addition to the SAT prep business everyone associates with Kaplan, Kaplan Test Prep (KTP) offers test prep programs for graduate admissions tests (GRE/LSAT/MCAT/GMAT) and for professional licensing tests (medical, nursing, bar, CFA, CPA, real estate, insurance). As of 2008, revenue was about evenly split between professional licensing and admissions prep, but the mix has probably shifted away from professional licensing since then.
The decline in the professional licensing business has been the chief driver of weakness, as it is closely tied to financial services. As one example, the real estate test prep business alone generated $20 million of operating income at the peak in 2005/2006, a number which declined to zero by 2007. Management stated in May 2010 that they were no longer losing money in the professional licensing business, and the 2009 10-K stated that operating results in professional licensing improved over the year prior, so professional licensing probably hasn't been a positive contributor since 2007.
The traditional test prep business has been challenging as well. According to management, the internet has lowered barriers to entry, and the industry has gotten more competitive. Commentary from their major competitor, Princeton Review (REVU) suggests that pricing in test prep has been weak. KTP is investing in its own online offerings, which has probably held down margins as well.
Based on the evidence, it appears that a return to the heights reached in 2005/2006 is unlikely, as those results were achieved at a time when there was a bubble in financial services, and the competitive environment in test prep was much softer. However, I think there is evidence that the business has more earnings power than it has shown in the last two years, and a return to something close to a 2008 level of profitability ($58 million) is not out of the question. To be conservative, I assume the business has earning power equivalent to half that achieved in 2008 ($29 million pre-tax, $19 million after-tax), and value it at a market multiple (13x) of after-tax net income, which works out to be $250 million.
KTP is largely the product of acquisitions, and every year WPO must test the goodwill carried on the balance sheet against the fair value of the business as determined by their internal DCF. As of year-end 2009, WPO showed $334 million of identifiable assets and $237 million of goodwill related to Kaplan Test Prep. According to the 10-K, WPO estimates that fair value of Kaplan Test Prep exceeds its carrying value by a margin in excess of 50%. This suggests that my valuation of $250 million is very conservative.
Kaplan International ($400 million)
Revenue Operating Income
2007 $442 $55
2008 $545 $60
2009 $537 $54
2010E $579 $54
1H 2009 $244 $19
1H 2010 $271 $17
Kaplan International offers English Language, Test Prep and Higher Ed programs in Europe (UK) and Asia. As of 2008, approximately 80% of revenue came from the UK. Within the UK, revenue is roughly split between test prep (mostly for accounting and financial services) and English language programs for students looking to study in English speaking countries. Within Asia, Kaplan International has operations in China and Australia.
The International test prep business has been fairly solid, and it seems to have been relatively immune to the challenges faced by its domestic counterpart. Note that the results above include the effect of acquisitions. Excluding acquisitions, revenue would not have grown between 2007 and 2009. However, the weak trends over this period are partially attributable to the weak pound and the recession.
I value Kaplan International at a market multiple, 13x 2010E net income, which is about $400 million. There could be additional earning power hidden in the business; remember that the domestic test prep business achieved margins of 20% at its peak, while the International business is at 10%.
Kaplan International is largely the product of acquisitions, and every year WPO must test the goodwill carried on the balance sheet against the fair value of the business as determined by their internal DCF. As of year-end 2009, WPO showed $625 million of identifiable assets and $433 million of goodwill related to Kaplan International. According to the 10-K, WPO estimates that fair value of Kaplan International exceeds its carrying value by a margin in excess of 50%. This suggests that my valuation of $400 million is very conservative.
Newspaper Publishing & Kaplan Ventures ($0)
A valuation of $0 might be on the aggressive side for the newspaper business, which continues to lose money. The newspaper business reported a pretax loss of $163 million on $679 million in revenue in 2009, though that shrinks to $13 million if early retirement, pension expense, and depreciation are excluded. There is no obvious path back to profitability for the Washington Post, in my opinion. I believe that WPO management is sufficiently shareholder oriented not to allow a business with no future to act as a drain on the Company for too long. They have already jettisoned Newsweek, and if they cannot come up with a plan to turn around the Post, it will follow.
My rationale for valuing the newspaper business at $0 despite losses as far as the eye can see is that the losses are not particularly large, and they on the other side of the ledger they have some assets of value, including two office buildings in downtown Washington, DC, a variety of other properties, and some digital media assets that may have some value, like Slate.
WPO owns some other early-stage education businesses that operate under Kaplan Ventures. The most significant of these is an online high school for non-traditional students (think athletes). Kaplan Ventures lost $17 million pre-tax on revenue of $124 million in 2009. To keep things simple, I value this division at zero.
Kaplan Higher Education ($1.5 billion)
Revenue Operating Income Margin
2005 $672 $73 11%
2006 $797 $101 13%
2007 $933 $124 13%
2008 $1160 $173 15%
2009 $1540 $282 18%
2010E $1895 $408 22%
1H 2009 $710 $114 16%
1H 2010 $918 $212 23%
Kaplan Higher Education (KHE) operates under two segments: Kaplan Higher Education Campuses (KHEC), and Kaplan University (KU). KHEC mostly offers Associate's and Diploma programs, predominantly in Allied Health (think dental assistants and medical technicians). KU is entirely online and enrollment is split between Bachelor's and Associate's programs. Most of the growth has been at KU, which was up to 60,400 students at the end of 2009, from less than 1,000 in 2002. KHEC enrolled 44,500 students at the end of 2009, up from 32,500 in 2004.
Like its peers, KHE will likely be negatively affected by the proposed regulation, however it ends up looking in its final form. Two KHEC campuses were caught in the recent GAO investigation into recruiting abuses, and Kaplan will have to make changes in the way it does business. Ultimately, some programs Kaplan offers may not be eligible for federal funding, and might face elimination. There has been a good discussion on VIC about the potential impact of gainful employment regs, most recently under Marlowe's EDMC writeup.
I feel that Apollo Group is probably the most comparable company in terms of exposure to regulation (Kaplan is better positioned in some ways and worse in others), so I use Apollo's trading multiple (currently about 7x current year earnings) as the best estimate of what Kaplan is worth. In a best case scenario, KHE may be worth twice that, and in a worst case scenario, it could be worth zero (both outcomes are clearly very unlikely).
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