photo credit: qnr

This article is a reprint of my February 21, 2008 RealMoney column

The last year hasn’t been a good time to own a newspaper. The best performing stock was Washington Post (WPO), which managed not to decline significantly. New York Times (NYT) and Gannett (GCI - Annual Report) are down as much as half, while smaller firms like Lee Enterprises (LEE), Belo Corp. (BLC - Annual Report), McClatchy (MNI) and Journal Register (JRC) have registered declines ranging from 60-80%.

Always on the eye for a contrarian opportunity, I wondered if the time might be right to take a stake in one of the papers. The one that most attracts my eye is Lee. Lee provides of local news, information and advertising in primarily midsize markets, with 50 daily newspapers and a joint interest in five others, rapidly growing online sites and more than 300 weekly newspapers and specialty publications in 23 states. In 2005, the Company acquired Pulitzer and has since trimmed the combined operations by selling certain local papers and printing operations.

Although its valuation multiples and price performance resemble those of the other small firms, Lee is less heavily leveraged (a mere 3:1 debt/market cap ratio compared to 4:1 at McClatchy and 12:1 at Journal Register) and generates a significantly higher free cash flow yield than those firms. Compared to Belo, its Zacks rank of 2 indicates favorable earnings revisions, while Belo is in the worst category.

However, it will take more than being the best in a rotten bunch to make me take the plunge. Lee has to offer some real value, and pay me for the risk I would be taking by owning the name. At first glance, the 10% free cash flow yield (operating cash flow plus after-tax interest expense minus capital expenditures, divided by enterprise value) and 6.4% dividend yield would appear to do the trick. But are they sustainable?

There doesn’t appear to be much near-term risk to the dividend due to its relatively small share of annual cash flows. Pension plan is under-funded by $75 million, but the annual required contributions are just a few million.

The biggest concern relates to $306 million in notes issued in conjunction with the Pulitzer acquisition, which are due in April 2009. It would be tough to come up with that money in the current credit environment, but at some point over the next year I expect the credit markets to return to normal. Under its credit agreements, Lee can also increase its line of credit by up to $500 million as long as it meets certain financial criteria.

The Best Laid Plans

Over the longer term, Lee will have to generate at least modest revenue growth (the consensus five-year estimate is 5%) and execute according to its plan. Unfortunately, the plan is running into some road blocks.

Lee Enterprises’ Stated Corporate Plan

Source: Company filings

Earnings Quality

Until the management can effectively put their plan into action, revenues and earnings look set for continued declines. In 2007 operating income decreased $5,157,000, or 2.5%.

Tax settlements reduced income tax expense by $6,880,000 in 2007. On an apples to apples basis, earnings per share declined from $1.82 to $1.66.

While the earnings are declining, they do appear trustworthy. The accrual ratio measures the difference between cash-based earnings and accounting (accrual) based earnings. The closer to zero, the better. With the exception of a spike in 2005 related to the Pulitzer acquisition, Lee’s earnings quality has been high.

Source: Zacks Research Wizard, compiled by William A. Trent

I Would Look to Enhance Yield With Options

Although a put-write may offer another alternative play on the name, the options are thinly traded. The March 12.50 puts are available for approximately $1.45 at the time of writing, while the March 10’s are trading at about $0.30. The choice would depend upon the investor’s objective: someone wanting to own the shares at a lower price could use the $12.50’s to get an effective purchase price of just over $11.00, while an investor who doesn’t really want the shares could get a 3% one-month yield on money at risk using the 10’s.

I also think if I wrote put options and ended up with the shares, I would turn around and write covered calls to continue enhancing the yield and offsetting some of the risk.

Disclosures: None

Zacks Investment Research has provided Stock Market Beat with a complimentary trial subscription to Research Wizard.

Yahoo will issue its third-quarter report on Tuesday, Oct. 17, after the close of U.S. markets, while Google reports on Thursday. What are old media benchmarks saying about the state of the ad market?
National, local and classified revenue fell in September due to weakness in the help-wanted, automotive, department store, grocery, and the consumer electronics sectors, Gannett (GCI) said.

Journal Register (JRC) noted on their conference call that “Our third quarter financial results reflected the continued soft overall advertising environment. Particularly, in our Michigan cluster as a result of the slowdown in the auto industry.”

This week we’ll see if it is old media vs. new media or if it is a general advertising slowdown.

Speaking to investors gathered in New York for a conference sponsored by Goldman Sachs, (Yahoo! CFO Sue) Decker said weak sales of online automotive and financial ads during the last three to four weeks will cause the Internet giant’s revenue to “come in at the bottom half” of the $1.11 billion to $1.22 billion range Yahoo forecast in July. (MarketWatch)

We started getting a whiff of this possibility on June 26 when Valassis warned. As we said then:

The company attributed this shortfall to continued softness in Free-standing Insert and Neighborhood Targeted page volumes. Both segments are also experiencing pricing pressure.

Targeted ads and inserts are both areas that could be suffering at the hands of on-line advertising outlets, as the new media version may simply be more effective at reaching targeted consumers than the old. Proponents of this theory could point to the pricing pressure and infer that some of it may be due to the new options available to advertisers. This secular story is well known, and the ongoing shift of marketing dollars from newspapers and television into the Internet is a major contributor to Google’s share price.

Of course, the other side of the argument is that ad-driven business models are all highly cyclical and consumer dependent. With the consumer up to its eyeballs in debt and the housing market slowing, consumer cyclicals may be due for a slowdown. In this case, which is supported by the softness in volume, all ad-driven business models could suffer - Google included.

We brought up the potential link again on July 13 when Journal Register missed earnings.

Profits for newspaper publisher Journal Register Co., were down for the quarter ended June 25, largely because of weak advertising revenues in Michigan and Ohio. The company announced profits Thursday of $9.8 million or 25 cents per share, including a one-time charge of $2.5 million.

The fact that the worst of the slowdown is in Big Three Auto territory is telling but not surprising.
Now it’s Yahoo’s turn. Once again, the culprit is auto ads. This is officially not old media losing market share, but a full-fledged consumer slowdown-driven decline in advertising. The thing is, Yahoo! and Google have higher multiples that will come down along with the earnings estimates.

We don’t want to draw too many conclusions from the results of a small-cap newspaper publisher, but Watch List company Journal Register’s (JRC) earnings announcement is one more bit of information telling us the consumer may be slowing down. As we noted with Valassis’ earnings miss not long ago, the real question is how much old media is losing share to new media versus just facing the downturn in ad sales sooner.

AP Wire | 07/13/2006 | Weak ad market in Midwest drags down profits for Journal Register

Profits for newspaper publisher Journal Register Co., were down for the quarter ended June 25, largely because of weak advertising revenues in Michigan and Ohio. The company announced profits Thursday of $9.8 million or 25 cents per share, including a one-time charge of $2.5 million.

With the one-time charge excluded, net income was $12.3 million, or 31 cents per share, down 20 percent from $15.2 million or 37 cents per share for the Trenton-based company for the same period in 2005. The company’s performance slightly beat the expectations of analysts surveyed by Thomson Financial, who expected earnings of 30 cents per share.

The fact that the worst of the slowdown is in Big Three Auto territory is telling but not surprising.