Description

Introduction:

Lee Enterprises, Inc. is the second largest regional news company in the U.S. and operates 77 mid-sized print/digital papers in second and third-tier cities. It trades at 2.2x levered free cash flow (implied by 2023E management guidance) and has a 55.1% return on tangible capital employed (calculated as EBIT / (NWC + NFA)). I believe intrinsic value is at least $61 per share, representing a 4x from current prices.

Lee has been written up several times. I recommend going through those writeups for useful background beyond what I've detailed here. 

Why This Opportunity Exists:

Before the advent of the internet, newspapers were great businesses. They had large audiences providing recurring revenue. In addition, dominant regional papers had a local monopoly, cost advantages from their large-scale print operations, and meaningful pricing power with low churn. Then the internet came along and revolutionized the way people consume news. Many traditional newspapers tried building websites and giving their content away for free in a scramble to stay relevant. However, by doing so, they cannibalized their own print businesses. Returns on capital spiraled down and overall readership of physical papers dwindled away.

Indeed, Lee’s price reflects this bleak narrative. The legacy print business continues to face secular headwinds, declining at an over 10% clip annually. In addition, the capital structure is extremely onerous. Lee has $460mm of term loan outstanding (4.6x 2023E EBITDA) that burns $41mm of cash interest per year. The market is uncertain about Lee’s ability to simultaneously handle the rapidly declining print business, service the large interest burden, and deleverage the company. High uncertainty can beget considerable mispricing.

In addition, the company is covered by only 1 broker and average daily volume is under 7K. Because of its dire prospects, Lee has effectively been cast aside and forgotten over time.

Why I Believe the Market is Wrong:

1) Lee is increasingly becoming a digitally-native, recurring revenue, higher-margin business. Digital-only subscribers have grown each year from 2019 to 2022: 91K, 244K, 402K, 532K, 596K (LTM). Accordingly, digital revenue has also grown each year from 2018 to 2022: $113mm, $145mm, $164mm, $189mm, $240mm, $256mm (LTM). As of Q2’23, the digital business generated 38% of total company revenue. This is up from 14% in Q3’14. Management is guiding towards over 50% digital contribution to top line by 2026.

Digital subscription businesses have much lower capital requirements and higher margins than the legacy newspaper business. In addition, as the legacy print business is phased out, Lee has a chance to permanently take out a considerable portion of its operating expenses if it is successful in transitioning the business to digital. Total cash costs have declined from $1bn in 2017 to $693mm in 2022 and are projected to be about $610 to $620mm for 2023. Management has stated that there are still about $300mm of cash costs associated with the legacy print business. A meaningful portion of any reduction in this $300mm would drop to the bottom line. Admittedly, a non-negligible amount of these savings would have to be allocated to restructuring and severance costs and working capital outflows. However, the point is that coupled with the rapid growth in the digital business, there is an opportunity to realize considerable margin expansion.

2) Lee possesses a key competitive advantage in that it operates only in second and third-tier cities. Given the mid-sized nature of these markets, there is inherently less competition from large national chains because i) the marginal benefit of setting up business in smaller areas to the large chains is minimal, and ii) residents of these locales care more about local than national news (for many people, buying a home is the single largest purchasing decision of their life, so they understandably care a lot about news that will inform the value of their properties; this news isn't covered by the large chains). For these reasons, Lee effectively has a monopoly/oligopoly in many of its markets.

This moat provides Lee with latent pricing power. However, to date, Lee has not taken full advantage of this. As of Q2’23, monthly digital subscription ARPU is $7.8 but print subscription ARPU is $53.3. Digital ARPU is skewed lower because of Lee’s use of introductory pricing to entice print readers to switch over. As subscribers mature and their plans renew, they’ll be paying rates north of $10 per month. Digital papers are a much more convenient form of news consumption, so I believe Lee’s readers will switch over eventually.

The main argument against this is that if readers wanted to make the switch they would’ve done so by now. That is true. However, the difference is that readers are now being given an ultimatum. Either switch to digital or lose access to crucial and timely local news: as of June 2023, Lee announced that most of its papers will be shifting to a 3-day-a-week publication schedule. I’m inclined to believe that this will pan out to Lee’s advantage. The digital subscription is cheaper and more convenient, and with few other alternatives providing relevant local news, readers are highly incentivized to switch.

3) Digital advertising has substantial untapped monetization potential. Historically, advertising was a major boon for newspapers. Regional operators had strong relationships with local advertisers because they brought significant revenue and scale to each other. There was a reliance on papers for sourcing job opportunities, so local advertising helped develop moats around papers. While these relationships are not as prominent anymore given that print has been in structural decline, the difference now is that papers are obtaining a growing depth of knowledge on each individual subscriber via the digital side of the business. This is very valuable for advertisers. In aggregate, Lee’s digital websites get 76 million average visits per month. True, the usage of this data by newspapers is in its nascent stage. However, there are tons of eyeballs on the platform that Lee has the opportunity to monetize.

Year-to-date 2023, Lee generated $73mm of print advertising revenue and $94mm of digital advertising revenue. Currently, the digital business is effectively half the size of the print business (from a revenue standpoint), yet digital advertising revenue already exceeds print advertising (the cross occurred in Q3’22). In my view, this indicates that the long-term opportunity for digital advertising far exceeds the historical peak of print advertising.

4) Successful deleveraging is more feasible than the market believes. Management has a proven track record of deleveraging the business while also juggling the burden of the melting print business. Below is a breakdown of Lee’s historical debt-to-capital ratio, long-term debt outstanding, and interest expense.

Debt-to-Capital / Long-Term Debt / Interest Expense:

2014: 125% / $773mm / $103mm

2015: 123% / $701mm / $78mm

2016: 118% / $566mm /$70mm

2017: 108% / $496mm / $62mm

2018: 99% / $461mm / $58mm

2019: 102% / $429mm / $55mm

2020: 102% / $525mm / $60mm

2021: 85% / $477mm / $45mm

2022: 90% / $463mm / $42mm

LTM: 90% / $460mm / $41mm

Since 2014, Lee has been able to consistently pay down its debt despite the melting of the print business. Through to YE 2019, the company has sold off non-core assets and used organic cash flow to repay approximately $344mm of debt.

In 2020, Lee acquired BH Media and Buffalo News from Berkshire Hathaway. The acquisition was financed by a $576mm term loan due 2045 that has a 9% interest rate, no financial covenants, and no mandatory amortization; although there is an excess cash flow sweep set at $20mm where balance sheet cash above that threshold must be used to repay the term loan. The new term loan refinanced Lee’s existing debt and lowered the company’s cost of capital by 100 bps. Since that transaction, Lee has successfully deleveraged by about $116mm.

As I mentioned, Lee achieved this by monetizing non-core assets and generating sufficient discretionary cash flow. Since 2014, Lee has received asset sale proceeds of $80mm. Half of this has come in over the last three years. This implies $9 to $13mm in asset sale proceeds per year. To estimate future discretionary cash flows, let’s assume $10mm of proceeds per year.

Over this same period, PP&E has declined from $501 to $371mm (LTM). If we take this at face value, Lee has been able to monetize ~62% of the value of the gross PP&E that it sold ($80 / $130mm). To be conservative, let’s assume a 50% monetization potential on the remaining gross book value of PP&E. With $371mm on the books, Lee could potentially reap up to $186mm in total asset sale proceeds over the long term as it winds down the legacy business. How much will they actually realize? I don’t know. The point is that there is a large pool from which Lee can generate additional cash to fund incremental debt paydown. There is upside to my $10mm assumption above.

Offsetting this, however, are recurring restructuring and severance costs. Over the last 4 years, Lee has averaged $13mm to $14mm in cash expenses related to restructuring and severance. Net of proceeds and restructuring costs, let’s assume discretionary cash flow will be lower by $3 to $4mm per year ($10mm minus $13mm).

To get a grasp on what 2023 cash flow might look like, here is what management is guiding to for 2023:

Digital Revenue: $270 to $285mm

Digital-only Subscribers: 632K

Adjusted EBITDA: $94 to $100mm

Capital Expenditures: < $10mm

Taxes: $7 to $11mm

Using the mid-point of each, management’s 2023 guidance implies the following:

2023E EBITDA:                        $97mm

2023E Interest Expense:         ($40mm)

2023E Cash Taxes:                  ($9mm)

2023E Capital Expenditures:   ($10mm)

2023E Levered FCF:                 $38 mm

For the first two quarters of 2023, Lee has generated $30mm in EBITDA, paid $20mm in interest expense, negligible taxes, and $2mm in capex, netting to about $8mm in free cash flow. One thing to note is that this differs from the reported free cash flow amount. This is attributable to a negative change in net working capital. Accounting for this, free cash flow is virtually nil. However, I’m choosing to disregard this for several reasons. In 2022, Lee experienced outsized working capital cash outflows primarily because of decreases in pension obligations, accounts payable, and deferred revenue. As of the latest quarter, the outstanding balance of pension obligations is less than $1mm, meaning future cash outflows tied to this will be de minimis. In addition, over the last 10 years, changes in net working capital have averaged a pretty negligible amount. The company has $19mm on the balance sheet which I believe is sufficient to cover its working capital needs.

The combination of management’s implied guidance and the company’s performance year-to-date suggests strong performance in the back half of 2023 (about $30mm incremental FCF). On top of this forecasted cash flow, management has also stated in their Q2’23 earnings call that they’ve identified $30mm of non-core assets to monetize. These are in various stages of the sale process. Assuming they can monetize 50% of this value and then need to pay $10 to $13mm in associated costs, the company could presumably generate $2 to $5mm in incremental discretionary cash flow. With $32 to $35mm of additional FCF in the second half of 2023, Lee could pay down its term loan to about $425 to $430mm, reducing interest expense to under $39mm.

Let’s now try to get a sense of what cash flows might look like in 2024, 2025, and 2026. Since 2014, Lee has generated $120mm in average annual EBITDA. This has been trending down through to 2020. In 2014, EBITDA was $156mm and in 2020 it was $95mm. Since 2020 (i.e., since the acquisition), EBITDA seems to have plateaued around $95 to $105mm. Given that the higher-margin digital business is increasingly becoming a larger proportion of the company’s revenue, I believe EBITDA should around this level. In the interest of conservatism, let’s assume average annual EBITDA of $90 to $100mm over the next three years.

LTM depreciation is $11mm. This has declined consistently as print facilities have been sold off and management has foregone reinvestment in its fixed assets. Realistically, this number will continue to trend down, but for simplicity let’s assume it stays flat. For these same reasons, capex will also likely trend down, but let’s also assume it stays relatively flat at $10mm annually. Interest expense will cost the company around $30 to $40mm per year over the next three years. As debt is paid off, interest expense will decline. Cash taxes should come out to around $10 to $15mm per year. Accounting for the $3 to $4mm in non-operating cash outflows per year (asset sale proceeds net of associated costs), annual discretionary cash flows will be in the range of $27 to $41mm over the next three years (presumably higher in each subsequent year as interest expense decreases). Based on this level of cash flow generation, I believe Lee could get to $315 to $340mm of debt by YE 2026.

The Implied Numbers:

Shares Outstanding: 6.04mm (as of 3/26/23)

Market Cap: $85mm (as of 7/26/23)

Enterprise Value: $526mm (as of 7/26/23)

Based on my forecasts above, here are the implied numbers at the end of 2026:

2026E EBITDA:                         $90 to $100mm

2026E Interest Expense:         ($28 to $31mm)

2026E Cash Taxes:                  ($12 to $15mm)

2026E Capital Expenditures:   ($10mm)

2026E Levered FCF:                  $37 to $47mm

NYT trades at 15x to 25x levered free cash flow. As Lee deleverages, lowers the interest burden, and transitions the majority of its business to digital, it should trade for at least 10x cash flow while still being an over 5-turns discount to the industry leader. With 6mm shares outstanding, Lee’s range of intrinsic values by the end of 2026 is $61.3 to $77.8 per share. 

Let’s sanity-check the numbers. Here is what management is guiding for 2026:

Digital Subscription Revenue: > $100mm

Digital-only Subscribers: 900K

Digital Advertising Revenue: > $310mm

Total Digital Revenue: > $435mm

Digital Revenue as % of Total Revenue: > 50%

Total Debt / EBITDA: < 2.5x

Using $42mm as the comparator (mid-point of my 2026 FCF forecast), the implied FCF margin is 5% to 10% (implied total revenue is $435 to $870mm). For a digitally transforming business, I believe these are not aggressive assumptions. Additionally, my forecasted EBITDA and debt figures imply a 3.2x to 3.8x leverage ratio in 2026. This is a full turn above guidance of 2.5x. However, I find this discrepancy comforting because it suggests that my assumptions are likely quite conservative, offering potential upside via lower debt or higher EBITDA than I’ve estimated. In my view, there’s a considerable margin of safety here.

Buffett's Endorsement:

To further support my view that Lee can continue its track record of successful deleveraging, Buffett has also endorsed Lee’s operators:

1) “My partner Charlie Munger and I have known and admired the Lee organization for over 40 years. They have delivered exceptional performance managing BH Media’s newspapers and continue to outpace the industry in digital market share and revenue. We had zero interest in selling the group to anyone else for one simple reason: We believe that Lee is best positioned to manage through the industry’s challenges.” 

2) “No organization is more committed to serving the vital role of high-quality local news, however delivered, as Lee. I am confident that our newspapers will be in the right hands going forward and I also am pleased to be deepening our long-term relationship with Lee through the financing agreement.” 

3) “As Lee’s sole lender, Berkshire Hathaway remains highly confident in Lee’s board and management as they continue to navigate the ever-evolving newspaper industry.”

Although I have no way of knowing for certain what Buffett’s intentions were when he sold his papers to Lee, I still view this as a sign of confidence. While the capital structure is indubitably onerous, the silver lining is that Lee has much more favorable debt terms than its regional competitors. Lee also has more flexibility to execute on its business plan, and I believe Berkshire would be amenable to amendments in terms if things go awry. They don’t want the assets back and they obviously want at least par recovery, but they also don't want to avoid the perception of having led their "partners" into bankruptcy, as it would damage their reputation. The equity is priced as if it’s going to zero soon, but I think the downside is actually protected based on these implicit incentives.

Catalyst

Successful deleveraging will be the single biggest catalyst for this name. In addition, I want to highlight this quote from the Q2’23 Earnings Call:

"Over the last 3 to 4 years, we have been able to retain a lot more of our print subscribers and more of our print subscription revenue relative to others in the industry. And that said, we are seeing unit declines accelerating in 2023, resulting in revenue trends closer to what the rest of the industry has seen for a couple of years."

Based on management’s 2026 guidance of >$435mm in digital revenue and >50% digital contribution to total revenue, implied print revenues at face value are $435mm. At YE 2022, print revenues totaled $541mm. In effect, management is guiding towards a 5% annual decline in print over the next three years. Historically, print has declined at over 10%. In addition, this guidance is inconsistent with management’s commentary from the earnings call. With most of Lee’s physical papers switching to a 3-day-a-week publication, the annual decline in print should exceed 10%.

There are two ways to perceive this. The pessimistic view is that management in fact recognizes that print revenues could fall off a cliff and they won't be able to cut costs and grow the digital business fast enough to offset it. To temper investors, they've issued guidance that paints a rosier picture than reality. This would be a disaster. The optimistic view is that while print revenues may indeed decrease faster, print costs would also do the same. Additionally, management would be able to continue divesting assets as they would increasingly identify "non-core" pieces of the business if the phasing-out of print accelerates. In turn, digital would become an even larger percentage of the business, expanding margins and returns on capital. 

I'm inclined to think the optimistic view is more likely. The acceleration in the decline of print is being driven by Lee's decision to switch most of its papers to a 3-day-a-week publication schedule. This had to be a conscious, informed choice. To me, it's indicative of management's view that digital has reached, or is nearing, a critical mass that it can support more aggressive cost cuts.

This discrepancy in guidance and earnings commentary suggests to me that management has intentionally put out conservative figures that they'll revise upward as they successfully execute. Once the street catches wind of this, they will ascribe a more appropriate valuation to Lee.