Description

For the past two decades, the newspaper business has been a widow-maker for value investors. Even Buffett has thrown in the towel on the papers that he had purchased cheaply. With that disclaimer in mind, I’m long a basket of newspapers because an inflection is finally in sight and newspapers are about to become outstanding investments. Caveat Emptor!!

Newspapers are the original subscription business and for most of the past two centuries, they were surprisingly outstanding businesses. Dominant regional papers had large audiences, offering massive scale as every household got their news from papers. There was pricing power and churn was low. In fact, the businesses were so good that many of the owners could focus on pet investigative or community projects instead of even focusing on operating the business. These were businesses with lots of fat and mismanaged operations that continued to plod along despite the lack of financial focus, throwing off massive cashflow each year.

Then the internet came along, and newspapers weren’t sure what to do about it. Most papers built websites, gave the content away for free and literally competed against their own print subscription businesses. While many papers tried to implement paywalls on their online content, they found it impossible to achieve any traction while competitors were giving away similar content for free—readers just weren’t ready to pay for content. As a result, newspapers cannibalized their own print publications, and saw their businesses go into tailspins—often made worse by substantial financial and operational leverage. It was a disaster and after two decades of pain, investors now cannot stand newspapers—which is odd because they were such great businesses previously.

Over the past few years, change has been afoot, and investors are simply not paying attention. To start with, the papers dramatically improved the online experience. Websites have been replaced with apps for readings articles. The articles have been imbedded with video and links to prior articles. Algorithms can tailor a newsfeed for someone’s past reading preferences and online news is updated in real time. It’s simply a better product than folding a heap of paper and trying to find interesting articles that may be almost a day old—while getting ink all over your hands. The digital business is also a much more profitable business than the prior print one.

Think about what goes into getting a newspaper to your house before you wake up. A tree is cut down, it’s pulped, turned into newsprint, run through giant printing presses, and then delivered to your house—all for a buck or so per issue. It’s amazing that anyone ever actually made money at this business and there was a reason that margins were historically quite low in the industry. On the other hand, the incremental margins on delivering a digital product are nearly 100% and since you aren’t pulping trees and printing stories on them, the price-point for digital can be much lower than a print paper. This means that the TAM expands dramatically and churn declines. Who is going to cancel when it’s only around $10-$15 a month?? Digital newspapers are simply an amazing business, but at most papers, the economics are still hidden by the rapidly shrinking print business.

For years, newspaper companies spent a lot of time speaking about their nascent digital businesses, which admittedly were growing quite fast, but investors didn’t care as they were negligible when compared to the rapidly shrinking print businesses. We’re now to the point where the digital businesses are increasingly becoming relevant and the growth in digital is about to overcome the shrinkage in the print business—at that point, the newspapers will no longer be showing annual revenue declines, but revenue increases—I suspect that this is when the valuation re-rating takes place. The 2 key metrics to watch are digital advertising revenue and combined subscribers between print and digital.

When digital advertising revenue exceeds print advertising revenue and when combined digital and print subscribers starts to grows, you’re at the inflection where overall EBIT begins to grow, even if overall revenue is still declining. This is because print subscribers are producing a lot of revenue, but also a lot of expense (remember those poor trees). Depending on the paper, it takes between 3 and 5 digital subscribers to produce the same subscription revenue as one print subscriber, but the EBIT margins on digital subscribers are dramatically higher. Hence, when print subscribers churn or switch to digital, the overall subscription revenue declines, while EBIT grows. Unfortunately, it is impossible to allocate the overhead costs accurately to these four components (print subscriptions, print advertising, digital subscriptions and digital advertising) and as a result, investors do not see just how much more profitable the rapidly transitioning digital businesses have become—even if revenue is still declining.

It should also be noted that transitioning from a print business to a digital one is a difficult process as you lose all the scale benefits in operating printing facilities, along with route density in distribution. Along the way, there are innumerable special charges for severance and one-time expenses that depress results. As a result, it’s difficult to look at current-year numbers. Instead, you must look at where the puck is going. Rapidly growing digital subscription businesses have amazingly high ROICs and deservedly trade at SAAS-like multiples. Meanwhile, most newspapers trade for low single-digit EBIT multiples to equity. This is where the opportunity is. Once the business is more than half digital revenue on the advertising side, it is well in excess of half digital EBIT. At that point, you can almost ignore the low margin and shrinking print business—as most of the EBIT is already digital. EBIT-wise, many of these papers are already majority-digital business, hidden by melting print businesses that still have a lot of low margin revenue. This is the inflection point where newspaper businesses should re-value—or at least that’s when NYT’s shares went multi-bagger.

On a final note, I believe that in an advertising environment that is transitioning away from cookies, the depth of knowledge that the newspapers will ultimately have about each unique subscriber will be incredibly valuable from an advertising standpoint. Admittedly, today the mining of this data is in its infancy (newspapers haven’t been tech-forward businesses), but this is evolving fast. It makes me think of Facebook when it had a bunch of eyeballs but no idea how to monetize them correctly. In my mind, there’s still a LOT of upside here on the advertising side and it isn’t factored into my estimates.

With this summary out of the way, let’s focus on LEE Enterprises for the remainder of this posting. I believe that when this transition is completed by 2026, LEE will be producing in excess of $150 million in EBIT each year and a good chunk of that EBIT will be digitally native. For a point of reference, the current market cap is $105 million based on the closing price of $17.60. So, the business is trading at 2/3 of 1 times EBIT to equity (admittedly with a $551.9 million EV). If LEE succeeds in this digital transformation, why shouldn’t it trade at a premium to the market’s multiple? As a result, why wouldn’t LEE trade for a few hundred dollars a share or 10-25 times today’s quote?? Therefore, I intend to spend the rest of this posting to show how achievable $150 million in EBIT is. For a point of reference, LEE had $116.6 million of adjusted EBITDA in 2021 and is guiding to $95 to $98 million in adjusted EBITDA this year after $36 million in accelerated spending on the digital transformation ($131 - $134 million before this accelerated spending). A mostly digital business has negligible depreciation expense, so EBIT should roughly equal adjusted EBITDA as the transformation moves forward.

LEE owns 77 regional mastheads in 26 states, all of which are in second and third tier US cities. This is a strong competitive position as most of these cities do not have any large competing papers and there is a lack of viable news for consumers in these markets. They also own 82.5% of TownNews, a SAAS business that provides content and video hosting for approximately 2,200 smaller independent papers, particularly college papers. Following the $140 million acquisition of Berkshire Hathaway’s BH Media newspaper business along with the Buffalo News, LEE has become the second largest regional paper business after Gannett (GCI US). They needed that scale as they have aggressively invested in their digital business, while transitioning away from print.

The key datapoint for me is the subscriber growth metric. While it’s easy to say that digital subscription revenue is still quite anemic at $11.1 million in Q3/22 and completely dwarfed by the print subscription revenue of $78.1 during that quarter, the growth in digital subscribers has been rapid and will ultimately fuel future advertising growth. Please note that YoY comparisons only matter starting in Q2/21 as they annualize the large BH Media acquisition in Q2/20.

This rate of growth should ensure that LEE can exceed management’s guidance of 900,000 digital subscribers by 2026. In the 3rd quarter, LEE received approximately $7.30 per subscriber per month. This low level of revenue is the result of lower introductory offers for new subscribers. As subscribers mature, they’ll be paying stabilized rates north of $10. With a bit of inflation and pricing power, I believe that subscribers could be paying $12 a month by 2026. That would produce $129.6 million in digital subscription revenue.

900,000 X 12 X $12 = $129.6 million

How likely is it that LEE will get to 900,000 digital subscribers by 2026? Well, at the current YoY growth rate of 50%, they’d have 1.127 million subscribers in only 2 years. I think that 900,000 is easily achievable and is meant as a target to be exceeded with repeated guidance increases going forward as it would imply only 15% annual growth or less than a third of the current run-rate for growth.

What if LEE can grow subscribers to 1.2 million by 2026, which entails converting 29% of their 2.4 million “highly engaged” readers who make 4+ digital visits a month and LEE then charge $15 a month, which is still far less than many other newspapers in larger cities are charging.

1,200,000 X 12 X $15 = $216 million

Could they get to $216 in subscription revenue? Sounds crazy right?? Well, they did $315.3 million in print subscription revenue in the last 12 months. Why wouldn’t print subscribers trade down to a lower price point for a much better-quality product?? Could $315.3 million in TTM print subscription revenue become $179.4 million in incremental digital subscription revenue (compared with $36.6 million TTM digital subscription revenue) or a 47% savings for those readers?

I realize that management is guiding for $100 million of digital subscription revenue in 2026 and I’m thinking they get to more than twice that number, and you have every right to think I’ve lost my marbles. But I’ve seen many other newspaper groups start with low introductory subscription rates, then increase rates gradually by a dollar or two per year with minimal churn, then force print subscribers into the more profitable digital subscription business by reducing days of delivery or eliminating home delivery and forcing people to go find print copies at coffee shops. Eventually people transition to digital and the printing plant is closed or transitioned to an independent printing operation for the handful of coffee shops and news-stands that still sell paper versions and the majority of the subscribers go digital. This is the path that things are going globally, and the pace of change is accelerating. LEE has had the fastest subscriber growth of any US paper and I think that growth will continue, especially as LEE has over 1 million print subscribers and 1.2 million Sunday print subscribers to transition.

Let’s move onto advertising. The company is guiding to $179 million of digital advertising revenue in 2022 and $310 million by 2026, which would be a 17% CAGR in digital advertising revenue. This certainly seems achievable when you consider that digital advertising grew 27% YoY in 2022, driven by 74% growth at Amplified Digital, which is LEE’s omnichannel marketing solution. This revenue growth has been led by 85% YoY growth in total advertising customers to over 7,800 now. Keep in mind that given the growth at Amplified, LEE isn’t going to be relying on simply growing pageviews. Instead, it will be focused on getting better CPMs with its own inventory instead of programmatic inventory. I believe there will be continued growth here as their AdTech improves and they get better at targeting. While advertising with 3rd parties will have lower margins, the revenues will still be increasing as they can offer a better quality of distribution to their clients—many of whom are smaller advertisers. Ultimately, I believe that LEE will begin various initiatives in e-commerce through direct click and purchase options—which other papers have been more aggressive on. These options are amazingly lucrative, and Reach PLC (RCH LN) has been an industry leader at this with a good deal of success.

Taking LEE’s $310 million of digital advertising guidance at face value, the company should be at $526 million of digital revenue by 2026 ($216 million subscription + $310 million digital advertising when compared to $781.1 million of total TTM revenue). This is before considering any residual revenue from the print business which is only shrinking at about 10% a year. Basically, LEE will continue to shrink into a much more profitable and mostly digital business.  

Now, let’s look at costs. The company had $697.4 million in cash costs on a TTM basis. The three main buckets are compensation at $327.1 million, followed by newsprint & ink at $29.8 million and then other operating expenses of $340.5 million. It’s hard to say how these expenses are allocated between print and digital, but a digitally native business will certainly eliminate the majority of the newsprint & ink costs and management has stated that there are in excess of $300 million of costs tied to the legacy newspaper business that can be eliminated over time. If you simply take this at face value, you have;

$697.4 million - $29.8 million - $300 million = $367.6 million in total operating expenses for the business. With $526 million of digital revenue, you have a business that has $158.4 million in digital EBIT before any residual print business (yeah, maybe they don’t get all $300 million of cost savings if there is still a residual print business, but this is a management team with a lot of proficiency in reducing costs as they run off the legacy print business, so I assume they’ll sort it out correctly and shrink print at the appropriate pace). In any case, I don’t think that $150 million in total EBIT is going to prove that difficult to achieve as print will likely still be chipping in a good quantity of EBIT as it melts away. Clearly, this is all a work in progress, with a lot of messy moving pieces, but I tend to also think that LEE can exceed their digital advertising guidance. Besides, elevated US inflation will work in their favor against their fixed costs.

Before ending, I must mention the debt. LEE has $462.6 million in debt at a fixed rate of 9% and $15.7 million in cash for $446.9 million in net debt. This number sounds scary, but it’s less scary that you’d think. To start with, 100% of this debt is owed to Berkshire Hathaway, who agreed to refinance all of LEE’s higher cost debt when LEE purchased BH Media. This debt has zero covenants and Buffett is supportive of the media business. If needed, I’d expect him to be amenable to adjustments in the debt as he doesn’t want BH media back, nor does he want to push a media business into bankruptcy given how much he values his reputation. There is a cash sweep function where any cash over $20 million is used to amortize the debt and the company has now made amortization payments of $113.4 million since the refinancing.

Admittedly, debt payments have effectively ceased over the past three quarters as $66 million in adjusted EBITDA has not led to any cash generation due to working capital growth along with one-time costs related to reducing the print business. Offsetting this, the company has well over $100 million in property it can sell as it continues to close down printing facilities. Additionally, the company should return to cash flow in Q4 and should see a bounce in revenue during their fiscal Q1 due to the political cycle. While the cashflow may be choppy during the transition, as the expensive debt gets paid down, overall cash flow should dramatically expand, allowing accelerated debt paydown. However, the risk is that this is a business with a lot of debt, that hasn’t had any real cash flow in three quarters, undertaking a difficult operational transformation, potentially into an advertising recession.

Basically, it may still have the economic characteristics of a newspaper, but I think that times are changing and there's multi-bagger upside if they can pull this off…

Disclosure: Funds that I control are long shares of LEE

Catalyst

Return to cash flow. 

Continued digital growth.