Value Investors Club / The Washington Post Company (WPO)

Description

The Washington Post Company is not a newspaper company. It is a rapidly growing leader in the for-profit education industry with some media interests, one of which is an established cable franchise. Newspaper publishing only accounts for 21% of total revenues. Perceptions of the company as a declining newspaper business miss the two excellent underlying businesses that are emerging as dominant, and will propel the company to substantial revenue and earnings growth in the coming years.

Kaplan

WPO conducts its education business through Kaplan, which in the early 1990's was just a small testing prep business that was occasionally profitable. In 1994, 29 year-old Jonathan Grayer took over as CEO. In Grayer's first year, Kaplan had revenues of $75 million and lost $4 million. In 2006, the 13th under Grayer's management, Kaplan had revenues of almost $1.7 billion and had operating income of $130 million. Revenues have grown 34% CAGR since 1997, while employees have grown at 20% CAGR.

Kaplan has expanded its scope dramatically under Grayer, now including K-12, higher education, "distance education" (i.e. what used to be called computer based training), professional services (i.e. accounting, finance, CPA, real estate, etc), and others, and is constantly adding new products. Organic growth in each segment tends to be in the 3-13% range, and the balance is added by acquisitions, as Kaplan has been consolidating the fragmented for-profit education industry for years. In total WPO has invested $950 million in acquisitions, including the original purchase of Kaplan. For the 9 months ended 9/30/2007, Kaplan grew revenues by 21% year over year, or 12% excluding acquisitions.

This astonishing growth has made Kaplan WPO's primary business, as shown in the revenue breakdown below:

                                   Revenue by Segment
              Education    %       Advertising    %      Circulation %
              -----------------------------------------------------------
2007 YTD      1,493,863   49%        893,352    29%       613,941   20%
2006          1,684,141   43%      1,358,739    35%       782,527   20%
2005          1,412,394   40%      1,317,384    37%       747,079   21%
2004          1,134,891   34%      1,346,870    41%       741,810   22%
2003            838,077   30%      1,222,324    43%       706,248   25%
2002            621,125   24%      1,226,834    47%       675,136   26%
2001            493,271   20%      1,209,327    50%       653,028   23%
2000            352,753   15%      1,396,583    58%       598,741   25%
1999            240,075   11%      1,330,560    60%       579,693   26%
1998            171,372    8%      1,297,621    62%       547,450   26%
1997            117,268    6%      1,236,877    63%       519,620   27%

The tipping of the balance towards educational revenues is clear, as is the diminishing importance of advertising revenues. Chairman and CEO Don Graham acknowledged this in December, describing WPO for the first time as an "education and media" company rather than a "media and education" company.

Kaplan is run as an entrepreneurial company with young, ambitious executives, which some would consider stark contrast to the historical print business. After 13 years of brilliant leadership, Kaplan CEO Grayer is only 42. Kaplan tends to acquire additional executives with acquisitions and seems very adept at cultivating and incentivizing them. Executives are incentivized with stock options, the expense of which WPO pays in cash, as if Kaplan were public. Awards are based on growth in earnings.

Kaplan is enjoying broad trends in demand for education, coupled with high and rising costs of traditional colleges and universities. This is creating demand for education specific to certain careers or trades. There does not appear to be anything on the horizon that will halt their growth, except the law of large numbers and execution risk as the company gets larger. Kaplan does have some exposure to the real estate markets as they offer training for real estate professionals, and this business has flatlined in recent quarters.

Many of Kaplan's higher education services qualify for student loan financing. Funds provided under student financial aid programs were responsible for $580 million of revenues in 2006. On one hand this is a positive since such a student needs only availability to financing to enroll in Kaplan's services, thus allowing for a wider customer base. On the other hand, if there is a major disruption in student aid financing, which is a possibility given today's state of SLM, FMD, and other student loan companies, this could be a risk.

Kaplan has both a physical presence in "brick and mortar" testing centers and also does classes electronically. They have also expanded outside of the US into the UK, Ireland, Singapore, Hong Kong, and Australia. There does not seem to be anything ready to inhibit their growth, aside from their own growing pains. 2005 and 2006 saw some restructuring and consolidation charges as they digested recent acquisitions, and a $13M charge in 2006 for settling a lawsuit.

Cable ONE

Cable ONE is a cable franchise based in the south and west US with subscribers in 18 states. They were a little slow to adopt new technologies that required significant cap ex such as digital cable and high speed internet. As a result, both cable and satellite competitors were able to encroach into their territory somewhat until they caught up. They were also severely affected by hurricane Katrina and saw about 13% of their subscriber base affected. This led to a loss of both subscribers and homes passed, which is still recovering.

Period     Basic Subs     Homes Passed
--------------------------------------
2007 Q3     697,000
2006        693,500       1,315,000
2005        689,200       1,288,000
2004        709,100       1,307,000
2003        721,000       1,274,000
2002        718,000       1,255,000
2001        752,000       1,210,000
2000        740,000       1,025,800

My observation is that, on one hand, WPO seems both willing and able to spend money to develop their businesses, as evidenced by $950M spent on Kaplan acquisitions and hundreds of millions of cap ex in the cable business over the years. This probably comes from a long history of paying the cap ex required to keep the newspaper business running. At the same time, they seem to be a bit slow in making decisions and executing, which sometimes allows competitors to get the jump on them. They have mentioned that threats such as DirectTV and the "triple play" emerged and cut into their business. This also may be due to running what had historically been a slowly changing newspaper business. This approach can have advantages, for example in the cable segment, they have not paid a price premium in either dollars or risk for being an early adopter of new technologies. However, this has also led to mediocre revenue and earnings growth from the segment. This approach is more conservative though and less subject to mistakes, and consistent with building long term value.

In 2001 Cable ONE rolled out digital cable and high-speed internet service, in 2006 they introduced VOIP, and in 2007 they introduced digital telephone service. They are now prepared to offer the now-necessary "triple play" of cable, broadband, and telephone service and should be in a better competitive position going forward. Telephone service is now available to over 85% of homes passed and should be a new revenue driver. Absent any more hurricanes or similar disruptions, revenues should now enjoy the benefits of a stable subscriber base in conjunction with additional services and rate increases.

Other Operations

Even though WPO is probably best known for their newspaper and magazine businesses, in this write-up I will consider these businesses along with the television broadcasting to be "other operations" since they will almost certainly become an ever-smaller portion of the overall business as time goes on.

All of the company's struggles are in the print advertising segment (which itself is a subset of the total advertising), and while management is doing an admirable job of keeping the pile of sand in a tallish pile, they are destined to eventually lose the battle. Fortunately, the other high-growth businesses are already driving the company's results and this will only be more true in a few years. Circulation revenues have shown surprisingly steady gains of about 4.5% CAGR, based on increases in prices offset by circulation declines. This too will likely deteriorate over time.

The newspaper and magazine businesses are in decline for predictable reasons. As Warren Buffett so succinctly put it, "If cable and satellite broadcasting, as well as the Internet, had come along first, newspapers as we know them probably would never have existed." Newspapers and magazines are simply losing the battle to electronic media, and every aspect of their business is being picked apart by numerous fast-moving competitors large and small. News, classifieds, jobs, dating, weather, local news and businesses, movie listings and tickets, and all of the things that 20 years ago could only be found in the newspaper can now be found numerous places online. Additionally, my observation is that the few places where WPO has chosen to compete, for example online local jobs and classifieds, they have simply not been effective, moving too slow and taking few risks.

One bright spot in these operations is the current election year. If the Washington Post newspaper has a forte, it is in political coverage, which is already whipped into a fever pitch here in January. WPO has limitless possibilities for incremental boosts to revenues that it can play throughout the year. Once the election is over, though, we can expect this to fade.

The television broadcasting business, while also declining, is doing so much more slowly, and is still very profitable. WPO owns 6 TV stations in second and third tier markets, 5 of which are affiliated with a network. Presently there is no strong technical challenge for traditional TV broadcast business, and people still tune into basic network TV regularly. Operating income from the television broadcasting segment in 2006 was only 6% lower than in 1998, and is one of the sources of cash that is funding the other operations.

Unlike many other operators, WPO management can be trusted to manage these businesses in an efficient manner and wring as much cash as possible out of them, including being very cautious about new capital expenditures, selling suitable properties and things like sale-leaseback transactions, and also avoiding the reckless leveraging that is so common.

                                   Operating Income by Segment
             Education       Cable          Newspaper      Magazine       Television
           ---------------------------------------------------------------------------
2007 YTD   109,446   44%    93,206 37%     41,465 17%    13,938   6%    100,611 40%
2006       130,189   35%   119,974 32%     63,389 17%    27,949   8%    160,831 43%
2005       157,835   41%    76,720 20%    125,359 32%    45,122 12%    142,478 37%
2004       121,455   26%   104,171 22%    143,086 30%    52,921 11%    174,176 37%
2003       (11,709)   -     88,392 22%    134,197 33%    43,504 11%    139,744 34%
2002        20,512    5%    80,937 21%    109,006 28%    25,728   7%    168,826 44%
2001       (28,337)   -     32,237 12%     84,744 31%    25,306   9%    131,847 48%
2000       (41,846)   -     65,967 16%    114,435 28%    49,119 12%    177,396 44%
1999       (37,998)   -     67,145 15%    156,731 35%    62,057 14%    167,639 37%
1998        (7,453)   -     65,022 15%    139,032 33%    44,524 11%    171,194 41%

The breakdown of operating income reaffirms the points made above -- newspaper and magazine operations are declining but now contribute little, television is a stable cash cow, and growth is expected to come from cable and education segments.

A note about the losses for Kaplan prior to 2004. WPO was evidently generous with stock options when it first started to develop Kaplan in the 1990's, as options were all the rage at the time. WPO's policy on stock options (no doubt influenced by Buffett's outspoken views on the topic) is to pay stock option expenses in cash and charge the expense against operating earnings. This has led to large cash payments for exercised stock options, for example they paid out $118.7 million in the fourth quarter of 2003, with additional payments made from 2004 through 2007. According to filings in 2003, "a small number of key Kaplan executives will continue to hold the remaining 45 percent of outstanding Kaplan stock options, with roughly half of the remaining options expiring in 2007 and half expiring in 2011. The Company does not expect to issue additional Kaplan stock options in the future." So most of this expense is under the bridge, though we still see $20-30 million compensation expenses each year from 2004-2007. We can be comfortable that the reported operating income figures for each year are net of these expenses and there is no share dilution from these options.

Balance Sheet, Company History, and Whose Company You Keep

As you might expect from a stodgy old Berkshire holding, the balance sheet is rock solid, with just $400M of long term debt and shareholder's equity of $3.3 billion. The pension is substantially overfunded (also probably due to Buffett's outspoken views on that topic) and is a modest source of earnings rather than a cost. The company has ample liquidity in both cash and free cash flows. WPO pays a dividend of about 1% and buys back modest amounts of stock. In recent years, the buybacks have basically just covered dilution from options and other issuances, though this may increase.

Katherine Graham took over the company in 1963 when her husband Philip, the publisher and chairman, committed suicide. In a role surprising for a woman at the time, she took control of and ran the company, and continued until her death in 2001. Warren Buffett famously bought his ~10% stake in the company in 1973, which showed a loss of 20-25% after a few years but has now increased to about 117x his original investment. Katherine Graham was evidently worried about a hostile takeover, and, in a gentleman's agreement that Buffett evidently still honors today, he agreed to stop buying stock in the company and later became an advisor and friend to Graham. Katherine's son Donald succeeded her and still runs the company today, and the Graham family is very active in the business. WPO has two classes of stock, one of which has majority voting power, thus ensuring that the Graham family retains control. This inside family control is a potential risk, though the evidence is overwhelming that WPO management runs the company for the benefit of shareholders with an exclusively long-term view of building value.

Berkshire has owned its stake (now around 18%) since 1973. Wally Weitz has held a position in WPO for a number of years. Additionally, Longleaf's small cap fund made WPO a top 15 position in Q2 2007 and increased it to their top position in Q3 2007 at 7% of assets. Deutsche Bank upgraded WPO to a "buy" in October 2007, citing "its exposure to the counter-cyclical education division, sticky cable operations and politically-driven TV for next year," and "despite the fact that the Kaplan division is now about 30% of company, we think the market is still valuing WPO more like a local media company than an education company with high single digit revenue and EBTIDA growth."

Valuation

I believe that each line of business at WPO is very firmly entrenched and general trends of the past 5 years should continue. Further, these lines of business generate strong free cash flows, are fairly resistant (though not immune) to real estate, credit, and recessionary trends, and should fare well relative to the overall market should the economy continue to weaken. Management at WPO is, in my mind, unquestionably competent and shareholder-oriented, the company is entirely self-funding, and Warren Buffett's influence on the company is significant. These things should be worth a premium in this market.

Net income in 2006 was $324 million, up 3% from the prior year. Net income for the first 9 months of 2007 was $206 million and is running about 5-10% behind the prior year, though there were numerous one-time items in both years. With a market cap of about $7.6 billion, the P/E is about 25. While this is not cheap, I believe the company deserves a multiple in the 20-25 range based on the factors outlined above, and has historically traded there. I don't think that severe multiple compression is a real risk.

Precise earnings estimates are difficult with WPO because the results are somewhat lumpy, Graham just reports costs as they occur with no attempt to smooth results (which is perfectly rational but somewhat unusual), one-time items in the $5-30M range are common. So to avoid a sense of false precision, I'll talk in terms of general earnings trends. Given the multiple lines of business, I think operating earnings are best to examine for general trends.

Consolidated operating earnings peaked in 2004 at around $596M as strong results from Kaplan and cable were not (yet) offset by declines in print. You can see this reflected in the stock price which touched $1000 at the end of 2004. Subsequently, declines in print were a bit worse than anyone anticipated, and continued strong results from Kaplan and cable were overshadowed. I believe that, over the next 3 years, this trend will reverse, even if results further deteriorate in the print segments, as earnings from print make up about half as much of consolidated earnings in 2007 as they did in 2004. I would expect earnings from Kaplan and cable to increase at double-digit rates, print to decline at single-digit rates, and television earnings to remain roughly flat. Depending on how you want to model it, this should add up to increases in operating earnings in the 8-10% range for at least 3-5 years. While not a thrilling upside, I believe the downside is near zero, and relative to the rest of the market these gains may look quite good.

Catalysts

There are a few specific catalysts in the 3-5 year time frame:

- A major drag on Kaplan earnings over the past 10 years has been the stock compensation expense, which are cash expenses paid by WPO for stock options granted prior to 2003. This was $27.7M in 2006, and $24.1M in the first 9 months of 2007. Half of the remaining options expired in 2007 and the rest expire in 2011. While it is hard to model since we don't know all of the criteria that go into these awards, I would expect this to be less than the past over the next few years and terminate in 2011 when the remaining options expire.

- Kaplan took restructuring charges in 2005 and 2006 as it consolidated acquisitions and closed redundant centers. Graham believes that, while this took longer than they thought, it should be mostly complete, so earnings in 2008 and beyond should not be affected by this.

- 2008 is an election year and should boost WPO's media operations.

- Telephony roll-out in the cable segment in 2007 and continued recovery from Katrina should drive gains starting in 2008.

Risks

A substantial amount of revenue at Kaplan comes from student financing. Kaplan must ensure that they remain eligible for student loan financing, and the student loan markets are currently a mess. If student loan originations abruptly decline, Kaplan will likely be impacted as their students can't obtain financing. I feel that a long-term disruption of the magnitude necessary to impact Kaplan is very unlikely, but this is a risk.

Kaplan suffers significant execution risk as it gets larger, and constant acquisitions means constant consolidation and restructuring. They were able to restructure some operations in 2005 and 2006 without severely impacting earnings, and WPO has a broad and deep management team, but this is a risk.

WPO has exposure to the real estate and housing markets in different areas. Kaplan offers classes to budding real estate professionals. The media operations carry advertising for real estate and housing. These segments were down in 2006, probably flat in 2007, and aren't looking to pick up in 2008. While this is a risk going forward, I feel that a lot of this is already baked into current earnings.

Catalyst

- 2008 election year; Decline in stock compensation and restructuring expenses at Kaplan; new product roll-out in cable

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			2008	2009
Price:	792.00	EPS
Shares Out. (in M):	0	P/E
Market Cap (in $M):	7,530	P/FCF
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT