The thesis I am about to present has been argued for many years as a basis for the undervaluation of the Washington Post Company. And for many years, WPO has continued to decline in value despite the so-called mispricing. The thesis, as many of you know, and has been presented on this board before, is that WPO is not a newspaper company, but an educational company. Despite the risk of deeply angering the investing gods, I will utter the four most dangerous words in investing, “it’s different this time.” I believe we have reached an inflection point where WPO’s media assets have declined in value such to the point where they are only a small fraction of the value of the combined company and we are entering a period where educational assets will significantly outperform the market. Sometime in the near future, the undervaluation of WPO will be undeniable to the general market.  

 

First and foremost, WPO has a very strong balance sheet. The only debt it has is a $500m debenture that matures in February 2009. Despite having a maturity only 2 months away in an environment where refinancing is quite difficult, these bonds trade at 99.45. WPO has $247m in cash, $278m worth of Berkshire Hathaway Shares, $168m of other marketable securities including $100m worth of Corinthian Colleges equity (COCO), an overfunded pension fund (by over $1bn on 12/31/07), and an untapped $500m credit line. Unlike many of their media peers, WPO will have no trouble paying off their maturing debt and will not be forced to sell assets at distressed prices. Moody’s rates WPO A1 and Standard & Poors rates them an A+. 

 

Upon giving extremely conservative valuation estimates of its non core (non-educational) holdings, it is readily apparent that WPO is a vehicle for getting an extremely high quality for-profit educational company at a very cheap price. This cheap price also coincides with a time period where for-profit, counter cyclical education companies, will be entering boom times.

 

Sum of the Parts Analysis:

Despite the fact that WPO’s management has been unequivocal about their unwillingness to split the company up in order to amplify the value of its parts, I find it a useful tool to examine the pieces as if they were standalone, debt free companies. The parent company has enough cash to pay off all of the debt and the expenses allocated to the corporate entity ($38m LTM) can be offset by income from the overfunded pension and excess cash and securities.

 

For purposes of analysis, I lump WPO’s worst two businesses, Magazine and Newspaper publishing together. Clearly, the values of old media properties have plummeted. Newsweek and the Washington Post newspaper have been operating at a loss over the last twelve months due write downs of some of their properties and charges related to early retirement packages they have given to staff members in order to reduce expenses. As these are non-recurring items, once you add them back to operating earnings, the divisions remain profitable over a trailing twelve months. It is entirely possible that the coming twelve months may completely eliminate the profitability of these entities, but the low multiple on current EBITDA makes up for this possibility. In addition, expenses will be lower going forward as the voluntary retirements have slimmed the payroll. Solvent competitors such as NYT, MHP, and GCI trade at an average of 4.47x trailing TEV/EBITDA. The New York Times, which is facing a near term debt maturity and is looking to sell its non core assets, trades at a 4.5x multiple.

While, the NYT is a superior newspaper with a much larger subscriber base, I argue that a debt free Washington Post deserves at least an equal multiple. The Washington Post has a strong niche of local support and national interest due to its political coverage. Applying the NYT multiple to the group’s LTM EBITDA of $79.88m arrives at value of $359.46m. Clearly this is just a drop in the bucket compared to the market cap of the company and my estimate of intrinsic value. One could make an argument that WPO would receive a higher valuation of their combined company if they sold the Washington Post and Newsweek for $1 because the market focuses most of their attention on this business despite it being a very, very small component of valuation at this point.  

 

WPO’s cable business, Cable One, is a very good business. Despite being WPO’s most capital intensive business, it is a very strong free cash flow generative business. Its operating margins, at 21.4% LTM, are ahead of peers like Comcast and Cablevision and slightly lower than Time Warner Cables’. Cable One has been steadily growing its revenues and earnings over the last few years. It may see slightly lower earnings during this downturn due to increased bad debt, but subscribers seem to be very sticky and revenues should be relative secure. Comparable companies like CMCSA, CVC, and TWX trade at an average trailing TEV/EBITDA multiple of 6.1x. All of these companies have pretty heavy debt loads and a debt free Cable One would certainly be a more valuable entity, but to be conservative we will use the average multiple. Based on Cable One’s LTM EBITDA of $269.8m, this division is worth $1,646.04m.

 

WPO owns six broadcast television stations. While these are not a great business and profits are falling and likely to continue to decline, they are not as bad as the publishing assets. Competitors such as BLC, FSCI, HTV, and TVL trade at an average EBITDA multiple of 7.9x. Most of these have very significant debt loads which are impacting not only their valuations, but their solvencies. I believe a 5x multiple on LTM trailing EBITDA is conservative. Based on this valuation, this division is worth approx $685m.

 

The combined value of these divisions based on the above conservative estimates is $2,690.50m. Subtracting $509.1m of short term debt, $11.83m in preferred stock, $7m in long term debt and adding back $247.93m in cash, $168.4m in marketable securities, and $278m in Berkshire Hathaway stock gets to a NAV of $2,857,. This compares to a current enterprise value of roughly $3,629m implying the value of Kaplan is $772m.

 

Not only is Kaplan worth more than $772m, it is most likely worth more than the entire enterprise value of WPO on its own.

 

I refer you to Oscar1417’s write up on WPO for a detailed discussion of the quality of WPO’s education business. He did an excellent job describing the company, its earnings growth, and the lumpiness of its earnings. A recent study by McKinsey showed that in the previous two recessions (90-91 and 2001-02), spending on education rose by 90%. Out of all of the industries that Mckinsey surveyed, education was the most counter cyclical. I do not believe this recession will be any different as more and more people are already looking to go back to school and improve their credentials. Anecdotally, management has said that Kaplan’s higher education group has not seen any slackening of demand since the financial crisis began.

 

Education is an incredibly attractive business. Growth potential is still very high and cash flow can be reinvested back into the business at high returns. Paradoxically, this is also creating a situation where Kaplan’s operating margins are artificially low. Kaplan’s LTM operating margins were 8.94% which are about half those of their competitors. Cash stock options, acquisitions and growth capex have kept margins from expanding to the level of its competitors and there is no fundamental reason why Kaplan’s margins should be significantly lower. Management has said that margin growth is not a key objective at this point so I do not expect margins to improve in the near term. Margin improvement is a possible upside bonus when Kaplan stops spending on growth and recent acquisitions mature. In addition, WPO pays cash for Kaplan options which drives this expense through the income statement whereas competitors give shares. As these options mature and fewer options are being given out, this cash expense should decrease, improving margins and earnings.

 

From page 52 of the 2007 Annual Report:

 

A small number of key Kaplan executives continue to hold the remaining 69,662 outstanding Kaplan stock options (representing about 4.9% of Kaplan’s common stock), which expire in 2011. In January 2008, the committee set the fair value price at $2,700 per share. Option holders have a 30-day window in which to exercise at this price, after which time the committee has the right to determine a new price in the event of an exercise. Also in the first two months of 2008, 26,656 Kaplan stock options were exercised, and 21,325 Kaplan stock options were awarded at an option price of $2,700 per share.

Based on the above paragraph, it appears that for purposes of striking 2007 year end options, the compensation committee had an internal valuation of Kaplan at $3.8bln. [If 69,662 shares equals 4.9% of Kaplan shares outstanding and each share is worth $2,700, then the whole division is worth 1,421,673 x 2,700= $3,838,517,100]. This internally generated valuation is larger than the current enterprise value of the entire company. Interestingly this valuation was done by people who are incentivized to give as low a valuation as they can in order to limit option related expenses.

 

Competitors such as Apollo, Capella Education, Career Education, Corinthian Colleges, Devry, ITT, and Strayer have an average TEV/LTM EBITDA multiple of 14.33x. Applying this multiple to Kaplan’s LTM EBITDA of $280.25m derives a value of $4,015.98m.  

 

Both of these methods of valuation suggest that the value of Kaplan is significantly in excess of the current enterprise value of the entire company. This provides a huge amount of margin of safety as the other divisions are certainly worth more than zero. It also suggests that WPO as a whole is significantly undervalued and provides an opportunity to own a high quality counter cyclical company at a time when its earnings should increase substantially.