18 May 2012 by Jim Fickett.
Gannett, a news conglomerate best known as the publisher of USA Today, has a fairly steady, long-term free cash flow of about $900 million per year – about a 29% yield at current market cap. While their newspaper revenue is in decline, their on-line revenue and income is ramping up quickly. There is certainly a risk, in all news companies, that they will fail to adapt to an internet world but, if Gannett continues to make the transition, the current price might come to be seen, in retrospect, as a bargain.
It is well known that newspapers are having a hard time these days. People talk a lot about competition from free content on the internet, the loss of advertising revenue to Craigslist, and other problems. But fundamentally, newspapers have one, very simple but very big problem: they used to have more or less a monopoly, within their core territory, on information, and so they could charge a premium price, but the internet gave people a choice of many providers. Good information remains rare, but basic information is now a cheap commodity.
Despite this very big problem, however, and despite widespread pessimism about the newspaper industry, there will always be a news industry, and some news sites and newspapers will find a way to give people what they want at a profit. The Financial Times plays to a small audience, but makes money because, unlike other sources of business and financial news, it hires reporters who understand the subject matter they report on, and hence it can charge a premium price. Some local newspapers still have more or less a monopoly on local news and, once they adapt to loss of part of their revenue to Craigslist, are doing all right (Warren Buffet just bought a boatload of local papers).
I suspect Gannett will be a survivor. From my point of view USA Today serves up a bland and shallow porridge of commodity information. But many people like the colorful format, the sensational gossip, the strong sports coverage, and the articles purporting to help the reader make personal decisions. In addition to this paper, Gannett has many others, plus a network of TV stations, and a number of websites. All this means that they can spread the cost of gathering information across a large number of customers.
The rather low-profile, respected hedge fund manager Randall Smith, of Alden Global Capital, has taken a major interest in newspapers in general and Gannett in particular. Last year I saved a clipping from the blog Distressed Debt Investing, with notes from a talk by Smith, where we get a glimpse of his thinking on Gannett:
The long thesis for Gannett ($GCI): GCI is the most undervalued security that Randy knows of. It's trading at a stable 30% free cash flow yield. Only $2 billion of debt. It has a newspaper operation, for which it is unfortunately known, which attaches a stigma to the company. The newspaper operation has very healthy free cash flow and $700M of EBITDA. $4 billion valuation for the newspaper. It has probably the best collection of network stations in the country (20 stations). EBITDA going to $430M next year driven by the good political year (big source of advertising). Recent trade at 10x EBITDA, implies $4 billion value for the stations. Then they have $2 billion of digital assets (Career Builder, Classified Ventures). Aggregated value of $10 billion, less $2 billion of debt or $8 billion of value versus a $2.5 billion market cap. If you look at it that way, very cheap.
Free cash flow is central to the argument. Here is a graph of revenue, income, and free cash flow over the last 10 years, with average values over that range shown by dashed lines:
(All numbers from Gannett's annual reports on their website.)
Note, in keeping with the general pessimism about newspapers, that revenue has been dropping since 2006. Income has been rather erratic, in part because of a huge restatement of goodwill in 2008. But free cash flow has been remarkably steady, and high relative to the current stock price – the 10-year average free cash flow is 29% of the current market capitalization.
Where has the money been going? In part to improving the balance sheet – since 2008, when the restatement of goodwill occurred, long-term debt has dropped from $3.8bn to $1.8bn, and shareholder equity has risen from $1.1bn to $2.5bn. A significant amount of cash has been returned to shareholders – about $100 million was spent on share buybacks and dividends in 2011. This is set to increase significantly, with the dividend having been increased by 150% in February, and a planned share buyback of $300 million set for 2012 and 2013.
I don't see any big hidden problems that could eat up a lot of the cash flow. There is already a healthy spend on acquisitions and development in the digital space, the main place where capital investment is needed. And the retirement program is in relatively good shape, compared to many. Gannett has already frozen the defined benefit plans and switched to defined contributions. Remaining unfunded liabilities total about $1 billion. Company contributions have been reasonable, and if the deficit is taken care of over, say, 10 years, it should not greatly affect free cash flow.
The big question is this: as the company transitions to a new business model, in which printed newspapers play a much smaller role and the internet a much bigger one, how will their revenues and costs be affected? The valuation by Randall Smith seems to assume stable revenue and income, but in fact the situation is anything but stable.
In the last two years revenue in the publishing business was down 6% and 5%, and operating income was first up 25% and then down 26%. In the digital space, revenues were up 5% and 11%, and operating income was up 93% and 50%. In broadcasting, revenues were up 22% and then down 6%, and operating income was up 52% and then down 8%.
Perhaps if one really delves into this industry, it is possible to make revenue and expense predictions that enable a solid net present value calculation. Perhaps. Or perhaps no one really knows what future free cash flows are likely to be. If free cash flows of $900 million per year (or even half that) are likely to continue, then the current stock price is cheap. But as long as publishing is half of Gannett's business, and the whole newspaper industry is still searching for a working business model, I don't see how one can be at all confident in predicting cash flows.
All in all, I think Gannett is probably cheap at the current price, and perhaps a reasonable bet for a hedge fund with a big appetite for risk. However for a conservative investor who wants a margin of safety, the right course is probably to watch the transition a while longer, and re-evaluate when the new business model is a little clearer, and it looks as if cash flows can be predicted with some level of confidence.