Making It Second Nature

Someone who reads the blog sent me this email:

Hi Geoff,

The thing I have been pondering is what are the tools in valuing a shrinking / dying business. The one I have been looking through is Journal Communications (JRN). 

They trade under their book value, but only half of that is tangible so the market price would be about 1.5x tangible book. Most of that is PP&E so definitely no net-net situation. The bright side is that if you own 33 radio stations, 13 TV stations & a bunch of local newspapers there has got to be some intangible value there. Is it worth the 110m in the books is a whole other story.

I’m a bit stuck as what should I use to value the business. If I just take the average 10% FCF margin, apply that to current year revenues of ~370 & discount that to perpetuity with 22% (which is basically a hurdle rate of 10% + historical shrinking rate of revenues ~10-12%) I get something in the range of the current market valuation. The problem is that in real life your depreciation can´t exceed cap-ex till the end of days (if we ain´t liquidating) so the FCF would need to start to come down when they have to start to upkeep their PP&E. On the other hand the management has shown that they can keep ROE reasonable so the raising of cap-ex wouldn´t be such a bad thing IF they could maintain those revenues.

On second thought, am I barking the wrong tree here. Should I focus on the intangibles? I’m pretty sure the company is at least worth its book value (including the intangibles).

What got me to think about this was your article on Asset-Earnings Equivalence. Simplified I just see a lot of assets that have been historically successfully converted into cash (ok so there have been a couple of crappy acquisitions as always the case).

Best Wishes,
Pekka

One of the people I email back and forth with quite a bit is Gurpreet Narang. Here is his write-up on Journal Communications.

Gurpreet Narang's Report on Journal Communications (JRN)

And now my thoughts.

You're absolutely right when you say:

On second thought, am I barking up the wrong tree here. Should I focus on the intangibles? I’m pretty sure the company is at least worth its book value (including the intangibles).

What got me to think about this was your article on Asset-Earnings Equivalence. Simplified I just see a lot of assets that have been historically successfully converted into cash (ok so there have been a couple of crappy acquisitions as always the case). 

That's really where you turned your thinking in the right direction. Asset-earnings equivalence is the way to understand Journal Communications (JRN). This is both good and bad. On the good side, the asset values – when you actually go out and look at what radio stations and TV stations sell for – are well above the value of the company's stock in the market.

But now the bad news. A company doesn't just earn money on its assets. Its earnings often become more assets. Over time, earnings are reinvested in the business as assets. This is not true of all businesses. The best businesses do not require much reinvestment. But – even when a company does not require reinvestment – management often chooses to reinvest in the field it sees itself operating in.

Many companies don’t define themselves in terms of what drives their profits. We call Google, Microsoft, and Apple tech companies. Really, Google is an advertiser supported media company. Microsoft is a business services company. And Apple is a luxury consumer goods business.

That’s how they make their money. But it’s not where they intend to put their money. They see themselves as tech companies. That tells you what new assets they will buy with their old earnings.

One of the concerns with any business is where the cash thrown off by the assets will eventually end up.

I have no special love for dividend paying stocks. But I do like it when you know – or think you know – where a company will put its cash. I write about a company like Birner Dental Management (BDMS) or Omnicom (OMC) or Fair Isaac (FICO) because I think I know the assets they have and the cash flows they will produce. That’s true.

But there's a bigger point. I think I know where they will put that cash. I think investment outside of their narrow field will be limited. I think BDMS will pay dividends, buy back stock, and buy or open some dentist offices every year. I think Omnicom will acquire some ad agencies – but will ultimately decide it can't reinvest most of its earnings. I definitely think that is true at FICO. Especially under the management that came in a couple years back.

What does this have to do with Journal Communications?

Everything.

Journal Communications is named for the Milwaukee Journal Sentinel. It is largely owned by employees. It only became a publicly traded company – with different classes of stock – in the last decade.

This is a business tied to newspapers. If you could separate that newspaper I would feel fine about the business. If you had Warren Buffett or Henry Singleton running the place, I'd feel fine.

The theory that you could reallocate cash flows from the newspaper, radio, and TV stations into buying more TV stations – that’s a great theory.

The math on that theory works.

But it's a theory. And I worry that it won't pan out in practice.

The key here – as in my Barnes & Noble (BKS) mistake – is the human element.

Just how much were they willing to sink into the Nook? As it turns out, B&N seems willing to sink years of free cash flow from the stores into the Nook if that's what it takes. They'll end up spending a good portion of the entire market cap of the company on this device. And you may have noticed Amazon came out with something even newer and better called the Kindle Fire. Amazon will keep doing this every year. Barnes & Noble will need to spend a lot to stay in place. That’s not the kind of business you want to own.

It will earn a lot. But then it will go out and blow those earnings.

We have the same sort of problem here.

The newspaper is making money. But it won't keep making money.

Newspapers in the U.S. only work as dominant local papers. They are advertiser supported. The death of classified advertising as much as circulation declines killed these papers.

This is sometimes misunderstood. People say that you have to make Americans learn to pay for their news again. The problem with that idea is that Americans never paid for general news. No one in the U.S. actually paid for the cost of their news. Subscribers paid maybe 25 cents per dollar of a newspaper company's revenues. That's less than half what it cost to produce the paper. You would've had to more than double the price of papers just to run them as non-profit enterprises. It was never about readers alone. Readers never valued newspapers enough to make them profitable. Advertisers valued readers. And newspapers had readers. So advertisers valued newspapers.

It was about having the biggest megaphone in town. And renting that megaphone out to advertisers. That's how profitable papers worked.

Online media works the same way. The business of Google, Facebook, etc. looks exactly like the business of local media. It just isn’t local. But you still have to be either broad and dominant or narrow and necessary.

The Milwaukee Journal Sentinel was broad and dominant. It was the Buffalo Evening News of Milwaukee.

That’s changed. The advertisers have moved on. The readers have moved on. The paper is making money for now. But it’ll start losing money soon. It could conceivably lose a lot of money. Exactly how much money it loses depends on how much the parent company is willing to subsidize losses in the newspaper with profits in TV and radio.

That's the question you should focus on here.

Do I understand this company? Its management? The culture?

How do they see themselves?

Do they have an interest in running a money losing paper for years and years as long as shareholders can subsidize those losses with TV and radio?

That's the question.

As for the value, it definitely exceeds the stock price.

If you had control of the company, you could profitably increase its value far beyond the current market cap. All you need to do is starve the newspaper, keep the balance sheet clean (a big advantage over JRN's competitors), and take the cash flow from radio and TV and direct it away from newspapers and toward intangible media assets that might actually hold their value over time.

This news about McGraw-Hill selling their TV stations to Scripps for $212 million might help you value that part of JRN's business.

Scripps says the effective price is really $190 million because of tax benefits. Scripps also says this is 8 times cash flow.

I would look at the price-to-sales multiple for something like a TV station. Free cash flow margins are very high at TV stations. The amount that needs to be reinvested is minimal. It's like having a government charter to exploit an area.

The multiple here is basically 2 times sales. If you believe Scripps about tax advantages the $190 million price tag is 1.96 times the $97 million in revenue those stations had. We can apply the same roughly 2 times multiple to JRN's TV stations – which had revenue of $105 million last year – and get a value of about $210 million for the TV stations JRN owns.

That just gives you some idea of how much these properties might be worth. You can do the same thing with the radio assets by searching Google News for reports of radio station sales or by checking the enterprise value to sales ratio for pure play radio station companies in the U.S.

All of these companies are heavily indebted. That's one of JRN's big advantages. Almost no one who just owns TV stations or radio stations in the U.S. has a clean balance sheet. They are totally unprepared for any long-term downward trend in station revenues. And they may become motivated sellers at some point.

This would be a big plus for JRN. If they were going the route of shutting down the newspaper when its time came and focusing on other media assets.

That’s the big question in this investment.

It's easy to fool yourself into thinking people will do the rational thing. Businesses are alleged to be much more rationally self-interested than they really are.

The truthth is: businesses have crazy hopes and fears just like the rest of us.

And they can be just as self-destructive when their identity is threatened.

Talk to Geoff About Journal Communications (JRN)