Lee Enterprises & The Case of the Missing Cash Flows

Why I Took a Small Position in Lee

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On October 13th, I wrote a brief article discussing two companies: Lee Enterprises and Barnes & Noble Education.

Zombie Walking or Phoenix Rising: The possible Resurgence of Two Companies

Right before Lee reported its Q1 2024 results (for the quarter ending in December), I took a small position in the company. In essence, this is already a failure from some perspectives. In the previous post, I mentioned that I would closely monitor both positions to determine if I could feel comfortable owning one of them. Despite the stock continuing to fall after I wrote about it, with prices going as low as 7.90, I did become comfortable with owning Lee. The stock then experienced a 25% rise, reaching 10.83, while I was seemingly idle.

Thesis Recap

Lee operates a network of local small and medium-town newspapers in the US. Similar to the broader newspaper industry, Lee has faced challenges attributed to declines in the physical print aspect of its business model. Despite these challenges, Lee has demonstrated proficiency in expanding and capitalizing on the digital segment of its operations. The company carries a substantial debt load, with an equity value of approximately 60 million against the current stock price and net debt of around 450 million. This debt is characterized by a fixed 9% interest rate and a 25-year term.

The company's long-term fixed-rate debt, featuring minimal covenants apart from a cash sweep above 20 million, affords Lee considerable flexibility in executing its transformation toward a digital focus. The fundamental thesis surrounding Lee revolves around the notion that the company can reduce its debt burden using the cash flow generated by the declining legacy business. Simultaneously, it’s anticipates that revenues and profits will eventually experience an upturn as the digital business becomes more prominent than the legacy one.

Despite the overall strategy, the actual debt repayment has fallen short of shareholder expectations over the past two years, with only 20 million and 7 million allocated to debt reduction in 2022 and 2023, respectively. In this article, I will delve deeper into the cash flow dynamics of this declining business and why I believe debt repayment will re-accelerate.

Lee the Missing Cash Flows

In November 2022, Alden Global made a bid of $24 per share for Lee, which was more than double the current share price. At that time, both the management and shareholders rejected the bid, citing that it undervalued the company. Following this rejection, the stock reached highs in the low 30s but subsequently began a continued decline. This decline was primarily attributed to the aforementioned lack of cash flow generation and subsequent lack of debt repayment, which are likely core elements of most shareholders' investment theses.

Despite Lee reporting "adjusted EBITDA" in the range of $90 million, even after subtracting $40 million for interest payments, shareholders might have expected debt repayment in the range of $30-50 million in 2023. However, the actual repayment was a mere $6 million. This was primarily due to the decline in the print business. While most businesses typically generate more cash as they wind down, collecting receivables without replacing them, the physical newsprint business historically operated differently. It had negative working capital, meaning that most subscribers purchased yearly subscriptions upfront for a small discount. This provided newspaper companies with upfront cash from subscribers to use for their own working capital needs, which were limited anyway.

However, this negative working capital cycle, which resulted in great returns when a company was growing or stable, reversed when the business began to shrink. Now, with Lee's subscribers cutting back on expensive physical subscriptions, the company cannot replace the cheap liabilities their customers used to provide. This has led to a cash outflow. Even subscribers who switch to digital result in a cash outflow. While this may be advantageous in the long term as digital subscriptions are expected to have better margins, in the short term, it depletes cash. Digital subscriptions are cheaper, resulting in cash being eaten in two ways:

1. People who maintain yearly subscriptions pay less upfront due to the lower cost of digital subscriptions.

2. Due to the lower cost of digital subscriptions, fewer people opt to pay upfront, with many choosing monthly payments, leading to worse cash flow dynamics.

The second part of this cash flow issue can be attributed to the much faster decline in the physical print side of the business over the last two years compared to historical norms. This accelerated decline, though easily explained, was poorly communicated by management. While management mentioned discontinuing certain physical advertising products that were no longer profitable, they did not provide detailed explanations of their actions.

Specifically, for most of their smaller papers, Lee discontinued the Sunday edition and transitioned to only three more filled papers a week. This significant change affected many readers accustomed to receiving their daily news, well, daily.

However, with this transition underway, I believe the decline in physical print should return to the more typical rate of 6-7% per year. If this holds true, the decline should have a lesser impact on cash flows from the operation. Additionally, a slower decline in print would necessitate fewer cost-cutting measures compared to the previous year, resulting in reduced restructuring/furlough costs.

The faster-than-expected decline in the print side of the business has also accelerated the company's transition to earning a majority of its revenue from digital sources much sooner than anticipated. According to the latest 8K filing, 45% of the business for the quarter came from digital sources. Management has already indicated a revenue inflection point this year due to the growing digital business being more significant than the declining print business. While I am skeptical of this prediction, I agree with them that this year likely marks the bottom, with revenues projected to grow in the foreseeable future.

As revenues begin to grow again and digital becomes the predominant source, I anticipate the company will continue to expand its margins for some time. Firstly, there are likely numerous costs associated with the legacy print business that can be gradually eliminated. Secondly, there may be room for price hikes on digital subscriptions above inflation levels.

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My thesis revolves around the following set of assumptions:

A: Print will decline at normal rates, rather than the accelerated rates seen in previous years. This will result in reduced cash outflow, attributable to working capital movements.

B: Revenue will inflect next year, driven by digital growth surpassing the decline in print. Consequently, this should lead to expanding margins.

I believe the combination of A and B will lead to:

C: a re-acceleration of debt paydown.

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Considering Lee's current market cap of just ~60m, which reflects a very undemanding valuation, I anticipate a scenario where debt repayment approaches the current market cap. Management is currently guiding for 83-90m in adjusted EBITDA. While I anticipate they may fall short of this guidance, even with 40m in interest payment and 10m in capex, there should be sufficient room for severance costs and cash outflow to the declining print business. Once margins improve and these outflows diminish, I believe annual debt repayments exceeding 40m and growing are easily feasible.

I think Lee turning the corner from melting ice-cube to growing digital business also has the potential to significantly rerate the stock.

Risks

For all the good stuff, I still heavily advise against concentrating into Lee as it is a very risk-levered company. Other than the insane debt pile, some risks include:

1. Un-transparent management that only talks about the digital business, making it hard to understand what is really happening on the print side.

2. A material weakness that has been in place for some time.

3. Google Chrome depreciating third-party cookies. This could be a real hit to the digital advertising, which has now become an important part of the company's business.