Philip O'Sullivan's Market Musings

Financial analysis from Dublin, Ireland

Hanging up the keyboard

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I have been appointed Chief Economist at NCB Stockbrokers, which has recently become part of the Investec family.

 

Due to the time commitments that my new role entails, I will no longer be able to post updates on this blog.

 

I’d like to take this opportunity to thank  those of you who visited this site – I hope that you found it to be of value.

 

Should you wish to keep up with my ‘musings’, these can be read on the NCB website.

Written by Philip O'Sullivan

October 6, 2012 at 9:48 am

Posted in Sector Focus

Market Musings 19/9/2012

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It’s been a busy couple of days on the newsflow front, with a lot of the Irish smallcap exploration names prominent in this regard. Let’s round up on what has been happening since my last update.

 

To kick off with the energy sector, Kentz was awarded a $50m shutdown services and operations support contract by Exxon in Sakhalin, far-east Russia.

 

 

(Disclaimer: I am a shareholder in PetroNeft plc) Siberian oil producer PetroNeft released a reassuring update this morning, which revealed that output is steady at 2,000 barrels of oil per day, while early results from the Arbuzovskoye well 101, the first of ten planned new production wells on the Arbuzovskoye oil field, are encouraging. We should see a marked pick-up in newsflow from this stock over the coming months as the Arbuzovskoye campaign gathers momentum.

 

Elsewhere, Petrel Resources announced a “new start” in Iraq, with a new team in place that will “work with national and regional authorities in Iraq to identify projects in which Petrel can be involved”.

 

Providence Resources provided an update on its Rathlin Basin acreage. While this project is very much at an early stage, the company has identified a number of anomalies that it will now focus on evaluating.

 

In other resources related news, there was an interesting backward integration move by Samsung, which has invested in a gold mine in exchange for getting a cut of the output. This follows Delta Air Line’s recent purchase of an oil refinery, and may mark a shift by companies to ensure greater security of supply of key inputs and/or margin capture by buying key suppliers.

 

(Disclaimer: I am a shareholder in Smurfit Kappa Group plc) There was further M&A activity in the European packaging sector, with Mondi acquiring Duropack’s German and Czech operations for €125m. This is extremely welcome on two counts. Firstly, the European packaging sector has traditionally suffered from overcapacity and volatile pricing, but as I have previously noted, in recent times there has been a wave of consolidation in the industry. This should lead to more rational pricing and supply policies going forward, which will lift profitability across the sector. Secondly, from a Smurfit Kappa Group perspective, the multiples these deals are being done at highlight the value in the stock. As Davy note, using the Mondi-Duropack multiple would imply an equity value of €11.30 a share on SKG, well ahead of the €7.60 it is trading at this morning.

 

In other Smurfit Kappa news, following a recent similar move the company announced the sale of €250m worth of senior secured floating rate notes due 2020. The proceeds will be used to pre-pay term loans maturing in 2016/17 and while they will not make a significant dent in interest costs (the new notes will pay 3 month Euribor +350bps, versus the 3 month Euribor +362.5-387.5bps the term notes pay) they do push out the average maturity of the group’s debt, thus reducing the risk around the company and giving it enhanced financial flexibility.

 

In the food sector, Origin Enterprises released its full-year results this morning. These revealed a solid performance by its core agri-services business, with like-for-like operating profits up 7%. Net debt has fallen sharply to €68m compared with €92m a year earlier, which reflects the strong cash flow generation of the business (free cash flow was circa €70m, which implies a FCF yield of 12% or thereabouts). Given this, management has upped the dividend by 36%, which moves dividend cover from last year’s 4x to 3x now. Overall, these are solid results from Origin and shareholders (not least its majority owner Aryzta) will no doubt welcome the significant increase in the dividend.

 

(Disclaimer: I am a shareholder in Independent News & Media plc) There was some unexpected fall-out from the Irish Daily Star’s (appalling) decision to publish pictures of the Duchess of Cambridge, with 50% owner Richard Desmond saying that he would take “immediate steps to close down the joint venture“. This is easier said than done, given the troubles this would involve with redundancies, property leases, a loss of profits and printing contracts. While there has been speculation that this could be a stroke by Desmond to replace a 50% owned JV with his 100% owned UK Daily Star in the Irish market, I can’t see INM abandoning its sole presence in the national daily tabloid space. So, either this dispute is settled amicably (perhaps with INM agreeing a call option to buy out Desmond?) or not, in which case INM will likely launch a new tabloid (using a different title, as Desmond owns the rights to the Daily Star name) which should be able to more than hold its own against any imported competitor whose relevance to the Irish market could well prove to be uncertain.

 

In the blogosphere, Lewis looked at Wincanton, with his blog providing enough to persuade me that I don’t need to look at it in more detail!

 

And finally, if you’ve ever wanted to learn more about money and banking, UCD’s top-rated Professor Karl Whelan has very kindly put up his lecture slides from a course on this very topic.

Daily Mail and General Trust (DMGT.L) – Making The Right Choices

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At DMGT’s investor day last April, the group’s finance director, Stephen Daintith, outlined the investment case for the group. He said that it offered investors:

 

  • [An] opportunity to invest in a global portfolio of diversified market-leading media assets
  • Good organic growth opportunities – strong B2B pipeline, fast emerging consumer digital businesses and resilient national newspapers
  • [A group that is] highly cash generative
  • [A track record of] investment of strong cash flow and active portfolio management to drive sustainable earnings growth
  • [An] impressive track record of real dividend growth

 

(Disclaimer: I am a shareholder in Trinity Mirror plc and Independent News & Media plc)  In this piece I will examine all of these stated claims in turn, and also make a few observations comparing DMGT to its principal quoted peers in the UK and Ireland (which I have previously profiled e.g. Independent News & Media, Trinity Mirror and Johnston Press).

 

To start with, DMGT is correct to say that it offers “a global portfolio of diversified market-leading media assets”. While most people will be familiar with its national Daily Mail newspaper title, far fewer people will know that national media operations account for only 43% of group revenues. Indeed, DMGT’s combined national and local media units contributed only 55% of group revenues in FY11, down from 65% in FY06. The diminished importance of its core media base is further highlighted when underlying profits are examined, contributing just 29% of the group total in 2011, from 60% five years earlier.  Outside of national and local media assets, the group’s other businesses are: (i) RMS, or Risk Management Solutions, which provides “products, services and expertise for the quantification and management of catastrophe risk”. In 2011 this contributed 8% of revenues and generated margins of 29.9%; (ii) Business Information, which provides B2B “information to the property, financial, energy, and educational recruitment markets”. In 2011 this contributed 12% of revenues and generated margins of 19.7%; (iii) Events, which organises exhibitions and conferences, and which contributed 7% of revenues and enjoyed margins of 29.4% in 2011; and (iv) Euromoney, described as “a leading international business-to-business media group focused primarily on the international finance, metals and commodities sectors”, which contributed 18% of group revenues and achieved margins of 25.6% in 2011. These high-margin businesses stand out in contrast to the traditional base, namely the national media (margins of 8.8% in 2011) and local media (margins of 7.2% in 2011). It should be noted that these units do not solely comprise print assets, as they are also home to a number of digital business, including the wildly successful (and profitable) Mail Online.

 

In terms of growth opportunities, DMGT has excelled throughout the downturn. While the headline figures are distorted by the impact of the portfolio management measures discussed below, overall margins in the newer business areas have trended higher during the recession, while the topline performance has also been very resilient. In the case of the legacy businesses, these have experienced pressures similar to the rest of the sector. The national media operation has seen reported revenues and operating profits fall by 10% and 24% respectively between 2006 and 2011, while for local media the decline has been 48% and 81% respectively over the same period. The latter has been the subject of speculation in recent times about a possible disposal, with acquirers ranging from private equity to Trinity Mirror reportedly in the frame. I will discuss the merits of such a deal towards the end of this piece.

 

Switching to DMGT’s cash generation, this is a key bull point around the stock. Over the past 6 years the group has generated over £1.6bn in cumulative free cash flow, or circa 90% of its current market capitalisation. This has funded considerable investment in growing the business, with £908m of this cash used on acquisitions, £362m on gross capex and a further £63m invested in associates and JVs.  DMGT also paid out £332m in dividends over that period.

 

This brings us on to the next point, about portfolio management. As noted above, the group has been an active acquirer of assets, but it is not shy to divest non-core businesses. It recently concluded the sale of its Australian radio business, but this has only been one of a number of disposals in recent years (see slide 16). It is clear that DMGT is focused on increasing its exposure to high-margin, high-growth business sectors, and given the high margins and resilient sales in the ‘newer’ business areas noted above, who could blame it?

 

Lastly, DMGT distinguishes itself from the other listed UK and Irish companies who derive the majority of their revenues from media assets in that it is the only one that pays a dividend. Investors have seen dividends per share grow 25% between 2006 and 2011 – with no break in the payouts over that period – which is a remarkable achievement considering the economic backdrop. Dividend cover is very healthy, approaching 3x in 2011.

 

So, Mr. Daintith is clearly on the money with what he says. The questions that remain for me are: (i) What is DMGT to do next? and (ii) Is DMGT worth investing in?

 

To tackle them in order, one would be forgiven for thinking that ‘keep going’ would be reasonable advice for Rothermere et al. The company has clearly made the right choices in terms of diversification, investing in highly profitable and growing segments. The balance sheet is in a strong condition, with reported net debt falling from £1.05bn in FY09 to £720m by the end of last year (2x EBITDA). In the absence of any large acquisitions DMGT could very easily be debt free within 3 years. So, it has the luxury of not being compelled to do anything. However, given the portfolio management steps noted above, I imagine that sitting still is not something the management team is keen on. Further investments in growing the high-margin segments are surely to be expected, while for the legacy businesses we are unlikely to see much by way of acquisition activity given both the concentrated media ownership at a national level (and lack of obvious sellers) and the muted organic growth outlook for local papers. The group also has a number of joint ventures and associates that it may be tempted to fully buy-out / spin-off over time.

 

While DMGT is by no means under any pressure to do so, I suspect that we are likely to see the group divest the local media business, Northcliffe Media, over the medium term. It is an increasingly peripheral asset, accounting for only 5% of group underlying profits last year. Management are over a third of the way through a three-year restructuring plan for the division, and it will be interesting to see if it is still under DMGT ownership by the scheduled conclusion date of it. Whatever about its performance relative to the rest of the DMGT family, it is underperforming its listed peers, with operating margins of 7.2% in FY11 comparing unfavourably to Trinity Mirror’s 13.8% and Johnston Press’ 17.3%. I wonder (emphasis) if developments such as a recent advertising partnership indicate that DMGT would be open to resuming its previous reported talks with Trinity Mirror about a merger of their local newspaper titles (DMGT’s assets are profiled here, while TNI’s are profiled here). This could open up possibilities for cost take-outs in areas such as procurement, distribution, content syndication and editorial. Given both firms’ balance sheets, an all-share deal could be the best scenario for both as it would allow Trinity Mirror to continue its deleveraging drive while DMGT, which has no pressing need for extra funds, could share in the theoretical upside once the cost synergies noted above are implemented. Of course, this is clearly ‘fantasy M&A’, but it would offer an elegant solution for both companies. In terms of other speculated ‘interested bidders’, I would be surprised if private equity was seriously interested in DMGT’s local newspaper titles given their muted growth outlook, unless other large groups became available that would permit the achievement of serious synergies such as those mentioned above.

 

In terms of my investment conclusion on DMGT, I note that analyst opinion on the stock is divided. Of the 15 analysts who follow the stock 5 rate it a ‘buy’, 5 are neutral and 5 recommend that it be sold. This may be because the stock is not exactly cheap, trading on around 10x prospective earnings based on where the ‘A’ shares closed at this evening (488.5p). Recent updates from the company have been solid, with the Q3 IMS reiterating full-year guidance. For me, I view the DMGT story as one of a group that: (i) is on a solid financial footing + (ii) is mainly exposed to high-growth, high-margin business areas + (iii) has an enviable track record – on this note, I was impressed to see that it has not made a capital call on its shareholders since 1933 + (iv) has plenty of strategic options be they acquisition/investment/alliance/divestment to enhance shareholder value. Were the shares more cheaply rated, I would be tempted by it. However, for now I think I’ll hold back and wait for a more attractive entry level.

Written by Philip O'Sullivan

September 17, 2012 at 7:08 pm

Market Musings 15/9/2012

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It’s been an eventful few days since my last ‘general’ round-up on what’s been happening in the markets, with the Federal Reserve further opening the monetary sluices and continued positive developments around Ireland Inc (a well received sale of bills, positive noises from the IMF, soaring bond prices etc.)

 

For me, the central message to take from these markets at this time is that the monetary authorities on both sides of the Atlantic stand ready to do ‘whatever it takes‘ on the policy front. This is unambiguously bullish for a number of asset classes, in particular equities (in general) and commodities (including gold, which I’ve been a bull on for some time), however, it also has other consequences that are worth bearing in mind. While the growth outlook is concern enough in itself, the main overall threat in the system (in my view) remains on the prices front, as an enthralling battle takes place between the forces of inflation (central banks’ printing presses) and deflation (private sector deleveraging). Which force is likely to prevail? The old rule of “Don’t bet against the Fed” comes to mind. This to my mind puts the onus on investors to position themselves accordingly. We have seen from the share price reactions to Helicopter Ben’s latest move how they should do this, with mining stocks (e.g. commodity plays) surging, financials pushing higher (anything that pushes up asset prices a positive, while the funding outlook is improved) and a lift in those highly leveraged stocks operating well within covenants and who may take the opportunity to refinance at even lower rates as yields are pushed down elsewhere by central bank intervention (a good example being Smurfit Kappa Group, which I hold, whose balance sheet is to my mind still very much misunderstood by the market, and which rose 13% on 11 times average daily volume in Dublin yesterday as more investors wake up to to the story). Of course, it is also worth bearing in mind that higher commodity prices are likely to hurt a lot of stocks that are price takers on the input side and who will struggle, due to the tough economic backdrop, to pass on higher input prices to consumers.

 

In terms of my own response to all of this, I have been stepping up my exposure to financials, trebling my stake in Bank of Ireland and significantly increasing my exposure to RBS (which is now my third-largest portfolio position). The recent surge in the value of Irish government bonds prompted my Bank of Ireland move, given that BKIR held €5,945m worth of them at the end of June (up to €1.5bn of which were acquired following the LTRO earlier this year). As the notes to BKIR’s interim results show (see page 99), the vast majority of these are in the books on a ‘Level 1′ fair value basis, i.e. “valued using quoted market prices in active markets”. Given the recent lift in Irish bond prices, this should have a positive impact on Bank of Ireland’s NAV, given that “any change in fair value is treated as a movement in the [available for sale] reserve in Stockholder’s equity”. Elsewhere, in the case of RBS, the IPO of its Direct Line business and recent moves towards agreeing financial settlements for Libor and IT issues indicate that the narrative around the group may be about to radically shift, as I noted in a recent blog post.

 

(Disclaimer: I am a shareholder in Datalex plc) In other news, travel software company Datalex confirmed that interim CEO Aidan Brogan is to get the job on a permanent basis. This is a sensible decision. Aidan has been with the firm for almost 20 years, and his strong background in sales is likely to help Datalex build on its growing list of clients.

 

Elsewhere in the TMT space, Johnston Press has reportedly delayed its relaunch programme. You can read my recent piece on the firm here.

 

(Disclaimer: I am a shareholder in France Telecom plc) And in other TMT news, the team in aviate came up with an interesting angle on Apple’s latest toy, namely that “in the European launch only Deutsche Telkom and France Telecom were given the hallowed LTE version of the iPhone 5“. I must confess that what I know about ‘fashionable’ mobile phones could fit on the back of a postage stamp, so hopefully one of my kind readers will let me know if this is a significant advantage over other carriers or not!

 

In the energy sector, consolidation has been a big theme this year, as cash-rich majors have snapped up financially constrained small cap names with proven resources. This clip suggests that the trend has further to run (and indeed, assuming the latest QE moves push up oil prices, this will provide the large caps with even more cash to play around with).

 

In the blogosphere, Lewis profiled Impellam. Elsewhere, John took a good look at Rolls-Royce.

Written by Philip O'Sullivan

September 15, 2012 at 12:01 pm

STV Group (STVG.L) – Tidied Up, So What’s Next?

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Back in 2006 STV was a diversified media group, with a presence in television, outdoor advertising, radio and cinema advertising. Its total group turnover that year was £191.2m, underlying operating profits were £18.4m, net debt was £157.3m and total assets were £313.4m. Despite the strong asset backing, debt was an uncomfortable multiple of cashflow, prompting management to take action to fix the balance sheet.

 

Since then, the group has sold its outdoor business, Primesight, radio unit, Virgin Radio and cinema business, Pearl & Dean. These disposals produced gross cash inflows totaling £94.2m. STV raised a further £91m from a rights issue in 2007. However, the significant restructuring did not come cheaply, with the group seeing a cash outlay of £35m on exceptional and other one-off items, while a net £14m in cash was expended on discontinued operations over the period to the end of 2011. Net debt was reduced by two-thirds since the end of 2006, to £54.5m at the end of last year.

 

So, the group now is a slimmed down operation focused on television. It holds two of the 15 Channel 3 licences, covering northern and central Scotland. The other franchises are held by UTV Media plc (one, Ulster) and ITV plc (the other 12). In 2011 it generated turnover of £102m (consumer £93.6m / productions £8.4m) and EBIT of £15m. That year it tidied up a legacy legal dispute over content with ITV, while this improved relationship was further cemented with a new networking agreement signed this year between the three Channel 3 licence holders.

 

So, with the business simplified and legacy issues resolved, where next for STV? As slide 26 of this presentation shows, it aims to grow ‘non-broadcast’ (digital and production) earnings to represent a third of group earnings, double STV Productions’ revenues, be the most used digital service in Scotland, launch two new market-leading digital consumer propositions and maintain its position as the “Voice of Scotland”. These are, as STV itself says, “ambitious but achievable” goals. Digital enjoyed margins of 33% in H1 2012, producing operating profits of £1m, or 12.5% of the group total. Given Productions’ low revenue base, doubling it should not prove too big an ask. Moreover, while advertising conditions remain challenging in the UK, any improvement over time should have a positive effect on earnings given the operating leverage inherent in the broadcasting business.

 

But will it have time to implement these goals? Last year ITV bought Channel Television, which held one of the 15 Channel 3 licences. This gave rise to speculation (such as here and here) that it could move to buy out the remaining ‘independents’. ITV certainly has the resources to do so, given that at the end of 2011 it had gross cash of £801m and net cash of £45m. But would a deal make financial sense? I note that in 2011 ITV generated an impressive ROCE of 18.6%. Assuming that it would want at least that from a deal with STV, this would imply an enterprise value for STV of £80.5m (based off STV’s EBIT of £15m). Strip out STV’s end-FY11 net debt and pension deficit (£54.5m and £30.9m respectively) and you’re left with effectively nothing for the equity. However, this doesn’t include the likely synergies that would arise from such a tie up. If you assume ITV could eliminate 10% of STV’s costs (that sounds punchy, but in cash terms it’s less than £9m) and also save on the £1.4m in directors’ emoluments, you can get to an equity valuation of circa £50m, or £1.26 a share – that’s around 50% upside to where the shares are currently trading at (£0.842). Moreover, as the company continues to pay down debt, there will be a further transfer of value from debt holders to equity holders (its underlying operating cashflow is circa £10m a year, or around a third of its market cap). My estimates do not look demanding at all, given that Numis (140p) and Peel Hunt (216p) have far higher price targets.

 

If a deal fails to materialise, investors in STV will be left with a stock that is trading on a forward PE of just 2.5x that: (i) with the ITV litigation out of the way is now poised to seriously start to pay down debt (net debt / EBITDA was 3.2x in FY11); (ii) offers a good possibility of dividends being reinstated (an update on dividend policy is guided for February) to compensate shareholders for their loyalty; and (iii) is well-placed to benefit from an eventual recovery in advertising markets.

 

So, either way it seems the outlook is positive for STV. You can look at this as a story of either: (a) debt paydown and a future recovery in advertising markets driving an eventual re-rating off a low base; or (b) an opportunity to get in cheap for what could very easily become a takeover candidate for ITV. I like the look of this one, and I think I’ll add it to my portfolio.

Written by Philip O'Sullivan

September 12, 2012 at 11:18 am

Posted in Sector Focus

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Market Musings 10/9/2012

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This is a bit of a hotchpotch of what has been catching my eye over the past few days.

 

To kick off with construction, Abbey announced the results of the mandatory offer from Gallagher Holdings. The latter has raised its stake in the housebuilder by 10.7ppt to 72.6%. This is not enough to force a compulsory acquisition of the balance of the shares, so the stock will retain its listing. In the run up to the deadline, I had struggled about what decision to take about my own holding in the company. While the bid from Gallagher represented a nice exit price on a stock I purchased for only €4.60 a share, it was pitched at a disappointingly wide discount to NAV. In the end, I elected to take the cash, on the grounds that I didn’t want to stick around in a stock that has now arguably moved from ‘quite illiquid’ to ‘extremely illiquid’ (!), which makes it unappealing to many institutional investors. However, I may well re-enter the sector in the not too distant future given that the long-term drivers of growth are very much intact (a very old housing stock, net inward migration, severe pressure on housing in the South-East of England).

 

In the food sector, Investec argues that Premier Foods faces ‘death or glory’ by 2014. Elsewhere, NCB issued very different (in tone) reports on Aryzta and its majority-owned associate, Origin Enterprises. On Origin, NCB argues that weather and FX should provide a tailwind to earnings, while on Aryzta, NCB makes a persuasive argument that it may not hit its 400 cent earnings target for 2013.

 

(Disclaimer: I am a shareholder in Harvey Nash plc) In the recruitment space, SThree released an interim management statement that revealed slowing growth. On an annual basis its gross profits rose 6% in Q3 2012 (in constant currency terms) of its financial year (i.e. to end-August), down from +15% in Q1 and +9% in Q2. Drilling down into the numbers we see it has experienced weakness in both the UK & Ireland and ICT, with other areas performing more resiliently. The slowdown in the headline growth rate was, unsurprisingly, explained by “the difficult macro economic backdrop”, but SThree’s resilient overall performance highlights once more the importance at this time of choosing recruitment stocks that offer diversification (both by industry segment and geographic), an attractive dividend and a strong balance sheet. This is what attracted me to recently buy into one of its peers, Harvey Nash. I hope to find the time to research all of the stocks in the sector that fit this bill over the next while.

 

(Disclaimer: I am a shareholder in Bank of Ireland plc and RBS plc) There were a few items of note in the financials space. I saw a very bullish MarketWatch piece on Bank of Ireland, which served as a reminder that while a lot of the domestic commentary is ‘doom and gloom’ oriented, many international observers are bulled up on Ireland Inc (Franklin Templeton’s bold Irish sovereign debt move is a good example of this, as is this favourable coverage from CNBC). In other sector news, RBS is planning to shut down its precious metals trading unit, while it has also ceased commodities research. The FT also reported that it is nearing a Libor settlement with US and UK authorities, which would remove another legacy overhang from the group, which remains on my watch list. Finally, I offloaded my second biggest holding, Standard Life, which has had a great run of late and is no longer (in my view) in ‘cheap’ territory.

 

(Disclaimer: I am a shareholder in Trinity Mirror plc) I was pleased to see that new Trinity Mirror CEO Simon Fox has been set very demanding bonus targets based on the share price performance of the group. It is good to see a remuneration committee flex its muscles in this regard, especially in a way that ensures investors’ and management’s interests are very highly aligned.

 

In the blogosphere, John Kingham says: “When I look at BT I see a company and an investment that screams mediocrity“.

Written by Philip O'Sullivan

September 10, 2012 at 2:40 pm

Johnston Press (JPR.L) – Negative Equity

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As everyone who invested in Irish property over the past decade or so knows, equity is the difference between the value of your total assets and the value of your total liabilities. Another thing that every Irish property owner knows is that while the ‘value’ of your total assets can often be subject to wild swings either to the upside or downside, liabilities are much stickier. And as it is with property, so goes the traditional print media space, where investors have seen accountants significantly write down once extremely valuable newspaper assets, while debt levels have proven immune to such accounting adjustments.

 

(Disclaimer: I am a shareholder in Trinity Mirror plc and Independent News & Media plc) I have previously profiled two newspaper groups with a presence in the UK and Ireland, Trinity Mirror and Independent News & Media, in detail. In both cases, concerns around debt levels and extremely challenging (due to both cyclical – the economy – and structural – the threat of new media) market conditions have been to the fore. While the economy remains a headwind, both have made significant progress in improving their balance sheets. Trinity Mirror is the exemplar in this regard, cutting net debt by a third between FY09 and FY11 (to £201m), without recourse to its shareholders, while over the same period its net assets have risen by 38% to £675m. Over the same period INM has cut its underlying net debt by 26% to €427m (its movement in net assets is not particularly meaningful due to the impact of the deconsolidation of its Australasian business and other disposals).

 

Today I look at one of their peers, Johnston Press (JPR), which has faced similar balance sheet and economic pressures in recent years. The group publishes 13 daily newspapers, ‘more than 230′ weekly newspapers, ‘glossy monthly lifestyle magazines’ and 223 local websites in the UK and Ireland. Its flagship brands are The Scotsman and the Yorkshire Post, while Irish followers of this blog will be familiar with titles such as the Leinster Leader and Kilkenny People.

 

It has faced what can only be described as savage pressure on revenues due to the recession. Between 2007 and 2011 its total advertising revenues declined by 47% to £231m. All categories have been impacted by this, with employment advertising -75%, property -62%, motors -49%, ‘other classified’ -26%, display -24% and Ireland -63% over that period. Revenue from newspaper sales has held up much better, falling only 7% to £96m, while over the same period its very profitable contract printing business has seen revenues fall 23%.

 

In total, the group saw revenues fall £234m over the 4 years to 2011. Half of this was offset through reduced operating expenses, but the remainder hit the bottom line, with operating profits falling over 60% over the period to £65m. The diminished profit outlook has seen JPR book impairments against its intangibles (chiefly, the print assets) totaling £720m since the start of 2006.

 

This brings us back to the housing analogy of the opening paragraph. Due mainly to the impairments noted above, the book value of JPR’s assets has fallen by nearly half – from £1.9bn to just under £1.0bn – since the end of 2007. At the same time, the company’s level of gearing has risen from 98% in FY07 to 126% at the end of last year. It should be noted that net debt, in absolute terms, has been falling (FY07: £671m, FY11: £359m), helped by share sales totaling £207m over the past 4 years. Despite that decline, at the end of last year net debt stood at 4.1x EBITDA, which is an uncomfortably high multiple.

 

Earlier this year the group agreed the amendment and extension of its finance facilities until 30 September 2015. While this facility reduces the near-term risks around the group, it does not come cheap, as shown in this extract from JPR’s H112 results release:

 

The maximum cash margin in the case of the bank facilities is LIBOR plus 5.0% and in the case of the loan notes, a
cash interest coupon of up to 10.3%. In addition to the cash margin, a payment-in-kind (PIK) margin of a maximum
rate of 4.0% will accumulate and is payable at the end of the facility. If the loan facilities are fully repaid prior to
31 December 2014, the rate at which the PIK margin accrued throughout the period of the agreement will be
recalculated at a substantially reduced rate.

 

Looking through JPR’s accounts shows the diminished flexibility imposed on the group by its borrowings. Between 2009 and 2011 it generated some £227m in operating cash flows, but of this 37% went on interest payments and another 58% on repaying borrowings, loan notes and reducing the bank overdraft. This leaves very little for investment, and I was unsurprised to see capex average only £3m per annum over the period, down from an average of £40m per annum over the preceding 3 years. Given the ‘incentive’ to repay (or, as seems more likely, refinance) the facilities before the end of 2014, I would expect to see more of the same over the coming years. Which means no dividends (extremely unlikely in any event given the large stock of debt outstanding), no (meaningful, at least) acquisitions and limited resources (as I see it) for the group to effectively execute its digital-led strategy. On that note, while digital represents the great hope for traditional media, monetising it is proving a challenging task – in FY11 digital advertising contributed only £18.4m of JPR’s revenues, a rise of circa 20% on 2007 levels.

 

In terms of the valuation, at first glance Johnston Press appears very cheap, trading on less than 2x prospective earnings at its current share price (5.85 pence). However, it is important to note that the group comes with considerable net debt (£332m at the end of July) and a large pension deficit (£102m at the end of June). I ran a DCF valuation on the group using my usual 10% discount rate and applied a -2% terminal growth rate, which produced a negative equity value of -27.5 pence a share. However, it should be noted that this estimate is extremely susceptible to changes in the inputs – for example, every £10m move in the pension deficit moves my equity value by 1.6p. Excluding the pension deficit altogether (I always include it in my DCF calculations) produces a valuation of circa -11p a share. But if Johnston Press really has a negative equity value (in practice, zero, given that a share price can’t go below that!), then why is the share price at 5.85p and not closer to zero? I imagine that investors are betting on an eventual cyclical recovery in advertising, and I can understand why they would be making that bet – as I note above, while advertising revenue has effectively halved from the peak, newspaper sales has fallen by less than a tenth over the same time period, which to me indicates significant operating leverage that could accelerate debt paydown and transform the share price outlook if advertising was to stage a recovery.

 

Overall, my sense is this – if there is life in traditional print media (and I believe there is, hence why I’m long two stocks in the sector), Johnston Press represents a very high risk way of playing that theme. I feel that its hands are tied by its legacy debts, which limits the scope for investment, and there is a danger that equity investors could be significantly diluted (the firm has already agreed to issue warrants totaling 12.5% of its share capital to its lenders). Of course, were the outlook to improve, then the implied equity valuation would recover in tandem with that. However, at this time I see nothing in JPR to justify adding it to my portfolio either instead of or alongside my existing UK print media holding, Trinity Mirror. Both stocks are exposed to the same macro trends, but their balance sheet positions are fundamentally different - at the end of FY11, JPR’s net debt / EBITDA was 4.1x, while for Trinity Mirror it was just 1.6x. My thesis for some time, given the structural long-term decline that is underway in the print media sector, is that the financially strongest will be able to mitigate against a shrinking revenue pie with market share gains as weaker competitors close underperforming titles. Given that stance, I am happy to be a shareholder in the UK’s biggest regional press publisher, and not in the third biggest one.

Written by Philip O'Sullivan

September 9, 2012 at 6:02 pm

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