On JRN vs. JRC

A few days ago, a reader told me my post on Journal Communications had left him a bit confused. About midway through the article, he was starting to think this might be a good stock to buy. Then, my conclusion caught him a little off guard:

JRN has almost no downside. Sadly, it doesn’t seem to have a lot of upside either. There is a real danger investors will see their returns wither away as the time it takes to realize the value in Journal Communications proves costly. Time is the enemy of the investor who buys this kind of business at this kind of price. Objectively, I have to admit JRN is undervalued. But, I’m not sure it’s grossly undervalued – and I am sure there are better long term investments.

I did not do a very good job of explaining my position.

Journal Communications is undervalued. As I stated, I believe the constituent parts are worth somewhere between $1.25 billion and $2 billion. The $1.25 billion estimate is very low. I think it may be too low.

However, I am very pessimistic about the outlook for the kind of properties Journal Communications (JRN) owns. The company’s earnings power is largely derived from newspapers, network TV affiliates, and terrestrial radio stations. None of these businesses provides a very good value to its customers. I hate to say that, but I believe it’s true.

Although the web’s most conspicuous growth has already come and gone (in the United States), the utility of the web continues to improve. I believe online content will continue to improve in quality and approachability. Local newspapers will operate online sites; but, the economics of such sites will be far less favorable than the monopolies they now enjoy.

Network television has already been weakened tremendously. Its importance to mass audiences will continue to diminish. There is little reason for network television. More fragmented cable and online sources can better exploit niches, whether those niches consist of a certain subject or a certain geographic area. The current network TV model of focusing on programs that can bring in large audiences is a very poor model. I know it has been the model for years. But, it’s flawed. It doesn’t offer value to audiences or advertisers.

Some of today’s most successful advertisers eschew the networks entirely. I don’t think they’re wrong to do so. No network television program is large enough to justly claim a mass audience. So, if it is only possible to advertise to tiny fragments of the public anyway, why not target specific segments yourself?

Networks have an even greater problem with viewers. The great advantage they should have is the cross – selling of their programs and the increased stickiness of their viewers. Unfortunately, they tend to adopt a model that mitigates these advantages. How many networks fill an adequate amount of prime viewing time with interesting, ongoing programming? Look at the schedule for these networks. You’ll notice some big holes in …

On Lexmark (Again)

This completes a day of posting follow ups on companies I had previously discussed. I hope you didn’t mind these quick little reviews. I promise to bring you something new very soon.

Guru Focus is reporting Berkshire Hathaway tripled its stake in Lexmark International (LXK) during the fourth quarter of 2005. Berkshire increased its holdings from one million shares in the third quarter to three million shares in the fourth quarter.

As I mentioned in my earlier post on Lexmark, I believe the shares were purchased by Geico’s Lou Simpson. Lexmark shares currently trade at $46.79; so, the market value of Berkshire’s position is likely less than $150 million. That’s a rather small amount relative to Berkshire’s total common stock holdings.

Lexmark looks like a typical Lou Simpson purchase. However, I have not seen confirmation that this is a Lou Simpson purchase. If anyone has more information on the matter, please comment below or send me an email.

The important question is not who’s buying Lexmark; it’s whether you should be buying Lexmark. I think the answer to that question is yes.

Lexmark has a price – to – earnings ratio of 16, a price – to – sales ratio of 1.04, and a price – to – book value ratio of 3.49. If we knew nothing about the stock, we would probably say the price – to – earnings ratio doesn’t suggest Lexmark is anything special, the price – to – sales ratio hints at a bargain (but only hints), and the price – to – book value suggests the stock is most definitely not underpriced.

Of course, we do know something about Lexmark. We know the company’s free cash flow margin has usually been extraordinary. In 1996 and 2001, Lexmark had a (just barely) negative free cash flow margin. In every other year, Lexmark’s free cash flow margin has been truly remarkable. From 1997 – 2000, the company’s free cash flow margin ranged from 4.71% to 8.24%. From 2002 – 2004 the free cash flow margin ranged from 10.86% to 16.16%. So, we know Lexmark is a special business (or was a special business).

Even over the last twelve months, Lexmark’s free cash flow margin has been much greater than that of the average business. But, we can’t evaluate the company by using the free cash flow margin alone.

For much of the 90s, Lexmark had an average revenue growth rate in the high single digits or low double digits. However, during this past year, revenue has declined for the first time in a long time. What does this mean?

The explanation usually given is that competition has increased in the consumer printer market. HP, Dell, and Canon are the most frequently cited competitors. Will these worthy competitors crush Lexmark?

I doubt it. Lexmark’s expertise in printing is unsurpassed. Only about 50% of Lexmark’s sales and 25% of its profits come from the consumer segment. The Lexmark brand is not well – known to …

On the Journal Register Company

Let me begin with some of the eye – catching metrics that might lead an investor to consider purchasing shares of the Journal Register Company (JRC). This newspaper company has a price – to – earnings ratio of 11.3, a price – to – sales ratio of 0.93, a 5 year average return on capital of 17.6%, and a five year average pre-tax profit margin of 27.4%.

Now, for the bad news. The Journal Register Company has an enterprise value – to – EBITDA ratio of 9.07 and an enterprise value – to – revenue ratio of 2.24. Obviously, this company is carrying a lot of debt. So, perhaps the multiples on the common stock price are deceptive.

How should an investor value the Journal Register Company? Should he use JRC’s market cap or its enterprise value? I have usually encouraged a full and careful consideration of all debt when making any investment. In the case of JRC, such debt makes up a large portion of the company’s enterprise value. Is it really best to lump the debt and equity together to determine the true price Journal Register is selling for?

I think it is.

There are situations in which the leverage inherent in a debt – heavy capital structure works to the benefit of the common stock holder. The most obvious example is a highly leveraged, growing company selling at a bargain price.

The increase in earnings is amplified by the fixed debt, because the debt creates a sort of break even point, much like a traditional fixed cost. Just as greater production can give tremendous benefits to the owner of a large plant, or greater sales can give tremendous benefits to the owner of a large store, greater pre-tax earnings before interest charges can give tremendous benefits to the owners of common stock.

Does this scenario apply to Journal Register? Perhaps, but I don’t think so. Long – term, the economics of the newspaper business will likely be quite poor. Even for Journal Register’s properties, I am projecting a fall in circulation with no end in sight. Some may disagree with this assessment. However, I believe they are being overly optimistic.

Past performance is only a good estimate of future performance insofar as the future resembles the past. I believe the future of newspaper publishing will be sufficiently different from the past to render any estimate of Journal Register’s future performance based solely on its past performance quite inaccurate. So, for the most part, the leverage inherent to Journal Register’s capital structure will be working against the long – term investor.

For all practical purposes, the Journal Register Company’s assets are encumbered. The legal reality is immaterial to the shareholder. The company can not sell off its assets without either paying off its debt or maintaining control over sufficient free cash flow to meet its obligations. Today, money is cheap. It may not be so cheap in the future. Journal Register is insulated from …

Quarterly Newsletter

In addition to this free website, I also publish a (print) quarterly investment newsletter. The newsletter is only distributed to those individuals who pay for a single issue or a one-year subscription.

Each issue of the Gannon On Investing Newsletter consists of a brief commentary on the quarter, a summary of changes to my personal portfolio, and a discussion of the rationale behind each purchase. Most of the newsletter is devoted to detailed evaluations of individual companies.

You may now subscribe to the Gannon On Investing Newsletter via PayPal. I believe this payment option will prove more convenient for most subscribers. Of course, those who prefer to pay by check may continue to do so.

There is no charge for shipping. However, if you are living overseas, and are concerned new issues will not reach you as quickly as you’d like, please send me an email asking for details on international shipping speeds.

Disclaimer
The Gannon On Investing Newsletter is not intended, nor should be used, as investment advice.

Learn more about the Gannon On Investing Newsletter…

Marketocracy Clubs Open

I just want to let everyone know that I’ve changed the Marketocracy Clubs to “open” from “protected”. I was continually accepting applications and yet those applicants were not being admitted into the club. Until Marketocracy fixes this problem, I think it would be best to leave the clubs open to everyone. I don’t expect the open status to cause a problem. I can always exclude members later.

If you applied to join one of the clubs, but have yet to be admitted, please go join that club now. It should work.

Let me know if anyone has a problem with this new arrangement.…

On Overstock’s Fourth Quarter

I know some of you would rather I didn’t keep posting on Overstock. Unfortunately for you, I think it’s one of the best bargains out there. So, I’m following up on Overstock by breaking down the results of Q4. All quotes are from Overstock’s President, Patrick Byrne.

For those who hate these Overstock posts, you’ll be happy to hear I plan to post an analysis of the Journal Register Company (JRC) tomorrow.

On Tuesday, February 7th, Overstock.com (OSTK) reported its fourth quarter revenue and full year financial results. The headline numbers were a net loss of $25 million or ($1.29) per share for 2005 vs. a net loss of $5 million or ($0.29) per share in 2004, and total revenue for 2005 of $804 million vs. total revenue for 2004 of $495 million.

For the year, revenues grew by 63%. The rate of growth decelerated throughout the year. Revenue growth was 102% in Q1, 72% in Q2, 64% in Q3, and 44% in Q4. Management expects revenue growth to be much slower in 2006. “During this time that we are hardening our new systems, we will reduce growth to industry rates. Our emphasis in 2006 will be on an improved customer experience – – even if at the expense of growth.”

The three most important figures to watch in evaluating Overstock are revenue growth, gross margins, and traffic data.

Overstock’s traffic data for the fourth quarter of 2005 was encouraging. As one would expect, most of the traffic to Overstock came in the first half of December. Overstock’s traffic numbers were strong in both absolute and relative terms for the first three weeks of December, and then dropped off very sharply thereafter. Notably, Overstock achieved its highest traffic rank to date during the Christmas shopping season. The trends in Overstock’s fourth quarter traffic data were consistent with those found in other major online retailers. Traffic data should be treated as a qualitative rather than a quantitative consideration. It is most useful as a negative indicator. There was nothing troubling in Overstock’s fourth quarter traffic data; so, it adds little to the present discussion.

Overstock’s revenue growth for 2005 was also encouraging. For the year, revenue grew by 63%. My $1.5 billion valuation of Overstock was based on a five year annual growth rate of 15%. Revenues will grow much more slowly in 2006. The deceleration in revenue growth throughout the year neither surprises nor alarms me.

Management entered 2005 with some very high growth expectations. “I said that my goals in 2005 were to grow revenues 60-100% and break even +/- 1%. We achieved the first, but I failed on the second. 2005 started fairly well, but ended weakly.” I did not share management’s expectations, and thus was quite content with the growth achieved.

Overstock’s average customer acquisition cost increased 33%. This looks like an alarming number, but a closer look at the company’s financial results suggests the increase was largely unnecessary, or at …

New Podcast: “Phil Fisher”

I just finished part two of the three part series on spotting a great business. In it, I discuss the writings of Phil Fisher.

Listen to the Gannon On Investing Podcast: “Phil Fisher”…

Vote in the Widest Moat Contest

Win a copy of Benjamin Graham’s Security Analysis (1940 edition)

In the latest podcast episode, two new Widest Moat Contest picks were unveiled.

They are: Coca – Cola (KO) and SpaceDev (SPDV.OB)

Vote by sending an email to showmail@gannononinvesting.com

The author of the contest’s best email will win a copy of Benjamin Graham’s Security Analysis.

Listen to the Gannon On Investing Podcast: “Phil Fisher”…

Against the Top Down Approach (Again)

Guru Focus recently reprinted my post “Against the Top Down Approach”. In the discussion forum, there was a post by an author who disagreed with me. I wrote a response, and thought it was worth sharing on the blog. By the way, If you haven’t visited Guru Focus yet, you should. It’s a great resource.

Considerations as to the future growth or profitability of an industry are a part of a bottom up approach insofar as they affect the individual security being evaluated.

Obviously, any evaluation of a property in Baghdad would have included an analysis of the risks associated with the ownership of such a property. The fact that those risks also apply to many other properties does not mean a top down approach is necessary. A top down approach begins with those risks. A bottom up approach considers them only insofar as they affect each investment.

An intrinsic value analysis is not the same thing as applying a multiple to current levels of free cash flow. I know this is not what you suggested. However, it is implied in some of your criticism (particularly the Baghdad example).

For instance, if you believe current steel prices are unsustainable, your intrinsic value estimates for steel producers will be lower than they would be if you simply projected current free cash flow levels into the distant future. A belief that steel prices are high is not inconsistent with a bottom up approach. A bottom up approach simply requires you compare your intrinsic value estimates for each investment against your estimates for all other investments regardless of industry.

A retailer, a homebuilder, a steel producer, and a bank should all be judged on the basis of a conservative intrinsic value analysis. There is no need to first determine that any one of these groups is inherently more attractive than any other.

Buffett’s “play” on the dollar is exactly that. I wouldn’t criticize him for it. However, I believe that, if you were to ask him, he would say it was merely the best opportunity to deploy large amounts of capital for a short period of time. He would much rather make long term investments in common stocks at attractive prices. Mr. Buffett would not be doing the same thing if he had less capital to deploy, and therefore a much larger investment universe.

I suspect his attitudes toward the dollar play are similar to those he has expressed about his past arbitrage operations. They are short term commitments with limited upside, and are far less attractive than long term commitments in common stocks made at bargain prices. Berkshire’s investment universe has shrunk considerably as its pool of capital has grown. This is not the kind of investment Buffet made with his own money back in the 1950s, with the partnership’s money, or with Berkshire’s money in earlier years. I doubt he would suggest it is an attractive option for individual investors.

In my article, I wrote:

“All

Against the Top Down Approach (Reprint)

This is a reprint of a previous blog post. It was one of my first. My readership has increased greatly since then, and it’s an important topic. So, I thought I should post it again.

If you have heard fund managers talk about the way they invest, you know a great many employ a top down approach. First, they decide how much of their portfolio to allocate to stocks and how much to allocate to bonds. At this point, they may also decide upon the relative mix of foreign and domestic securities. Next, they decide upon the industries to invest in. It is not until all these decisions have been made that they actually get down to analyzing any particular securities. If you think logically about this approach for a moment, you will recognize how truly foolish it is.

A stock’s earnings yield is the inverse of its P/E ratio. So, a stock with a P/E ratio of 25 has an earnings yield of 4%, while a stock with a P/E ratio of 8 has an earnings yield of 12.5%. In this way, a low P/E stock is comparable to a high – yield bond.

Now, if these low P/E stocks had very unstable earnings or carried a great deal of debt, the spread between the long bond yield and the earnings yield of these stocks might be justified. However, many low P/E stocks actually have more stable earnings than their high multiple kin. Some do employ a great deal of debt. Still, within recent memory, one could find a stock with an earnings yield of 8 – 12%, a dividend yield of 3- 5%, and literally no debt, despite some of the lowest bond yields in half a century. This situation could only come about if investors shopped for their bonds without also considering stocks. This makes about as much sense as shopping for a van without also considering a car or truck.

All investments are ultimately cash to cash operations. As such, they should be judged by a single measure: the discounted value of their future cash flows. For this reason, a top down approach to investing is nonsensical.

Starting your search by first deciding upon the form of security or the industry is like a general manager deciding upon a left handed or right handed pitcher before evaluating each individual player. In both cases, the choice is not merely hasty; it’s false. Even if pitching left handed is inherently more effective, the general manager is not comparing apples and oranges; he’s comparing pitchers. Whatever inherent advantage or disadvantage exists in a pitcher’s handedness can be reduced to an ultimate value (e.g., run value). For this reason, a pitcher’s handedness is merely one factor (among many) to be considered, not a binding choice to be made. The same is true of the form of security.

It is neither more necessary nor more logical for an investor to prefer all bonds over all stocks (or all …