Do You Have the Cajones to Own This Stock?

Jun 1st, 2006 | By Penny Sleuth Contributor | Category: Investing Strategies, Penny stocks, Technology

Warning! The stock you will read about in today’s Sleuth is hated by nearly every investor on Wall Street — including many of my smart colleagues. It is trading for all-time, historical lows. And according to the company’s 2005 annual report, there were only 92 shareholders of record.

This is the kind of stock it takes cajones to own — big ones at that. If you are a day trader, momentum investor, technical analyst or rank-and-file investor who only follows the herd, turn away now. This is not for you.

However, if you are a contrarian or deep value investor with a long-term horizon, thick skin and you believe the best opportunities are usually found in Wall Street’s garbage heap, today’s Sleuth is right up your alley.

Here’s the deal…

Last week, I wrote to you about the newspaper industry. I told you it is the laughing stock of Wall Street. Daily circulation is down 28% over the last 12 years. The Internet has ripped advertising revenue from the one-time monopoly paper business. And many stocks are trading for 10-year lows.

The prevailing consensus is that business will continue to get worse for most newspaper companies, not better. Yet one of the smartest value investors in the country, John Rogers Jr. of Ariel Capital, is making a large bet that everyone is wrong.

His thesis is twofold. First, despite the Net’s presence in society, newspapers are still the only source of quality local content. When people want to read about local political developments, real estate information, dining reviews, sports, classifieds, business opportunities or school schedules, they will turn to their daily paper. As long as that remains true, there will be thousands of local businesses willing to buy advertising space.

Second, newspaper companies are finally using the Internet to their advantage. They are publishing content online, building traffic and recording new ad revenue. Although Web revenues make up only about 5% of total sales (industry wide), they are a fast-growing part of the industry. And Rogers strongly believes Web sales will make up 50% of total revenues in 10 years.

If he is right, there will be a massive run-up in newspaper stocks over the next 5-10 years — especially considering many have been left for dead today. And one of his favorite companies is local small-cap publisher Journal Register Co. (JRC:NYSE). John’s Ariel Capital is the largest shareholder, with more than a 14% stake in the company.

Journal Register is the epitome of a local provider. Is has 27 daily newspapers with 658,000 readers in cities and small towns all over Pennsylvania, Connecticut, New Jersey, Michigan, Ohio and New York.

Last year, JRC raked in $556 million in sales — up from $476 million in 2004. Net income totaled $46.9 million. The company threw off $87.8 million in cash from operations. And JRC bought 1.87 million of its own shares back at open market prices. (Since Jan. 13, 1999, the company has repurchased 9.46 million shares, at an average price of $14.92 per share.) Yet the stock fell from $19 to $14 in calendar year 2005. And today, it is all the way down to $10 a share — near all-time historical lows.

So what gives? Why is this stock tanking?

There are three problems with Journal Register.

First, fewer people are reading newspapers today than in years past. JRC’s daily circulation is down 6% in the last three years. And because fewer people are reading, advertising and classified revenues (the cornerstone of any newspaper business) are down as well.

Another reason both its circulation and advertising revenues are down has to do with location. JRC has major operations in the Detroit and Cleveland areas. And both of those cities have been ravaged by the declining auto sector. As a result, advertising revenue in those areas is down 6.8% in the last five weeks compared with a year ago. That is far higher than the industry average.

Second, the company’s sales growth (which looks great if you simply glance at its balance sheet) isn’t organic. In other words, the company isn’t selling more of its existing newspapers. Rather, it is fueling its growth through strategic acquisitions — a strategy that nearly ended Tyco and a bunch of other “high-growth companies.”

In 2004, JRC made four acquisitions, the biggest one being the $415 million bid to acquire 21st Century Newspapers — which owns four daily newspapers in Michigan and 85 nondaily publications, with approximately 1.5 million readers.

Since 1993, JRC has made 31 strategic acquisitions: including 18 daily papers and 294 nondailies.

Because of these acquisitions, JRC has accrued a lot of debt. In order to fund the 21st Century acquisition, JRC took out two loans in 2004 worth $625 million. With that, the company’s debt load jumped from $380 million to $781 million. And its interest payment more than doubled year over year (which is a drain on cash).

If JRC is going to rebound, it must pay off its debt and figure out a way to grow its top and bottom lines with the assets it currently owns. Sounds like a daunting task — something the company has failed to do for the last decade. But JRC just may be on the right track now.

In recent years, JRC has made a push to publish local content (and provide local services, like job postings) on the Net in order to complement its paper business. Today, it owns 212 Web sites. And sales from the Web have grown at a 35% compounded rate since 2000. Obviously, this is a good sign. If the company can keep compounding sales on the Web side of its business, it won’t take too long before organic growth becomes a reality.

The company also paid down $37.6 million in debt last year — a trend that is continuing in FY 2006. And as far as spending hundreds of millions of dollars on acquisition this year, well, we’ll have to wait and see.

In the meantime, JRC just may be worth taking a flier on if you are willing to put it in your back pocket and forget about it for a while. As I said earlier, JRC is a cash-generating machine. Last year, it cranked out over $80 million from operations. That means despite the fact it is a declining business, it is still a highly profitable and liquid one.

As you know, cash is king when it comes to investing. The true value of any business can be determined by calculating a company’s cash flow (into the future) and discounting it back to today. The idea is you never want to pay more for a company than it is worth in cash.

If the company is trading for less than its discounted cash flow, it is undervalued and worth owning today. However, if the company is trading for more than its discounted cash flow, it is overvalued.

To determine if JRC is a value at its current price, I ran three discounted cash flow projections. I did a worst-case scenario, a likely scenario and a “good” scenario.

The worst-case scenario assumes JRC will decline 10% a year. The likely scenario assumes JRC’s business declines 4% a year into perpetuity. And the good case assumes JRC can grow just 1% a year. Using those numbers to guide my assumptions, here’s what I found…

If all hell broke loose and JRC declined 10% a year, its stock should trade for $7 a share — or 30% below where it is today. In other words, the lowest this stock should ever fall to is $7.

If JRC’s business declined 4% a year (which is certainly possible), the stock should trade for $15 a pop. Or said another way, based on its normalized cash flow, this stock is worth 50% more than it is trading for now even if the business declined 4% a year over the next 10 years.

And if John Rogers is right and JRC does right the ship and start to grow (just 1% a year), the stock’s fair value is $25 a share.

If I am doing my math right, the upside potential on JRC is at least 150%. The downside is 30%. Not a bad risk-to-reward scenario, is it?

Something to consider for those with the cajones to go against the crowd and own a stock no one likes right now.

Good investing,

James
June 1, 2006

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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