Value Right Under Your Nose?

Scary headlines
Few things get a value investor's attention like an entire sector or industry group that's out of favor, and it's not tough to see that many of the country's biggest integrated media companies -- we used to call them "newspapers" -- are currently in the dumps. Yes, despite years of buying TV stations, gobbling up smaller papers, getting Webby with Internet news sites, and other get-rich-slow schemes, much of big media is lagging. Could there be a bargain in the crowd? There are certainly worse places to look.

Shares of Tribune (NYSE:TRB), New York Times (NYSE:NYT), Gannett (NYSE:GCI), and Knight Ridder (NYSE:KRI) are all trading near their 52-week lows. Here's an ugly chart. Wanna see something even uglier? (That's what we ex-carnies call the "soft sell.") Check this out. The Trib and the Times are actually trading near their two- and three-year lows. Ouch. The gold standard in the group, The Washington Post (NYSE:WPO), is doing much better. Let's toss the pretty boy aside for today and concentrate on the stuff at the bottom of the dumpster.

The problem for most of these wordmongers is that revenues have not been climbing with much strength over the past few years, even as other sectors of the economy have seen decent growth. The earnings picture has been similarly lackluster.

For those who like to compare current market multiples to the past, the four horsemen are also trading at price-to-earnings multiples that look like minor discounts to what they've been commanding over the past few years.

No hope?
One of the things we try to do at Inside Value is look for the market's mismatches between similar, stable companies. That's why I find the following table so interesting. It shows that, despite the wide variation in the ratios of price to earnings and enterprise value to sales, enterprise value to free cash flow (EV/FCF, an admittedly imperfect little measure I often use) is in a narrow range.

Those of you who don't think the market tends toward some kind of efficiency -- or that free cash flow matters -- take a look at the right column one more time. Apparently, Mr. Market is pretty consistent in his belief that these big newspapers are worth somewhere around 20 times FCF. Rats. Then there's no mismatch here for us to exploit, is there? Maaaaaybe not. Let's look a little closer.

Fine print
There are simple reasons why investors should keep their eyes on the newspaper biz. When it's good, it's extremely profitable. And when it's bad -- as it has been during the past few years -- it's still pretty darn profitable. Net margins for the group inhabit a range between 9% and 11%, except for overachieving Gannett, which takes home closer to 18% of sales.

Free cash flow is also generally very strong. The problem is, those big presses and buildings demand a fair amount of capital spending, but only periodically. That means free cash flow can be very lumpy. The margin of free cash flow (MoFCF) is another goofy little shortcut I use to get a picture of just how much money a company is really generating -- earnings being more easily obfuscated. Basically, it's cash from operations minus capital expenditures, divided by revenues. By looking at an average value over a few years, we can smooth out those cap-ex lumps.

Here's where I think we might see those mismatches we're hoping to find. At least in the abstract. Take a close look at the second two columns. Free cash flow at all four firms has been less than stellar this year. The result is that the MoFCF is significantly lower than the average over the past seven years. And a couple of the contenders, Tribune and the Times, happen to have seen their MoFCF drop even more than the rest.

Can you see what I'm getting at here? What if next year's FCF ticks back up toward the levels notched by the seven-year average MoFCF? Presumably, if Mr. Market applied the same multiple to the higher FCF, the stock price would rise accordingly. Here's a crazy example for you. If you took the Tribune's seven-year average FCF margin and multiply by 2004's revenues, you'd be looking at what I call a fake FCF -- because it's, well, totally fake -- of $1.36 billion instead of the real $850 million.

Apply the market's current multiple of 19 to that, shed the debt, divide by shares outstanding, and, voila, the stock would be close to $70 per share rather than today's $40. That's a bummer. Unless you think Tribune's going to be screaming back toward that average. Then you might see a real deal.

Truth is harsher than fiction
Alas, it's not clear that the four pillars here will get back to those levels of cash flow any time soon, if at all. Tribune's annual report -- the first of the four I've been able to digest, and it took a dose of Pepto -- suggests that next year's free cash flow will look a lot like this year's. Additional spending will likely offset the myriad one-time charges -- including a hit for settling a circulation scandal -- that helped keep this year's earnings and cash flow on the down low.

While I'm confident that these stocks will eventually pull up and move toward their former profitability, my own DCF thumbnail valuations, assuming low, 5% growth rates, suggest that they're 90-cent dollars at best, with the Times actually looking more than a bit overripe. I know Philip Durell has his eye on Tribune, but I suspect he feels the same way I do for now. We Inside Value types are cheap and patient, and we prefer three $10s for a $20.

But that's precisely why you should keep these companies on your investing radar. Should any of these stalwarts see unjustified market weakness or show improvement in cash generation, it might easily become a screaming bargain.

For related Foolishness:

• Is Tribune missing a scoop?
• How about that circulation scandal?
• Pay up for online newspapers? Maybe it's a sign of the Times.

Seth Jayson used to work for newspaper wages, which is why he'd much prefer to own newspaper stocks. But at the time of publication, he had positions in no company mentioned. View his stock holdings and Fool profile here. Fool rules are here.