I'll have the one with the whip marks
That subhead comes from one of my favorite lines in movie history, uttered by the late, great Rodney Dangerfield in Caddyshack: "This steak's still got marks where the jockey was hitting it."

One of the things we like to do at Inside Value is look for companies that have already been soundly thrashed by the market. Bad vibes tend to magnify sell-offs in what are otherwise good companies, like Merck (NYSE:MRK) or newsletter pick Colgate-Palmolive (NYSE:CL).

What we like even better is a beaten-down stock in a beaten-down industry. When an entire group of enterprises is out of favor and thoroughly tenderized, there's twice the opportunity for short-term market stupidity. That makes it more likely that you can find -- if I may mix my metaphors -- some beautiful babies that have been tossed out with the bathwater. And in today's market, you'd be hard-pressed to find an industry that's been more thoroughly whipped than newspapers.

Black and white and read all over
Journalism gets a bad rap in America today, both in popular thought and on Wall Street. Opinion polls continually show that the average Joe Bagadonuts ranks journalists somewhere below paramecium on the scale of trustworthiness. Heck, I myself take regular swings at the shoddy financial reporting out there.

But the business of print journalism isn't nearly so bad. Profit margins tend to be hefty, and newspapers with established turf become the kind of monopoly toll bridge that Buffett loved so much.

Unfortunately, the past couple of years have been particularly unkind to newspaper shareholders. I've written about this before, as has my bottom-feeding colleague Stephen Simpson. Unfortunately, the declines in the big newspaper stocks are all too easy to understand. Revenues have been flat, growth opportunities have been slim, and expenses continue to climb.

Still, I recently stumbled across a smaller newspaper outfit that was unfamiliar to me. In the course of my normal, weekly, bottom-fishing routine, I noticed The Journal Register Company (NYSE:JRC) somewhere on the 52-week-low list. This elicited a raised eyebrow from me because, frankly, the majority of the junk on the 52-week-low list is just that: junk. But as a firm believer that a newspaper chain, properly run, is much better than junk, I decided to take a deeper look. And I like what I see.

Meet the meat
The Journal-Register Company -- let's just call it the JR from now on -- operates 27 dailies and 338 non-dailies in "clusters" stretching from the eastern U.S. -- where the Philadelphia area is a major hub -- westward to Michigan. The firm's goal is to operate in affluent, growing suburban locales, strategically grouped, in order to capture the neighborhood advertising markets by providing intense local coverage. The idea is to become the indispensable source of news on local sports, politics, etc., while taking advantage of cost-efficiencies and cross-selling opportunities afforded by the clustering strategy.

Prospective shareholders will need to be able to cope with a company that considers acquisitions to be an important part of its growth strategy. Over the past decade, the firm has added papers at a clip of about three per year.

I happen to have spent some time working in a similar chain of newspapers, and I'm familiar with the opportunities that exist here. Though our profitable little operation was nearly killed by disastrous bungling after a takeover by scandal-riddenHollinger International (NYSE:HLR), if done right, these kinds of newspapers enjoy strong reader loyalty that can be converted into solid advertising sales. And I'd say there's strong evidence that the JR knows how to do this business the right way.

JR, before and after the bullet
The market has been particularly unkind to the JR recently. Over the past year, shares have declined 25%, a situation that mirrors the fall at large peers like the New York Times (NYSE:NYT), Gannett (NYSE:GCI), and Tribune (NYSE:TRB).

But it would be too much to blame JR's share-price malaise entirely on the industry. Last quarter's earnings, released just this week, showed a 25% drop in earnings per share compared with the prior-year quarter, although management blamed some of that drop on the cost of new efforts to comply with Sarbanes-Oxley. This came despite a 40% increase in advertising revenues -- which were juiced by a 2004 acquisition. On a comparable basis, advertising revenues were flat.

By now, you should be thinking, "Hmm. Flat revenues. Lower profits. Dude, why do you bother?" For the simple reason that I'm more sanguine about the JR's future prospects -- especially given the discount the market has already laid on the stock.

As a small-cap player with a reasonable growth policy, I believe it's got more room to run than its larger peers do. I don't know if any of you have noticed, but our nation's urban centers are increasingly moving outward, into growing and increasingly affluent suburbs -- exactly the kind of market the JR serves. And management's track record of identifying and exploiting these markets has been enviable so far.

Return on capital has been consistently good, in the mid-teens or better, with a five-year average around 17%. Margins are consistently high -- though special charges and benefits make the GAAP net look pretty lumpy over the past half-decade. EBITDA margin, which strains out some of the knobs to give us a picture of operational trends, stands near 26%. That represents a gradual winding down from the 30% levels of five years ago, but it still looks strong.

Boring numbers

2004 2003 2002 2001 2000
Net Income (millions) $116.5 $72.0 $49.2 $78.1 $169.3
EPS, adjusted* $1.23 $1.19 $1.14 $0.80 $1.07
Free Cash Flow (millions) $71.4 $58.9 $61.6 $57.1 $86.7
*Earnings per share adjusted to reflect asset sales in 2000 and 2001, and tax benefits.

If you peruse the latest 10-K or listen to JR conference calls -- which I encourage you to do -- you'll notice that management talks a lot about free cash flow (FCF). In my opinion, this is a good thing, as I think cash flow is, generally speaking, a better measure of a firm's payoff for shareholders than are plain old earnings. This is an area where the JR continues to shine. In the first quarter, despite the drop in earnings, the $0.33 per share in FCF actually matched the prior-year's tally. That cash earning strength gives the JR a substantial safety net and allows it to engage in other shareholder-friendly behavior. Take share buybacks, for instance. Management recently announced a repurchase plan that would retire up to 1.8 million shares at today's prices, or somewhere around 4% of the diluted shares outstanding.

As bad as it gets?
It would be futile to try to gaze into the crystal ball and guess where newspaper revenues and expenses are going. But let's do it anyway. OK, let's not. Seriously, a major reason the newspaper biz is in such a general funk is that it's at the center of a perfect storm. Expenses are rising while revenues are flat. On the outflow side, at the JR, the major non-human expense is newsprint. And the cost of newsprint has risen nearly 20% since 2002. The total spent came to 7% of newspaper revenues for 2004. But keep in mind that minced wood is a cyclical commodity and can just as easily drop in price -- as it did in 2002, when it dropped 22%. And there's continuing pessimism on the advertising side. With car sales, a big source of ad revenue, sagging and worries about retail spending, no one -- except online-ad juggernauts like Yahoo! and Google -- is seeing big increases in ad spending. Is this as bad as it can get? Maybe not, but it seems to me that predicting the long-term death of newspaper advertising is a bit premature, and newspapers like the JR, that continue to thrive despite difficult conditions, are ideally positioned to capitalize on any upturn.

Stuff I don't like
As with any investment, there are warts to consider. One of the things I don't like about JR -- or any company, for that matter -- is the share-flooding poison pill provision that lets management save its hide should a takeover be imminent. Since management's been doing a bang-up job running this show, I'm willing to overlook this particular blemish. More frightening for some will be JR's debt load. The $762 million puts the firm's debt-to-equity ratio at 3.9. Yes, interest payments gobbled up 40% of operating income in the first quarter of this year, but JR's strong free cash flow allowed it to retire $16.6 million in debt. One mark of smart management is borrowing cash when cash is cheap, and it's rarely been cheaper than it has over the past few years. Last year, the firm's weighted-average interest rate was only 3.5%, but management expects that to be more like 5.25% for this year -- and some of the exposure to variable rates is reduced via hedges.

Valuation
I ran several cash-flow-based valuation thumbnails through Inside Value's handy discounted cash flow calculator -- you'll need to take a free trial if you want to take it for a spin yourself, alas. I used a share price of $15.80. Note that the free cash flow (FCF) figure I've used ($71.4 million) takes out a big tax windfall from last year, so these results aren't juiced -- at least not by that figure. At a conservative discount rate of 14% and using growth rates far below analysts' estimates, the firm comes out as just slightly undervalued. These results are in the top row. On the bottom row, a more generous discount rate and more robust expectations for the next five years' earnings growth yields a value that looks significantly better, with a margin of safety of more than 37%.

Discount
Rate
Earnings Growth
1-5 years
Earnings Growth
6-10 years
Earnings Growth
Terminal
Intrinsic
Value
Margin of
Safety
14% 5% 5% 3% $17 8.1%
14% 8% 5% 3% $20 22.4%
12% 8% 5% 3% $25 37.2%


The Foolish bottom line
Unfortunately, when you're hunting for values, there are no easy answers. If you believe newspaper advertising is on its last legs and you think the JR is a risky business, you won't find much of a margin of safety. But if you disagree with the market, as I do, the JR looks like a relatively safe investment in a solid, if slow, business with a good chance of market-beating returns. Management shares this belief and is putting its money where its mouth is, buying back shares at the current low prices. That alone will boost earnings per share in the future, and if the economy picks up steam and advertising revenues follow, there will be even more free cash flowing off the Journal Register printing presses.

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Seth Jayson doesn't regret leaving the newspaper biz, though he does miss those high school basketball games. At the time of publication, he had positions in no firm mentioned. View his stock holdings and Fool profile here. Fool rules are here.