收购后抛售令人困惑的新媒体可能太便宜了

New Media shares have seen an odd, and sharp, sell-off after its agreement to acquire Gannett was made official.

The company\'s financial targets suggest substantial upside from current levels.

But the risks in a leveraged buyout of a declining business are obvious - and those targets already look too aggressive.

As a long-time NEWM bear, it\'s tough to turn too bullish too quickly - but fresher eyes might see an opportunity here.

I've been a bear on New Media Investment Group (NEWM) for some time. My core reason for being skeptical of - and, on occasion, short - the stock is that its model of acquiring declining newspapers seemed almost illogical on its face. In fact, as I've pointed out before, that exact same strategy drove the company's predecessor, GateHouse Media, into bankruptcy.

There perhaps is a way that strategy can work - if management focuses on free cash flow and on returning that cash flow to shareholders as soon as possible. New Media instead has continued to make acquisitions, with its hefty dividend funded not by that cash flow, but rather a steady stream of equity offerings. Those offerings have meant that NEWM's dividend yield - which was 14% just a few sessions ago - actually came from forced liquidations of a shareholder's equity, rather than payouts from the company's cash flow. (That's why those distributions have been treated as a return of capital.)

That long-running skepticism didn't change amid reports that New Media was looking to acquire Gannett (GCI). The deal seemed like a rapid acceleration of the same strategy that had led NEWM to all-time lows in late May. (The company was spun off from Newcastle, now Drive Shack (DS), in 2014, after being owned by Fortress Investment Group, which is now part of Softbank (OTCPK:SFTBY).) And it seemed like further 'thesis creep'. New Media already had purchased papers in mid- to large-sized markets like Columbus, Ohio and Austin, Texas after originally arguing that a focus on smaller, local markets was the path to prosperity:

The details of the acquisition - including a staggering interest rate on the debt used to fund the purchase - don't seem to inspire much confidence, either.

Even with all those worries, however, I'm surprised to see the sharp sell-off in NEWM shares, which have declined by one-third in just three sessions. And I'll admit to being somewhat intrigued by the stock at these levels. Management's post-merger targets leave the stock as cheap as almost any in the market. The deal itself takes away some of the negative attributes of a standalone NEWM, including an onerous management agreement with Fortress. Going forward, this might be a company that actually is operated as a 'cigar butt' - and it's easily cheap enough if that's the case.

For a couple of reasons, I'm not quite ready to turn bullish, or even to assume that the declines are at an end. But if New Media is even close to right in how it sees the Gannett deal playing out, NEWM shares are going to rally at some point.

One reason to at least consider going against the grain here is that the declines in recent sessions don't make all that much sense. Shares of acquirers do sell off quite often, of course - and New Media is buying a business whose same store revenue declined almost 10% in the second quarter.

But, again, this is a deal of which the market already was aware. In fact, NEWM stock actually rose 3.1% when the Wall Street Journal reported on the talks back in late May. The $12.06 price - a little over half in cash - couldn't have been a surprise, either. Gannett rejected a $12 per share cash bid from MNG/Digital First in January, and then went through a proxy fight with an activist who wanted the company to consider that bid. After that battle, any New Media offer almost had to top that bid - and at $12.06 (at least at the time of the deal), that's exactly what happened.

The interest rate on the debt used to fund the acquisition certainly raised some eyebrows. According to the merger announcement, New Media arranged a term loan for $1.792 billion from private equity giant Apollo Global Management (APO). The interest rate, per the conference call, is a whopping 11.5%.

But this too shouldn't have been much of a surprise. New Media closed Q2, according to its earnings presentation, with a term loan balance of $434 million at LIBOR + 6.25%. Its existing blended rate on its debt at quarter-end was 8.56%. The company wasn't going to be able to borrow more than four times as much at a lower interest rate.

Did earnings from either company spook the market? It's possible. As noted, Gannett's revenue did decline almost 10% year-over-year on an organic basis, and that appears to have missed Street expectations by roughly four points. EPS was higher than consensus, however. New Media posted an organic revenue decline of 6.9%, and while that doesn't sound great, it was a sequential improvement from Q1 and appears roughly in line with management's expectations. The one big disappointment was in the company's UpCurve digital marketing business, where growth decelerated sharply to just 14%. Still, for both companies, the declines may have been larger than expected - but it's not as if the market was surprised that revenue didn't grow.

The other piece of news in the quarter was that New Media will cut its dividend in half, to a payout of $0.76 annually. Once again, this shouldn't have been a surprise. New Media as a standalone was distributing $90 million a year. There should have been no expectation that it could increase that figure while funding a ~$750 million cash payment to GCI shareholders, let alone assuming the target's $300 million-plus in debt.

All told, it's exceedingly difficult to explain why NEWM shares have dropped 30%+ once the acquisition was made official. Again, the stock mostly rallied while rumors of the deal swirled: at Friday's close, NEWM had climbed 24% (albeit from an all-time low) in a little over two months. There had been no other material news, and peers Lee Enterprise (LEE) and Tribune Publishing (TPCO) both declined double-digits over that stretch.

The dividend cut might have spooked some investors. UpCurve's deceleration is a worry, but seems less important for the combined company given that it's Gannett that is driving the majority of near-term profits. Still, there simply doesn't appear to be enough new information here to support such a big sell-off. And that might suggest an opportunity, if only for a trade.

From a long-term standpoint, there's one core reason to consider NEWM stock here. If management targets are hit, the stock is ridiculously cheap:

Pro forma share count is roughly 128 million, putting the pro forma market capitalization at $910 million. Net debt at closing should be in the $1.7 billion range, with the enterprise value around $2.6 billion.

Meanwhile, Adjusted EBITDA for the combined companies is about $500 million, according to the presentation - and New Media sees another $275-$300 million in synergies. Pro forma EV/EBITDA, then, is about 3.4x. Even assuming organic declines of 10% a year - roughly in line with what both businesses have generated of late - and full synergies arriving in year 3, NEWM still trades for a little over 4x year 3 EBITDA at its current net debt level. Assuming deleveraging plays out as planned, the multiple drops below 3x.

Meanwhile, as seen in the slide above, free cash flow should be robust. New Media closed 2018 with $263 million in NOL carryforwards, per the 10-K, which should keep cash taxes minimal. That company has been able to convert Adjusted EBITDA to free cash flow at something close to a 70% clip. The combined company likely won't keep that pace, but the projections above suggest conversion should stay somewhere close. Meanwhile, at the year 3 target of $500 million, NEWM now trades at less than two times free cash flow - with leverage at that point dipping toward 1x. (For what it's worth, the 1.0x figure in that slide appears to either be an error or outrageously optimistic, as it suggests year 3 Adjusted EBITDA of ~$900 million - and 20%+ organic growth plus full synergy realization.)

To be sure, the combined business should be cheap: profits are declining on an organic basis and should continue to do so. But shareholder returns should be solid in the near- to mid-term: New Media CEO Mike Reed said on the conference call that he expected the dividend to rise over time, and the current yield even after the 50% cut is 10.7%. The focus on deleveraging, meanwhile, likely pauses New Media's aggressive roll-up at the local level, which itself might not be a bad thing. That plan, as I wrote in March, didn't seem to be working.

There's another quiet benefit to the deal. New Media's agreement with Fortress is coming to an end. The company paid Fortress over $20 million a year in incentive compensation and management fees, though that spend included Reed's compensation. Fortress is getting one more gift on the way out: 4.2 million shares and 3.2 million options. But the agreement now ceases at the end of 2021 - and those options have a strike price of $15.50.

At least on paper, NEWM looks awfully cheap here. In fact, it looks cheap enough that even a failure to reach targeted EBITDA and free cash flow levels still could lead the stock to gain. Obviously, there's a bit of a virtuous/vicious cycle in those targets, as weaker-than-expected EBITDA growth leads to lower-than-expected free cash flow, slower deleveraging, and thus even lower free cash flow and deleveraging.

But NEWM trades at barely 3x pro forma 2020 free cash flow - with $275-$300 million in synergies on the way, which represent over half of pro forma Adjusted EBITDA. Organic profit declines are likely - but, again, these are businesses that have seen ~10% declines of late. Those organic declines may accelerate, if only because there simply isn't that much fat to left cut (beyond the targeted synergies) - but the potential savings from the tie-up can paper over a lot of margin pressure. And at 3.1x current free cash flow, with a nearly 11% yield, stable profits for even several years likely suggest upside at some point. A 5x multiple (below NEWM's pre-merger valuation) to $700 million in 2023 EBITDA, with net debt of $1 billion, suggests NEWM returns ~200% including dividends.

Obviously, the biggest risk here is that New Media is overpromising. And there's some evidence that is the case.

First, Reed has continued to insist, for years now, that his legacy business was on a path to growth. Most recently, he said on the Q3 conference call that the company was two years away. Performance since strongly suggests that target, will be missed. Reed did say after Q1 that near-term efforts - among them a pause in steadily increasing subscription costs - had hit organic revenue by roughly three points, but with circulation revenue giving way and digital advertising and subscriptions still relatively small, getting revenue to stable still seems like too much to ask. Similarly, the insistence on buying papers at 4x EBITDA - instead of repurchasing New Media shares - suggests that Reed still doesn't see the industry as one in terminal decline. It's quite clear at this point that the CEO is in the minority in holding that opinion.

Second, specifics on synergies and the combination of the digital assets was rather light. Reed was specifically asked about a planned $115 million in projected newspaper operations savings, and said the company was "extremely confident" in reaching its targets. The CEO noted - correctly - that both companies have experience in integrating acquisitions and cutting costs in the process. But he gave little in the way of specifics, saying that the companies still needed to firm up plans and communicate with employees.

One question that wasn't asked - or answered - is how the companies' respective marketing businesses will be united. Gannett acquired ReachLocal for $156 million back in 2016. That business generated $410 million in revenue over the past twelve months. New Media's UpCurve is smaller, with TTM sales just over $100 million - but it's growing faster, even with the 14% growth in Q2 below the company's 25-35% target for this year.

It's likely that management sees that vertical as driving some growth going forward. ReachLocal alone has generated ~$50 million in Adjusted EBITDA over the past four quarters, while profitability metrics for UpCurve haven't been disclosed. But with UpCurve soft in Q2, and ReachLocal revenue actually down modestly in the first half, that growth may not materialize.

In the legacy publishing business, there is the potential for the all-too-common M&A outcome where the sum is less than the parts. Integration can cause disruption. Cultures may clash. The fact that both companies have a history of M&A certainly helps, but investors can't forget that mergers always make sense on paper, and often fail in practice.

Finally, there are extraneous costs that need to be considered. Gannett had net pension liabilities of about $300 million at the end of 2018, per its 10-K. It has committed to payments of ~$50 million in each of 2020 and 2021. Reed, on the conference call, estimated roughly $100 million in costs required to drive the projected synergies. That's a combined $400 million (valuing the pension liabilities as carried, which might be aggressive even in this low-interest-rate environment) - against a pro forma market cap of $900 million-plus.

Still, there's quite a bit of slack in the current valuation. Even if organic EBITDA declines $70 million a year (15% of the current pro forma figure), and synergies come in at $200 million, consolidated Adjusted EBITDA still gets to $470 million. Interest expense is probably $175 million, assuming modest deleveraging along the way. Capex for the two companies combined in 2018 was about $75 million. Cash taxes, again, are minimal (with a D&A shield also helping). In this disappointing scenario, New Media still is generating $200 million-plus in free cash flow. That likely doesn't result in a great outcome for shareholders: that cash flow figure is going to decline, even with deleveraging help, and $200 million in year 3 might well lead to basically zero gains for NEWM, or worse. But a 10%+ yield provides some cushion in even this scenario.

This sell-off simply looks like it's gone too far. And while management hasn't necessarily earned the benefit of the doubt (Gannett is contributing its new CEO to head the operating business, who has been out of the newspaper industry for quite a while), it doesn't need to be right for NEWM to gain from here. Even missed targets mean the business is going to generate an awful lot of cash, and probably enough to keep the dividend intact and NEWM afloat. Meanwhile, anything close to success means NEWM is going to soar.

I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.