QUALIPORT
Johnston Press: What the Papers Say

By Maynard Paton (TMFMayn)
July 16, 2001

Rochester, Kent – A few weeks ago, I officially revived the Qualiwatch ("Twenty Companies to Watch Out For"). The watch list contained Johnston Press (LSE: JPR), a local newspaper publisher that had sneaked on to the list without a full explanation. Today's Qualiport will address that issue and review the merits of Johnston.

U-turn

Regular Qualiport readers will be aware of my ever-changing attitude to local newspaper publishers. After much indecision, I dismissed Johnston in January on the grounds of its debt level. However, on reflection, I've concluded that the fundamental attractions of the newspaper industry, plus the scope to reduce the debt mountain, outweigh the current level of borrowings.

Over time, I've gradually realised that newspaper publishers possess much in the way of operational and industry predictability – probably the most important factor to look for when investing.

Take national newspapers. How many new entrants have there been in this field over the last twenty years? I can think of only the mainstream Independent, niche players Sunday Business and Sunday Sport, and the defunct Today.

In general, it's the same old national titles that divide up the industry's revenues. And the same can be said at a local level too. Overall, it's an industry that's not at risk from newcomers or rapid change, which is all good news for the established players. Indeed, newspapers have still prospered even with the advent of radio, television and teletext.

So while growth may be low, minor working capital and fixed asset requirements mean newspaper businesses are typically drowning in cash. Buying a steady flow of free cash, at the right price, can make for a great investment.

The business

Johnston owns around 180 local newspaper titles whose reporting covers various towns throughout Scotland and England. Alongside the cover charge, the company's income is derived from two other sources – selling advertising space and contract printing.

Advertising mostly comprises the classified type, typically concerning employment, cars or property. Such revenues, therefore, are quite sensitive to the health of the general economy.

To utilise the spare capacity on its own printing presses, Johnston also operates a contract printing service for smaller newspaper players. While this perhaps provides less economically sensitive income, the division does operate in a more competitive arena and requires substantial investment from time to time.

The financials

The table below highlights Johnston's five-year financial record.

To 31st December           1996    1997    1998    1999    2000 

Turnover (£m)             165.0    212.0   201.7   242.6   292.2
Operating Profit (£m)      28.7    45.8    51.4    66.2    84.2
Exceptional Items (£m)      0.5    (3.5)    0.7    (5.2)      0
Net Interest payable (£m)  (5.1)   (7.7)   (6.2)  (11.2)  (18.8)
Pre-tax profits (£m)       24.1    34.6    45.9    49.8    65.4

Earnings per share (p)      9.8    13.1    15.8    19.2    23.3
Dividend per share (p)      2.5     3.0     3.5     4.0     4.5

Alongside an economy helping advertising rates to improve around 5% per annum, growth since 1996 has largely been fuelled by two major acquisitions. In 1996, Johnston bought the newspaper interests of Emap (LSE: EMA) for £213m, and in 1999 it bought Portsmouth & Sunderland Newspapers for £266m.

The integration of the two acquisitions plus the fixed cost nature of the company (allowing rising advertising revenues to fall straight to the bottom line) have worked wonders for Johnston's margins. Operating margins have jumped from 17% to nearly 30% since 1996.

It's also worth noting that Johnston's two major acquisitions have brought relatively little in the way of exceptional items. Including another £5m expected in 2001, exceptional "integration" changes will amount to just £14m over five years. That compares very favourably to annual operating profits of £84m.

Debt

The downside of the acquisitions is the debt now saddled on Johnston's balance sheet. With borrowings mostly funding the two major purchases, debt now stands at £260m. Interest payments are covered a rather thin 4.5 times by operating profits.

While debt levels could become an issue should the UK economy deteriorate sharply, on balance, I'm reasonably comfortable with the present borrowing situation.

For starters, there are very few obvious acquisitions left that could tempt Johnston to load up on even more debt. Only Regional Independent Media (currently subject to a possible three-way carve-up by Johnston, Gannett (NYSE: GNI) and Guardian Media, though RIM are currently considering alternative options) presents a substantial acquisition opportunity at the moment.

Then there's Johnston's attention to "value". With consolidation in the newspaper industry heating up, it's somewhat reassuring to read how Johnston have backed down on "shareholder value" grounds during corporate "auctions". Of course, the comments may be sour grapes because Johnston missed out, but the company's record does show some prudence. Its two major acquisitions were bought on price to earnings (P/E) ratios of 20.

In general, I'd like to think Johnston's excess cash will soon be used to reduce borrowings. Looking back after the purchase of Emap's newspaper interests, Johnston quickly lowered its debt level during the next two years.

Working capital, capital expenditure and return on equity

To 31st December           1996    1997    1998    1999    2000 

Operating Profit (£m)      28.7    45.8    51.4    66.2    84.2
Working capital change (£m) 1.3     4.4     0.0    (2.4)   (2.3)
Capital Expenditure (£m)   (5.5)   (9.9)   (7.9)   (9.0)  (19.9)

Johnston excels on the working capital front. Little in the way of accounting profits becomes tied up in stocks or debtors. But capital expenditure is a slightly different matter. There was a large jump in fixed asset expenditure during 2000 as a major printing press upgrade began. Over the next two years, another £43m is planned to complete this and other fixed asset projects. While yearly capital expenditure should reduce for 2003, I'm comforted by this analysis showing Johnston generating relatively more profits from its fixed assets than a wide range of other companies.

The low asset requirement of Johnston filters through to the incremental return on equity figures. With post-tax profits jumping from £16.0m in 1996 to £46.9m in 2000, and shareholders' funds increasing from £202m to £312m over the same timescale, the incremental return on equity over that period comes to a magnificent 28.1% ((£46.9m - £16.0m) / (£312m - £202m)).

However, that performance isn't sustainable in the long term. The debt used for the acquisitions has significantly boosted profits without the need for additional shareholder funding. And as mentioned earlier, opportunities for further corporate purchases are limited. But after using various incremental return timescales and a fair bit of intuition, I've no problem in deeming Johnston a company that can reinvest its profits at above-average rates of return.

Valuation, risks and summary

Johnston is a solid, stable company operating in a very predictable industry. However, the risks of a sharp economic slowdown or a costly acquisition remain. Further out, there's also the question mark over the Internet. Will all the classified advertisers eventually jump online? It's far too early to make any sound judgement, but Johnston does have a notable digital presence waiting for any newsprint deserters. Indeed, given the distressed nature of many start-up Internet businesses, it's my firm belief that the winners of digital media will be the traditional media firms anyway.

At 303.5p per share, Johnston sits on a historic free cash flow yield of 6.6%. Factoring in minimal growth of 3% for 2001, a rate underpinned by a cautious trading update published last month, and the prospective free cash flow yield comes to 6.8%. Should the shares fall to around 265p, equating to a near 8% free cash flow yield, the Qualiport would be a buyer.

More: Paper Talk Turnaround | Johnston Press discussion board