Is Gannett Co. (GCI) A Value Bargain or Value Trap?

In my last post I introduced the concept of 'Value Traps' - where the business looks like it is a 'bargain', but there is in fact a justified reason behind the market's discount.

There are some industries that experience significant upheaval and change as a result of a disruptive technology or change in consumer behavior. The erosion of economic fundamentals that occurs will impact a Value Investor's estimation of a business' intrinsic value.

An immediate example that comes to mind is the newspaper and print media industry. Let's see what Buffett has to say on the matter:

From the 1991 Berkshire Hathaway Letters to Shareholders:

"We have a significant investment in media - both through our direct ownership of Buffalo News and our shareholdings in The Washington Post Company and Capital Cities/ABC - and the intrinsic value of this investment has declined materially because of the secular transformation that the industry is experiencing."

And again in his 2006 Letter:

"And fundamentals are definitely eroding in the newspaper industry, a trend that has caused the profits of our Buffalo News to decline. The skid will almost certainly continue."

And for those who might believe that each newspaper's website will substitute for any lost revenue Buffett continues:

"True, we have the leading online news operation in Buffalo, and it will continue to attract more viewers and ads. However, the economic potential of a newspaper internet site – given the many alternative sources of information and entertainment that are free and only a click away – is at best a small fraction of that existing in the past for a print newspaper facing no competition."

And now for a real-life example: Gannett Co [Ticker: GCI]. Founded in 1906, Gannett's operations are primarily in the US and UK, and include 90 daily newspapers, 1,000 non-daily publications as well as 23 television stations that reach an estimated 20 million viewers in the US.

In order to establish an estimate of Gannett's Intrinsic Value, I will first need to obtain an estimate for free cash flow. Going to last year's Cash flow Statement. I take Net Income, add Depreciation and subtract Capital expenditure. Free Cash flow comes out to be around $1.24 billion.

Now comes the tricky part: estimating future earnings growth. I go to analyst consensus earnings - here. Scrolling down to the bottom of the page I see that analysts are expecting average annual earnings growth for the next 5 years of 4.35%.

I now plug both these figures into a simple DCF calculation, use a 10% discount rate, divide by the total number of shares outstanding and get an intrinsic value of about $64 per share - a 55% discount to current market price. On the face of things - this seems like a bargain, right?

What's wrong here? Going back to Yahoo's analysts consensus earnings estimates, I take a look at earnings growth for the last 5 years - an average of just under 2%. Many studies have shown that analysts tend to be optimistic in their assumptions - and here we see it in action. The last 5 years earnings growth was barely 2%, and analysts believe that in the next 5 it'll be double that? I doubt it.

What happens if I plug in 0% growth for the next 10 years into my DCF - in other words the industry remains stagnant and goes nowhere. I come up with an intrinsic value of $44 - still a 7% discount to today's price. In other words, contrary to analyst consensus, the market believes that the industry will experience continued erosion.

Gannett looks like a bargain, but a Value Investor who looks past the numbers, takes analyst estimates with a pinch of salt, and investigates what's happening in the industry may come to a completely different conclusion.

In my next post on Value Investing Principle #4, I will reveal what I believe is the best way to spot a 'Value Trap'.

Please read the Legal Disclaimer.

Disclosure: Author does not hold a position in GCI.

Avi Ifergan is the Managing Partner of Israel Value Funds (www.israelvalue.com) an Israel-based investment partnership that follows a disciplined and long term oriented Value Investing approach, with a primary focus on Israeli public companies. Avi is a former equity analyst, corporate advisor and serial entrepreneur. These days he spends his time teaching economics at a major Israeli university and seeking value investing opportunities. He very much appreciates your feedback at avi@israelvalue.com.

Value Investing Principle #3 (Part 3): Value Investors Love a Good Bargain

In the previous 2 posts on Value Investing Principles (here and here) I looked at the concepts of Margin of Safety, and Intrinsic Value. I explained that the calculation of the intrinsic value of a business is not an exact science but rather a rough estimate of value, hence the need for a margin of safety.

As promised in my previous post, in this post I am going to attempt to answer the last of the 5 questions that I posed:

Isn’t it possible that the reason the price of a stock is so cheap is because the company is poorly managed, is not profitable or is a high-risk business?

In attempting to answer this question I will introduce a new Value Investing concept - 'The Value Trap' . I'll also explain why some investors tend to be fooled by Value Traps, and in a later post will provide some advice on the best way to recognize them.

Drawing on the metaphor I used in the first post, imagine you are shopping and you see packets of pasta at half price. Instinctively you may want to take advantage of the bargain and buy in bulk. Savvy shoppers will immediately ask 'where's the catch?' - and will attempt to identify something faulty with the good (perhaps the pasta is close to its expiry date or is of poor quality). If you've discovered a valid reason why a product is 'on special' or trading at a significant bargain to market prices, you have discovered a 'Value Trap'.

Simply put, I define a Value Trap as a company that appears to be undervalued and a Value Investing opportunity, but in fact does not possess any recognizable significant investment potential.

So, to answer the question I posed: In my humble opinion I believe that for the most part, when a business is valued cheaply, there is a good reason for it and I seek to identify it. Most of the time, the market is to a large extent correct. This is expected. Never in the history of mankind have investors had so much company and industry information available at no cost, and never have they been as savvy and educated.

There are instances, however, when the market has mispriced or undervalued a business with little justification. These include:

(i) When it focuses on the Short Term and ignores Long Term potential: I think this is a primary reason for pricing inaccuracies as analysts and investors with a short term investment horizon focus solely on quarterly earnings. Long Term Value Investors take advantage of such short-sightedness to pick up quality companies cheaply.

(ii) The Market Confuses Uncertainty with Risk - this is a underlying theme of Mohnish Pabrai's investment philosophy. You can read about it in detail here. Basically, investors tend to react in simialr fashion when there exists business uncertainty as when there exists business risk - they panic. Two recent examples come to mind: in 2005 Mercury Interactive's CEO and CEO were accused of fraud with regards to the backdating of options. The market responded with a significant sell-off and drop in market price. Mercury's business and clients had not changed. The only difference is that 2 of Mercury's former senior management would now be wearing orange overalls. Hewlett Packard was able to take advantage of the negative market sentiment and less than a year later to acquire the company for $4.5 biliion in cash. A similar story occured with M-Systems and an internallly-initiated options backdating enquiry which resulted in the market severaly overeacting. Nothing had changed in the business at all, but the end was the same as Mercury's. SanDisk took advantage of the negative market sentiment and low share price and acquired M-Systems for approximately $1.5 billion

(iii) When Investors Do Not Properly Understand The Business: Sometimes investors do not understand the fundamentals of a specific business, and when certain industries face negative sentiment, these businesses included and collectively punished. A current example is the sub-prime crisis. There may exist certain mortgage businesses or financial insitutions that have little exposure to low-quality loans, and yet they have suffered the same fate as the others in the industry.

Rear-View MIrror Investing: Why Investors Fail To Recognize Value Traps?

The main reason that investors fail to recognize Value Traps is what Buffett calls 'Rear View Mirror Investing' - making investment decisions based on past experience. (See the entire article here). Psychologically we all tend to place significant weight on our past experiences and extrapolate them into the future. This is one of our prime learning mechanisms. If we get food-poisoning from dining at a certain restaurant, we most likely won't return there again. And the converse with positive experiences. Unfortunately, this does not exactly work in the investing game, and is a major cause for failing to recognize a 'Value Trap'. As John Maynard Keynes suggests:

"It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinghuish the broad reasons why past experience was what it was."

There are many examples of businesses that were once dominant players in their industry, and in fact still remain dominant, yet the fundamentals of the industry as a whole have changed.

In my next post, I will provide an example of a great business that looks absurdly cheap, but which, because of massive changes in the industry it is in, make it a 'Value Trap'.

Can you think of the industry that I am referring to? Or a business in such an industry?

Until next time: "May you possess the Wisdom to see what the market does not, and the Courage to act on it".