Rizzi Capital

Don’t be fooled by the way the market is trading. It falls rapidly, then some good news is announced, and it jumps right back up. Looking beyond the headlines, we see deeper troubles.

1) Volumes are at historic lows compared to their moving averages. A large drop on high volume followed by a large increase on low volume, is not a good sign.

2) On a macro level, the data from the US clearly shows that the economy dipped into recession in April or May. It has deteriorated since. With this too you must be cautious, because a recession is usually only officially declared many months after it actually starts, and by that time, stocks have already usually dropped considerably.

3)Anecdotally, Ford and GM are once again announcing “employee pricing” deals in an effort to sell more cars, this is always a negative sign. Lots of companies are suddenly stuck with a lot of inventory because purchases have suddenly dropped.

4)  If the US economy dips into recession, the Canadian economy will follow. With governments around the world trying to reduce spending, this will directly cause a reduction in overall growth and lead to more economic troubles on a worldwide level. With Canadian consumers holding a record amount of debt, even a small recession will reverberate and cause massive problems. Given the influence of the federally backed CMHC within the Canadian housing market, should  a recession cause home prices to dip, even marginally, the CMHC will likely have to be bailed out by the government, which would cause a drop in the Canadian dollar. Whereas this would help increase profits at large Canadian exporters (commodity exports),  the average consumer would be negatively affected as Canada is a huge importer of consumer goods (most of which are priced in US dollars (Imports from China).

In the event of a recession, there will be no safe haven; the challenge would be to maintain portfolio stability as much as possible while limiting risk.

At the fund, our largest position is now CASH, and we will be happy to maintain this position until either stock prices decrease considerably (>20), or stability is restored (unlikely). Since we have considerable breathing room, we look forward to a downturn, while still having some money in stocks in case things miraculously increase.

Overall, the market are not well. The prospects of more stimulus from the US Fed is temporarily causing some buying, but it will not last long. Moreover, unless the Fed announces something truly extraordinary in September, the market will react negatively. I think the chance of a large intervention is slim. Any considerable stimulus will cause commodity prices to increase rapidly and dramatically, further damaging the world economy.

In our opinion, the best plan is to walk away and just wait for things to revert to a more normal level. In general, stocks have not fallen very much and almost everything is still expensive. Are you smart enough to spot the rare opportunities? Neither are we. We prefer to wait until things are obviously cheap. It will be easier to spot deals and there will be much lower risk.

It’s safe to say that traditional newspaper publishers are having a rough time these days. Revenues have collapsed as subscribers switch to online content and advertisers are spending less. Once great publishing giants like The Chicago Tribune, The Philadelphia Inquirer and The Journal Register Company have filed for bankruptcy in the last few years. With most newspaper publishers swamped in debt and burdened by heavy fixed costs, there will likely be many more victims in the future.

The Rundown

One of those once high flying publishers sitting on the brink is Lee Enterprises (LEE). Lee is struggling under almost $1.1 Billion in debt coming due in April 2012. While the company is profitable, making a profit of $46 million in 2010 and had strong cash flow of $106 million, it could all come crashing down if lenders are unwilling to refinance Lee’s debt at favourable terms.

Lee has been shopping for a deal for over six months and has met with over 150 potential investors. While debt-refinancing proposals have been made, management has declined them, citing poor market conditions and unfavourable terms from investors.

On May 5, 2011, CEO Mary Junck released a letter to shareholders after the company decided to withdraw its private placement refinancing plans. In the letter, Junck explains that analysts are being unfairly “pessimistic” about the company’s “prospects,” and that a recent revenue shortfall was only a “temporary.” She states that Lee has “reduced debt by $732 million since June 2005” and expects “revenue trends will improve again as economic conditions” improve.

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Investors are obviously not as enthusiastic. Shares have dropped by 70% in the last three months. On July 8, 2011 the company received a delisting warning from the NYSE as its share price is below $1. Furthermore, despite the rosy outlook recently mentioned by the CEO Mary Junck, on July 15, 2011 Lee revealed that Q3 revenue would decline again, coming in at “4.2 percent below the same period for the prior year.”

Analysis

Lee Enterprises is operating in a dying industry, but it still has a loyal following and good earnings. It probably has another decade before its core product (newspaper) is rendered obsolete, and with a bit of tinkering it can likely migrate to a profitable digital business model. Even without evolving at all it should be able to keep generating cash for a few more years, but what then?

Lee’s balance sheet is a mess. Two thirds of Lee’s assets are composed of Goodwill and Intangibles. Together they represent almost $1 billion. The company has very little cash, and while it does have over $500 million in hard assets in the form of Property, Plant and Equipment, you have to ask yourself, what will be the real value of a printing press in 10 years? These obsolete beasts will probably be valued as scrap metal. From a liabilities perspective, you have a massive $1 billion in debt. Net it out and you are left with a paltry $77 million in equity.

As for the refinancing deal, the company was likely being forced by the market to offer junk bonds at a very high interest rate; about 11% to 15%. If Lee had accepted this deal, most of its cash flow would have gone to debt repayment, but the company’s survival would have been guaranteed for a few more years. Lee declined the offers and chose to shine up its short-term results in a bid to get a better deal. Furthermore, it is hoping that the economy might improve to the point where advertising dollars come back to the newspaper industry. Both ideas seem to be wishful thinking. As far back as 2009 Lee’s CEO was extolling her accomplishments and expecting advertising sales to increase. Back then the shares were trading 250% higher.

The Verdict

There is an old real estate saying that states, “Your first offer is your best offer.” I think this may also be applicable in the newspaper publishing business. Lee’s management was slow to adapt throughout the last decade and now the company finds itself at the mercy of creditors. Management has never taken responsibility for this. Even as bankruptcy rumours swirl, management blames the poor stock performance and negative press on pessimistic debt holders and media fear mongering.

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For shareholders, the last 6 years have been absolute torture as the stock price has fallen over 98%. Management wants to eke out the best possible debt refinancing deal in order to “recognize the future value (they) expect for Lee stockholders.” I say, it’s too little too late and management must wake up to the real problem.

Management should bite the bullet and admit that it has been stagnant for many years and led the company down a bleak path. Had management accepted the debt refinancing deal, they could have at least temporarily halted the share price collapse and gained a few more years in order to some how turn the company around. On the contrary, management has chosen to gamble again. As the economy sours and publishing revenues continue to drop it is unlikely that a better deal will materialize. As the company continues to teeter on the brink of bankruptcy, management is quixotic and shareholders will likely be left holding an empty bag.

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

I’m starting to hear the word “Resilience” a lot. People use it when refering to the stock market, political atmosphere, economy, etc. It’s always a bad sign.

When obviously bad news has little to no impact on the stock market, and, as we have seen lately, even has a positive impact, this is not resilience; it’s insanity. Insanity not in the sense that everybody trading in this market is mentally unstable (although I could debate that) but in the sense that people in general are not rationally acknowledging the degrading economy and factoring this into their earnings projections.

The traders have become obsessed with watching the Fed’s money printing, commodity prices and currency rates.  What about fundamental earnings, balance sheets and stock prices? That has all gone out the window, as long as people think that there will be inflation and higher stock prices.

It’s actually pretty pathetic. Honestly, I have to blame the young traders. There’s always the hot shots who come in, thinking they know it all, think they can see 10 steps ahead and make some quick bucks. I’m sure they can make money, in this kind of a market, it’s all about leverage and buying risk. A young persons specialty. But it’s nothing more than gambling. The old hats are trading this thing too, they’ve seen this movie a dozen times, and although they know the ending, they’re perfectly happy to watch it and make some money too.

Sooner or later, the market seems to re-adjust. Notice that I do not write “revert back to the mean,” as the market has not been mean reverting in 30 years. In today’s high paced world, we go from one extreme to the other (I honestly think it has something to do with the raging antidepressant abuse in society). So now everybody is giddy and can fully predict the future 5 years forward. There will be little bumps along the way which people will call black swans (Japan earthquake, Libya, Portugal). These are in fact nothing like black swan events (a word which is becoming far too overused). They are slightly grey swans at best.

But sooner or later, as things are humming along and the S&P is closing in on 1500,  BANG.  And then we have a real problem again, and no amount of hope-ium and monetization will bounce the market higher. I live for those days.

All this to say, watch out, because just when you think everything is fine, it all comes crashing down.

NOTE:

Speaking of crashes, YRCW has taken a beating. As previously noted, it’s a risky stock, and a risky company. Management will do all in their power to save it, which pretty much means they will give up almost all equity in the company to the debt holders. With the way things have been going, we will probably get a 90% dilution. Maybe a bit more even. With shares at $1.70, it is advised to wait a bit for more clarity before buying, and even then, just nibble.

From my perspective, I still think that these shares will at some point be a good buy and will bounce fast a high off their lows. We are still following developments and will likely purchase once  we get more clarity on the dilution rates.

So, what exactly caused the erratic stock prices in the final seconds of trading?