A Hold on Washington Post (WPO)

Contrary to what many might still believe, WPO is no longer a newspaper, but this is not news to many investors. WPO is a holding company whose main assets are:

• Kaplan – for-profit education and test prep services
• Cable ONE – cable T.V. and high speed internet
• T.V. broadcast stations
• Real estate
• Marketable securities
• Newspaper and publishing

For many years WPO has been a favorite among value investors. Buffett himself has been a long-time investor in WPO and has had a long relationship with the company’s leaders. Many have made the case over the years that WPO is extremely undervalued on a sum of the parts basis. Up until recently, I believed this to be the case, but recent political and regulatory events (in addition to other more qualitative factors) have the potential to substantially decrease the value of WPO and reduce the margin of safety for potential investors.

Sum of the Parts

To properly value the WPO, we must use a sum of the parts method. I’ll go in order from greatest to smallest in terms of size of assets.

Kaplan

Recently there has been much news about the for-profit education industry. There was a recent Frontline investigation into this industry that paints an unflattering picture to say the least and which has undoubtedly provided an additional incentive for more regulation. Among other things, the investigation explains how students have extremely high default rates on their loans, how education companies spend a disproportionately high amount on advertising rather than on students, how some recruiters use questionable and high-pressure tactics to sign up students, and how some students have earned degrees they can’t use for the jobs they wanted.

Additionally, Steve Eisman (one of the few investors who both saw the sub-prime crisis way ahead of everyone else and made a bundle going short) made a very convincing presentation of his short thesis for the for-profit education industry at the 2010 Ira Sohn Conference. Eisman feels the industry has all the characteristics of the recent sub-prime mortgage bubble, saying that: “The for-profit industry has grown at an extreme and unusual rate, driven by easy access to government sponsored debt in the form of Title IV student loans, where the credit is guaranteed by the government. Thus, the government, the students and the taxpayer bear all the risk and the for-profit industry reaps all the rewards.”

The bubble-like nature of the industry coupled with evidence of very high student loan default rates and the fact that these companies are profiting from easy access to government money, has attracted the attention of regulators and I think rightly so.

Since the Obama administration has gotten situated, there has been a year-long battle between the U.S. Department of Education (DOE) and the higher education community regarding changes to student aid rules. On June 16, the DOE released its Notice of Proposed Rulemaking regarding fourteen different student aid issues, the most important being the rule regarding gainful employment. The idea behind the gainful employment rule is to limit student debt to more realistic levels, which will likely force the industry to reduce tuition costs and/or cut programs.

Other proposed rule changes will affect the operations of the for-profit education industry. For example, the DOE recommends tightening oversight of “Ability to Benefit” tests, exams on which many institutions rely to enroll students who do not have high school diplomas. The DOE also recommends strengthening the metrics by which students must show academic progress, the goal here being to prevent schools from receiving federal-aid funds from students with near-failing grades.

The DOE’s draft rules will be open to public comment for 45 days and plans to issue a final rule by Nov. 1, with changes taking effect beginning July 1, 2011.

With new rules negatively affecting the profitability of Kaplan and a convincing argument that the for-profit education industry is a bubble, this has reduced the value of WPO’s most important asset. I peg the value of Kaplan at about $2.5 billion based upon my best estimate of discounted cash flows.

Cable ONE

In 2008 Cable ONE bought a smaller cable television business for $2,300 per basic subscriber. I’ve also found that other transactions in similar geographic areas have averaged about $3,000 per subscriber. Multiplying $3,000 by Cable ONE’s 669,000 basic subscribers we get a value of about $2 billion. This imputes no additional value for the 392,800 high-speed data subscribers and 109,600 telephony subscribers so I think this is a conservative estimate.

T.V. Stations and Broadcasting

WPO owns three T.V. stations in the top 10 through 20 viewership markets and four stations in the 20 through 50 range. Based on other sales of T.V. stations in similar viewership markets, I originally estimated that a T.V. station in the top 8 through 20 market area range was worth about $213 million and that stations in the top 20 through 50 market area were worth about $93 million each for a total valuation of roughly $1 billion.

Currently I am giving a 50% haircut to my original value of the T.V. stations, though a larger haircut may eventually be required. I have two reasons. First, I believe these assets will decline in value much like the value of newspapers and publishing assets of WPO have declined. I also believe that WPO will do nothing about this, choosing to hold onto these assets until there is little to no value left. I’m afraid that Don Graham, current chairman, CEO, and owner of the family business, might be trying to ape Buffett’s “buy and hold” approach to the detriment of the company.

Second, I found that a transaction between CBS and Cerberus at the beginning of 2008 valued several stations in top 20 through 50 market range at about $26.5 million per station, about 70% less than my original estimates. I feel that this transaction is more representative of the current and possibly future environment for the television broadcast industry.

Real Estate

WPO owns a fair amount of real estate. I was able to find the total assessed value (as assessed by local authorities for tax purposes) for most of WPO’s real estate and found that the total assessed value is about 40% greater than the book value of WPO land and buildings as stated in its June 28, 2009 quarterly report (the last quarterly that broke out the values for land and buildings). Thus, with a stated book value of about $400 million, a more accurate estimate of the true worth is about $560 million.

Marketable Securities

WPO has marketable securities (a large portion of which are Berkshire shares) that are worth about $440 million as of April 4, 2010.

Newspaper and Magazine Publishing

I assume the newspaper and magazine are worth zero.

Sum of Parts

Summing up all the parts…

• Kaplan: $2,500 million
• Cable ONE: $2,000 million
• T.V. stations: $500 million
• Real estate: $560 million
• Marketable securities: $440 million
• Newspaper and magazine: $0
• Long-term debt: $396.4 million

We get a net intrinsic value of $5,600 million. With 9.241 million shares outstanding, that’s a value of $606 per share, or lets say an even $600 to be on the safe side.

At a market price of $454, that’s only a discount of 25%, an amount that I think is insufficient to compensate for the risks of:

• impending higher education regulations
• the likelihood that the for-profit education industry is a bubble
• the high possibility that the T.V. broadcasting industry will soon be in permanent decline like the newspaper industry (if it isn’t already in decline)

However, if the price of WPO shares declines to $360 (a ~40% discount), then I would start getting interested in the stock.

Variant Views

Some might say fears are overblown regarding regulations that will affect Kaplan and that it will be able to adjust to a new, lower-profit reality. However, I feel regulation is well-deserved in this industry and there is just no telling how far politicians and regulators are willing to go with new rules, especially if there is truly something to dislike about an industry.