By Tom Gibbs – February 29, 2012 | Tickers: GRPN, VCI | 0 Comments

Tom is a member of The Motley Fool Blog Network — entries represent the personal opinions of our bloggers and are not formally edited.

In following the Fool’s “celebration” of the Leap Year, this article proposes a contrarian short hypothesis on traditional advertising mediums. 

Valassis Communications (NYSE: VCI)

Offering a variety of media solutions including shared mail, newspaper, in-store, and digital delivery, VCI is heavily (more than 90%) reliant on national retailers and service providers increasing overall expenditures on newspaper advertising and direct mail pieces.

The market, especially the consumer goods retail sector, is still attempting a slow recovery from a trough period of revenue and advertising expenditures.  A bet against VCI shares is essentially a play on how those ad dollars will be spent when (and if) volume begins to improve in the near term.  Following the trends of paper mail — newspaper inserts, direct mail pieces, etc. — versus Internet ad spending shows that VCI truly operates in the wrong business to experience the full effect of a possible resurgence in overall business levels.

Several headwinds that will hinder the stock’s future performance exist:

Shift in Advertising Mediums

Traditional ad mediums like newspaper (and even TV to a certain extent) are becoming increasingly less attractive routes towards reaching the most influential consumer population.

Some key newspaper ad trends exemplify the slow death of the medium (source: Newspaper Association of America):

  • In late 2010, one in four Americans say that they read the newspaper in print every day, down from 38% in 2006
  • Less than 25% of 18-34 year olds read the newspaper daily
  • Daily readership of newspapers for those over the age of 65 has only dropped by 11% over the past ten years, compared to the 25% drop for those between 18 and 44 years old
  • In late 2010, 17% of Americans say that they surfed a newspaper’s website within the past 24 hours, up from 9% in 2006

The medium’s ad generation is at its lowest level in the past two decades

The population still desires exposure to national and local news stories, but younger generations (and even some of the older population, for that matter) are becoming increasingly less willing to browse through a physical newspaper copy.  The trend is well appreciated and it is not surprising — the use of an Internet news portal allows for much more convenient access to many of the other popular services not offered by a traditional newspaper.

The decrease in the use of newspapers as a news source and an advertisement vehicle are fully explained by the opposing trends in the online medium.  Based on a recent Interactive Advertising Bureau (IAB) Internet Advertising Revenue Report, Internet ad revenues in the US totaled $14.9 billion in the first half of 2011, up 23% from the comparable period in the prior year.  As depicted in the chart below, online ad spending has increased at a robust 22% CAGR between Q1 1999 and Q2 2011 (Source: IAB).

 

One hardly requires the research figures to fully appreciate the drastically changing advertising landscape.  Especially among the younger population (age 18 – 34), the swiftly growing popularity of sites like Groupon (NASDAQ: GRPN) and Facebook exemplifies the future of targeted advertising.  The only reliable way for retailers and service providers to reach this demographic, as well as the 74 million Americans below the age of 18, is to eventually abandon or shift a majority of ad expenditures away from the failing non-Internet space.

With a very minimal portion of its current business devoted to the ad industry’s future direction, one would be very hard-pressed to assume the corporation can fully and successfully change the course of its ship before it starts to feel the effect of decreased profitability.

Possible Catalyst in USPS Restructuring

Reporting a cumulative net loss of just over $20 billion over the past four years, there can be no doubt that the United States Postal Service is also in need of a new direction.  The organization projects the decline in revenues from all of its mail service types, and has estimated that volumes in 2020 will be roughly equivalent to what was handled more than thirty years ago in 1980. 

The most logical solution, and one that the House of Representatives has recently proposed, includes a drastic workforce reduction (nearly 20%) and possibly the suspension of Saturday mail delivery service.  If such a restructuring arrangement was proposed, the failure of the VCI strategy would be experienced much more quickly. 

Many countries operate without Saturday mail service, and it would not be difficult to envision a United States with a similar arrangement (most probably wouldn’t be able to tell the difference).  The cancelation of weekend services would be disastrous to the VCI traditional medium model, as advertisements targeted to consumers on the weekends are much more effective than those received during after-work hours on weekdays. 

High Fixed Cost Burden

An investment in VCI is a hope that the corporation can shift the large majority of its annual revenues to sources that are not plagued by declining popularity.  The corporation has made an entry into the digital space through its redplum.com and save.com offerings, but these sources comprise less than 10% of its recent revenues. 

VCI’s core business, reported through its “Shared Mail,” “Targeted,” and “FSI” segments, have been rapidly losing their effectiveness to continuously grow revenues.  The following illustrates the corporation’s compound annual growth rates, broken down by reporting segment and operating period (quarterly).

 

* The Shared Mail segment originated in Q1 2007, and did not report a full quarter of revenue

The increase in Internet ad expenditures reported earlier, as well as the increasing revenues in VCI’s own digital ad segment, shows that these declining revenues in VCI’s core traditional medium segments are more of a function of a decreased use of such ad types than a broader weak economy hypothesis. 

Due to a high level of fixed costs – such as paper goods, postage expenses, etc. – the corporation has a very unfavorable exposure to decreased profitability when and if revenues in its core business continue to fall.  Even as overall business volumes continue to increase during the economy’s improvement, one needs to question the proportional share of increased ad expenditures that traditional mediums will command as online entities (the aforementioned Groupon and Facebook) continue to gain in popularity. 

All of this goes without even mentioning the company’s rather inefficient operations.  Excluding a large, one-time $490 million litigation settlement in the most recent fiscal year, the corporation has earned an average of 7.7% on core assets between 2009 and 2010.  The corporation, from a residual earnings standpoint, is not generating any meaningful excess on its core assets yet the market is pricing those assets at more than two-times their book value.  Management has not made any meaningful purchases of the stock, even as it has lost nearly 40% of its value since late 2010. 

Why a Leap?

Other than the risks inherent in with a short strategy, there are several other:

  • Even though the corporation generates a large portion of its revenues from advertising sources that face the threats of being phased out, and although it is not growing at a rapid pace, Valassis is not extremely expensive — 10.9x earnings and 5.8x enterprise value (both trailing twelve month basis)
  • Analysts expect earnings to grow 28% to $3.11 per share over the next operating year
  • The corporation is cash-generative, and in generating more than $150 million in free cash over the past year, the stock offers a near 13% FCF yield at current valuations
  • There is no certain catalyst for the short hypothesis other than a continuation of stagnant performance.  The USPS Saturday service cancellation, likewise, is but a conjecture

However, with a short interest representing more than 17% of the total float, the number of contrarians with a similar hypothesis is growing! 

The Motley Fool has no positions in the stocks mentioned above. gibbstom13 has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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