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April 18, 2006

Newspaper Industry Earnings Wrap-Up

Newspaper companies are among the first to report each quarter. As of today, most of the companies have reported. In the "Continue Reading" section linked below, I have posted a series of notes beginning with a preview and including summaries of the reports from Gannett, New York Times, Tribune, and Dow Jones.

I entered the earnings period looking for a bullish trade in the group. My thought was that everyone hates the group and the stocks have been going steadily down. If earnings were no worse than expected and the outlook for the balance of 2006 did not deteriorate further, a trading oppoortunity might exist. I don't own newspaper stocks so taking the unpopular stance seemed like the right idea. As it turned out, results didn't warrant getting long. I remain onthe sidelines but I think my bullish thesis still could work out if 2Q trends show stability. For that reason, it might be worth your time to wade through the lengthy post and get more familiar with what is happening in the newspaper industry.

Earnings Preview

Heading into 1Q06 earnings season for the newspaper companies, earnings estimates continue under pressure virtually across the board. As recently as late March, industry leader Gannett (GCI) told analysts that earnings would come in at the low end of range for 1Q, citing ongoing weakness in automotive and national advertising. While GCI also continues to feel pressure from its UK operations, the problems with automotive and national advertising are plaguing the entire industry. Retail advertising and subscriber losses are also hurting industry growth rates.

The newspaper industry problems run deep. Some are cyclical, others are structural. As earnings reports begin to come in this week, here are some things to keep an eye on:

Automotive advertising, a major category for the industry has been dropping at double digit rates. In this case, the problems appear to be cyclical and structural. Clearly, there is a trend toward the internet for auto advertising. However, weak auto sales and scaled back incentives also are exerting cyclical pressure. Advertising Age recently noted that Ford (F) would have flat to lower ad expenditures this year and a greater proportion of the spending was headed online.

National advertising, another major category, has also been weak. Telecom has been a big culprit but I believe this is largely due to recent mergers, particularly among wireless carriers. The wireless industry has been a big newspaper advertiser but mergers have taken AT&T Wireless and Nextel out of the picture over the past two years, allowing the acquirers, AT&T (T) and Sprint (S) to gain economies in the advertising budget. Thus, this factor would seem to be cyclical and as the mergers are lapped on a year-over-basis and new branding comes from T, the recent pressure on this category could dissipate and growth might return.

Mergers have also caused a problem in retail advertising. As Federated Department Stores (FD) has bulked up, it has meant loss of advertising in key markets where the company formerly competed with Marshall Field's or May Department Stores. Since FD is switching from a regional to a national branding strategy by putting the Macy's nameplate on hundreds of stores, the impact on newspapers is structural. FD will now spend much more of its ad budget on the most effective national ad platforms like TV.

Another structural issue the industry faces is loss of subscribers. Until about a year ago, the decline was steady but modest. However, the losses accelerated last year. At least part of the problem came from subscriber restatements as newly audited figures revealed many instances of overstatement. These losses will soon be mitigated in year-over-year measurements but I have to believe that some small part of the acceleration in subscriber losses is due to what appears to be round 2 of the internet wave, this time driven by broadband connections.

One other thing to consider as newspaper companies begin to report is that in general, advertising and circulation trends have been worse in larger markets. There have been some signs recently that smaller markets are beginning to succumb. Lee Enterprises (LEE) is a smaller market operator that has recently seen its ad trends revert toward the industry mean. The Ottaway division of Dow Jones (DJ) has also had weak numbers. Nevertheless, the problems are worse at large daily metros and it is earnings reports from GCI< New York Times (NYT) and Tribune that will set the tone for investor sentiment toward the industry.

Turning the current setup in the newspaper stocks, nothing I have written should come as any surprise. The demise of the newspaper industry has been widely discussed and is conventional wisdom. The recent sale of Knight Ridder (KRI) to McClatchy (MNI) at a modest multiple was a convenient excuse for pundits to dump on the industry so sentiment is currently about as bad as it has ever been. Newspaper stock prices which have declined steadily for the last few years and valuations, commonly judged on enterprise value to EBITDA, are slightly below long-term historical averages at around 8 times 2006 estimates.

Of course, one could argue that given the challenges the industry faces "slightly" cheap on a historical basis is not saying much. The same thing could be said about valuations relative to other media sectors. Multiple compression in entertainment and cable has been worse so the discount for newspapers has actually shrunk significantly. Maybe the other sectors were even more overvalued and are now responding to their own set of challenges. However, intra-sector relative valuation is a headwind for newspaper stocks.

Despite lousy fundamentals, with sentiment poor and conventional wisdom well entrenched, I am actually entering this earnings season looking for a reason to become bullish. As mentioned, some of the problems are cyclical. Comparisons on advertising and subscribers will begin to ease in 2Q06. Newspaper management teams have kept a tight lid on controllable costs with many companies keeping costs close to flat on a year-over-year basis.

Consider these questions. If cyclical trends stop declining, might we be at the point where estimates stabilize? Could success in monetizing internet traffic to local newspaper websites provide a growth engine? Have recent internet acquisitions provided the opportunity develop large, growing business units that can move the needle on the top and bottom lines? Is sentiment poor enough and are valuations cheap enough to ignite a tradable rally in the group?

Since I am not long any newspaper stocks beyond an odd lot holding of TRB, I plan to enter earnings season looking for affirmative answers to these questions. I've got nothing to lose and at this point I think the any investment opportunity in the group lies on the opposite side of the deeply entrenched conventional wisdom.

Gannett's Results

Gannett (GCI) shares are trading flat as the conference call discussing the company's 1Q06 earnings wraps up, rebounding from a decline of more 1% as the call began. The earnings were pretty close to analyst estimates, which is no surprise, given that the company lowered guidance less than a month ago. EPS of 99 cents matched analyst estimates as did revenue of $1.88 billion. The operating figures underlying these results show absolutely no momentum as pro forma revenues were down less than 1%. Based on what I know so far, I don’t think GCI supports my trading rally thesis but there are a lot more newspaper earnings coming in the near future.

Looking more closely at the segments, overall newspapers saw revenues decline 1.8%. This figure was penalized by foreign currency but the bigger drag was the continuing poor results out of the company's UK operations. On the call, management noted that March revenues in the UK were down about 8% and stated that trends were "very soft." UK results were a focus of Q&A on the call and my impression is that estimates in this business will be going lower.

Newspaper results in the U.S were better. The press release stated that 1Q06 newspaper in the U.S.-only were up 1.5%. Smaller papers outperformed larger papers and USA Today was a big drag with a revenue decline of over 4%. Simultaneous with the earnings release, the company released its March Revenue Report. This report indicated that department stores, auto, and telecom continue to be weak categories. One of things I am looking for is flattening growth in these categories as comparisons ease. Based on what I read and heard today, I'd have to say I am less hopeful this will be the case in 2Q06.

The other are of focus on the conference call was how GCI would manage its balance sheet and cash flow. The company currently carries $5.2 billion in debt, mostly in commercial paper. Interest expense was up sharply year-over-year to $65 million from $45 million due to rising short-term interest rates and higher debt levels due to share repurchase. In response to a question, management said that they might be terming out some of the debt soon. I wonder why they have not already given the uptrend in short-term interest rates has been so obvious. One reason maybe because free cash flow not dedicated to acquisitions could be used to paydown debt. Analysts pressed for share repurchase but I got the impression management was non-committal. They seem to prefer acquisitions and stated that while no large deals are out there, the pipeline is strong for deals less than $1 billion in digital media, broadcasting, and newspapers. Given the lack of growth in newspapers and TV and secular challenges, investors would prefer GCI to buyback shares.

While the easier comparisons are ahead in newspapers and broadcasting pacings are already getting less negative, I fear that rising interest expense and worse-than-expected IK results could keep modest pressure on estimates. The bull thesis is that stabilization of estimates leads to share price relief. GCI might not be a good indicator as its debt and UK situations are not mirrored throughout the industry. However, I am not ready to call things for the bull case without hearing from other domestically dominated newspaper companies.

New York Times Recap

New York Times (NYT) reported 1Q06 earnings in line with estimates. EPS of 28 cents was a penny better than expected on in line revenues of $8.32 billion. The New York Times Group and the Regional Newspaper group had positive advertising revenue growth but the New England Media Group (primarily the Boston Globe) continued to struggle with negative growth. The publishing websites were a bright spot with revenue up 23%. In response to a question from Lauren Fine of Merrill Lynch, management admitted that revenue growth at all the publishing operations would have been negative if the internet revenue was excluded. Easter timing also was a benefit so underlying print growth is still clearly declining. About.com was a star in the quarter with revenues rising 98% to $19 million. This acquisition seems to be working out well for NYT. Management stated that they'd rather do "more About.com's than buyback stock."

While the EPS and revenue numbers were inline, it is worth noting that cost controls at NYT are not quite as tight as reported by peers Gannett (GCI) and Tribune (TRB). NYT's expenses were up 3.2% in the quarter vs. flat to lower at GCI and TRB. The press release quantified the increase as coming more or less equally form distribution and printing costs, raw materials, and promotions. Newsprint expense rose 5.9%.

Q&A had a few revealing items. First, like TRB, NYT said that telecom advertising was growing again. This is a good sign as one of the cyclical challenges appears to have turned favorably. Hotels were also mentioned as a strong category along with real estate. Also like TRB, entertainment was noted as a laggard, falling more than 10% in the case of NYT. I missed the entire comment but management said that this category was 14% of ad revenue. That seems high, so I am guessing that what I missed was that this was just at the NY Times. Shorter runs for movies and small films nominated for Oscars were the reason for the lousy entertainment numbers.

Second, the dominant area of interest to analysts was the NYT's internet revenues. Analyst seemed impressed by the numbers and pressed management on sustainability and margins. The company responded positively and appears very confident in their assets and strategies in this area. As noted above, management would like to acquire more internet assets but at current prices, I have to wonder how the street would greet any reasonably sized deal.

I didn’t come away from the call with a lot of enthusiasm for going long NYT shares. So far, I think TRB is the best bet in the group because it is the cheapest stock and its fundamental underperformance relative to its peers seems to be moderating. If I had to build a bull case for NYT, it would be based on their growing internet operations. On a percentage basis, NYT is not generating any more in revenues from the net than its peers. However, the assets are easier to understand and appreciate given the national, even global, brand that is the New York Times. Additionally, About.com is a standalone business that investors can understand. The bull case would be that the stock deserves a premium to the group because its internet assets increase the likelihood that growth returns to the entire company.

Tribune Results

Tribune (TRB) reported slightly better than expected 1Q06 earnings after adjusting for one-time items. The company reported 38 cents adjusted vs. consensus of 35 cents. Revenues came in as expected at $1.3 billion. The upside appears to emanate from tight cost controls and equity income. Based on commentary on the conference call, it sounds like both of these things could recur over the balance of 2006. Consequently, if revenue trends don’t get worse, EPS estimates for TREB ought to stabilize or even inch up slightly.

While this is important to generating a bull case for TRB, I think the real upside comes from improved performance relative to its newspaper and broadcasting peers. I think the 1Q06 numbers support a relative improvement. Circulation trends are stabilizing as most weakness is now isolated to bulk and other sales. Advertising revenue trends remain anemic but they aren’t really any worse than their peers. TRB shares trade at a 10-15% to the group so if investors appreciate that the many self-inflicted problems the company has faced over the past year are fading, the shares could have some upside. For now that is my operating thesis for TRB shares but I'd like to read some analyst commentary to confirm.

In the quarter, TRB had flat newspaper revenues. The big drags were movie advertising at the LA Times, which fell 8%, and continued pressures at Newsday resulting from the circulation issues. In reality, flat overstates the results because interactive, up 30%, is included in publishing revenue, and the company stated that the Easter shift helped March results. National and retail advertising remain the weak areas. Besides movies, national auto remains weak. Interestingly, TRB noted that national telecom/wireless spending was up and that the company felt it had largely cycled the merger induced weakness. Local ad trends were better as classified categories like help wanted and real estate continued to grow strongly offsetting continuing weakness in auto. Management noted that homes were selling more slowly in Florida and this was actually boosting advertising spend.

The real story in publishing was in cost controls. Cash expense fell 2% on a 5% reduction in staff. Management felt these trends would continue and pointed out that savings from cost reductions at Newsday would kick in later this year.

On the broadcast side, management spoke optimistically despite the fact that revenues fell 2%. This is a better performance than occurred at any time in 2005 and trends at the company's Fox affiliates are quite strong. Cash expenses in broadcasting are also under tight control. Management believes the shift from the WB to the CW Network later this year will provide a boost to revenues. This transaction also accounted for some of the surprise in equity income as TRB is no longer reporting losses from the WB.

As expected, Q&A had numerous inquiries about share repurchases. Analysts seem disappointed by the recent pace of repurchases and management was not particularly firm about future plans. Potential acquisitions were mentioned but with the stock at under 7 times EBITDA, investors aren’t interested in adding businesses which would certainly be acquired at a premium.

Overall, I'd have to say TRB's report support my bullish trading theses for the industry and for TRB uniquely. There are signs of stabilization in revenue and cost controls remain tight. Growth will remain challenging but all I am looking for is stability in estimates. I think that is in the cards at TRB.

Dow Jones Recap

Dow Jones (DJ) shares are down sharply following the company's 1Q06 earnings report and conference call this morning. The company reported an adjusted EPS number of 14 cents on revenues of $452 million. These figures compared to estimates of 15 cents and $445 million. 2Q06 guidance was also provided, with EPS estimated in the low to mid 30 cent ranges against a current consensus estimate of 38 cents. Revenue growth in 2Q06 looks a little better than current analyst estimates. This data above suggest that operating expenses are higher than expected. Management attributed this to advertising mix, newsprint, the Community newspapers, and equity income.

Revenue growth clearly seems to be on the rebound. Even excluding Weekend Edition, growth is in the upper single digits and management seems confident that it will hold at that level for the balance of 2006. This is partially due to easy comparisons but management noted that all categories are contributing (I continue to think that online growth could be stronger – up 15% in 1Q at DJ, while NYT reported a 23% gain). Mix is an issue, however, as classified real estate is showing unusually strong growth. Unfortunately, this is a low margin category. Newsprint also continues to rise in price and pressure margins. Management isolates newsprint expense but clearly this is a recurring area of operating expense. Community newspapers (less than 20% of revenue) are also feeling pressure as advertising revenue growth remains elusive.

Overall, the shares are succumbing to the worse than expected guidance. I think the negative reaction is worse than warranted. However, sentiment toward the group is terrible and DJ trades a big premium. Furthermore, DJ shares had enjoyed solid gains so far this year, up about 8% prior to today. The bar was set high for a turnaround and investors are not willing to tolerate a shortfall.

That said, I think investors are willing to pay for growth, so I believe that weakness in DJ shares may be limited to the damage today. Solid downside support exists due to the operating turnaround (1Q EPS rose 27% year over year), takeover potential, and the highest online exposure in the newspaper group. Key for the shares is for revenue gains to continue in 2007 when comparisons stiffen. This will require a cyclical turn for the industry, something that few investors are predicting or willing to pay for.

If I were going invest in newspaper stocks, which I do not currently plan, I would use a combination of DJ and Tribune (TRB). DJ offers the best potential growth, while TRB is the cheapest stock in the group and the fundamentals are o longer any worse than its peers.

Summary and Wrap-Up

Based on the first round of earnings from newspaper companies, I don’t think my thesis of a bull trade off of stabilization in estimates seems likely to occur in the near-term. Results did show signs of stability and some negative cyclical factors such as telecom mergers are reversing. However, there is no sign whatsoever of growth in print advertising, so despite generally good cost controls, there is no sign of operative leverage or operating income growth. Share repurchase activity does create a little growth in EPS, but the bottom line is that investors are unlikely to get interested in the group in the immediate future.

To get the group moving again requires a return to top line growth. I still believe that as 2005 troubles from mergers and circulation restatements get put in the past, it is possible that print advertising could start growing again in the low single digits. And that just might be enough to drive total revenue growth into the mid-single digits because online advertising at newspaper companies is beginning to grow large enough to make a difference.

I mentioned on last week's New York Times (NYT) earnings coverage that analysts were very focused on the company's online activities. NYT generated 7.5% of its revenue in 1Q06 from online services. Tribune (TRB) reported a similar 6.5% of revenue from online sources. At NYT, online revenues grew in excess of 30% including the 98% gain from About.com. Core online revenues grew by 23%. NYT is projected to generate $3.5 billion in total revenue this year, so we are talking real money here (at least $250 million in 2006).

With print advertising and circulation revenue barely growing, it seems plausible that online revenue could be 8-9% of total revenue generated by NYT or TRB in 2006. If so, and if in 2007 that revenue stream grew by 25%, online would generate at least 2% top line growth next year all by itself, even if all other traditional revenue sources endured another flat year.

If all other revenue sources began to grow again, even modestly, the idea that certain newspaper companies could generate mid-single digit revenue growth in 2007 is not far fetched. As mentioned, some of the things that have been pressuring revenue are cyclical in nature. If cost controls remain tight and operating expenses are held to very low single digit growth, operating income could grow in the upper single digits, ongoing share repurchase could turn that into double digit EPS growth.

I don’t sense investors are willing to pay for this potential yet. After all, it is just potential, and it is hard to have confidence in a rebound in traditional revenue sources. However, conventional wisdom seems aligned virtually 100% against investing in the industry. To me, that is time to do your homework and look at what might go right.

Posted by Steve Birenberg at April 18, 2006 11:10 AM in Newspapers