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July 20, 2006

Dow Jones Shows Signs of Life

Dow Jones (DJ) reported better than expected 2Q06 earnings. EPS rose 15% to 39 cents, ahead of the consensus estimate of 35 cents. Revenues actually came in a little light of expectations, growing just 6%, but margins expanded and operating income rose over 16%. This quarter showed evidence of the operating leverage that investors expect from DJ. I think this is the main reason why the shares are responding so well to the quarter, especially in light of 3Q EPS guidance that was several cents below the current consensus.

DJ shares still look too expensive to me, but with evidence of operating leverage finally emerging, I feel that 2007 estimates now look more realistic. This makes the premium valuation more palatable. I don’t think the stock will visit my buy point in the $20s. Downside should now be limited to recent lows assuming the market doesn't get further clobbered. If you want exposure to newspapers, DJ is the stock to own....

One thing that I think will limit upside in the near-term is that with recent strategic initiatives seeming to gain traction, pressure from the Bancroft family to sell the company will remain low. The unique nature of DJ's assets and the control by the Bancroft family are partially responsible for the premium valuation. For now, the stock will be driven by perceptions of the top line and how that translates to big gains down the income statement given the return of DJ's operating leverage.

As mentioned, the company guided 3Q below current estimates. In my preview, I mentioned that tougher comparisons loomed. I think analysts were not surprised by the guidance. Furthermore, I think Q&A revealed that the guidance is probably conservative. The company exited the quarter with pretty good momentum, including 5% growth in the top line at the Journal after backing out the Saturday edition. Management acknowledged the tougher comps and pointed to a stall in the recovery for recovery advertising and a sharp reduction in the growth rate of classified real estate advertising. They also commented that given that business leader confidence was declining due to a slowing economy and the geopolitical tension, they decided to budget cautiously. Investors bidding up the shares today expect that 3Q EPS will be closer to the 17 cent consensus than the low teens guidance. I think they are probably correct.

DJ's biggest division is consumer media which includes the Journal, Barron's, Marketwatch, and the other online businesses. Operating leverage was very high in this division with a 9% revenue gain translating to a 47% operating income gain on a 170 basis point rise in margins. Looking just at the print editions, management noted that over 80% of incremental ad revenue fell to operating income.

The digital businesses grew a faster than expected with ad revenue up 23% and subscription revenue up 33%. Marketwatch growth picked up and outperformed the corporate average. Subscription revenues benefited from growth in WSJ.com subcribers and the new revenues coming from separating Barron's Online.

The smaller divisions did not receive a lot of focus on the conference call. Enterprise had an excellent margins but top line growth remained limited at under 2%. Community Newspapers eked out 1.7% top line growth but saw operating income fall over 4% as it is feeling the same pressure as other traditional newspapers.

Finally, management spoke positively about future cost savings with respect to the redesign of the Journal to a smaller width. These savings should start hitting in 2007 providing further support for continuation of the operating leverage witnessed in 2Q06.

Posted by Steve Birenberg at July 20, 2006 11:36 AM in DJ