Looking Ahead: E&P's Analysts Roundtable

By: Mark Fitzgerald and Shawn Moynihan Top Wall Street analysts assess the industry now and into 2011, and - surprise! — a couple are bullish on newspapers In recent years, Wall Street stock and credit analysts as a class have often seemed the harshest critics of the newspaper industry. After cheering the big blockbuster deals of the first half of the 2000s, most quickly turned sour on newspapers as the business stumbled. Some firms even stopped following publicly traded publishing companies. But newspaper shares staged a remarkable run-up in value starting in the summer of 2009, a rally that stalled only at this beginning of this summer, when the wider markets also dropped. So how do analysts feel about newspapers these days? E&P talked with six of the top equity and credit analysts who follow newspapers, and found skepticism mixed with cautious optimism about future performance. Similarly, there’s disappointment and impatience among some with the pace of newspapers’ transition to digital, but also admiration for the radical steps publishers took to return to profitability and pay down debt. There were even a (very) few buy signs on newspaper sector stocks. The participants: James Goss Vice President and Senior Research Analyst Barrington Research Associates Inc. Barry L. Lucas Senior Vice President - Research Gabelli & Company Inc. Joscelyn MacKay Analyst and Credit Specialist Morningstar Inc. Alexia Quadrani Managing Director JP Morgan Robert Roman Partner PricewaterhouseCoopers LLP Mike Simonton Managing Director Media & Entertainment Fitch Ratings Q: How would you assess the performance of newspaper companies in the first two quarters of 2010? Any surprises? James Goss: I don't think there were major surprises. The intensity of the downward pressure on ad spending appears to have lessened, though the extent to which all of that volume is recaptured will remain in question. A reduction in the rate of revenue decline is a favorable trend, but it is still a decline, and against a weak base period. However, cost-cutting efforts at Gannett have enabled that company to create positive comparisons in profitability. Barry L. Lucas: Surprises? [Newspapers’] ability to continue to cut costs and generate EBITDA increases despite ongoing ad revenue declines. Joscelyn MacKay: I’d say the performance is disappointing given that advertising dollars are returning as the economy improves, but newspapers are realizing less of the upside relative to television and Internet. For instance, Gannett's publishing ad revenue continues to decline even as ad-spending growth enters positive territory. Alexia Quadrani: After a strong rally in the second half of 2009, [newspaper] stocks have been relatively range-bound in the first half of 2010.  The one exception would be E.W. Scripps (NYSE: SSP), which is up slightly year-to-date in part driven by the high concentration of broadcast revenues as well as the cash inflow from the sale of United Media. Robert Roman: It appears that results to date are indicating positive signs that 2010 will show some improvement over 2009. There are positive trends, and any recovery in ad spending as the recession eases will produce positive bottom-line results. Additionally, many of the comparisons for 2010 are coming after one of the worst years for advertising, when some companies experienced significant revenue declines. Newspaper companies have done a nice job embracing change and many are exploring new operating models such as outsourcing and off-shoring common tasks, deploying new technology to store, recall and use content across multiple platforms and to reduce manual labor needs. Mike Simonton: On the revenue side, performance is in line with expectations as they are doing better off of really weak comparables. We've been more surprised on the cost side. Newspapers have done a great job of continuing to extract meaningful cost savings against prior years when they were also very focused on costs. What are your expectations for the rest of the year and into 2011? Goss: I remain hopeful that the economic recovery will regain sounder footing, and that the ad recovery regains greater momentum. Lucas: I see more moderate declines in ad revenues with potentially some up revenue comps late in the year. Newsprint costs are expected to be less favorable as the companies cycle past last year's low prices. MacKay: We expect the newspaper industry to struggle given its perpetual decline. As newspaper circulation drops, newspaper ad spending should also decline, creating a vicious cycle. U.S. newspaper circulation has fallen each of the past 15 years and newspapers' share of ad spending decreased to 23% in 2009 from 31% in 2002. The advent of portable digital technology, such as smartphones, has only accelerated the decline of newspapers. Roman: We should continue to see companies re-evaluate their daily newspaper strategies and — in some cases - either exiting the local edition or adopting an "Internet-only" news source, similar to 2009. There will be a continued focus on leveraging opportunities from the rapid expansion of wireless mobile and other broadband access/reading devices. Simonton: We expect newspapers to continue to see declines, but at a decelerating pace relative to last year. We also expect them to continue find permanent fixed-cost savings. As several of you mentioned, publishers propped up profits in the past three quarters as deep cost cutting paid off in the bottom line. Going into 2011, do you expect newspapers to bump up against some tough comparables in expenses? And how is the market likely to react to that? Goss: Hopefully the dynamic of moderating revenue declines and perhaps even some improvement, assuming the economy recovers, should match up well with expenses that will not likely be allowed to get out of hand. If revenues rise modestly and expenses are flat, profitability should be able to improve at least somewhat. However, business mix issues can come into play. With Gannett, the favorable impact on this year's broadcasting business from political revenues will not be present in 2011, suggesting lower profitability from that source next year. Lucas: Numbers that decline at a slower pace are not enough. For the market to be more comfortable with the stocks, I think we have to have positive ad-revenue comps. MacKay: Newspapers have cut a number of costs in an attempt to right-size the business, but we are not confident they will be able to keep pace with the decline in revenue over the longer term. In addition, we are concerned that the newspaper companies will run out of fat to trim and have to cut into muscle, negatively impacting the quality of its products. In addition, we expect newsprint prices to rise from current cyclical lows, negating some of the recent expense declines. In our view, these companies need to show some real top-line improvement in order to hold on to margins gains. Quadrani: We do believe comparisons on the cost side become tougher in the second half of the year, and with rising paper prices it will be more challenging to recoup some of the profit erosion from the last few years.  However, with moderating declines in newspaper advertising it may be possible to keep margins flat for the rest of the year. Next year will become even more of a challenge particularly for those companies with broadcast assets who will suffer from lack of political spending. We generally see modest margin erosion in 2011. I believe for the most part the market is anticipating some erosion. However, if it becomes more severe than expected it could weigh on the stocks. How would you assess newspapers' progress in transitioning from print to digital? Goss: This is still a work in process. Barriers vary, including the notion that people do not like to pay for something they have been used to getting free. The opportunities (presented by iPads and other e-readers) seem to be especially encouraging. However, editorial and production effort and expense will be required to create the best set of formats and applications. Pricing will be critical. And, of course, an installed base of device will be necessary to create a meaningful economic opportunity. This will all take time. However, it is worth it, and necessary for the endgame is to redefine the notion of newspaper publishing in terms of the content being created and distributed rather than the specific form or medium in which it is delivered. Lucas: Disappointingly slow. I am hopeful that the success of the iPad will translate into more digital distribution, but it is still early days. MacKay: In our view, as long as there is free mobile or home Internet access to news flow, digital media will not become a meaningful portion of overall revenue and certainly not enough to offset the loss of print advertising and circulation dollars. Quadrani: We believe the progress has been mixed. The companies have generally cast a wide net investing in digital properties as well as developing their own digital arms to complement their traditional businesses. Digital revenues range from 10%-20% of total revenues at most newspaper companies. The large majority of these revenues are advertising driven as we believe it remains a challenge for newspaper companies to charge for content. Hopefully with consumers moving more toward mobile devices where they generally have to pay for applications, the mind set may change a bit making them more willing to also pay for content online. What newspaper company stocks, if any, are you bullish on and which more bearish? Goss: My newspaper coverage currently is only GCI (Gannett Co.) I am very positive on the efforts management has made and continues to make. I also feel the company's presence in broadcasting plus a variety of digital media including CareerBuilder, Captivate and PointRoll demonstrate management's intensity in redefining its corporate mission. I still have a Market Perform rating on the stock to acknowledge that the process continues to evolve as well as that the stock has recovered from its extremely low levels a year ago. Lucas: In the pure-play area, I am most comfortable with AH Belo (NYSE: AHC), in part because it has no debt. In the diversified names, EW Scripps has no debt either and is helped by its television business. Gannett has done a superior job on the cost side. Its two major print properties, The Arizona Republic and USA Today, could be helped by separate economic trends, that is, a regional recovery in Phoenix and/or an overall economic rebound for USA Today. Importantly, GCI should recapture lost classified advertising through its digital initiatives, particularly CareerBuilder. (Lucas disclosures: I have Buy recommendations on AHC, GCI and SSP, and own no shares of Belo or Gannett, but do own 400 shares of SSP. GAMCO Investors, an affiliate of Gabelli & Company, Inc. may, and does, own shares of AHC, GCI and SSP.) MacKay: We are not currently bullish on any newspaper sector stocks. Quadrani: Our only overweight rating currently in SSP given the discounted valuation at 3.9 times 2011 EBITDA, the large percentage of cash flow coming from broadcast as well as the strong balance sheet. We remain neutral on the rest of the stocks in our publishing universe given the more challenging comps ahead an overall uncertainty surrounding longer-term growth. On The Credit Side A couple of questions about newspaper debt and credit ratings to Mike Simonton, Managing Director, Media & Entertainment and credit analyst for Fitch Ratings. How would you assess newspapers' debt situation in mid-2010? Are they deleveraging fast enough? Even if there are favorable economic tailwinds, the newspapers that didn't go bankrupt will continue to struggle under their debt loads. They've done a good job of extending the day of reckoning by refinancing short-term debt, but the reality is that they can't repay the debt from internally generated funds and it's unclear if they will have a financeable business when the debt comes due. They've pushed out the problem, but have not eliminated it. What will it take for newspaper companies — most of whom have debt rated in junk territory — to regain investment-grade ratings? Are they on track for that? It is unlikely that a pure-play newspaper company with a material amount of debt could achieve investment grade ratings in the next five years. A company with other revenue streams might be able to achieve investment-grade status but the rating would be based mostly on the proportion of newspaper profit and the strength of other business lines.