Wall Street Sours on Newspaper Stocks as Threats from the Internet MultiplyBack to News

By Lauren Rich Fine, CFA, Merrill Lynch

A Litany of Negatives — Loss of Share, Declining Circulation

Newspapers have lost share of US ad dollars for almost 50 years, having peaked at 36.7% of the total in 1949 and ending 2004 with 18% share. There is no reason to think that trend is about to reverse. Even ignoring the recent circulation scandals, industry circulation is in decline; the major TV networks have successfully raised rates during a long period of ratings decline, so this in and of itself is not necessarily a significant issue but it also cannot be ignored. Further, we acknowledge that many newspaper sites do well garnering online traffic and they should be able to monetize that value, yet given the level of competition online (for both their print and online revenues), we do not think the online potential will offset the print decline. Classifieds are better online. That is a fact; you can search, you can browse, you can get extra value added features. And, it is cheaper (to produce and to buy). Based on a recent McKinsey study, there would appear to be more risk prospectively for the group should real estate, auto and general classifieds suffer the fate of help wanted.

Some Potential Positives — Product Innovation to Retain Readers

We do not think there are any cliffs on the horizon, but we do see a gentle long term descent. On the positive side of the ledger, we are enthusiastic about the role newspapers could play in citizen journalism, community interest blogs, photogallerys, etc,. as ways to both retain readers and attract younger demographics. We are impressed by the plethora of youth and ethnic targeted publications. We have seen some interesting acquisitions aimed at enhancing growth rates. While all is not lost, we still maintain a neutral stance.

Lowered 2005 & 2006 Ad Forecast

We are reducing our 2005 and 2006 industry ad revenue forecast to 2.4% and 2.0%, respectively, from 3.3% and 2.8% previously. It would seem that Federated, even ahead of consolidating brands, has shifted spending from newspapers to broadcast and direct mail. We had already assumed some reductions in spending from Federated in our 2006 estimates due to the expectation that certain chains would be rebranded; combined Federated/May represents about 2% of industry ad revenues. The shift in spending was unanticipated and, unfortunately, likely to continue.

Circulation Revenues to Continue to Decline

It is no longer a secret that newspapers are suffering circulation declines. This fact combined with heightened discounting in order to hold on to customers rather than spending to attract new, high churn customers leads us to forecast a 1-2% circulation revenue decline per year.

Margin Compression — Expected Margins Likely to Decline over Time

We believe newspaper industry operating margins could compress from roughly 22% in 2005 to 20% in 2010. Newspaper companies have managed costs very well over the past handful of years, and we believe they will continue to do so going forward. However, newspaper companies will have to continue to invest in new products and their online strategies, which will constrain the ability to cut back too severely.

Are We Being Too Conservative? Revenue Assumptions Could Be Saved by the Cycle

Our revenue assumptions might seem harsh to some, optimistic to others. From a big picture perspective, it is hard to imagine, after almost 50 years of a declining share of total ad dollars, that newspapers would suddenly regain share. Newspapers will still be able to raise rates, online and in print, but the shift in mix to online will still hurt the revenue realization per ad as the industry faces new competition that can afford to price differently and much lower. When we think of the opportunities for newspapers to participate in the digital revolution, we actually get very enthusiastic except when we try to map out the economics. Despite those notes of caution, a better economic cycle and/or higher inflation would probably lead to better top line performance than we have assumed.

Kind on Costs

We suspect that we have been overly kind on the cost side of the equation given the likely investments that are going to have to be made. We have theoretically assumed that the new projects are neutral from an operating margin standpoint, when in reality, the non-daily products likely have lower margins. The investment in on-line products could also hurt margins in the short run. We have also assumed a relatively tame environment for newsprint, but we note that newsprint producers have had some success in pushing through increases despite lackluster demand, in large part due to reduced industry capacity