(Cross-posted at Winds of Change)
Could things get much worse for the newspaper industry? After all, right now:
- McClatchy's September print advertising sales dropped 23 percent year on year (YOY).
- The entire industry is forecast to lose 16.5% of its annual ad revenue from 2007 to 2008.
- Q2 industry statistics show overall revenue dropping 13.9%, with a whopping loss of 27% YOY in classified.
- Gallup's polling shows that 52% of the American public do not trust news media.
As it turns out, they could get worse, and quite suddenly. Like the housing bubble and the financial crash, the signs are already there, and visible to those paying attention. It could be the credit crunch that puts the capper on the trends above and drives an entire industry sector over the brink. It couldn't happen to a more deserving bunch.
To understand why and how, a brief detour into the financial model of newspapers is necessary.
The Ups and Downs of Subscribership
Newspapers are the paradigm case of a subscriber business model. Financiers generally love subscriber business models because of their predictability. People being creatures of habit, they tend to persist in their behaviors and in their purchasing habits, once established. A stable subscriber base can turn into a reliable cash cow, and such businesses are often able to attract equity and debt financing on favorable terms.
Subscriber businesses can get even better as they grow. A growing subscription base means corresponding increases in some variable costs: newsprint, ink, physical distribution. However, the fixed costs associated with the business - e.g., print plant, news room and other staff, office space - are amortized over a larger revenue base. This nice little bit of leverage means margins should grow as the business expands. A business valuation that looks at the future cash flows thrown off as margins increase can be quite attractive, let's say.
There's a catch, of course. Subscribers don't just magically appear and sign up. The reality is called 'subscriber acquisition', whether done by advertising, annoying phone calls, or kids knocking on doors in the old days. So before you can get the annuity income of the subscriber model, you have to pony up cash in advance to attract them. But, if you can make a good enough case of their long term value, you can likely get financing to not only acquire them the hard way, but even buy them outright (in other words, do a takeover on another newspaper). Remember, the bigger you get, the better the margins, so a consolidation of similar subscriber businesses makes sense on the face of it.
But then there's the word that subscription businesses, and their financiers, hate: churn. Churn is subscribers that leave - moved away, now use the Internet instead, or cranked off at the latest editorial. For whatever reason, they're gone, and with them the future cash stream ascribed to them. So to keep the business at the same size, they must be replaced. Incurring another subscriber acquisition cost, which just as before has to be paid up-front. That cost may even have increased, if the same market forces driving up churn are also making it harder to find new subscribers.
Churn is what analyst types call a highly sensitive variable in the on-going financial model of a subscriber business, and in its long-term valuation. If churn goes too high, all of the sudden the favorable model begins to run backwards. The acquisition costs that were paid up front no longer yield enough discounted cash flow over the long run to cover them. This nasty reality may not appear for some time after those costs have been sunk.
If keeping the subscriber base growing, or even steady, can no longer be financed, then the leverage model also starts to run backwards. Fixed costs eat up margin, cash flow per subscriber falls, and being able to cover new acquisition costs becomes an ever-receding goal. Slashing at fixed costs may delay the downward spiral for a while, but if it further damages the value of the product, the churn rate may rise further.
The Debt Bomb
All this should sound familiar to anyone with a modicum of business savvy who's been following the newspaper industry, or any of the legacy media for that matter. And it's been going on for several years, so why an impending crash just now?
Let's go back to that revenue forecast for the threats to the industry's ad bookings:
- Retailers who are seeing consumer demand dry up...
- Auto dealers who can’t sell cars because many potential buyers are postponing purchases...
- Real estate agents who can’t find buyers because no one knows what anything is worth...
- Employers who aren’t buying help-wanted ads because their businesses are shrinking...
So just as newspapers have a 'supply' problem, that is, trouble acquiring subscribers (who are all that advertisers care about), they also have a advertising 'demand' problem from market sectors that are having their own issues. There's something else those sectors have in common. Here's part of what I elided from the list above:
- Retailers... struggling to borrow the money they need to make payroll and stock their shelves.
- Auto dealers ...scrambling to finance the fleets of unsold vehicles clogging their lots.
- Real estate... buyers... generally have found mortgages difficult or impossible to obtain.
- Employers ...report difficulty borrowing the working capital they need to buy raw materials or make payroll.
That's all a result of the credit crunch, and it's the force that may put the newspaper industry down sooner than later.
Return to the deteriorating business model above, and consider the problem of debt. If the newspaper in question went on an acquisition binge, either a subscriber or a whole company at a time, they likely sold bonds or took out bank debt to pay for it. In so doing, they (and their lenders) made a futures bet on the value of the subscriber base built with those funds. Right now, due to Internet competition, churn and decreased advertiser demand, those bets are looking about as good as a portfolio of BBB-grade mortgage backed securities. We're not talking trivial sums: Tribune Co. is still carrying almost $12.5 billion in bond and bank debt after it was taken private late in 2007.
Spent profitably or not, the interest costs on the debt must be paid, and that digs ever more deeply into free cash flow being generated by the business. That's already too much for a lot of papers to bear. The Minneapolis Star-Tribune, the Journal-Register paper family, and the Philadelphia Inquirer and Daily News have all skipped interest payments in October. Technically, any of these papers could now be forced into bankruptcy by their creditors, if they thought there would be any value to be realized by doing so. Instead, they are largely renegotiating the debt terms to require the sale of assets such as real estate, or to place constraints on dividend payments or operations.
But that's still not the big problem.
Just like any other business, a newspaper has to roll over its debt periodically as loans and bonds come due. Sooner if it's a bank loan or line of credit, usually later if it's in the form of bonds. Recall that many of these bonds were issued, or loans and credit facilities extended, a few years back when credit was running like water, and when a modest, mid-2000's uptick in advertising revenue made it look like newspapers might have weathered the storm.
Things are rather different now. It would be hard to imagine a more hostile credit environment for a borrower who's losing money and whose fundamental business metrics are in deep trouble. This is already forcing newspapers whose debt is coming due to make large concessions to persuade lenders to carry them.
Back in 2006, the McClatchy chain took out $3.75 billion in bank loans to buy a string of papers from Knight-Ridder, which was exiting the business. In spite of selling off some assets to cover the loans, McClatchy still carries $2.1 billion in debt on its books, of which nearly $1.2 billion is term bank debt. At the end of September, the company was forced to agree to new conditions on the debt from its lenders. In spite of some sighs of relief that the company had survived the crisis, Moody's continues to rate the company's debt below investment grade, and the liquidity of the overall business as 'speculative'.
The details of the McClatchy loan rewrite make instructive reading:
"The pricing on all outstanding loans was increased to include interest at the London Interbank Offered Rate (LIBOR) plus a spread ranging from 200 basis points to 425 basis points, based upon the consolidated total leverage ratio.... increased to allow indebtedness of a maximum of 6.25 times cash flow (as defined in the Amendment) through the Company's fiscal quarter ending December 2008; stepping up to 7.00 times cash flow from the fiscal quarter ending in March 2009 to the fiscal quarter ending in September 2010; and declining to 6.25 times cash flow as of the end of each fiscal quarter thereafter."
One thing to notice here is the pegging of the loan to LIBOR, the London interbank lending rate which has fluctuated all over the place during the credit crunch. McClatchy now has no defense against short-term interest rate variations; they have effectively taken out an ARM on their entire business. The other interesting point is a cap on the borrowing as a multiple of free cash flow in the business. This goes up at the start of 2009 (one might guess as a result of already foreseen declines in cash flow) but then back down in 2010. So it's not just an ARM, it's an ARM with a balloon two years away.
Nor is McClatchy the only large newspaper chain in this mess. At the end of September, Gannett drew $1.2b from a bank revolving credit line, raising its borrowings under the facility to $1.9 billion. Why did it do this? From the filing: "...to repay commercial paper at scheduled maturity." Gannett is seen as one of the most stable companies in the business, but also being forced to replace longer term bonds and commercial loans with spot rate money. Gannett has a total of $4.32 billion in debt outstanding, so there's plenty more that will have be rolled over in the coming months.
The Tribune Company, now private, no longer publishes its financials, but its bonds are rated as junk. It's now scrambling to sell properties such as the Chicago Cubs to cover the bonds due for payment in 2008. The next big tranche of this debt must be covered in the fall of 2010. And the bonds of the once-mighty New York Times have been reduced to junk status as I write this.
And here is where the downside of the subscription model becomes a horror. Unlike a manufacturing business, a newspaper can't just lay off workers, shutter factories, and hope for a better day. If the paper doesn't come out on a schedule, the business will collapse overnight.
And yet, the papers are in this mess because they borrowed to acquire subscribers based on a faulty notion of their long term value. Taking more money to acquire more non-profitable subscribers is just a way to dig the hole deeper. If taking outside money for acquisition is a losing proposition, then using internally generated cash for the same purpose will also destroy value long term.
Given this, how do the lenders ever get repaid? There's only one answer: Milk the current subscriber base as long as it exists. By slashing at fixed costs, and by eliminating the cash demands of new subscriber acquisitions, the business can be made to yield free cash flow as its size declines. But it's largely going to be covering debt service, not rebuilding the subscriber business or creating equity value for shareholders. (It seems the market agrees with me: 42% of McClatchy's share float is sold short.)
Newspaper subscriber counts have been falling even as they've been spending on acquisition to replace churn. With funds for acquisition drying up, look for those counts to drop even more precipitously. Newspapers will be trying ever more desperately to shift to the Internet or other businesses, looking for any way to get their cash flow positive before support from the old business dries up forever. Don't believe me? Try an industry insider who's drawing similar conclusions.
Putting In The Boot
One of the reasons that churn is up for the newspapers is the political bias. I'm with Orson Scott Card on this. The industry has abdicated its social function to support a well-informed electorate, and become a propaganda arm of the left. In so doing, they have sullied their brands and lost the trust of their readers. The economic consequences of this default of their value proposition are now becoming apparent. The Internet and an economic crisis together would be bad enough, but the industry has only itself to blame for the egregious behavior on display for the last few years, and at its worst right now.
This is a blog, and I make no vacuous claims to freedom from bias. You can check everything said above from public records, but I do have a dog in this fight. These people deserve to lose, and if the newspaper industry crashes as a byproduct of the economic crunch, then it's a silver lining for a dark cloud. They have done their level best to trash the political system of my country, and I will dance on their grave when they go.
Is that clear enough?
If you're part of the over 50% of the populace that have had it, then it's time to put in the boot and accelerate the crash:
- Cancel your subscriptions, if you haven't already.
- If you buy advertising, move it to the Internet, and find out how to meet your customers 1-1.
- Keep your ads and clicks away from Internet properties owned by the papers, e.g., Careerbuilder, cars.com and about.com.
- Should you provide product or service to a newspaper, cut their credit or demand cash up front. You'll find plenty of reasons that this is prudent business.
- Help an older person find what they need online instead; they're nearly the only demographic the papers have left.
When the lights go out at the New York Times, our work will be finished.