Description

Overview

Equity investors were able to make nice returns over the past two years by shorting newspaper publishing companies in the US and the UK. At first glance, one might think that the opportunity has passed: the most heavily levered names have declined such that the remaining equity is a small sliver representing highly uncertain and volatile option value, while the less indebted have seen EV/EBITDA multiples compress to levels that more fairly appraise their future prospects. However, opportunities to profit from the demise of newspaper publishing still exist, though slightly further afield.

Australia is an interesting geography within the larger newspaper publishing world. Newspapers still command an unusually high percentage of Australian advertising dollars - in the low-to-mid 20% range - vs. levels in the high teens elsewhere in the English-speaking world. While high end newspapers in the US and UK have seen circulation declines on the order of 15% over the past few years, premium dailies like the Sydney Morning Herald and The Age have held steady. While EBITDA margin expectations elsewhere have collapsed from the mid-to-high twenties to the high teens range, Australian newspaper margins are expected to prove resilient, demonstrating the unusually high faith in the volume and pricing power of these businesses. Executives at Australian newspaper companies would contend that there is something inherently different about the Australian market: the daily newspaper is a more important cultural fixture, a dispersed population adds to the value of local print advertising, etc. However, conversations with current and former employees of newspaper publishers, as well as with some of their key customers at media buying firms, would suggest that such optimism is unfounded. The Australian newspaper industry has not, and perhaps will not, see a cataclysmic collapse as in the US and the UK, but the same secular trends are present, and will continue.  

We have focused our work on Australia's largest newspaper publishing company, Fairfax Media. Its properties include the traditional leading dailies in Sydney and Melbourne (Sydney Morning Herald and The Age), as well as the Australian Financial Review (sort of the WSJ of Australia). Fairfax also owns a collection of smaller regional and rural newspapers in Australia and New Zealand. Its most valuable internet property is TradeMe (sort of eBay and Craigslist rolled into one for New Zealand). It also has web versions of its key print publications, along with online classified ad platforms. For a variety of reasons, Fairfax's assets are weaker than they appear, and they stand a low chance of producing a sharp cyclical rebound in earnings. Despite this, Fairfax is among the most expensive old media companies in the world, with an enterprise value at nearly 10x forward year consensus estimated EBITDA.

Key Points

Circulation data is misleading. Management and analysts point to circulation numbers for the Age and SMH that are much more impressive than those of other premium newspapers, the New York Times for example. Between 2005 and 2008, combined circulation for the SMH and The Age remained flat, while it declined by 15% at the NYT. However, Fairfax's numbers are heavily manipulated. Promotions giving out free CDs effectively bought readers at unsustainable cost. Outright mis-reporting has also been employed: Fairfax routinely under-reports circulation when the results look good (acceptable because it is worded as "more than x copies sold"), so as to opportunistically pad year over year comparisons.

Margins are overdue for a fall. As underlying trends in circulation and readership become more apparent, ad pricing will need to come down. Fairfax, along with other Australian newspaper publishers, currently enjoys much higher margins than comparables in the US and the UK, which seems unlikely to last. EBITDA margin trends tell the story (forward years are consensus):

  *comparable publishing companies in the US and UK

Online assets are overrated. Analysts claim that Fairfax should get a higher valuation because of its online assets. There is some truth to this, and the earnings from online should certainly be given a premium to the print assets. However, the online assets are, for the most part, not terribly impressive. The crown jewel is TradeMe, the eBay/Craigslist of New Zealand. Performance has been strong, but its market penetration is likely largely played out, and in a stagnant and finite market, it is hard to get excited about long term growth prospects. SMH and The Age online have good site traffic numbers, but they are inherently tied to the health of their print counterparts. This was shown in the reporting half ending 6/30/09: excluding TradeMe, online EBITDA dropped over 15%. In addition, EBITDA from online newspapers are likely overstated as editorial costs are borne by the print business. In the potentially most lucrative area, online classifieds for real estate, employment, and autos in Australia, FXJ's offerings are also-rans in each category with market share no higher than 20%, relative to market leaders in the 60%+ range.

Expected sharp bounce back not likely to materialize. Several characteristics of this downturn suggest that FXJ's revenue woes are far more structural than cyclical, particularly in the traditionally most profitable employment and real estate categories.

• Employment classifieds are increasingly dominated by SEEK.com, Australia's equivalent of Monster or CareerBuilder. Given the lack of need for imagery, there is little reason to post employment ads in print. Lost employment classified revenues are almost all structural, not cyclical. Furthermore, in Australia, layoffs have been less prevalent than pay cuts or shifts to part-time: less churn means less potential rebound.
• Real estate advertising is holding in better than the other categories, because its voyeuristic appeal lends itself to the print format. However, it is difficult to blame any losses on a cyclical downturn, because there has been little downturn in Australian real estate. The very high end has slowed, but in general, home sales are at record levels in Sydney and Melbourne.

Management potentially ill-equipped for challenges ahead. The recently installed management team came from Rural Press, the rural/regional publisher with which FXJ merged in 2007. As such, they are not acquainted with the challenges of operating in more competitive markets. Newscorp's publications in Sydney and Melbourne are perceived to be lower quality, but they have surpassed FXJ in circulation, so are increasingly a threat. Constant re-segmentation (every reporting period in recent memory) also raises red-flags.

Summary financials

Valuation

Based on traditional metrics, Fairfax is very expensive, especially in comparison to other old media companies, many of which face less severe secular challenges and can look forward to a more robust cyclical recovery if the global economy continues to improve:

FXJ's current share price implies a lot of progress. If we use the (generous) 2012 consensus EBITDA estimate of $716 million and give credit for a couple of years of net debt reduction with free cash flow, FXJ still trades for ~8x EBITDA. Alternatively, applying reasonable multiples to forward year earnings suggests that the share price could easily drop by 50%: 

Risks

• Strength in broader Australian economy (and markets) pulls Fairfax along with it (an offsetting long position in an Australian index could be a good way of reducing this exposure)

o FXJ is one of the few large cap Australian media plays, so it is a favorite for local investors attempting to play a cyclical recovery 

• Australians are truly "a breed apart" - circulation holds up indefinitely; print advertising holds firm

Disclaimer: We and our affiliates are short FXJ AU.  We may short more shares or cover without notification.  This is not a recommendation to buy or sell shares.

Catalyst

Management provides weaker than expected outlook for fiscal 2H 2010 (June end).  Weakness in circulation data (released quarterly) challenges view that Australia is different.