The Big Blots on Newspaper Stocks

Fuzzy Outlook for Newspaper Publishers S&P sees a sector still shaken by economic trends and widespread scandals over bogus circulation numbers

Here's one story that shouldn't surprise investors in U.S. newspaper publishers: The industry continues to face a challenging operating environment. Economic trends in 2004 were too inconsistent to provide for a healthy recovery in advertising revenues, and we at Standard & Poor's Equity Research Services think this is likely to continue through most of 2005. The consensus forecast for 2005 from both publishers and industry observers is for ad revenues to increase in a range of 4% to 6%, vs. 3.6% growth in 2004.

The positive comparison primarily reflects the continued strength in classified ads, particularly employment. However, the revenue outlook for these companies remains hazy due to concerns over the strength of the economy and consumer spending. The wild cards: The impact of higher oil prices and interest rates, continued consolidation in the telecommunications and retail industries, and the situation in the Middle East, among other factors.

FUDGED FIGURES. Some newspaper outfits have run into problems on yet another front. In October, 2004, the Securities & Exchange Commission asked several large publishers for information on the calculation of circulation figures. The inquiry was sparked by disclosures earlier in the year of routine circulation overstatements at Hollinger International's (HLR ) Chicago Sun-Times, Tribune's (TRB; $39) Hoy and Newsday, and Belo's (BLC; $24) Dallas Morning News.

S&P believes the probe is unlikely to result in an SEC clampdown on the sector, but that could change if significant irregularities crop up. Until now, newspaper and magazine circulations have been self-audited through Audit Bureau of Circulations (ABC), a nonprofit oversight organization operated by publishers and advertisers.

All of the newspapers involved took remedial action. In a move to strengthen advertisers' confidence in circulation figures, ABC also acted. After the overcounting disclosures, the bureau announced several sanctions against four newspapers, The Sun-Times, Hoy, Newsday, and Dallas Morning News).

LINGERING IMPACT. In addition, all four publications will have their circulation numbers audited by ABC every six months, instead of annually, for the next two years, and the newspapers were required to submit to the bureau a "plan of action" for fixing their problems.

Although it doesn't appear advertisers shied away from the papers that falsified figures, the affected publications had to lower their official numbers. Thus, ongoing advertising rates are calculated on smaller circulations. Those involved also had to set aside cash or "make-goods" (i.e., advertising space used to compensate marketers when circulation falls short of promised levels) on their earlier promises to compensate advertisers who had been paying higher rates based on inflated circulation statistics. We look for most of this debacle's dollar impact to last through 2005 at the affected newspapers.

We have seen no concrete evidence that this scandal has hurt advertising demand on an industrywide basis. Nevertheless, the disclosures have tainted the industry, and it will probably take several years of "truth in reporting" for this to go away.

DAMPENED APPETITE. In late January, 2005, the Bush Administration abandoned plans to ask the Supreme Court to allow a set of controversial rules proposed by the Federal Communications Commission (FCC). These would have loosened restrictions on the expansion of large media conglomerates. It is now up to the FCC, led by its new chairman, Kevin Martin, to decide whether it wants to craft a new set of changes, or leave the current rules alone.

Opposition to the original FCC proposal has been strongest in the area of TV ownership caps. The easing of newspaper/TV cross-ownership restrictions has generated little opposition. If cross-ownership does ever become legal, S&P expects newspapers in qualifying markets to become more attractive as acquisition targets.

However, we don't anticipate a stampede of merger activity. In the past, M&A activity has picked up ahead of the actual passage of such rule changes. But this time around, uncertainty over the passing of the rules dampened the appetite for preemptive deal making.

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