Media Companies: Not So Boffo in 2006


By Heather M. Goodchild Standard & Poor's Ratings Services' outlook for the media and entertainment industry in 2006 has become less optimistic, with traditional advertising representing an area of slowing momentum and potential negative surprises that could neutralize the expected boost from local elections and the Winter Olympics. This follows 2005's uninspiring revenue performance in the radio, magazine publishing, and newspaper sectors.

In nonadvertising-related sectors, movie exhibitors will be hoping for a year of stronger releases after 2005 finishes lower, and for the Hollywood studios, DVD sales growth is slowing, with the huge-volume titles in release raising inventory risk. The music industry is still under siege from piracy, and industry legal efforts have not turned the tide of shrinking CD sales.

ADS AND MINUSES. We're currently targeting 5% ad spending growth in 2006 and have scaled back our previous forecast for 2005 to 4% from 4.7% (which was lowered in September from 6%). Hurricane Katrina's damage to property, industry, and employment, together with the nationwide gasoline price spike in midyear/early autumn, are key culprits in our receding ad spending outlook for 2005.

Our 2006 downshift in ad spending dovetails with a slightly lower forecast rate of GDP growth -- 3.3%, vs. 3.6% in 2005 -- reflecting expectations that consumer spending and equipment investment will slow. For 2006, only the elections and Olympics, and to a much lesser degree the new Medicare prescription program, are likely to offer much oomph to ad demand.

There are numerous concerns for the ad outlook. Most important, continuing deterioration of the financial health of U.S. auto makers is a major risk to ad spending, already visible in the third quarter of 2005, and notwithstanding General Motors' (GM) recent shift back to incentives. Detroit outspends its foreign counterparts, and even foreign auto makers have experienced some challenges with sales recently.

THE YEAR AHEAD. Separately, rising interest rates rank among the foremost risks to consumer spending, the savings rate has been negative for a record four straight months, and the relationship of debt to household income has already crept up from more normal levels. Any economic factor or turn of events that unhinges consumer spending will likely flow through to ad demand. A prominent example is the retail sector, in which ad spending has already been under pressure as a result of consolidation.

What are the prospects for the coming year for key segments of the industry? Here is S&P Ratings' sector-by-sector view:

Broadcast & Cable Networks

S&P expects broadcast-network revenue to grow in line with, or slightly faster than, GDP in 2006. We see the effects of potentially ongoing auto ad spending weakness, competition from alternative media, and sponsors' cold feet over ad fast-forwarding as together balancing the benefits of elections and Olympics in that year.

Cable networks should maintain revenue growth at a percentage rate in the mid-teens, slowing from recent years as the playing field continues to sprout new cable channels with initially low subscriber penetration, audience, and pricing. Cable networks, as much as broadcast networks, will be subject to fears of ad zapping and persistent programming price pressures.

Cable networks likely will have to manage with slower affiliate fee increases from cable systems as the latter grapple with their own programming cost pressures. Broadcast networks face a longer-term squeeze of sports-rights costs, for which cable networks may be prepared to outbid them.

It's unclear whether new technologies will represent genuine opportunities for either broadcast or cable networks. Advertising revenue streams will still be minuscule from transmission to mobile phones, video on demand (VOD), video iPod, and Internet efforts, and their longer-term potential is uncertain. Some opportunity exists for secondary digital channels, such as the digital CBS channel expected in late 2006 or early 2007, and from broadband networks being launched by cable channels.

TV Station Groups

Total spot revenues are forecast to grow between 6% and 8% in 2006, according to the Television Bureau of Advertising (TVB). Factors that could influence growth in 2006 include the impact of oil prices on consumer spending, the strength of the automotive and political categories, the pressure from nontraditional media, and advertisers' call for enhanced measurement of the effectiveness of their ad spending.

Sizable political and Olympic ad spending in 2007 results in difficult revenue comparisons with non-election, non-Games years. Accordingly, the TVB's predictions call for total spot revenues to be up or down only slightly compared with 2006. Although pressure on LIN TV's (B+) and Gray Television's (B+) ratings in the second half of 2005 resulted primarily from debt-financed acquisitions, the lack of significant political ad spending this year exacerbated financial risk.

Radio Station Groups

S&P expects radio advertising to grow only in the low-single-digit percentages in 2006. Radio ad demand is under pressure from competing media such as the iPod and satellite radio, as well as from excess commercial loads. Radio advertising may not gain a meaningful boost from industry leader Clear Channel Communications' [CC

] (BBB-) inventory reductions, the sector's plans to roll out high-definition radio, and the initial popularity of the iPod-like "Jack" radio format.

Although the number of paid satellite-radio subscribers is still relatively small compared with terrestrial radio's national audience, we will monitor whether shock radio host Howard Stern's move to Sirius Satellite Radio [SIRI

] (CCC/Stable/--) in January, 2006, boosts subscriber growth next year. Even with lethargic revenue growth, radio broadcasters generate significant free cash flow.

The majority of radio operators, who had been using cash flow to pay down debt or for acquisitions, are increasingly using it for share repurchases and dividends while stock prices are under pressure. Operators are pursuing spin-offs and asset sales -- as in the cases of Clear Channel, Viacom [VIA.B

] (BBB+), Susquehanna Media (BB-), and Emmis Communications (B+) -- as radio operators aim to placate shareholders amid generally soft ad demand.

Online Advertising

S&P expects that online ad growth in 2006 will exceed 20%, reflecting the continued strength of both search and brand advertising. Marketers appear to be gaining confidence in the Internet's ability to reach consumers. For example, Yahoo! [YHOO

] (BBB-/Stable/--) indicated that its brand-marketing revenue from the top 200 U.S. brand advertisers grew more than 45% in second-quarter 2005, and Ford Motor [F

] has allocated about 15% of its marketing budget to online initiatives. Furthermore, some marketers have begun to incorporate search advertising as part of their overall branding campaigns, which could spur more online-ad spending.

All these events suggest that online advertising will continue to experience above-average growth over the medium term. Even assuming that growth decelerates somewhat, Internet advertising is likely to exceed magazine advertising in 2006. Spending on Internet ads could potentially surpass spending on radio in 2008, assuming 1% to 2% growth in radio ad spending and a minimal contribution from satellite radio.

Magazines

S&P expects that magazine ad pages will post minimal growth in 2006, in the low single-digits. Ad pages increased an anemic 0.3% in the first 10 months of 2005, according to the Publishers Information Bureau, as declines in pages for home furnishings, technology, and automotive -- the largest category -- offset improving advertising demand.

The industry has been struggling to reestablish a growth trend since 2001. The sector's share of total ad spending has steadily declined, to about 4.5% of total advertising expenditures in 2005 from 5% in 2000, losing to cable TV and the Internet. Complicating a bleak growth outlook, the industry is still embroiled in a scandal over the use of subscription agents that have overstated paid circulation, impairing affected magazines' credibility with advertisers.

New magazine launches are likely to continue at a robust pace in 2006, as publishers seek to gain revenue share through better niche targeting -- increasing already stiff competition for circulation and advertising dollars for established titles.

Circulation-related costs are expected to remain high. Paper, printing, and postage costs account for approximately 40% of magazine publishers' operating expenses. The industry will face a modest postage-rate increase, which will likely be implemented in January, 2006, the first hike since June, 2002. The independent Postal Rate Commission has approved a 5.7% increase in the postage rate for weekly newsmagazines, to 18.5 cents, and a 5.5% hike for household magazines, to 28.9 cents. Paper cost increases have eased in late 2005 and could be on a flattish trend going into 2006.

Newspapers

Newspaper publishers in 2006 are expected to face challenges similar to those that have affected them this past year. Advertising demand is uneven, circulation and related revenues remain under pressure, and operating costs -- including newsprint prices and employee-benefit expenses -- are rising.

Advertising revenues in 2006 are expected to grow slightly faster than the 2% to 3% anticipated for 2005. Revenues should benefit from the continued solid growth in classified advertising, the one bright spot this past year, and the cycling of industry consolidation that affected the retail and national segments. Online revenues are expected to continue their rapid growth, although the base is still fairly small, as more advertising migrates to the Internet.

Companies with television operations will benefit in 2006 from significantly increased political advertising and, for those with NBC network affiliates, revenues related to the Winter Olympics.

S&P expects relative ratings stability next year, as reflected in the stable outlooks for the majority of the rated universe. However, to meet this expectation, companies will have to maintain a more conservative financial posture in light of the revenue and cost challenges they face.

Printing

S&P expects North American printing companies to continue to confront credit-quality challenges in 2006. For the industry overall, challenging pricing conditions because of overcapacity, high levels of competition, and consolidation are expected to persist in 2006 -- in short, a continuation of 2005 trends. Revenue is expected to grow more slowly than GDP.

As of September, 2005, utilization levels remained lower than the historical average. As a result, cost containment is expected to continue to be a focus of industry players. As unpredictable volumes and price competition continue to pressure profits, companies that build flexibility into their cost structures -- through streamlined operations that lower labor costs or through gains in procurement efficiencies from increased scale -- have greater pricing flexibility to challenge competitors and keep existing volumes, or to compete for new business.

Importantly, the intensity of pricing pressures varies depending on the printing segment. The impact of pricing pressure on a narrowly focused print provider poses a greater risk to its credit profile than that of a more diversified company.

Capital spending is expected to remain elevated in 2006, as companies attempt to improve efficiencies on the manufacturing floor, buying new equipment to complete job runs faster and upgrading technology to enhance networking efficiencies.

Advertising Agencies

Advertising spending is expected to grow 5% in 2006, slightly faster than the 4.7% rate that we expect for 2005. Growth areas in 2005 have included cable TV and the Internet and both are likely to continue as such in 2006. The most important drivers of slightly higher growth in 2006 will be election and Olympic ad spending. Other key drivers of our 2006 forecast include trends in consumer spending and the health of the auto sector. Continued pressure on car sales and on the financial well-being of the auto sector could severely undermine overall ad spending and even certain market-services areas in 2006.

Marketing-services growth in 2006 will likely vary depending on the niche. Customer relationship management and Internet ad services are likely to experience more robust growth than other niches, such as recruitment and direct-to-consumer health-care advertising. Increasing fragmentation of the media landscape should steadily increase the value of and revenue potential in media planning.

Music

The outlook for 2006 is likely to be a continuation of 2005 trends of declining CD unit sales, with total unit sales rising only when including paid digital downloads. Illegal downloading remains a prominent concern, notwithstanding the International Federation of the Phonographic Industry's November, 2005, filing of 2,100 lawsuits against individuals and illegal file-sharing service Grokster's agreement to shut down.

Although the timing and popularity of new releases can cloud sales trends, the underlying movement is one of transition to a digital world and away from physical sales. The number of major companies competing in online-music retailing underscores the industry's distribution shift toward online sales. In addition to Apple Computer (AAPL), Sony (SNE), Microsoft (MSFT), RealNetworks (RNWK), and Yahoo, Bertelsmann more recently announced its foray into offering music downloads.

However, the success of the iPod and competing devices continues to fuel download demand. The ability of major labels to maintain profitability under current pricing and cost structures is in doubt because their traditional, high-margin revenues are being cannibalized by rising sub-$1 singles sales through online outlets.

Assuming a continued migration to paid digital downloading, the industry will need to adapt its pricing model from a currently low flat wholesale rate and continue to scale back its fixed costs, or face the prospect of further margin erosion in the short to medium term.

Motion-Picture Producers

Movire producers will face mixed trends in 2006, as DVD sales growth likely slows. Rapid growth in feature film DVD sales and the emergence of a healthy market for TV series on DVD have cushioned individual studios' volatility for several years. Slowing growth will require all studios to more carefully gauge their DVD release scheduling, inventory management, and ordering.

Potentially offsetting this, easy comparisons in the key summer season of 2006 could benefit results if new releases find reasonably receptive crowds. A repeat of the 9% decline in 2005 summer box office results could renew concerns that crowds are being lured away by alternative entertainment or turned off by intrusive onscreen advertising. Introduction of the new, high-definition generation of DVDs, originally planned for Christmas, 2005, has been pushed into 2006, pending the resolution of format wars among would-be manufacturers of the new hardware.

Movie Exhibitors

The outlook for motion-picture exhibitors in 2006 is negative because, even though the summer box office was down this year, exhibitors continued to acquire theaters, incur additional operating leases by selling and leasing back theaters, and build and expand theaters. A lukewarm summer movie lineup in 2005 contributed to a 9% box-office revenue drop-off in the critical summer months (according to Nielsen EDI data) and lower revenue from concessions.

Reasons for the mid-2005 slump, other than weak Hollywood concepts, are unclear. Suspected culprits -- higher fuel costs, higher ticket prices, shorter windows between theatrical and DVD releases, and consumer annoyance over run-on theater advertising, to name a few -- haven't measurably changed in the fall season, and box-office revenue comparisons have leveled off. It shouldn't be difficult for 2006's summer-film slate to be better than 2005's lineup.

However, the box office isn't expected to show improvement until the second quarter, when easier comparisons will emerge. If exhibitor profitability improves in 2006, then cash flow, leverage, and interest coverage measures should return to healthier levels. Still, the long-term credit quality of the movie exhibitors could remain the same, or even fall, unless the exhibitors reestablish their value proposition to consumers, are prudent in spending on acquisitions and capital expenditures, increase cash flow, and begin lowering debt.

Goodchild is a credit analyst who follows media and entertainment companies for Standard & Poor's Ratings Services


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