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For the past year or so, private equity firms have spent tens of billions of dollars acquiring some of America's most storied businesses. Fortress Investment Group, meanwhile, has been doing due diligence in places like Sleepy Eye, Minn., Heber Springs, Ark., and Canandaigua, N.Y. Quietly and methodically, the New York private equity firm has assembled the largest collection of small-town newspapers in the U.S.

Through GateHouse Media Inc. (GHS), Fortress controls more than 400 publications, from Michigan's Upper Peninsula to the California desert. This year the company is expected to generate $23 million in net earnings on $400 million in revenues. GateHouse went public in October, raising $248 million, before Fortress, which still holds a 60% stake, resumed gobbling up local papers.

Given the parlous state of the newspaper industry, sinking money into print may seem contrarian, crazy even. But as national chains are broken up and young readers and advertisers flee to the Web, Fortress has spotted an anomaly: There's good money to be made publishing newspapers in small towns and exurbs.

These are places where readers are loyal and plentiful. And local advertisers are keen to reach them. GateHouse's growing grip on local advertising dollars could soon be giving big dailies headaches in some markets. It also could put a crimp in plans by Yahoo! Inc. (YHOO) and Google Inc. (GOOG) to colonize the local ad business. Yes, GateHouse lacks the scale of a giant like Gannett Co. (GCI). But its local papers generate margins of up to 40%, double that of some big-city dailies. "These newspapers are the dominant media in their towns," says GateHouse Chief Executive Mike Reed. "That's why we never look at a market and say it's too small."

Fortress' newspaper play marks its first foray into the media business--and the firm hired Reed for his experience running an Alabama-based newspaper chain. Nine-year-old Fortress, which itself is in the midst of going public, owns seven public companies, including the jet-leasing outfit Aircastle Ltd. (AYR) and Brookdale Senior Living Inc. (BKD), a national chain of retirement communities. Fortress declined to comment for this story, but it has a reputation for holding and managing companies for the long haul--and paying decent dividends. Peter Appert, a Goldman Sachs Group Inc. (GHS) analyst who has a buy rating on GateHouse, notes this is unusual in the private equity world. "Others haven't duplicated this widely," he says.

From the start, Fortress has gone after publications with little or no competition and then bolted them together in regional clusters. Doing so allows Fortress to cut costs by consolidating back-office operations and use the savings to build a strong online presence. In June, 2005, Fortress made its first move, purchasing Liberty Group Publishing Inc., (GHS) a Northbrook (Ill.)-based chain of small-town newspapers, from Leonard Green & Partners. The deal got little attention at the time--which was just fine by publicity-shy Fortress. But the acquisition became a key building block as the private equity firm began constructing its newspaper empire.

What did Fortress executives see that so many didn't? For starters, they noticed that a medical and technology services boom was drawing thousands of people to Rust Belt towns that had once seemed terminal. Take Honesdale, Pa., a former railroad hub. There, a major hospital expansion and flourishing office parks have supercharged the local economy. Meanwhile, the area has become an admittedly distant suburb of New York City. Today the region boasts the state's fastest-growing population. Fortress owns a daily there called The Wayne Independent and a weekly, The News Eagle.

Fortress noticed that these places, despite their rapid growth, fell into something of a media no-man's-land. The big dailies and network TV didn't provide much in the way of local coverage. Meanwhile, the cable and phone companies so far have deemed it insufficiently profitable to roll out broadband in some of the more remote towns. So people rely on the local rag, and in hamlets like Devils Lake, N.D., and Waynesboro, Pa., 70% of the people are reading it. By contrast, a big-city daily is lucky to get 40% of the market.

BUNDLING THE HYPERLOCAL

Hence, Gatehouse's so-called hyperlocal strategy. Editorially, that means if a fistfight breaks out at the school board meeting, the news goes on the front page. Pee Wee football? Huge news, especially for parents hoping their ball-spiking kid gets major play on the sports page. The Bastrop Daily Enterprise in Louisiana recently featured a front-page story about a man who won a radio station contest and a trip to the Grammy Awards.

Big papers have been losing national advertisers to cable TV and the Internet, and classified listings to the likes of Monster.com (MNST) and Craigslist. But local hardware and grocery stores rely on the hometown paper to advertise their price specials. "We are in a town of 10,000, and the local paper is maybe 8 to 10 pages. People will read that,"says Randall Jones, a dentist in Arkadelphia, Ark., and a regular advertiser in the Arkadelphia Daily Siftings Herald. "Our message would be lost in a larger newspaper."

GateHouse is going after regional advertisers as well. For example, 125 of its local publications, including The Patriot Ledger in Quincy, Mass., now form a ring around Boston. GateHouse can offer an advertiser, say Macy's (FD), a package deal for all its Boston-area newspapers and Web sites. Look out, Boston Globe and Boston Herald.

For the time being, Google and Yahoo present no real challenge to GateHouse because they lack sales reps in Smalltown, USA. Not that Fortress is taking any chances. It's starting to publish its online content under Creative Commons licenses, whereby copyrights are waived and anyone can pick up stories for noncommercial use--a boon to local bloggers. Reed says making content freely available will bring more eyeballs, attract new advertisers, and allow it to raise rates.

As Fortress continues to add to the GateHouse empire and consolidate operations, there is always the temptation to take an ax to newsroom operations. Clear Channel Communications Inc. (CCU), after all, vowed to stay local when it was rolling up stations in the late 1990s, only to homogenize lots of programming to save a buck. "Good journalism is our duty," Reed contends. "If we don't do that, we know we will lose our readership in buckets."

Journalists have heard this before, of course--most recently from Brian P. Tierney. He bought up Philadelphia's newspapers and vowed to do good journalism, but ended up laying off dozens of reporters and editors. Fortress seems less likely than its private equity counterparts to cash out quickly. And it may have bought peace with GateHouse shareholders; in October, Fortress issued an annual dividend of $1.28--not bad for a stock trading at about $19.

Still, the company needs to keep the deal machine revved up. GateHouse must generate sufficient cash flow to pay down $560 million in debt (a debt-earnings ratio that's twice the newspaper industry average), continue to invest in new Web initiatives, and keep those dividends coming. CEO Reed will be spending a lot of time on the road, scouring the country for deals. They shouldn't be hard to find. Fully 8,000 daily and weekly newspapers still roll off the presses in the U.S. And many do business in the outposts that GateHouse considers its sweet spot.

By Tom Lowry


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