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Wednesday, April 7, 1999

An Investment Opinion
by Louis Corrigan

ZDNet Adds Zip to Ziff

When I last looked at Ziff-Davis (NYSE: ZD), a leading publisher of tech-oriented magazines and host of the popular Comdex trade shows, the stock had been pummeled to a lowly $4 a share. Just six months later, it sits at $20 1/16, up 400% but still well off its high of $29 hit just last Tuesday.

Arguably, Ziff-Davis was simply cheap back in October, with its Internet assets valued at close to nothing. So as the overall market recovered from panic, this stock had even further to climb than most. Moreover, Ziff depends on advertising spending by PC companies. As it became clear that the U.S. economy would not fall into a recession that would exacerbate global troubles for tech companies, the overall outlook for ad spending brightened.

On the other hand, Ziff's recent results have hardly been the stuff of five-baggers. For the December period, revenues declined by 6.3% year-over-year to $378 million. Even backing out a Q4 FY98 restructuring charge of $52 million, pre-tax income fell 6.7% to $68 million. Excluding the charge, net earnings per share sank to $0.40 from $0.73 a year ago. Media companies are often valued based on their EBITDA (earnings before interest, taxes, depreciation, and amortization), but Ziff's EBITDA plunged 13% to $138 million in Q4.

The reasonable conclusion, then, is that most of Ziff's stellar performance since October can be chalked up to one thing: ZDNet, the firm's Internet unit. Last Wednesday marked the introduction of a tracking stock for ZDNet (NYSE: ZDZ), with 10 million shares sold to the public at an IPO price of $19. The stock quickly doubled, topping out at $55 1/2 on Monday before closing today at $39. Though ZDNet's results will still be consolidated with those of the parent company, which retains an 84% ownership stake in ZDNet, the new stock is designed to track this separate unit, allowing investors to participate more directly in its success and failure. (Click here for more on tracking stocks.).

What's striking is that ZDNet's market cap is now greater than that of Ziff-Davis, despite the latter's 400% appreciation since October. Indeed, the parent's substantial remaining interest in ZDNet is alone worth more than Ziff's entire market cap. At least in theory, that means that for a fixed amount of money, investors can buy ZDNet stock directly -- or, they can purchase Ziff-Davis shares and get a similar stake in ZDNet plus the rest of the Ziff-Davis empire for less than nothing. Consider these numbers.

ZDZ shares outstanding: 71.5 million*
Value @ $39: $2,789 million
Shares of ZDZ owned by ZD: 61.5 million
Value @ $39: $2,399 million
Shares of ZD outstanding: 103.1 million
Value @ $20 1/16: $2,068 million

*(excludes 10 million shares that may be purchased for $4.29 per share upon exercise of options).

What's doubly striking, of course, is the kind of Internet premium afforded ZDNet. This Internet unit consists of some 60 interconnected sites devoted to content about technology products and services, with over 1,200 news stories a month. It includes content from the parent company's publications, such as PC Magazine, the nation's most widely circulated business magazine. ZDNet had 1.84 million registered community members at year end and 6.4 million average daily page views in the fourth quarter. Media Metrix ranked ZDnet the 14th most popular Web site, ahead of rival CNET (Nasdaq: CNET), which came in 16th. Nonetheless, ZDNet's pro forma FY98 results look like this:

Revenue $56.1 million
Pre-tax operating income ($7.5 million)*
Net profit $8.6 million)
EPS ($0.12)
EBITDA ($0.9 million)*

*(excludes stock-based compensation)

Although ZDNet's revenue rose 74% last year, its results don't begin to compare with the parent's. Consider Ziff-Davis's pro forma FY98 numbers, excluding ZDNet.

Revenue $1,052.7 million
Pre-tax operating income $38.6 million
Net profit ($46.5 million)*
EPS ($0.46)*
EBITDA $241.0 million

*(excludes restructuring charge)

Of course, the Internet business is growing rapidly while Ziff-Davis's regular publishing business has been weak. Moreover, Ziff-Davis carries a whopping $1,393 million in debt after the offering and just $32 million in cash. Add $1,361 million (debt net of cash) to the $2,068 million market cap, and Ziff-Davis sports an enterprise value of $3,429 million. So its ZDNet stake really accounts for just 70% of its overall value.

In addition, ZDNet's rich price partly reflects pure supply and demand dynamics. It's just unlikely the stock would be hanging around $39 if Ziff tried to liquidate its stake by spinning off ZDNet to shareowners who could trade it freely. That's why many investors discount the value of such ownership positions, often using a multiple of about 0.6 to value them. So in this case, ZDNet's imbedded $2.4 billion value for Ziff would translate into an asset worth $1.44 billion ($2.4 billion x 0.6), valuing the rest of Ziff at about $2 billion. Given that Ziff had $1.5 billion in debt net of cash as of October, when it traded for $4 a share (market cap of about $400 million), one could argue that Ziff-Davis now trades exactly where it should given the price of ZDNet. That is, minus ZDNet, it trades exactly where it did in October, when few were assigning any value at all to the Internet unit.

Clearly, though, Ziff shareowners have enjoyed this little effort to maximize shareowner value because it's worked exceedingly well given the market's continued love affair with Internet issues. The share price appreciation is obvious, but consider the other accomplishments. Before subtracting underwriting expenses, the offering raised $161.5 million for Ziff and $28.5 million for ZDNet. Ziff will use the money to pay down some debt. For comparison, in order to raise a similar amount from the sale of Ziff-Davis stock, the company would have been forced to issue 40 million shares at the October low, or about 40% of the total then outstanding. Meanwhile, ZDNet now has capital to grow its business. It also has a premium currency for dealmaking.

In addition, Ziff now enjoys a kind of long-term option on its Internet unit. The prospectus explains the complex terms of the arrangement. But under different conditions, Ziff can exchange Ziff-Davis stock for ZDNet stock at a premium of just 15%. Or, it can issue ZDNet stock in exchange for Ziff-Davis stock at a 15% premium. Or, it could exchange the stock on a value for value basis. While ZDNet investors today literally own a stake in the parent company, this exchange option makes that doubly true. Though this relationship could ultimately dampen ZDNet's ability to fly ever higher on the wings of Internet valuations, it ensures that Ziff-Davis can operate using whichever currency ultimately proves more valuable.

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