As a contrarian investor, I love hearing stories about an industry's decline. Such dire predictions often present investment opportunities as all affected stocks -- of good companies and bad -- are lumped together and pummeled. Digging in and understanding the industry and its evolution can result in some very successful long-term investments.
I've been eyeing the newspaper industry for a while, as it has fallen further and further out of favor. Historically, the business has been a superb one, with most companies holding monopolies in their locality and generating huge and growing cash flow. But that strong track record seems hopelessly imperiled these days.
The beginning of the end?
Newspapers have long been coping with declining readership as younger people increasingly get their news from other sources, such as TV, radio, and online sources. Despite reduced circulations, higher advertising rates were typically able to provide companies with revenue growth.
The continued development of the Internet has accelerated these challenges. Improved news and information sites not only provide stronger alternative news sources to siphon off readers, but also provide better venues for commerce that could snare all-important advertising revenues.
According to the Newspaper Association of America, classified advertising represented $17.3 billion of the industry's $47.4 billion 2005 advertising revenue. This figure has grown modestly over the past two years as the economy strengthened, but it's ultimately destined to fall.
Why use a newspaper's classified section when a free ad can immediately be posted on Craigslist or an item can be listed on eBay (NASDAQ:EBAY) and reach millions of people? What added value can a newspaper's help-wanted section offer when online sites list more jobs, while also allowing sorting and filtering and providing access to more information, as well as the ability to apply instantly?
On top of challenges in classified ads, general display advertising is also under attack. Retail consolidation reduces the number of stores advertising, and the conversion of the old May Department Store brands like Hecht's, Foley's, Filene's, and Kaufmann's -- all of which were heavy newspaper advertisers -- into Macy's will crimp local papers over the course of the next year.
Truthfully, though, most newspapers will likely see gradual circulation and advertising declines rather than rapid obsolescence. Although online sources offer great access to requested information, it's hard to replicate the pleasure of taking a newspaper to the dining room table, sofa, or coffee shop to skim community and world events. As long as readers stick around, newspaper advertising will remain a viable option for reaching a mass audience -- an increasingly difficult challenge as media usage splinters.
Content and cash
The most valuable attributes of most newspaper companies are strong reputations with readers, as well as the ability to create lots of content and generate strong cash flows. Finding companies that can catapult these strengths into profitable growth opportunities should yield the biggest investment winners.
Not all content is created equal. Local news in a small town will continue to be interesting to that city's residents, but it's not likely to garner readership outside the town (barring a scintillating angle). On the other hand, compelling niche content from recognized leaders could draw a wider eye. Political commentary from The Washington Post or business news from The New York Times, for example, might attract a wider audience online than in the print world.
I believe that companies with strong reputations in non-geographical specialties could find meaningful online opportunities. Dow Jones (NYSE:DJ) has already demonstrated this with its Wall Street Journal-related WSJ.com site, the largest paid subscription news site on the Web. Competition will be intense, given low barriers to entry, but papers with outstanding reputations and content have formidable competitive advantages.
Another wonderful attribute of newspapers is profuse cash flow generation. Industry kingpin Gannett (NYSE:GCI) has cash flow from operations minus capital expenditures totaling 15% to 18% of revenue over the past two years. The results of McClatchy (NYSE:MNI), which is in the midst of acquiring Knight Ridder (NYSE:KRI), on that basis, are just below 12%. That's not too shabby at all.
Many companies are using their excess cash flow to repurchase shares or acquire competitors. While I usually enthusiastically support such moves, these investments will be mediocre at best if industry conditions deteriorate and management teams don't address fundamental challenges.
Companies plowing their cash into profitable growth markets are more appealing to me. Washington Post (NYSE:WPO), which has been investing in its Kaplan education unit for more than a decade, best represents this strategy. This profitable and growing division is now the biggest business in the company's empire, which also includes cable TV, broadcast TV, and magazine operations.
Dow Jones' purchase of MarketWatch last year also makes sense, since it expands the company's online reach in finance news and information beyond its core WSJ reader (and eliminated a potential competitor). The acquisition of about.com by New York Times (NYSE:NYT) could prove to be a good move, but I don't yet completely understand the logic of that deal.
My picks
My favorite investments in the newspaper sector are those that can leverage their content and cash. Dow Jones, which has a leading position in business news and strong (and highly profitable) online operations, is my top pick. Next up is Washington Post, which owns meaningful (and profitable) non-newspaper operations and can potentially leverage its political news coverage nationally. The New York Times is on my watch list, but I'm not yet convinced that its current strategy can offset challenges in its core properties.
Dow Jones is an interesting case in that its operations seem to be on a different cycle from most other papers. The company's print publications actually had an operating loss last year because of the tremendous decline in technology and business advertising since the stock market bubble burst in 2000. With continued economic strength, the company could see a cyclical upturn in demand in the next few years (the company's recent ad lineage volume indicates that a bottom may have been hit).
The company has also invested substantial resources to expand the coverage into "The Business of Life," adding sections on personal finance and launching a Saturday edition. Targeting affluent baby boomers, these sections should attract more general consumer advertising to the Journal's online and print properties, opening up substantial new revenue opportunities. Meanwhile, the company's institutional and online businesses are posting impressive results.
On the other hand, local newspaper companies don't interest me right now despite their seemingly attractive valuations. I simply can't envision these companies' strategic moves offsetting the likely continued declines in circulation and advertising revenues. Unless that happens, my investment dollars will stay on the sidelines.
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Fool contributor Warren Gump owns shares of Dow Jones and Washington Post but no other companies mentioned in this article. The Fool has an ironclad disclosure policy.
