Paper Chase

Some fund managers see hidden value in beaten-down newspaper stocks.

These are turbulent times for the newspaper industry. With circulation continuing its 50-year slide and advertisers chasing younger readers, who are defecting to new media, most publicly traded newspaper companies have been reporting flat-to-falling profits. Even as they slash costs, their stocks are tanking. This year through mid-November, shares of nine leading newspaper publishers fell, on average, by nearly 10 percent, compared with about a 12 percent return for the Standard & Poor’s 500 index.

“The market is recognizing correctly that the future value of these companies is declining,” says Cindy Sweeting, research director at Templeton Investment Counsel, a Fort Lauderdale, Florida, affiliate of money manager Franklin Templeton Institutional.

Not everyone agrees. Despite the gloom, some value-oriented managers are betting heavily on the future of U.S. newspaper companies. Leading the pack is Chicago-based Ariel Capital Management, which as of September 30 had more than a $530 million investment in Tribune Co., publisher of such dailies as the Los Angeles Times and the Chicago Tribune. Ariel’s 16.4 million shares account for nearly 7 percent of Tribune’s total outstanding and are a top holding in its Ariel Fund and Ariel Appreciation Fund.

The firm also has roughly a $193 million stake in McLean, Virginia–based Gannett Co., publisher of USA Today, the largest-circulation newspaper in the U.S., and an investment worth more than $330 million in Sacramento, California–based McClatchy Co., another major publisher. That company made headlines earlier this year when it bought Knight Ridder — then the second-largest publisher by circulation — for some $4.5 billion in cash and stock and promptly sold off 12 of its acquired papers.

“We’re looking for great companies and great industries that are out of favor,” says Ariel vice chairman Charles Bobrinskoy. “There’s absolutely nothing more out of favor than newspapers.”

To the contrarians, broadsheets are top producers of two key assets: high-quality content and strong cash flow. They also have strength in local markets and unrecognized value in their growing online operations.

Proponents contend that the stocks are cheap. Robin Kollannur, co–portfolio manager of the $1.21 billion-in-assets Northern Large Cap Value Fund, based in Chicago, has initiated positions this year in Tribune and Gannett. At recent prices of $32 and $59 per share, respectively, both are trading at multiples of less than eight times Kollanur’s projection of average earnings before interest, taxes, depreciation and amortization over the next five years, down from their average historic multiples of ten times ebitda.

John Linehan, manager of Baltimore-based T. Rowe Price Value Fund, which oversees $4.85 billion in assets, has been adding to his positions in Dow Jones & Co., publisher of the Wall Street Journal, and New York Times Co., which publishes the New York Times and the Boston Globe. Times’ stock is currently trading at about $24, but the value of its assets amounts to $40 or more per share, asserts Linehan, whose fund has outperformed the S&P 500 index for five years running. Similarly, Ariel’s discounted cash flow analysis suggests that McClatchy, recently trading at $42, is worth $66 per share.

Newspaper companies’ beaten-down stocks are also attracting interest from activist shareholders and private equity bidders, who point to a potential catalyst for a price run-up. In October an investor group led by former General Electric Co. CEO Jack Welch went public with an offer to buy the struggling Boston Globe, even though Times Co. says the property isn’t for sale. While that Boston P/E party unfolds, a Morgan Stanley fund has been stepping up pressure on Times’ board, seeking, among other changes, to end the company’s dual-class share structure, which keeps control in the hands of members of the Ochs-Sulzberger family.

Ariel is betting on a buyout or spin-off transaction at Tribune Co. and has been adding to its position all year, including in the second and third quarters, when the stock fell below $30 per share (the firm won’t disclose its average cost).

Last month the Wall Street Journal reported that preliminary offers for Tribune Co. amounted to the “low $30s” per share, where the stock continues to trade. Los Angeles billionaires Eli Broad and Ronald Burkle then joined in with a bid (terms were undisclosed). Ariel’s Bobrinskoy expects Tribune to be sold for more than its current share price because of the ease of debt financing; the as-yet-unrecognized value of its stake in jobs Web site, which it jointly owns with Gannett and McClatchy; and the trophy nature of properties such as the Los Angeles Times, the Chicago Cubs baseball team and various television stations.

“People will pay a price that exceeds the economic value of the assets,” he says.

Another possibility: Tribune could pursue a so-called sponsored spin-off of assets to existing shareholders — a tax-free transaction if a private equity buyer acquires less than a 50 percent stake.

Regardless of the outcome, media bankers say the attention being showered on newspapers isn’t likely to abate. “I think you will see continued interest by private equity in the newspaper business,” says James Rutherford, executive vice president and managing director at Veronis Suhler Stevenson, a private equity firm that specializes in media and communications. Many leading newspaper companies have upgraded their production facilities within the past 15 years, Rutherford points out, so they don’t need to make major capital expenditures. “It’s a very good cash flow and margin business,” he adds.

Portfolio managers who are buying newspaper stocks base their optimism on a key thesis: that the corrosive influence of the Internet has been overstated. Newspapers still boast more than 77 million daily readers and nearly 90 million on Sunday — and these readers are an especially attractive target for advertisers.

“They earn higher-than-average incomes, have higher-than-average educations and spend a lot of time with the product,” says Bobrinskoy.

Newspapers offer advertisers another advantage. “They have the best position for local jobs and local sales,” says Veronis Suhler’s Rutherford.

Case in point: Newspaper revenue from classifieds has actually grown in the past two years — by 5.1 percent in 2004 and 4.2 percent in 2005, according to a Veronis Suhler study published in September. Rather than draining newspapers’ revenues, says Rutherford, Web sites like Craig’s List that run classifieds may simply be expanding the overall market.

Last year newspapers eked out top-line growth of 1.5 percent. Even though online revenues account for only about 10 percent, the growth potential of the companies’ Internet assets is often overlooked, asserts Bobrinskoy. In the first half of 2006, for example, newspaper Web sites enjoyed a 31 percent gain in unique visitors, compared with that posted for the same period last year, according to the Newspaper Association of America. Traditional media, including newspapers, sopped up 37 percent of online advertising in 2005, up from just 23 percent in 2000, according to the Veronis Suhler study.

And in recent months has been attracting more job listings and traffic than Monster Worldwide, its publicly traded online rival, which is trading at about 160 times its trailing 12-month earnings. Bobrinskoy argues that’s value remains buried in Gannett, Tribune and McClatchy shares. “We would say the Street is underestimating it,” he says.

Newspaper companies are hedging their bets by partnering with online operators. To enhance the appeal of their classifieds, several publishers, including publicly traded Belo Corp. and Journal Register Co., recently entered an agreement to place their job ads on Yahoo!’s HotJobs Web site. In a pilot project, Google is taking bids for ad space in papers owned by Tribune Co. and McClatchy, among other publishers.

Some large advertisers, meanwhile, are adopting a more sober outlook on online advertising, potentially slowing the migration of ad dollars away from print. According to Click Forensics, a consulting firm in San Antonio, Texas, click-through rates on some high-cost, pay-per-click Internet ads are inflated by 20 percent or more as a result of fraud: Ads are intentionally clicked on by an advertiser’s competitor or by Web sites seeking to swell ad revenue, skewing the cost to advertisers. Google CFO George Reyes has characterized this phenomenon, called click fraud, as “the biggest threat to the Internet economy.” Although Google says the problem is manageable, it paid $90 million this year to settle a click-fraud lawsuit, and Yahoo! has agreed to settle a similar case. Some national advertisers, including automakers Ford Motor Co. and BMW, now require audited reports on their Web site ads.

“If fraud continues at current levels or gets worse, it could serve as a serious deterrent to spending online,” says Nick Pahade, president of advertising consulting firm Denuo and chairman of the new media committee of the American Association of Advertising Agencies.

What’s most damaging to Internet media is that click fraud affects text ads, the small items that typically run alongside Internet searches and that are considered the least objectionable and most effective form of Web advertising. The problem could highlight the relative attractiveness of traditional media like newspapers. “People look for the auto ads and the help-wanted ads,” notes Bobrinskoy, who says that newspaper advertisements are not intrusive.

Bobrinskoy and his fellow newspaper bulls are sanguine. “Wall Street has overestimated the paradigm shift to online media,” says Northern Large Cap Value Fund’s Kollannur. But the deep pessimism over print media isn’t the only reason he believes the newspaper industry will bounce back. “I would never bet against smart people with egg on their face,” he explains.