QUALIPORT
No Room For Newspapers

By Maynard Paton (TMFMayn)
January 11, 2001

Carburton Street, London -- Over the past twelve months, I've blown hot and cold over the newspaper industry. Almost a year ago, I reviewed Southnews (LSE: SNW), a publisher of local papers. My conclusion at the time was a "definite maybe" for the Qualiport. Back then, I expressed concern that Internet-based competitors could steal the whole industry's classified advertising base.

Fast-forward to October 2000. With Internet startups now having a hard time to raise new funds, and thus becoming less of a threat to the newspaper industry, I changed my tune. In my Paper Talk Turnaround, I declared that the Internet would become a "broadly neutral" factor for newspapers and that "a Qualiport re-assessment" of the industry would be in order.

When I performed the U-turn, the Qualiport had a cash balance of around £5,500. But all that money was subsequently invested in PizzaExpress (LSE: PIZ) and MMT Computing (LSE: MMT). So why did the Qualiport invest in those two companies over and above any newspaper proprietor? I need to do some explaining.

Industry players

First off, the newspaper industry fundamentally remains as financially attractive as ever for investors. Recent history has shown that it has been almost impossible to establish a new and successful newspaper from scratch. That, coupled with little ongoing capital investment, makes each existing publisher a wonderfully predictable cash cow. The review of Southnews highlights the enticing accounting features of a newspaper publisher in more detail.

Unfortunately, Southnews is no longer an investment opportunity. The day after my October turnaround, Trinity Mirror (LSE: TNI) announced a bid for its smaller cousin. So, in terms of quoted companies, that just leaves Trinity and Johnston Press (LSE: JPR) as the only remaining pure newspaper plays. (An honourable mention must go to Daily Mail & General Trust (LSE: DMGT), though, which generates 70% of its profits from its stable of national and local papers.)

Consolidation

In fact, Trinity's purchase of Southnews removed the most attractive sector player from the stock market.

Capitalised at less than £200m (compared to the £1b Trinity and £600m Johnston), Southnews was always going to be the main beneficiary of the three players from the ongoing consolidation in the industry (limited organic growth in the newspaper market means the publishers must acquire their smaller sector cousins to increase their profits).

Standing in the sector middle ground, either Southnews would have made a tasty morsel for a larger player (as it eventually did), or the company could benefit proportionately more by gobbling up the multitude of private microcap operators.

For Trinity and Johnston, the potential for their growth-by-acquisition strategies was, and still is, more restrained. Apart from regularly attracting the attentions of the competition authourities, there just aren't that many notable opportunities available for the two remaining players. Although the privately owned Regional Independent Media is currently up for grabs (Gannett (NYSE: GCI), Guardian Media and Johnston Press are currently devising a three-way break-up of the company), the only other sizable independent operator is Eastern Counties Newspapers.

Debt

Although acquisitions are part and parcel of the industry (both Trinity and Johnston do have a sound record), the process always creates additional investment danger. There's always the risk of overpaying (Trinity's bid valued Southnews at a pricey 24 times forecast earnings), plus there's the possibility of subsequent operational problems that continuing corporate activity often brings.

However, what is more concerning is the high level of debt required to operate as an aggressive consolidator in the newspaper sector. Trinity and Johnston have their interest payments covered only 5 times by operating profits, both companies gearing up substantially to implement their consolidation plans. Although there are financial advantages to using the additional leverage, in general, the greater amount of debt a company has, the greater the investment risk.

Adjusted for goodwill, a simple return on equity (ROE) calculation for Johnston Press gives a figure of 13%. Unfortunately, any sensible ROE calculation for Trinity is out of the question at the moment, given the large operational comings-and-goings at the firm. However, my gut feel is that Trinity's ROE would be in line with Johnston's and, just as we saw with JD Wetherspoon (LSE: JDW), not being able to obviously generate an above-average ROE with large amounts of debt is not impressive. Granted, some acquisitions may have to "bed in" still, but all the same, it doesn't look like we're dealing with companies that can generate superior returns for their equity owners.

Comparisons

Of course, newspaper publishers aren't the only stocks on offer for investors. And here's the crux of the matter. On two important counts, the investment merits of PizzaExpress and MMT clearly outshine those of the available newspaper operators:

* Potential for organic growth: It's not too far-fetched to say that both PizzaExpress and MMT could organically double their profits over the next five years. There's plenty of scope for additional pizza parlours and demand for corporate Internet development is strong. The only way Johnston or Trinity could double their profits is through acquisition, with all of the aforementioned risks that that brings.

* Lack of debt: Both MMT and PizzaExpress operate without recourse to debt. MMT, in fact, sits on a large cash pile. Both companies have traditionally recorded 20%-plus returns on equity too.

While the prospects of PizzaExpress and MMT may not have the ultra-predictability of a newspaper publisher, the above points heavily offset the lower business "certainty" that selling pizzas and IT services creates.

Overall, newspaper publishers are fine constituents for any "quality" portfolio. As I wrote earlier, the newspaper industry fundamentally remains as financially attractive as ever for long-term investors. But there are few berths available in the Qualiport these days. Simply, PizzaExpress and MMT offer greater long-term growth prospects, notably without recourse to excessive debt, than the remaining newspaper opportunities.

Your turn

Have I made a mistake in dismissing newspaper publishers for the Qualiport? Let me know your thoughts over on the Qualiport message board.

Where next?

Read previous Qualiport articles on the newspaper industry:

* Was Southnews Qualiport Material?
* Paper Talk Turnaround