• by December 2, 2004

DARLING YOU GOT TO LET ME KNOW -- We always knew that when it comes to analysis of media industry securities, Merrill Lynch's Lauren Rich Fine rocks. But when we received her equities research report about the newspaper industry on Thursday, we realized just how much she actually rocks. The report entitled, "Should I Stay or Should I Go Now?," is an obvious allusion to The Clash's 1982 song of the same name. But somehow, we don't think the Wall Street diva had the same anarchic spirit in mind for newspaper stocks. Then again, it's difficult to say given the relatively non-committal rating Fine assigned to the newspaper medium.

"After wavering for a while, we are maintaining our largely neutral stance on the newspaper group, a view that we have held for the last two years," wrote Fine, adding, "This is despite our decision to lower our newspaper industry ad revenue growth forecast in 2005 from 5% to 4% and as a result, our 2005 earnings estimates by 2.2% on average. As a result, we are now looking for 5-6% earnings growth for the group in 2005." Okay, so it doesn't sound like Fine's exactly neutral on the subject of newspaper industry growth. So why the "neutral" rating? Mainly, she says, because there are far too many unstable factors confronting newspapers to justify additional investments in the medium.

The main factors, according to Fine:

1. A tepid outlook for newspaper advertising revenues in 2005, as evidenced by our forecast reduction. In short, retail advertising remains sluggish due to secular industry changes, help wanted comparisons will become more difficult in 2005 and real estate growth seems likely to slow.
2. The recent circulation misstatements and worsening circulation trends have cast a shadow on the newspaper industry's ability to raise ad rates in 2005, in our view.
3. We expect newsprint prices to rise by another 10% in 2005 after a similar increase in 2004; newsprint expenses represent about 15% of operating costs. While a projected decline in newsprint consumption in 2005 due to sluggish advertising and lower circulation volume is not conducive to price increases, the opposite forces of newsprint producer consolidation, a reduction in production capacity and a weaker U.S. dollar might be difficult to overcome.
4. Newspaper stocks tend to underperform the S&P500 in periods of rising newsprint prices and vice versa. We clearly are still in the upswing cycle of newsprint prices.
5. On our new estimates, the newspaper group is trading at 10X 2005E EBITDA on average, or the high end of historical trading range of 6-10X. More importantly, the valuation is now also in line with, to even above, the valuations of other media sectors, even though newspapers' growth profile is not as strong as most of the other media sectors'.
6. We have long-term concerns about the health of the industry due to competition from the Internet and other media sectors, especially as it relates to both the classified and national categories. As we will explore later in the report, we think the impact from the Internet is also being felt in the anemic effective ad rate increase that the industry is experiencing, as much of the revenue growth is coming from the lower-rated online classified sources

Other key issues cited by Fine include the "wildcard" of the merger of two retail advertising giants - Sears and Kmart - and economic conditions that could put downward pressure on newspaper ad rates. "In a low inflation environment with declining circulation and the proliferation of new media outlets, it is unlikely, in our view, that newspapers will be able to raise ad rates much, if at all," said Fine, predicting that newspaper ad rates would be little better than flat in 2005, and that they are not likely to be helped the recent circulation scandals at a few major papers.