Newspaper Stocks Could Deliver

We Don't Think It's Different This Time
The recent past has certainly been tough on newspaper publishers. Readership has declined, with many thinking that the Internet will bring about newspaper publishers' ultimate demise. Plus, untimely circulation overstatement scandals have poured salt in the wounds of declining circulation.

Media pundits have been guilty of crying "wolf" before. When radio was introduced, some thought newspapers would die. When broadcast television appeared, many thought radio was doomed. And when videocassette recorders surfaced, movie studios were so terrified that VCRs would wreck the movie industry that they went all the way to the Supreme Court to try to outlaw the technology. Each one is still with us today (with VCRs morphing into DVD players).

It's no secret that newspaper readership is down. This isn't a phenomenon that began yesterday, but rather a trend that started decades ago, as dual-income families became more common and Americans in general found themselves with less free time. According to data provided by the Newspaper Association of America, the percentage of the U.S. adult population who read both weekday and Sunday papers fell more between 1970 and 1985 than it did between 1990 and 2004. In other words, total readership fell more before the Internet came about than it did during a similar time period after everyone began surfing the Web.

Economic Moats
We don't think it will be different this time because of newspaper publishers' economic moats. Here at Morningstar, we look for companies that display certain competitive advantages. These advantages, which can come in the form of high barriers to entry, high switching costs, or exclusive licenses, among others, allow the firms to generate sustainable economic profits. We'll be the first to say that the Internet has eroded some of the economic moat enjoyed by newspaper publishers. Even so, we think newspaper publishers still display attractive characteristics, and their moats still exist.

In our opinion, the newspaper industry's best quality is its focus on local content. The old media axiom "content is king" is just as true for newspapers as it is for any other form of media. Someone who's interested in the latest news about the war in Iraq or happenings in the White House can get this info quickly and conveniently from a number of national Web sites such as cnn.com or foxnews.com. But if this resident of Anytown, USA, wants to keep up with the local mayoral race or his favorite hometown sports team, he'll most likely turn to his local paper or its Web site (which is able to leverage content from the paper). And as long as newspapers and their Web sites keep attracting consumers, we think that they'll continue to pull advertising dollars from local and national marketers.

Newspapers typically don't face much direct competition from other dailies in their particular markets. Newspapers were among the very first businesses to experience what is known today as the "network effect." In almost every market, the paper with the largest circulation has tended to attract the most advertising, as marketers are interested in getting their message to as many consumers as possible. As the larger, more powerful paper gained more share of the market's advertising dollars, it was able to steal more readers from its smaller competitor. This larger circulation attracted even more advertising, and on and on, until the smaller paper was squeezed out. Because of this tendency, there are very few multiple-newspaper towns today.

Aside from the network effect, we don't think it's very likely that an established daily newspaper will ever face competition from a startup in its market. Anyone attempting to introduce a daily newspaper into an established market faces a significant barrier to entry in the form of the incumbent's economies of scale. Newspapers have high first-copy costs. Whether it sells 1,000 copies or 100,000, it costs the publisher the same to gather news, create content and design the paper. These economics don't look too good to a startup with no unique content and no initial readership base in an already-established market.

Even in this mature and declining industry, these competitive advantages allow newspaper publishers to generate impressive results. Many regularly produce operating margins of 20% to 30% and free cash-flow margins in the teens. Many have returns on invested capital greater than our estimate of their cost of capital, a true measure of economic profitability. Quite a few companies would be envious of such results, and these kinds of results are what led to investments in newspapers by legendary investor Warren Buffett.

Creating Shareholder Value
The last few years have been tough for newspaper publishers' stock prices. Circulation overstatement issues at a few companies and concern about the Internet have weighed on the entire industry.

We think the market has overreacted on some of them--it's not recognizing their full value. Based on some recent activity, others agree with us. On Aug. 12,  Knight Ridder  began implementing the stock buyback program that its board authorized in July; Knight Ridder's stock price finished up more than 5%--a big jump for a newspaper company. Earlier this week, the New York Post ran an article indicating that members of  Dow Jones'  (publisher of The Wall Street Journal, among other papers) controlling family, the Bancrofts, were looking to sell the company, hoping to get a premium on its lagging stock price. We've heard that story before, but while that remains a rumor as of the date of this piece, Dow Jones' stock price rocketed up more than 11% on the thought that someone would buy the company because of its currently cheap price. And back in January,  Lee Enterprises (LEE) bought Pulitzer for a juicy premium of more than 20% over our fair value estimate. As management teams of other newspaper publishers see the results that some of these decisions have had, we think they'll be inclined to follow suit in some fashion.

We think this is a great time to take a look at some of these high-quality, undervalued companies that may provide you with some attractive returns. In our opinion, these three especially hold untapped value at their current prices:  The New York Times Company (NYT),  Tribune Company  and  Washington Post Company (WPO).