Wednesday, February 06, 2008

MNI faces 50% writeoff of KRI deal

The McClatchy Co. could be on track to write off half of the $4.4 billion it paid for the Knight Ridder newspapers it proudly acquired in the summer of 2006.

The dramatic failure of the transaction – which took place in the early days of a catastrophic downturn for the newspaper industry that few foresaw at the time – is evident in McClatchy’s announcement today that it will have to take the second writedown in three months to reduce the value of the KRI assets it carries on its books.

McClatchy said it would take a still-to-be-determined accounting adjustment to reflect the $602.2 million drop in the price of its shares in the fourth quarter of last year. Since the end of 2007, its shares have plunged another $173.4 million to close today at $10.54 per share. Thus, the market capitalization of the company has fallen in five months by $775.6 million from $1.6 billion on Sept. 30 – a plunge of 51%.

Lest we forget, McClatchy’s shares were worth some $2.5 billion on the day before it announced its plans to buy KRI in March, 2006 – vs. $865.9 million today.

The deep drop in the value of the McClatchy’s shares in the fourth quarter of 2007 is forcing the publisher to take the second extraordinary charge against its earnings in as many quarters. In the third quarter of 2007, McClatchy wrote off nearly $1.4 billion of the value of the goodwill of the assets it acquired when it purchased Knight Ridder.

If you add the $1.4 billion writeoff in the third quarter to the $775 6 million drop in the stock to date, the sum is equal to a shade under $2.2 billion, or almost exactly half of what McClatchy paid to buy Knight Ridder in the summer of 2006.

Accounting rules require a company (like MNI) to take a charge against its earnings in the event the shares it issues to fund an acquisition (like KRI) fall below a certain level. The exact amount of the charge against earnings, also known as a writedown, remains to be calculated. It is possible that auditors will conclude the writedown should be less than the full drop in the price of the shares. If so, then the writedown of the KRI deal would be less than I have projected.

But the size of the writeoff is only one measure of how badly things have gone for McClatchy since 2006, when it bought 20 KRI papers – including the Miami Herald, Charlotte Observer and Kansas City Star – and divested a dozen other properties, including the Philadelphia Inquirer, San Jose Mercury News and Akron Beacon-Journal.

“Opportunities like this come perhaps once in a company's lifetime, and we're thrilled to have this chance to extend McClatchy journalism and our proven newspaper operations to 20 high-quality newspapers in high-growth markets,” said Gary Pruitt, McClatchy’s chief executive, in announcing the transaction. “Combining the two creates a company particularly well-positioned to lead the way in a changing media landscape. It's truly a chance for McClatchy to do more of what it does best.”

Unbeknownst to Gary, he heavied up on newspapers in the early days of an unprecedented and precipitous decline in advertising sales that has accelerated in almost every quarter since the day the deal was announced.

Now, he sings a different tune. “The advertising environment in 2008 does not appear to be improving," Gary told investors today. “In fact, in January we've seen headwinds from a worsening national economy. We now expect advertising will likely be down in the low double-digit range in the first quarter of 2008.”

While all newspapers suffered from weak sales in 2007 that likely reduced total industry ad revenues by some 8% for the year, McClatchy was hit especially hard by the concentration of its properties in California and Florida, where revenues fell by, respectively, 16.3% and 15.7%. California and Florida together accounted for 35% of the company’s $1.7 billion in ad sales in 2007.

Ironically, McClatchy’s troubled portfolio resulted from its decision to cherry-pick Knight Ridder’s assets at the time of the merger and to jettison papers in places like Akron, Philadelphia and the Dakotas in favor of titles in what then were believed to be fast-growing Sun Belt markets. Real-estate busts on both coasts since have foiled the Sun Belt strategy.

(McClatchy also sold three Northern California newspapers to Media News in the belief, which turned out to be prescient, that those markets would not grow fast enough to outpace the publications’ high operating costs.)

In addition to evidently betting on the wrong geography in 2006, McClatchy also failed in the first year after the merger to build an effective new-media strategy. For reasons that remain inexplicable to this day (see this post), McClatchy’s $164 million in online sales in 2007 represented an increase of just 2.2% over the prior year at the same time industry gains likely averaged 20%.

Regardless of whether management could have done more to stimulate print or online sales, there are questions within the industry as to whether McClatchy acted rapidly enough to control costs to protect its margins as revenues eroded.

The company’s operating margin 0f 25.4% in 2007, while respectable, pales next to the EBITDA of 28.6% it achieved in 2005, the year before the KRI merger. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.)

More significant than the drop in the company’s operating performance is that McClatchy’s debt climbed to more than $3 billion after the KRI transaction from $202 million in 2005. With McClatchy’s debt today 16 times greater than it was in 2005, a huge portion of its profits must be dedicated to interest payments, instead of investments to build revenues or control costs.

If McClatchy is to avoid defaulting on its towering interest obligations, it needs to bring its operating expenses in line with its lower (and seemingly falling) revenues.

So, it’s a safe bet that aggressive new cost cuts are on the agenda this week at the annual meeting of McClatchy’s publishers and editors.

2 Comments:

Blogger Banjo Jones said...

Alan,
what's your prediction? Might the company be forced to sell some of its papers?

Also, anyone besides Dean Singleton interested in the Chicago Sun-Times? What do you think that paper might fetch in this lousy environment?

7:03 PM  
Blogger Michael Josefowicz said...

Thanks for the post. Great detail.
Just want to add my 2 cents.

The stock valuation and the profit stream are two very different things.

The stock valuation is a reflection of what the market thinks it's worth.

The profitability is a more useful indicator of the state of affairs.

What the numbers say to me is it seems that aggregating readers and selling them to advertisers is broken. I can't see how that is ever going to come back, either on the web or anywhere else.

If that's true, what are other ways of leveraging the value of newspapers?

Maybe the on the ground delivery system is a value that can be monetized? I notice that Amazon is hiring local delivery services in addition to UPS or USPS.

Maybe the proven ability (where it really exists - as opposed to reprinting the AP) to contextualize and investigate local politics, economics and community health?

I don't pretend to know the answer.
But I think that until newspaper folks stop trying to recreate the days when they were they were the default reader aggregator in a protected market, it's not going to work.

12:47 PM  

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