Fitch U.S. Media Outlook: Economy & Regulation Are The Wildcards For 2003.

Business Editors

CHICAGO--(BUSINESS WIRE)--Dec. 11, 2002

While top-line growth for the media and advertising companies remains a question mark, Fitch Ratings believes that the advertising trough may have been reached, which positions the industry for strengthening cash flow and potentially improved credit metrics. Apart from economic trends, particularly employment and consumer confidence, the salient factor in the credit outlook for 2003 is the potential effect of regulatory changes on consolidation in the media sector. Fitch believes that these changes could usher in a new wave of asset consolidation in the newspaper/broadcast industries, with potentially significant credit implications for the major consolidators.

Looking back at 2002:

The gradual erosion of credit quality in the media and advertising sectors that marked 2001 continued largely unabated in 2002. Broad-based efforts to lower operating costs and reduce capital expenditures in response to the weak environment proved to be insufficient to uniformly stabilize credit quality across the sectors. The persistent sluggishness of the U.S. economy along with geopolitical uncertainties combined to restrain consumer confidence and advertisers willingness to appeal to cautious consumers. Advertising sub-categories such as employment in the newspaper sector followed the general course of economic trends, while other sub-categories, including financial and technology advertising, experienced acute declines, reflecting contraction in the respective industries. Strong theater attendance helped several major studios, and $1 billion of political advertising benefited broadcasters in the fall, while vacation/leisure travel remained depressed following the events of Sept. 11, retarding a recovery among theme parks and resort operators.

Some companies were able to buck the trend of negative rating actions that continued from 2001 into 2002. However, over half of the companies in Fitch's media/advertising sector were subject to negative rating actions. Companies that were able to maintain stable credit profiles in 2002 were typically those whose earnings streams were partially or wholly de-linked from the weak advertising environment. But for most companies in the media sector, 2002 was a year in which either their credit profiles continued to weaken, resulting in a downward rating action or a prolongation of a Negative Outlook. The background for all of the negative rating actions across the media/advertising sector was the weak operating environment that prevailed in 2002, with companies that had increased their leverage through acquisitions, investments or share repurchases susceptible to a more pronounced deterioration in credit metrics. For the advertising companies, the factors precipitating rating changes were variable, but also reflected a generally weak operating environment. Even the large diversified companies with unique brand franchises, leading market positions, and cross medium and promotional platforms and the cable operators, who benefit from subscription-based revenues, were not immune to the downward pressure on ratings.

Looking forward into 2003:

Current market consensus has the elusive advertising recovery beginning in 2003, although this view is conditioned on sustained positive economic performance by the major economies, improving corporate profitability, reasonable levels of consumer confidence and the absence of war. Further, it seems likely that when the recovery commences, it will lag behind improvements in the economy, as it traditionally has, with advertisers reluctant to commit to new product launches early in the recovery cycle. It also seems likely that the heady growth rates of the late 1990s will not soon be reestablished, as dot.com and to some degree, other categories have permanently shrunk. The advertising sector had initially expected a recovery to commence in late 2001 or early 2002, predicated on the assumption that economic growth in the U.S. would resume. The sluggish performance of the U.S. economy in 2002 precluded a sustained recovery despite incremental benefits from two global sporting events, the Winter Olympics early in the year, the World Cup (the latter primarily benefiting the large international subsidiaries of the advertising agencies rather than the domestic media companies) and the U.S. congressional elections in the fall.

The stronger-than-expected broadcast upfront market that ended in June seemed a harbinger of improving conditions, where prime-time sales totaled $8.1billion as compared with $6.8 billion in 2001, for a 20.1% increase (Source: Advertising Age). Fitch believes this figure should not be viewed as a conclusive turning point for advertising. First, the sell-out for the 2002-2003 season was close to the traditional 80% level, while the sell-out in 2001-2002 was lower, in particular because CBS chose to hold back more inventory for the scatter market and only sold about 65% upfront. Second, some of this strength, according to industry insiders, reflects a shift by advertisers in the U.S. from the scatter market (the unsold portion of inventory that is sold throughout the season) to the upfront market.

Within the media sector, newspaper advertising is among the most sensitive to the direct performance of the economy, with major components in retail and classified categories. While newspaper advertising has recently been trending more positively, the all-important recruitment portion of the classified category will not likely develop sustained momentum until an economic recovery is well in place. One factor that should benefit advertising rates for the newspaper group is a pick-up in circulation at several major metropolitan and national newspapers in 2002, following a multi-year trend toward circulation declines. Whether the trend is durable or not is unclear. Some of these gains have apparently occurred in response to aggressive pricing strategies, but a heightened interest in news may also prove to be one of the legacies of the events of 9/11. Higher benefits costs and recent increases in the price of newsprint will put some pressure on newspaper margins. But the roughly $35/tonne increase that is expected to hold only represents about a 5-8% increase, with newsprint typically representing 15-20% of operating costs. Fitch believes a moderate pick-up in advertising combined with benefits from restructuring activities could outweigh these factors and lead to cash flow growth for the group in 2003. Newspaper publishing is a high-margin business, with incremental margins on new advertising running as high as 80%.

In general, the cable industry experienced significant downward pressure on debt ratings in 2002 due to a variety of factors. Accounting scandals and regulatory scrutiny affected participants to different degrees. Heightened competition from DBS (digital broadcast satellite) providers continued to be evident in reduced basic growth rates, with many operators reporting negative growth rates, a trend that is only expected to moderate slightly in 2003. Despite the failed merger between Hughes' DirecTV and Echostar, increased competition for video customers along with rising programming costs will continue to put pressure on core operating margins. With the further maturation of modernization programs of the cable operators, investment focus will shift to the expansion of new services including Video-On-Demand (VOD). Nevertheless, capital expenditure levels should decline in 2003, which will help to maximize free cash flow. Fitch believes growth in new services or revenue-generating units (RGUs) will be keys to maintaining the cash flow growth that operators have historically experienced.

The success of cable modem service in 2003 will be critical to revenue and cash flow growth, with the slowing growth of high-margin digital cable. As a result, bundling of services has become a strategic necessity in order to stem basic subscriber losses and reduce overall churn. Video service rate increases, which have helped to offset higher programming costs, will be more difficult for cable operators to realize in 2003 in the face of strong competition from DBS. Therefore, adding new services and bundling services becomes increasingly important. While advertising is still a relatively small component of total cash flow, an improved advertising climate combined with the cable operators ability to continue to siphon off audience from the broadcast networks bodes well for the sector in 2003.

Consolidation and acquisition activity remain an event risk for the cable industry in 2003 due to the number of cable systems that could potentially be available following the AT&T Broadband and Comcast merger, the Adelphia bankruptcy filing, and from the financial difficulties of other operators. Economies of scale remain an important financial and operational benefit to cable operators, particularly as it relates to programming contracts. Fitch believes, however, that many of the multisystem operators (MSOs) will continue to be focused on strengthening their balance sheets to improve their credit profiles. Although financial flexibility for many cable operators is improving, with some major MSOs generating free cash flow in 2002 as their major capital expenditure programs wind down, their balance sheets are strained at current rating levels and unfavorable equity markets will limit alternative forms of acquisition financing. These factors could delay significant acquisition activity.

Another important event risk relates to the anticipated regulatory changes that are expected to have a significant effect on the acquisition outlook for the entire media industry. The Federal Communications Commission (FCC) is expected to issue major new regulations in early 2003 regarding cross-ownership rules (restrictions on the ownership of both newspaper and broadcasting assets in a single market), duopoly restrictions (limitations on two-station ownership in single markets) and ownership caps for television station groups (limitations on the ownership of a television station group to 35% national coverage at present, but which may be raised to 50%). These changes could usher in a new wave of asset consolidation in the newspaper/broadcast industries, with potentially significant credit implications for the major consolidators.