Fitch U.S. Newspaper Outlook Negative: Optimal Capital Structures Come Into Question Given Secular Issues.

NEW YORK -- Key operating fundamentals in the U.S. newspaper industry have continued to generally trend negatively in 2005, with paid weekday circulation declines accelerating from negative 1.9% for the six-month period ending March 30, 2005 to negative 2.6% for the six-month period ending Sept. 30, 2005. Nine of the top 10 newspaper companies showed circulation declines in the period ended Sept. 30, 2005 ('New York Times' being the outlier). Circulation scandals, elimination of poor circulation measurement practices and, more importantly, the defection of readers toward competing sources of news and information caused the declines and also pressured print newspaper advertising revenue in 2005. These negative circulation trends and tepid advertising environment strained newspaper company stock prices, influencing some management teams to re-evaluate their financial policies, which led to negative rating actions during 2005. Fitch expects this trajectory of operating performance and ratings to generally continue in 2006.

In 2006, newspaper companies will continue to face challenges common among slow-growth companies in mature industries. However, these challenges are intensified by the secular issues facing the newspaper industry. Specifically, Fitch expects that there will be continued migration of readers toward electronic media coupled with the logical redirection of advertising dollars toward the media being consumed. Moreover, Fitch anticipates that trends toward increased consumer control and portability of news and a general shift in some markets away from traditional broadsheet newspapers will continue in 2006. These secular shifts were accelerated within major urban markets in 2005 where free commuter-friendly dailies combined with high broadband penetration levels (which led the shift of consumers and advertisers toward the internet), posed significant competitive threats and negatively affected newspaper circulation and advertising revenue. With broadband penetration rising rapidly in second tier and rural markets, Fitch believes that some of the pressure felt in urban settings in 2005 may extend to these other markets in 2006 and beyond.

In addition to, and as a result of the secular trends described above, the newspaper industry will continue to face a number of major considerations. First, the industry remains exposed to consolidation activity among major advertisers. For example, the merger of Federated and May Department stores, which made up roughly 4% of retail newspaper advertising in 2004 (according to AdAge), could affect the absolute levels of advertising spending for the combined entity, as well as enhance its power during annual advertising purchasing negotiations with the newspapers.

Next, as one of the highest CPM (cost per thousand) media forms, at around $25, newspapers will need to justify the pricing differential in the face of circulation declines. With the advertising community increasing its focus on return on investment (ROI), newspapers will bear the burden of demonstrating and quantifying reader engagement. This will be of particular importance as newspapers compete directly with online advertising for advertising dollars given the perceived enhanced capabilities of online advertising in computing ROI. In Fitch's view, the newspaper industry's efforts at promoting adoption of a 'readership' metric in lieu of circulation could prove difficult as the trends in readership (excluding online) have likely tracked the negative trends in circulation, and Fitch believes the trends, rather than the absolute levels, are weighing more heavily in advertiser considerations.

In addition, high margin print classified advertising (roughly 36% of advertising revenues for newspapers) will remain under pressure as the number of users of online classified advertising grew dramatically during 2005, up 80% over 2004, according to comScore Media Metrix. While some industry participants have joined forces in forming consortiums and have developed viable web sites like CareerBuilder.com, online competition is fierce as Craigslist.com has attracted a significant classified user base in major markets, EBay usage remains strong, and Google and Microsoft have announced significant forays into the classified space in the second half of 2005. Classified advertising growth for newspapers over the past 10 years has been sluggish, up about 1% on a compound annual growth rate basis, compared with overall newspaper advertising, up around 3% during the same period according to the Newspaper Association of America. As a result, it is down 2% as a percentage of overall newspaper advertising revenues during that time. Help Wanted ads (28% of the total) have been most affected by online competition, but Fitch anticipates that the other two significant categories, Automotive (30%) and Real Estate (25%), will be under increasing attack from online competitors in 2006 and subsequent years.

Another consideration relates to newsprint costs, which were up in the mid-single digits in 2005 and are expected to remain elevated in 2006 due to cost pressures at the primarily Canadian newsprint producers (only about 20% of North American newsprint is produced in the lower 48 states). In U.S. dollar terms, newsprint prices have risen some 34% since the middle of 2002, but in Canadian terms, prices have only climbed 1.5%. During the same period, costs (in Canadian dollars) to produce and sell newsprint have risen over 15%. Due to the compression of their margins, these Canadian producers are likely to continue to attempt to push through price increases even though consumption in the U.S. is generally down. Fitch notes, however, that while newsprint typically makes up between 10%-20% of newspaper production costs, newsprint cost increases to date have been largely offset by other cost reductions. As such, these cost increases have not had a significant impact on newspaper company margins, but as cost reduction offset opportunities diminish, margins could come under increasing pressure.

Also, the industry will continue to remain highly exposed to cyclical advertising trends. Fitch notes that the challenges the newspaper industry faced in 2005 and is expected to face in 2006 exist against the backdrop of a generally healthy phase of economic expansion. The pressures outlined above would be exacerbated should the economic environment deteriorate in 2006. Furthermore, while many newspaper companies in Fitch's rating universe also have substantial television station operations, Fitch does not believe these operations provide significant diversification benefits, noting that these operations are also exposed to this advertising cyclicality. Newspaper advertising revenue was down roughly 9% in the 2000-2001 advertising recession, while broadcast television station advertising revenue was down about 17%. In addition, TV advertising is the highest CPM media alternative (over $25) and is facing significant secular challenges as well.

Finally, historically the investment-grade ratings (currently ranging from 'A-' to 'BBB-') for the newspaper companies in Fitch's coverage universe have been based generally on solid margins (in excess of 20%), relatively stable advertising bases and costs elements, and resilience through economic downturns. Management teams have typically maintained conservative financial policies, balancing the demands and interests of shareholders and bondholders while reducing debt levels commensurate with disruptions in operations and in relation to increases in acquisitions, share buybacks, and dividends. In 2005, this balance between shareholders and bondholders within several companies shifted significantly in favor of shareholders (consistent with shifts among companies in the broader media landscape). With newspaper stocks generally lagging the stock market indexes going into 2006 and with no meaningful catalyst for reversing the negative operational trends, Fitch expects that shareholders will continue to place pressures on these companies, forcing management teams to further re-evaluate capital structure strategies.

The winners among newspaper industry participants in 2006 and subsequent years will be the operators that develop and defend their unique content franchises in both print and electronic form. Companies that adapt most swiftly and thoroughly to the behaviors of their readership and technologies they are utilizing and that can demonstrate to advertisers the level of return they receive from their ads will be in the best position to compete. Operators that view the online phenomenon as a minor complement to the core print newspaper franchise rather than a potential replacement medium could risk being left further behind in the evolution of information consumption.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria, and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance, and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.