Description

Dow Jones' financial performance has been atrocious over the past five years as the company struggled with a weak advertising environment, particularly in the important financial and technology sectors. Not surprisingly, the stock has fallen along with this performance -- with an added reduction for association with the seemingly "dead" newspaper industry. I think this terrible performance and investor disillusionment has created a great opportunity for investors.

Behind the scenes, Dow Jones management has laid the foundation for a transformation that will likely be followed by others in the newspaper industry. The company has successfully embraced the online environment with both subscription-supported and ad-supported sites. The company has also leveraged its content infrastructure to pull in licensing revenues. Finally, in its traditional print product the company has invested heavily to broaden personal finance/lifestyle coverage that should enable the company to leverage its affluent audience to garner a greater portion of lucrative consumer goods advertising.

Valuing the company is a bit tricky, but I think underlying assets are worth up to about $60 today, with opportunities for substantial growth in the years ahead. The company could be close to achieving some of this value. After several years of investment in its transformation, the company should begin to reap the rewards with limited incremental costs. The two remaining big-ticket items are getting to the anniversary of the Weekend Edition costs (Sept. '06, expected dilution of about $0.15/share this year) and retrofitting printing presses and training employees so the company can launch a redesigned, smaller Journal that will use less newsprint next January (completed by Jan '07; total of $43 million in CAPX, $13 million in expenses (about 0.10/share after-tax).

Even more important, a resumption -- and recent acceleration -- in growth of print advertising volume bodes well for near-term earnings and could portend the beginning of a longer-term trend after a long downtrend. Outside of the print journal, the electronic publishing unit seems well positioned for continued growth from the consumer online, licensing, and index businesses. Finally, a newly appointed CEO with a strong finance background should cause the company to focus more on financial performance.

Business Breakout (Dow Jones recently reorganized into units comprising Consumer Media, Enterprise Media, and Community Media, recognizing that users are more focused on content rather than how the content is received. I'm describing the company in its old structure because that is the basis of my valuation estimate -- and is how data is reported in the 2005 10-K).

Electronic Publishing (29% of '05 revenues, 66% of '05 operating income)
This unit includes DJ's online operations like WSJ.com, MarketWatch.com, Dow Jones Newswires, Dow Jones Indexes, and the radio/audio business. This unit has increased operating income every year since 2000, demonstrating the strong growth inherent in its various products as well as the value of the Dow Jones' products in the marketplace. While Newswires is likely to be a fairly slow-growth business, the other units have solid growth outlooks.

Segment revenue has grown from $328 million in 2000 to $507 million last year due to acquisitions and internal growth. More important, operating income has grown from $40 million (12.3% margin) to $112 million (22% margin) over that same time period due to the business' high operating leverage.

Consumer electronic publishing revenue (WSJ.com, MarketWatch.com, and BigCharts.com) has increased to $172 million in 2005 from $60 million in 2000 due to the MarketWatch acquisition and internal growth. WSJ.com remains the largest paid subscription news site on the net with 768,000 subscribers. MarketWatch.com and BigCharts.com, with about 7 million unique visitors, represent strong offerings in the ad-supported online world.

Dow Jones Newswires revenue has grown modestly to $268 million from $232 million in 2000. This business is fairly stable, but does have some volatility related to the financial services industry economic environment. Revenue dipped to $213 million in 2003 when market conditions were weakest. This is a solid business, but its growth is likely to be modest.

Dow Jones Indexes (licensees indexes for financial products) and Ventures (primarily reprints) has been a strong performer over the past few years with the proliferation of index-based investment products. Revenues have grown from $35 million in 2000 to $66 million last year with continued solid prospects.

Print Publishing (52% '05 revenue, -14% '05 operating income)
This segment, which publishes Barrons and the domestic and international Wall Street Journal, has been the true Dog of Dow Jones from a financial perspective over the past five years. Revenue fell to $916 million last year from $1,519 million in 2000. In fact, revenue has decreased every year during that period except for 2004, which eked out 3.6% gain. In a high operating leverage business, it's not surprising to see that operating earnings have plunged from $400 million in 2000 to a loss of $23 million in 2005.

Dow Jones' management could have sustained higher margins in this business if it had cut costs more aggressively and maintained the status quo. Instead, it embarked on the expansion of the print publications coverage to include a redesign, more color printing, as well as the launch of the Personal Journal section and the Weekend Journal. These efforts thus far haven't offset the costs of changes, but the publications appear to be at the inflection point, particularly in regards to consumer advertising. In addition, the expanded coverage has enhanced the product offering and helped fuel the growth of the company's electronic publishing operations.

The key driver to this business is advertising, which has been weak for several years. After strong results in the late 1990's, advertising volume has plunged at the Journal (and other print publications) in the 2000s. Specifically, Journal advertising volume was down 38% in 2001, 18% in 2002, 1.3% in 2003, 0.5% in 2004, and 0.7% in 2005. While all segments except classified (real estate) have been weak, the worst have been financial and technology. With stronger markets, these very cyclical categories (particularly financial) could be on the cusp of a rebound. General advertising has actually stabilized, with a 4% increase in 2004 and a 1.2% increase in 2005.

With the launch of the Weekend Journal and a general improvement in business, fourth quarter advertising volumes at the Journal were up 8%, helped by Classified (21.9%), General (12.5%), and Technology (3.2%). Only the Financial (-14.9%) segment experienced a continued decline. Improving trends have continued into 2006, with WSJ ad volume up 13.4% in the first two months of the year. This should flow through nicely to the bottom line given the high operating leverage of the business (management has stated the flow-through to operating income is around 80%).

Community Newspapers (19% of Revenues, 47% of Operating Income)
This unit publishes 15 general interest dailies, 19 weeklies, and 21 other publications in relatively small markets, primarily on the West Coast and in the Northeast. The dailies have average circulation of 431,000 (473,000 on Sunday). In 2005, this segment had $347 million in revenue and $80 million in operating revenue. Revenue has increased modestly over the past couple of years while operating income has been basically flat.

This unit has characteristics typical of most other newspaper companies -- solid cash flow generation that has been fairly stable, but risk of increased competition. The small town, isolated nature of most publications should insulate them from significant competition, but internal growth for this division appears limited.

Balance Sheet
Dow Jones has balance sheet debt of about $472 million, most of which was added last year for the MarketWatch acquisition. Equity of $162 million has been driven down by share repurchases from years ago when the stock price was higher (the average basis on the 19.1 million treasury shares is $45.68).

Cash Flow
Cash Flow has been sluggish over the past few years, but better than earnings performance. Operating cash flow for 2005-2003 was $198 million, $252 million, $220 million, respectively. CAPX was $65 million, $76 million, $56 million over that same time period. Dividends payments, which have been flat at $1/share, should total $83-$84 million this year.

The company made meaningful business acquisitions the past three years: $439 million in 2005 (primarily MarketWatch), $98 million in 2004 (Alternative Investor), and $150 million in 2003 (Stockton Record community newspaper).

Management
CEO: Richard Zannino was appointed CEO on February 1, 2006, after spending four years (2002-2006) as COO and one year (2001-2002) as CFO. Prior to joining Dow Jones he had executive roles in finance at Liz Claiborne, General Signal, and Saks. Having a finance-oriented CEO should be helpful in allowing Dow Jones pursue its strategic objectives with financial discipline.

CFO: Chris Vieth has been CFO since 2002. He joined Dow Jones in 2000 from Barnes and Noble, where he had been controller.

President, Consumer Media & Publisher, WSJ: Gordon Crovitz was appointed to this role on February. He had been president of the company's very successful electronic publishing unit since October 1998.

President, Enterprise Media: Clare Hart was appointed to this role in February after heading up Factiva, a Dow Jones/Reuters joint venture serving business news, since 2000.

Share Structure/Ownership
As of January 31, 2006, the company has 62.7 million common shares and 20.7 million Class B supervoting shares (10 votes each).

Directors and executives, including many members of the controlling Bancroft family, own 12.9% of common shares and 60.7% of the Class B shares. T. Rowe Price owns 14.9% of common shares.

Pension/Post Retirement Benefit Obligations
Dow Jones has a Projected Benefit Obligation of $208 million compared to plan assets of $158 million, leaving about $50 million unfunded. The company also has $261 million in other postretirement benefits, which are currently unfunded. The total of both these plans is about $311 million in unfunded obligations.

Stock Options Expensing
Dow Jones has elected to use the modified prospective method of options expensing, beginning 1/1/06. The company expects 0.04/share of options expense this year, which will rise over the next three years as layers of options are included. Footnoted options expense was 0.16 - 0.20/share between 2002-2004, although grants were notably reduced in 2005 when a new program was implemented. The company also offers stock-based awards that are expensed, with a total cost of $10 million in 2005.

Legal Issues
Dow Jones has a long-running dispute with Cantor Fitzgerald and Market Data Corp that was recently resolved. Since Dow Jones expensed its liability in 2000, the company will record a $63 million after-tax accounting gain in the first quarter. But the company will be paying out $202 million cash (by the end of March) to eliminate this obligation, to be funded with commercial paper and short-term borrowings. (The company should get a tax benefit of about $75 million from this payment).

Valuation
I struggled valuing Dow Jones because its profitability is so depressed and the company makeup continues to shift more towards electronic commerce. In addition, the company doesn't have many great comparable organizations. After mulling the issues, I came up with a quick-and-dirty sum-of-the-parts estimate that seems conservative given the "crown jewel" quality of most of the company's assets. I suspect that even the high-end of my estimates don’t reflect what others would pay for the company's strong brands, market position, and audience.

Print publications - This division doesn't currently have any operating earnings, so it's hard to use an earnings-based model. But the division does have the ability to be solidly profitable, as demonstrated by 1998-2000 when operating margins ranged between 15% and 26%. Knight Ridder was taken out an EV/Sales ratio of a bit over 2x, which I figured was the bottom valuation range given the WSJ's unique positioning and attractive client base. Assuming a premium for the WSJ brand and audience, I figure a high-end valuation of 3x sales. At 2.0x-3.0x the $916 million segment revenues, this division would be worth $1,832-$2,748 million. (Giving me added comfort about this range's conservativeness is the depressed state of sales -- they were $1.2 billion in the positive environment of 1998 and $1.5 billion in the 2000 bubble.)

Electronic publishing - This division is a combination of the company's slow-growing and highly profitable newswires as well as the fast growing and highly profitable consumer electronic media and indexes business. The multiples paid for iVillage (6.6x revs, 35x EBITDA) and even what Dow Jones paid for MarketWatch (5.5x EV/sales) seem too high given the inclusion of the slower growing businesses. I feel very comfortable giving this business a multiple of 3x-4.5x sales, which on $507 million in '05 sales implies a value of $1,521-$2,282 million. As a crosscheck, this implies an EV/EBITDA multiple of 10x-15x, which doesn't seem unreasonable given the desirable attributes of this business.

Community publishing - This unit is probably the least desirable of Dow Jones, although it still generates a lot of cash and faces less competition than many newspapers given its focus on smaller, more isolated markets. Knight Ridder was sold for about 9.5x EBITDA, so to be conservative I'll use a valuation range on Dow Jones of 7x-10x this segment's $92 million EBITDA, implying a value of $644-$920 million.

Adding everything together (in millions):
1,832 - 2,748 Print Publishing
1,521 - 2,282 Electronic Publishing
644 - 910 Community Publishing

3,997 - 5,940 Total Enterprise Value
-472 - -472 less Debt
-202 - -202 less Settlement w/ Cantor Fitz/MDC
-311 - -311 less Unfunded Pension/Post-retirement benefits
3,012 - 4,955 Total Equity Value

36.07 - 59.34 Equity Value on 83.5 million shares

Note that this valuation leaves out Dow Jones' 50% stake in Factiva and SmartMoney, as well as several other smaller ventures. In addition, the company has capital loss carryforwards worth over $170 million that have been fully reserved against and are not included in this analysis. A good portion of these will expire this year, but the Cantor Fitz/MDC settlement should provide 5 years to use about $75 million of these.

Summary
I think that Dow Jones is an attractive value today based on its assets. More important, this value is likely to grow as the company continues to leverage its content in the online world. The company's recent restructuring to combine print and online consumer publications recognizes that the driver of the company is content, not delivery method. This value of this company's content enables it to easily transfer to the online world, as has been demonstrated by the success of the company's electronic publishing unit. On the print publishing side, the company has made important investments to cause the company to be more relevant to its readers' personal lives, opening the door for substantial consumer-related advertising.

In a few years, instead of viewing Dow Jones as a dog of the publishing industry, I suspect it will be viewed as a leader -- and will be accorded a premium multiple on much higher sales and earnings. With most of the company's required investment in its transformation completed and signs of an improving advertising environment, now seems to be a good time to initiate a position.

Risks
· Downturn in economy and print advertising environment
· Weakness in and consolidation in financial industry, reducing advertising spend
· Intensified competition and pricing pressure on online advertising
· Unwillingness of consumers to continue to pay for quality online business news
· Inability to turn around profitability of print publications
· Loss of business at Dow Jones Newswires due to availability of lower cost options online

Catalyst

· Improved print advertising volumes from traditional businesses as the cycle improves
· Improved print advertising volumes from general advertisers due to increased focus on personal finance issues/lifestyles
· Continued success in electronic publishing, particularly online consumer and indices
· Increased investor interest due to new CEO with strong finance credentials
· Recognition that Dow Jones has transformed itself from a newspaper company to a integrated content provider with mass appeal to affluent audiences