I believe the NYT is a good short from a timing standpoint because things look fairly good for the company, at least right now (away from the cliff’s edge so to speak). Ad revenue was up for the first time in a while, and the digital business is generating enough revenue for people to conclude that the NYT’s revenue won’t completely disappear (I agree). This compares to 2002-2007 when investors grew more positive on newspapers even while the industry dynamics that would crush many newspapers were becoming stronger. Yet, because most investors are biased towards focusing on how things are (as opposed to how things will become) newspaper stocks rallied. If the negative trends re-emerge, the stock could call 30-40%. If the trends do not, I don’t see that much upside given the obvious risks and terrible industry dynamics.

Thesis Summary and Valuation

For context, the NYT’s EV/EBITDA is around 7x EV/EBITDA (factoring in the future value of the NYT headquarters which the company can repurchase in 2019). I tend to think a company with limited prospects for any growth combined with meaningful headwinds and some terminal risk long-term should trade at closer to 4-5x EV/EBITDA to compensate investors for these risks. As a result, I think the short’s risk level is low with 30-40% upside in the reversion scenario. And, in the recession scenario, the NYT’s high debt load and uncertain long-term prospects would make it likely the company would be at risk of a Chapter 11 filing (emphasis on RECESSION scenario, not base case).

NYT’s Hurdle

The NYT’s total M-F circulation is 1.93 million, and the Sunday circulation is 2.41 million (all 2013 year end numbers). Giving a 60% weight to the M-F and a 40% weight to the Sunday (a disproportionate amount of revenue comes from the Sunday edition but this is still a guess that will not impact the numbers in a material way) the NYT’s circulation is around 2.12 million. Backing out the 760k digital only subs and adding international edition subs (220,400) gives a print subscriber total of 1.58 million.

According to UBS’s calculation, the NYT’s digital ARPU is $216 as of Q4 2013 (flat in 2013) which implies $164 million in digital only revenue. Also, I backed out $50 million for non-paying digital only readers (estimate with non-material impact on conclusion) and “other” revenue not directly related to print subscribers for the most part. Based on this, print revenue is around $1.3 billion. Therefore, print subscribers are worth around $825 per year in NYT’s revenue.

How many digital subs NYT needs to offset a single print sub loss?

First, some print subs become digital only. Others leave altogether. To build in a margin of safety I will assume 100% of departing print subs become digital subs. Based on this, the NYT needs around 3 new digital subscribers to offset the revenue loss from one lost print subscriber. At the most basic level, I think investing in a business that needs strong growth in the smaller lower margin side of the business to offset the declines the larger, higher margin business is risky and supports my viewpoint that the NYT’s valuation should be much lower than it is even if things remain stable long-term.

Can the Digital Business Grow Rapidly?

In Q1, the NYT’s print daily was down 6.5% while Sunday was down 2.5% (I will use 5% using the 60/40 weighting.  Based on the 1.58 million print total, the NYT lost 79k print subs. In Q1, the NYT only brought in 39,000 (156k annualized) new digital subs. Digital sub growth is actually decelerating (45% y/y growth in Q1 2013 versus only 18% y/y growth in Q1 2014). It is worth noting though that in the near-term, the NYT has plenty of levers to pull to avoid major issues (raising print subscription rates is a big one). Those levels keep the metrics stable enough which gives a short seller a decent valuation to make an entry.  

From a digital advertising front, the situation is anything but strong:          

-          Digital ad revenue only grew by 2% in Q1 2014

-          Digital ad revenue declined by 4.3% in 2013.

-          According to the NYT’s Q1 2013 press release, “the increasingly complex and fragmented digital adverting marketplace” is creating problems for the company.  This is code for: there are thousands of opportunities for advertisers to place ads online. Unlike with their dominate market presence in print-based national newspapers, the NYT is just another online website competing for ad dollars. And yes, they do have high income readers. But high income people go to a wide variety of web properties so the NYT doesn’t necessarily have a special edge in that market.  

I believe digital growth will remain weak for a number of reasons (see part two of thesis for the rest). A big reason is saturation. The NYT is one of, if not the most, well-known newspaper in the U.S. and to a lesser degree around the world. Most people who both a) want a digital only NYT sub; b) can afford and/or want to pay for online news, already have a subscription (the NYT has been marketing its presence heavily for several years now). And, the NYT’s target audience is not an incredibly broad demographic (educated people with the time and desire to read a politically/culturally directed newspaper who are also probably not conservative politically for the most part). 

By itself, the declining print trend will not put the NYT out of business unless it accelerates. But, based on the previous recession, the trend away from expensive traditional advertising accelerates when there is a cut back in overall ad spending (i.e. companies want their dollars to travel further). As a result, my upside really comes in the stressed scenario that seems to arrive every 8-10 years (NYT’s ad revenue dropped by 25% in Q1 0f 2009).

Additionally, the NYT has been gradually cutting jobs at every level. This can’t easily continue for several reasons: 1) The NYT is a “generalist” paper. Unlike many regional newspapers, they can’t use AP stories very often without damaging their brand. At the end of the day, doing high quality journalism the way the NYT does it is very expensive. Yet the shift from print to digital reduces how much they get paid to generate the expensive content, which is a core issue with the business model.

Furthermore, the digital trend actually increases the need for journalists given the 24 hour news cycle. 25 years ago, newspapers printed at most two editions. Today, news happens all over the world and journalists and editors need to be ready to react quickly.

I will now describe the industry dynamics that will make it very difficult for the company to overcome the print/digital hurdle.

READERSHIP LEVELS OVERALL WILL REMAIN UNDER PRESSURE

LARGE NUMBER OF ALTERNATIVES TO DISTRIBUTE NEWS: In 1971, Daniel Ellsberg physically handed over the now famous Pentagon Papers over to the NYT. The NYT then placed the contents of the papers on the newspaper’s front page. During this era, 50 copies of the NYT were delivered to the White House every day, 39 papers were delivered to Moscow, 2 were smuggled into China, etc. No one could question the place the NYT had in the world of journalism.

In 2010, WikiLeaks founder Julian Assange published classified intelligence information including video footage of U.S. airstrikes which killed between 86 to 147 Afghan civilians. As the news circulated around the world within minutes, the NYT was just another observer.  

Today, with the help of news aggregators, Twitter and other forms of social media, people do not need to pick up a NYT paper to be fully informed on world events. Twitter alone has played a material role in five different revolutions, most notability in Egypt (http://en.wikipedia.org/wiki/Twitter_Revolution). And at some level, the NYT competes against itself as aggregators pick up its stories.

Subtle point: the value of media credibility is actually declining. In 1970, if you wanted the facts you need a high quality paper like the NYTs. But now, because there are so many online news outlets, a paper that prints misleading information gets exposed quickly. Thus, news tends to be accurate across the board.

COMPETITION FROM YELLOW JOURNALISM GROWING: Yellow journalism seeks to sensationalize the news in a way that attracts readers. During the Revolutionary War in the 1770s, the U.S. had a large number of pamphlet writers who were essentially yellow journalists. Newspapers like the NYT in many ways built their brand by avoiding sensational news. And in an environment where most people had access to only a few newspapers, the NYT’s credibility edge drove readership.

As the internet has developed, the demand for yellow journalism has increased. Many people skim the headlines of credible newspapers but then drift towards more exciting stories with less long-term significance. Furthermore, many “yellow” publications piggy back on the NYT high quality journalism by repackaging the NYT’s stories in a more attention grabbing way. One example of this is the NYT’s unwillingness to write heavily slanted “hit jobs” on public figures. Yet, these pieces generate a lot of reader interest, and they are becoming more common in even the mainstream media because these outlets are simply trying to survive.

In addition to demand growth, the supply of yellow journalism has also increased as the costs required to publish have converged towards very low levels (financial barriers to entry are very low). Consider the Drudge Report. It was the first publication to break the Monica Lewinsky scandal in 1998 when Newsweek decided not to pursue the story.  And, with respect to the cost issue, even high quality direct competitors to the NYT like the Politico can quickly gain both a large readership and meaningful credibility. Business Insider is another example of a very useful business media outlet that can deliver a lot of value less nimble NYT publications can. Clearly they will co-exist (different purposes for existing) but it still results in less time spent on NYT content. All this to say is that the barriers to entry in the media industry are low.  

One last point on this topic: the term “yellow journalism” is obviously imprecise and it implies a range of media content. Newspapers with factual credibility (i.e. they don’t print lies like some media outlets) are drifting towards where the demand is. For example a quality online news source might jazz up their stories and headlines some to grab readers in the competitive world of online news. The NYT can’t go down this path without damaging its reputation.

HABBITS ARE CHANGING: A huge source of demand for NYT content is people with enough time to sit down and actually read something that is longer than a few paragraphs. Yet, for the NYT’s core demographic, time is becoming scarcer. http://20somethingfinance.com/american-hours-worked-productivity-vacation/. As people squeeze in more work every day, mornings become more compressed to conserve sleep (Americans are also sleep deprived as a group).  Thus, it is likely that readers will continue to shift towards more efficient mediums for gathering news like Twitter or Yahoo/Google news.

In addition to leading busier lives, news consumers are becoming more accustomed to instant gratification (i.e. a reduction in attention span which is related to the rise of yellow journalism).  If someone has 20 minutes of time to kill, they might prefer to read the headlines quickly and then surf the social media world or gaming centers. Publications like the NYT that produce very high quality, but at times lengthy and dense, articles are exposed to this dynamic. According to this (http://www.huffingtonpost.com/2013/10/24/attention-span-book_n_4151059.html) and many other articles, the attention spans of people are actually being reduced by things like smart phones and other mobile devices. Based on recent discoveries in the field of neuroplasticity, the “focus” portion of many peoples’ brains are shrinking because of all the cheap but entertaining content on the web. As a result, the NYT’s customer base is physically becoming less able to appreciate high quality journalism.

DEMOGRAPHICS: The NYT ‘s readership is generally an older group (weighted average). That does make a difference with respect to retention rates, and retention levels are critical in an environment where the next generation has ittle interest (or little money) in paying for news. I obviously don’t have the precise age breakdown of NYT’s readers, but take their block of 65 year old readers. Approximately 1.3% of the 65 year-olds will pass away based on the Social Security Administration’s actuarial table (http://www.ssa.gov/oact/STATS/table4c6.html). I am not an actuary but I would bet that the NYT’s higher income profile has a longer life expectancy than the average American (as a result, call it 1%). In addition to deaths, various forms of morbidity can reduce the reader count (vision issues, Alzheimer’s). I will still stick with the 1% estimate.

Without attempting to generate a precise estimate, for every 0.5% “age” loss (spread between mortality rates) of NYT subscribers the NYT needs around 30k digital only subs to replace the lost revenue.  In addition the small mortality headwind, the older generation especially is still adapting to digital devices that make it much less likely for a person to pay for news (especially print news). As this trend continues to play out, NYT’s print subscriber base will face ongoing pressure.    

With respect to the younger readers gradually replacing the older readers it is important to point out the economic status of the current “20-35” generation is not good especially after the recession. Unemployment rates are high and so are student debt levels. Thus, the willingness to pay for potential NYT customers is likely to trend lower.

THE HURDLE NYT NEEDS TO CLEAR

Despite the current pattern of declining growth, predicting the future of the NYT’s digital business is difficult. For example, the company could reaccelerate growth by switching completely over to a pay model . Currently, the company still lets people access 10 articles per month. If they lowered that to 5 or even zero, they could grow their subscription base by a substantial amount.

The NYT has hesitated to do this largely because they lose influence in a global news market that is primarily driven by free access. In other words, a reader who browses 5-10 different publications per week can’t afford to pay even small amounts to any one news organization. Furthermore, as mentioned previously, the NYT’s exclusive content is a thing of the past. In addition to lost influence, the reduced traffic would hurt ad revenue. The exact amount is difficult to know.

One other point worth mentioning (U.S. specific comment) is the limited number of people who would ever be interested in the NYT. For the most part, only college educated people with a strong interest in U.S. and world news would ever read the paper. Furthermore, many educated people with a conservative political philosophy would avoid reading the paper. All this to say is that the low hanging fruit is already reading the NYT. The incremental reader is not going to be as easy to acquire.

The other wildcard is the NYT’s attempt to grow internationally (re-branding, more sales reps, etc.). I believe this growth avenue represents the most promise for the company in the long-run. However, the upside will be limited by a number of dynamics. First, free news is even more available in many of the larger population centers around the world. Second, the NYT’s brand power carries much less weight than it does in the U.S. Third, users looking for international sources of news are even much less likely to be loyal to a single publication and are therefore less likely to want to pay for a specific source of news. Regardless, if the international growth initiatives take off somehow, NYT could be a $20 stock very quickly.

Overall, the short thesis is based on shorting a stock with a stretched valuation even using the base case outlook (slow but steady growth and stabilized fundamentals). Additionally, the substantial headwinds (print declines) combined with the “distressed” possibility in a deep recession scenario provide both modest upside and the potential for larger returns.

Key risk: The NYT has $1.4b in operating costs. I can’t predict how much lower this can go. In 2000, the NYT operated with $2.8b in operating costs.  As mentioned, unlike middle market papers, the NYT needs to maintain a large newsroom to maintain its brand promise to readers. Yet, even now I read the newsroom cost is only around $200 million. So I think long term, NYT will exist which is a very good thing for maintaining healthy societies. But, it might be a much smaller organization with materially lower earnings.

My bet is merely that revenues will remain under pressure. The shift away from a large high margin business to a low margin is difficult to overcome. In 10 years, I would not be surprised to see NYT’s revenue at around $1 billion with declining profit margins. In some sense I think the NYT will cut as much as they need to. If revenues stop dropping they will stop cutting. If revenues tank they will be forced to make hard decisions. They will only face a problem if there is a sudden drop (i.e. a deep recession).  

In terms of a catalyst, renewed signs of advertising and subscriber weakness would send the stock back towards a more reasonable 4-5x EV/EBITDA multiple. In that “realization” scenario, I would cover and realize a 30-40% return. If a recession or worse hits, the NYT’s long-term viability will once again come into question. I would definitely cover and consider going long if the stock was trading on bankruptcy watch again. The brand is valuable long-term despite the prospects of declining cash flows. The family that currently owns the controlling shares in that case would probably sell given their alternative would be to give the company to debt holders.

Other risks:

-          If the family that controls the NYT were willing, there are many billionaires who would take the NYT off their hands for a big premium (trophy asset) to whatever the market price was at that time. I view this scenario as unlikely as do most people.  

-          The NYT is filled with smart people. If they can figure out ways to attract a wide group of people who are willing to pay for content (maybe video?), revenues could grow. Even a small % of the global viewer could send the stock above $20. I will be ready to cover in this scenario.  

Because of these risks, my position is average in size. 

Renewed signs of advertising and subscriber weakness would send the stock back towards a more reasonable 4-5x EV/EBITDA multiple. In that “realization” scenario, I would cover and realize a 30-40% return. If a recession or worse hits, the NYT’s long-term viability will once again come into question. I would definitely cover and consider going long if the stock was trading on bankruptcy watch again. The brand is valuable long-term despite the prospects of declining cash flows. The family that currently owns the controlling shares in that case would probably sell given their alternative would be to give the company to debt holders .