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Stock: Fairfax Media Ltd

Code: FXJ

Market Cap: $2bn

Recommendation: Hold

Stock markets around the world are breaking new bear market lows. Companies bearing the brunt of the falls have been those with cyclical incomes, whose earnings are the most exposed to the contraction in global economic activity. Media stocks are in the unfortunate position of fitting nicely into this category. Their incomes are generally driven by advertising spend, which, being discretionary, is usually the first area that corporates cut back on when times get tough.

As the current downturn has emerged ‘out of left field’, and has been more severe than usual, many media companies have been caught off guard. Generally these companies have a high proportion of fixed costs, meaning that the resources required to generate their products, whether it be articles for a newspaper, or shows for a TV channel, are fairly constant. So with limited scope to reduce their cost base in line with declining revenues, earnings can come under considerable pressure during periods of demand contraction. With the current downturn marching onto the scene hard and fast, many media companies have had little time to implement the limited cost cutting initiatives that actually are available, which is why their bottom lines and share prices have been hit with full force.  

So why invest in a media stock or any other cyclical company with a large fixed cost base if the risks to earnings are so high?

The pro’s are easily forgotten in times like these, but investors should know that the earnings risks are skewed to both the downside and the upside. When the advertising cycle does eventually pick up, where does all the extra revenue go? Straight to the bottom line – meaning a small recovery in advertising markets could have a big impact on earnings and share prices in the sector.

No one can predict when this will occur, so for now investors in the sector need to be taking a contrarian approach, searching for value while times are tough and sentiment weak. Plenty of ‘big swinging’ institutions made such a move in recent weeks on Fairfax Media, proprietor of the Sydney Morning Herald (SMH) and The Age. Facing challenges typical of the sector, Fairfax has been cornered into a large equity raising to restore its thinning capital base.

The $685m 3 for 5 rights issue is priced at 75c and can only be taken up by existing shareholders. With the raising price 85% below the stock’s 2007 highs, shareholders have a dilemma on their hands. Adopt a value approach, subscribe to the issue, and thereby reduce their effective entry price into the stock? Or pass up their rights on the fear of throwing good money after bad?

Should the company survive and recover as the advertising cycle picks up, shareholders may look back at the rights issue as the ‘bargain of century’. But on the other hand, if conditions continue to worsen, will this raising provide a sufficient buffer?

All important questions to consider. Fairfax’s institutional shareholders gave the raising the tick of approval, with that part of the issue attracting strong support. No doubt the institutions see value at current levels, but will this be the last of Fairfax’s woes?

Apart from declining earnings, the company’s problems have arisen following its merger with Rural Press in mid 2007, which saw it enter the credit crisis with a debt balance that was more than ideal. This combined with management wrangling had a nasty impact on investor sentiment.

At last report, the company had total debts of $2.5bn against annualised operating earnings (excluding non cash writedowns) of $620m. This was 27% below the $847m reported in the previous corresponding period. Following the latest rights issue, recently announced dividend reductions and asset sales, we estimate that debts could fall to $1.5bn. In our view, this figure appears manageable on current earnings, and has taken the company out of the woods for now. However, if we haven’t seen the worst of this downturn then balance sheet pressures could re emerge.

The other deadweight hanging on the share price has come from the management ranks. But CEO David Kirk and CFO Sankar Narayan have since ‘fallen on their swords’ – and regardless of whether they were victims or scapegoats, the move should shake off the company’s poor risk management practices during the boom times. We are taking notice of the fresh dose of leadership at the helm. Brian McCarthy has been appointed as replacement CEO and he carries a strong industry background, having served as Managing Director of Rural Press for 13 years before the merger with Fairfax.

McCarthy has the credentials needed to steer this ship around, however the outlook for earnings remains an X factor for the share price. If recent cost cutting initiatives place the worst of its earnings declines behind us, then there is cause for optimism. However if the rot has not stopped, then the company’s balance sheet may not have seen the last of the spotlight. Therefore shareholders could be well served keeping close tabs on the company over the coming reporting periods.

Tim Morris is an analyst at wise-owl.com, one of Australia’s leading independent stockmarket research houses. Click here for your complimentary report.

 

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