Debt vs. Equity

Rumors have begun to circulate about Journal Register's (JRC) fate over the past several days. Their stock has seen the bottom drop out of it. There are plenty of signs that things are going very wrong out there. Alan Mutter wrote an excellent piece about the issue, which I won't try to rehash here.

The main issue is a simple one, the company has a truckload of debt. Debt is hard - you simply can't miss payments without dire consequences. Equity on the other hand is soft. If you miss your estimates the stock might get crushed, but you can live to grow another day. This is a bit oversimplified, but the point is important. If a company wants to access additional capital for purchases or other growth purposes, it has two choices. Debt or Equity. If you are sure about your companies long term projections, debt is fine; but if you aren't, equity issuance is the way to go.

Equity is usually more "expensive" than debt, in more ways than one. Equity issuance will cost in terms of dilution of existing shareholders, who will suddenly own less of the company in which they invested. Equity dilutes the voting rights of existing shareholders as well, leaving them with less power than when they started.

All of the recent purchases of newspaper companies have been debt financed. The Tribune takeover, McClatchy's purchase of Knight Ridder, the purchase of the Philly Inquirer, and Journal Register's purchase of the Detroit suburban papers. All may be leaving their companies in a dire situation.

You would only do these sorts of buyouts if you believed that the long term situation was stable. Private equity funds will often buy companies in decline with the hope they can cut expenses faster than revenue declines. Otherwise, the risk is not only dilution, but bankruptcy. It would appear that the assumption of stability or the rate of decline was wrong.

Why would you make that assumption in the first place?

First - Newspaper CEO's want control. Many have the infamous dual class structure to assure that remain at the helm regardless of the situation. Anything that could jeopardize that is simply unacceptable. I would surmise that the value of control to them is frequently more compelling than the straight finance of the situation.

Second - Equity deals may not have been well received. Presumably, the selling faction here believed that the long term prospects for the industry were poor. Offering a portion of a bigger company that is still tied to the same industry really wouldn't make them any better off. It would have been like trading a broken Honda Civic for a broken Jaguar. Same situation, just more expensive to fix.

Third - I personally believe that the purchasing parties believe that the situation would "flatten" They believe that there will always be a demand for the printed newspaper and they could generate economies of scale from the purchase. This is the one that explains both the insider buys and the outsider buys. Given the data from last year, this may have been the most dangerous assumption of all.

Frequently the public CEOs will be questioned about why they remain public. They state access to capital markets as one of the reasons. Debt is available to public and private companies. We've stated that few, if any, buyouts will be done through equity. So what access are they buying exactly? Compensation through options and restricted stock units. A few hundred thousand share dilution per year is hardly noticed by most investors, but can be very valuable to individuals granted these bonuses. Cynical, I know, but an observation that I can't explain any other way...

Unlike most of my other postings, I really don't have any good advice here. This is a bed that was made, and its going to be very difficult to get out of. The only interesting investments that newspaper companies have made are those outside of the newspaper sector, and most of those are a mixed bag. Washington post has done very well with Kaplan, but NYT has been mediocre with about.com. It's hard to run a venture fund with a public company, but Hearst has done fairly well investing with this philosophy as a private company.