Pumping up the volume

The operational leverage of Fairfax’s business was on display in the second half of the 2010 year. The company will be breathing a sigh of relief as advertising volumes pumped some life into the operating earnings. But there is no sign yet that Fairfax has any pricing power to match. A big strategic review is underway which might determine how much sway the digital new kids in the company get on the 169 year old company’s future.

Fairfax Media’s net profit after tax for the 2010 financial year of $278.7 million was up 23% on the prior year, excluding significant items. Although total revenue decreased 2%, there was a discernable turnaround in the second half of the year, boosted partly by the mining tax issue.

Operating profit (EBITDA) however, enjoyed a much better recovery in the second half displaying the significant operating leverage of this company. The regional publishing business leapt 12% in the second half almost restoring the full year to a flat position. The metropolitan media division showed an even stronger gain of 81% in second half EBITDA while the full year figure limped across the line at 1% growth.

Fairfax Media chief executive Brian McCarthy said the first five weeks of the new financial year had been similar to the second half of 2010. He said revenues were more than 5% ahead of the corresponding period last year. If that trend holds, Fairfax expects high single-digit earnings growth in the first half of 2011.

The improvement sounds like good news at first glance. But a closer inspection shows the company is relying heavily on advertising volume growth, in real estate particularly, to provide the impetus. Ad volume growth of 22% in the 2H10 classifieds and 7% in display ads is good to see, but Mr McCarthy noted that automobiles and employment remained weak categories.

With the benefit of having seen the full year results from Carsales.com.au and Seek, the market is well aware that online auto and employment advertising is not in the doldrums. Fairfax’s competitors are clearly taking market share, revenue and earnings in these two important categories.

Although advertising volumes are clearly recovering, Fairfax is not able to push for price increases. Mr McCarthy acknowledged the entrenched weakness of yields in advertising and does not see this factor contributing in FY11. By implication, most of the growth in FY11 will be either ad volume driven, or through increased circulation revenue.

Circulation is subject to a systematic decline that Fairfax is fighting with heavy promotion and discounting. Mr McCarthy noted that the lower promotion and advertising spend of FY10 ($106.6 million) will be significantly increased to try and win back more subscription circulation. Expect to see some big discounts on the cover prices of the mastheads in return for six-monthly or yearly subscription packages.

There is an important benefit to improving circulation numbers for any newspaper. Higher circulation generally boosts readership figures upon which advertising rates are usually based. Protecting this currency is crucial if ad rates are to be sustained or (hopefully) increased.

Fairfax is unlikely to give the newspapers away and forego the circulation revenue. Some newspapers in the UK have already tried this strategy which involves massively increasing the print run and thereby lifting the readership and associated ad revenue. But Fairfax has too much capital invested in its printing operations to try that tactic.

Even though the company is spending the bare minimum on its main printing plants at Chullora (Sydney) and Tullamarine (Melbourne), Fairfax has another clutch of printing plants obtained from the merger with Rural Press three years ago.

In fact, Fairfax generated $535.9 million of revenue from its printing operations in 2010, although $452.9 million of this represented internal sales. The Australia and New Zealand printing division contributed $111 million EBITDA to the group total of $639.1 million.

The following table shows the detail of the full year result:

As the digital side of the business ramps up even further, Fairfax is looking to raise its full time staff by about 1.5% in FY11. At $842 million in FY10, employee costs are easily the company’s largest and together with annual pay rise we expect this cost to increase by about 5% in FY11.

Fairfax is now past the balance sheet difficulties it faced last year. After raising $640 million in new equity, the balance sheet covenant ratios are once again back in comfortable territory with net debt to EBITDA at 2.2 times (maximum 4.0x) and EBITDA to interest at 5.0x (minimum 3.25x). The equity raising significantly increased the number of shares on issue.

Fairfax paid a final dividend of 1.4 cents per share bringing the full year dividend to 2.5 cents per share as guided last year. That represents a payout ratio of about 22% of earnings. The company previously said it would return to a normal 80% payout when economic conditions allowed. At this point, there is no indication of that change in policy occurring offering a hint of the board’s caution.

Turning to the charts, Fairfax managed to break above the 50 period moving average (top chart, green line) at $1.42 and is likely to continue to move higher to test key resistance at $1.525. This level successfully provided firm resistance on three previous occasions. Thus, a convincing break of this barrier would entail a strong boost of upside momentum which is currently lacking.

The cyclical downturn in advertising was exaggerated by the GFC but now appears to be abating although it is only volume driven, not price. The New Zealand economy has yet to improve creating another drag on the group.

The spread of assets is strong though, especially in regional Australia. The metropolitan mastheads might attract all the attention when thinking about Fairfax, but at 16% of operating profit it does not affect the group as much as it used to. This has been a deliberate strategy and one of the key benefits of the Rural Press merger.

But the digital economy still perplexes Fairfax which is still muddling its way into the digital age. It has a strong suite of websites but no real dominance in any particular facet of digital news and entertainment. Fairfax makes good money from its digital businesses but needs to make significantly more to be taken seriously.

The market is valuing Fairfax appropriately at the current share price. We think there is better value elsewhere.