Competing for Customers and Capital

Do the Economics Make Sense?

Sorry to disagree with analysts at two of the biggest companies on the planet, but the economics make a lot of sense if you look at the long term impact of Mr. Murdoch's buyout of Dow Jones through the lens of the enterprise marketing framework.

BACKGROUND
In my post on "Dow Jones: Anomaly or Hidden Value? I placed the company in a strategic group with the New York Times (NYSE: NYT), Gannett Company Inc. (GCI), and the Tribune Company (TRB). The result of applying my Competitive Stock Valuation theory suggested that both the market and Mr. Murdoch undervalued Dow Jones. The present value of its stock four years out was $75 a share, or the company was worth a little over $6 billion. I discounted the forecast (nominal) value of its stock in 2010 (about $118) by 12.5% to adjust for my guess about the riskiness of Mr. Murdoch's acquisition.

THE HEAVYWEIGHTS: IT DIDN'T MAKE SENSE
At 9:00 this morning the following report appeared on the New York Times DealBook:

General Electric’s NBC unit and Microsoft explored making a joint bid for Dow Jones … But after the preliminary discussions and a more detailed analysis by NBC and Microsoft executives, they decided against going further. “Mainly, the economics just didn’t make sense,” a person close to NBC and Microsoft told The Times.

WHAT WOULD MURDOCH DO?
On June 6, 2007 Steve Stecklow and Martin Peers published a wide ranging interview of Mr. Murdoch's role as a proprietor and his plans for the Journal. This was one of the most revealing exchanges in that interview:

WSJ: So you would focus on generating more ad revenue?
Mr. Murdoch: … The Journal has had no money spent on marketing that I'm aware of for years. I imagine whatever we do would take the profit down in the short term… I mean of the Journal… It's got to have money put back into it, particularly on the digital side.

STRATEGIC ASSUMPTIONS
What if his bid for the company were successful? To find out I made these assumptions as inputs in my Competitive Stock Valuation model to forecast DJ's price in 2010:

(1) Mr. Murdoch's skill at running a paper combined with his marketing savvy would cause the CAGR in group revenues to jump from its historical 3.8% to 4.8%.
(2) he would stop in its tracks the steady 2.3% compound average annual decline in DJ's percent gross margin;
(3) his competitors would back-off the compound annual rate of growth in enterprise marketing (SG&A) expenses from 4.2% over the past decade to 1.8% in the ensuing four years;
(4) under Mr. Murdoch's leadership a revitalized Dow Jones would achieve maximum earnings market share;
(5) the number of shares outstanding would remain constant at 82.1 million.

THE ECONOMICS DON’T MAKE SENSE?
This table compares my 2010 Dow Jones forecast based on these assumptions with actual results in 2006. Group revenues increase from $18,625 to $22,467 million. DJ's share of group revenues increases from 9.6% to 22.4%, driving sales revenues up from $1,784 to $5,023 million by 2010. With profit margins held constant at 51% of sales, gross profits increase from $879 to $2,450 million in the forth year. With Mr. Murdoch pouring money into enterprise marketing, SG&A expenses nearly triple from $652 to $1,902 million.

The last three lines in this table are where it gets really interesting. Earnings (EBITDA) nearly double from $245 million to $548 million, driving EBITDA per share from $2.99 to $6.67, while the SG&A expense to revenue ratio increases only about 4%.

THE MOMENTUM EFFECT
How can Dow Jones become so radically transformed under Mr. Murdoch's leadership that it's 2010 stock price is $118? By becoming what Professor J. C. Larreche of the INSEAD Business School in Fontainebleau, France calls a "momentum-powered firm."

It all comes down to delivering more compelling values to its advertisers, its readers, employees, partners and shareholders -- and focusing on those that deliver the greatest equity to Dow Jones & Company. More on Professor Larreche's book on "The Momentum Effect" in later posts.

~V

Anomaly or Hidden Value?

WHY THE BANCROFTS WANT TO TALK
On May 31, 2007 the Dow Jones & Company (NYSE: DJ) said that a director who is a representative of the Bancroft family, Michael B. Elefante, had informed the Dow Jones Board of Directors that:

After a detailed review of the business of Dow Jones and the evolving competitive environment in which it operates, the Family has reached consensus that the mission of Dow Jones may be better accomplished in combination or collaboration with another organization, which may include News Corporation.

Friday the New York Times reported a noon meeting was scheduled for Monday June 4, 2007 between representatives of the Bancroft family and Rupert Murdoch's News Corporation. It is said that Mr. Murdoch will be there.

Mr. Elefante's reference to "the evolving competitive environment" motivated me to look at a group of four leading publishers through the lens of the Enterprise Marketing Framework. So I downloaded the 10-K filings of Dow Jones, Gannett Company Inc. (GCI), New York Times (NYT), and the Tribune Co (TRB) from 1997 through 2006. Fortunately, the fiscal year end for all four companies is December 31st, so all their annual reports were on file with the SEC.

If you want to know the nitty-gritty details behind this analysis, check out this audio slide show of my Competitive Stock Valuation theory. If you don't want to know these details, take my word for it. It's what you need to get a bead on "the evolving competitive environment" using company financial accounting data. Competitive stock valuation boils down to these two measures of company performance:

(1) risk-adjusted differences (RAD) between share of value and sales revenues and

(2) relative earnings productivity (REP).

RISK-ADJUSTED DIFFERENTIALS
RADs tell you how a company is performing in its competition for customers (in product markets) compared with its competition for capital (in equity markets). It’s a bit like the value/revenue ratio, with two important refinements: it's adjusted for risk (volatility) and takes competitive performance into account. RAD is a whole numbered index that runs from a minimum of -100 to a maximum of +100 points.

A negative RAD is bad news. It means your share of value is less than your share of sales. Or, put another way your company's share of churn is greater than its share of capitalization. And the greater this (negative) difference, the worse off is your company. Alternatively, and for opposite reasons, a positive RAD is good news. And the bigger the better.

In a study I did for the Marketing Science Institute of 38 member companies and 299 of their competitors over ten years I found the expected value of RAD was zero. Another of its useful properties is that the standard deviation of a company's RADs over time is exactly one. Which means any RAD smaller that -2.0 is really bad and any RAD greater than +2.0 is really good.

DJ's risk-adjusted differential was really bad. In 1997 its RAD was -3.0. But over the decade investors and management brought the company up to average (it was 0.0 in 2006).

RELATIVE EARNINGS PRODUCTIVITY
REP tells you how productively your company is using its resources to generate sales and earnings. I was inspired to create this metric by Al Rappaport's book Creating Shareholder Value. Here's what he said about the relationship between competitive advantage and shareholder value:

It is … productivity that the stock market reacts to when pricing a company’s shares.  Embedded in all shares is an implied long-term forecast about a company’s productivity – that is, its ability to create value in excess of the cost of producing it.  When the stock market prices a company’s shares according to a belief that the company will be able to create value over the long term, it is attributing [this belief] to the company’s long-term productivity or, equivalently, a sustainable competitive advantage.  In this way, productivity is the hinge on which both competitive advantage and shareholder value hang (Rappaport 1998, 69).

Relative earnings productivity is the percentage difference between a company's actual earnings and its maximum potential earnings. I purposely scaled this metric so the best REP is zero. That's when actual and maximum earnings are equal. When a company is losing money, relative earnings productivity can be a very large negative number. Think of it as a new measure of earnings quality that links competitive advantage to shareholder value. Which brings me back to "the evolving competitive environment."

TAKE THE MONEY AND RUN
This chart shows DJ's risk-adjusted differentials (RAD) on the horizontal axis, ranging from -3.0 to +10.0, plotted against its relative earnings productivity (REP) ranging from 0.0% to -41% over the ten years 1997 through 2006. In the upper left-hand corner of the graph DJ's 1997 RAD was -3.0; its REP was -11%. In 2000 DJ's REP deteriorated to -41%, but its RAD jumped to -0.5. The company's actual earnings were $606 million, while its maximum potential earnings were $1.0 billion.

One would think DJ's risk-adjusted differentials would have deteriorated further to, say -5.0, but they improved to -0.5! By 2006 DJ's relative earnings productivity remained low at -27% but RAD increased further still to 0. What does this mean? It may be a good time to take the money and run.

ANOMALY OR HIDDEN VALUE?
How can relative earnings productivity fall while risk-adjusted differentials increase? It comes down to these two possibilities: the DJ results are an anomaly or investors see serious hidden value in the company.

I opt for the hidden value theory. Dow Jones & Company with two of the most widely recognized brand names in the world – the Dow Jones Average and the Wall Street Journal – would be far more valuable under new leadership. Want some evidence of this? For one thing, based on Interbrand data, the Reuters Group ADR (NasdaqGS:RTRSY) brand was listed in Business Week's 100 Top Brands in 2006 with a value of $4.0 billion. Neither the Dow Jones Average nor the Wall Street Journal appeared on the top brands list! There's gotta be a lot of hidden value there. Want more proof? Rupert Murdoch has offered the family $5 billion for their company.

Is Mr. Murdoch the only one who believes there's hidden value in these two global brand names? No. Under the right leadership, four years out (with a discount rate of 12%) my analysis shows the present value of DJ is $75 a share or a little over $6 billion.

~V