Plumage of debt will sort out canaries from the swallows

How does a canary become a swallow? Not a riddle from a Christmas cracker, but the question facing the boards of every media company in the UK as they peer into the impenetrable gloom of 2009.

In 2008, their sector has been the caged bird whose early signs of suffocation heralded tribulation for the wider economy. But industry leaders know that in previous recessions the media – especially in the cyclical advertising-driven subsectors such as newspapers, broadcasting and directories – has also proved to be the harbinger of warmer financial climes.

“Our analysis shows that [media] picks up about three months ahead of the [gross domestic product] trough, but we’ve got to be a few quarters away from that still, so we are not getting too excited just yet,” Nick Bertolotti, senior analyst at Credit Suisse, said. “You just have to call the GDP trough: easier said than done.”

He foresees little merger and acquisition activity in 2009, with private equity groups dormant, partly because their recent media deals have not gone well.

Analysts cite the purchases of EMI by Guy Hands’ Terra Firma and Apax’s co-purchase of Emap with Guardian Media Group.

“We talk to a lot of them about what they are doing at the moment and the answer is they are not doing anything,” Mr Bertolotti said.

However, that inertia may not last.

Stephen Grabiner, global head of media for Apax, sees opportunities for bargains. “The key is to separate those structurally challenged subsectors – consumer publishing, free-to-air television, radio – from those that will come out of the cyclical downturn and be able to grow: business-to-business, outdoor advertising, internet-based media and advertising agencies,” he says.

He agrees there would be little activity in 2009 involving large amounts of debt.

All commentators agree that the plumage of debt is critical to distinguishing the swallow from the canary.

According to a highly respected banker in the sector: “Everybody has got to delever. They have to access capital, across the board.

“It is a discussion we are having with all these guys, whether they are sponsor-owned [private equity] or public: decreasing leverage, increasing equity and selling off parts of the business even if that means selling at what looks like a bad time in the market,” he says.

“It could become a question of surviving to fight another day. That’s what everyone is thinking about.”

Recent ratings downgrades have hit companies such as ITV and Daily Mail & General Trust, making it necessary for them to think primarily about minimising debt and cutting costs.

Andrew Mendoza of the strategy consultants OC&C says: “Cost reduction on its own is a necessary, but not a sufficient, provision. Companies must end up being different from what they are now rather than just doing what they do now, only better. That may involve selling things, it may involve shutting bits of their business down.”

Groups with heavy gearing, such as the directories business Yell (with net debt 4.8 times earnings before interest, tax, depreciation and amortisation), Trinity Mirror, Johnston Press, Virgin Media and Informa are those that give most concern. David Elms, media partner at KPMG, said: “The issue next year is there is likely to be a series of accelerated downgrades leading in many cases to an associated need to refinance.”

Even some regarded until recently as highly defensive stocks, such as Reed Elsevier, now have much higher debt ratios because of M&A activity.

Informa, the publisher of Lloyd’s List, for instance, has £1.2bn of net debt, roughly four times ebitda. Its loan maturity is not until 2012, but a deterioration in trading may necessitate early refinancing.

The group was the subject of a failed bid by private equity companies in 2008, as was the Reed Business Information arm of Reed Elsevier.

As well as marking the end of significant deal activity in the sector, the collapse of the RBI sale this month underlined that even the industry’s most robust sub-sectors are being tested.

Reed expected the sale proceeds to pay down debt following the group’s $4.1bn acquisition of ChoicePoint, an insurance industry service provider. However, the company says it did not rely on the RBI sale to cover its other deal costs. Analysts say Reed is still well positioned as a broadly-based business, both internationally and by product, with strong brands.

A straw poll of analysts and bankers indicated none expected a takeover move in the first half of 2009 on ITV, the UK’s largest commercial broadcaster, not least because of uncertainty over its pension fund liabilities.

They identified the most resilient companies in the sector as British Sky Broadcasting, the satellite television company; Pearson, owner of the Financial Times, which now derives the majority of its revenue from education publishing; and United Business Media, the business-to-business company.

For the other traditional media companies, newspapers, magazines and free-to-air television, there is a hint of a more relaxed attitude to regulation from the government to allow consolidation.

Claire Enders of Enders Analysis said: “I think it’s extremely likely that the government will introduce legislation to allow more consolidation at a local level. They have learned that from what happened in banking.

“We will see a lot of consolidation in the sector but it’s not going to be a capital phenomenon, rather more of a rearrangement. For everyone this is going to be a time for enormous ingenuity for investment banks in terms of proposing new structure that will involve more job losses but can sustain companies a bit longer.”

Whether canaries or swallows, it is clear that media companies are not birds of a feather. Some may soar when blue skies appear again; others may not.

But Mr Bertolotti cautions a limit to pessimism. “I don’t expect bankruptcies. Unlike retail, say, our sector is cash regenerative and doesn’t have huge capital expenditure,” he said.