Restaurants, Publishing & Radio

Consumers are reeling from high gas prices, battered stock portfolios, declining home values and rising unemployment. Although we expect a continued decline in gas prices to provide a badly needed financial respite, we expect consumer spending pressures to remain intense as the economy slows, unemployment climbs and many people have no savings to tap (national personal savings are negative). At a time of waning demand for their goods and services, the corporate sector also faces liquidity issues from inhospitable credit and equity markets.

With these challenges in mind, we recommend investing in companies that have solid balance sheets, are fully funded for the next 12 months, pay attractive dividends in no danger of being cut, and have catalysts for top-line growth.

Restaurants

Opportunities

In the restaurant sector, we recommend companies that are actually benefiting from the recession as consumers "trade down" to cheaper eats. McDonald's ( MCD - Analyst Report ) and Yum! Brands ( YUM - Analyst Report ) are the top of our Buy rated recommendations that we expect to outperform the overall market and the restaurant sector over the next 6-12 months. MCD and YUM pay healthy dividends, currently yielding 3.5% and 2.8%, respectively, and we expect continued revenue and free cash growth, both domestically and overseas as the trade down phenomenon picks up Europe and rapid unit growth continues in Asia.

Weaknesses

Conversely, we expect restaurant companies with poor balance sheets and waning customer traffic to under-perform the overall market. Jamba ( JMBA - Snapshot Report ) is our strongest Sell recommendation. In the midst declining sales, rising food costs and heavy capital expenditures, Jamba faces a severe cash-flow shortage that poses a risk of bankruptcy, in our opinion. To secure badly needed cash, in September the company borrowed $25 million in a two-year note that pays interest in cash and shares equivalent to 18.5%!

Publishing

The publishing sector is facing a secular decline, exacerbated by the current cyclical downturn. Print advertising industry-wide has been decelerating for several years, eroded by the secular migration to the Internet. Newspapers have fared far worse than magazines as web-based news options have proliferated in recent years.

Most publishing houses are rapidly cutting costs in line with their shrinking revenue stream, while attempting to build complementary Internet operations. But many are saddled with debt, leaving few options other than disposing of formerly attractive assets at trough valuations and cutting their dividends. A revitalized ad market requires an economic upturn, to which there is no visibility at this time.

Opportunities

Not all publishing companies are suffering however. We expect Martha Stewart Living Omnimedia ( MSO - Snapshot Report ) to outperform the overall market and the publishing industry. Despite the potential for a protracted recession, we think MSO can meet or exceed our EPS estimates, driven by top-line growth and margin expansion in the merchandising segment. The company continues to execute on its original strategy of leveraging its Martha Stewart brand across all business segments, signing a slew of high-margin merchandising deals since 2006, including deals with Wal-Mart, Costco and Macy's. These deals should increase margins as the license fees have little costs associated with them. MSO has a strong balance sheet and generates positive free cash flow, although the company does not pay a dividend, making it a slightly more speculative play.

Weaknesses

Our top Sell recommendation in the Publishing sector is McClatchy Company ( MNI ) . As we warned of in previous reports, McClatchy cut its dividend in September by half. We expect more pain ahead for McClatchy. One-third of MNI's revenues are in the hard-hit California and Florida markets. Circulation revenue is falling for the third consecutive year (-5.2% in 2Q08), while ad revenue sinks disproportionately. In our view, MNI can't shrink its costs fast enough, posing a risk of tripping bank covenants if the revenue decline should accelerate. Given the continued downward trend in earnings and cash flow, coupled with the company's high debt-load, we are not surprised the company cut its dividend.

Radio Broadcasting

The radio sector, like publishing, is being battered. Radio stocks have continued to hit new lows since their highs in early 2004. The industry is in the midst of both a cyclical slowdown, pressured by a weak economy, and a secular downturn, which has slowed industry revenue growth to 1% annually over the last seven years. Satellite radio, MP3's, video games and streaming music from the Internet have all grabbed listeners from traditional terrestrial radio.

Simultaneously, advertisers have gravitated towards other mediums, which have better audience-measuring systems. As revenue stagnated and negative operating leverage eroded margins, stock multiples contracted and prices collapsed. We see no upturn in sight without an economic rebound. Nevertheless, valuations are low and some of these companies are strong free cash flow generators. In turn, we think there could be renewed interest in the sector by private equity investors when credit markets relax.

Weaknesses

Some of the more highly levered radio operators may not survive the recession. Radio One ( ROIAK ) is one such operator. We believe that the company's high leverage (6.6x) will hinder its acquisition activities in the near future and thus, its attempts to diversify into higher-growth areas. Moreover, in a period of declining earnings and cash flow, Radio One is nearing its covenant limits. The company's leverage of 6.6x is not far from the 7.5x covenant limit, and similarly its interest coverage ratio was 1.85x, slightly above its lower limit of 1.60x. Although, the company is utilizing sale proceeds to pay down debt, we think any additional near-term sales will be small and thus don't expect debt levels to decline substantially.