Buffeted   

Newspapers are paying the price for shortsighted thinking.

When an acclaimed investor like Warren E. Buffett questions the current state and likely future of the newspaper business, it's time to take a hard look at just how newspapers are faring and what this portends.

The picture is not encouraging. Through the first half of 2007, using results of publicly reporting newspaper companies as a proxy for the industry, total revenue was down nearly 5 percent and operating profit was off more than 14 percent.

Newspapers' performance hasn't been this bad since the 2001 recession, when revenue slipped nearly 6 percent and profit was down more than 26 percent. And this year the nation is not in a recession. But the newspaper industry surely is, and it is worthwhile examining why.

Advertising currently contributes 75 percent to 80 percent of most newspaper companies' revenue. Retail advertising from department stores and other merchants accounts for about half of this, and this category has been flat to down a bit in recent years. The real pain for newspapers is classified, about 35 percent of total advertising, which has declined this year in the double-digits.

It's not hard to figure out why: Automotive, employment and real estate--the three principal categories of classified--have plunged, reflecting the woes of the underlying industries. There will be no hope for improvement until auto sales, job creation and housing sales rebound.

Even then, the question remains whether newspapers will recapture their usual share of the advertising that will flow from a recovery. In effect, this is what Buffett wrote about in his annual letter to the shareholders of Berkshire Hathaway, the huge investment combine he heads. Buffett is no novice when it comes to the newspaper business. His company made major investments in newspaper companies in the 1970s and 1980s, appreciating their near-monopoly status at the time in most markets. Berkshire Hathaway still owns 18 percent of the Washington Post Co., where Buffett is on the board of directors, and all of the Buffalo News.

He asserts in his shareholders' letter that the "fundamentals are definitely eroding in the newspaper industry" and predicts that the "skid will almost certainly continue." He writes that many newspaper executives "were either blind or indifferent to what was going on under their noses," although they now know that newspapers are "constantly losing ground in the battle for eyeballs." Most jarring of all, he writes: "Simply put, if cable and satellite broadcasting, as well as the internet, had come along first, newspapers as we know them probably would never have existed."

Most newspaper executives now are banking on a successful transfer of their business online to ensure future profitability. Unfortunately, they came late to the realization of how important this is and did not invest enough capital in the early years of the Internet.

Instead, most newspaper companies concentrated on shoring up the profitability of their traditional newsprint-oriented business, chiefly through laying off employees, downsizing their newspapers and cutting back on circulation in distant areas of little interest to advertisers in their core markets. It was a classic defensive strategy that undermined the very things--standing, reputation, influence--that are crucial to success on the Internet.

Despite double-digit gains, newspaper online advertising--most of it from up-selling from print editions--remains a small part of newspapers' advertising revenue, a little more than 5 percent of the total last year. A major reason for this small presence is that other entrepreneurs in the early years of the Internet era did invest the money necessary to develop online competitors that are now drawing away newspapers' readers and business.

The newspaper industry remains highly profitable by comparison with most other businesses. Bad as 2007 has been, the publicly reporting companies still produced an average operating-profit margin of nearly 16 percent in the first half of the year--a level many businesses can never hope to achieve. Still, the average profit margin has been in steady decline since 2002, when it was 22.3 percent.

That newspapers have been able to maintain such high margins has not been due to improving business but to cost-cutting and, recently, a decline in newsprint costs. But no industry can cut its way to future success. At some point, the business must improve.

Whether newspapers will be able to meld a combination of print and online into a sustainable and thriving business model is a large question. In newspapers' favor is the fact that they are the only form of media organized to gather mass amounts of news and to provide a forum for serious analysis of important issues. Anyone who loves democracy should hope this will continue.

But clearly newspapers now find themselves ensnared in a competition for readers and advertising that is as unfamiliar as it is intense. A sure consequence of this will be lower profitability. On this point I will give the last word to Buffett, who writes in his shareholders' letter of his company's Buffalo News: "..the days of lush profits from our newspaper are over."