Before the iPad achieved its current popularity, magazine publishers pointed to digital tablets as a possible knight in shining armour, a way to offset inevitable declines in print advertising. As it turns out, the knight emerged wearing a black turtleneck and jeans.
Under the direction of Steve Jobs, Apple's (AAPL) (Premium: Equity Research) iPad, by some estimates, accounts for more than 80% of the nascent tablet computing market. Early versions of magazines on the iPad are visually impressive and allow for an enhanced experience with embedded video and interactive advertising. At the moment, a major roadblock for magazine publishers is moving beyond single edition versions available and transitioning into a formidable digital subscription business.
The current dominance of the iPad (after just over one year on the market) essentially forces publishers to work with Apple for a subscription model through its application storefront. It has been widely reported that Apple wants to retain 30% of the subscription price, as well as most of the customer data, which is crucial to magazine publishers and the heart of their sales pitch to advertisers. Magazines typically sell a certain demographic to advertisers, with categories like average age and household income among the more basic buckets. Magazines have relied on this customer information throughout their history and are looking for the same access with digital subscriptions. We don't blame the magazine publishers from balking at the terms from Apple, as the obvious risk is that Apple becomes the dominant middleman for digital subscriptions and uses the leverage to gradually extract better economics.
Magazine subscriptions would be a very minor part of the iTunes business, so Apple retains the upper hand in this relationship. The publishers need a subscription model on the iPad more than Apple needs this business. However, we think there are limits to how far Apple will push the magazine publishers, and within the past month, Apple has softened some of its rules for publishers looking to sell subscriptions. Part of the appeal of Apple's hardware is the vast amount and variety of entertainment options within its closed ecosystem. Also, while we believe the iPad is very likely to dominate the tablet market, it is possible that an Android-based competitor could eventually emerge as a viable number-two player that would allow publishers more favourable terms.
We expect the publishers and Apple to eventually come to terms for a viable subscription model. However, tablet penetration remains low, so it will take several years for any material digital revenue to materialise. Additionally, the pricing of the digital content is likely to be a dynamic process for magazine publishers, with the newsstand price as their likely measuring point versus consumers who are accustomed to a heavily discounted subscription rate for the print edition.
For now, print advertising remains a key source of revenue for the industry, and ad sales grew 3% in 2010 after falling 8% and 18% in 2008 and 2009, respectively. However, we're still concerned that if the economy softens and overall ad spending weakens, publishers are likely to get hit harder than companies selling television and online advertising, two categories that remain secular growth stories.
The magazine publishing industry constitutes a small portion of our media coverage universe. Time Warner's (TWX) (Premium: Equity Research) Time Inc. is a heavyweight in the industry, but magazines account for a small percentage of its overall cash flow. Meredith Corporation's (MDP) (Premium: Equity Research) magazine enterprise is much smaller than Time Inc, yet is a crucial part of its overall business.
We think Time Warner is undervalued, with the stock trading at roughly a 15% discount to our fair value estimate. What we really like about Time Warner are their dominant video content businesses, which include leading television and movie studios, cable networks, and its premium HBO product. With over-the-top providers like Netflix and Hulu looking to build online content businesses, companies that consistently generate quality content like Time Warner should benefit from additional distribution, in our view.
At the current price we believe Meredith stock is fairly valued. Relative to other magazine publishers, we view Meredith as well-positioned in a tough industry due to owning several strong titles like Better Homes & Gardens and Parents, which remain popular with women. We think the unique content in its magazines will allow it to maintain readership better than its peers. Also, Meredith has leveraged some of its key brands outside of magazines. For example, the company's Better Homes & Gardens brand has been licensed to more than 2,500 SKUs at Wal-Mart (WMT) (Premium: Equity Research).
