Reader's Digest: When Bad Things Happen to PE Firms

Reader's Digest is just the latest old media company to file for bankruptcy protection, in order to restructure a massive debt load.

The Company had been acquired by private equity firm Ripplewood Holdings a little more than 2 years ago for $2.8 billion. Under the restructuring, the debt will be reduced from $2.2 billion to roughly $550 million, quite a haircut for both Ripplewood and its creditors.

But should it be a surprise to anyone that this company is in bankruptcy?

Let's read what Standard & Poor's had to say about Reader's Digest following the acquisition, as it lowered its credit rating to 'B' from 'BB':

The ratings reflect the company's heightened debt leverage, trend of lower profitability, and Standard & Poor's expectation of only modest discretionary cash generation. These factors are minimally offset by its market positions in the highly competitive publishing and direct marketing businesses. Standard & Poor's remains concerned about Reader's Digest's business risk and uncertain long-term growth prospects.

More specifically, they state the obvious:

The core Reader's Digest worldwide magazine and direct-marketing book businesses, accounting for about half of sales, have exhibited little revenue growth. We believe that management's success in restoring previous levels of profitability will be challenged by changing demographic and lifestyle trends and the company's mature customer base.

Now, let's take a look at Moody's comments from the same period (February 2007):

The company's print publishing and direct marketing businesses nevertheless have high customer churn and acquisition costs, and recurring editorial and paper costs that restrain margin potential. Moody's believes the high leverage and weak margins limit financial flexibility over the intermediate term.

Now, use the content industry sanity test by asking yourself these questions:

Do you know anyone who currently reads a Readers Digest product?

and, more importantly:

Can you describe a clear path to how Readers Digest can become an effective digital media company?

I'd be hard-pressed to find anyone who can answer yes to either of those two questions, which should tell you the future growth potential of the company.

Of course, Ripplewood is hardly the first company to use debt and leverage to buy a dying business. During my years at Primedia, the company struggled to pay down the debt used to fund the acquisition of too many companies which were on the wrong side of the growth curve.

And the team at Ripplewood will no doubt blame the credit crunch and the recession for their woes. But the economy simply exacerbated the bad business decision, which was to believe that a declining business would be able to fund a large debt load. Debt + leverage only work when you can generate strong organic growth or eliminate significant costs.