The debt threat at Reader's Digest

    A $2 billion burden from its private-equity takeover has put the 87-year-old icon in a financial jam.

    By William Cohan

    It truly is the best of times and the worst of times for the Reader's Digest Association. At the same moment last week that Peggy Northrop, the current editor-in-chief of Reader's Digest, was accepting the 2009 National Magazine award for general excellence, the company that publishes the 87-year-old flagship and some 44 other magazines and Web sites is struggling for its financial life.

    The Reader's Digest Association, overburdened with $2.1 billion in debt from its two-year-old acquisition by a group of private-equity firms led by Ripplewood Holdings, is running up large net losses, its debt is trading for pennies on the dollar, and its balance sheet is a disaster.

    America's pocket-sized icon, which benefited from a major design makeover, looks like it's headed for a financial overhaul as well.

    In the last few months, Ripplewood, controlled by billionaire investor Tim Collins, has called in the professional reinforcements. The firm has hired lawyers at Kirkland & Ellis and bankers at Miller Buckfire, a financial advisor that specializes in restructurings, to advise Reader's Digest "on a wide range of restructuring and financing issues," according to William Adler, vice president for global communications at the company. "They will assist the company in staying ahead of the problems in the market by exploring strategic initiatives, including but not limited to raising additional capital and easing our debt burden."

    The company has "no plans whatsoever to file Chapter 11," said Adler, and is in compliance with all its debt covenants. The most likely outcome for the company would be for Kirkland & Ellis and Miller Buckfire to attempt to negotiate some sort of out-of-court restructuring with the creditors. Other options for Ripplewood include putting new equity into the company, using that money to buy back debt and trying to protect Ripplewood's original investment. At the urging of new Reader's Digest CFO Tom Williams, the company has also hired Alix Partners, an operational turnaround firm, "to build a multi-year, bottom-up business plan," Adler said.

    Naturally, there was a surfeit of optimism when Ripplewood and its co-investors agreed to take the Reader's Digest Association private in November 2006 for $17 per share, at an aggregate value of $2.4 billion. "We are very excited to reach this agreement to acquire Reader's Digest, a truly wonderful company with a broad array of global assets and growth businesses that are extending a rich heritage," Tim Collins said back then. Of the equity account of $375 million, Ripplewood invested $275 million. (Its co-investors: J. Rothschild Group; GoldenTree Asset Management; C.V. Starr & Co.; GSO Capital Partners, now part of the Blackstone Group; Merrill Lynch, now part of Bank of America; and Magnetar Capital, an $8 billion hedge fund founded by Alex Litowitz.)

    At the time, many analysts believed Ripplewood had out-negotiated Reader's Digest and faulted both its board of directors and its financial advisors, Goldman Sachs, which received an $11 million fee for its advice, and former Goldman banker Michael Lynch, who received a $2.75 million fee, for failing to get a better deal for shareholders. Lawsuits on their behalf against Reader's Digest, Ripplewood and its co-investors were later settled. (Ripplewood, Goldman and Miller Buckfire all declined to comment for this story.)

    During the course of the six-month negotiations, Ripplewood twice offered $18.50 per share, and both times the Reader's Digest board rejected the offer, claiming the company was not for sale. By the time the board came around to selling, Ripplewood's price had fallen to $16.50, based in part on the due diligence it had performed, and then was increased to $17 per share in a final negotiation. Ripplewood paid a 25% premium to the average stock price of the company during the previous 60 days.

    As part of the buyout, Ripplewood also merged two of its portfolio companies, Direct Holdings Worldwide, the publisher of Time Life books under a license, and WRC Media, the publisher of the Weekly Reader and the World Almanac, into the Reader's Digest Association, for $100 million and $60 million respectively in cash and stock of the newly private company. Allen & Co. provided a fairness opinion regarding these acquisitions. On March 3, 2007, the deal closed, ending Reader's Digest's 17-year run as a public company. That same day, Mary Berner, the former president and CEO of Fairchild Publications, became the company's new CEO.

    The timing of the deal for Ripplewood could not have been worse. The global recession was just beginning, resulting in severe declines in advertising and subscribers for traditional print media. Reader's Digest was not immune. The magazine's massive circulation, long the envy of other magazine publishers, fell to 16.5 million, from 18.3 million when the deal was announced, according to the company's public filings. The magazine's net paid advertising pages fell to 9,459 for the twelve months ended June 30, 2008, down from 10,520 in the previous year.

    In the six months ended December 2008, its three core business units - U.S. and overseas publishing, along with school and educational services - suffered an operating-profit collapse of 70%, falling to $30.8 million, compared to the same period in 2007.

    Meanwhile, in typical private-equity fashion, Ripplewood had larded the company's balance sheet with about $2.2 billion of committed debt facilities, in the form of $1.6 billion of senior secured debt and $600 million of senior subordinated notes, with an interest rate of 9%, due 2017. These senior subordinated notes, which became publicly traded after the completion of an exchange offer last June and were issued at par, now change hands at around six cents on the dollar, reflective of the risks the company faces as a going concern with its present debt burden. (Fidelity and Eaton Vance appear to be the large holders of the subordinated debt, according to public records.) There is little doubt that the $375 million invested by the private equity firms is at serious risk of being lost.

    Citing a "drop" in consumer spending and magazine advertising, Mary Berner announced on Jan. 28 that the company would adopt a global "Recession Plan," which included the firing of 8% of its global workforce, the cessation of matching contributions to the company's 401(k) plan and five mandatory unpaid "shutdown" days for remaining employees.

    Soon, the credit-ratings agencies reacted to the market's concerns. On February 19, Standard & Poor's downgraded the debt ratings of the company to CCC, from B-, with a negative outlook. S&P said the downgrade reflected the company's "very high leverage, thinning margin of compliance with its financial covenant, and limited liquidity."

    The next day, Moody's downgraded the company's debt to Caa3, from B3, citing Moody's expectation that week projected earnings "will make it increasingly difficult to maintain covenant compliance and sustain the existing capital structure, factoring in the broadening global decline in consumer spending and the erosion in RDA's mature print-based publishing products." Moody's predicted that there was a "high probability" of a financial restructuring with in the next 12 to 18 months. As for the lower debt ratings, Adler said, "This is understandable and does not impede the normal functioning of the company."

    William Roy DeWitt Wallace started the Readers Digest Association in a Greenwich Village speakeasy in 1922 and would no doubt have appreciated the Dickensian irony of his magazine at this moment winning for the first time the award for general excellence. In the magazine equivalent of the best-picture category, Reader's Digest vanquished Time, Real Simple, Martha Stewart Living and National Geographic for magazines with a circulation greater than 2 million.

    "Reader's Digest has reinvented itself with fresh design, imaginative and timely feature stories and an engaging contemporary voice," the award's judges concluded. "Articles about ordinary people overcoming extraordinary obstacles, useful and accessible service pieces on health and personal finance, and delightful humor columns make Reader's Digest not only a good companion but also a great escape."

    The next day, Northrop shared her excitement with her staff at the magazine's campus-like headquarters in Pleasantville, New York: "What happened last night is we won an Oscar," she said. "...I'm not too embarrassed to admit I fantasized about that moment for many, many years. ... It doesn't get any better than this."

    But there is no question that the time has come for the highly paid executives at these firms to do all that they can, in the great tradition of Reader's Digest, to overcome some extraordinary obstacles if this LBO is ever going to pay off.