Over the past couple of months, I’ve sought out some of the smart people that I know in the media and finance business to ask them how they see the future of media.

The conversations have been engaging, but lack a clear consensus about how media companies will develop, and what the path to creating value will look like.

The puzzle is daunting.

First, media businesses are supported by two components of the economy that have terminal value: advertising spending and consumer spending specifically on information and entertainment, and more broadly on goods and services. During a period of accelerating economic expansion, media companies benefit on both sides, with consumer spending fueling advertising and media; during a period of accelerating economic decline, media companies are hampered on both sides.

Screen shot 2009-10-30 at 12.11.11 PM.jpgAmerica Needs to be EntertainedTo determine the available pool of dollars for media companies in the future, you can combine a projection of GDP with a historical view of media spending. Advertising will be somewhere around 2.0% to 2.2% of GDP. Consumer spending on media and entertainment has held roughly steady at $940 dollars per person, or around $218 billion dollars.

On a macro perspective the key variable is the rate of growth of the economy. Overall, the media industry will grow at roughly the same rate. On a micro-perspective, the growth of media companies will be influenced by shifts between media channels and the ability to move market share within each category.

mediaspend.jpgSo, in my conversations, it’s been fairly easy to directionally define the overall scale and composition of the media market. Advertising dollars have shifted toward the Internet. Several key categories will experience sharp share declines over the next few years, exacerbated by the overall decline in media spending. The media market will become more fragmented, which will lend more pricing power to advertisers. Consumer spending will also shift towards interactivity and mobility, with integrated devices becoming portable entertainment and information centers. Certain traditional media categories supported by consumer payments will need to adapt to highly fluid distribution channels, or will become marginalized.

In many traditional media categories, there will continue to be good companies that execute well and consolidate market share. One investment banker put it simply: There will be fewer companies making less money, but they will be good companies.

How will value be created, I ask? How will the capital markets respond to media properties and what will be the factors that drive the kind of returns that will attract capital?

This question doesn’t lend itself to as easy a response.

Part of the reason is because of the incredible washing out of value that has occurred during this great economic disruption.

An industry in default

As I was in the middle of these conversations, I asked my friend Reed Phillips, one of the principals at the media M&A firm DeSilva & Phillips, if he could put together some data of publishing acquisitions since 2005.

According to the DeSilva & Phillips database, there were 508 acquisitions in the magazine market between 2005 and 2008. Of that total, 73% of the deals were backed by private-equity investors.

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The investment model for private-equity is fairly direct. Identify companies with strong cash flow and consistent operating models, use leverage to finance the acquisition of a company, and pay down debt with free cash flow in order to improve the value of the company. This value equation can be accomplished in several different ways, including increasing revenue, cutting costs and using the relative borrowing power of the company to acquire smaller companies.

The magazine publishing business, with its strong cash flow characteristics and the promise of increased diversification during the expansion of media channels, was an attractive investment target for private equity.

Picture 61.jpgThe model isn’t working right now.

Using a very conservative set of assumptions about the capital structure, we can assume that the private-equity backed deals in the magazine business had a total of $10 billion of debt put on them, with estimated annual cash interest payments of $854 million.

Total earnings for those businesses in the midst of this economic crisis have likely dropped to $837 billion or less.

The companies are not generating enough cash to pay their interest charges, leaving the entire group of deals in technical default.

Picture 62.jpgThat doesn’t herald the end of the industry. Many of these companies have strong franchises and are producing significant free cash flow. Many of them have identified new ways to do business, new opportunities across media channels, and are laying the foundation of increased growth in the years ahead.

Screen shot 2009-10-30 at 1.30.20 PM.jpgIt does mean that the current debt and equity invested in the market are greatly diminished in value. Again, using some conservative estimates, the current debt in these private-equity backed deals is likely worth about 40 cents on the dollars, leaving about 28 cents of equity — of which very little is likely to be held by the current equity owners.

The financial devestation is epic. Billions of dollars of invested capital, tens of thousands of jobs, historic, established brands, publishing companies with generations of history: all have been washed out in the torrent of economic decline. It is sad. It is amazing to have experienced.

But it doesn’t bring an end to the business. The businesses need to retool and rework. The balance sheets need to be cleaned up. The companies need to be reinvented. Leadership needs to get refocused. And then the work of grabbing your fair share of a market comes back to the center of everything that gets done.

How to pick out the path to value?

I’m excited by the dynamic change we’ve experienced in the media business. A two-decade long march of technological innovation, driven by the goal of linking content and consumers across digital networks, is coming to an end: the focus today is less on abtruse technology and more on effective strategies for building communities, content, brands and value against discrete markets.

The markets are still in such meaningful flux that it’s difficult to distinctly define the parameters of capital investment in the media market.

Capital wants a return. It’s a basic law. The sources of capital for media are looking for annual returns from 10% to 50%, with public equity at the low end and venture capital at the high end. To deliver that return, a company has to be able to generate growth, and that growth ultimately has to produce increased profit.

I had lunch with Jonathan Knee of Evercore just when the Atlantic published an article based on his new book The Curse of the Mogul. The article is a succint commendation of strategies of major media companies over the past decade. Knee’s fundamental conclusion is that it’s time to get back to nuts and bolts, to operate media properties efficiently, with close market contact, in order to generate reliable returns to investors.

Without drastic action, the performance of media enterprises during the next 10 years is unlikely to improve—and is likely to get much worse. The drastic action required here entails jettisoning all four entrenched media myths and going back to basics: understanding the key characteristics of various media segments and applying established business principles to determine the best way forward. Although such an approach is hardly revolutionary on its face, the stark contrast between it and the conventional wisdom suggests how much work needs to be done.

In the media industry, senior executives seem to prefer “strategic visionary” to “first-rate operator” as an appellation. There is nothing wrong with searching for ways to reinforce competitive advantages under threat. But once the barriers have fallen, managers are left with the most unglamorous of activities—improving the efficiency of their operations. In the absence of investments likely to generate superior returns, an executive committed to shareholder value would not diversify for the sake of diversifying or reinvest in a clearly dissipating franchise, but simply return the money to investors. Empire-builders may find that course distasteful, but over the past two decades, media investors would certainly have been far better off if this had been the road taken.

As I try to imagine the future for media companies over the next several years, a few paths to creating value for capital emerge.

The first is market focus: Businesses that are able to create an incentive for talented people to focus on a specific market opportunity, with close contact with the market, with the goal of increasing share of the market through execution and innovation will have more likelihood of success than businesses that either discount the value of their talent or spread their talent too thinly.

The second is creating a justification for scale: Scale for the sake of scale will have minimal value to capital over the next decade. Scale can generate two opportunities: A lower cost of commoditized goods and services or a higher impact on revenue by virtue of superior market engagement and penetration. These two characteristics can’t be linked, and both will have a diminishing value over time.

The third is expanding innovation: Over the next several years, new ways of organizing media companies will develop, driven by the availability of distribution platforms and the desire of talented content creators to generate more economic value from their work. At key points in this process, growth capital will be required in order to accelerate the creation of these new models. The capital shouldn’t get deployed until a clearly profitable business model has been proven. The capital shouldn’t chase disproportionate scale. But the capital will likely generate a meaningful return.

Those are the three things that feel clear to me. The path to value creation will be slower than over the past decade, with much less help from leverage and GDP growth. The competencies of identifying and acquiring companies, of raising and deploying capital, of identifying and launching markets will remain valuable. But they will need to be augmented by the competency of being a media operator: of knowing how to wring efficiencies out of the system, so that operating cash flow can be used to attract and retain the highest quality talent.