Further Thoughts on the Times' Paywall

There is an inescapable and very simple formula that describes the financial activity of all organizations that do business. It is the income statement for a given period of time:

Revenue - Expenses = Net Income

Most income generated in a given period fits under revenue, and most of the money spent for that same period fits under expenses. Complete the formula and you have a sense of the general capacity for an organization to create income. If net income is negative, then the organization obviously can't sustain that business model. If it is positive, then possibilities exist for growth.

Much has been made about notions of 'free' in the new internet economy, and it is certainly an important marketing component that plays to the strengths of digital distribution, but it cannot and should not in the long run be taken out of its context in a process that ultimately has to deliver a reliable revenue stream--a business model in which revenue ultimately exceeds expenses.

Anything given away for free costs money to create and distribute. Those costs go directly to the expense side of the formula. But they don't merely offset an equal amount of revenue. The cost of free comes directly out of the net profit of the company on a one to one basis. Here is how that works.

Let's say hypothetically that the New York Times has a net profit margin of 10% (for 2010 it's actually about 4.5%). That means that for every $100 it spends, it takes in $110 to make a profit of $10. Or we can say that every $110 worth of news sold by the New York Times cost it $100 to make. 

Now let's say that the New York Times decides to give away $100 in product. So they make $100 worth of news and give it away for free. Conventional logic says that the Times now has to make $100 in sales to make back that $100 loss. But because zero revenue comes in to offset that $100 expense, the New York Times is actually in the hole for $1000. Here's why. To get the money to make the $100 unit it gave away for free, the Times had to make and sell $1000 worth of news, bringing in with the 10% profit margin $100 in profit. So the $1000 dollars in operating expense brings in $1100 in revenue, and the profit, the $100 balance left over goes to pay for the $100 gift.

Now, the above theoretical example is based on the idea that the Times has a relatively stable operating business model. In this climate that is not the case, and technological advances in digital distribution have destabilized the model to the extent that there is little precedent to demonstrate the actual market value of the content recently being distributed for free.

What does all this have to do with the rollout of the New York Times paywall? 

Here is where it starts to get interesting.

Net income for the New York Times Company for the past five years is as follows:

2010: $108 million
2009: $20 million
2008: ($58 million)
2007: $209 million
2006: ($543 million)

Despite the recession that started in 2008, the Times' worst year was in 2006. If the recession bottomed out in mid 2008, then the Times has been making slow gains in its overall operating profitability, with a net income of $108 million in 2010.

What this is telling us is that its operations without the paywall are narrowly in the black, returning a modest net income in 2010 of $108 million on revenues of $2.4 billion, or a net profit margin of 4.5%. That is for the entire New York Times Company. The New York Times Media Group, publishers of the New York Times newspaper and NYTimes.com, makes up about 65% of that revenue.

According to the Times this improvement in profitability results from increasing online ad sales and cost cutting and increased efficiency in the print division.

Here's where I think the explanation for the current paywall system may reside. The Times is in the black, but barely. The industry is in flux. Change is already happening. Growth will happen online. The print division is cost cutting, but there are limits to how fast and how far that can go. The opportunity for an increase in net income comes mostly from NYTimes.com. But, whatever happens with NYTimes.com, online advertising needs to be sustained. Loss can come too. Make the paywall too tight and online advertising will drop off as readers fall away. Surges of readership through social media sharing will be constrained.

The middle spot? Make a paywall that is more of a nuisance than a real deterrent. This will keep advertising rates as high as possible through free readership and will begin to migrate concerned and conscientious readers over to a paying online model. Gradually the tightness of the paywall can be adjusted as its financial impacts become more known. 

If print revenues can be kept stable, the move to a loose paywall produces a powerful effect. Once the approximately $40 million invested in the paywall's implementation, plus the paywall operational costs are recovered, and any loss in online advertising is offset, online subscription revenues go nearly straight to net profit. Remember, NYTimes.com is already giving the news away for free. Their operations don't have to change for the paywall to take effect. They already produce and distribute the news. All things being equal, production costs don't rise.

It is one of the most unusual rollouts in business history. A company that is in full operational flow suddenly and somewhat loosely begins to charge for a product that it has been giving away for free.