A Sad Story at the Digest

By Stacy Perman

Things are really nasty in Pleasantville these days. The Reader's Digest Association, best known for its pocket-size magazine, is in a state of protracted turmoil. The sputtering 76-year-old publisher founded to "inform, enrich, entertain and inspire people" has lately just incited a group of big-game-hunting shareholders, who want to see the Digest company restructured or sold. "This is a company that has been asleep," says Nell Minow, a principal of Lens, an activist Washington-based money manager with a substantial stake in the firm. "We are trying to bring them into the 20th century before we get to the 21st."

In the midst of a historic bull run, Reader's Digest stock has gone south and its market value has fallen by half. Revenues stumbled 8%, to $2.8 billion, in fiscal 1997. Operating profits at the company, situated in the Hudson River valley, have fallen for the past four years, from $393.7 million to $227.8 million (adjusted for restructuring). In January, Digest posted a 35% drop in its second-quarter earnings--the sixth straight quarter of bad news.

When a company such as Reader's Digest performs so poorly for so long, shareholders usually revolt, forcing directors to make drastic changes. But in Digest's case, the board, which is supposed to be independent, is in the grip of the CEO. That would be George Grune, 68, who because of an unusual stock arrangement holds sway over enough voting shares to remove every Reader's Digest director. Grune's power source is his role as chairman of two charitable funds established by the company's childless founders, DeWitt and Lila Wallace, who died in 1981 and 1984, respectively. The funds hold 71% of the company's class-B voting shares; fund directors currently occupy three of the eight board seats. Grune also oversees seven foundations that, along with another, smaller, fund, now own 25 million shares (30%) of the company's nonvoting stock. They supply money directly to a few elite New York City institutions, including the Sloan-Kettering Cancer Center and the Metropolitan Museum of Art. When the company slashed its dividend in July, these institutions were confronted by a drop in their yearly payouts from $58.7 million to $29.4 million. The funds, for instance, provided $8.2 million, or 11%, of the $75 million operating budget of the Wildlife Conservation Society, the New York Times reported. The dividend cut could cost the society $2 million, the amount it costs to keep 1,105 birds alive at its Bronx Zoo.

Faced with declining dividends, the institutions wanted to sell their stock, but the CEO held the cards. The stock price, meanwhile, slid from its $56 high in 1992 to about half that in the summer of 1997. At the close of 1997, Grune agreed to let the institutions divest. Six of eight foundations dumped 11.8 million shares, worth more than a quarter-billion dollars. Critics like Paul Tierney, whose company Corporate Value Partners owns 1.5 million shares, think the deal is less than charitable. The institutions had to sell at 25% under the market price. They were "like lambs being led to the slaughter," he says.

Tierney is part of a Greek chorus of money managers who assert, as loudly as they can, that the company's corporate-governance system is totally compromised by the cross directorships with the foundations. "We as class-A [nonvoting] shareholders are impotent to effect any kind of change," complains Jonathan Lewis, an analyst at Franklin Mutual Advisors, which is headed by the feared raider Michael Price. The outfit, which has made runs at Dow Jones & Co., Chase Manhattan Corp. and Sunbeam Corp., wants Grune gone. Says Lewis: "Grune is an ineffective manager, and I think the board of directors should expeditiously seek to replace him and/or to pursue the sale of the company." It's not quite the welcome back Grune anticipated when Digest lured him out of retirement to reclaim the CEO job last August. Grune declined requests for an interview.

The company and the angry shareholders agree on one thing: Reader's Digest has a tremendous amount of hidden value. They have locked horns over how to unlock that value for shareholders. "This is a $3 billion global business," says Craig Monaghan, Reader's Digest treasurer. "When it's running properly, it's a cash machine. It hums. We need to fix that."

And fast. While Reader's Digest still boasts the world's largest magazine circulation--more than 27.8 million monthly copies sold in 19 languages--its feel-good stories and aging readership (average age: 47 and rising) have kept it out of step with the competition. Even before oral sex became a dinner-table topic, the Digest had lost resonance with generations of today's readers. The U.S. subscription base has decreased by a million since 1993. That's not terrible, but to maintain circulation levels, the magazine must add 5 million new subscribers a year. Not an easy task.

The Digest, while it accounts for only 26% of the company's revenues, provides the brand name that has been used as a front door to roll out a range of books, music and videos, sold mostly through direct marketing. These home and entertainment divisions bring in the bulk of the sales and profits. Recent attempts to move into new markets through joint ventures with Avon (to sell magazines with makeup) and Microsoft (to create CD-ROMs) have been unsuccessful. At Digest's immensely profitable overseas businesses, which accounted for 57% of its revenues last year, sales have fallen from $1.9 billion in 1995 to $1.6 billion in 1997.

Last April, four months before he resigned, CEO James Schadt unveiled a $400 million revitalization plan to push the company out of its morass and move it forward. But his approach, which upended the firm's age-old philosophy of dedicated product testing prior to direct-mail pitches, was roundly criticized by Wall Street as lacking coherence. In the week the plan was presented, the stock dropped 21%. Schadt's strategy was further hampered by the departure of more than two dozen senior executives.

The company's strength has become its weakness. Reader's Digest has been unable to exploit its greatest core asset: a monster database. Despite 100 million households logged in and millions of dollars spent maintaining the data, the company has yet to find an effective way to match products with new consumers. "They are wedded to the past," says Minow.

And that's exactly where Grune is headed. After reclaiming his office, he axed three top executives and replaced them with managers who had worked under him previously. On his earlier watch, the company did indeed hum. He dumped unprofitable subsidiaries and added new specialty magazines. He took Digest public in 1990, and in three years revenues shot up, to $2.9 billion from $2 billion. But when he left in 1994, the company's descent had already begun.

Insiders say Grune played a role in ousting Schadt, his handpicked successor, and then dismantled much of what Schadt had set in motion. Two weeks after Grune returned, the company pulled the plug on a costly Internet search engine called LookSmart. "Over the last few months Grune has basically disowned everything his predecessor did," says Dennis McAlpine, an analyst with Josephthal & Co. Digest says it is just returning to basics. "In the last few years we drastically reduced our testing," says Thomas Gardner, vice president of U.S. marketing. "Our general philosophy was to focus on new initiatives and not on our core business."

So Reader's Digest has returned to the tried and true. "We don't publish things because we think they are a good idea," says Gardner. "We publish them because our customers tell us it is." Last year research showed that customers would buy a book called Foods That Harm Foods That Heal. They did--2.2 million copies were sold worldwide. It is also targeting new areas, such as young families. The company says it expects to turn the corner in 1999, given the long lead times in the business.

Grune, a former Marine, is supposed to be an interim CEO, but he has dug in deep, and has reportedly told staffers not to call him "interim" anymore. A spokeswoman states that the company hopes a new CEO will be in place by July. That won't be soon enough for the chorus of critics down the river.

--Reported by Valerie Marchant/Pleasantville

With reporting by Valerie Marchant/Pleasantville