It’s no secret the newspaper business is in trouble. As more consumers get their news online, advertising and circulation rates in the print world have been steadily falling. In response, many of the major newspaper chains have been cutting staff at a regular clip. The process has been underway for half a decade and, judging by the numbers at one major newspaper publisher, the bloodletting may continue until creditors take control of the business, rendering its stock worthless.

I’m talking about McClatchy Co. (NYSE: MNI), the nation’s third-largest newspaper publisher, which owns publications such as the The Miami Herald, The Sacramento Bee, the Fort Worth Star-Telegram and The Charlotte Observer.

McClatchy’s struggles are no secret — its stock has already fallen 75% this year to around $1.00. Still, even at this price, investors may be looking at 100% downside.

This potential bankruptcy candidate came up on my radar after a recent glance at the most current short sale data. As of Nov. 15, short sellers held 26.6 million shares of this stock short. Considering this stock trades roughly 630,000 shares a day, such a large short position represents 42 days worth of trading volume, which is the second-largest figure of any major company. (Rogers Communications (NYSE: RCI) is number one).

Why are short sellers targeting McClatchy Co.? Because they’ve taken note of the fact that the company has almost no margin for error and simply can’t afford to see revenue fall any further. Revenue fell 16% in 2008, 23% in 2009 and 7% in 2010, respectively, and is expected to drop another 8% in 2011, so a hoped-for stabilization in revenue is vital for this stock to survive. In this year’s third quarter, however, advertising revenue fell 10%, while circulation revenue dropped 4% compared with the same period in 2010.

How tight is the margin for error? In the third quarter of 2011, McClatchy posted $45 million in operating income, but net interest expense ate up $33.4 million of that amount. The first nine months of 2011 presented an even more sobering view: McClatchy posted $108.5 million in operating income, but had $106 million in net interest expenses. Thanks to a high level of depreciation, EBITDA was a more robust $190 million. (EBITDA is operating income with depreciation and amortization added back in.)

McClatchy carries $1.6 billion in long-term debt, but at first blush, there is no need for imminent concern. After all, the publisher doesn’t face any major bond redemptions until 2014, and the bulk of the debt isn’t due for a decade or more. But bondholders put in place some restrictive conditions — known as debt covenants — and they are the real problem. These covenants dictate that McClatchy must maintain EBITDA levels that are at least 50% higher than net interest expenses (or an interest coverage ratio above 1.5). Although the company currently remains within the stated covenants, 2012 may tell a different story.

Right now, using figures from the first nine months of 2011, EBITDA coverage is 1.79, slightly above the 1.5 threshold. But if EBITDA fell just $20 million in 2012, then those covenants would be breached. Taking the long view, EBITDA peaked at $445 million in 2006 and fell 24% to $337 million by 2010. This works out, on average, to be a $27 million drop in EBITDA each year. If history repeats itself and EBITDA drops by a similar amount in 2012, McClatchy won’t likely be able to avoid a date with bankruptcy court.

As it stands, McClatchy also has $600 million in unfunded pension liabilities. Judging by the recent $17 million in cash parked on the balance sheet, it’s not clear where this money will come from. The publisher owns a 15% stake in CareerBuilder.com, which is carried on its books for about $327 million, covering only about half of the pension liabilities. But this figure may be optimistic when you consider that rival Monster Worldwide (NYSE: MWW) has seen its value fall by 70% during the past 12 months.

Looking out in the next few years, it’s simply hard to see how McClatchy can survive as a publicly-traded company — unless management figures out a way to generate top-line growth. The financial performance in the past few years hardly inspires confidence.

Risks to Consider: A rebounding economy might lead many companies to boost advertising spending in 2012, which would help McClatchy reverse recent revenue declines and generate the cash flow to keep creditors at bay.

Action to Take–> McClatchy will provide an update on business trends at an investment conference on Wednesday, Dec. 7, which will be available on the company’s website. Short sellers will be watchful for any signs that business has weakened even further in the fourth quarter. If you’re looking for a stock to short, then you should do the same. With such a small margin for error, any sign that debt covenants may be breached in 2012 will most likely cause shares to spiral even lower.