Valuentum Exclusive Analysis for the Discerning Investor

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Image shown: The first seven annual volumes of Valuentum's Best Ideas Newsletter. 

Valuentum is dropping coverage of the book publishing industry to focus resources elsewhere.

Structure of the Book Publishing Industry

Firms in the book publishing industry compete primarily on the basis of quality and price. Rivals include numerous book, ebook, textbook, library, reference material, and Internet resellers. Industry constituents can carve out advantages by offering a comprehensive offering, as in the case of Scholastic’s suite of reading intervention products and services. Still, firms are subject to rapid changes in consumer preferences, especially within the ebook market, which is just beginning to take shape. We’re neutral on the group’s structure.

Barnes & Noble (BKS)

We've lowered our fair value estimate for shares after the company reported disappointing 2017 holiday sales numbers. Online sales felt meaningful pressure as well.

Barnes & Noble pioneered the concept of the book superstore. The firm provides customers access to books and other content across its multi-channel distribution platform. Its fortunes are as tied to book publishing as its peer group. The company operates ~650 stores in all 50 states. It was founded in 1986 and is based in New York, New York.

The bookstore industry has been undergoing a significant change. Barnes & Noble has been transforming its business from a store-based model to a multi-channel model centered on its retail stores, Internet and digital commerce. 

Barnes & Noble recently spun off its college bookstore business into a company called Barnes & Noble Education. The business has 724 locations across the country and reaches 24% of all college students in the US. Management is hopeful that the renewed focus will benefit both of the now-separated businesses. The parent company recently resumed paying dividends.

Barnes & Noble's survival is not guaranteed, but shares have benefited from rumors of a go-private deal. We've lowered our fair value estimate, however, after the company reported disappointing 2017 holiday sales numbers. Online sales felt meaningful pressure as well, and the firm is expecting 2018 comps to fall in the mid-single digit range.

Reports of Amazon launching physical bookstores are not helping sentiment for bookstores. Barnes & Noble entered the e-book market in 2009 and launched its NOOK brand of e-reading products, but the NOOK business has turned into a cash burn.

Our published fair value estimate range for Barnes & Noble is $4-$11 per share, with a Valuentum Buying Index rating of 3 and an Economic Castle rating of Unattractive.

Educational Development Corp (EDUC)

Education Development Corp is the exclusive US trade publisher of the line of educational children's books produced in the UK by Usborne Publishing.

Education Development Corp is the exclusive US trade publisher of the line of educational children's books produced in the UK by Usborne Publishing. The firm also owns Kane/Miller Book Publishers. Selling children's books is the firm's only line of business. A material portion of its revenue comes from multi-level direct selling efforts.

Though the firm boasts a hefty dividend yield, we're not interested in it. The company's Valuentum Dividend Cushion ratio is subpar. We wouldn't expect much dividend growth from here, nor do we think the company should pursue such expansion.

We're not too fond of Educational Development Corp's weak cash flow generation and high financial leverage. Although this combination does not guarantee financial problems down the road, it could potentially be a recipe for disaster during tough economic times. The firm's size does not lend itself to sound visibility into its business.

Though top-line growth has been strong in recent years for Education Development Corp, the inordinate level of demand has created some challenges, including shipping and distribution process issues. This has caused a material order backlog and could impact growth potential moving forward.

We can think of a large number of companies that we'd rather own than Education Development Corp. These companies are included in the Best Ideas Newsletter portfolio and Dividend Growth Newsletter portfolio.

Our published fair value estimate range for Education Development Corp is $4-$17 per share, with a Valuentum Buying Index rating of 7 and an Economic Castle rating of Attractive.

Pearson (PSO)

Pearson plans to sell its US publishing unit while pursuing additional cost cutting initiatives amid the difficult operating environment.

Pearson is an international media and education company with its principal operations in the education, business information and consumer publishing markets. It generates ~60% of sales in the US and ~20% of sales in Europe. The firm is currently engaged in a significant reorganization program to reduce exposure to structural pressures (it is shifting toward digital).

Pearson has agreed to sell 22% of its 47% stake in Penguin Random House as part of its portfolio restructuring. Proceeds will be used to shore up the balance sheet. It also plans to rebase its dividend, which will be now covered by its business excluding any contribution from its remaining stake in Penguin.

Pearson's portfolio restructuring is a result of it miscalculating US college enrollments and revenue forecasts, among other missteps. As a result, the market leader in US higher education has reduced its guidance for 2017 and has pulled its adjusted operating profit target for 2018. We've reduced our fair value estimate as a result after the firm's fifth profit warning in four years.

Pearson also plans to sell its US publishing unit while pursuing additional cost cutting initiatives, which are expected to result in £300 million in cumulative expense reductions by 2020. Its US publishing business has been slow to adjust to the digital transformation of the teaching materials market and will require high levels of investment.

Pearson's portfolio reconstruction is aimed at accelerating its digital transition. It will enhance its courseware services capabilities investment by £50 million in 2017, as well as increase participation in the courseware rental market by reducing eBook rental prices by up to 50%.

Our published fair value estimate range for Pearson is $6-$14 per share, with a Valuentum Buying Index rating of 3 and an Economic Castle rating of Attractive.

Quad/Graphics Inc (QUAD)

Quad/Graphics produces over 90% of its revenue in the US but is looking to expand to higher growth markets such as Latin America and India.

Quad/Graphics is a leading global printer and media channel integrator. The company's print and related products and services in North America, Latin America and Europe include: print solutions, media solutions, and logistics services. It has a diverse customer base of 8,000+ clients. The firm was founded in 1971 and is headquartered in Wisconsin. 

Quad/Graphics has done an excellent job with growth through diversification. The firm's sales have expanded from $1.8 billion in 2009 to nearly $5 billion today, and it has reduced its dependence on magazines and catalogs. Retail inserts now account for ~25% of revenue.

Quad/Graphics had done well in reducing its leverage ratio (total debt and capital lease obligations divided by LTM adjusted EBITDA) as of late, bringing the measure down to 2.25x as of the second quarter of 2017 from 3.07x just 21 months earlier. This is within the firm's target range of 2.0x-2.5x over the long run. 

Quad/Graphics hopes to expand into higher growth product lines through both organic growth and acquisitions. The firm produces over 90% of its revenue in the US but is looking to expand to higher growth markets such as Latin America and India. We think it will have a tough time growing in the near term.

The firm operates primarily in the commercial print portion of the printing industry. Print represents ~24% of the total US advertising market of ~$40 billion. The industry is highly fragmented, but excess manufacturing capacity has kept utilization rates below 70%.

Our published fair value estimate range for Quad/Graphics is $13-$25 per share, with a Valuentum Buying Index rating of 3 and an Economic Castle rating of Neutral.

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Quad/Graphics issued a $2 per-share special dividend in 2012. Its Dividend Cushion ratio is weighed down by its large debt load.

Quad/Graphics' lofty dividend yield is based on its solid free cash flow generation, which is tied to its capital-light business model. The firm has created what it believes to be one of the most efficient manufacturing and distribution platforms in its industry, giving it an advantage as a low-cost producer. Average annual free cash flow generation of ~$205 million from 2014-2016 covers annual run rate cash dividend obligations of ~$61 million multiple times over. Should such solid free cash flow generation be pressured in any way, the firm's Dividend Cushion ratio would only fall to more unattractive levels. Though we are not fond of Quad's debt load, it has no significant maturities occurring until April 2019, offering some financial flexibility. 

In addition to Quad/Graphics' mixed financial profile, it does not operate in an attractive industry. The firm must continue to diversify in order to grow its top-line materially, which could be quite capital intensive. This has the potential to eat into its historically solid free cash flow generation. Our biggest issue with the company’s dividend prospects rest on its balance sheet in the form of nearly $1.1 billion in net debt as of the end of the first quarter of 2017. With an already elevated yield, we see dividend growth as an afterthought for Quad/Graphics at this point in time, and our concerns with the safety of its current payout are material over the long run. We think there are far better income ideas available, even after considering its outsize yield. 

Our published Dividend Cushion ratio for Quad/Graphics is -0.3 with a Dividend Track Record of Healthy.

Scholastic Corp (SCHL)

Scholastic is the world’s largest publisher and distributor of children’s books, but its performance is 'hit-based' to a degree. 

Scholastic is the world’s largest publisher and distributor of children’s books and a leading provider of educational technology products and related services and children’s media. The firm's reputation is a key asset. The company was founded in 1920 and is headquartered in New York, New York.

The company's performance is 'hit-based' to a degree. The inability to publish best-selling new titles in future years could cause difficult year-over-year comparisons given the recent successes of Harry Potter and the Hunger Games.

Scholastic's school-based book clubs and book fairs are core businesses, which produce a substantial part of the company's revenues. Though trends in this area have been resilient, the company is subject to the risk that it may not be able to execute new promotional strategies. Trends in e-books are the biggest threat in this area.

A growing global middle class will continue to drive international demand for English-language books and instructional materials, particularly in Asia. The firm may also see a near-term benefit from the high circulation in classroom magazines. It has doubled its magazine subscriber base in the last 4 years, but such a trend is not likely sustainable.

In-line with its hit-based performance, Scholastic expects the lack of a new Harry Potter book to lead to revenue in a range of $1.65-$1.7 billion (was $1.74 billion in fiscal 2017) and a 'commensurate decline' in operating profits. Excluding this impact it expects operating income to grow by double digits.

Our published fair value estimate range for Scholastic is $32-$48 per share, with a Valuentum Buying Index rating of 3 and an Economic Castle rating of Attractive.

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Scholastic Corp's Dividend Cushion ratio is impressive.

Scholastic is the world's largest publisher and distributor of children's books. The firm anticipates the growing global middle class to continue to drive international demand for English-language books, especially in Asia, and it will also continue to benefit from the doubling of its magazine subscriber base in the last four years. The company's balance sheet health is a key component of its strong Dividend Cushion ratio, and average annual free cash flow generation of more than $50 million covers annual run rate cash dividend obligations of just over $20 million from fiscal 2014-2016, even with negative free cash flow in fiscal 2016. Scholastic's dividend yield leaves a bit to be desired, and it will continue to fight against the dying of hard-copy literature. 

Scholastic's dividend growth potential is certainly strong, as its Dividend Cushion ratio indicates. It net cash position of ~$410 million as of the end of fiscal 2016 gives it a decent safety net on which to fall back on should it experience material weakness in its free cash flow generation. While we tout the firm's international growth potential, there is a bit of risk associated with the popularity of the titles it releases, which can cause lumpy results associated the release of best sellers. However, the firm recently sold its Educational Technology Business for $575 million and has reinvested the proceeds into its core businesses. We like the growth potential for both its overall business and its dividend.

Our published Dividend Cushion ratio for Scholastic is 5.9 with a Dividend Track Record of Healthy.