Why Textbook Publishers Are Better Investments Than Their Trade Publishing Peers

Why Textbook Publishers Are Better Investments Than Their Trade Publishing Peers

Book publishers are hardly the same, and can easily be classified based on the type of books they sell and who they sell to. These differences in product type and customer segment have a huge impact on their attractiveness as investment candidates. Textbook publishers like Houghton Mifflin Harcourt and Pearson are far more attractive than trade publishers such as Scholastic because of their specific market characteristics.

K-12 textbook publishing
The K-12 textbook-replacement cycle is long, typically lasting more than five years. This is a function of the K-12 textbook-adoption process, where the 20 states (adoption states), accounting for more than half of the U.S.' K-12 population, approve new textbooks every five to seven years at the state level. Individual schools in these 20 states are only allowed to purchase textbooks on the approved list during this period.

For example, if a school administrator purchases a science textbook published by Houghton, it will likely be the same textbook used by the school for the next five years or more. This enhances the 'stickiness' of textbook purchases, making it more difficult for new K-12 textbook publishers to enter the market with competing products and take market share away from leaders like Houghton.

Furthermore, a new wave of K-12 textbook upgrades driven by regulatory forces is in the cards in the next year or two. As of November 2013, 45 states have adopted the Common Core State Standards as part of federal guidelines to ensure a consistent and high-quality level of K-12 education for every U.S. student. School administrators in these states will have to replace their existing textbooks with new ones to meet the standards by the start of the 2014-2015 school year. This should result in a spurt in textbook spending and an increase in Houghton's sales in the near future.

Higher education textbook publishing
Besides being a major textbook publisher in the K-12 market, Pearson is also a dominant player in the higher education market where the demand drivers are equally, if not more, favorable.

Professors, like most humans, are creatures of habit. They prefer using the same textbook for their classes; and when they need to upgrade their teaching materials, they go for the latest editions of their existing textbooks. They also need to make fewer changes to the course curriculum by staying with the same textbooks that they are already very comfortable with in terms of style and structure.

On the flip side, instructors don't see any need to put their personal reputation on the line by going with a new textbook. This reminds me of the old adage in corporate purchasing that "nobody ever got fired for buying IBM." In fact, a cursory examination of Pearson's online catalog shows that many of its higher education textbooks are already into their 10th version and beyond. The longevity of Pearson's higher education textbooks suggest that competition from new textbooks and new entrants is limited.

Trade publishing
In contrast to the favorable economics of K-12 and higher education textbook publishing, trade publishing's hit-driven model is far less assuring for investors. For trade publishers like Scholastic, most of its profits are concentrated with the blockbuster successes and winners, which pay multiples of losses incurred by other books that don't sell. But there is simply no guarantee that Scholastic can churn out winners like "Harry Potter" and "The Hunger Games" consistently.

Even for hits like "The Hunger Games," there are many uncertainties. For example, Scholastic reported its full-year fiscal 2013 results in July 2013. A 25% year-over-year drop in sales was attributed to lower sales of "The Hunger Games" trilogy resulting from fading reader interest. However, Scholastic saw its revenue for the second quarter of fiscal 2014 increase by 1.5%, as sales of "The Hunger Games" trilogy benefited from renewed reader interest following the screening of The Hunger Games movie.

Also, trade publishing is more volatile than textbook publishing because of shorter lifespans. While the lifespans of textbooks can be almost extended infinitely by refreshing later editions with updated content, most other non-fiction books don't go beyond their second editions, and there is a natural limit on the number of sequels or trilogies for successful fiction best-sellers.

Of the three listed book publishers, Houghton is my top pick because textbook publishers face less competition and are less reliant on blockbuster hits than their trade-publishing peers like Scholastic.

Moreover, Houghton is a much purer proxy for K-12 textbook publishing than diversified Pearson, and is therefore better positioned to benefit from the upsurge in demand resulting from the adoption of the Common Core State Standards.

But is Houghton the Fool's favorite stock?
There's a huge difference between a good stock, and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report: "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

The article Why Textbook Publishers Are Better Investments Than Their Trade Publishing Peers originally appeared on Fool.com.

Mark Lin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2014 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

Originally published