March 15, 2011 - 11:10pm EST by
2011 2012
Price: 32.83 EPS $2.76 $2.85
Shares Out. (in M): 301 P/E 11.9x 11.5x
Market Cap (in $M): 18,537 P/FCF 11.1x 11.8x
Net Debt (in $M): 5,702 EBIT 2,491 2,512
TEV ($): 24,239 TEV/EBIT 9.7x 9.6x

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Long: Reed Elsevier (REL LN)

Note: the data on the top of this page is data for the Reed Elsevier PLC ADR, so the data is in dollars.  The rest of this write up is shown in the actual London shares priced at 508pence, and any other data is shown in GBP.

Price: 508 pence

Market Cap: £11.6 Billion

TEV: £15.1 Billion

TEV / EBITDA: 8.5x

TEV / EBITDA - Capex: 10x

TEV / Adj. Op Profit: 9.6x

'11 P / E: 11.5x (11x consensus)

Dividend yield: 4.5%

FCF yield: 8.5%


Reed Elsevier is a great company trading at a very reasonable price.  It has an amazing business model - REL owns a bunch of mini-monopolies on informational content that is critical to legal, scientific, medical and academic fields.  With exclusive ownership of this critical content, REL has a tremendously strong market position and pricing power.  REL's exclusive content and captive customer base is impossible to replicate. 

The company has great financial characteristics - negative working capital, low tax rates, significant tax shields from previous acquisitions.  Add it all up and the business is yielding ~8.5% FCF yield after only 25% debt/TEV leverage.  Longer term REL should continue delivering mid-single digit organic revenue growth and high single/low double digit cash flow growth in the core businesses.  There are some nearterm headwinds on academic funding which should largely be offset by an ongoing recovery in legal and business spending. 

I'd argue that this business just shouldn't be available at an 8-9% free cash flow yield, under 12x cash earnings.  Near term growth will continue to be lower than usual in the low single digits (op profit growth mid single digits).  But longer term it should regain mid single digit sales growth and high single digit/low teens operating profit growth.  I'm thrilled to buy this business at a low teens cash earnings multiple.  I don't put much stock in historical trading multiples, but for reference REL has historically traded at an average of 18x earnings, and one would think expect it should trade at a higher multiple now given cyclical compression in the RBI and Exhibitions businesses.  Based on REL's market and pricing power and long term growth prospects, I would still be a buyer of this company at a 30% higher price (15x earnings, ~6.5% free cash flow yield) and I would be a very happy owner at that level.   

A quick note on all the Reed Elsevier tickers -- Ownership structure is a little messy with 2 publicly traded companies - the UK company has a 52.9% economic interest ("REL LN", or ADR is "RUK") and the Netherlands company has 50% economic interest ("REN NA", or ADR is "ENL").  The UK co trades at a premium because management grosses up UK dividends for withholding tax.  So if you are a taxpayer, your UK dividends come with 10% tax already paid on it. So the rough rule of thumb is buy UK in your onshore fund where you can utilize the witholding tax, buy Netherlands in your offshore or tax free fund. All the numbers I use in this write-up are for the premium priced UK business, so multiples look slightly better on the Nethernalds company. 


Company Overview

REL's business model is to collect information from an industry, analyze, accredit, review, catalogue and re-package this information, embed its information services in the core of its customers' businesses and sell access at a large markup.  Though this seems like a business model ripe for disintermediation, in conversations with market participants it appears the fragmented nature of the industries REL serves, the mission critical nature of the information REL provides, the high value of the packaging and cataloguing  services REL performs and the credibility and trust associated with the Company's brands give REL a very powerful position within a highly fragmented user and information generator markets (illustrated by 4-8% annual pricing increases and 29% EBITDA margins).

REL has 4 platforms: Elsevier, Lexis Nexis, Reed Exhibitions and Reed Business Information.  Elsevier and Lexis Nexis, contribute ~80% of its operating profits.  The two other businesses (primarily B2B magazines and trade shows) are highly cyclical but stabilized at low levels in 2010 and generally offer strong cyclical upside from here.  The Company has an emerging new platform in its monopoly insurance data business Choicepoint (contained in Lexis Nexis) which will provide a new growth engine going forward. 


Elsevier - Science Technology & Medicine publishing - 34% of revenue, 45% of profit

Elsevier is the leader in STM publishing, generating ~25% of the scholarly articles published each year, and more importantly, controlling many of the most prestigious journal titles.  Publishers own the copyright on published research, giving them exclusive control of the content and essentially mini-monopolies on each piece of research.  This research is critical to the daily work of academics, universities, institutions, doctors and hospitals who have little choice but to purchase these journal subscriptions at the publishers' asking price (typically >$1k/year).  In discussions with librarians and users it is clear that Elsevier is the single most important STM publisher, controlling not only the broadest content but much of the most valuable content (heavily searched & cited).  The journal business typically pushes through 8-10% pricing increases on its captive customer base.  While the academic library community sometimes fumes at this treatment, Elsevier has actually won points recently (or to quote, "is less evil") by increasing prices "only" ~6% while some competitors continue to try to push through double digit increases despite customer budget cuts.  Elsevier and other major publishers bundle journals in 3+ year contracts, though the contracts have renegotiation outs which today are being triggered by budget cuts.  The squeeze between increasing journal pricing and ongoing budget cuts falls mostly on print titles, and on marginal journals (those with the least searches).  This gives Elsevier the opportunity to continue growing organically at the expense of competitors despite an academic spending recession.  Organically growth that was historically 5-6% per year was reduced to 4% in '09, and 2% in '10.  Much of this impact is from the 10% of revenue that was derived from pharma advertisements and was hit hard during the downturn.  This business will continue growing, but it should be at reduced low single digit rates for another year or two.  There are two risks to this business that deserve consideration, but I don't expect either to have a major impact:

Near term - Academic & Research budget risk - Elsevier's customer base is under budget pressure.  This has been the case for a few years, and Elsevier has continued squeezing through price increases, but has pushed for smaller price increases to be respectful to its customers.  There is some risk that customers drop titles altogether, and this risk is highlighted by Bernstein research.  Bernstein thinks the "big deal" might be at risk (the big deal is where Elsevier packages access to a huge bundle of titles at a rate vastly reduced from list price).  Bernstein points a few examples of libraries that cut the big deal because they needed to reduce their budgets.  I usually have a very high regard for Bernstein's market research, but in this case their findings just don't square with the customer base that I've spoken to, al of which feel budget pressure but none of which are considering dropping the big deal (call your local university library, librarians are happy to chat).  In fact every library I spoke with said they would cut lesser journals, cut print, but wouldn't consider cutting Elsevier.  In fact the examply library Bernstein cites underscores just how contra-logical it would be for a library to cut it's big deal --- by going off the big deal to list pricing, the library was able to save 30% on its Elsevier subscription cost, but only by sacrificing 93.5% of their titles.  To be a competitive research institution your participants must be able to access the latest research and you just can't do that if you cut your access by 93% (even if this is the least-used 93%, it is still used). 

Long term - Disruption risk - the inherent inequity of Elsevier's model to a) take content authored by the industry for free, b) peer review it using industry resources for free or minimal cost, c) sell it back to the industry at exorbitant rates, has always been criticized.  Open Access to research is being championed louder during current budget cuts, but it has been championed for over a decade without much real progress.  Some research funding institutions, notably the NIH and Harvard, have now mandated open access for research they fund, but only 12 mo. after publication (which is not a threat to journals' business model because institutions must have the latest information).  However, Open Access continues to face significant industry resistance that has prevented its adoption to date:

  • Prestige & being published in the right journals is the currency of the academic trade, dictating job opportunities, pay, research funding etc. Authors will not choose an open repository if they have quality work worthy of publication in a prestigious journal.
  • Peer review process run by publishers truly does add value and credibility to scientific work (top journals have >80% reject rate). The industry needs a process to validate research and separate the mundane from the extraordinary.
  • 12-mo lagged Open Access does not threaten the publishing model
  • Silo'd research fields and publications distribute risk of any sudden shift towards OA
  • Historical research copyrighted by journals is valuable (39% of research published in '09 referenced pre-1990 work)
  • The publishing process is costly and Open Access suffers a lack of credible funding solutions

Open Access pressure appears confined to science rather than medicine.  Medical librarians I spoke with recognized the costs but were a bit blasé about the issue - if healthcare ever does focus on cost there will be plenty of wood to chop before they get down to the subscriptions (though an academic-led Open Access revolution could always inspire the medical libraries).  I believe Open Access is far and away the greatest long term risk REL faces but at this point it is nothing more than talk, and that hasn't changed much for a decade.   


Lexis Nexis - 43% of revenue, 38% of profit

Legal products - Lexis (28% of revenue, 15% of profit) (sub segment of Lexis-Nexis)

Reed Elsevier's Lexis product is one of two main legal research services in a tight duopoly.  Westlaw and Lexis (collectively "Wexis") services are vital to the legal profession and each service has lifelong loyal client bases.  Like Elsevier's scientists and doctors, lawyers across the board tell me they could not do their job, period, without Wexis service.  The services go beyond simple legal search, with both Wexis firms employing large legal teams (>1,000) to creating their own proprietary content and analyze, tag, interpret, link etc. legal research to make it accessible, usable and authoritative. 

Westlaw and Lexis win their market share in law schools where 1Ls become preferred users of one system for life.  Wexis each give their services to law schools nearly for free, hook their young lawyers, then charge very expensive subscription fees to professionals. Both companies are aggressive on pricing, pushing through 4-6% base price increases per year augmented by continued addition of more paid services.  Most lawyers estimate the market is roughly 50/50 westlaw/lexis users which underscores the ubiquity of each system, but a greater proportion of lawyers and legal students I spoke with are westlaw users, in keeping with westlaw's higher overall market share. 

Large firms will purchase access to both services, with usage driven by jr. associates who do most of the legal research.  While large firm librarians convey mild frustration with Wexis' price increases, they do not appear empowered to push back too hard as the research is viewed as critical to the legal process and research fees are passed through to clients anyway.  Associates' usage is not typically monitored.

Smaller firms may have access to one or both services.  The small law firm market is more price-sensitive and will monitor its associates use to varying degree, though it still passes on much of its research costs to clients.  However Lexis and Westlaw don't compete on price and both continue to push through large price increases.  Small firm market share is very stable driven by deeply-ingrained lawyer preference to stay on the system they are familiar with. 

In conversations with law students, Westlaw seems to be the preferred service by a small margin, mainly for its user-friendliness (Lexis is aware of this as they revamp their system).  Most users estimate a 50/50 or 60/40 type share split. 

Reed just recently showed Lexis legal profitability separated from Risk solutions, and legal had surprisingly low 14% margins (vs. ~29% for Reuter's Westlaw).  Management explained these margins had fallen from the low-20s in the past few years based on increased investment as they revamp the Lexis platform, and slightly reduced revenues (revs down ~7% in total over the past 2 years as the recession hit).  Mgmt believes margins are steady in the near term as increased investment continues, and increase in the longer term.

Disruption risk - The market is concerned about 2 possible disruptions.  First, that Google Scholar and other simple indexing services (fastcase, casemaker) could supplant portions of Wexis' business.  These free search services have been around for a long time but are simply not comparable services to Wexis (akin to swapping a Bloomberg terminal for yahoo finance).  A lawyer estimated using free services would require 1.5-2x his time, and he would never trust the results.  Today's renewed concern seems more of a reaction to headlines and the brand "Google" being involved than an improvement in free-to-use product (incidentally few lawyers or students I spoke with had heard of Google Scholar, none had used it).  

Second, Bloomberg ("B-law")is again trying to rollout a competing product, following a failure 5 years ago.  Bloomberg did hire a legal team to try to build content comparable to Wexis.  However, 3 major law firm head librarians I spoke with who tested the product agree it falls far short on content.  Further, none of the 3 can picture themselves ever paying for the Bloomberg service.  These top-10 law firms are the ones that would be most likely to pay for Bberg - relatively insensitive to cost, do a lot of securities work (where B-Law is focused).  Further, no law students I've spoken with are interested in trying B-Law.  B-Law faces a chicken and egg problem - law students won't learn a system that's not used professionally, and law firms won't pay for a system that none of their lawyers know.  On top of all that, it's a me-too product, it doesn't have anything Wexis doesn't already cover.  So what's the point?


Risk Solutions - (15% of revenue, 23% of profit) (sub segment of Lexis-Nexis)

Risk solutions is primarily composed of the Choicepoint business which was acquired in 2008 (85% of risk solutions' profitability).  The remainder is a small background check business.  The Choicepoint business is an industry database that gives consumers' risk histories.  Insurers won't share their customer histories with eachother for competitive reasons, but provide those histories to Choicepoint as an industry repository.  Every time you get an insurance quote on the internet the companies pay Choicepoint to access your history (it's all automatic data feed).  No other company does what Choicepoint does, insurance companies aren't allowed to share their information with others, and no insurer could compete in the market without this information.  It's a great business that is growing quickly and churning out 38% margins.  Transaction volumes are growing quickly driven by internet comparison pricing, and Choicepoint costs are a tiny portion of the insurance cost structure with large impact on underwriting results.  This business is already contributing 23% of REL's profit and has enormous potential as the 3rd main REL business platform.


Reed Exhibitions - 11% of revenue, 10% of profit

The exhibition business runs big industry expos and trade shows.  Exhibitions gets most of its revenue from exhibitor participation fees, supplemented by advertising and sponsorship revenues.  Reed is the #1 exhibition player in a very fragmented industry.  This is a cyclical business, when the economy is bad fewer participants attend shows fewer presenters pay for space.  It is also produces volatile profits as some of the big shows occur every other year instead of every year.  However it is a lucrative business to be in if you have the leading show in a given industry.  Every industry will have multiple trade shows, sometimes dozens.  But there is always THE important show - for instance there are dozens of electronics trade shows, but only one CES. It is having that most desired show that allows a company to charge the highest prices, make the most profit, drive the highest ROIC.  In a downturn a company may decide to only attend the 2 important industry shows rather than having a presence at all industry shows.  Reed's Exhibition portfolio is concentrated in the #1 and #2 slots, which enables them to make very strong margins and ROIC.  The difference between a #1 show and a #5 show is simply consumer perception and it is damn near impossible to change because it is self-reinforcing, the big players will make their big announcements at the big shows (much like how Elsevier's leading journals are self-reinforcing, the best research studies will apply to be published in the most respected journals first). 

At the same time Exhibitions can still expand organically by creating new number one shows, often by being a pioneer in emerging markets or emerging technologies that are undercovered (early leader in photovoltaics, took some early beachheads in emerging market shows).  Despite the quarterly and annual volatility in this business it is a great business with higher returns on capital and strong margins.  It is poised for cyclical recovery with the economy.  Revenue decline slowed to 3% in 2010 from 13% in 2009 (that decline is on a like-for-like basis, exhibitions actually grew 8% organically in 2010 but it was mainly due to the bi-annual impact of show cycling). 


Reed Business Information - 12% of revenue, 6% of profit

Reed was trying to sell RBI in the year leading up to the downturn.  Price expectations had been ~£1.5B, but it is unlikely Reed could receive that today.  This is the toughest of Reed's businesses.  They produce industry publications and maintain some subscription-based industry databases.  Although Reed has many leading titles and some valuable database sales in here, the business as a whole is challenged.  Print subscriptions are under pressure, and many of the titlesm particularly the US-based magazines, are free circulations supported by paid advertisement.  This is cyclically driven advertising spend for Reed's customers and Reed was slammed during the downturn with 2009 revenues organically down 18% after growing low single digits for most of the decade.  This is not a great business but it appears to have reached a bottom, revenues declined only 2% in 2010 and operating profit actually organically grew 4%.  A number of underperforming business were sold or closed in 2010 and the remaining businesses appear to have steadied and have significant cyclical upside from current levels.  This business is only 6% of profitability. 


Company Outlook

Reed Elsevier faces a few subpar growth years as REL's subscription lag (45% rev) will extend the impact of the economic cycle.  Revenues grew 1.7% organically in 2010 after falling 6.4% organically in 2009.  Going forward I expect to continue seeing low single digit growth in the legal & Elsevier businesses in the near term, and higher growth in RBI and exhibitions as they recover from a hard cyclical hit in '09.  On an aggregate basis this translates to low single digit topline growth with moderate continued operating margin expansion for the next 2 or 3 years, followed by growth accelerating back to the mid single digits topline, ~10% at the op profit level over the next 4-5 years. 


Overall this is an incredibly well positioned business.  Reed's business strategy has been to get exclusive, monopolistic control over content that is entirely critical to customers' ability to do their jobs.  Reed's customers simply can't do their work if they don't pay Reed for information (lawyers, researchers, doctors, insurance companies).  Reed has an exclusively monopoly over this mission critical information and though Reed doesn't supply it cheaply in the grand scheme of things Reed is not a large part of an institution's research budget, a lawyer's business costs or an insurance company's underwriting costs.  The opportunity to buy into that kind of market position at an 8.5% free cash flow yield is compelling. 


Not really a catalyst driven stock, just a fundamentally cheap one.  I expect there is upside when management releases more guidance, likely at their May investor day.  I also expect in a year's time the market will have stronger conviction in REL's growth prospects.
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