Rumors Have It

I wanted to introduce you to Hedgehog Henry brought to life by Cheryl  Kirk Noll’s in her new picture book dummy.  At the end of last month, I featured Cheryl on Illustrator Saturday – http://wp.me/pss2W-5l5.  That was the week I was away running the Ocean Writer’s Retreat.  I had most of it up before I left and figured I could finish it on my down time.  Well, my best laid plans didn’t work out and I struggled to get Cheryl’s post finished in time.  Lot’s of connection problems and working on a small laptop had me pulling out my hair.  So I want to apolgize to Cheryl and put up Henry, since he was left behind.  He is a very cute character and I feel bad that I missed showing him off to you for Cheryl.  Hope you like him.

Publisher’s Lunch reports that the fanciful rumors of a Penguin/Random House merger changed to a factual possibility on Wednesday morning when Pearson issued a brief statement responding to recent press accounts: “Pearson confirms that it is discussing with Bertelsmann a possible combination of Penguin and Random House. The two companies have not reached agreement and there is no certainty that the discussions will lead to a transaction. A further announcement will be made if and when appropriate.”

Penguin Group ceo John Makinson followed the Pearson press release with a short cover note to Penguin employees soon thereafter, attaching the announcement “concerning a potential partnership.” Makinson acknowledged “that this will be unsettling” to employees and apologized for being unable to say more, telling staff that they were “thinking first and foremost about the best and long-term interests of the company.” (A Random House spokesperson said the company and Bertelsmann were not commenting.)

By multiple accounts, the two parties are discussed a separate entity that would own the two publishers. The WSJ’s source says Bertelsmann would hold “slightly more than half the shares” in the combined book publisher. If the ratio were based on last year’s sales, Penguin would comprise about 43 percent of the combined revenues of roughly $4 billion. The FT’s versionsaid “discussions have focused on a merger in which Bertelsmann would have a stake of more than 50 per cent, according to three people familiar with the negotiations, who warned that talks could still fall apart…. If the merger talks are successful, both Markus Dohle, chief executive of Random House, and John Makinson, chief executive of Penguin, are expected to take senior leadership roles.”

That said, “a combination of two of the world’s top four publishers may face scrutiny from competition authorities in various markets.” One market where you can be certain discussions with the authorities would be required is the US, since Penguin is currently in litigation with the Department of Justice over ebook price-fixing allegations. Presumably in order for a combination of those two companies to win antitrust clearance in the US, Penguin would wind up settling the lawsuits (which raises the secondary question of whether they would do so in such a way that it affects only the Penguin part of the business, or would it apply to the entire merged company).

How big would the combined market share of “Penguom House” in the US? The practical answer is, “big enough to have some negotiating leverage with their largest customer.” Popular accounts talk about a Penguom House having over 20 percent share of the US market–which is based on a modeled BookStats vision of a trade world that generates $12.5 billion a year for publishers. (One erroneously low trade account puts their combined US sales at just $1.8 billion, so be careful what you read.) If you go by the measurable “mainstream” trade business, the pool of close to 1,200 publishers now reporting actual sales figures to the AAP, you get to a business that’s more like $6.5 billion, and the two houses combined start looking like 40 percent market share–and a higher percentage still of bestsellers and “big six” books.

Pearson is probably happy to have less than a controlling share, since it would let them separate Penguin’s accounting from the rest of the company, and allow Pearson to trade as more of a pure education-focused company. Still, the deal would need to account for Pearson could exit further down the road. A separate FT account cites a source confirming “‘they want the ability to put their stake to Bertelsmann,’ but Bertelsmann’s balance sheet may constrain its ability to guarantee a full takeover in the near term.” Indeed for Bertelsmann, which has been evaluating a variety of other investments–including buying back Springer–growing their trade publishing presence without significant cash investment has significant appeal. Bernstein Research, often an advocate for Pearson to sell Penguin, writes in a research note, “As long as there is a good set of shareholder rights that put Pearson in a strong negotiating position at the moment they want to dispose of the business, you should imagine shareholders would not have too many qualms about it.” They add, “The flipside is, once you commit to this structure, there’s no other buyer for the stake.”

For Pearson, it may be a very clever answer to continuing calls from some investors and analysts to explore a sale of Penguin. The problem has been how do you sell a trade publisher of Penguin’s size in today’s investment market at a price that Pearson investors will tolerate? The proposed deal provides a palatable answer by effectively serving as a “cashless sale.” At the same time, the news of the deal lets Pearson softly shop Penguin before finalizing anything, and without hiring a banker and making a formal offering. At this point, anyone who might have had serious interest in Penguin knows they need to make a move now.

The initial reaction from analysts and investors looks to be giving Pearson plenty of room to maneuver. The reaction has been mildly positive with shares up less than 1 percent in today’s trading. As an analysts at Investec put it, “we view this as a possible net positive but not a game changer – while we see some EPS upside via near-term merger/cost synergies in a pressured top line business, this does not imply cash returns to shareholders or re-investment in long-term growth education assets.” So with or without an actual deal, Pearson and Penguin should come out of this well.

Such a combination would have other trade players quickly evaluating combinations of their own to achieve similar increases in scale. HarperCollins is thought to be in a solid place in News Corp.’s planned spinoff publishing company, since the book business is much more stable than the newspaper business right now. They are still integrating Thomas Nelson, and that $200 million investment was another sign of confidence from management. (You’ll recall that News Corp. famously turned down a reported $2 billion offer for Harper from Bertelsmann a number of years ago.) That leaves Lagardere Publishing, long an aspiring buyer of more trade publishing assets, though not as flush now as they have been in recent years, particularly with the market weakness in France and Spain. Simon & Schuster, for years the subject of sale rumors without ever being sold, the prime focus of the next round of speculation.

In a prescient session at our Publishers Launch Frankfurt conference earlier month, Providence Equity Partners senior advisor Brian Napack suggested that now is a good time for investors like his company to be looking at trade publishing assets. “Consumer demand has been very stable for a long period of time,” he said. “We know people like to read books, and have proven willing to pay for them.” Napack suggested that “I do think scale really matters now…. The scale of having a backlist, with brands and product that people want is going to be immensely helpful in this transition period that we are going through. The ability to leverage the assets that are on your balance sheet is going to be critical.” He also emphasized having “a global perspective on the industry,” noting that “he who owns the most rights wins.”

In a separate, little noted item, Germany’s Manager Magazine, which was the first to report on the Penguin-Random House talks, also maintains that Bertelsmann is in separate negotiations to buy out Mondadori’s share in the Spanish-language joint venture Random House Mondadori. They claim those “talks reportedly stood close to completion.”

Talk tomorrow,

Kathy