Strong Digital Presence Supports Wiley's Growth Prospects

Wiley's key publishing areas in its research segment include physical sciences, health sciences, humanities, and life sciences. The firm is consistently at or near the top of its peers in the Thomson ISI Journal Citation Report, a leading evaluator of journal influence that measures the frequency that peer-reviewed journals are cited by researchers in other journals. Authors and researchers want to be associated with the leading journal in their specialized field, so there isn't much appeal for competitors to start rival publications. The firm's journal portfolio includes titles owned by Wiley, titles owned jointly with a professional society, and titles owned by societies that are published by Wiley under long-term contracts averaging seven years.

Wiley's education business is facing headwinds, with print book sales declining an average of 13% annually the past three years, the education textbook market in the early stages of its transition to digital from print, and the ongoing shift to rental textbooks. Wiley is looking to become more of an education services business, as evidenced by the acquisition of Deltak, a business that works in close partnership with leading universities to develop and support online degree and certificate programs. The acquisition positions Wiley as an online education services provider and expands the services and content value chain for how people teach and learn. With Deltak (now called online program management), Wiley will now provide a complete solution to help traditional colleges and universities transition their programs online. We view this unit as a key to Wiley transitioning into a digital knowledge and services-based enterprise over the next several years.

Research Segment Drives Wiley's Wide Moat Wiley is a global publisher that generates more than three fourths of its operating profits from its research business segment (formerly called STMS), which we believe is worthy of a wide economic moat. A majority of the company's research segment customers are academic and institutional libraries that consider Wiley's journals and books to be must-have content. The company often licenses its research content with multiyear contracts and has successfully built out its own online distribution platform, Wiley Online Library. The business benefits from high renewal rates, low competition, and high profitability, with contribution margins averaging 45% the past three years. The subscriber base for many of the journals is relatively small, so there is minimal appeal for creating a substitute product, which makes the most popular journals mini-monopolies. We think Wiley's professional development and education segments have narrow economic moats. The education segment focuses on hard-line subjects such as accounting, economics, and science, which benefit from revised editions to generate recurring cash flow.

A portion of Wiley's research journal content contains government-funded research, and there has been continuous debate about whether this research should be made available for free immediately or following a period of embargo after publication. While this has not affected Wiley's results to date, the issue could become more of a headwind in the future. Funding cutbacks at public universities could lead to lower admissions and fewer textbook sales for the education segment. About half of Wiley's sales are international markets, exposing the company's earnings to exchange rate volatility.

Stewardship Remains Exemplary The departure of Stephen Smith as CEO in June for previously disclosed medical reasons and the appointment of COO Mark Allin to the head role will not affect our Exemplary equity stewardship rating. We acknowledge Smith's strong leadership since taking on the CEO responsibilities in May 2011, particularly his oversight of the company's transition from a consumer print publisher to a digital content distributor, international expansion, and integrating value-creating acquisitions like Deltak, Hungry Minds (which added several key brands to the professional trade business), and Blackwell (which allowed Wiley to compete on a more global basis). However, we believe the company is also in good hands with Allin. We expect a seamless leadership transition, as Allin has held a number of leadership responsibilities at Wiley across the globe since joining the company in 2000 with the acquisition of Capstone Publishing (a company he founded) and played a key role in the company's evolution throughout his tenure. We also believe the board will remain committed to returning capital to shareholders through buybacks that tend to accelerate during opportunistic times when the share price declines.

Wiley's financial health is strong. We expect the firm's EBITDA to cover interest expense more than 20 times on average over the next five years. We believe Wiley generates enough cash flow--we forecast free cash flow as a percentage of revenue to average 13% annually the next five years--to comfortably manage its debt, which currently consists of $750 million under multiple revolving credit facilities. We expect Wiley to use future free cash flow to repurchase shares, increase dividends, and make smaller bolt-on acquisitions to boost its capabilities in technology and distribution.