Companies change during ownership, sometimes a growth company slows down and becomes a mature company. Other times a mature, stogy company gets a breath of fresh air and experiences new growth. A cyclical company gets to experience all of these dynamics in the period of a business cycle, growth, to maturation, to decline, and back again. Goodheart-Willcox (GWOX), the subject of this post is most definitely a cyclical, but they've also experienced some change since I first purchased them.
I ran across Goodheart-Willcox in the Walkers Manual, the numbers in the manual intrigued me, from 1998-2001 the company had earned anywhere between a 24% and 32% return on equity, and EPS had grown at 25% annually. I was even more impressed with the ROE when I noticed the company was debt free. I was curious about how they were doing now, so I picked up some shares and contacted the company for an annual report. I received a few years worth of reports and liked what I saw. In the years between 2001 and 2011 the company had continued to throw off excess cash, but with reinvestment opportunities limited cash just piled up on the balance sheet. The company had become what value investors affectionately call a "cash box". A cash heavy company with a business bolted on.
So what is the business of G-W you ask? They're a textbook publisher. Most readers will see the last line and think "no wonder they're a cash box, dying business, dying industry, and relies on government funding." That's the bear case in a nutshell, a bit more information might change some perceptions, but my guess is for 99% of my readers this stock is untouchable because of some preconceived negative bias. I understand that, I've wrote about this stock to a number of investor friends, and all of them came back with some variation of my above sentence. I've heard it said that courage of conviction, and patience are two skills investors need to succeed. Both of these traits are required in double doses for G-W.
I want to try to respond to the bear case as best as possible, but I understand most who grab onto it won't ever be persuaded. Even though text books in paper form might be going the way of the dodo bird, G-W is ready, they already publish digital formats of each book. My guess is everyone who believes paper books are going away imminently doesn't have any close friends, or relatives who work within the education system. My wife was a teacher before our kids came along, and for better or worse it's safe to say that American schools aren't exactly the type of institution that implements change quickly. Some could make an argument, a good one, that the system is almost setup to avoid any change. Change does happen, but it's slowly, and even more slowly in rural districts. One more in favor of G-W is that they don't actually print the books, they're strictly a publisher, all printing is sub-contracted out. This means if paper textbooks were to disappear G-W wouldn't be saddled with factories full of idled printing presses.
The biggest argument against G-W is that they're beholden to school districts and education budgets at the state level. The company's revenue comes from two sources, technical schools, and statewide textbook adoption. If a state doesn't renew their books G-W's results take a large hit. This can be clearly seen in their 2012 results, a year where no states renewed any textbooks. Sales dropped from $21m (2011) to $16.9m (2012), furthering the pain, net earnings dropped from $3.27 p/s to $1.11 p/s.
The school book adoption cycle and renewal phase is what makes G-W cyclical. Their business cycle closely matches the economic cycle in the US. In the late 1990s the company was very profitable and thriving only to be hit in the 2002 downturn. Coming out of that sales and profits picked back up peaking at $10.79 in 2006. The latest downturn has hit G-W the hardest with EPS dropping close to 90% as sales bottomed out at $16.9m in 2011.
My thesis on G-W has been that schools can't put off textbook adoption forever. When I first came across the company I spent a lot of time reading about textbook purchases, as well as interrogating my wife on her experiences. Some books like math don't change much, but five years without an update to a history book is an eternity. Even a relatively static book like an English textbook needs to be updated to keep pace with the constantly evolving language. I read a few articles which mentioned parents who were so upset that they purchased their own textbooks for their children. I'm glad to see this level of investment on the parents part, but it's sad that it takes years of underinvestment on the school's part before the parents get involved. All of this is a long way to say that while the current trend is depressing I felt it couldn't go on forever.
The reason I'm writing this post now is because I just received G-W's first quarter results in the mail on Saturday. It's an old fashioned letter from the CEO explaining the state of the business concisely, without any legalese. More is expressed in this letter, which is only two pages, than in some 10-Qs that are multiple times as long.
What's important isn't the actual letter, but the content, and the sign that the market is finally turning. G-W's first quarter results were a 31% increase over last year, and a 5.4% increase over two years ago. The company is also making significant progress in their digital sales, an encouraging sign for a world going digital. Operating profit in the first quarter alone is double what the company did in fiscal 2012. The company earned $3.06 per share in the first quarter.
I mentioned in the beginning that the company was a cashbox when I purchased them. During the time I've held the shares the company has changed undergone a change. Management determined that instead of holding tons and tons of cash, they should only hold tons, and use the other ton to buy back shares. Over the past year share count has been reduced 20%. The shares were purchased at or below book value, when the outlook has been the worst. I'd say management did a pretty good job at timing the market with their repurchase. It's also encouraging to see that management is shareholder friendly, and willing to return cash when reinvestment opportunities don't exist. The share buyback should supercharge earnings as results improve.
For a cyclical the big question to ask is how much could they ultimately be worth at the top of the cycle? The company still has $48.94 p/s in cash, and could potentially earn $10-12 p/s in earnings again once the economy eventually recovers. I don't think it's a stretch to say G-W is potentially worth double where they trade now.
For those interested I've included the financials that I have for the company below. Before anyone asks where the following is from, it's from a project on unlisted stocks I've been working on, and I'm hoping to unveil shortly. I believe the dividend data below is incorrect.
Talk to Nate about Goodheart-Willcox
Disclosure: Long GWOX