Education's Hot New Trend

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Typically, when we hear about the outrageous spike in tablet sales, we hear only about how the growth is fueled by a shift from PCs to tablets. But that thesis ignores growth from another important segment: the textbook market.

Remember when tablets first hit the market? When Apple (NASDAQ: AAPL) first released the iPad in spring of 2010, not everyone quite got it. Believe it or not, there was a time when both consumers and analysts didn't think that anybody would want what seemed like an oversized iPod Touch. 

However, tablet sales exploded, and soon every tech giant from Samsung to Amazon (NASDAQ: AMZN) launched a tablet onto the market. According to research firm Gartner, tablet sales grew by 97% in 2012, an increase of nearly 60 million units.

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Source: Gartner.

Now that the textbook market is within reach, tablet sales are set to jump even higher.

Kids like screens

What if every high school student in America were issued a tablet on the first day of freshman year? What if it became necessary for every college student to buy a tablet upon enrollment? Those days aren't as far off as they might sound.

E-books have a fixed production cost and a marginal cost of zero, meaning that each additional book sold doesn’t cost the producer a dime. Therefore, relative to hardcover books, e-books can be sold far more cheaply. 

Yes, e-book producers won’t pass every dime of that savings on to consumers – but marketing costs or affiliate payouts aside, e-book dealers like Amazon can use the proceeds from new e-book sales to offset fixed production costs. This means that they will be able to keep excellent margins no matter how cheaply they choose to sell digital textbooks.

In the eyes of savings-hungry college kids, the large initial cash throw down required to buy a tablet might equate to four or five brand new hardcover textbooks. But when you realize that a typical college student will buy 40 books or so in four years, all of a sudden a tablet looks quite attractive.

Textbook publishers hurting

On July 2, textbook giant Cengage Learning filed for Chapter 11 bankruptcy protection, lining up a deal that would erase more than $4 billion in debt from its balance sheet. Cengage’s revenues peaked in 2010 at $2 billion, but revenues slid 7% and dropped to $1.8 billion in 2011, enough to cause serious trouble.

What happened? Two things: debt, and the iPad.

In 2007, Cengage was acquired from Thompson Reuters by a partnership led by private equity group Apax Partners for $7.75 billion. According to Apax CEO Michal Hansen, $7.75 billion was too much, and the high price overburdened Cengage with debt. Hansen also said that “what happened recently was the market came under pressure on the print side,” alluding to the pressure from tablets and digital textbooks. It’s fitting, then, that Cengage now plans to restructure to support its “long-term business strategy of transitioning from traditional print models to digital educational and research materials.”

Cengage isn’t the only textbook company negatively affected by tablets. Conglomerate McGraw-Hill (NYSE: MHFI) recently sold its education unit in an effort to lifts its struggling stock price. The move was triggered by activist investors who were tired of seeing the declining education business weigh down McGraw-Hill’s stock price. Unsurprisingly, education didn’t fit into the company’s new “growth and value plan.” I think that the firm made the right call: since the March sale, McGraw-Hill has seen its stock rise 19%. 

It’s happening now

Replaced by an influx of e-books, textbooks (and the companies who make them) are falling from favor. When Apple released its iBooks application last year, for example, Apple processed over 350,000 textbook downloads within 72 hours. Today, as e-books continue to gain popularity, Amazon and Apple hold 62% and 10% respectively of e-book sales, respectively.

Some readers may be concerned about Apple’s recent reprimand for colluding with e-book publishers to gain market share, but I don’t think the lawsuit will have a large impact on Apple’s e-book sales. The Justice Department isn’t seeking damages, and market share that Apple snagged from Amazon won’t disappear overnight.

On a personal note, the public high school in my area is gradually transitioning to an e-book-only system. Already, each teacher was given an iPad, and students are to be outfitted with them as well (note that the students must return the iPad each year). Administrators say that the plan will save money over time because the school won’t need to purchase thousands of costly textbooks every year.

Final Thoughts

Which stocks will make a killing on the shift to e-books? First, tablet producers Apple and Samsung. The two tech companies own 58% of the tablet market, with Apple in the lead at 40%. Being the first mover in a market is a major advantage, and Apple effectively created the tablet market from scratch.

Second, Amazon and Apple are in position to corner the digital textbook market – both have various deals with publishers that will make market penetration difficult for future competitors. And if history is any indicator, taking down an industry’s major players is a difficult feat.

Lawsuits aside, both Apple and Amazon will benefit from a vastly expanded e-book market in coming years. Apple’s e-book sales will help drive iPad growth, while Amazon’s large market share will push both Amazon’s Kindle tablet and Kindle e-reader sales.

There is more to the tablet boom than a declining PC industry . Digital textbooks are here to stay. 

This article was written by Randy Holcombe and edited by Chris Marasco. Chris Marasco is Head Editor of ADifferentAngle. Neither has a position in any stocks mentioned. The Motley Fool recommends and Apple. The Motley Fool owns shares of and Apple. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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