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"We all face the same paradox. We faculty do the research, write the papers, referee papers by other researchers, serve on editorial boards, all of it for free ... and then we buy back the results of our labour at outrageous prices." That sentiment, expressed in April by Robert Darnton, the director of the Harvard library, is the reason why the rich profit margins enjoyed for so long by publishers like Reed Elsevier will prove unsustainable in the face of technological change.

Reed Elsevier(RUK) is the world's largest publisher of academic journals, with more than 1200 scholarly titles. The publishing division operates at a 36% profit margin - an outstanding margin for any business - but the basis for that profitability looks increasingly vulnerable as the open access movement matures and academics become increasingly aware of viable alternatives. Because profits from the Elsevier publishing division accounted for nearly half of the company's adjusted operating profit in 2011, downside risks to margins could have a significant impact on the overall profitability of the company. The analysis of changes in the open access movement, below, explains why the stock can be expected to underperform its peers. In the following section, we explain why RUK is so dependent on revenues from the core Elsevier division and the obstacles to any future margin expansion. Then, we review the "old" open access movement, the recent move to boycott Elsevier journals, and the new threat posed by competing open access publishers.

Reed Elsevier is dependent on profits from scholarly journals, but while the upside in that business appears limited for the foreseeable future, downside risks are not adequately discounted. Consider the outlook for the other major divisions of the company:

- LexisNexis Risk Solutions (22% of 2011 operating profit) is the brightest spot: growth in operating profits for the risk management services and analytics division has been stable, although momentum has slowed and overall revenue has been flat for several years.

- LexisNexis Legal (14%) is under significant pressure. The division has been losing market share to the Westlaw product from Thomson Reuters, and the successful entry of Bloomberg Law into the field has only intensified competition. The sell-side outlook for this division seems uniformly negative.

- Exhibitions and RBI (17% combined) - these divisions have proven to be cyclical and somewhat unstable, as they are so small that management is not expected to devote significant capital or attention to them. Deutsche Bank noted in a recent report that neither of these businesses seemed to have a "natural home" in RUK.

Source: Reed Elsevier 2011 Annual Report

2011 RUK Adjusted Operating Profit

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A major source of pressure on Elsevier is the decline in university library budgets. The global recession caused widespread reductions in the spending of both public and private universities, and there is little indication that library budgets will resume rates of increase seen in recent decades. Additionally, the political climate in the United States is becoming more hostile to public research and education: Republican state legislatures have made aggressive moves in recent years to slash public university budgets, resulting in the closing of entire departments and university presses and increased pressure on library budgets. It has even become

de rigueur

to ridicule public spending on research and medicine, with anecdotes appearing in GOP presidential campaign speeches in the last two cycles. The climate of fiscal austerity, in short, is unfavorable for any company that depends on well-funded public academic institutions.

Industry analysts are also already highlighting better value in other publishing companies. A February note from Macquarie identified better value in peers like Thomson Reuters, UBM, and Informa, while an April 2012 report from GlobalData flagged the possibility of the Elsevier division losing market share to Thomson, Wolters Kluwer, and in other businesses to Pearson, Dow Jones, and McGraw-Hill. Standard & Poor's recently reaffirmed a sell rating on the company.

Elsevier's upside potential looks capped, since there is no room for top-line expansion given tight university library budgets, and no room for cost-cutting in an industry where the labor of academic researchers, editors, and peer reviewers is provided, literally, for free. Critics note that even the functions provided by Elsevier - journal layout and reviewer coordination - are often outsourced or poorly performed. For some journals, even layout is handled gratis by academics, who submit their articles pre-formatted according to provided LaTeX templates.

We regard the common stock as an implicit naked short put option because, while the upside potential from the publishing division is limited, the downside risk from any revolt by its customers (libraries), laborers (academics), or funders (governments) is not. Elsevier's substantial profit margin has persisted for as long as it has partly because of the lack of awareness and the apathy among stakeholders; those factors are changing.

Open Access, Radicalized

The old publishing model made some sense in a world where expensive print distribution was needed. As the internet made electronic distribution the norm, journal publishers fought to keep prices high even as their costs declined. The open access movement advocated, instead, for passing the savings and simplicity of online distribution on to the academic community. Over the last decade, public opposition to the old model was periodic and sparse, usually limited to a few outspoken professors, librarians, or journal editors.

Social media and improving technology have allowed opposition to rent-seeking by publishers to become more coordinated and widespread. The public relations disaster and boycott triggered by the Research Works Act (RWA) provides an excellent example. In 2005, the U.S. National Institutes of Health (NIH) introduced a widely-praised policy ensuring that the public could access any published research that had been made possible by NIH funding. In December 2011, Representatives Darrell Issa (R-CA) and Carolyn Maloney (D-NY) introduced a bill, the RWA, designed to ban open-access mandates for publicly funded research. The Research Works Act would have prohibited the NIH policy and any others like it from being instituted by any federal agency.

Alarm regarding the Research Works Act quickly spread among the online academic community, and in early 2012 more than ten thousand academics signed a boycott of Reed Elsevier ("The Cost of Knowledge"), promising not to edit, referee, or publish in Elsevier journals until "radical changes" were made to the publisher's business model. The boycott garnered attention from many major media outlets. When Elsevier promptly pulled its support from the RWA, its representatives in Congress -- Issa and Maloney -- announced hours later that they would not push for action on the legislation. It was later learned that Elsevier had made numerous donations totaling $29,000 to the 2012 campaigns of friendly politicians including especially Issa and Maloney (The Guardian). Instead of being content to fight a rear-guard action, open access advocates went on the offensive by pushing for the Federal Research Public Access Act (FRPAA), a bill that would extend the NIH access mandate to every federal agency. In addition to the FRPAA legislation, a campaign sprang up to seek the help of the White House. access2research was founded by Michael Carroll, a law professor at American University and a founding member of Creative Commons, John Wilbanks, a senior fellow at the Kauffman Foundation for entrepreneurship, Heather Josef, Executive Director of the Scholarly Publishing and Academic Resources Coalition (SPARC), and Mike Rossner, Executive Director of the Rockefeller University Press. The four open access advocates met recently with John Holdren, Director of the White House Office of Science and Technology Policy. The meeting was less than The campaign asks open access supporters to sign a White House "We the People" petition---petitions garnering 25,000 signatures are promised a response from the administration.

Opposition is not limited to individual researchers and online coalitions. There is mounting evidence that university libraries and faculties are also finding their voices. In April, 2012, the Harvard University faculty advisory council instructed the faculty and graduate students of the university to pursue several steps to shift university funds and focus away from for-profit scholarly publishers, including shifting their own submissions to open access journals, resigning from the editorial boards of journals that would not permit open access or low-cost subscriptions, "moving prestige" toward open access journals, and several other steps. (Harvard University) A few weeks later, the mathematics department of the Technical University of Munich announced that it had cancelled subscriptions to all Elsevier journals, citing unsustainable subscription prices. In May, Winston Hide, an editor of a top Elsevier-published biomedical research journal, stepped down from his post, citing the publisher's unwillingness to grant access to researchers in developing countries. (Times Higher Education) Inspired by the move, another editor of an Elsevier journal, Bart Knols, resigned from his position days later to embrace the open access movement. The Wellcome Trust, a major charitable organization in the U.K., recently announced an open access policy for the research it funds, and the British government asked Wikipedia founder Jimmy Wales to help develop an open access policy for all taxpayer-funded research. Finally, the Horizon 2020 framework, an ¿80 billion research funding framework for the European Union, will apparently feature significant new policies mandating open access for publicly-funded research. Elsevier denied reports that it had made concerted lobbying efforts to strike open access language from the policy proposals.

Beyond the concrete policy proposals, the fight to make taxpayer-funded research available to taxpayers is radicalizing young academics who were previously content to ignore the issue. One activist, a principal investigator at a research lab at a major university who manages the Twitter account @fakeelsevier and writes at http://fakeelsevier.wordpress.com/, described himself as previously apathetic about access issues. But the effort to stop the RWA radicalized him and many of his peers, he said: it coincided with the campaign to stop SOPA and PIPA legislation, tying the open access movement into the already well-established net neutrality campaign online. The proposal of the Research Works Act was not just a public relations misstep, he said, but a watershed moment that granted new life to the open access movement. The researcher offered a succinct choice to Elsevier and similar publishers in a recent post: "Adapt, or be disintermediated."

Open Access, Sustained

The best argument that the company has put forward to defend their business model is that, in exchange for all of the free labor that makes the business so profitable, Elsevier provides academics with the "high-impact" journal brands that committees want to see on the CVs of tenure applicants. Until recently, the only response from the open access movement was to point out that rentier capitalism is unjust. Today, the best response is that high-impact open access journals exist as a viable alternative to the old model.

Open access publishing is typically divided into two methods. "Green" open access consists of databases and websites where authors archive their papers for free access by the public. Examples include arXiv in the physical sciences, SSRN for social sciences, philpapers for philosophy, and RePEc for economics. Archived articles are usually either reprints of work already published in traditional journals or final drafts completed just prior to publication. "Gold" open access publishing involves full access to the public, right on a traditional publisher's website, often paid for by the article authors. The Public Library of Science (PLoS), founded in 2000, has become an influential gold open access provider. Article publishing costs are typically paid by the institutions or foundations sponsoring the research, and those costs range from $1350-$2900 per article; PLoS offers a fee waiver for authors who do not have the funds to cover publication fees. PLoS attained profitability in 2010. "Public Library of Science is a non-profit organization," says Wilbanks, "but they are making revenues hand over fist. PLoS One went from nothing to become the largest journal by volume in the world three years." Another gold open access model has been successfully demonstrated by the Rockefeller University Press, which voluntarily opens access to its journals after a 6-month embargo (half the time of the NIH access mandate) and yet remains profitable. Executive Director Mike Rossner, one of the access2research founders, notes that institutional libraries are still willing to pay for current research and that switching to a rolling 6-month current access package has not reduced Rockefeller's revenues.

BioMed Central, another open access startup founded in 2000, had established annual revenues in the range of $15-20M when it was purchased in 2008 by Springer Science+Business Media, the second-largest scientific, technical, and medical publisher and Elsevier's closest competitor. Other open access publishers like Frontiers Media and Nature Publishing Group have followed the gold OA model. Wilbanks takes the success of PLoS and the profitable exit of BioMed Central to be signs that the first wave of open access startup models is complete, such that "now we are seeing real experimental business models, competition between open access publishers, and the big guys laying their bets." But where Springer and other major traditional publishers are either buying up open access publishers or developing their own models in-house, Elsevier seems trapped within its current configuration. "Elsevier reminds me of Microsoft during the antitrust lawsuits over the integration of Internet Explorer into Windows...they knew they would have to unbundle Internet Explorer from the operating system, but it was not in their interest to give up a day early." Wilbanks describes the research and development capabilities that Elsevier has by virtue of its size, its user data, and its profitability as unique in the world, but acknowledges that, given its profit margins, it is understandable why the company would not pursue R&D that might undermine its own position.

Elsevier's position, however, is giving an advantage to Nature and to Springer. Brand is still important in the online space, and the reason the Cost of Knowledge boycott is only targeted against Elsevier is that it alone has taken an oppositional approach - its competitors have all embraced alternative and evolutionary business models. Where Elsevier lobbies regulators and attempts to buy favorable legislation, publishers like BioMed actually urge support for the open access petition.

The financial community is taking notice. In March of this year, ING downgraded Reed Elsevier from a buy rating to a hold, citing increased expected capital expenditures, decreasing market share in the legal division, and the success of the open access movement: "Some open source titles have been achieving impressive citation share. For example, PloS Biology now achieves the highest citation share in its subject....Open source is likely to act as a negative pressure on pricing, or at least on price inflation, in the journal market. As a result, we have nudged down our organic growth estimate for Elsevier between 2014 and 2016 to 3% from 4%." Macquarie analysts noted in February that the boycott was indicative of a larger, more threatening trend: " Looking forward for Reed Elsevier, we believe this petition raises the specter again of what technology tends to do to pricing: it makes business models more transparent, and it reduces pricing overall." They pointed in particular to downward trends in both revenue growth and operating margins for the Elsevier and legal divisions. Claudio Aspesi, the senior analyst for European media at Sanford Bernstein, has said that there is no open access model that would allow Elsevier to maintain its current profit margins, and has actually called for the company to break itself up.

Source: Macquarie Capital

Organic Revenue Growth and Operating Margins are Declining

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In a lengthy April report, HSBC tried to rebut several of these concerns, and claimed that open access "has not prove

n a significant risk to date for a number of reasons. There is no business model behind it, meaning it is not clear who will pay to support the labour intensity of organising the editorial process and peer review." This response misses the fact that it is the academics and editors themselves who

already

pay for the process of peer review by contributing their own labor. Additionally, authors and institutional backers have proven willing to fund gold open access journals via article fees. Additional costs related to journal layout, reviewer coordination, and website development are trivial by comparison. Moreover, several open access business models have already been successfully demonstrated, as described above.

Rossner believes that a public access policy like the one instituted by NIH or proposed by FRPAA would not necessarily harm the revenues of publishers. But his optimism and Rockefeller's record of profitability may be better suited to more agile, flexible companies. If open access after a short embargo posed no threat to Elsevier's profit margins, the public relations boost alone would justify a policy about-face, and it is hard to understand why the company was so eager to make campaign contributions to politicians in exchange for their support of the Research Works Act, or why the company would have pushed for the Act in the first place. Instead, the company has remained silent on the issue, and has not dissented from the Association of American Publishers's opposition to FRPAA. Several phone calls and emails to Reed Elsevier seeking their comments on this story were not returned.

One point made by every open access proponent we spoke to was that this is a thoroughly non-partisan issue. Taxpayers are responsible for the overwhelming majority of the scientific, technical, and medical research that is produced around the world, whether via direct governmental agencies and grants or through publicly-funded universities. It only stands to reason, they argue, that taxpayers should get access to the research for which they pay.

There is also a sense of inevitability about the open access movement. The generation that laughed at the thought of paying $18 for a music CD has become the generation that is already used to finding the research they care about in pre-print or open access form at sites like arXiv, SSRN, and PLoS. The special pleading made by for-profit publishers about the costs of data tagging and infrastructure are belied by the straightforward usability of sites like those. While interviewing graduate students and younger scholars for this story, several of them volunteered that if the paywall-ridden publisher sites disappeared from their library access portals tomorrow, they would hardly notice, while any downtime at SSRN or arXiv would be felt intensely.

As for the White House petition and the FRPAA legislation, some observers wonder whether some executive leadership on this issue wouldn't be a painless, costless way for the President to rekindle some enthusiasm among the tech-savvy, young, engaged voters that made such a difference to his 2008 campaign. Giving taxpayers access to resources that they've already paid for is impossible to spin as a partisan special interest, and many companies in the industry have come around to the idea that it is also good policy.

Source: Marketwatch

One-year Performance of Reed Elsevier plc (REL), Wolters Kluwer (WKL), and Informa (INF)

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The short investment thesis for Reed Elsevier is based on: 1) the low-probability but high-impact scenario of a revolt on the part of academics, libraries, governments, or any combination of the three that decides it no longer wants to subsidize this particular corporation; and 2) the new threat from disruptive green and gold open access competitors. As long as Elsevier takes a defensive, oppositional posture, competitors like Springer and others have the experimental open access field to themselves, with all of the brand-building and academic goodwill that comes with it. Neither scenario is likely to have an impact on share prices in the very short term. Even if the White House were to endorse immediately an open access policy on all federally-funded research, it would take some time before the effects would be felt in corporate profit margins. However, lackluster performance in the other business divisions and the short put option payoff structure of the Elsevier division make the company look like a safe short candidate than most. One short term risk to watch for is of an unexpected sale of the exhibitions or RBI divisions at a significant premium.

U.S. investors considering short positions in the stock should note that Reed Elsevier is dual-listed in London (REL) and Amsterdam (REN), with ADR shares of each company trading in New York under the symbols RUK and ENL, respectively. There are listed options on the plc in London, although they are not actively traded.

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At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.