April 20 (Bloomberg) -- Just inside the Borders bookstore on Park Avenue and 57th Street in New York, a large rack labeled ``Fiction Bestsellers'' displays 10 large-format paperbacks.

Smaller mass-market paperbacks from such publishers as Pearson Plc's Penguin Group don't have their main display until well into the fiction department: wall racks of romance novels near the yellow-covered CliffsNotes guides beloved by students.

Penguin created the market for cheap paperbacks during the Great Depression in the 1930s. Now it's grappling with an upheaval in the industry that led to its first sales decline in six years last year. Mass-market paperback sales in the U.S.'s $23.7 billion book industry have fallen 11.5 percent so far this year, following an 8.9 percent drop in 2004, according to the Association of American Publishers.

``It has been a drag on the business,'' says Robert Talbut, chief investment officer at Royal London Asset Management Ltd., which oversees 24 billion pounds ($46 billion) in assets, including Pearson shares.

Talbut says Pearson, which also owns the Financial Times and the world's largest textbook publisher, might be better off selling Penguin, publisher of thriller writer Tom Clancy. Asked whether Royal London Asset Management will keep its Pearson stake, Talbut says: ``Unsure.''

Marjorie Scardino

Penguin has been harder hit than competitors such as Viacom Inc.'s Simon & Schuster and Bertelsmann AG's Random House because it still gets a third of its revenue from the smaller paperbacks, says Luke Swanson, a Pearson spokesman. That compares with less than a quarter for the industry overall, according to the New York- based Association of American Publishers.

Pearson Chief Executive Officer Marjorie Scardino, who will address shareholders at the annual meeting on April 29, is under growing investor pressure to boost sales and earnings. Pearson's shares have dropped 5 percent to 634 pence since she took charge in January 1997. Scardino, 58, an American who grew up in Texas, said at the time she aimed to double the value of the company, which also owns half of the Economist magazine.

Pearson has no plans to sell Penguin because it fits well with the textbook business, Swanson says.

Pearson's stock plunged from a record 2,329.46 pence in 2000 during the Internet boom, as the education division stagnated in the U.S., where an economic slowdown forced state governments to slash spending on textbooks. A drought in advertising by banks and technology-related companies pushed the Financial Times to losses in the last three years.

`Secret Life of Bees'

By contrast, Penguin's sales and earnings rose every year from 1999 to 2003, driven by best-selling novelists, including Patricia Cornwell and Sue Monk Kidd. The publisher, based in New York and London, has sold 3.5 million copies of Kidd's 2002 book ``The Secret Life of Bees.''

Then the tables turned. As the Financial Times returned to profitability in the fourth quarter last year and Pearson started predicting a new wave of U.S. textbook orders, Penguin posted an unexpected 41 percent decline in 2004 operating profit to 54 million pounds.

``There's been an element of serial disappointment at Pearson,'' says Jim Stride, managing director in London of Axa Investment Managers UK Ltd., which owns about 18 billion pounds of stock in the U.K., including Pearson shares.

Penguin started the mass-market industry 70 years ago when it converted U.K. library-book borrowers into buyers by selling paperbacks for just sixpence, then the price of a pack of cigarettes. The small-format books now generally cost $7.99 in the U.S., where Penguin gets two-thirds of its sales. That's on average more expensive than the price of cigarettes now.

Dowdy Gold Embossing

Today, consumers shun mass-market paperbacks, which still feature the gold embossing they've had for decades, because they have a dowdy image compared with flashier trade paperbacks or handsomely packaged CDs and DVDs, Penguin CEO John Makinson, 50, said at a Feb. 28 meeting with analysts in London. ``The consumer is trading up,'' he said.

Discounted hardbacks, trade paperbacks and used books promoted on the Internet are also killing the main appeal of mass- market paperbacks: their price, says Albert Greco, a marketing professor at Fordham University in New York and researcher for the Book Industry Study Group, a nonprofit organization in New York whose members include publishers, retailers and libraries.

The competition comes from within Penguin itself in some cases. At a Barnes & Noble Inc. store in midtown Manhattan, Clancy's 2003 novel ``The Teeth of the Tiger'' sells in hardback at the discounted price of $5.98 on a table for ``Former Bestsellers.'' His $7.99 mass-market paperbacks line shelves just 20 feet (6 meters) away.

Migration to Trade Paperbacks

Trade paperbacks, which use larger print and have more space between the lines, tend to cost from $12.95 to $14.95. They are attracting older readers, who have more disposable income and prefer the comfort factor, as well as younger consumers, says Tom Dwyer, director of trade books at Borders Group Inc.

``There's been a migration to trade paperbacks as the preferred format,'' says Dwyer, from the company's headquarters in Ann Arbor, Michigan. ``It is more aesthetically pleasing.''

Harlequin Enterprises Ltd., best known for its sultry, mass- market romances, now publishes one-third of its titles in the trade paperback format, says Katherine Orr, a spokeswoman.

``The whole marketplace is changing as people's reading habits are changing,'' Orr says. Harlequin is owned by Torstar Corp. of Toronto.

Chick Lit

Harlequin had to bring its storylines up to date, as well. Instead of the traditional happy ending with the heroine finding true love, the new themes often focus on landing a job or other sorts of fulfillment, she says. One such title, ``Fashionistas'' by Lynn Messina, chronicles the adventures of an editor at a hip magazine. It's being made into a movie starring Lindsay Lohan.

``Chick lit shows that a whole generation is willing to buy trade paperbacks, where mass market is seen as their mother's genre,'' says Louise Burke, executive vice president of New York- based Simon & Schuster and publisher of its Pocket Books imprint.

In an attempt to lure readers back to smaller paperbacks, Penguin and Simon & Schuster are starting competing lines of $10 ``premium paperbacks'' with bigger print and better paper quality, about $2 more than their mass-market editions. Six of Penguin's best-selling authors will be published in the premium format in the next several months.

`Designed for Comfortable Reading'

Early sales of Penguin's first premium paperback, Minette Walters's ``Disordered Minds,'' published in December, are encouraging, Makinson said in February. The book stands about a half-inch taller than the mass-market versions and has a red circle on the cover stating: ``Specially designed for comfortable reading.'' The book has 29 lines of text per page, compared with 38 lines in the shorter editions.

To reduce its dependence on big-name authors who command high royalties, Penguin has added nine book imprints -- such as Portfolio for business topics and Sentinel for conservative political writing -- in what Scardino terms a ``focus on the book, not the author.''

Penguin began its orange Penguin Classics series in 1946 with a translation of Homer's ``The Odyssey.'' Pearson bought the publisher in 1970 and helped it expand in the 1980s with purchases that included Frederick Warne, known for Beatrix Potter's ``Peter Rabbit'' titles. In the last decade, Penguin expanded into the travel-publishing business, acquiring Rough Guides and the Dorling Kindersley line of illustrated books.

`The Da Vinci Code'

Penguin also says it has fixed a software malfunction at a new warehouse in the town of Rugby in central England. The glitch kept books from reaching stores and led to 9 million pounds in costs last year to pay for alternative delivery systems, it says. Authors' representatives are talking to Pearson about compensation for lost sales; Pearson says it isn't liable for general damages.

The company is optimistic it can restore growth this year, Pearson's Swanson says.

While some of Penguin's new initiatives may help, Fordham University's Greco says growth still hinges on the ability to generate hot-selling authors and titles.

That's what Bertelsmann's Random House did with Dan Brown's ``The Da Vinci Code,'' which sold 10 million hardback copies. News Corp.'s HarperCollins publisher has topped best-seller lists for more than two years with Rick Warren's nonfiction ``The Purpose- Driven Life,'' a self-improvement guide.

Some Penguin stars, including Clancy, Cornwell and Sue Grafton, have registered a sales decline of as much as 35 percent for their most recent books, according to BookScan figures cited by trade magazine Publishers Weekly in February.

For example, Grafton's ``R Is for Ricochet'' had sold slightly more than 240,000 copies when the report was published, compared with more than 350,000 for ``Q Is for Quarry,'' the magazine said.

``People don't buy the product, they buy the author and the genre,'' Greco says.

To contact the reporter on this story: Charles Goldsmith in London at cgoldsmith3@bloomberg.net.

Last Updated: April 20, 2005 02:29 EDT