Description

INVESTMENT THESIS

Scholastic (SCHL) is a business in secular decline with a terrible management team trading well above market multiples.  The company’s competitive position has been, and will continue to be, eroded by an incompetent, entrenched management team that spends more time on the phone with their brokers placing sell orders of granted stock options than developing an online strategy and positioning the company for success in an increasingly digital world.  It took Scholastic nearly two years to develop their first ereading platform, Storia, which launched in the Fall of 2012 and is not expected to provide meaningful revenue until 2014 at the earliest.

The stock might appear cheap looking backwards, but the company has been underinvesting in digital platforms and benefitted from the recent success of the Hunger Games and Harry Potter, Amazon.com’s two best-selling series of all time.   Recent financials mask what is a declining, hits driven business that is significantly overvalued trading at 19x consensus 2013 earnings that exclude frequently recurring cash severance charges. 

As investors lose faith in an entrenched management due to a late entry to online platforms and a 35% cut in 2013 EPS guidance - only two months after confirming guidance - and wise up to the fact that 2012 represented peak earnings for the company, the stock could easily be cut in half.

I will walk through Scholastic’s business first, then discuss the management team that has crippled the business and wrap up with a discussion on why Scholastic’s model will not fare well with transition away from print media.

BUSINESS OVERVIEW

Scholastic reports under five divisions:

Children’s Book Publishing and Distribution (52% TTM revenue, 55.9% of TTM Op Profit, 11.1% TTM Op Margin) – operates as an integrated business which includes the publication and distribution of children’s books, media and interactive products in the United States through school-based book clubs and book fairs and the trade channel.

The unit includes the company’s  bread and butter book club and book fair businesses as well as Scholastic’s Storia ereading and ebookstore app which I will discuss in more detail later.

Classroom and Supplemental Publishing Materials (9.5%, 5%, 5.5%) - includes the publication and distribution to schools and libraries of children’s books, classroom magazines, supplemental classroom materials and print and on-line reference and non-fiction products for grades pre-kindergarten to 12 in the United States.

The two divisions above, accounting for 60%+ of revenue and operating profits, are in secular decline and will be hurt by the move to digital from print publications.  The erosion to top and bottom line numbers over the past decade have been masked by the success of Harry Potter and Hunger Game trilogies while the company’s transition to digital has been painfully slow. 

Educational Technology and Support (11%, 12.1%, 11.5%) - includes the production and distribution to schools of curriculum-based learning technology and materials for grades pre-kindergarten to 12 in the United States, together with related implementation and assessment services and school consulting services.

This is supposed to be Scholastic’s highest margin division (20% Op Margin in 2012, 16.5% in 2011) but according to management has been hurt in recent quarters as schools have delayed the higher price point products due to budget constraints and worries about the fiscal cliff.

International (24%, 27.4%, 11.9%) - includes the publication and distribution of products and services outside the United States by the Company’s international operations, and its export and foreign rights businesses.

Scholastic has been operating in many overseas countries for decades and does not have as much runway as one might think in Canada or Australia.  The company’s relationship with teachers and school districts in the US does not help with entering Asian markets and their lack of online platforms will further hinder growth. 

Media, Licensing and Advertising (3.5%, N/A, -1.1%) - includes the production and/or distribution of digital media, consumer promotions and merchandising and advertising revenue, including sponsorship programs. 

Impressively the licensing division has had negative operating profits in 2 of the last 3 years.

MANAGEMENT

Two key data points tell you most of what you need to know: CEO Dick Robinson owns nearly 15% of the company and they launched their first online platform in 2012.  Not surprisingly, Dick has been with the company since 1962, CEO since 1975, and Chairman of the Board since 1982.  His father Robbie founded the company in 1920, and through full ownership of Class A shares Robinson and his family control four of the five board seats.  Dick and his father built a strong company for the pre-digital age but have not adapted to the rapid shift to ereaders and eplatforms.  In short, the company that they have built over the past 90+ years is not one that can succeed over the next ten years, and as a result the company will be left behind by the competition in the years to come.

Management is out of touch with the realities of their business, and much like the investment community, has not realized the $3.21 they earned in FY 2012 was peak earnings.  On their Q4 2012 conference call on September 20, 2012 management reaffirmed 2013 guidance of $2 billion in revenue and $2.20-$2.40 in EPS.  Exactly two months later, on November 20, Scholastic filed a brief 8-K in which they cut guidance to $1.8-$1.9 billion and EPS of $1.40-$1.60.  In the filing the company noted that sales at their book fairs were negatively impacted by Superstorm Sandy and that fiscal cliff worries led to fewer sales in their higher margin business lines due.  I’m assuming Q3 sales will be slow due to the flu influenza that is sweeping the nation.  Moreover the leverage inherent in the business is troubling; a 5-10% cut in sales leading to a 35% drop in EPS does not bode well for the future given that past revenue has been inflated by the success of the Hunger Games and Harry Potter series.  Investors did not complain that a 12.7% increase in revenues in 2012 led to a near tripling of EPS but leverage works both ways and with a broken business model Scholastic’s future operating results can trail off faster than the market is anticipating. 

Management clearly agrees that the stock is overvalued – if I needed to hit a word count I would cut and paste the huge amounts of insider selling over the past few years.  The selling is relentless and covers nearly every executive and board member at the company.  Link here: http://finance.yahoo.com/q/it?s=SCHL+Insider+Transactions

One of the few things the company does consistently, other than sell stock, is record discontinued operations charges.  Granted, most of the charges are non-cash but it does provide a good sense of the management team you are counting on to develop and monetize a digital platform.  Scholastic took discontinued operations charges that completely wiped out operating profits in both 2008 and 2009 and has taken discontinued operations charges in 2010 and 2012, and will take “one-time” costs associated with new layoffs in 2013.  Unfortunately for Scholastic, as one analyzes their business units, it looks like they will have more discontinued operations and one-time charges over the coming years as many of their segments are in real trouble.

SCHOLASTIC’S FUTURE

It would be difficult to overstate how strong the sales of Harry Potter and the Hunger Games have been and the impact they had on results over the past decade.  The first of seven Harry Potter books was released in 1997, the last in 2007.  The first of the Hunger Games trilogy was released in 2008 and followed by new books in 2009 and 2010.  The movie was released in 2012 and led to another huge jump in sales and record earnings in fiscal 2012 (year-end May, 31, 2012).  In August of last year Amazon.com announced that the Hunger Games trilogy had passed the Harry Potter series as the best-selling book series in the company’s history (includes print and ebooks).  In 2012, after the theatrical release of the Hunger Games, the three books were 1, 2 and 3 in the USA Today bestseller ranking for fourteen straight weeks.  Selling 50 million copies of a series in a four year period is impressive, but not something that can be counted on year in and year out - as such 2012 revenue and EPS numbers are an outlier and represent peak earnings.  Finally, a key success to both Harry Potter and the Hunger Games is they appealed to a far greater audience than Scholastic’s typical Young Adult consumer which makes replicating their success all the more difficult.  None of Scholastic’s current or expected hit series, Captain Underpants, 39 Clues, etc., extend beyond the Young Adult market.

Scholastic’s two main assets are their relationships with schools/teachers and a strong editorial staff that finds content (i.e. Harry Potter and Hunger Games) – both are at risk as Scholastic struggles to carve out a presence online.

Scholastic’s ereader platform Storia debuted in 2012 and is not going to be the success that management and the investment community thinks that it will.  Scholastic has had print success in part by convincing other publishers to sell their titles through Scholastic’s book fairs and clubs.  Simplified, from another publishers perspective there isn’t a big difference between a book sold at a Scholastic book club/fair or at a Barnes and Noble.  That is NOT the case when it comes to selling through online platforms.  Each publisher wants to drive traffic to their respective online platforms and develop a relationship directly with the end consumer.  Scholastic has not awoken to this and from conversations with industry experts it is not offering authors attractive terms and is having a very difficult time getting content from other publishers. 

If Scholastic is not able to recruit other publishers to Storia, they will be solely reliant on their ability to sign and develop their own hit content.  So in essense, they are leveraging (through increased CapEx spending) a leveraged (hits driven) business model.  This works great when you publish Harry Potter and the Hunger Games but the wheels could come off pretty fast if they cannot find and develop new hit series as they continue to sink money into the platform.  The catch is that in order to recruit other publishers/authors they will need to offer much more attractive terms which means it will take longer to get a return on their Storia investment.  Finally, the move online has caused CapEx to more than double over the past five years, from $57 million in 2008 to $129 in the TTM, a trend that is unlikely to reverse.

The competitive aspects of online versus print will squeeze Scholastic as the latter becomes obsolete.  Scholastic has a virtual monopoly in the school book fair/club market and has been acquisitive when another book fair company reaches scale.  The online market is FAR more competitive with threats from Apple, Nook (strong in the educational space), Amazon and thousands of start-up companies and app developers.  Scholastic’s relationship with schools and teachers becomes far less valuable when purchases are made online and consumers can chose from a wide variety of online platforms.

If Scholastic is unable to make Storia a success, and as part of a secular shift print continues to lose share to online, Scholastic could begin to lose its other key source of value, the ability to sign authors.  There is no question that Scholastic has a strong editorial team, but they also benefit from the ability to promote authors through their book clubs and fairs.  As such, Scholastic is able to pay less than a Random House or Harper Collins.  As print moves to digital and Scholastic no longer dominates the young adult market, authors will be more likely to take the higher upfront payment offer from another publisher.  Alternatively, Scholastic will need to bid more competitively squeezing margins.  Harper Collins has a new YA President and the bidding process could become more competitive in the near future.

Scholastic’s business is built for an era that has passed.  The $3.21 the company earned last year, on the heels of the wildly successful Hunger Games trilogy, will not be repeated in the years to come.  From 2008-2013E, a period that included the Hunger Games series in its entirety and a tailwind from Harry Potter, Scholastic earned an average of $1.85 from continuing ops.  It is impossible to model out a hits driven business but Scholastic has earned between $1.34 and $1.65 in operating profits in three of the past four years.  The midpoint of 2013 guidance is $1.50 but if you subtract out the midpoint one-time severance charges of $17.5 million you are left with earnings of $.96, which might be a bit on the low side but somewhere between $1.00-$1.50 sounds about right for baseline earnings power.  A bull might say SCHL trades at 11.7x TTM EPS or 9x 2012 EPS or maybe even 19x 2013 EPS, I would argue that the company trades at 15-20x, with declining earnings power.  As the publishing industry moves towards digital and away from print, Scholastic will lose their competitive advantages - coupled with declining sales from the Hunger Games the company should move towards a more normalized EPS figure in the coming years.

SUMMARY

Management has proven they are inept at running the business and keeping up with changes in the industry.  The fact that their first ereading app and ebook system did not come online until last year says much about the company’s future.  Management is smartly running for the exits and selling shares hand over fist before the market realizes that Storia will be a failure, and that Scholastic is a hits driven business with huge earnings variation from year to year and is highly seasonal, typically posting losses in Q 1 and Q3.  Investors should not be placing such a lofty valuation on lumpy cash flows from a declining business.

While not a zero, Scholastic’s biggest assets are in secular decline, the management team should have retired twenty years ago (and can’t wait to sell you stock), and earnings are erratic and seasonal – there is no reason this stock should trade anywhere near 19x earnings estimates for the year which exclude severance costs that seem to pop up nearly every year.

RISKS

Share Buybacks/Tender – Management has done a decent job of returning capital to shareholders.  The dividend has been raised multiple times in the past two years and the stock now yields just shy of 2%.  The company bought back a lot of stock in 2008 and 2011 but has put that on hold and now plans to use their cash on hand to buy back their 5% debt in April of 2013.  After the company buys back the debt they will be debt free or have a slight net cash position which will allow them to buyback or tender for shares in 2H calendar 2013.  A small buyback would not change the thesis but I am somewhat concerned about a tender offer which is why this is only half of a position for us right now.  In September of 2010 (FY11), with the stock at $25.51, the company’s Dutch Auction tendered up to $150 million at a price of $27-$31.  The stock only moved to $27.27 the day after but the tender was ultimately completed at $30/share.  I think the situation today is different from 2010 and that a tender is less likely than a buyback.  In 2010 Harry Potter already had tremendous success as had the Hunger Games trilogy and the company wasn’t funneling as much money into their online platform as they are today.  I think the company’s poor performance this year coupled with an uncertain 2014, a lack of hit new series, and the need to commit significant resources to online platforms makes it less likely they will do a large repurchase/tender but it is certainly a risk.  It is also likely that some sort of capital return is baked into the stock at these levels. 

Management Overhaul – The market would likely respond well to a change in management however conversations with industry insiders make it sound like Dick Robinson has no plans to step down in the medium term.  Dick has a long history at the company, the gig pays well and is fairly stress free (listen to the softball Q’s on the last earnings call, then remember this call comes after slashing EPS projections by 35% a month earlier).  Plus I’m sure he feels he is doing “good work”, children’s publishing isn’t exactly hawking cigarettes to kids.  This seems like an unlikely situation for an activist to step in as Robinson controls the Board, holds 15% of the shares outstanding, and the company has lumpy cash flows making it riskier to lever up the balance sheet.  Additionally, starting a proxy battle with a well-known children’s publishing company has some headline risk.

New Hit Series – This is a hits driven business and Scholastic has a strong set of editors looking for the next hit series.  It will be difficult to find another Harry Potter/Hunger Games but if they can come close to that success, earnings will exceed my estimates.  It’s also possible that when Harry Potter and the heroine from The Hunger Games, Katniss Everdeen, become consenting adults they could start a romance in a series that would become the best-best-selling series of all time but I think both of those series, much like the CEO Robinson, are past their prime.

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