Post of the Day
March 12, 1998
Scholastic Corp Board
Subject: SCHL recommendation
Scholastic Corp. has been publishing and distributing children's books for the past 75 years. Investors with school age children are undoubtedly accustomed to seeing their children bring home the colorful monthly book order forms. Many of us fondly remember these order forms from when we were children. It is an established business but one whose future prospects have recently become very exciting, for reasons I will outline below.
In the past several years, SCHL has learned how to leverage its traditional book and magazine publishing in exciting and profitable new ways:
1) the company has taken advantage of its sterling reputation among teachers to enter into the instructional publishing market. Their phonics-based reading program Literacy Place has debuted with great success, particularly in the huge California market.
2) the company has begun offering educational software through its book clubs, and new software clubs. The growth rate in this area was a phenomenal 50% last quarter, and they have hardly scratched the surface of what they will be able to accomplish.
3) the company has begun publishing software based on its own properties, such as I Spy, Wiggleworks, Goosebumps, and the Magic School Bus.
4) the company has begun taking advantage of the media and licensing potential of its publishing properties. For example, SCHL has been publishing Clifford the Big Red Dog books since the sixties, but is only now starting to sell stuffed Clifford toys and a new Clifford tv show. The company's eyes were first opened to such lucrative opportunities when they transformed a book series called Goosebumps into a ubiquitous phenomenon--on tv, corn chip bags, you name it--a couple of years ago.
5) the company is expanding abroad, with the recent purchase of a Spanish language children's publisher (Lectorum), and the opening of branches in Hong Kong and India (operations in Anglo-Saxon countries have been up and running for some time).
So, with all these positive developments occuring in the past few years, why does the stock price remain low enough to constitute a nice, buying opportunity? The answer is that new opportunities require new investments. The company has had to put up a lot of upfront cash to enter the Instructional arena, to create TV shows, to develop software, etc. These investments are poised to pay off big time but they produce an initial drag on earnings before the explosion.
Permit me to quickly explain the earnings situation: When Scholastic spends cash on something that will pay off down the road (i.e. prepublication costs, such as royalties, or acquisition costs), they categorize such spending as an investment that will not be immediately subtracted from earnings, but will be amortized (spread out) over a given period. This is typical in media companies. It means that investors should keep an eye on cash flow. For the past several years, SCHL was overinvesting to fund expansion into new areas. Great move for the future, but it meant that reported earnings were actually better than cash flow. Attentive investors would have been aware of this, and stayed away when SCHL's price was inflated. However, since then, the situation has turned around completely. The last quarter showed a gigantic turnaround in cash flow--for two reasons: one, a summer restructuring that cut costs, and, two, improved revenue owing to the pay off of those investments in media, software, instructional, etc. Attentive investors now realize that cash flow is telling a BETTER story than reported earnings, because the company will, for a little while, still be dealing with higher level of amortization. Operating cash flow was 48 mill for last quarter versus 25 mill a year ago, yet reported earnings were lower. Opportunity is knocking.
Now, the question is: when will earnings reflect the cash flow turnaround at SCHL? Soon. In the upcoming 3q, SCHL will handily beat estimates. SCHL is projected by analysts to lose 19 cents in the quarter. That will not happen. (Numbers: SCHL profit was hurt in the fall quarter by the loss of some 27 mill in GB licensing revenues. That will not recur because GB added no profit at all in the 3q a year ago. In addition, SCHL is paying off about 5 mill per quarter in higher Amortization than a year ago. 27 plus 5 = 32. The company, based on those problems, should have run 32 mill behind last q. It didn't. It ran only 15 mill short of the spectacular fall 1996, because ex-goosebumps, business was strong. Business looks strong again this q, especially with Oprah Winfrey single-handedly putting SCHL's Bill Cosby series on the top of the Best Seller list. So lets assume that, much like last quarter, the company is ex-goosebumps about 14 mill better than a year ago. Subtract 5 mill in higher amortization--now it is 9 mill. Subtract zero in lost goosebumps revenue. Add a million for the Oprah Windfall. Subtract three million in higher taxes. That takes us to a number about 7 million above last year. Last year, before extraordinary stuff, was negative 28 cents. Adding seven million takes the company to about POSITIVE 20 cents. This before the extraordinary gain the company will make from selling off some magazines and the extraordinary write-off the company will take to reduce amortization in the future).
Beyond the 3Q: the future looks fabulous. The company has a huge publishing property in Animorphs, which is about to become a huge media and licensing property with the fall debut of the Animorphs tv show on Nickelodeon. The company has a movie with Gillian Anderson, Sharon Stone, etc coming out in the fall (called Freak the Mighty). The company is investing less heavily this year, so that Amortization will not become a greater drag. The company's cash flow is lowering interest costs. The company has recently signed contracts with LucasFilms to produce books for the new Star Wars films and contracts with Warner Bros. to make the books based on all WB movies. Instructional is growing. Software is booming. K.A. Applegate is signing on to a new series (tentatively titled Otherworld). Clifford's tv show should become reality. And the quarterly comparisons will be easy to beat next year. And some of this info hasn't even hit the business wires but is hidden off in publishing sites. Here are some links:
(make sure to see late Feb 1998 edition)