Scholastic (NASDAQ:SCHL) has passed a sleepy quarter with the upcoming Q4 and FY being the major one for the business, concentrated on book fairs at the end of the school year. There are some declines, book club being the biggest disappointment, consistent with the poor guidance we covered some quarters ago that disappointed markets. However, the bright spots are falling COGS and the 9 Story acquisition. With a decent pipeline for Q4, they shouldn't have an issue hitting the flat EBITDA guidance. Nonetheless, we just don't see any special reason to be interested in them.
Q3 Earnings
The first thing to point out is the reversal of the hoarding effects that we saw in the 2023 year, as the company had to hoard inventory in order to guarantee they had product to sell in an important season for the book business.
The hoarding inventory management policies that a lot of companies were implementing in 2023 meant that inventory got priced at higher levels, in part due to the general inflation caused by the inventory management practices that pervaded 2022 into 2023, but also the fact that certain costs, particularly freight and material costs, were considerably higher at the time they were accumulating that inventory. With those concerns now in the rearview, companies like Scholastic have been on the winning side of destocking. Despite stable revenues YoY, COGS fell more than 10% leading to meaningful gross margin improvement.
The next thing to note is the continued pressure in the book club business, which has the more discretionary component of school involvement. They are downsizing this business in a capitulation to at least restore its unit economics.
Last quarter, we also further refined our plan to strategically resize Book Clubs to a more profitable core as part of our plan to achieve long-term profit growth in School Reading Events over time. We’re already seeing cost savings as a result. That said, lower teacher participation and spending from earlier this school year is carrying over into Club’s spring results as expected.
Fairs are doing alright in Q3, but due to it being one of the weakest seasons for Scholastic, there is less informational value in these figures. It's all about Q4, which should be reporting soon.
Bottom Line
The pipeline isn't too bad. They recently came out with the last book in the Amulet graphic novel series, as well as a new Suzanne Collins book, and there is another Dog Man book coming in the next quarter as well. They should be able to give the already released titles a second wind as book fairs come, and the new titles a strong debut, with 2024 school fairs being completely COVID-19 free. With the improvement in gross margins from lacking hoarding effects, even being behind last year in terms of revenues in the nine months, if they have a worse revenue showing they should be able to meet the flat EBITDA guidance that they gave at the beginning of the year.
The other major development is the acquisition of 9 Story, a production company and longstanding vendor capable of bringing Scholastic properties to audiences through the screen. They will try to capitalise on newstalgia with a reload of Magic School Bus as well as some other beloved properties. They bring in a lot of distributable content, including thousands of episodes of Clifford the Big Red Dog, as well as other properties that continue to have traction with kids. They paid around 1.8x EV/Revenue on the business, paying $183 million. Assuming around a 10% EBITDA margin, it's only a slight premium to what's being paid for production companies in entertainment in 2024 in terms of EV/EBITDA of around 16x.
Scholastic overall isn't that cheap, though. It trades at a discount of around 20x on forward earnings, compared to a Japanese peer like Kadokawa (OTCPK:KDKWF) at 25x. Kadokawa has been much more forward looking in bringing its library to the screen, and is already an established producer of anime. They also have a lot of non-operating assets, with the stock values alone, covering around 15% of EV. These holdings of stock don't flatter the earnings multiple, so it's debatable if Scholastic's discount is even there. Then there's the difference in operational performance lately. We think there's more room to go for Japanese properties than for Scholastic's line-up.
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