Description

Recommend Initiating a Long Position in SCHL; See Upside 4.4x Downside over the Next 6 Months

Thesis:

SCHL is in the process of going from a small net debt position in its earnings release last March to a large net cash position by the end of this calendar year that we believe will leave the company with more than $20 of net cash per share (note SCHL finished trading today at $41.57). We anticipate this money will be returned to shareholders this calendar year, most likely in the form of a large special tender offer at a 25%+ premium to the current share price, as the company has done a Dutch auction before in a similar position (September/October of 2010).

Quick Business Background:

Scholastic Corporation (founded in 1920) is the world’s largest publisher and distributor of children’s books and a leading provider of educational technology products and related services and children’s media. Scholastic creates quality books and ebooks, print and technology-based learning materials and programs, magazines, multi-media and other products that help children learn both at school and at home. The company is the leading operator of school-based book clubs and book fairs in the United States. It distributes its products and services through these proprietary channels, as well as directly to schools and libraries, through retail stores and through the internet. Scholastic has operations in the United States, Canada, the United Kingdom, Australia, New Zealand, Ireland, India, China, Singapore and other parts of Asia, and, through its export business, sells products in more than 150 countries.

Valuation and Financials:

We see SCHL at least 27% undervalued today (with upside to 48%) and expect this to be realized primarily over the next two quarters (first earnings release is in late September). The three components of SCHL’s value are:

1.     In April, SCHL sold off its EdTech division to HMHC for $387.6 million of after-tax proceeds. We later found out from HMHC on their roadshow that they wanted to buy the whole company, but SCHL wouldn’t sell. With the sale of this segment, SCHL currently has a net cash position of $348.6 million, or $10.27 per diluted share (after deducting for their upcoming $186 million tax payment related to the gain on the sale of the EdTech business and including the $34.5 million of restricted cash SCHL will earn in increments from its shared services agreement with HMHC over the next two years).

2.     SCHL is in the process of selling part of its incredibly valuable SoHo (NYC) real estate. Per The Real Deal, SCHL was offered $400 million from Madison Capital for just the first, second, and part of the third floor of its two joined buildings (555 and 557 Broadway), while SCHL would retain ownership of the remaining seven upper floors. While SCHL put its real estate monetization strategy on hold to finalize the EdTech sale to HMHC, the company now intends on proceeding ahead with the sales process. Please note the value of SCHL’s real estate is backed by recent comparable deals in the neighborhood. For example, Zara recently paid more than $20,000 per square foot for a building literally a block away from SCHL’s two joined buildings. In our model, we assume SCHL gets $350 million of after-tax proceeds from their real estate monetization (a $400 million sale minus a small tax payment of $50 million given the company’s existing DTAs and high cost basis for one of the buildings).

3.     SCHL’s peers trade between 8.0x and 10.0x NTM EV/EBITDA; however, SCHL has typically traded at a discount due to the Robinson’s family exclusive control over the company. Putting an 8.0x NTM EV/EBITDA multiple on consensus’s projected NTM EBITDA of $137 million, implies an enterprise value of ~$1.1 billion for the remaining business.

Putting these three components together, we see a fair value for SCHL shares at ~$53, representing upside of 27%.

Risk/Reward Framework:

We see 4.4x more upside than downside over the next six months.

·         Best Case: Stock rises 48% over the next six months. Underlying assumptions are: 1) investors give SCHL credit for $450 million of potential after-tax cash proceeds from real estate monetization given depth of holdings (still have the remaining seven floors of their 555/557 Broadway headquarters) and deferred tax assets; 2) putting a NTM EV/EBITDA multiple of 9.0x on the remaining business; and 3) estimating EBITDA of $144 million next year, 5% higher than the consensus estimate on the possibility of stronger-than-expected top-line growth and solid margin throughput.

·         Worst Case: Stock declines 11% over the next six months. Underlying assumptions are: 1) no cash proceeds from the monetization of the real estate; 2) putting a NTM EV/EBITDA multiple of 7.0x on the remaining business; and 3) estimating EBITDA of $130 million, 5% lower than the consensus estimate on the possibility of weaker-than-expected top-line growth and poor cost control management.

Catalysts:

·         An announcement regarding management’s decision to return excess cash related to the EdTech sale (likely announced with the company’s 1Q earnings)

·         Announcement of the company’s real estate sale (mostly likely by calendar year end)

·         1Q16 earnings (estimated September 24^th)

Risks:

·         Perhaps the greatest risk an investor could see is that 100% of the company’s voting rights are retained by the Robinson family (including four-fifths of the Board of Directors) and they may not be interested in returning the cash, choosing instead to pursue M&A or reinvest in the business. However, when we spoke to the company, management made it clear that Dick Robinson has been returning cash to shareholders for years and “you can’t teach an old dog new tricks”. When SCHL has chosen to pursue acquisitions, they tend to cost less than $15 million. Moreover, even if SCHL wanted to acquire another player, there are very little assets that are for sale at any given time and large players, such as HMHC, have larger balance sheets that can outbid them.

·         Limited trading liquidity as SCHL has traded slightly less than $10 million on average per day over the past three months.

Catalyst

  An announcement regarding management’s decision to return excess cash related to the EdTech sale (likely announced with the company’s 1Q earnings)

·         Announcement of the company’s real estate sale (mostly likely by calendar year end)

·         1Q16 earnings (estimated September 24^th)