Scholastic Corp (NASDAQ:SCHL). suffered a bit of a decline after its recent third quarter earnings report. Management blamed lower than expected sales of “The Hunger Games” trilogy for much of the publisher’s almost 19% revenue drop from the prior year, and lowered forecasts for the full year. Lower sales and lowered expectations leading to a lower stock price seems reasonable. But let’s take a step back for a moment and ask ourselves: why exactly was the fall off in Hunger Games sales unexpected, as management seemed to imply?
Here’s the thing about a hugely popular book series – eventually, the story comes to an end. And when it does, well, sales of the books in that series are going to drop, perhaps rather dramatically. Isn’t this the sort of thing that a book publisher should expect, and factor in to their forecasts? Especially since Scholastic Corp (NASDAQ:SCHL) went through this sort of thing before, with Harry Potter? It seems to me that ups and downs in sales and corresponding earnings is simply going to be a fact of life for a relatively small publishing company that has had the good fortune of occasionally hitting a home run with a previously unknown author, and management should certainly be aware of it. Maybe they can’t do anything about it, but at the least, they can make sure their investors are aware of the phenomenon, and try to properly set expectations.
Simply saying there is nothing management can do about this cyclicality may be unsatisfying for some investors, and they might be tempted to look at companies in other industries for potential solutions. One might attempt to draw an analogy with the video game industry, which also produces mass market entertainment, though in a different medium. The comparison isn’t quite the same, I don’t think. Take Activision Blizzard, Inc. (NASDAQ:ATVI), for example. Don’t they have similar issues, inasmuch as they generate substantial revenue from wildly popular video game franchises which may come to an end some day? Similar issue, sure, but not really the same thing.
Potential solutions from other companies?
Activision Blizzard, Inc. (NASDAQ:ATVI)’s massive multiplayer online role playing game, World of Warcraft, doesn’t have an inevitable ending like a fiction book series. It’s not story-based, in the sense that it relies on an externally provided plot, but rather is driven by the interactions among players. The primary concern is keeping the game fresh and engaging enough to encourage customers to continue forking over a monthly fee (and perhaps engaging in a few micro-transactions as well). Similarly, its Call of Duty franchise doesn’t have the same “end of story” risk that you find in novels. Yes, there is a rudimentary plot involved in each installment, but that’s not why customers buy the games. It’s the gameplay experience that drives sales, and the challenge is to make each new title in the series different enough for a fan to justify buying it, while retaining the familiar and enjoyable elements of past titles.
Perhaps one might look to Hollywood to see how successful companies address the problem of successful stories coming to an end. After all, sequels to hit movies are general hits themselves. (The aforementioned Harry Potter is a great example.) Marvel Studios, now a subsidiary of The Walt Disney Company (NYSE:DIS) has quite successfully capitalized on this phenomenon. Marvel spent years establishing their current film universe, slowly building with stand-alone films based on favorite characters like Iron Man and Captain America, culminating in last summer’s release of The Avengers. Multiple sequels set in the same universe are currently in the works.
But Disney and other Hollywood studios have at least one advantage over book publishers when it comes to handling the end of a story. Movie-going audiences seem to tolerate, and even crave, remakes, re-imaginings, and re-boots. If you are Disney, what do you do when the story ends? Just start over from the beginning, with different actors, a different director, and maybe a slightly different take on the characters. This approach worked reasonably well with Batman, Spider-Man, and Star Trek, among others, and there’s no reason to think it won’t continue to work in the future. It’s hard to see this working in the book publishing context. Would you really rush out to buy a new Harry Potter series by a different author, just to see how they handle the characters you’ve come to know and love? I suspect not. In fact, when it comes to satisfying any potential itch for a slightly different vision of an existing story, the publishing industry tends to outsource the job by selling the movie rights.
In addition, Disney has attempted to deal with this issue using a well-known technique employed by large conglomerates throughout history – diversification. How do you guard against the loss of a particular hit series? Have multiple hit series in play at any given time. It’s probably not much of a stretch to say that smoothing out earnings and cash flow, as well as hedging against the potential deterioration of any one franchise, was at least part of the motivation behind the acquisitions of Pixar Animation Studios, Marvel, and LucasFilm Ltd.
Implications for value
Would this approach work for Scholastic Corp (NASDAQ:SCHL)? Maybe. But there are also risks associated with more production. You certainly don’t want to end up in a situation where the substantial financial rewards that come with the occasional breakout series aren’t doing anything more than offsetting the losses from the large number of mediocre books you are putting out each year.
In any case, one thing we can take away from Scholastic Corp (NASDAQ:SCHL)’s recent quarter is the need to be careful and realistic when projecting out future cash flows and earnings for purposes of valuation. If you are making future sales projections based on past sales, you have to carefully consider whether past sales are sustainable. If the past period you are looking at includes, as with Scholastic, sales of a hit product, they may not be, and you may find yourself unpleasantly surprised when sales revert to sustainable levels.
On the plus side, Scholastic Corp (NASDAQ:SCHL) has demonstrated an ability to identify previously obscure authors and successfully bring their work to a mass market that includes adult readers, not just the children’s audience at which the books are aimed. If you believe the company can continue to do this in the future, then the recent drop in stock price following from this “surprise” sales decline may be a fine buying opportunity.
The article Scholastic – Victim of Unrealistic Expectations? originally appeared on Fool.com and is written by Toby Bordelon.
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