Book publishers have been facing great challenges in the last few years due to the fast-changing landscape of their business. The sales of traditional books are in a secular decline while consumers are shifting towards new technologies, such as e-books. Scholastic Corporation (SCHL) is in the process of adjusting its business model towards a more technology-driven approach and thus the market has rewarded the stock with an abnormally rich valuation level. Nevertheless, the big question is whether the stock will eventually justify its rich valuation or the stock will deflate at some point in the future.

Scholastic was founded in 1920. It is a publishing corporation that markets children’s books, magazines and teaching materials. The company operates in three segments: Children’s Book Publishing and Distribution, Educational, and International.

Scholastic has been severely hurt by the coronavirus crisis. Due to the lockdowns imposed in response to the pandemic and the fierce recession caused in 2020, the company incurred losses in 2020. Even in its fiscal 2021, despite the recovery of the economy, Scholastic failed to make a profit.

However, the company has finally begun to recover from the pandemic. In the second fiscal quarter, Scholastic grew its revenue 29% over the prior year’s quarter, mostly thanks to abnormally low sales of children’s books in the prior year’s period. It also posted adjusted earnings per share of $1.93, which were nearly double the earnings per share of $1.02 posted in the prior year’s quarter.

Moreover, investors should be aware that the second quarter, which ends on November 30th, is by far the strongest quarter of the company thanks to the beginning of the school season. As the earnings per share in that quarter were only 4% lower than the pre-pandemic level of $2.02, it is evident that Scholastic has begun to recover strongly from the pandemic.

On the other hand, the company was facing secular challenges even before the pandemic. To be sure, Scholastic has a remarkably volatile performance record. Even worse, its earnings per share have decreased since 2012, even without taking the pandemic into account. This decrease has resulted from the secular decline of the sales of traditional books. A part of this decline has been offset with the rising sales of e-books, but it is evident that the increased focus of consumers on their smartphones has taken its toll on the time they used to spend on books.

On the bright side, Scholastic is doing its best to adjust to the new business landscape. It also has an exceptionally strong brand in its ammunition, namely Harry Potter. Whenever there is a new release of Harry Potter, the company enjoys a great boost in its results. This factor also helps explain the volatile performance record of the company, at least to some extent. Overall, we expect Scholastic to grow its sales and its earnings off the somewhat low comparison base formed this year due to the pandemic.

However, it is important to note that the stock is currently trading at a forward price-to-earnings ratio of 35.4. This is a decade-high valuation level for this stock, much higher than our assumed fair price-to-earnings ratio of about 17.0. If the stock reverts to its fair valuation level over the next five years, it will incur a 13.6% annualized drag in its returns. Investors should be well aware of this risk factor, which may cause excessive downside to the stock whenever an unexpected headwind shows up.

To sum up, Scholastic is recovering from the pandemic and is doing its best to address the challenges it was facing before the pandemic. However, the market has already priced a great portion of future growth into the stock. We also advise investors to avoid companies with volatile and unreliable performance, as these stocks tend to offer poor returns in the long run. Due to all these characteristics, we advise investors to avoid purchasing Scholastic around its current stock price.

Image by Peggy und Marco Lachmann-Anke from Pixabay