Can Harry Potter's Publisher Make Magic, Too?

Sometimes you can take the old Peter Lynch adage about investing "in what you know" a little too far. Take the Harry Potter mania that has been sweeping the Western world since midnight on July 21. That's when fans from eight to eighty dressed up, lined up and paid up ($34.99, full price) for the seventh and presumably final adventure of everyone's favorite schoolboy wizard.

Some 8.3 million copies of J.K. Rowling's Harry Potter and the Deathly Hallows flew off the shelves in the first 24 hours after its release, according to its publisher, Scholastic And it looks like more than one investor in the Barnes and Noble queue figured that shares in Scholastic (symbol SCHL) might make some magic, too.

Yes, the shares did get a bump, closing at $34.03 on July 23, up 0.7%. But even Harry Potter's wizardry, not to mention Peter Lynch's homespun aphorisms, might not be enough to lift Scholastic shares appreciably higher than the market overall over the next several months.

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Instead of reacting to the hoopla surrounding the final book in the series, investors would be better served focusing on Scholastic's fiscal fourth-quarter earnings, released on July 19th. The company posted a profit of $40 million for the quarter ended May 31, or 93 cents a share, up from $38 million, or 91 cents a share, in the same quarter a year ago. But analysts had expected earnings of $1.02 a share. Result: Scholastic shares sank as low as $33 on July 19 before rebounding to close at $34.21 that day.

The problem spot in Scholastic's book bag is its "Continuities" business, which sells books and other merchandise primarily over the phone for direct delivery to customers' doorsteps. The Do Not Call registry has put a crimp in this business, which accounts for about one-fifth of the company's children's book sales. (Children's book publishing and distribution makes up about 57% of Scholastic's sales; educational publishing accounts for about 18%.)

Had Scholastic not been in the direct-to-home sales business last year, fiscal 2006 earnings might have been 13% higher, according to analyst Neil Godsey at Friedman, Billings, Ramsey, and fiscal 2007 earnings would have been better by a similar percentage. For fiscal '07, Scholastic reported earnings of $1.42 a share, down from $1.63 a share in fiscal '06, when Harry Potter and the Half-Blood Prince, sixth in the series, hit the bookshelves.

Chief executive Richard Robinson says the company has a plan to "substantially improve results" in the troubled segment, and added that if profitability isn't restored this fiscal year, the company is determined to "take other action." A credible plan could have significant positive implication for the company's earnings and its share price, says FBR's Godsey. "An inability to fix or sell the business would cause us to reconsider our [buy] rating on the stock," he adds.

Analyst Drew Crum, at Stifel Nicolaus & Co., who's had the most accurate earnings estimates for Scholastic in recent years according to forecast tracker StarMine, has already lowered his opinion on the stock, downgrading it from "buy" to "hold" on July 16. If prior trading patterns are any guide, a sell-off could be in the making -- which might be even worse this time around, considering that No. 7 is the last in the series. Harry Potter's parting gift will likely be 62 cents of the $2.75 in earnings per share that Crum foresees for the fiscal year ending May 31, 2008.

Longer-term investors needn't give up on Scholastic, however. Not including Hogwarts-related earnings, the stock is selling at just 16 times Crum's fiscal '08 earnings estimate -- a reasonable value, especially considering the stock's comparable four-year average price-earnings ratio of 18. FBR's Godsey sees Scholastic trading up to $38 a share over the next 12 months, as the rest of Scholastic's businesses continue to grow modestly -- an indication that there likely is life after Harry Potter, after all.

But for now, savvy investors will resist the urge to transfer their excitement about a great book to an okay stock. You've got plenty of time to read all 784 pages -- and then some -- before revisiting this one.

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