Dot-Connecting.

“The art of pattern recognition is the ability to see what is invisible to others.”
Jonathan Swift

As I begin my twelfth letter, I realize that prior letters may have made the wrong impression. In the past, I’ve written extensively about markets and the economy, which suggests these topics are essential to my process (they’re not). I chose to write about them out of necessity, as the fund’s investments are proprietary and I’m hesitant to discuss them in real time, especially as the fund scales. Consequently, I’ve favored generalities (the economy) over specifics (what I’m buying).

While macro color may provide some insight into how I think, it’s unlikely to make either of us much money. Otherwise, the world would be full of wealthy economists. You should know I spend the lion’s share of my time on individual securities and have taken notes on 182 different companies in the past year. As the fund matures, you can expect more specific investment ideas and less color commentary.

The second impression I wish to amend regards performance. I report monthly performance which implies that I find it meaningful (I don’t). More than one of my partners has said this frequency could foster short-termism and I suspect they’re right. I’ll continue to report it because I value transparency and want to update you on the fund’s progress, but investors chronically underestimate the time required for a manager to demonstrate his or her skill. Academic studies suggest that it can take between five to ten years to prove a fund’s results are anything other than random noise. Compare this to the average mutual fund holding period of two years and it’s no wonder the asset management industry is so dysfunctional.

Obviously, I’d prefer to demonstrate my value sooner rather than later, but urgency and good results are often antithetical and make for strange bedfellows.

Having cleared that up, I’d like to shift the discussion to opportunism. In July’s letter, I showed the fund’s ten largest positions as of May 31st, a habit I’ll continue one month after each quarter’s end. In June, the fund began accumulating shares in Scholastic (SCHL), the children’s book publisher, known for popular titles like Harry Potter, The Hunger Games and Dog Man. One of the advantages of my size is that I’m able to take positions quickly without impacting a stock’s price. Today, Scholastic is the fund’s second-largest holding, approaching 7%, and was accumulated in just 27 trading days. From first purchase to now, it’s risen 45% and is the largest contributor to performance year-to-date.

Scholastic is not a great company. Its stock price is roughly half of its 2002 all-time high, which coincided with peak Harry Potter sales. Investors have been right to ignore it ever since. You’re probably wondering why bother with a company with such an uninspiring track record?

Funny you should ask. Scholastic owns 555/557 Broadway, a building in the heart of SoHo and 1.4 million sq ft of warehouse space in Jefferson City, Missouri. In March, they announced their intent to monetize these assets via sale leaseback which I estimate could generate between $450 and $600 million before taxes. Considering their market cap was recently below $500 million, my interest was piqued.

A few facts:

·       555/557 Broadways consists of 355,000 sq ft of retail and office space. SoHo has some of the densest foot traffic in the US and ground floor retail commands a significant premium. Scholastic currently receives $11 million of rent income from the first floor alone.

·       The remainder of the building is office space. You’re likely aware that office demand is relatively weak, especially in Manhattan, but has been rapidly improving. Vacancy has fallen meaningfully post COVID and leasing has improved 17% through the first half of the year. Average rents for Class A recently hit an all-time high of $94/sq ft.

·       In June, SL Green listed two properties including 110 Greene Street which is a block from Scholastic’s headquarters for $300 million at a 6.5% cap rate (cap rates are calculated as rents over the purchase price). It’s of similar age but 60,000 sq ft smaller and has less retail square footage.

·       In August, Educational Development Corporation, another children’s publisher, completed a sale leaseback of its Tulsa warehouse facility at $80/sq ft. A sale leaseback isn’t just a reflection of a property’s value, but of its tenant’s credit worthiness and Scholastic is far more credit-worthy.

·       Scholastic has averaged $165 million of operating cash flow per year since 1998, making them an attractive tenant with ample rent coverage. While their balance sheet has almost $400 million of debt, I suspect part of the proceeds will reduce leverage with the remainder directed towards buybacks.

I’m providing these data points not because I expect you to calculate your own value (although you’re certainly welcome to), but because I’m in the business of dot-connecting and this fact pattern provides a lot of dots. Suppose the company successfully monetized its real estate holdings, what then? That’s where the plot thickens.

·       Maurice Robinson began Scholastic as a magazine in 1920, started its first book club in 1948 and entered the publishing business in the 1960s. His son Richard (Dick) became CEO in 1975, took it public in 1987 and died in 2021 at age 84.

·       Like most media companies, Scholastic has two share classes to maintain voting control. When Robinson died, rather than bequeath his voting shares to his two sons or ex-wives (both former employees) he left them to Chief Strategy Officer, Iole Lucchese, with whom he’d had a decades-long romantic relationship. Neither Lucchese nor his family were aware of his wishes. The will has not been contested but remains in probate.

·       I’m not drawn to scandal per se, and I wouldn’t wish this kind of conflict on any family but what I find most compelling is that Scholastic has repurchased almost $400 million in stock and paid $93 million in dividends since Robinson’s passing. In the past four years, it has generated $21 per share in cash flow compared to the fund’s $17.50 initial purchase price.

·       Given the challenges in publishing, the industry has been rapidly consolidating. Private equity acquired McGraw Hill in 2021 and Houghton Mifflin in 2022. Simon & Schuster was approached by Penguin Random House in 2023 but later sold to KKR after the merger was blocked. Other strategics like Harper Collins, Hachette and Macmillan have all been acquisitive.

·       Scholastic is an attractive acquisition target for numerous reasons. It distributes one-third of all children’s books. While its delivery model is expensive (90,000 in-school book fairs a year), owning their distribution helps insulate them from Amazon who has siphoned much of the profits in publishing. Their content and intellectual property is valuable and easily monetized. The recent Goosebumps series on Disney+ generated over 118 million hours of viewing.

·       An activist investor, Ananym Capital Management, took a 5% stake in March. It’s historically been rare for activists to target controlled companies as their ability to influence management is limited, yet the practice has recently become more common. Numerous parallels could be drawn to the Redstone family saga at Paramount (upon which the show Succession is loosely based): a company past its prime, the death of a patriarch, a contentious transition, a rapidly consolidating industry and activist involvement. That story ended with Paramount being sold to Skydance.

·       The company has a legacy of prioritizing literacy over profit and relies upon the goodwill of educators for access to readers. While Robinson’s will likely sought to preserve these values, public shareholders and his descendants may feel differently and I expect the company’s priorities to evolve under new leadership.

I chose this example because I’ve always been drawn to special situations. Scholastic’s real estate is extremely valuable, in four years it has returned almost its entire market cap in cash, an activist investor is working behind the scenes to create value, a contested succession plan increases the likelihood of a change in control or outright sale and private equity is active in the industry.

As an unapologetic dot-connector, I can see numerous paths to value creation. I may not have a lightning bolt-shaped scar on my forehead like Harry Potter, but if I did, I suspect it would be tingling right now.

Sincerely,

Dan Walker