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Executives

Elizabeth Higashi - Investor Relations

Mike Lavelle - President and Chief Executive Officer

Dave Vander Ploeg - Chief Financial Officer

Analysts

Dick Ryan - Dougherty

David Epstein - CRT Capital

Gregory Macosko - Lord Abbett

Peter Ellingboe - Q Investments

Owen Douglas - Gleacher & Company

School Specialty, Inc. (SCHS) F2Q 2013 Earnings Conference Call November 20, 2012 11:00 AM ET

Operator

Good morning and welcome to the School Specialty’s Second Quarter Fiscal 2013 Earnings Conference Call. As a reminder, this conference is being recorded. It is now my pleasure to introduce Elizabeth Higashi responsible for School Specialty’s Investor Relations. Ms. Higashi, you may begin.

Elizabeth Higashi - Investor Relations

Thank you. Good morning everyone, and welcome to School Specialty’s fiscal 2013 second quarter conference call. Our presenters this morning are President and CEO, Mike Lavelle and Chief Financial Officer, Dave Vander Ploeg.

I’d like to point out that the presentation this morning will include the use of slides. The slides will be automatically advanced during the presentation and are available on the Investor Relations portion of our website at www.schoolspecialty.com. If you are listening via conference call, let me have the webcast on mute. There might be a slight delay on the slide change.

Before I turn the call over to Mike, I’d like to read our Safe Harbor provision. This presentation may contain statements concerning future results of operations, expectations, plans or prospects. Such statements are forward-looking statements. Forward-looking statements also include those preceded by or followed by words like anticipate, believe, could, expect, intend, may, should, plan, target or similar expression. These forward-looking statements are based on School Specialty estimates and assumptions as of the date of this presentation and as such involve uncertainty and risks.

These statements are not guarantees of future performance and actual results may differ materially from those contemplated by the forward-looking statements due to a number of factors, including those described in Item 1A of School Specialty’s fiscal 2012 Annual Report on 10-K. These factors are incorporated by reference. Except to the extent required under Federal Securities Laws, School Specialty does not intend to update or revise the forward-looking statements.

And now, I’d like to introduce our President and CEO, Mike Lavelle. Mike?

Mike Lavelle - President and Chief Executive Officer

Thank you, Elizabeth. As you can see from our release this morning, our second quarter’s results are beginning to reflect some improvement compared with previous quarter results, primarily reflecting the effect of improved gross margins and impacts on prior quarter cost action. And while we typically point out the importance of viewing the school season in the entirety of the first six months. I think it’s even more important that we point out our improving quarterly operating trends despite the challenging environment. We are working hard on our turnaround strategy even as we focus on EBITDA and working capital in the short-term.

This morning, I’d like to start by updating you on the overall marketing current school environment and then discuss the status of our major turnaround strategies, including our initiatives at schools in the areas affected by Hurricane Sandy. Then Dave will cover the latest operating results for the quarter and year-to-date results.

Moving on to the industry. School spending trends in 2012 have continued to be challenging in the school season. The Association of American Publishers reported year-to-date declines through September of 19% with sales in adoption states down 25% and open territory states down 12%. Many of our education peers primarily those in the textbook and curriculum markets continued to report double-digit declines in revenue in their latest quarterly results.

The School Market Research Institute also disclosed a couple of weeks ago 60% of its survey respondents recorded sales declines through September. As you can see from our second quarter results, our revenue declined and our gross margins and operating income percentage has improved, particularly in the largest part of our business, educational resources, which represents just over 70% of our revenues.

As discussed in previous calls, market headwinds have been more severe than we had anticipated in planning for the school year. Our curriculum business notably our Science division has been most affected due to delays in the finalization of next generation science standards with delays possibly moving into Q1 2013 for finalization of the standards. School districts continue to withhold spending as the impact from the pending changes to common core standards and general economic conditions remain uncertain.

Again, as shown on prior calls, local funding provides approximately 44% of school budgets with state funding providing about 47% and federal funding providing the remaining. While there continues to be a mixed forecast of state budgets, some positive news is beginning to pop up around the country. And while per student expenditure is down in some states, overall education budgets are showing signs of growth and property and state tax revenues are beginning to recover in selected markets from post-2008 recession levels.

On the state funding side, Proposition 30 in California was approved by voters that means about $6 billion annually should be available for educational spending in K-12 and state colleges and universities due to spend over the next three years. Oregon also repealed a kicker for corporate tax surpluses, which will meet about $120 million over two years for education. And Colorado’s government proposed the budget to increase K-12 spending by $416 million in the next school year. At the city and district level, following Hurricane Sandy’s devastation, the City of New York also said that they will provide $200 million for school infrastructure repairs. Although, these were isolated to specific states and/or events, there are actions moving in the right direction for our market.

Looking ahead at the state adoption market and school construction, the adoption market is expected to improve with planned science adoptions. Texas, which hasn’t updated the science curriculum since 1999, has already announced their intention to adopt new curriculum for the 2014 school year. As you can see, Texas represents over 5 million students in the K-12 grade and it will be an important contributor to industry sales. Year-over-year forecast by third-party industry sources show gains in K-12 construction spending for the first time in five years this school year. And we are hopeful these trends will fuel improving purchases of classroom supplies and furniture purchases longer term.

Moving on to an update on our turnaround framework, as I have mentioned previously, the selling season has continued to be a challenge. We are making progress in our turnaround initiatives although we are at different stages of implementation. We continue to integrate our marketing initiatives through a restructuring of product marketing support and branding. And while we are still playing catch-up in terms of product management, we are moving in the right direction.

Pat Collins, our new Senior Vice President of Sales joined us in early September and has been extremely busy analyzing and planning the implementation of a sales organizational structure and process for the company. We are focused on implementing the changes that will help us improve market share and expand sales, where we can achieve our long-term goals of double-digit EBITDA margins.

Another major initiative on the list is business optimization and we continue to work on programs more cost effectively source the way we buy materials and services. Our analysis of business operations suggest that opportunities exist to buy more effectively and efficiently with benefits to begin to start accruing by next year. And we continue to make progress in expanding our product lines through partnerships with this fall’s launch of InCommand in partnership with New York University. In addition, we have recently signed a partnership agreement with Curriculum Concepts International to distribute an early intervention and prevention solution to our student playing and development group. Lastly, the company is pleased to announce that we have engaged Perella Weinberg Partners to help us analyze these matters and provide support in achieving the company’s goals.

With that, I’ll move on to the financials section and pass it on to Dave Vander Ploeg.

Dave Vander Ploeg - Chief Financial Officer

Thank you, Mike and good morning everyone. As Mike mentioned, we continued to be impacted by a challenging market. And for the second quarter just ended, total revenues declined 5.8% to $237 million. As you can see from slide 12, Educational Resources revenue was $171 million or about flat with the prior year. Our basic school supply sales volumes improved while purchases that schools viewed as more discretionary in nature continued to be postponed.

During the quarter online, sales were up, were about 36% of Educational Resources non-project sales. Accelerated Learning, our curriculum and student planning business was off nearly 16% compared to the prior year with revenues of $65.6 million. Uncertainty over funding priorities and the finalization of assessments for next generation science standards has many states in a holding pattern before they make any curriculum decisions.

Turning to slide 13, consolidated gross profit was $92.7 million compared with $95.1 million last year or a decline of 2.5%. Consolidated gross margins improved to 39.1%, an increase of 130 basis points primarily due to strong margin improvement by both Educational Resources and Accelerated Learning. Educational Resources improved second quarter gross margin by 250 basis points to 33.4% following a 240 basis point improvement in the first quarter. Positive pricing and disciplined cost management continued to drive these favorable results.

Despite revenue declines, Accelerated Learning gross margins improved to 54% in the quarter from 52.3% or an improvement of 170 basis points over the prior year. Reading, Health, and the Agenda businesses, all improved year-over-year driven primarily by favorable product mix in the quarter. And on a consecutive basis, as you see on slide 14, we have been making progress overall for the last three quarters and on a trailing 12-month basis have increased gross margin by 70 basis points.

On the next slide, you can see that selling, general, and administrative expenses decreased 8.2% to $67.4 million compared with $73.4 million last year. The improvement was primarily related to lower employee costs reflecting a 10% decline in our average headcount and restructuring cost savings compared with last year’s fiscal quarter. In addition, the company benefited from variable cost savings related to this lower volume.

During the current quarter, we received a $3 million settlement of a note issued to the company in the divestiture of a business back in 2008. The payment related to a long-term asset, which resulted in an impairment charge of $1.4 million. This activity brings closure to certain divestiture activities dating back four years.

Interest expense for the quarter was $9.3 million compared with $6.9 million in the previous year. This increase is largely driven by higher interest rates on our term loan and a prepayment charge on the term loan principal payment. The provision for income taxes in fiscal 2013 was $343,000 compared with $6 million last year. The decline in taxes was related to projected tax losses for the current year in combination with tax valuation allowances reported in the fourth quarter of last year. The decrease in tax expense of about $5.5 million amounted to approximately $0.30 per diluted share.

Net income increased 59% to $14 million compared with $8.9 million last year. Diluted earnings per share in this year’s second quarter increased 60% to $0.75 versus $0.47 in the prior year. EBITDA defined as earnings before interest, taxes, depreciation, amortization, and impairment charges increased 9.3% to $34.2 million.

Now, for a quick review of the year-to-date results, let’s turn to slide 16. Revenues for the six months declined 7.3% to $489 million, a decline of $38.5 million from the prior year. Nearly two-thirds of the decline was related to the slowdown in curriculum sales within the Accelerated Learning Group primarily due to postponements of purchasing by districts awaiting further clarification of assessments for certain core subjects. This revenue decline was comparable to other curriculum providers. Educational Resources which represent 70% of our revenue declined 4% for the six months. Our online business continues to grow with total revenues up 8% year-to-date and now account for about 36% of our non-project sales.

On the next slide, you can see that gross profit for the six months declined about 5%, as the decline of $12.7 million in Accelerated Learning offset the $3.7 million improvement in gross profit by Educational Resources, which benefited from the previously discussed pricing and costing actions implemented earlier in the year.

Slide 18 summarizes our six-month results at a glance. SG&A expenses declined 7% consistent with the volume declines in the overall business. This decrease was primarily driven by a reduction in employee cost as previously mentioned as well as reductions in variable expenses and reduced catalog circulation costs. For the six months, interest expense increased about 22%. However, this year’s results include a combination of debt issuance cost as well as the prepayment charge previously mentioned. For annualized modeling purposes, cash interest expense is running at about $19 million a year.

We continued to benefit from federal tax credits as the valuation allowance as we took in the fourth quarter of last year reduced our taxes substantially for the full year. And we expect to pay no federal tax and little state tax for the full year. Net income improved nearly 45% to $32.5 million for the six-month period with diluted earnings per share of $1.72 versus a $1.18 in the prior year. EBITDA, which excluded the impairment – the impact of impairment charges was $71.8 million for the six months compared with $71.7 million in the previous year.

Slide 19 shows that on a non-GAAP basis, net income per diluted share would have been $0.82 for the quarter compared with $0.51 last year and a $1.98 for the six months of this year versus a $1.26 per diluted share of last year.

Moving to the cash flow statement on slide 20, for the six months, net cash provided by operating activities totaled $19.5 million, an increase of more than $27 million from the previous year. We invested nearly $6 million in capital spending and product development costs. We received $3 million for the long-term asset I previously mentioned which offsets the change in restricted cash, which is there for letter of credit purposes.

In total, we generated $13.9 million in free cash flow, an improvement of more than $27 million compared with the prior year. This improvement was largely driven by timing of certain working capital items and careful planning around capital spending and product investment decisions. Total funded debt ended the quarter at $302 million, a decrease of $70 million from Q1 levels. We met our financial covenants for the latest period and our priority continues to be to pay down debt. We anticipate total funded debt to come down slightly to our typical trough at the end of our third quarter.

As we have said in our press release, given the ongoing market headwinds, we estimate that fiscal 2013 revenue is likely to decline in the mid single-digit range compared to the $732 million the company reported in fiscal 2012. Although revenue is behind our planned levels, we are making progress on our immediate priorities and turnaround initiatives to improve EBITDA and thus are holding to our fiscal 2013 EBITDA guidance and expect to continue to make good progress on improving gross margin.

Finally, since we will undoubtedly get questions around the debt covenants, let me reiterate what we have previously said in our 10-Q disclosures. The company closely evaluates its ability to remain in compliance with the financial covenants under our asset-based credit and term loan credit agreement. The recent challenges affecting the company’s performance have placed and are expected to continue to place in the near-term pressures on the company’s ability to maintain acceptable levels of liquidity and to remain in compliance with its covenants.

As previously noted, our priorities include improving EBITDA and closely managing and improving working capital. The company continues to pursue a number of alternatives including those that were previously announced as immediate priorities and long-term initiatives to address these goals. Given that these alternatives are still under evaluation, we do not intend to comment further during this call.

And now operator, we are ready for question.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Dick Ryan of Dougherty. Your line is open.

Dick Ryan – Dougherty

Congratulations on the good job of executing in a pretty tough environment. Dave, on the costs control side that you did a much better job than we were modeling, can you kind of give us a sense what we should maybe consider for the next couple of quarters?

Dave Vander Ploeg

Yeah, great question, Dick and I appreciate your comments. I think it comes in two fronts. One is we continue to do better than even our internal plans, where for improving the gross margin in the Educational Resources business. And while we will now begin to lap ourselves with new catalogs that are coming out in January, we would anticipate that we will continue to see gross margin expansion in Educational Resources. On the Accelerated Learning side, it really comes down to the mix of business and so it could go up or it could go down a little bit in any given quarter based on just the mix of the products. On the SG&A side we’re doing a great job of managing our labor costs and driving productivity throughout the organization most notably in our DCs and we would continue to expect to see the types of improvements from an SG&A leverage standpoint that we’ve seen in the first half of the year.

Dick Ryan – Dougherty

Okay my follow-up on the term loan side Dave what – or can you talk about what how much you paid down and of the $9.3 million how much was prepayment and if there is a component there of a prepayment fee versus interest?

Dave Vander Ploeg

Yes, great question. So, on the $3 million settlement that’s something we’ve been working on obviously for four years since we divested of our visual media business. And because that long-term asset was part of the collateral within our term loan agreement, we were obligated to pay down the term loan by the amount that we collected which was the $3 million it did come with a prepayment make whole provision and that totaled about $1.4 million. And so that kind of the facts around bringing down the term loan from $70 million to now it is at $67 million. And then really included in the $9.3 million for the quarter would be the fees to prepay that.

Operator

Thank you. Our next question comes from David Epstein of CRT Capital. Your line is open.

David Epstein – CRT Capital

Hi folks. So, I’m sure I can back into it now that you’ve given the term loan balance, but can you just give the ADL balance and how much of that might be considered short-term and what are criteria for a piece of that to be classified as short-term?

Mike Lavelle

Yeah, the term loan at the end of October was $55 million.

David Epstein – CRT Capital

Do you mean ADL?

Mike Lavelle

I’m sorry the ABL I apologize and then especially the $7 million was the term loan and $10 million of that is classified as current.

David Epstein – CRT Capital

What is the criteria for that if it’s backed by some inventory or receivables that’s going to be worked down or?

Mike Lavelle

Yes exactly.

David Epstein – CRT Capital

Okay and any guidance on what CapEx might be for the full year?

Mike Lavelle

Yeah we still believe that CapEx will be between $15 million and $16 million. You can see we’re running a little light of that in the first half of the year, but based on the projects that are in the queue that’s what I would use for modeling purposes.

David Epstein – CRT Capital

Okay. And one more and then I’ll get back into the queue. Were there any one-time gains in the quarter?

Mike Lavelle

No, there were not.

David Epstein – CRT Capital

Thanks very much.

Operator

Thank you. (Operator Instructions) We have a follow-up question from Dick Ryan of Dougherty. Your line is open. Mr. Ryan your line is open.

Dick Ryan – Dougherty

Hello.

Operator

Yes your line is open.

Dick Ryan – Dougherty

Hello.

Mike Lavelle

We can hear you.

Dick Ryan – Dougherty

Okay maybe a two part question you mentioned Sandy briefly and the funding from New York, have you seen or heard anything on the New Jersey side and maybe lumping in with that or what do you see I mean how is your furniture business been tracking and what percent was that in the quarter?

Mike Lavelle

Great question Dick, this is Mike. I will answer this in two pieces, so the first question on Hurricane Sandy. I mean obviously our thoughts and prayers are with everyone on the East Coast that suffered from the damages from the storm. The School Specialty has approached the challenges in New York and in New Jersey through multiple approaches. One we’re working with some donation charitable contributions with the Red Cross. We are also working through our state contracts also our district level support to see how we can assist the efforts in getting the schools back up in running. In the short-term obviously the impact of the storm will cause some delays in traditional normal buying given the schools are closed in a lot of places, but then ultimately we expect they pickup in revenue and some incremental revenue as the schools replace a lot of their damaged materials and damaged furniture, and we expect that to be the case in New York as well as in New Jersey. And ultimately, the rate of those replacements we expect will take place over time, not all at an immediate basis. When we look at our furniture business, I think Dave has mentioned this in the past, our furniture pipelines, backlogs, have been good this year. We’ve seen them moving in the right direction, but it’s always is the case. It’s a business that has long lead times, long cycle times, so they are subject to change when you talk about pipeline, but we have seen good movement and they are parts of our business that we continue to focus our efforts in growing.

Operator

Thank you. Our next question comes from Gregory Macosko of Lord Abbett. Your line is open.

Gregory Macosko – Lord Abbett

Yes, thank you. I may ask a few questions that maybe a little bit standard or fundamental, but could you speak just a little bit about where we stand with regard to the school budgets, is there anything with regard to municipal bond funding or other issues that maybe affecting the weakness that you saw a little bit more than you had expected?

Mike Lavelle

That’s a good question. I would answer that question this way. I mean, obviously when we look at funding, we look at the education market. Multiple sources of funding impact the overall funding picture. So, federal funding, state funding, and local funding, and ultimately, activities at all those levels impact how schools operate and buy. From our evaluation of all of the metrics that are out there and all of the market data as well as what we experienced in the market, we envisioned that the market will remain over the short-term challenged, maybe not as challenged as what we have seen in this past year, but will remain challenged. On the flipside, we are encouraged by some of recent movement that we have seen over the past couple of months and with the recent election around parts of the country seeing recovery on local property tax receipts, the continued movement of improvement at state levels with state tax receipts at an obsolete of selected states that we have talked about that of approved new funding sources for education. We believe are all actions moving in the right direction albeit they are isolated in different places and at different levels.

Operator

Thank you. Our next question comes from Peter Ellingboe of Q Investments. Your line is open.

Peter Ellingboe - Q Investments

Hey Dave, hi Mike, congratulations on the good quarter. I just have a question on accelerated side. I know that there is a covenant that relates to just the term loan balance versus Accelerated Learning EBITDA is there, how should we be thinking about what Accelerated Learning EBITDA looks like after sort of being down so much on the top line?

Mike Lavelle

Yeah, we do have that covenant and obviously by paying down $3 million of the term loan that improved our position on that. And we’ll just continue to manage that side of the business like we really have been in the entire portfolio to work at staying in compliance on it.

Operator

Thank you. Our next question comes from Owen Douglas of Gleacher & Company. Your line is open.

Owen Douglas – Gleacher & Company

Hi, I just have a quick question this is talking about your balance sheet for a second. I noticed that at the end of the quarter I thought of just looking year-over-year I was bit more in inventories than I imagined that you would have, this has indicated that you’re saying that some of the revenue is going to be a little bit higher in Q3. I know you’ve said you think year-over-year is going to be lower. So, I’m just trying to make sensitive why you have more inventory ending this period than you did last year?

Mike Lavelle

Yeah great question there are really two factors that tie into it. One is we – as we’ve talked about we had software sales in the first half of the year than we had anticipated and much of that inventory comes into our warehouses in the February, March, April timeframe. And so we didn’t get quite the inventory turns that we were hoping for because of the softness that we experienced that’s probably a part of the answer. The other part then is we do have a pretty strong backlog in the furniture and we have partially assembled parts that tie to our furniture sales that are on our balance sheet and those will be converted in the finished goods and sold in the back half of the year. So, those are the two primary drivers of why inventory is up slightly.

Owen Douglas – Gleacher & Company

Okay. So, I should expect to see that get monetized pretty quickly then?

Mike Lavelle

That’s correct in the second half of the year.

Owen Douglas – Gleacher & Company

Okay. And also just looking at the payables though, the payables that’s up quite a bit year-over-year, so I was just wondering to what extent are you guys taking working capital as a means to try to help by your liquidity position and just wondering whether or not you are noticing any pushback on the part of some of your suppliers?

Mike Lavelle

Yeah, great question. We have said for the last several years that working capital is always a key focus of ours. It continued to be in the current quarter. We are regularly in communication with our vendors. They have been very supportive and we’ll just continue to make that a priority.

Operator

Thank you. I am not showing no further questions in the queue at this time. I’ll hand the call back to Ms. Elizabeth Higashi for closing remarks.

Elizabeth Higashi - Investor Relations

Thank you so much. We appreciate your participation in the call today, and of course we’ll follow up with any other questions that you might have later today, and have a great Thanksgiving. Bye-bye.

Operator

Thank you. Ladies and gentlemen, this concludes the conference for today. You may all disconnect and have a wonderful day.

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