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Scholastic (NASDAQ:SCHL)

Q2 2013 Earnings Call

December 20, 2012 8:30 am ET

Executives

Gil Dickoff

Richard Robinson - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Maureen E. O’Connell - Chief Financial Officer, Chief Administrative Officer and Executive Vice President

Margery W. Mayer - Executive Vice President and President of Scholastic Education

Judith A. Newman - Executive Vice President and President of Scholastic Book Clubs & E-Commerce

Ellie Berger - President of Trade Publishing Division

Analysts

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q2 FY 2013 Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded.

I'd now like to turn the conference over to your host, Mr. Gil Dickoff, Senior Vice President, Treasury and Investor Relations. Please go ahead.

Gil Dickoff

Thank you so much, operator, and good morning, everyone. Before we begin, I would like to point out that the slides of this presentation are available for simultaneous viewing on our Investor Relations website at investor.scholastic.com.

I would also like to note that this presentation contains certain forward-looking statements which are subject to various risks and uncertainties, including the condition of the children's book and educational materials markets and acceptance of the company's products in those markets, and other risks and factors identified from time to time in the company's filings with the Securities and Exchange Commission. Actual results could differ materially from those currently anticipated.

Our comments today include references to certain non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in the company's earnings release, which is posted on the Investor Relations website at investor.scholastic.com.

Now I'd like to introduce Dick Robinson, the Chairman, CEO and President of Scholastic, to begin our presentation.

Richard Robinson

Thank you, Gil, and good morning, everybody. Thank you for joining our fiscal 2013 second quarter analyst and investor conference call. For this morning's prepared comments, I'm joined by Maureen O'Connell, CFO and CAO. Our members of the management team will also be available to answer your questions later on the call. And today, I will cover our Q2 performance and key developments during the quarter, and I will then update you on our continuing development of digital reading and learning products for use in school and at home.

We had a tremendous year in fiscal 2012 with the phenomenal success of The Hunger Games trilogy and impressive sales of READ 180 Next Generation, and we knew that we would have a challenging year in fiscal 2013 given the timing of our planned product launches and tough comparisons for The Hunger Games. And indeed, 2013 has been a challenging year, and those challenges were exacerbated by external forces as well.

On November 20, 2012, we updated our outlook as a result of deferred decision-making affecting sales of our higher-margin educational technology products as school districts focus their spending on professional development training for the new Common Core Standards, as well as lower-than-anticipated sales in the Children's Book Publishing and Distribution segment. Our second quarter results were in line with the revised fiscal year 2013 outlook that we announced in November. Importantly, our operating performance did reflect the sales uplift in several of our businesses in November.

To align our cost base with our revised fiscal 2013 outlook, we have immediately begun to implement cost savings actions, which include our decision not to pay management bonuses for this fiscal year. These cost reduction actions, which Maureen will address shortly, will result in savings in the range of $20 million to $30 million over the remainder of the fiscal year and will impact all the businesses.

In Children's Books, we had strong sales of both our front list and back list in Trade, with sales of new releases partially offsetting anticipated lower year-over-year sales of The Hunger Games trilogy. Fast-paced sales of the new Captain Underpants title, the first in 6 years, attest to the enduring interest in this wonderful character. While our new multi-platform series, Infinity Ring, and the first book in the new Maggie Stiefvater quartet, The Raven Boys, both hit the New York Times and Publishers Weekly Bestseller List.

Strong Thanksgiving week sales demonstrates that our titles, including The Hunger Games box set, are proving to be popular holiday gifts this season. We also expect that next year's release of the paperback version of Catching Fire and anticipating -- anticipation for the Catching Fire film next fall will help support ongoing interest in The Hunger Games trilogy.

We also have a number of exciting new releases planned this year, including the third book in the Infinity Ring series, which will be available in February 2013; a new young adult novel by Paul Rudnick entitled Gorgeous; and My Adventures as a Young Filmmaker by Andrew Jenks, the award-winning filmmaker and star of MTV's critically acclaimed series, World of Jenks.

In School Book Clubs, revenue declined versus the second quarter of last fiscal year. Large increases in order volumes were offset by greater declines in customer spending per order. Superstorm Sandy also affected ordering in the quarter as some of our best customer schools were closed. We are making adjustments to our cost base in this business to reflect the revised outlook and the changing buying patterns of more than 800,000 teacher customers, representing 20 million children and their parents.

Despite Sandy-related fair cancellations, School Book Fairs revenue grew year-over-year, largely due to an increased fair count. Fairs did well despite abbreviated and delayed fairs in the Northeast while schools continue to support the growth of fairs as integral to school-wide literacy programs.

In Educational Technology and Services, our higher-margin product sales were impacted by purchasing delays as school districts focus spending on professional development to prepare for the Common Core State Standards this fall. Our professional development sales were very strong this quarter as a result. However, as you know, Services have a relatively low margin -- lower margin than products. The alignment of our educational technology products with the Common Core, including the 3 major new products we will launch next calendar year, will substantially benefit educators, students and our business in the long term.

The recovery in product sales in November indicates that we are moving toward a better balance of sales between our services and our educational technology products. We also believe that our recovery in November shows that educators feel greater certainty about support for education spending at the federal level and the upcoming agreement on the federal budget should leave Title 1 and IDEA intact, which provide major sources of fundings for our products and services.

In International, the growing global commitment to expanding English-language instruction, combined with the launch of our new educational publishing unit in Singapore, helped us to achieve strong sales in emerging markets. We are quickly expanding our product development in English-language learner programs in Southeast Asia to drive long-term growth.

During the second quarter, we made substantial progress on the digital transition of our businesses, which will open new opportunities for growth for the company. Our investments in e-commerce, e-books and new digital instructional programs in education will expand our sale of e-books in school and at home and will support school districts as they strive to raise student achievement and implement the new Common Core State Standards.

Our extensive digital product development centers on 3 key areas. First, in fiscal 2014, we are adding to our already robust list of industry-leading educational technology products for teaching and learning, which currently include READ 180, System 44, Fraction Nation, FASTT Math and others. Our new major Common Core-aligned educational technology programs are: MATH 180, which is a groundbreaking research-based math intervention program scheduled to launch in fiscal 2014. It is designed to teach the critical math concepts that are essential for meeting the higher standards for proficiency. We are launching Math Core, the first stage of MATH 180, this summer. MATH 180 is highly adaptive, research-based and motivating, patterned on our major READ 180 reading intervention program.

The second program, iREAD, also scheduled for introduction in fiscal 2014, is a technology-based literacy program for primary grades, and educators are asking for a system to help ensure that students are on track by Grade 3. The iREAD release is coming at just the right time to meet this need. Several states and districts have increased their attention on primary reading, and iREAD is designed to work universally with any reading approach or program.

System 44 Next Generation is set to launch later this fiscal year and is our foundational technology-based reading and phonics program. It is a prequel to READ 180 Next Generation. It serves middle school and upper elementary students who still struggle with phonics and fluency. It uses features that customers love in READ 180 Next Gen, including dashboards, more writing, more rigor to support the Common Core. We are also making progress developing mobile versions of our products. We have just released our READ 180 teacher dashboards for the iPad, and we'll be announcing more enhancements over the next few months.

The second area of digital product development includes our subscription-based products, such as BookFlix, TrueFlix, Grolier Online and Classroom Magazines, all of which are ideally positioned to help teachers use more nonfiction content in classroom instruction as is supported by the Common Core State Standards. We are rapidly developing new subscriptions of digital support programs in several key curriculum areas.

The third area of digital product development is Storia, our e-reading application, which we introduced through clubs and fairs in September. Storia is an e-reading app designed exclusively for children, which also allows teachers and parents to have a full view of each child's reading level and progress. And it has received strong support from teachers, as well as glowing reviews from critics in technology and media sectors.

We're building momentum in our Storia e-reading app downloads and registrations and are adding several thousand more titles to our e-book library, including those from other publishers. While this initiative is still in its early stages, we expect the longer-term benefit for e-book sales through our strong school-to-home connection and our school channels.

Focus group feedback indicates that teachers have a high level of interest in using Storia in the classroom, which we believe will drive even broader consumer demand for children's books. We are, therefore, adding more bookshelves and additional features to our classroom management system and dashboards for teachers who are eager to use Storia in their classrooms.

We're on plan in terms of the magnitude and timing of our investments, and we continue to expect these digital initiatives to generate strong profit growth in the future. With our strong cash position, cost savings program and recently amended long-term credit agreement, we have ample flexibility to continue investments to fuel long-term profitable growth, including our development of new technology-based learning products. At the end of next fiscal year, we expect to reduce our development costs for Storia and e-commerce and focus expenditures after that on maintenance and the expansion of our list of titles.

Maureen O'Connell will now review our financial results for the second quarter.

Maureen E. O’Connell

Thank you, Dick, and good morning, everyone. Let me begin with the income statement. Looking at the second quarter results, revenues declined 10% relative to last year, primarily reflecting stronger sales of The Hunger Games in the prior year period and lower educational technology product sales and Book Club revenues in the quarter.

Cost of goods sold as a percent of sales increased by approximately 100 basis points this quarter, primarily reflecting a change in our product mix in Trade and Educational Technology. SG&A, excluding onetime expenses of $4.7 million related to a voluntary retirement program and a $6.2 million charge related to a lease impairment in the prior year, was essentially flat. Overall, earnings per share from continuing operations were $1.89 compared to earnings per share of $2.62 a year ago.

Turning to segment results. In Children's Books, first quarter sales decreased due to declines in Trade and Book Clubs, reflecting the anticipated decline in Trade sales of The Hunger Games trilogy compared to the previous period. Book Fair revenues and profits were approximately in line with last year despite the effect on performance of cancellations due to Sandy. In School Book Clubs, revenues declined by approximately 21% compared to a year ago, primarily reflecting lower revenue per order. Overall, Children's Books profits were down compared to the previous period due to lower sales and our continued investment in e-commerce and e-books.

In Educational Technology, revenues and profits were down, as indicated by our revised 2013 guidance, due to decreased sales of educational technology products in the quarter. However, November sales were in line with November of last year. Classroom and Supplemental Materials Publishing sales and profits declined as expected as prior year results benefited from significant nonrecurring contracts with Reading is Fundamental. However, Classroom Magazines performed strongly in the quarter, driven by schools' growing need for nonfiction content in order to meet Common Core State Standards.

International revenues were slightly lower in the quarter, primarily due to weaker performance in Canada, which was partially offset by stronger results in the U.K. and Australia. Operating profits declined modestly as a result of lower sales. Media, Licensing and Advertising revenues and profits declined due to lower sales of consumer magazines and lower console sales.

Finally, corporate overhead in the quarter was $6.8 million. Corporate overhead a year ago included onetime, mostly noncash expenses associated with cost reduction programs of $10.9 million. Excluding these items, corporate overhead a year ago was $11.8 million. Corporate overhead was favorable due to employee-related expenses.

Turning to our balance sheet and cash position. Free cash flow for the quarter was $60.4 million as compared to $129.6 million in the prior year period, primarily due to the timing of collections and payments and lower earnings in the current period. Fiscal year-to-date cash flow was $64.4 million compared to $61.6 million in the first half of the last fiscal year, largely the result of the collections of Hunger Games-related receivables and the payment of royalties and better accounts payable and inventory management, partially offset by lower net income and higher incentive comp and tax payments related to last year's overall operating results.

At the end of the quarter, our cash and short-term investment position exceeded our total debt by $103.7 million compared to net debt of $44.4 million this time last year. We ended the quarter with $257.3 million in cash on hand, and in early December, we announced that we have successfully amended our long-term committed credit agreement, which, among other things, upsized the available credit to $425 million and extended its term to December 2017. As we have indicated, we plan to use this facility to repay our 5% senior notes upon maturity in April 2013.

To date in the current fiscal year, we have bought back approximately $1.5 million of our common stock and now have just under $30 million remaining under our previously announced repurchase limits. Yesterday, we announced our regular quarterly dividend.

As Dick mentioned, we have a cost reduction plan that we are in the process of implementing to offset pressures on operating income. As part of this program, we will not pay management bonuses for fiscal year 2013. In addition, we have implemented a hiring freeze and are actively reducing staff levels in some areas, such as Book Clubs. We are also targeting a 30% reduction in travel and entertainment and general expenses and seeking other operational efficiencies.

The new cost reduction program will result in savings of $20 million to $30 million over the rest of the year, and we expect a onetime charge of approximately $10 million to $15 million in the second half of the year related to this cost-reduction initiative. We will continue to take action to protect our profitability as necessary.

Looking at the rest of fiscal 2013, we are affirming our revised fiscal 2013 outlook for total revenue of approximately $1.8 billion to $1.9 billion and earnings per diluted share from continuing operations in the range $1.40 to $1.60 before the impact of onetime items associated with cost reduction programs and noncash nonoperating items. Based on our strong year-to-date working capital management, we are also affirming our revised outlook for free cash flow in the range of $100 million to $120 million.

Richard Robinson

Well, thank you, Maureen. Before we open up the call to your questions, I would like to address the news of the Sandy Hook school shootings last Friday morning. This was a school where we have 15 teachers using our magazines, book clubs and other scholastic materials, including one of the teachers who died protecting her children.

Through our materials, including our websites, which are used by 1.5 million teachers weekly, we have sadly had considerable experience in helping students, families and teachers understand and deal with tragic events. These events remind us that our teachers and our schools are the greatest support that children and families can have at all times, but especially in times of tragedy and that we must not let this event cause us to fortify our schools or board up our classrooms in fear. Instead, we must ensure that our schools and our teachers can continue to provide families with optimism and hope, coupled with practical ideas for ensuring that our schools remain safe places for learning.

We ask our officials to take measures to protect schools and children against school shootings while providing mental health resources and other support our schools must have. As always, Scholastic is proud to provide the ideas and suggestions to help teachers give hope and direction, especially in these most difficult moments, and to continue to make schools a place that is dedicated to the highest and best hopes of society. Our hearts go out to the families who lost their dear first-grade children, and we mourn and honor the 6 educators who gave their lives to protect students, showing the heroism which is emblematic of the teaching profession at its finest.

I will now moderate the question-and-answer period. And in addition to Maureen and Gil, I am joined this morning by Ellie Berger, President of Trade; Margery Mayer, President of Scholastic Education; Judy Newman, President of Book Clubs and e-commerce, as well as other members of our executive team. And operator, we are ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Drew Crum of Stifel, Nicolaus.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Want to start with the education publishing business. Dick or Margery, could you comment on your expectations for timing of implementation on Common Core and the delay or deferment that you experienced in the current quarter, the second quarter? Is that what you view as a onetime item? Or is that possible we continue to see that in front of Common Core implementation? And then, the second question as it relates to ed publishing is it sounds like you're anticipating the System 44 Next Gen product to launch sometime at the end or near the end of fiscal '13. Could we see a bump in revenues for ed tech products in your May quarter?

Richard Robinson

Yes, the answer to your last question is yes. We do expect a bump in May of 2013, which is the last month of our fiscal year. Drew, I'll ask Margery to address the Common Core State Standards. Of course, those standards affect our entire company and all the things that we do. But they're -- particularly, the delay in purchasing of product has definitely connected to the thought that schools are putting into adapting to the Common Core State Standards, and Margery can address that question for you.

Margery W. Mayer

Drew, it's Margery. Anyway, so Common Core, it's interesting how pervasive Common Core is in the 46 states that have adopted it. And we're seeing schools really spending some time and thought on thinking about how are they actually going to make this happen, and that's why a lot of it is going into professional development right now. And all of our professional development teams, our literacy team, our leadership team and our math team are doing a lot of Common Core work. We see Common Core as coming in phases, and we think we're, right now, in Phase 1, which is a readiness and learning phase. And we believe that schools and districts are going to emerge from that rapidly and start thinking about, "Okay, what are the materials that actually we're going to have to use in order to make this happen?" So I think we're extremely optimistic about what Common Core is going to mean for kids and also for Scholastic. All of our new products are strongly aligned to Common Core. We've added some Common Core stretch lessons to READ 180, which we're getting a great reaction to. So I think we have a terrific team of people working on how to make sure our materials support Common Core. I think you know that there's a lot of concern about the new assessments that are going to be out in 2014 and what are -- and the thought that we're going to -- the way they're going to be more rigorous and more kids are going to be -- appear to be having difficulty, and we think that's going to be really, sadly but truly, good for our business.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Okay. Just shifting gears to Clubs. If you take out the impact from the hurricane, maybe for Judy or Dick, can you talk about what you would attribute the weakness -- the underlying weakness in the business to? I think you mentioned lower revenues per order. Any additional color you can provide there and what you can do to fix that business from a top line perspective, at least?

Richard Robinson

Sure, let me -- I'll ask Judy to address that, but let me just give you a thought here, Drew. As teachers use our e-commerce more effectively, and almost 85% of them are using it now, there seems to be a trend toward many greater orders but they're smaller orders. And we're analyzing that, and we're putting in promotion ideas that will help the teachers expand the revenue per order. That's a key part of the situation. There's a tremendous amount of engagement from our 800,000 teacher customers. They're ordering more, more frequently, but we're -- the issue seems to be, are they ordering differently and ordering lower-priced product because they're able to search more through our system? And how can we return them to ordering more broadly from all their classes and engage more kids and parents in the process. There's also some very good support for the PCOOL, that is the PARENT COOL, where parents are ordering through credit cards right to the teacher, and that's -- the people who are doing that are buying more and buying more frequently. So there are several trends going on there, and we're trying to piece them together. Judy can enhance that with her comments.

Judith A. Newman

Drew, we are seeing, as Dick said, a huge adoption of our COOL system by teachers. About 85% of our 800,000 teachers are actively ordering on COOL. And so what we're experiencing in all this huge surge of orders is the parents sort of starting to move onto PARENT COOL under the teacher's direction. And when -- as Dick said, when the parents are online ordering, we're seeing higher revenue, more units, more engagement, more frequency. And so we're all about sort of transitioning some of those "paper parents," if you will, onto PCOOL. And when we do see that dynamic, we see a lot of more larger orders rather than just smaller orders, which we see more with the paper people. So we're very optimistic as we move these people to online. And of course, we are also offering e-books through the club channels, and we're starting to see great adoption among parents and teachers there. So we see a great future as people move online into digital to this tried-and-true marketing channel where there is so much activity amongst so many classrooms

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Great. Last question from me, just with respect to The Hunger Games, you mentioned the paperback for Catching Fire next year, along with the theatrical release. As I think about, historically, what Harry Potter sales did in conjunction with theatrical release, is that a fair way to think about book sales for Hunger Games going forward? I think you guys would generally get about $10 million to $15 million in the quarter that coincided with the theatrical release around Harry Potter. Is that how you're thinking about Hunger Games sales for fiscal 2014? Or maybe you can provide some color there.

Richard Robinson

Before we turn to Ellie, Maureen has some comments she would like to make on this point, Drew.

Maureen E. O’Connell

Yes. I'd say we are expecting a sales increase with the movie release. We were disappointed with the video release that we did not see the lift that we had anticipated. So we're not expecting as much as we would have expected with The Hunger Games release, but we will have assumed lift for that.

Richard Robinson

Ellie, you want to further comment?

Ellie Berger

Yes. No, I think that the strong -- the sales actually, right now, are very strong on the core books. We -- as Maureen said, we didn't see the lift we had hoped for against the DVD, but we're seeing tremendous sales right now on the box set. And as we go towards the movie, we expect to working closely with Lionsgate in making sure the book's out in front of the section and selling strongly.

Operator

[Operator Instructions]

Richard Robinson

Well, thank you all for supporting our conference call. We have a strong cost-cutting program, with some signs of pickup in our revenues. We believe we will enter -- we'll finish our fiscal year as promised. And we thank you for your support and wish you a very, very happy holiday season.

Operator

Ladies and gentlemen, this does conclude today's conference. You may all disconnect, and have a wonderful day.

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