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Scholastic Corp. (NASDAQ:SCHL)

F2Q09 Earnings Call

December 18, 2008 8:30 am ET

Executives

Dick Robinson - Chairman of the Board, President, Chief Executive Officer

Maureen O'Connell - Chief Administrative Officer and CFO

Ellie Berger - President, Trade Publishing

Margery Mayer - Executive Vice President and President, Scholastic Education

Judith Newman - Executive Vice President and President, Book Clubs

Hugh Roome - Executive Vice President

Jeffrey Mathews – Vice President, Corporate Strategies and Investor Relations

Analysts

Drew Crum - Stifel Nicolaus

Catriona Fallon - Citigroup

Amy Minella – Cardinal Capital Management

Operator

At this time I would like to welcome everyone to the Q2 2009 earnings conference call. (Operator Instructions)

I would now like to turn the call over to Jeffrey Mathews, Vice President of Corporate Strategies and Investor Relations.

Jeffrey Mathews

Good morning and thank you. Before we begin, I’d like to point out that the slides for this presentation are available for simultaneous viewing by going to our website, www.scholastic.com, clicking on Investor Relations and following the links on that page.

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 market, the 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.

Now I’ll introduce Dick Robinson, the Chairman, CEO, and President of Scholastic to begin our presentation.

Dick Robinson

Thank you Jeff and good morning and thank you everyone for joining us on our fiscal 2009 second quarter conference call. This morning I am joined by Scholastic’s Chief Administrator, Administrative Officer and CFO, Maureen O’Connell, and members of the executive team are available for Q&A at the end of this call.

In a tough three month period for most businesses we are strongly encouraged that we held revenues, reduced costs significantly and maintained a healthy balance sheet last quarter. In the face of cut backs in consumer and education spending, Scholastic had strong support from its customers, has seen an increased order and unit volume in school book clubs, higher participation in revenue per fair in school book fairs and a strong, solid list of best sellers and trade publishing.

In educational technology in addition to sustaining our sales levels we had solid sales of consulting services to our installed base of customers who increasingly rely on us to help them raise student achievement. Last quarter we also achieved the top end of the cost savings target we announced in July, eliminating $35 million in annualized expenses including $25 million in salaries.

While these cuts will primarily benefit fiscal 2010, we will see some positive effect in the second half of fiscal 2009. We also continued exiting unprofitable businesses.

While we continue to be solidly profitable, operating income declined by approximately $30 million last quarter. This reduction was primarily due to $11 million in severance and one-time expenses associated with our cost reduction actions as well as an unfavorable foreign exchange impact of $7 million. We also had higher royalty and bad debt reserves in the U.S. and international trade businesses of $6 million reflecting a more conservative outlook.

The remaining year-over-year decline in operating income was due to increased investment in customer retention and acquisition of school book clubs which I will discuss in a moment. Excluding these factors, operating income was approximately flat year-over-year in line with revenue.

To provide further profitability in this year we have cut our spending plan for the second half of fiscal 2009 by an additional $20 million and continue to streamline our key businesses which Maureen will discuss in a moment.

Finally, we finished the second quarter with a healthy balance sheet, the result of five years of strong free cash flow with which we have paid down debt and returned cash to shareholders. Based on the company’s solid financial foundation, our rock solid relationships to our children’s book and education customers and our growing e-commerce strength, we are positioned well to meet our goals in growth in our core businesses and long-term operating margins of 9-10%.

School book club, school book fairs and trade publishing all maintained second quarter sales levels compared to last year excluding an anticipated decline in Harry Potter sales. September revenues have also been strong in each channel, boding positively for the third quarter. These results reflect Scholastic’s unique value proposition and the resilience of the children’s book and education publishing sectors during economic down turns.

In school book clubs order volumes rose 6% in the quarter. Strong unit growth showed that club’s value pricing is attractive to our teacher, child and parent customers. We also invested in customer retention and acquisition, offering more bonus points and increasing customer service staffing. Club’s strong bond with teachers and families has always been the foundation of this business so we are encouraged by these results and the strong December order volumes as well. Book club customers did buy lower priced items last quarter, yielding lower revenue per order which offset higher order volumes.

Gross margins actually improved because of pricing changes we implemented through the school year. We continued boosting revenue per order and know that when teachers enable parents to order their kids’ books on line the total classroom order grows significantly. Last month we began a phased roll out New Cool, the revamped online selling and marketing platform that is a key element of this strategy. We expect full deployment by the end of this school year.

While this will have some benefit in the second half, the more substantial impact is expected in fiscal 2010 when New Cool will be operating for the whole year with all of our customers.

School book fair’s value proposition focuses on supporting schools and less on price. Last quarter revenue per fair rose a solid 6% driven by increased fair traffic from kids, parents and grand-parents. This indicates success with a number of initiatives to drive participation as well as greater interest in helping schools in the current environment on the part of families.

In a pattern similar to that in clubs, average purchase order sizes were smaller reflecting tighter wallets and purses partially offsetting the benefit of higher participation. Fair’s other key revenue driver is the number of events held which declined 5% in the second quarter. However, this was largely the result of a late Thanksgiving holiday and as a consequence, December has been very strong compared to the prior year and we are confident of achieving solid December results and a full-year fair count in line with last year.

Scholastic trade publishing also had another strong quarter and robust front and back list sales excluding Harry Potter which had strong revenues from box sets in last year’s quarter. Earlier this month we released One False Note, the second title in the 39 Clues series, our innovative new franchise that combines books, our interactive website, prizes and collectible cards. This title immediately reached the top of the NY Times Best Seller list. Meanwhile Maze of Bones, the first title, remains at number five.

The 39 Clues website is also seeing great engagement with user registrations growing quickly. Given that successful series typically follow a stair-step pattern with each successive release driving sales of previous titles, we are excited about such strong reaction to the 39 Clues after launching only two of the ten titles.

Our publishing shows broad strength too with six titles in the upcoming NT Times Best Seller list including The Hunger Games by Suzanne Collins and we are also seeing revenue for the Charlie Bones series and Too Many Toys by David Shannon among other front and back list titles.

On December 4 we released the Tales of Beetle the Bard by J.K. Rowling which will improve third quarter revenue. However, because most of the proceeds go to the author’s charity it will only have a modest impact on Scholastic’s bottom line. There has, however, been a positive impact on the sales of the Harry Potter series books which are rejoining this week’s NY Times Children’s Series Best Seller list.

In international revenue was up strongly in export. Australia, Canada and Asia offset by unfavorable foreign exchange and an expected decline in U.K. sales. Revenue in the media licensing and advertising segment was also up last quarter driven by strong results in the consumer magazine group as well as sales in interactive products and programming such as Word Girl on PBS and Turbo Dogs on Qubo.

Turning to Scholastic education, our leading educational technology business also largely sustained sales levels last quarter. Despite tighter budgets and longer sales cycles school districts continue seeking solutions like Read-180 and Fast Math that have been proven effective to raise student achievement. Providing services to our installed customer base also continues to be a growth area. Last quarter’s results did not include sales of System 44, the prequel to Read-180 for which we have already shipped $4 million in sales in December and did not include a sale to a major urban district we announced last call. Both should benefit the second half.

In addition, last month the California State Board of Education by unanimous vote adopted Read-180 and System 44 for reading intervention with students including English language learners in grades 4-8.

Total education segment revenue declined last quarter primarily because of lower classroom and library sales. However, this was largely a matter of timing with a key sale occurring earlier this year than last. For the first half of the fiscal year, total classroom library sales rose relative to last year.

Segment operating income and margin both increased despite lower sales as a result of our actions to reduce sales force costs while improving operating efficiency. Overall, Scholastic Education’s outlook for solid revenue and improving margins is positive despite a difficult market for many educational publishers.

To sum up, our core children’s book and education businesses held sales steady in the quarter and we are having a strong December. Our balance sheet and cash position remains strong and we have achieved our $35 million cost reduction goal. We have also reduced costs by an additional $20 million for the second half.

While we are conservatively reducing our full-year guidance to $120-150 to reflect the current business environment, our current operating plan calls for us to match last year’s performance for the second half with cost reductions providing an extra measure of profit. We believe we will achieve this plan bringing us to the higher end of the range.

While the economy remains uncertain, our core children’s book and education businesses are strongly based on parent, school and teacher need for our products and services and deep loyalty and support for the service we provide to them. This quarter we saw increased engagement and involvement from our customers, leading to steady sales. December revenues which occur in our third quarter are ahead of last year’s levels. We have achieved solid cost savings and are committed to doing more. We are therefore confident in our business plans for the second half.

Now Maureen O’Connell will provide further detail on our balance sheet and cost reduction program as well as our current results and our outlook.

Maureen O’Connell

Thank you Dick and good morning everyone. Scholastic has had a strong track record of carefully managing its cash, debt and current assets. As a result our balance sheet is strong with net debt levels at 30% of capitalization. Our debt is mostly long-term with low interest rates and we have no refinancing needs until June 2012.

At the end of the second quarter we had approximately $160 million in public debt, paying 5% interest and maturing in 2013. We also had $234 million in bank debt. This included $157 million in an amortizing loan currently priced at libor plus 87.5 basis points. We pay quarterly principle payments of $10.7 million through June 2012. We also had $45 million borrowed under a mostly untapped $325 million revolving credit facility which is contractually committed until June 1, 2012. We use this facility for working capital and other general purposes. It is currently priced at libor plus 70 basis points.

Finally, we had $27 million in credit line advances for our international operations. All of Scholastic’s bank debt is unsecured. Relative to a year ago total debt was down last quarter reflecting principle payments on the term loan and repurchases of some public debt. Last year’s very strong cash position was hoisted by strong Harry Potter cash received before we made significant royalty payments later in the fiscal year. Also impacting the year-over-year cash position were repurchases of $40.1 million in common stock which was accretive to earnings.

We are also very focused on current assets, particularly receivables and inventory in the current environment. Collection is rarely an issue in Scholastic’s businesses where we collect cash with orders in the case of school book clubs and fairs, or target the public sector in the case of Scholastic Education. In trade publishing where we extend credit to retailers and distributors we are working very carefully with all of our accounts.

Our largest trade accounts include WalMart, Costco, Target and Barnes and Noble, representing a total majority of our trade receivables. We are confident in the ability of these key partners to pay. Finally, we have been focused on reducing inventories which are largely driven by school book fairs over the last several years. Early buying this year to avoid a potential port strike has temporarily increased inventory but beyond this timing factor we expect to achieve continued progress by year end.

Cost reductions have also been a top focus this year as we adapt to the economic environment and continue to target long-term margin improvement. Many of our peers in the book and education industry have recently announced cost and headcount reduction efforts. Anticipating a challenging environment last year in July we announced our plans to reduce annualized spending by $25-35 million. Consequently we have already made significant progress and achieved the high end of that goal.

First, addressing external costs and vendors we were able to avoid an offset of approximately $10 million in increases in significant cost areas such as paper, manufacturing, shipping and temporary labor. We then made the difficult decisions about salaries and headcount. By suspending annual salary increases for most of the staff and management, implementing a voluntary retirement program and eliminating other positions we reduced annual salary expense by approximately $25 million. In total, approximately 300 positions have been eliminated representing 6% of domestic work force primarily in corporate and division headquarters.

These savings will primarily benefit the next fiscal year. In addition to the $10.9 million of expenses incurred last quarter we expect additional pre-tax severance and one-time expenses related to cost reductions of approximately $5-6 million in the second half, primarily in the third quarter. As Dick mentioned, we reduced our spending plan for the second half of the fiscal year by $20 million by eliminating management bonuses as well as discretionary spending including consulting, T&E, training and sales conferences. We also are continuing to improve efficiency in our core businesses such as Children’s Books.

Finally, we continue to review our portfolio of businesses, exiting unprofitable, non-core areas. Last quarter this included our Argentine Subsidiary and door-to-door sales operations in Puerto Rico as well as a trade magazine. For accounting purposes these businesses are now classified as discontinued operations in the current and prior year period. Last quarter’s year-over-year increase and losses from discontinued operations primarily relates to non-cash write downs associated with these businesses.

Turning now to the second quarter results, revenue declined 4% in U.S. dollar or 1% in local currencies excluding $21.5 million in foreign exchange impact. Cost of goods sold increased slightly as a percent of revenue primarily due to higher royalty reserves and trade.

Sales, general and administrative expenses rose as a result of severance and one-time items related to cost reduction. In addition to $10.9 million in one-time severance and stock compensation associated with accelerating vesting of restricted stock for employees who are eligible for retirement, it was $2.7 million of normal core severance last quarter compared to $2.6 million in the prior year period. Also recorded in SG&A was normal core stock compensation of $2.4 million up from $1.7 million a year ago. SG&A was also higher because of increased investment in customer acquisition and retention programs in book clubs.

Lower sales expense in education partially offset these factors. Bad debt expense rose $3.9 million due to higher reserves in the U.S. and U.K. trade businesses. While now classified as a discontinued op in the prior year, the significant bad debt associated with continuity business was eliminated when we sold the business.

These mostly one-time expenses and reserve adjustments in addition to unfavorable foreign exchange explain the year-over-year decrease in operating income. Otherwise operating income was approximately level and in line with revenue. Scholastic’s effective tax rate rose last quarter reflecting losses in foreign operations for which we no longer expect to realize a benefit and the loss of deductions resulting from lower income tax.

Free cash flow in the quarter was $48.4 million compared to $299.3 million in the prior year period. This difference is primarily because of Harry Potter related working capital factors a year ago including the timing of cash receipts and royalty payments as I just mentioned.

As Dick and I have discussed this morning, the company has taken significant actions to best position itself in the near and long-term. Based on the current environment, year-to-date results and spending cuts we have revised our outlook for fiscal 2009 earnings per diluted share from continuing operations to $1.20 to $1.50 excluding severance and one-time expenses related to cost savings. This revised full-year outlook equates to approximately $0.65 to $0.95 per share in the second half or flat to $0.30 above the prior year.

Our plan fills the second half gap in several ways. The additional $20 million in spending cuts I just described, $10 million in salary savings we expect to realize this year from the $25 million reduction in salaries we just achieved, higher educational technology sales following this month’s launch of System 44 which is already generating strong second half sales, lower sales expense in that business should also continue to benefit operating income. Partly offsetting these factors will be continued investments in new products, customer retention and acquisition and strategic initiatives such as Cool and point-of-sales systems that position us for long-term growth.

As Dick indicated, this revised range for guidance reflects uncertainty in the current operating environment at the low end and at the top end our cost reductions and generally solid outlook for children’s books and education. Based on this outlook for earnings, free cash flow is now forecasted to be $55-80 million. With solid profitability and free cash flow we continue to expect our balance sheet to be stronger at year end.

Now I’ll turn the call back over to Dick.

Dick Robinson

Thank you Maureen. As I mentioned earlier our core business remains solidly based on needs of schools and families. In difficult times this is particularly important. Every day 55 million children attend grades K-12 and many more attend early childhood programs. These children, along with their parents and teachers, use Scholastic clubs and fairs, read Scholastic books and use our educational technology and supplementary materials. This consistent, renewable market place is the foundation for Scholastic’s steady sales and long-term growth as we saw last quarter in a difficult environment.

Based on these solid results and our success in reducing costs and managing our balance sheet, we remain confident we will reach the higher end of our guidance in the second half based on our current operating plan and cost reductions. Longer term we will continue to grow our core businesses, serving our loyal customers while improving profitability and maintaining a solid financial foundation.

Now I will moderate a question-and-answer period. In addition to Maureen, I am joined this morning by Ellie Berger, President of Scholastic Trade Publishing; Deborah Forte, President of Scholastic Media; Margery Mayer, President of Scholastic Education; Judy Newman, President of Scholastic Book Clubs and Hugh Roome, President of Scholastic International.

With that let’s open the call to questions.

Question-And-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Drew Crum - Stifel Nicolaus.

Drew Crum - Stifel Nicolaus

I want to start with the guidance for 2009. Is there a revenue range you are looking at for 2009 now?

Maureen O’Connell

In line to our current performance we are looking for a slight increase to flat revenue in the second half of the year excluding Harry Potter.

Drew Crum - Stifel Nicolaus

The $0.65 to $0.95 you mentioned in the second half for 2009 that is excluding the severance charges and one-time items?

Maureen O’Connell

Correct. It includes normalized severance. As you know we had severance in the past on a normal basis but we have included that $8 million of normalized severance but this additional severance related to these cost action programs we have put in place such as the voluntary retirement and other cost programs is not included.

Drew Crum - Stifel Nicolaus

What are you assuming as far as the allowance for doubtful accounts which I believe was about $6 million pre-tax in the second quarter in addition to foreign currency? Can you talk about what your assumptions are there for the second half of 2009?

Maureen O’Connell

We prudently reserve for our trade receivables in both our domestic and U.K. businesses. So that does include an enhanced reserve for bad debt for those two businesses looking more conservatively at the current outlook.

Drew Crum - Stifel Nicolaus

Anything on foreign currency?

Maureen O’Connell

We are assuming a flat foreign currency base in the second half.

Drew Crum - Stifel Nicolaus

I also wanted to ask you about the pricing strategy you implemented at the beginning of the academic year. Can you measure the success of that initiative? Can you quantify the benefit you got or recognized during the second quarter? You mentioned you had seen a transition or flight to lower ticket items.

Maureen O’Connell

If we look at our cost of goods sold where the impact of higher pricing will show up, that rate has actually improved before you factor in the increase in royalty reserves and higher amortization associated with our new product development so we are seeing real benefit from the price increases. Even though they are migrating to lower price items there was still a big value gap there and we were able to raise the prices on those lower priced items as well. So we are seeing in all our book businesses the benefit of the price increase.

Drew Crum - Stifel Nicolaus

The Harry Potter contributions in the second quarter I know you released the 10th anniversary book. I just wanted to get a sense of the contributions from Harry Potter in the second quarter and what the comp is there.

Maureen O’Connell

Harry Potter box set was worth about $10 million on revenue in Q2.

Operator

The next question comes from Catriona Fallon – Citigroup.

Catriona Fallon - Citigroup

I’m just trying to work out the after tax impact of the severance. My estimate tells me it is about $0.17 of severance before tax. Is that about $0.12 after tax?

Maureen O’Connell

I believe it is in the press release. $0.17 after tax. Our tax rate has gone up this year so that is affecting that calculation.

Catriona Fallon - Citigroup

Regarding the Puerto Rico and Argentine businesses, can you walk me through the thought process a little bit there? How long have you been thinking about discontinuing these businesses and what other businesses are there similar that you might also look to discontinue?

Hugh Roome

We have been looking closely at all our businesses overseas. In the case of Argentina, difficulties in the local economic environment meant that we didn’t see that business which had been making losses was going to go into profitability in the next two years or more. In the case of Puerto Rico we have a good Scholastic business in Puerto Rico for book fairs and book clubs and a very sound educational business. This was the door-to-door selling operation where we sell encyclopedias. It was the former Grolier business there. That business in a high unemployment and difficult economic environment also did not look like it would make profits going forward.

So these were two examples. On the international side we continue to look at all sides of the portfolio but this will enhance our profitability going forward.

I will go back to Maureen regarding our view overall.

Maureen O’Connell

At this time we are going through our strategic planning process and we are looking at all of our businesses in light of the current environment and what is the likelihood we will achieve our margin goals in each of these businesses with a very critical eye and that is why we are saying we are looking at our portfolio businesses and if there are businesses that were strategic investments in a better economy that may not pay out in this economy we will look at that and decide whether we should be in this for the long-term.

Catriona Fallon - Citigroup

It seems a lot of companies are taking a look at their operating margins in this type of environment. I’m wondering if there is any change to your 9-10% operating margin goal.

Dick Robinson

No, we are very committed to that. In fact we are increasing our commitment to cost reduction in the second half this year. We achieved our $35 million first half goal and we are continuing to sharpen our focus on margin. We are holding steadfast to our 9-10% operating margin goal.

Catriona Fallon - Citigroup

On the 39 Clues, there have been two books released so far. Can you give us an update on the print volume and sales volume of those two books?

Ellie Berger

The second book that released earlier this month we are really excited to see sales actually doubled from what the first book had come out at. Back list sales of the first book continue to grow as do hard sales and in fact the second book will hit number one on the Times Best Seller list this week and we just learned it will be for the following week as well at number one. So we are very excited and look forward to the launch of the third book in March.

Catriona Fallon - Citigroup

But no detail on the print?

Ellie Berger

We have over a million copies of the three. The first two books and the card pack out in the market right now.

Operator

The next question comes from Amy Minella – Cardinal Capital Management.

Amy Minella – Cardinal Capital Management

On the fairs and you mentioned in the second quarter some of the fair revenue was pushed to the third quarter. Could you tell us how much that is from a dollar point of view?

Dick Robinson

Probably around $4-5 million for fair revenue that got pushed to December.

Operator

At this time there are no further questions. Are there any closing remarks?

Dick Robinson

I would like to ask Judy Newman and Marge Mayer to briefly summarize their view of the current businesses in clubs and education and then we will make some final remarks.

Judy Newman

Thank you Dick. Going into this market we believed we had really a big opportunity to embrace our customers and really strengthen our relationship with the teachers and students and parents who turn to book clubs and to dependable sources of books and learning products really during all times.

As we have been saying through this call we strategically gave teachers more bonus points to reward them for participating in book clubs. We promoted our low price, great value and by the way great margin products. We added some additional catalogs with our Vote for Reading offer which tied into the [inaudible] and we increased our customer service staff to make sure our customers had access to our experts so that they could have their questions about products and service answered immediately with no wait.

We had very low abandon rates as we call them. As we said this did yield a little bit of incremental promotion expense but we saw an extraordinary customer response. We have seen it in the second quarter and we are continuing to see it through December. We literally had those trucks lined up at the warehouse until 1:30 a.m. shipping those boxes to make sure that the teachers got their orders before the holiday break.

So customers have been purchasing the lower priced, higher margin products and this offset kind of that trend towards the lower priced product they were buying but this was really offset by a 6% increase in orders and a tremendous increase in units. We are really, really excited by this great response to our business. It is just once again a validation of the resiliency of the book clubs in all times as a tremendous partner to teachers, parents and children. We are well positioned for the second half of the year and we are very excited about that.

With that I will turn it over to Margery.

Margery Mayer

Thanks Judy. Good morning everybody. We were really pleased with our quarter. We felt that we had good margin improvement in the quarter. We think we made some really wise decisions about re-engineering our selling costs. We reduced some productivity costs while we invested more in service where our business is growing extremely well. Our technology sales held up in the quarter and overall we feel that there is opportunity in the market place if you follow the money.

A lot of our purchasing comes from funds that have not been cut. They come from Title I funds, from Special Ed and we are seeing some good estimates coming from those funds. Going forward we are excited about System 44. We have had an incredible response to it. The program is designed to teach skills that help children do well in Read-180 who are really not ready for 180 and so we have been going back to our devoted customer base for Read-180 and we are getting an incredible reaction to it. We are delighted we got listed in California for the upcoming intervention call and System 44 is a lead product in that adoption so it is submitted with Read-180 but we have a combination product now of 44 and 180.

Overall, we believe this can be a good market for us. There are still kids who need achievement. We are excited about the Obama administration and their investment in early childhood. We think they are going to be unrelenting about raising achievement for all kids. So we go into the second half full of hope.

Dick Robinson

We obviously are proud of the fact we sustained sales in a difficult quarter, that we achieved our operating cost target of $35 million and have added $20 million more to that cost reduction program for the second half and we have a strong balance sheet going forward. Our businesses are rooted in deep need of schools, parents and families. We believe that is what sustains us and sustains them in difficult times. Our staff is very, very committed to achieving the top end of our guidance for the second half and we will do everything we can to reduce costs and achieve the sales we believe we can achieve in this difficult environment.

Thank you all for your attention and for your support of Scholastic.

Operator

This concludes today’s conference call. You may now disconnect.

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