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School Specialty, Inc. (NASDAQ:SCHS)

F3Q09 (Qtr End 1/24/09) Earnings Call

February 19, 2009 11:00 AM ET

Executives

Mark Fleming - Investor Relations Director

David Vander Zanden - Chief Executive Officer

Thomas Slagle - President and Chief Operating Officer

David Vander Ploeg - Executive Vice President and Chief Financial Officer

Analysts

Trace A. Urdan - Signal Hill Capital

Robert Evans - Craig-Hallum Capital

Mimi Noel - Sidoti & Company

Operator

Greetings, and welcome to the School Specialty Third Quarter 2009 Earnings Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this call is being recorded.

It is now my pleasure to introduce School Specialty's Investor Relations Director, Mark Fleming. Mr. Fleming you may begin.

Mark Fleming

Thank you, Sherry. Good morning everyone and welcome to School Specialty's fiscal 2009 third quarter earnings conference call. Our presenters today are Chief Executive Officer, Dave Vander Zanden; our President and Chief Operating Officer, Tom Slagle; and our Executive Vice President and Chief Financial Officer, Dave Vander Ploeg.

Before I turn the call over to Mr. Vander Zanden, I'd like to take a moment to read our Safe Harbor. Any statement made during this call concerning future events of operations, expectations, plans or prospects are forward-looking statements. Forward-looking statements also include those preceded by or followed by words like anticipates, believe, could, estimate, expect, intends, targets or similar expressions. These forward-looking statements are based on School Specialty's current estimates and assumptions 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 the company's annual report on Form 10-K for the 2007 fiscal year. Those 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.

With that, I'll turn the call over to Dave Vander Zanden. Dave?

David Vander Zanden

Hi. Thank you, Mark. Good morning everyone. Same that... one that most of my comments to the macro environment what's going on with the state spending and how the stimulus funds work the way into education to see if that can help frame that for you on what's happening out there.

Before that I'll just give you some very brief comments on Q3. Q3 is really not predictable future results. At the end of our selling cycle, most new product offerings, pricing strategies and so forth are introduced in January. And so Q3 really represents the results of last year's decisions.

It's also the time here we drop products so just after lessons reserves for any products that were dropped where we have issues and small changes whether they are positive or negative tend to influence the results. And for this particular year we'd also comparing to record results in the prior year.

So at this point, I'll leave to Dave and Tom to the color of Q3 and they can comment as well on some of the current initiatives. So what's going on out in the marketplace. The schools basically are in a wait and see what happens mode. All the talk of state deficits and the challenges where the economy had really spooked to the school administrators and they are sitting on funds waiting to see how this is going to settle out.

The governors, of course, were waiting to see what happened with the stimulus package, and a lot of politics occurred. The governors are certainly going to talk about huge challenges and deficits, many of which are real as they wait for the decision on stimulus funds. They certainly don't want to indicate thing are fine.

Now that is past, the governors will begin to prepare their budgets what pulls us out. In the meantime a lot of that talk has secured the schools into sitting type and holding funds.

Normally, at this time of year we have the governor's budgets out. We're probably running about 30 to 45 days behind where we normally are at this time in the year and receiving those budgets. This stimulus plan which is finally signed on Tuesday, we're not just beginning to hear how if we'll help each state in this age are just calculating their funding for schools, and the governors are just preparing their budgets. And I'll comment in a few minutes of what we have learned in the last couple of days and how this might affect state budgets and give you some examples.

The federal stimulus plan was good for education. We estimated that K-12 is going to receive about 80 billion from this package over the next couple of years. Of the state stabilization fund of 53 billion over 40 is designated for schools. So that will come through the states. In addition, the schools have accessed to ITEA (ph), early childhood, title one and hedge start funds that will come directly from the feds that's another roughly 40 billion. All of this is going to help us as we're going to help schools access funds in those areas.

The safe funding for schools must be distributed through the normal sale allocation plan and be at least at the 2006 levels of spending for education for the stage to accept the funds and there are exemption opportunities for states federal and some trouble from that 2006 level.

Any excess funds over that level are going to be distributed according to the title one formula, and the funds are generally available beginning July 1. So the start of both the state and... generally the states start year at July 1 and the school budget years of July 1. So now that the stimulus bill is been passed, the budget process will probably begin, and we'll start to see what's going on.

To remind you the state funding is about 50% of the revenues that the schools receive. So it's very important to understand this piece. The national conference of state legislator which we look at as a source of how the states are doing issued report two weeks ago and they project that states will have a deficit of 84 billion in 2010. And to remind you, states have to pass the balance budget. So they are going have to address that.

Now, to understand the 84 billion, it assumes that there are no increases in taxes or cuts to expenses of the states that are incurring today, represents a lowered forecast of revenues which could go yet lower, and it represents the current run rate of expenses. So any cuts that you are giving a thought that are occurring right now in the marketplace are not reflected in that plan. So our 2009 budget cut will lower that deficit amount. It's not the governor's budget proposal, and it generally does not consider any federal stimulus funds.

So the process really starts right now with the governor's budget and are very few amount. So let me you take you to four examples of what's going on. In California, we're talking about a $40 billion deficit. On Monday the legislature, they have discussed the 14 billion in new taxes, spending cuts of 15 billion and borrowing of 11 to balance the budget. Those spending cuts include an 8 billion cut to education, but that doesn't consider federal stimulus dollars about the 10 billion that may offset some of that.

California must spend at the2006 level unless it get an exemption that 8 billion GAAP is going to be addressed because it exceeds the level from 2006 by quite a bit. So, last year as an example, California set the record education 4 billion and they ended up increasing spending. I don't think they are going to be able to be in the same position that seriously we expect a cut there. But that's an example of what these states are sorting through right now and trying to determine what to do with the stimulus dollars and how to bring these budgets together.

In New York, Governor Patterson issued this budget in December and he forecasted debts of 13 billion or said he would cut education 2 billion or 3.3%, and that's prior to the stimulus dollars. The New York State estimates they are going to receive 24 billion in stimulus funds, and of that 2. 5 billion will be state aid for education and an additional 1.5 billion for IDA and title one. That's 4 billion over two years and that can offset the 3.3%, $2 billion decline in New York State. So the opportunities are in front of these states to make decisions about what to do. And they have the functions stimulus plan and need to put the pieces together so the schools know where they stand.

In Texas, there is a $2 billion deficit. Governor Christ has said out loudly, he may not want to stimulus funds. My bet is that he takes it. And Texas will have a lot of money for education this year.

In our state, Wisconsin is one of the few states where the governor's budget is actually out. Initially there was a 5.6 billion deficit. After stimulus funds are received the governor is projecting that he will not cut educational ought to be a slight increase. Prior to stimulus fund, the education budget was going to be cut as well. So, you are going to see a lot of state taxes raise this year and lot of fee increases, and you are going see a lot of actual state operating cost cuts.

In the stimulus plan and the funds from the stimulus plan should help education, restore some of those cuts that are being discussed. So where does that leave us from here? We don't expect to have good visibility on school spending until our first quarter. We're also not expecting an increase in schools spending over the current levels until then which we took into account in our 2009 guidance. The schools will need to see the state budgets past before they complete their own. And we expect that the stimulus plan will raise schools spending from the current levels, but we don't have enough information today to calibrate it.

We haven't continued to take aggressive action on cost reduction which Dave and Tom will comment on and we continued to look for more. We expect the decline in the gross margins year-over-year that we've seen this year would be behind us as we enter our fourth quarter. We expect to grow gross margins for the next several quarters. Our new pricing strategies are in place and they are working.

And our cash flow remains strong. We expect that to continue and we have more we can take out of current assets in the next couple of quarters. So we're really focused on debt reduction and our banking relationships are solid.

So I'd like to pause there and turn the call over to Tom and Dave for more color. And then I'll be back again for questions. Tom?

Thomas Slagle

Thank you, Dave. Good morning everyone. Thank you for joining us this morning. I want to provide you with a brief update of activities in the quarter as well as an overview of the key initiatives that we are working on to address some of the challenges that are being dealt through us in the market.

I'll start by acknowledging that our third quarter was more challenging than we first saw coming out of Q2, based on a lot of the areas that Dave covered in his comments. We did have a few bright spots in the quarter. And we are remaining very focused as Dave mentioned on driving the fundamentals of our business and are positioning ourselves to help our customers work through the difficult times that they are facing in this economic environment.

Despite some of the slowdown that we saw in the third quarter, as I mentioned we had several market and product category highlights. Our science group continued to perform well. Our results were below the prior year level only due to the strong state curriculum adoption last year. Excluding that adoption spike, our curriculum sales and non-adoption states performed to our expectations, and we have grown in our science apply and get replenishment lines during the quarter due to new customer acquisition.

Our furniture and equipment performance for the quarter was also inline with expectations. The pipeline there remains in a good position, and we see no signs of weakening in that part of our business as school construction projects that are already underway and funded moved to completion by mid-to-late summer. We also continued to see a positive backlog against prior year as we evaluate our pipeline and future opportunities.

Our Canadian growth remains positive, and while the global recession is being felt in this important market the slowdown felt here in the state is not being felt as it roughly in Canada. We remained very focused on growth, and what we consider this under penetrated market for School Specialty.

I'm also pleased to report against our progress with category management in the third quarter. As we are forming the educational resource segment of our business and consolidating our categories of early childhood, our furniture equipment, classroom supply supplementary materials and office products, we are executing and beginning to realize the integration synergies that we had expected from this model.

The centralization of merchandising was completed early in Q2 and has positively impacted our assortment strategies, pricing models, strategic vendor agreements, a forecasting accountability and the introduction of product lifecycle management. Also, we have implemented our lean process thinking with these changes and integrated the linkages with procurement to drive further efficiencies around our supply chain. The benefits of all this work will help us to drive customer value and operational gains going forward.

During the third quarter, we also completed the consolidation of two call centers into our operations into Wisconsin and Ohio. We have centralized the educational resources accounting group here in Greenville, and we're also in-process of centralizing the catalog production and create a services function which will be completed in our Q4.

We've realigned the field selling organization to strengthen our coverage model across the categories. The marketing leadership team within this educational resource group will be centralizing to Greenville and new category management thinking and strategic planning is underway.

This new operating model will allow us to exit two locations this fall and drive a cost savings in the $6.5 million range which is part of the $20 million objective that was referenced in last quarter's savings objective. This model will also help us to simplify and improve our go-to-market phase to customer which is the longer term benefit of this entire strategy.

The true test of this operating model will be market share growth. As we near completion I remain confident that we are positioning ourselves to take very much advantage of the opportunities for growth in the marketplace.

Next, I'm going to let Dave Vander Ploeg talk specifics around margin rate. In his comments to follow, I am going to focus on the areas that we are working on to improve our performance from prior quarters.

I believe we've made good progress against the cost issues that pressured our margins in Q1. Both, international and domestic costing and pricing models have been completed and implemented as of January 1st. Transportation costs are back inline and in some areas we are seeing transportation rates move lower than what we saw last year at this point.

We have been aggressive in vendor cost negotiations and have linked this with a more disciplined pricing strategy which will contribute to improving our margins in various segments year-over-year. We are targeting selected markets with aggressive pricing and promotions and will continued to use our database analytics group to drive relevant programs. Overall, we are on track to see margins improve versus prior year at the product line level.

Our new catalogs have been distributed and our database marketing team and campaign management capabilities are now providing us with measurable results from every campaign launched. This provide us the ability to react proactively to the market versus past practice of one in done.

As mentioned during our last call, we've also taken very aggressive approaches to our cost structure, anticipating the economic impact from this recession to the school market and hence our financial model. Last quarter, we talked about the $20 million cost savings plan. And we are on target to driving the benefits from that plan as we sit here today.

We're also driving benefits from variable cost reductions related to raw material, fuel, aggressive vendor negotiations as I mentioned, reductions in discretionary spends and process efficiencies gain through the lean activities that have been actively ongoing.

Our focus on working capital continues to drive improvements in our cash flow. Inventory is an ongoing focus and a core part of our procurement and lean process work. Our receivable balances are also improving as we've become more proficient with the new Oracle system.

SG&A cost reductions will remain a top priority and we are aggressively pursuing all opportunities to leverage our assets for infrastructure, working in human capital through the upcoming busy season and throughout fiscal 2010. Again Dave Vander Ploeg will give you some more color regarding the working capital piece.

So in summary we're encouraged that the stimulus bill has been passed which will move the state budget process for minimal help provide better clarity around education spending. We anticipate that this may help schools move out of this wait and see mode that they are in right now into more of the replenishments spending pattern for the remainder of the school year; that is yet to be seen.

The visibility to how the money may flow on a state-by-state level is still work-in-process but we have specific and very targeted programs in the market today to entice schools to spend what dollars they have with School Specialty. The current pace of furniture continues positive and the pipeline backlog remains strong. The margin improvement trending is positive within EE and we have stronger discipline in our cost and pricing models across the business.

Our $20 million cost savings plan is on target and producing the results we expected. And we will remain intensely focused on opportunities to accelerate initiatives that can improve our cost model. And we're remaining very aggressive in the market at both the district and educated level with new promotions, assortments, pricing incentives to acquire new customers and expand existing customer relationships that we hold.

We remained very focused on the core strategies of the business even during these tough times, particularly category management and lean which are being pushed in an accelerated pace. I do believe that we're making very good progress in these areas and this will drive our results and position us positively to win in the current economy and beyond.

So with that, I'll turn the conversation over to Dave Vander Ploeg.

David Vander Ploeg

Thank you, Tom and good morning everyone. I'll begin with the review of our operating results for both the third quarter and the nine months ended January 24, 2009. And as Dave referenced in his opening comments, the third quarter is the slowest season of the year for School Specialty. And as a result expense and mix shifts can have an exacerbated affect on the reported margins and ratios. So as I go through my comments I'll touch on this a little bit further.

Third quarter consolidated revenues came in at $121.7 million or a decline of 9.7% over 2008. After encouraging order of velocity in the month of November, orders did tail-off in December and January as schools shut down for the holiday breaks and spending was curtailed in the wake of the economic uncertainty that both Tom and Dave talked about.

While sales continued to show strength in furniture and projects as well as our science offering, the segment revenues for both essentials and specialty were down 9% and 11% respectively.

Gross profit for the quarter was $43.3 million or down 8.4 million over the same period last year. While I will go into more detail in my year-to-date comments, lower volumes and product mix contributed to the majority of this decline. Gross margin declined 270 basis points which is somewhat influenced by the seasonally low revenue levels.

Product mix, both with in segments and between segments accounted for nearly 60% of the overall variance, while unabsorbed overhead product promotions and inventory adjustments accounted for the remainder. Once again, given the low revenue levels in the quarter it does not take much to shift margins one way or the other. As such, the quarter in isolation really does not give a good representation of the direction of the business.

Moving onto expenses as Tom briefed you on earlier, our $20 million cost reduction initiative that was launched in November is progressing on plan. Excluding the restructuring charge which was primarily for severance costs, the reported SG&A expenses came in at nearly $5 million below last years level. Lower volumes and falling fuel prices also contributed to this positive variance.

With most of the activities implemented near the end of the quarter, and by that I mean centralization of functions, reductions in workforce, changes to incentive plans et cetera, the fourth quarter will be a more accurate picture of the new run rate. Suffice to say we are meeting and in some case exceeding our goals and commitments in this area.

Let's turn to a brief update on the year-to-date results. Revenue for the first nine months was down 2.6% at $890.8 million. This reduction was almost entirely attributable to the expected $25 million decline in state adoption revenue, which we have discussed many times in the past.

Adjusting for this, revenue was up slightly in the first nine months of the year. Gross profit for the first nine months was $366.4 million or a decline of 26.2 million versus 2008. The gross margin percentage for the same period declined a 180 basis points. And as we normally do, this variance has broken down into three buckets. Volume contributed about $10 million to the shortfall, mix contributed about 8.5 million and cost contributed about 7.5 million.

A few comments on each. First; volume is relatively straightforward and directly tied to the $23.5 million drop in revenues. Mix has an impact both between the essentials and specialty segments as well as with any segment. Product mix between the two segments had a negative profit impact of about $3.5 million or 40 basis points of margin.

Because of the drop-off in the curriculum based adoption revenues, specialty became a slightly smaller component of our business. Consistent with the comments I made in prior quarters, we basically had left high gross margin sales activity and more lower gross margin sales activity.

In addition, product mix within the segments also contributed to the decline in gross profit by about $5 million. But furniture and projects business has been strong all year, but it does carry a lower gross margin because it normally a shift directly from the manufacturer to our customers. Within specialty, sales of classroom supplies, and by that I mean things like arts and crafts, science kit replenishments and the like were a larger percentage of the total within the higher margin content and curriculum based products.

Third; cost increases impacted gross profit by approximately $7.5 million. We have discussed on both calls earlier this year unexpected vendor, commodity based increases in the both furniture and consumables, combined with higher inbound transportation costs and certain domestic substitutions of foreign sourced products, all created an unprecedented cost pressure.

This is becoming much less of an issue today as we have re-priced and drop new catalogs in January, and vendor cost negotiations have yield that the expected results for the upcoming season. Specifically, as it relates to the essential segment, the gross margin percentage change year-over-year has improved from a negative 260 basis points in quarter one to a negative 170 in Q2 to a negative 50 basis points in the current quarter. We anticipated achieving our targeted correction going forward.

Turning our attention to year-to-date selling, general and administrative expenses, the reported figure of $274.4 million includes $3 million of restructuring cost, so adjusting for this we see a $5 million year-over-year improvement. Included in these figures are outbound transportation costs which are up about $900,000 or 4% year-over-year, due to fuel surcharges, additional shipping cost to address our busy season backorders.

So if you adjust for these more operational expenses, true SG&A has shown an improvement of nearly $6 million. The business is showing tangible signs of internal productivity gains and is currently operating with about 12% fewer associates from last February. In addition, every discretionary and incentive related expense is being reviewed closely.

Moving onto interest expense, year-to-date we have reduced our total financing costs by $3.9 million or over 19%. This is accomplished through a combination of lower effective rates that were in place for the comparable periods and about $5 million left in average outstanding debt. As it relates to the tax provision, income tax has have been accrued at 39.5%, up slightly from the previous years 39.1. This change is driven primarily by the incremental tax benefits realized in fiscal 2008 for the favorable tax treatment on certain inventory donations.

Finally, our year-to-date income from continuing operations of $45.8 million was down 12.7 million or 22% essentially a combination of the lower volumes we've been talking about and the cost pressure on gross margin which we have discussed previously.

I would like to transition to a few comments on the balance sheet and cash flow starting with the balance sheet. We have just completed our strong cash collections season and the solid results are reflected on the balance sheet.

Net working capital which is primarily receivables, inventory and payables improve by over $30 million which translated directly into addition of free cash flow. Our rolling 12 months day sales outstanding has improved by nearly three days over the past two quarters a we continued to get more comfortable with the advanced collection tools that Oracle is providing us.

Overall receivables are down approximately $30 million year-over-year with about $10 million related to volume and the remainder associated with the stronger collections. And as Tom mentioned earlier, inventories continues to be a weekly focus and we are pleased with the $14 million year-over-year improvement in that category.

Turning to the cash flow statement, the free cash flow has been a real bright spot with improvement of over $23 million year-over-year. Working capital management has been a strong contributor but we have also continued our diligence and focus around capital spending and product development. Most of this free cash flow has gone into debt retirement. Utilizing the strong free cash flow to reduce debt has enabled us to continue to comply with our debt covenants and provided us $36 million of liquidity quotient on our leverage ratio governance.

While I'm on the topic of cash and debt, I would like to update the group on our capital structure and recent changes. With regard to the asset-backed securitization program, this facility has typically been renewed at the annual expiration date at the end of January. However, as the facility expired on January 28 of this year which is really the start of our fourth quarter, we elected not to renew the facility. The future expense for this program with the proposed new pricing became cost prohibitive when we compared it to utilizing our revolving credit facility.

We're confident that the availability under our revolver is more than sufficient to meet our liquidity needs. The benefit to us of this securitization facility in the past was simply to provide us with a more cost effective borrowing vehicle versus incremental liquidity. And since it's no longer cost effective to maintain the program in today's current credit environment, we have decided to let it expire. That's not to say that we can't resurrected at some future points if the pricing comes back inline.

Finally, a few comments regarding our fiscal 2009 guidance. In light of the caution being exercised by most school districts, we are lowering our revenue guidance to a range of 1.40 billion to 1.55 billion from the previous range of 1.065 billion to 1.08 billion. Included in this new range is an estimated loss of $27 million in adoption revenues.

Furthermore, we are lowering the guidance on fully diluted earnings per share to $1.80 to $1.95, before the effect of the total restructuring charges in fiscal '09 that are estimated to be about $0.14 per share. This comparers to previous guidance of $2.04 to $2.24 per share. Given the strong cash performance, however, we are maintaining previous guidance in this area.

Before I close, I would like to comment on the new segment reporting which is forthcoming. As we have discussed for the last several quarters, our new educational resources group is coming together as a result of the many initiatives tied to what we have previously referred to as category management. This work is nearly completed and as we embark on fiscal 2010, we will begin managing the business as two new divisions. One called educational resources and one called publishing and other.

As such, beginning with the fourth quarter press release and the fiscal 2009 Form 10-K which will be filed in June, our segment reporting will be changed in order to be consistent with how we will be managing and assessing performance of the company beginning with the new fiscal year. The educational resources segment will consist of the current essential segment and those specialty segment products that are more geared to supplemental education, things like art education and early childhood.

Our other segment will be primarily publishing related, and will be comprised of the business units that's focused on our curriculum based product offerings. We will provide re-stated quarterly segment results in order to be consistent with this segment change around the time of the fourth quarter press release.

With that, I will turn back over to Dave Vander Zanden.

David Vander Zanden

Great. Thank you, Dave. Sherry, I think we're ready for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions). Our first question is coming from Trace Urdan from Signal Hill. Please post your question.

Trace Urdan - Signal Hill Capital

Hey good morning, guys.

David Vander Zanden

Trace.

Trace Urdan - Signal Hill Capital

I really want to focus on the free cash flow number. And I understand that's maybe some of the gains this quarter were the result of sort of increased diligence around collections and the like. Could you just maybe speak to the sustainability of the kind of rate of increase that we saw? Because it was pretty stunning and it doesn't look like there is anything that's obviously sort of onetime in nature but maybe you can talk qualitatively around how you feel about the ability to maintain this kind of free cash flow growth?

David Vander Ploeg

Sure Trace. This is Dave Vander Ploeg. We are actually very pleased by the progress we have made in this area, especially in the working capital management area. That said we are also confident that there is more work to do and more gains to be had in both the areas of day sales outstanding as well as in the area of inventory management. I think in both cases as we apply the lean principals and as we get more accustomed to using some of the tools that have come with the Oracle platform and some of the other forecasting tools that we have, we believe that we can even drive more efficiency into the balance sheet in that area. So that would be one comment.

I think the second I would make is that we've been very diligent about managing and monitoring our capital spending investments as well as our product development investments. And we certainly do not want to short change the product development area because it's so critical to our future. But as we really meet monthly on those topics and those projects we're finding that we will not have to invest as much this year and probably going forward not as much as we've seen.

I typically get the question just on CapEx spending so I'll comment on that. We're currently looking at about $11 million spend for this year, which is down from I think a previous estimate I had shared on the call of 15. And in the area of product developments we're looking investments in the 8 to $9 million range as opposed to something closer to 11 on previous call. So we're getting... we think equal value for lower investments. We've talked from time to time that in kind of a steady state when we don't have a major Oracle implementation that we ought to be able to run this business with 16 to $20 million of CapEx and product development, and we see that going forward.

So those are really a couple of the areas that are providing a lift in the free cash flow. And then as we've talked about also in the past, we have a large number of non-cash items that flow through our income statement. And those will continue and will continue to provide positive results on the free cash flow side of it.

Trace Urdan - Signal Hill Capital

Okay. And then related to that, does it... may obviously you sort of taken a tougher look at spending and product development expenses here. Does it change your view, perhaps if any of the product lines that you are maintaining? I mean, are there some product lines that you might have kind of indulge for sort of their future potential that maybe you are going to take a tougher line on now, given the environment that we're in?

David Vander Zanden

Yeah Trace. This is Dave Vander Zanden. You might recall a couple of years as we focused on what parts of the business we felt were core and what parts of that we want to move away from last year we sold to media business. We also said the mass merchant business was something wasn't core to our future. And we're continuing to look at the business as we go through this economic cycle and revisit all those decision. So, you'll see us rationalize different segments in the next several quarters.

Trace Urdan - Signal Hill Capital

Okay, great. And then, finally I guess I'd love to hear your take on the competitive environment. If would seem intuitive this smaller vendors, but maybe we're benefiting from personal relationships and so forth and different areas might be facing greater challenges in this environment. And I wonder if there is any opportunity that you can see for market share gain in this economic environment.

Thomas Slagle

Trace, this is Tom. Clearly, the pressures that we're feeling, we have verified that indeed that's being felt across the industry and it's the smaller regional distributor levels and even some of the small competitors and some of the of the product specialties we participate in. We do believe that there are opportunities right now to take advantage of the situation relative to credit, to cash et cetera and we are aggressively pursuing active programs in the market right now to go after and try to move some of that market share our direction.

Trace Urdan - Signal Hill Capital

Great. Thank you. I got an answer from each one of you. So I'm going to declare victory.

Thomas Slagle

Thanks Trace.

Operator

Thank you. Our next question is coming from Sabina Bhatia (ph) from Basso Capital Management.

Unidentified Analyst

Hi, guys. Just a couple of very quick questions. Can you just tell us as far as your revolver had term loan mark us and what is outstanding at the end of the quarter?

David Vander Ploeg

Yes, at the end of the quarter we had $47 million on the securitization, the AR securitization, and we had $13 million out on the revolver for a total of $60 million.

Unidentified Analyst

$13 million, and the term loan. The term loan, did you say --

David Vander Ploeg

The term loan we had nothing.

Unidentified Analyst

Nothing, exactly, okay. And anything new or trying to refinance this or try to restructure this term loan on a revolver. I know you have a wild as far as the next put on your converts is concerned, but --

David Vander Ploeg

Yeah.

Unidentified Analyst

Go ahead.

David Vander Ploeg

Yeah, we have 18 months left, so we really don't feel like we have a gun to our head. We think we have a lot of time, a lot of options and we're thinking through it very judiciously.

Unidentified Analyst

Okay. That's fine. Thank you.

Operator

Thank you. Our next question is coming from Bob Evans from Craig-Hallum Capital Group. Please post your question.

Robert Evans - Craig-Hallum Capital

Hi, good morning everyone.

David Vander Zanden

Hey, Bob.

Robert Evans - Craig-Hallum Capital

Hi. Dave Vander Zanden, can you give me more of a summary if you were part of that was interrupt a little bit in terms of your assessment on the school funding, I hear what you are seeing as it relates to the governor setting their budgets, and I think you said 84 billion of net deficit. But what's the net, net? Is that your view that given the stimulus plan that will be able to offset the education spending deficits. So you expect net, net growth or I want to make sure I heard you right?

David Vander Zanden

Yeah. I can't say clearly that the stimulus is going to offset education deficit. So it's just too many states that haven't given us their governor's proposal to start with. Normally that helps us kind of fine tune things. So, at a higher level there is a lot of money coming in from that stimulus fund that's certainly going to plug a lot of holes. And I do think the states are going to raise a lot of taxes and they are going to cut a lot of other expenses, the balances of budgets.

So those three categories I think will bring it into shape. And I always rely in the fact that education is on a last place that's safe like to cut. They don't want to rip the kids out there. And I think they will take that into account and I think the feds did as well in the way they designed the stimulus plan not flow through the fund. So it certainly is going to serve a lot of problems so we just can't pinpoint and calibrate exactly what its worth until we see those governor's proposals come out.

Robert Evans - Craig-Hallum Capital

I mean, I understand you don't have an update because it's still too early. But am I still going to bracket it, I'm going it and now you are saying up overall spending up fractionally to down modest or I think speaking of it was kind of bracket plus one, two to down one, two?

David Vander Zanden

Yeah, hard to get there Bob. California becomes our last part. They talk big deficits, they generally don't lack education very hard but you don't know in this environment different. So, we really can't pinpoint anything at this point.

Robert Evans - Craig-Hallum Capital

Alright. And then I believe you'd made a comment as well as to a fourth quarter for SG&A that will be run rate to use. Can you give us some sense of what run rate we should be thinking about?

David Vander Zanden

Well, I would think about as we talked about the $20 million initiative and most of the actions were taken and we're going to start see the results in fourth quarter. So I wouldn't want to say that the full benefit would flow through but certainly a big part of that will begin to flow through in the fourth quarter and then it will continue on next year.

Robert Evans - Craig-Hallum Capital

Okay. So we shouldn't necessarily expect to see a full $5 million benefit in the fourth quarter?

David Vander Zanden

No. But I think that as I said most of the actions were taken so we're optimistic that we're on track.

Robert Evans - Craig-Hallum Capital

Okay. Okay. And similarly on the secured comments on the margin improvement that you are expecting for variety of reasons, can you give us some sense of magnitude on the gross margin side?

David Vander Zanden

Yeah, I think what we've been watching is especially in the Essentials grow where we had that large 260 basis point delta in Q1 and we've been able to kind of work that down to a minus 50. And now that the catalogs are repriced and dropped and most of the negotiations have been completed with vendors, we see ourselves correcting on that going forward.

Robert Evans - Craig-Hallum Capital

Okay. Correcting on that, does that mean giving back, making up 260 points delta or just getting back to the fact that you are not shrinking anymore?

David Vander Zanden

Yeah, I think we are... our goal was to basically get back to the levels that we saw the previous year.

Robert Evans - Craig-Hallum Capital

Okay. It is starting basically next fiscal year?

David Vander Zanden

Correct.

Robert Evans - Craig-Hallum Capital

Okay. All right. Okay. Thank you.

Operator

Thank you. Our next question is coming from Abigail Honjas (ph) Waterstone Capital Advisors.

Unidentified Analyst

I have a couple ones. With the lack of the securitization facility, what is the implication for your working capital, usually there is a onetime usage to adjust for that, for the company?

David Vander Zanden

It will go up by 47 million.

Unidentified Analyst

Okay. And when do you expect that to hit the second quarter?

David Vander Zanden

Our fourth quarter. Like the quarter we're in currently.

Unidentified Analyst

Okay. And then regarding your revolver, your bank facility, is there any ability to buyback converts early before maturity using any of the language or the covenants, baskets?

David Vander Zanden

There is a $10 million basket, but essentially we would need an amendment from the banks to buyback these.

Unidentified Analyst

And than can you still buyback equity using the current language of the revolver?

David Vander Zanden

Yes, we currently have $35 million out in a previous authorization.

Unidentified Analyst

Is that something that you guys think is worthwhile to reduce your leverage at this point in time? Just go talk to the banks?

David Vander Zanden

I'm not sure I understand the question, ma'am.

Unidentified Analyst

Well, it's you can buyback equity but you can't buyback converts. And there are many people out there and your guys issues that are buying back, making a huge investments at very large payback potential by buying back converts. And it's kind of unusual that you can buyback the lower part of the capital structure but not the higher part. And it appears that it just would be a discussion with your banks. Is that something you guys would want to do?

David Vander Zanden

Yeah, we've been in ongoing discussions on multitude of ideas and alternatives.

Unidentified Analyst

Thank you.

Operator

Thank you. Our next question is coming from Gordon Lasic (ph) from Robert W. Braid.

Unidentified Analyst

Hi. Thanks a lot. I just had a couple of questions. First for David Vander Zanden. Can you talk a little bit about the supplemental education funding, where you think that can go? I mean on previous calls you talked about the states have to cut education funding. Typically they cut on the teacher expense line and if I'm something thinking about this, this stimulus is pushing through. Do you think most of that is going to go to teachers or how do you think that will break out.

David Vander Zanden

Sure. Typically it's at the school district level and not really at the state level assets are going to pass these funds through their normal allocation process. At the school level, about 80% or so of the budgets go to the headcount. And so when the schools need to balance larger dollars, it's typically headcount reduction. They tend not to want to really heard what's going on in the classroom, the curriculum programs and so forth.

So, I think what you should watch for this spring our teacher layoffs and the longer the governors wait to get these proposals out, the more the educators are going to have to issue layoff notices to teachers. And they have to do that either by setting margin in contract. It's likely as budgets are pass that some of those layout notices to get pulled later in the summer. So that's the easiest way for them to balance.

Unidentified Analyst

Okay. Thanks a lot for that color there. And just one question Tom Slagle. Can you can talk a little bit more about the pricing cost negotiations that you've done with your vendors? I mean can we just pass pricing increases or have the contracts been adjusted to allow for more flexibility as fuel and commodity costs would have spike up again next year? I mean how would that situation play through in 2010, so if it were to happen again?

Thomas Slagle

Yeah, Gordon I think we've been able to really attack this in a number of fronts. Clearly we took a very proactive approach towards the cost negotiations, watching commodity indexes and utilizing our vendor relationship models to drive us down and built influx to that as well knowing where they were at last year and then how we were trending into this year.

We were again utilizing our pricing strategies in our catalogs and our contract models and our bid models to reflect I would say a conservative view of what we saw we could end up with costing. And the way that these commodities have trended I think we actually have created a little bit of room for ourselves there. Relative to building and if you will some flexibility I think we are in a better position than where we have been in prior years. We still do have some fixed price contracts for some customers but I would say that's lower than where we have been in the past. And we have built language into our contractual languages that give us some ability to move with the market to a greater degree than we've done in the past.

Unidentified Analyst

Thanks lot guys.

Operator

(Operator Instructions). Our next question comes from the Mimi Noel from Sidoti and Company. Please post your question.

Mimi Noel - Sidoti & Company

Good morning. Most of my questions have been answered, but I do have one for Dave Vander Zanden. More of a point of clarification. If there are fewer teachers out in the field to spend on the extras in the classroom, how is that not going to affect the supplemental or specialty business?

David Vander Zanden

Mimi I think there is an impact that I just don't think it's going to be that significant.

Mimi Noel - Sidoti & Company

Okay. And why not significant just because way the layoff won't be a significant?

David Vander Zanden

No, I think it's because really the head count of the students are still in place and what tends to happens is cost size goes up. So for you the 10%, cost size goes from 20 to 22, so the same kind of spending and so that classroom per student tends to continue on.

Mimi Noel - Sidoti & Company

Okay. Thank you.

Operator

Thank you. Our next question is a follow-up from Bob Evans from Craig-Hallum Capital Group. Please post your question.

Robert Evans - Craig-Hallum Capital

Yeah, hello again. I had a question as it relates to the guidance. It seems like the EPS range was maybe lower disproportionally relative to the revenue, and I guess I am trying to... if we're thinking about what's moved or changed in your mind, I understand that the revenue is down, but it doesn't appear to me that it would be just the revenue in terms of why the EPS range was low verdict. If you give us some color in terms of your thinking on the lowering of the guidance?

David Vander Zanden

Bob, this is Dave Vander Zanden. I think the EPS range reflects what we're doing in SG&A and gross margin at the same time. And there really isn't anything unusual in there. We are reflecting some lower SG&A costs as a little bit of onetime charge work its way through and Q4. And there are some mix issues with revenues as Dave talked about as well.

Robert Evans - Craig-Hallum Capital

Okay. So would be aside slower revenue would mix be the next biggest item as a it relates to the range going out?

David Vander Zanden

Yeah, I think it is. I think you'll... from the lower borrowing volumes and the rates you'll see a little improvement there. So I think between the SG&A and onetime charge and gross margin mix changes that's about the bulk of the changes.

Robert Evans - Craig-Hallum Capital

Okay. All right. Thanks.

David Vander Zanden

Yeah.

Operator

Thank you. At this time, we have no further questions. So I would like to turn the call back over to the speakers for any closing comments.

David Vander Zanden

Very good. Well, thank you all very much for attending and listening to the call today. Our next call will occur in the June timeframe and by then we should have good visibility and school spending and budgets and so forth and be able to give you some good clarity on what we think it's going to happen. We'll see you next time. Thanks.

Operator

Thank you. That does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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Source: School Specialty F3Q09 (Qtr End 1/24/09) Earnings Call Transcript
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