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Executives

Richard Robinson – Chairman of the Board, President and Chief Executive Officer

Maureen O’Connell – Chief Financial Officer, Executive VP, Chief Administrative Officer

Judith Newman – Executive Vice President, President – Book Clubs

Margery Mayer – Executive Vice President, President – Scholastic Education

Ellie Berger – President, Trade Publishing

Deborah Forte – Executive Vice President and President, Scholastic Media

Hugh Roome – Executive Vice President

Jeffrey Matthews – Vice President, Corporate Strategy, Business Development, and Investor Relations

Analysts

Drew Crum - Stifel Nicolaus

Peter Appert - Piper Jaffray

Barry Lucas – Gabelli & Company

Jim McGarry - Neuberger Berman

Scholastic Corp (SCHL) F4Q10 (Qtr End 05/31/2010) Earnings Call July 22, 2010 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q4 2010 earnings conference call. (Operator instructions). As a reminder, today’s conference call is being recorded.

I’d now like to introduce your host for today’s conference, Mr. Jeff Matthews, Vice President of Corporate Strategy, Business Development, and Investor Relations. Please go ahead.

Jeffrey Matthews

Thanks, Ally, and good morning everyone. 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, Scholastic.com, clicking on Investor Relations, and following the links on that page.

I’d also like to note that this presentation contains certain forward-looking statements which are subject to various risks and uncertainties, including the conditions of the Children’s Books and Educational Materials markets, and acceptance of the company’s products in those markets, and other factors and risks identified from time to time in the company’s filings with the Securities and Exchange Commission. Actual results could differ materially from those anticipated.

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

Richard Robinson

Thank you, Jeff. Good morning and thank you everyone for joining us on our Fiscal 2010 year end analyst and investor conference call. For this morning’s prepared comments I’m joined by Maureen O’Connell, CFO and CAO; Judy Newman, President of the Scholastic Book Clubs; and Margie Mayer, President of Scholastic Education. Other members of the executive team will also be available to answer questions at the end of this call.

Today I’m pleased to report hat we exceeded the key three financial goals that we laid out for fiscal 2010 a year ago. We grew adjusted operating income from $75 million to almost $185 million. We achieved a long-stated goal by expanding our adjusted operating margins to 9.6%, and we generated $172 million in free cash flow, well above our goal of $90 million to $120 million, with which we reduced net debt to $9 million and funded a total of $22 million in dividends and stock buybacks.

In addition we achieve key strategic goals in fiscal 2010. We dramatically grew Scholastic Education, reflecting strong execution, new products and adoptions, as well as the significant benefit of federal stimulus funding. We had a strong close to the year in Children’s Books with a 6% sales increase in the quarter, and high profits for the quarter and the year. And finally we tightly managed costs and cash while reducing our cost base. These accomplishments place Scholastic in an excellent position to maintain strong performance in fiscal 2011, as we focus on key digital initiatives in Children’s Books - both ecommerce and e-books - reflecting the fast growing opportunities in these areas while consolidating our dramatic gains in Education.

In fiscal 2010 Scholastic Education - our educational technologies, services, and curriculum division – grew by a record 54% to $270 million. Overall educational publishing segment revenue rose 24%, and operating income rose over 80% to $103 million for the year, excluding one-time, non cash charges. A number of factors supported the expansion of Scholastic Education, which is now firing on all cylinders with a strong team and strategy. First, we executed well, particularly in sales and marketing following significant investments in these functions over the past two years. We also gained especially in the first half of the year from the successful introduction of System 44TM, the prequel to Read 180®, and an adoption of both products in California.

Second, stimulus funding accelerated our growth as an unprecedented injection of federal money into local school districts helped offset budget deficits. A significant amount of this funding was channeled through federal Title I and Special Ed programs, which are already important drivers of our sales, further benefiting the business. When this legislation was signed into law in early 2009 we anticipated $100 million in incremental sales over two years. Based on the speed with which school districts spent the stimulus funds and the sales growth we experienced in fiscal 2010, we estimate that we captured about 2/3 of our originally anticipated benefit in fiscal 2010, with the rest to come in fiscal ’11.

Together these factors drove an unprecedented expansion of Scholastic Education’s business in fiscal 2010, resulting in significant gains in the installed base of school districts using Scholastic programs and in the depth of our partnerships with those districts. The business also became much more diversified in terms of the breadth of products contributing significant revenue, and in terms of the mix of products and recurring service revenue.

Scholastic’s Classroom and Library Group - the company’s print and supplemental education division – was up 6% in the Q4, finishing the year approximately flat. This market, particularly the library channel, continues to be impacted by tight state and local budgets, and our experience is it is not seeing the same benefit from stimulus funds which have been mostly used to keep schools open and teachers employed, or to address high priority needs, such as reading intervention. In this environment our strategy has been to build market share while carefully managing costs. We are digitizing many of our products for use on the web and interactive whiteboards where we see good growth opportunities, as well as building new supplementary programs in reading and language arts.

In Children’s Books last year we achieved solid sales, especially in the Q4 in spite of a challenging economic environment for teachers and families. For the year, sales held level with the prior year, excluding approximately $25 million in sales from The Tales of Beatle the Bard, which we published on behalf of J. K. Rowling’s charity in 2009.

These results reflect gains in book fairs, where sales grew 7% in the Q4 and 4% for the year, partly due to the success of Scholastic’s new incentive program for schools, which led to strong participation and higher revenue per fair. We also had numerous New York Times bestsellers in trade, including the company’s multiplatform series The 39 Clues, the first two titles in the Hunger Games trilogy by Suzanne Collins, and the first title in Maggie Stiefvater's Shiver trilogy. Book Clubs also had a stronger Q4, with revenues approximately flat as targeted spring promotions helped restore teacher order volumes. In addition to sustaining sales we also improved efficiencies across the segment. As a result, segment profits rose 16% to $118 million, reflecting savings from last year’s consolidation of Operating Regions and Fairs and effective returns management in Trade.

In summary, Scholastic’s Children’s Books business ended fiscal 2010 on a strong and more profitable note, with teachers, kids, and families continuing to be deeply engaged with our unique channels and publishing franchises.

In fiscal 2011, which we of course have just begun, Scholastic’s plan is to sustain last year’s operating income before spending an incremental $20 million on our key digital initiatives in Children’s Books, where we have a unique opportunity to leverage our position as the world’s largest children’s book publisher and distributor. Scholastic is already a major online bookseller to teachers and students in their classrooms through book clubs, and we have an opportunity to expand these sales by further engaging teachers and parents. And while sales of children’s e-books are small compared to the fast growing adult e-book market, we have an opportunity to leverage clubs’ online ordering, and our unique strengths as a publisher and distributor to stake out a position in this emerging market, which we think will grow substantially in upcoming years. In a moment Judy Newman will discuss our plans to launch important new online and e-book initiatives in fiscal 2011.

In education we have already successfully made the digital transition, which has driven tremendous growth over the past 10 years. Following last year’s record expansion, our plan for fiscal 2011 is to consolidate our growth. We also are investing in a significant pipeline of reading and math products and services, which should dive robust sales beyond 2011. Despite an anticipated decline in federal stimulus funds, and fewer product introductions and adoptions, we expect to hold revenue in fiscal 2011 in lien with last year with a high percentage of renewals of services and follow-on product sales to our significantly larger base of existing customers, as well as by reaching new customers with our market-leading technology-based programs We believe that holding onto our nearly $100 million gain in revenues in 2010 will be a good performance in a market where new funding is slowing. Margery Mayer will lay out the strategy and product development plans in a moment.

Finally, we expect that our continued cost saving efforts will offset increases in some areas, as Maureen O’Connell will discuss when she presents the full fiscal 2011 plan. We also expect to continue to generate free cash flow in excess of net income by aggressively managing working capital while setting higher spending on product development.

I’ll now ask Judy Newman, President of Scholastic Book Clubs, to address our e-commerce and digital opportunities for children’s books.

Judith Newman

Thanks, Dick. Good morning, everyone. As the seller or publisher of approximately half of all the children’s books sold in the United States, Scholastic has unmatched relationships with teacher, kids, and families, and a unique understanding of the needs of young readers. So as the market for children’s books opens up on the web and in digital formats we intend to maintain this leading position in two ways: first, by providing the easiest, most compelling way for parents, kids, and teachers to buy children’s books and e-books online; and second, by creating the best experience for kids and families to read and enjoy e-books.

In fiscal 2011 we’re launching major initiatives to do both. First, we’re fully rolling out Cool, the new clubs online ordering platform, this August. This move will make Scholastic’s unique school-based distribution model and value proposition accessible directly to parents and kids online, as well, of course, to teachers. New Cool will make it much easier for parents and their children to order competitively priced, high quality books online and pay for them with a credit card, and even buy books for students in other classes, siblings and so on. New Cool will maintain all the benefits of engaging teachers, who will still earn bonus points and manage their students’ orders. Also we will continue shipping orders to the classroom. These key points differentiate our value proposition and economics from other online booksellers.

Second, employing the extensive reach and strength of our school channels, and in particular new Cool, to parents, teachers, and kids across the country, we will launch a uniquely Scholastic children’s e-book offering for kids and families which we believe will be the first of its kind. It will include a large, carefully curated selection of quality children’s titles from Scholastic and other publishers. They will be delivered through a downloaded e-reader program for multiple platforms that is specifically designed for young readers.

As Dick described, these initiatives will involve $20 million in increased operating expense in 2011. We’re confident that this environment will generate growth for Scholastic in terms of greater market share and incremental demand for children’s books in print and digital forms over the next several years.

Now I’ll pass the call over to Margery Mayer, President of Scholastic Education.

Margery Mayer

Thanks, Judy, and good morning everyone. As Dick described we’re coming off of a transformational year for our Education business, a year which gives us a base to continue our strong performance in 2011 and for driving growth in 2012 and beyond. As you know, our business model is not that of a traditional textbook publisher. Rather, we work with districts as a true solution provider, providing consultative support, data analysis, effective programs and professional development. This model allows us to develop our relationship with our customers and help them drive achievement. By so doing we can typically expand our programs and licenses, renew services and technical support, and introduce new solutions.

Our business model delivered extraordinarily well in 2010. This has positioned us for 2011 as a more diversified business, with Read 180 ® continuing as our flagship, but also with a robust service business with about $50 million in revenues, and an expanding math business which is already about 15% of our product sales and a significant business in its own right with System 44TM.

Our plan is to continue to drive business in 2010 and beyond with new products and services that address education’s most pressing need – raising student achievement in reading and math and making sure that they succeed with the new common course standards. To this end we are working on a series of significant enhancements to Read 180 ® and System 44 TM which we look forward to announcing later this year. Additionally we’re moving forward aggressively in math. We have a real hit on our hands with Marilyn Burn’s Do the Math, an intervention program for grades 2 through 6. We just launched Fraction Nation TM, an innovative new software program to address the challenge students face with fractions, and we are a week away from shipping a new math assessment called The Scholastic Math Inventory. The results for American students in math are only marginally better than those in reading. According to NATH (sp), about only 2/3 of our eighth graders are not proficient in math. We plan to take on the challenge of math intervention just as we have done with reading, and we are well along with a Math 180 line of products which are scheduled to begin release in 2012.

We are also optimistic about near- and longer-term opportunities for our service business. A very real benefit is how this business strengthens our relationships with our customers. Through our educational consultant team and through the International Center for Leadership in Education which we acquired two years ago, we are providing an expanding set of services both aligned to our products and product agnostics. At $50 million this business is at once a recurring revenue stream, a differentiator relative to much of our competition, and a growth opportunity.

As Dick pointed out, Scholastic Education significantly strengthened, expanded, and diversified in 2010. We also emerged as a key component of the company’s earnings. In 2011 we need to capitalize on ongoing federal support for improving our most challenged schools and on our strong, diverse business model. And looking beyond we believe we can continue to build our business, building on our effective programs, great sales and marketing, and the Scholastic brand which continues to strengthen in meaning to our customers.

Now, I’m going to turn it back to Dick.

Richard Robinson

Thank you, Margery. Maureen O’Connell will now review our strong financial results for the Q4 and full year and lay out our financial goals for fiscal 2011.

Maureen O’Connell

Thank you, Dick, and good morning, everyone. Before I review our financial results, I’d like to address the mostly non-cash one-time items incurred in fiscal 2009 and 2010. The majority of these one-time items in both years have been non-cash impairments and write downs of investments. These account for $45 million in fiscal 2010, and $32 million in fiscal 2009. The remaining cash portion of one-time items had been focused on reducing the company’s cost base and liabilities. In fiscal 2009, $20 million in severance was incurred related to the reduction of our workforce by over 500 people and the corresponding $30 million reduction in salaries. In fiscal 2010 we incurred approximately $5 million in cash expenses for restructuring UK operations in order to make this business profitable, and an additional $7.5 million associated with the settlement of the sales tax negotiation.

Although these one-time items have impacted our GAAP earnings, the ongoing operating results of the business have improved, as evidenced by our strong free cash flow growth.

Now I’d like to review the income statement adjusted to exclude the one-time items I just described. For the full year revenue increased 3%, primarily as a result of strong Education results as well as the benefit from foreign exchange. This was partially offset by a modest decline in Children’s Books related to sales of Beatle the Bard in the prior year. Cost of goods sold declined by nearly 3 percentage points, primarily due to strong growth in higher education technology sales throughout the year and the prior year Beatle the Bard sales. In addition improved fulfillment efficiencies and better buying also contributed to high growth margins.

Selling, general, and administrative expenses held level for the year. This reflects the benefits of the prior years’ headcount reductions, which offset increases in sales commission and field staff costs related to higher education sales, as well as higher bonus, benefit, and stock compensation expense, primarily in the Q4.

The effective tax rate for fiscal 2010 was 47%. In addition to federal taxes, the key components are state and local taxes, and foreign tax without tax benefit. Earnings per diluted share for continuing operations excluding one-time items was $2.60, double $1.28 a year ago. This exceeded the company’s most recent guidance of $2.00 to $2.30 per diluted share. Better than expected earnings for the quarter and the year reflected strong performance in Children’s Books, where both book clubs and book fair sales improved over the previous quarter, and trade experienced favorable returns. A strong performance in Education also contributed to a positive end of the year.

This slide provides segment results on an adjusted basis, excluding one-time items. In fiscal 2010 we also generated significantly higher free cash flows, due to both strong cash earnings and working capital improvements. A key focus in 2010 was on reducing inventories, especially in book fairs, which we successfully achieved through more efficient and better coordinated purchasing across channels. At year end, inventories were down by 29 million or 8% compared to the prior year. A higher accounts receivable is the result of higher education sales, while lower accounts payable reflect lower spending.

Higher free cash flows for the year reduced the company’s total debt and net debt. As of May 31st, 2010, net debt was $9 million, down from $160 million a year ago. This reflected significantly higher cash on hand as well as debt repayments and repurchases over the past 12 months. We remain undrawn on our committed $325 million revolving credit agreement.

We continue to purse efficient means of returning cash to shareholders. In the Q4 we acquired approximately 341,000 shares of common stock for $9.3 million. During fiscal 2010 we bought back approximately 410,00 shares in total for $10.8 million. Since the beginning of fiscal 2011 we’ve repurchased an additional 124,000 shares for $3.1 million, and have $7.1 million remaining on our current Board authorization. In addition to share buybacks, we returned $10.9 million directly to shareholders in the form of dividends in fiscal 2010. And yesterday we declared our first quarterly dividend for fiscal 2011.

No I’d like to turn to our outlook for w011. As Dick stated at the beginning of the call, our plan is to sustain the strong operating results of 2010 before incurring an incremental $20 million in operating expenses to implement and promote our key digital initiatives in the Children’s Book segment. Following last year’s strong finish in this segment, we expect solid growth in fiscal 2011 overall, and in particular in clubs with new Cool. Fairs are also expected to maintain modest growth. Trade sales are anticipated to be down slightly next year. A strong summer and fall front list with much anticipated releases of Suzanne Collin’s Mocking Jay, the final book in The Hunger Pains series, and a new Captain Underpants from Dave Pilkey, among others, should mostly offset the impact of fewer new titles in The 39 Clues series.

In Education our plan is to sustain sales at approximately the same level as fiscal 2010 as Margery discussed. Renewal of services and other reoccurring revenue streams are expected to comprise a modestly larger portion of sales, reflecting the larger installed customer base. In International we expect solid top line growth through primarily Asia and export, and continued improvement across the international business.

In overhead areas we continue to control headcount while improving efficiencies throughout the company. This could help offset expected increases in commodity pricing, manufacturing, and medical expenses, as well as merit pay increases. Pre publication and production spending is expected to increase, reflecting increased product development in the Education segment. This factor should be offset by further working capital improvements, allowing us to generate free cash flow in excess of net income for another year.

On a consolidated basis we expect total revenue of approximately $1.9 billion to $2 billion, and earnings per diluted share on continuing operations of $1.95 to $2.20. This outlook corresponds to operating income of $150 million to $165 million. Our outlook for EPS and operating income excludes the impact of one-time items associated with non-cash, non-operating items. Excluding $20 million of strategic spending and digital initiatives, this is in line with fiscal 2010 results and an operating margin in excess of 9% at the top end of the range. The bottom end of this range contemplates a scenario in which education sales are lower than expected because of a tightening in state and local budgets, or in which books clubs and fairs do not experience growth in spite of increased investments in Cool and promotions.

Stock based compensation expense is expected to be approximately $14 million, or $0.23 per diluted share in line with fiscal 2010. Our current outlook for tax is for it to improve from 47% to 46% based on lower UK losses. We expect free cash flow of $90 million to $100 million in fiscal 2011. Capital expenditures will be between $50 million and $60 million, while pre-pub and production spending is expected to increase modestly to $65 million to $75 million.

With that, I’ll turn the call back over to Dick.

Richard Robinson

Thank you, Maureen. Fiscal 2010 was a strong year for Scholastic financially and strategically, and we’re committed to hold onto those gains in fiscal 2011. In Education we’re determined to maintain the revenues we achieved in 2010 despite declining stimulus funds, and to increase the pace of new product development momentum for sale in 2012 and beyond. In Children’s Books we’re focused on achieving solid sales increases in line with the last quarter. At the same time we will increase our investment in digital and e-commerce initiatives to transform and grow the business. And across the company we’ve taken steps to hold our cost base and maintain our strong free cash flow conversion.

Together we feel that these three elements will deliver strong results in fiscal 2011 and position Scholastic well for long-term growth. Meanwhile we are proud of having overachieved the goals we laid out a year ago for 2010. This performance gives us renewed confidence that we can continue to grow solidly while maintaining our new higher levels of profitability.

Now I will moderate a question and answer period. In addition to Maureen, Margery, and Judy I’m joined this morning by division presidents Ellie Berger of Trade, Deborah Forte of Scholastic Media, and Hugh Roome of Consumer and Professional Publishing. With that, let’s open the call to questions.

Question-and-Answer Session

Operator

(Operator instructions). Our first question comes from Drew Crum of Stifel Nicolaus. Please go ahead.

Drew Crum - Stifel Nicolaus

Good morning, everyone, thanks. I have a couple questions on your e-book strategy. Can you give us a little more detail on the nature of the investments you’re going to be making? Were there any made in 2010? And then from an accounting perspective, are these investments you’ll be capitalizing and amortizing, or is this something you’re going to run straight through the P&L? And then finally what is the plan as far as use of platforms? Are you going to be partnering with Apple and Amazon and the like, or are there other providers you can fill us in on?

Richard Robinson

Thank you, Drew. I think we’ll ask Maureen to answer the question about the spending, which is operating cost expense in the $20 million, and is in addition to what we’ve already been spending in the preceding years.

Maureen O’Connell

Yes, as Dick mentioned we are expecting to spend $20 million on our digital initiatives this year, and that really includes technology infrastructure and marketing costs and people associated with this collaborative effort which includes our E-Scholastic group, our IT group, our Book Club group and our Media group.

As far as the accounting, the accounting only allows you to start capitalizing when you have a viable product that's on the market with market revenues that you can ascertain. And so our expectation is through our prototyping phase and our testing phase we will be expensing the spend.

Richard Robinson

Drew, we’ll turn to Judy to talk a little bit about the e-book strategy and the e-commerce strategy.

Judith Newman

Hi Drew, how are you?

Drew Crum - Stifel Nicolaus

Hi Judy.

Judith Newman

We’re getting ready for our market pilot of our e-book program at the end of this calendar year, and our goal is to have our proprietary Scholastic e-reader ultimately available on any device that anybody wants to read it on. But we’re going to be starting with PC and then moving onto Mac and rolling out subsequently from there.

Drew Crum - Stifel Nicolaus

Got it. And Maureen, real quickly, can you quantify what the investments were in 2010?

Maureen O’Connell

There was some minor staffing added in 2010 and we began to spend a little bit with outside vendors as we’re building the digital initiative. I’d say it was under single digits, low single digits.

Drew Crum - Stifel Nicolaus

Okay. And then just moving to Clubs, you guys provided some guidance there. Can you give us some additional color on expectations around revenue, given that you are rolling out the new Cool. Against that you have unemployment still elevated and well documented concerns around teacher layoffs. And then on the cost side, if I remember it correctly you’re running the dual platform. And I guess I’d also like to know how the promotional spend plays into your overall strategy given that you’ve got this new digital initiative.

Richard Robinson

Judy will tackle those questions, Drew. Thank you.

Judith Newman

We had some great results in the Q4 and we learned a lot about targeted promotion, and we were able to reverse some of the lagging sales that we’d seen in the prior quarter. So with that knowledge of how to target our promotion spending, we’re approaching the new fiscal year with new energy and new strategies to try to find the teachers where they are. We’re very mindful of what’s going on in the schools and the classrooms, and we know that it will vary by state where there are teacher issues. We have good intelligence and good programs targeted to get our catalogs to where the teachers are when they need them.

We’ve also learned a lot about promotion and we know that we have to make exciting programs to teachers to get them involved in clubs and to bring them into the club system so then we can be moving them on to new Cool. And then we have some really exciting stuff ready for back to school, which launches in just a couple of weeks.

Drew Crum - Stifel Nicolaus

Okay. And then my last questions are on Educational publishing, I guess for Margery. If you take out federal stimulus, how would you characterize the funding environment today relative to a year ago? Have things gotten better, worse, or are they kind of the same for your business? And then I think looking out longer-term, with common course standards looking to make their way into the system, do you see that as a catalyst for your business or is it a headwind?

Margery Mayer

Hi, Drew. So the funding environment outside of federal funding, you know, I don’t think it’s great but it doesn't affect us as much as it would affect other educational publishers because so much of our business is linked to federal funding. And you know, there’s no question that school districts are feeling the pinch of state budgets right now, but we’re optimistic about our business going into the coming year.

In terms of common core, we think it’s an opportunity for us. We think it’s going to be great for our country and good for our business. We’ve never been a company that’s linked a lot of individual programs to individual state standards. We have a more universal approach. We like to drive our products based on efficacy and research rather than meeting individual state’s standards. So we think this is going to be great. If anything we feel that our products are very well designed for the common core, and it’s going to be a driver for our business.

Drew Crum - Stifel Nicolaus

And I apologize if I missed this, but did you guys talk about the digital revenues for Education publishing in the Q4? I know you guys gave a 2010 number but is there something you can share for the Q4?

Margery Mayer

Our revenues were up 25% overall on Educational technology in the Q4. I think that’s pretty much what we do.

Richard Robinson

Drew, on behalf of Judy I’d like to say that I think the promotional program for Clubs in the fall is really great and will engage teachers even though teachers are in a complicated frame of mind because of all the financial pressure on school districts. Additionally we will be spending some amount on promotion to move parents to new Cool, and as Judy described working directly in the system with their credit cars. And we believe we can double the number of parents that are in new Cool.

Drew Crum - Stifel Nicolaus

I guess this is my last question. Given the use of credit cards, are you anticipating any change in your bad debt expense profile?

Richard Robinson

No.

Drew Crum - Stifel Nicolaus

Okay, guys. Thank you.

Richard Robinson

Thank you, Drew.

Operator

(Operator instructions). Our next question comes from Peter Appert of Piper Jaffray. Please go ahead.

Peter Appert - Piper Jaffray

Thanks, good morning. Maureen, does the $20 million of e-book spend, is that all operating costs or is a part of that capitalized?

Maureen O’Connell

No, that is the operating cost because that is through the pilot stage; it’s not through a marketing stage where we have the products completely rolled out. And so at that point we can begin capitalizing.

Peter Appert - Piper Jaffray

Okay. And then do you have, this is for Judy, I guess, an estimate on the number of titles you’ll be doing on the e-book channel? And are you thinking about products in e-book only or is everything going to be hybrid?

Richard Robinson

Some will be hybrid. I think Judy’s the best person to answer that one. Thank you.

Judith Newman

We’ll be kicking off the pilot with about 2000 titles from Scholastic as well as from other publishers, and our strategy in the e-book market is to have a carefully curated selection of titles and bring our expertise to bare, just like we do in our regular print business. I think that’s a big differentiating point for us. So we’ll be kicking off with those very carefully curated 2000 titles and then continue to roll out from there.

We will be working on some enhanced e-books as well as eventually some books that will be conceived originally with the Trade department for e-book publication at the same time they’re being published in print.

Peter Appert - Piper Jaffray

And Judy, what kind of price points are you thinking about?

Judith Newman

We’re experimenting with different price points. We’re talking to other publishers. We're working on our pricing strategy. I don’t think we’re quite ready to talk about that yet, but we’re looking at different models and making sure that we can ensure good revenues and profitability, as well as royalties to authors and so on.

Peter Appert - Piper Jaffray

Will you be following the same model that you would follow in the club channels, that the price points would be at a discount to what would normally be a price point for a similar kind of product in the Trade channel?

Judith Newman

Yeah, I think our goal in the school market e-book business as well as in the print business is value. And so we really price each title individually . We want to make sure there’s enough value. I don’t think we see ourselves undercutting our own physical books in our e-books. And we’re looking at a set of different models to make sure we’re getting the same great value for e-books. And as we enhance titles there may be some opportunities for some incremental pricing there as well.

Peter Appert - Piper Jaffray

Can you give a thought in terms of just sort of preliminarily what the revenue from this initiative could look like in the first year?

Judith Newman

I think I’ll give that to Maureen to answer.

Maureen O’Connell

Peter, we haven’t budgeted any revenue really in the first year because right now we’re working on our testing and experimenting with different price models as Judy said, so we really haven’t budgeted any revenue for this year.

Peter Appert - Piper Jaffray

Thank you, got it. And Margery, you guys continued to do a great job from a competitive perspective in the remediation market. I’m wondering if you could just talk a little bit about how you see the competitive dynamics evolving in this market. And then also I’m wondering if you have any metrics you could share with us in terms of what kind of renewal percentage you see from existing users, if there’s anything you could talk about in terms of proportion of sales coming from upgrades that might help us to better understand the revenue outlook going forward.

Margery Mayer

Yeah, okay. You know, Peter, thank you for those nice words. Really what, I think what’s been going on and part of why we had such a fantastic year is our strategy - I think we were good on what schools were going to need and what direction they were going in. And that’s part of why we’ve been able to solidify our position so well. This isn’t something that just overnight we had a magic wand and we made it all happen. We’ve been working on building our services business for years. We’ve been working on the idea that when we go into a school district and we sell Read 180®; we don’t walk away, we try to put in the implementation work. We work with them to take a look at their results, how is it going. And all of these things came together to position us in a different way than other companies have been abele to position themselves.

In terms of competition, we do run into competitors, but honestly, not as often as you would expect. And for System 44 ® there is a set of competitors that have been selling phonics programs for a long time. We feel like we’re getting great results now and we’re seeing our customers willingly move to System 44® from other programs that they’ve been using for a long time with not very much success.

In terms of our base, Maureen, do you want to talk about how much of it is selling to our existing customers and how much is new? Cause she’s got the numbers right in front of her.

Maureen O’Connell

Yes, I’d be happy to, Margery. Peter, this year has been extremely successful in both fronts. I mean our renewal rates have increased as well as our new business rates. The majority of our income and revenues still come from our existing base of customers, but the revenues from our new customers have increased. And we are very happy with the number of new districts that we added this year that we didn’t previously have any business with, and then again our renewal rates are stronger than they’ve ever been.

Peter Appert - Piper Jaffray

And can you share what the number is in terms of renewal rates?

Maureen O’Connell

We don’t break out that number but it’s quite high.

Peter Appert - Piper Jaffray

Okay, great. Thank you.

Richard Robinson

Thank you, Peter.

Operator

Our next question comes from Barry Lucas of Gabelli & Company. Please go ahead.

Barry Lucas – Gabelli & Company

Thanks, and good morning. A couple of quick items. On the digital initiative, is any of the funds that you're talking about, the incremental funds that you're talking about spending, is any of that in support of a physical product – the new e-reader that would either compete with the Apple product or with the Kindle?

Richard Robinson

No portion of that is related to an e-reader device. Some of it is related to the development of an e-reader piece of software, front end, that will enable children and parents to access the system.

Barry Lucas – Gabelli & Company

And Dick, how do you regard the sort of the current price points of the Apple products or the decline that Amazon announced with Kindle? Do you think that you still need a kids’ version, as we’ve talked about, a Fisher Price type product out there to drive sales?

Richard Robinson

Back to the question about the device, well, a device could be helpful but we’re focusing primarily on the e-reader software front end that we can use in our exiting Cool delivery platform - and that is our book club online ordering system - in which we can utilize other people’s devices. So that’s our focus.

Barry Lucas – Gabelli & Company

Just coming to the guidance, as you try and play with the numbers of an incremental $20 million digital spend and a shift in the stimulus dollars that I don’t know, could have been- If you had spilt the difference and said it was $50 million in each year, so maybe you picked up, what would you say - $10 million to $20 million in revenues for the year just ended as opposed to the one that we’re in, so we borrowed a little bit. Any way to normalize the two years? Cause the $20 million in spending is $0.25 a share or something like that. Do you think about that or- Cause I think the guidance that’s being offered is certainly a little less than we would have hoped.

Richard Robinson

I think we indicated on the call that we think about 75% of the stimulus money was received, that is $75 million of the initial $100 million estimate was received in the 2010 fiscal year. Barry, there’s still some left to go but at the same time there’s a reduction in overall spending that has to be made up for. So we’re, despite the fact that we have a higher base we believe that we would do well to hang on to the dramatic revenue increase the we experienced in 2010.

Looking at a two-year number, from 2009 to 2011 that would equate to a more than 25% sales increase in each of the two years if you look at it that way, as you sort of indicated in your comment. We’re focused on getting an operating income level that was parallel to this year, but we realize that the $20 million of investment that we’re going to have to be making and that we want to make in the digital consumer book area is important to the company’s future. That is, we don’t want to sit and wait for the digital market to unfold only to see that we’re not in it. We want to maintain our leadership position and the $20 million of operating cost that we’re devoting to both e-commerce and e-book digital transformation, we think is critical to the company’s future.

Barry Lucas – Gabelli & Company

I hate to look in the rearview mirror, but it looks like there’s a product hole in the current year. So you know, last year you had the great sales of Read 180 TM and System 44® and you’re working on the new math products but some of those don’t hit till ’12. So if I look back do you feel you were constrained in investments because of what was happening in the financial world and conservatism? Or how would you describe the sort of gap that you have to backfill here?

Richard Robinson

Well, we certainly weren’t constrained in our investment in this business, which we feel is a remarkable, fast growing business that’s delivering tremendous value to the company and to the shareholder. What you’re constrained by is just the ability of the people to develop the product as fast as we can. There’s a finite number of people focused on this, and it’s a unique skill in terms of developing an intervention product. And so it’s more of a- If there’s a constraint it’s in that area. We have a tremendous pipeline, Barry, and a lot of that is going to be affecting the future fiscal years as you point out. Margery, perhaps you could talk a little bit more about some of the details involved in our pipeline.

Margery Mayer

Well we have, right now we just launched these two new software programs out of our Boston office: Tom Snyder, as I mentioned, Fraction Nation and then the Scholastic Math Inventory. We also have just published a new early childhood program which we just had approved by the Adoption Committee in the state of Texas a couple of weeks ago, so we’re going to be going into an early childhood campaign in Texas in the fall. Those revenues will be in our following fiscal year but we’ve done very well in those adoptions in the past.

Our big investment right now is going into Read 180® where we’re going to be announcing some really exciting enhancements; very soon you’ll hear about them. And we have a lot of investments going on in math, additional new reading programs that we’re not ready to talk about. We feel that the company is making a big investment in this business going forward and we’re extremely optimistic about what kind of growth we can get in the market.

You know, our strategy of focusing on intervention and helping our most challenged students, that seems to be extremely well-aligned with where the Obama administration is directing the reauthorization of ESA. Our services business is growing by leaps and bounds, and we’re hopeful that we can make a strategic acquisition or two in the service realm that can enhance that business. We feel we’re, you know, we feel great about this.

Richard Robinson

In terms of the outlook, Barry, obviously we have a choice of trying to maintain the record that we’ve just established in this year where we overachieved our goals. We do not want to go back to where we’re putting out goals that we don’t make, and we’re particularly proud of ourselves - if that sounds boastful it’s not trying to be - but of having overachieved a really big goal that we set for ourselves this past year.

We recognize that there were several options. One is we could not make the investments in the digital world, which we did not want to do. We wanted to make those investments and we wanted to acknowledge those investments to everybody who is following the company. So we feel that we’re consolidating the year that we have had, and we’ve had a tremendous gain this past year of more than $70 million in operating income improvement x the one-time items. And we want to consolidate that and build a new platform for digital expansion in the Children’s Book area, which we feel is going to be coming relatively quickly.

So that’s our philosophy. We hope to come out at the top end of these goals, of course, but we absolutely do not want to disappoint on the one hand, and we don’t want to fail to make the important investments that we’re all very excited about - about extending the reach of our business and finding new customers, and children who are excited about using digital versions of books. So that’s really our position for the coming year. We would have been very happy to say we could do all that and add another $1 per share, but we don’t think that’s achievable.

Barry Lucas – Gabelli & Company

…the authorization given the stock that you bought post year-end is starting to run out, the dividend is flat. And I think Margery just mentioned looking for some strategic opportunities for M&A maybe in the service business. So how do you see using the free cash that you expect to generate this year?

Richard Robinson

Well, I think certainly we’d be looking at acquisitions that would fit our style in the Education area. Those are, ther’re not many of them but we’re certainly on the lookout for those. Our Board has shown willingness to look at different options for returning cash to shareholders. They consistently look at evaluating that question. We have made no decision about that, and we’re really kind of consolidating our position here. We’ve had a great year. We’re optimistic about the future. We see very good growth opportunities in the digital area and we want to consider our recourse to be able to be sure we can take advantage of those.

Barry Lucas – Gabelli & Company

Terrific. Thanks very much, Dick. That’s it for me.

Richard Robinson

Thanks, Barry.

Operator

Our next question is a follow-up from Drew Crum of Stifel Nicolaus. Go ahead.

Drew Crum - Stifel Nicolaus

Okay, thanks. Just two quick follow-ups. Can you give us a sense as to how the timing of the federal stimulus monies revenues that you recognize will flow in fiscal ’11? And then my second question is just an update on the UK business. You’ve gone through some restructuring there. Are you anticipating any additional charges in fiscal ’11 or is this a business that should be profitable this year? Thanks.

Richard Robinson

Starting with the UK, Drew, we’ve reduced our losses in the UK this past year by quite a bit. We’ve completely reengineered the footprint there which will lead to a further reduction of losses. There is some pale, which Maureen will describe, in terms of the one-time costs, because not all of it got spent in the current fiscal year. Maureen, can you deal with that one?

Maureen O’Connell

Sure. Our estimate was to spend between $7 million and $10 million and we spent $8.5 million through the fiscal 2010. We do expect to reach the $10 million spending that we had anticipated, and it will come in the Q1 as a one-time item of $1.5 million. And that really was due to the timing of when we could move our fair operations. We really couldn’t move them when they were busy shipping to their customers. So we weren’t able to make the fiscal timing, so that will spill into the Q1.

Drew Crum - Stifel Nicolaus

Okay, and that’s not contemplated in the guidance you’ve given, correct?

Maureen O’Connell

No, but it’s about $1.5 million.

Drew Crum - Stifel Nicolaus

Got it.

Richard Robinson

And Drew, Margery will talk about the timing of the fiscal stimulus spending.

Margery Mayer

So Drew, hi. We expect to see federal stimulus money this summer and also continuing into the future quarters. We think there’ll still be spending, and especially in the Q2. In addition to the federal stimulus funds there’s something called School Improvement Grants, which is earmarked money that is being competitively awarded to the very lowest schools, and we expect to see some school improvement money as well as the stimulus funds coming in, mostly we hope in this quarter but also some bleeding into the second quarter.

Drew Crum - Stifel Nicolaus

How about Race for the Top? Is that an opportunity for the company?

Margery Mayer

Yeah, I think it can be. I mean we’ve got to see what’s awarded and how it’s awarded. It's, you know, there's going to be more announcements coming up soon. We have, we think we’re well positioned with our consulting arm which is called ICLE, the International Center for Leadership in Education. And states where literacy is part of their Race to the Top drive, we think that we’re the go-to company for that.

Drew Crum - Stifel Nicolaus

Okay. Thanks, guys.

Operator

(Operator Instructions). Our next question comes from Jim McGarry of Neuberger Berman. Please go ahead.

Jim McGarry - Neuberger Berman

Hey, good morning, Dick and everyone at Scholastic, and congratulations on a, by my calculation I think you got your multi-year operating margin target.

Richard Robinson

We did.

Jim McGarry - Neuberger Berman

It came up about 9% so that’s wonderful to see and I know it was a big effort. So I wanted to just ask you know, the sustainability of that. Are there any more levels to pull?

Richard Robinson

Well, we think that we- Obviously in the current year we’re trying to maintain our operating profit before the investment, the $20 million operating cost investment in digital initiatives in the Children’s Book area. And as we noted in the script that would keep us at the 9% operating margin level. As the Education business with its higher margins becomes a larger portion of the company’s overall total revenues, there will be some additional impact on our operating margins, favorable. So that’s an opportunity for us.

I do believe as we look at the changing nature of the book market and the move to digital purchases, and particularly in the younger children’s area where there’s a lot of interest in digital apps and so forth and so on, we need to figure out where that market is going and how we can maintain our market share, expand our market share, get more units sold and still maintain our profitability. No one has a crystal ball on that – it's just a lot of hard work and figuring out exactly where the market is going, and maintaining the investments and making it easy and wonderful for children to experience children's books in the new medium.

That's going to be a skill matter in addition to a money matter, and we’re really focused on it and we’re looking forward to it. It’s hard to predict the impact to margins but it’s our determination to maintain our operating margin where it is.

Jim McGarry - Neuberger Berman

Okay, very good. And I also wanted to talk about, you had such a strong free cash flow. It was really pretty staggering. And you’ve now got the company in a very good position in terms of financial flexibility. So I think Margery started talking a little bit about how you might look at some service acquisitions and there was a prior conversation, a little bit of a prior conversation on the Board looking at what to do. And I just wanted to open up if you had any further thoughts on cash deployments.

Richard Robinson

No, I think that’s about- I think I stated were the position of the company is, and we continue to look at this. But we also recognize that we paid off debt over a period of time. We’re now close to a net debt free position. But we still aren’t sitting there with hundreds of millions of dollars in cash in addition to, over and above the money that we owe. So I think we’ll take this cautiously and just looking at what our opportunities are. We do look forward to having around $100 million of free cash flow in the current year, in the fiscal ’11 period, and that will give us further opportunity.

Jim McGarry - Neuberger Berman

Great, thanks so much. And wonderful results this year.

Richard Robinson

Thank you so much, Jim.

Operator

Now I’ll turn the call back over to Dick Robinson for closing remarks

Richard Robinson

Well, thank you very much for listening to our year-end story. As you know we’re very excited about what we achieved in 2010. We’re very future-directed for 2011 and beyond. W're making our digital investments, we’ve continued to expand our remarkable educational technology business. We’re very confident about our ability to run the company efficiently and effectively, and we’re really looking forward to the new digital opportunities and how we can take advantage of those to make sure that we maintain our leadership position in children’s books as well as in educational technology. So for your support we thank you, and we’ll look forward to reporting on our progress and our digital investments and our educational expansion as the year goes on. Thank you very much and we’re happy about our fiscal 2010 numbers. Thanks a lot.

Operator

Ladies and gentlemen, that does conclude today’s conference. You can now disconnect and have a great day.

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Source: Scholastic Corporation F4Q10 (Qtr End 05/31/2010) Earnings Call Transcript
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