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Scholastic Corporation (NASDAQ:SCHL)

F1Q2011 Earnings Call Transcript

September 23, 2010 8:30 am ET

Executives

Jeff Matthews – VP, Corporate Strategy, Business Development and IR

Richard Robinson – Chairman, President and CEO

Maureen O'Connell – EVP, CFO and Chief Administrative Officer

Judith Newman – EVP and President, Book Clubs

Ellie Berger – President, Trade Publishing

Margery Mayer – EVP and President, Scholastic Education

Deborah Forte – EVP and President, Scholastic Media

Analysts

Drew Crum – Stifel Nicolaus

Barry Lucas – Gabelli & Company

Operator

Good day ladies and gentlemen, and welcome to the Scholastic’s fiscal 2011 first quarter earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will be given at that time. (Operator instructions) As a reminder, today’s conference call is being recorded.

I would now like to turn the conference over to your host, Mr. Jeff Matthews, Vice President of Corporate Strategy, Business Development, and Investor Relations. Please go ahead.

Jeff Matthews

Thank you Ellie, and good morning everyone. Before we begin, I would like to point out that the slides for this presentation are available for simultaneous viewing by going to our Website, Scholastic.com, clicking on the Investor Relations, and following the links on that page.

I 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 risk and factors identified from time to time in the company’s filings with the Securities and Exchange Commission. Actual results could differ materially from those currently anticipated.

Now I will introduce Dick Robinson, the Chairman, CEO, and President of Scholastic to begin our call.

Richard Robinson

Thank you Jeff. Good morning and thank you everyone for joining us on our fiscal 2011 first quarter conference call. This morning, I am joined by Maureen O'Connell, Chief Administrative Officer and CFO, and other members of the executive team are available to answer questions at the end of the prepared comments.

Scholastic had a solid start to fiscal 2011 as we moved forward with our plan to sustain last year’s strong performance. Though it’s still early in the year, we remain confident that we will achieve our goals for the year based on the stimulus funding outlook for Scholastic Education, early positive indicators in our School Book Clubs channels and a strong start for trade.

At the same time, we have taken significant steps to leverage our strong free cash flow and balance sheet to drive long-term shareholder value. We increased internal investments in the key ecommerce and ebook capabilities for children’s books. We accelerated development of new technology programs and also made a small but highly strategic acquisition of Math Solutions, the leading brand in K-12 math instruction and professional development. And in addition, we continued to return value to shareholders.

This morning, we announced that the Scholastic Board has authorized the repurchase of up to 150 million of the company’s common stock through a modified Dutch auction tender offer. After exploring possible ways of returning cash to shareholders in addition to our current dividend, we concluded that cash tender offer is an efficient mechanism for stockholders and seek liquidity at a premium over current trading prices. At the same time, stockholders who do not participate in the tender offer will share a greater portion of Scholastic’s future potential.

We intend to commence the tender offer during the week of September 27. Additional information is available in this morning’s announcement and in the tender offer statement including the offer to purchase, Letter of Transmittal, and related tender offer documents when it becomes available on investor.scholastic.com and sec.gov.

Now, turning to the quarter’s results. In Scholastic Education where we benefitted significantly from the initial disbursement of federal stimulus funds a year ago, first quarter revenue declined this year, but we continue to target full-year revenue in line with last year’s record-breaking levels. Though the federal funding landscape has changed somewhat, we expect that federal Race to the Top and School Improvement Grants, in addition to higher service sales to our expanded customer base, will help drive growth later this fiscal year.

In addition to last year’s flow of federal funding which particularly benefited sales in new districts, two other factors affected the first quarter comparison. Last year, we recorded strong sales for a major adoption of READ 180 in California as well as a significant sale in the classroom and library group, which was not repeated in the current quarter. Offsetting these factors, we recorded strong growth in services last quarter, reflecting a larger installed base of school districts using READ 180 and System 44. Higher service sales, much of it already under contract will also help the remainder of the year.

In upcoming quarters, we expect sales to also benefit from a pickup in federal funding, which has changed from a year ago. This fiscal year in addition to formula-based title 1 and IDEA funding, more stimulus dollars are being directed through competitive programs including Race to the Top and School Improvement Grants. As widely reported, the competitive programs have delayed the flow of dollars to schools, since states must apply and be approved before they can award dollars to local districts.

In addition to our strong partnerships at the local district level, we are working with state level decision makers who are directing Race to the Top and SIG grants. As a result, we are listed in multiple states as an improved external provider. While executing our plan to consolidate last year’s record growth, we continued developing new products and services to drive long-term growth. Two weeks ago, we announced the acquisition of Math Solutions, a leading authority on K-12 math instruction and professional development. Math Solutions and its founder Marilyn Burns, a renowned a math educator and author of major Scholastic programs including Do the Math are closely aligned with our current strategy of helping districts implement turnaround strategies, helping teachers become more affective and helping children achieve their full potential.

As part of Scholastic Education, Math Solutions will help us expand our professional development and services in math, and to accelerate the development of the upcoming Math 180 suite of programs, which should benefit revenue and profit in fiscal 2012 and beyond.

In the Children's Books segment, last quarter results were very positive, in terms of the summers trade sales, the outlook for Clubs and Fairs and our progress on key digital initiatives. In trade, we beat a strong comparison a year ago with the help of Mockingjay, the final book in Suzanne Collins' Hunger Games trilogy. Mockingjay was a global phenomenon debuting at the top of all national best-seller lists in the U.S., Canada and Australia, driving strong sales of Hunger Games back list. The 10th book in the 39 Clues series also hit children’s best-seller list and this morning, we are announcing Part 2 of the 39 Clues to include six more titles from best-selling authors including David Baldacci.

In Clubs and Fairs, which are ramping up with the new school year, we are optimistic based on some important early indicators. In Clubs, we are seeing positive customer response since the start of schools several weeks ago, with the total number of teachers sponsoring clubs and order volumes both up from a year ago. In fairs which performed solidly last year, fair bookings are on plan and we continue to project a slight increase in total fair count. Now, all fairs this year will have new point of sale devices, which helped to lift revenue per fair in tests last year. Overall, based on our first quarter results and positive customer metrics, we expect to continue solid growth from Children’s Books in fiscal 2011.

This year, we are also accelerating key digital initiatives in Children’s Books where we have the unique opportunity to leverage our position as the world’s largest children’s book publisher and distributor into a leading position online where we already have a significant presence and in ebooks. In many ways, this parallels the transition we successfully and profitably have made in Scholastic Education starting 10 years ago and where we are now the market leader in educational technology.

In Children’s Books, we have already hit significant milestones this year in our digital development. In August, we fully rolled out our new online ordering platform, also known as New COOL to all book club teachers and parents. This is a key achievement for our fiscal 2011 plan and our longer term strategy to grow online. New COOL makes Scholastic’s unique school-based distribution model and value proposition accessible directly to parents and kids online as well as to teachers. We are already seeing a significant increase in the percentage of orders coming in online from parents this year.

In addition, we are moving forward with our plans to begin selling children’s ebooks later this fiscal year. In the first quarter, we saw a strong increase in ebook revenue for our Hunger Games series where ebooks are approximated 10% of total sales, and we believe that these sales are primarily incremental. They also indicate potential for significant long-term demand for children’s ebooks, which could represent more than 25% of the children’s book market in 2015 or before.

For this to happen, we are addressing three critical needs in the marketplace. First, we are leveraging Scholastic’s brand and reputation and our marketing scale and book channels including New COOL to reach the kids, parents and teachers who drive book purchases today.

Second, we are developing a robust selection of ebooks and enhanced ebooks using our own content and working with other publishers too, to offer a large, carefully curative selection of quality children’s title at launch.

Third, with our deep knowledge of kids and reading, we are developing a compelling children’s ereading experience that also involves their parents and teachers. This will be delivered through a downloaded software application distributed through Cool and available on multiple platforms. There is still much to be learned about how children’s e-books will evolve. As part of our strategy to lead and understand this market, we are moving aggressively towards launching a robust ebook offering later this fiscal year.

As you know, these digital initiatives will involve $20 million in increased operating expense in 2011, and investments that will generate growth for Scholastic in market share and driving demand for children’s print and electronic books over the next several years.

Now, I will ask Maureen O'Connell to review our first quarter financial results and the outlook for fiscal 2011.

Maureen O'Connell

Thanks Dick, and good morning everyone. Looking at first quarter results, revenues declined relative to a year ago primarily reflecting lower educational sales. This was partially offset by strong results in international and trade. Cost of goods sold increased slightly as a percent of sales compared to a year ago due to a decline in educational, technology product sales this quarter.

SG&A was down compared to a year ago, reflecting lower salary-related expenses, as well as lower commissions related to the educational technology sales. This was partially offset by approximately $5 million in incremental spending on digital initiatives in the quarter, most of which was recorded in SG&A.

We also incurred $1.2 million in one-time costs in the UK. This completes our restructuring reducing our footprint in the UK by 40%. Operating income declined by $11.5 million related to lower educational sales and increased spending on digital initiatives. Overall, the loss per share from continuing operations was $0.95 a share compared to $0.68 a year ago.

Looking at the balance sheet and the cash flow, free cash flow in the quarter was a use of $96.9 million compared to a use of $74.8 million last year. Scholastic typically uses cash during the summer with schools out of session and the need to build inventories before the fall. The year-over-year increase was primarily driven by the timing of inventory purchases and lower tech payments as compared to a year ago as well as investments in POS technology and fares and New COOL in Clubs.

Accounts receivable declined reflecting lower educational sales. Accounts payable increased partly reflecting the early inventory purchases. As a result of improved free cash flow during the prior 12 months, total debt and net debt continued to decline. As of August 31st, 2010, net debt was $118.1 million, improving from $236.4 million a year ago as a result of strong free cash flow over the last 12 months.

We also completed share repurchases of 9.7 million this quarter and at quarter-end remained undrawn on our committed $325 million revolving credit facility. We are affirming our fiscal 2011 outlook for revenue of $1.9 billion to $2 billion and EPS of $1.95 to $2.20, which corresponds to operating income of $150 million to $165 million, excluding $20 million of strategic spend on digital initiatives. This is in line with fiscal 2010 results.

We continue to expect free cash flow of $90 million to $100 million for the year. Note our outlook is prior to any impact which could result from the proposed tender offer and excludes the impact of one-time items associated with non-cash non-operating items.

Now, I would like to turn the call back over to Dick.

Richard Robinson

Thank you Maureen – financially and strategic, following a strong fiscal 2010 both financially and strategically, we are committed to holding on to those gains in fiscal 2011. For Scholastic Education, despite a decline in the first quarter, we continued to target revenue in line with last year based on the outlook for federal stimulus funding and growth and services and follow-on sales to our expanded customer base. In children’s books, we had a great quarter in trade and are positive about the outlook for Clubs and Fairs and our progress with ecommerce ebook initiatives. And across the company, we are holding our cost base and maintaining strong free cash flow conversion.

Together, we feel that these elements will deliver strong results in fiscal 2011 and position Scholastic well for long-term growth, we look forward to reporting on further progress on next quarter’s investor call.

Now, I will moderate question-and-answer period. In addition to Maureen, I am joined this morning by Ellie Berger, President of Scholastic Trade; Deborah Forte, President of Scholastic Media; and Margery Mayer, President of Scholastic Education who will be joining us from the airport where she is en route to a sales call; and Judith Newman, President of Scholastic Book Clubs and ecommerce; and Hugh Roome, President of Scholastic 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

Okay, good morning everyone. Thanks. I want to start with the New COOL launch. Can you talk about metrics you guys will be keying on in terms of evaluating or measuring the success of this initiative and in addition to that, I think last year you guys experienced some weakness owing to some teacher displacement, but it sounds like you are encouraged by the early trends you are seeing. Can you just comment there, you are anticipating an impact from teacher displacement?

Richard Robinson

Thanks Drew. I will ask Judith to answer those questions.

Judith Newman

Good morning Drew. So, as you know going into this year we have really a two-pronged strategy and one was to get back those teachers who we knew were displaced last year for various reasons. And so, we had an aggressive promotion and of course it’s early, but indicators are that, that plan is really working to bring those teachers back in the fold. And the second big part of this strategy as you know was to launch New COOL fully and we did that successfully on August 1st. We rolled it out to all teachers and all parents. And the metrics that we are looking at are of course the responsiveness to the site and we are constantly monitoring satisfaction as well as a number of teachers and parents using it and how the teachers are spending across all the different clubs that are open to them as well as the number of parents that are coming online. And again, it’s early, but we are very encouraged by what we are seeing with this great new site.

Drew Crum – Stifel Nicolaus

Okay, and somewhat related to digital and ebooks, any comment on the profitability of the ebooks in the quarter? I think you mentioned it was about 10% of the mix.

Richard Robinson

No, ebooks sales were just Hunger Games we said was about 10% of the total sale of the Hunger Games trilogy including Mockingjay and the other two books that have already been published. But ebooks really are highly dependent on best-seller status, and ebook sales for other books were far, far lower than 10% of total. Now, as we develop our ebook initiative and launch our Scholastic store for ebooks, which is coming later in this fiscal year, we will give an opportunity to our COOL customers in particular to order a wide range of ebooks and that will really begin to tell what the demand will be like when we ourselves are beginning to promote these ebooks as opposed to accepting ebook orders via largely Kindle and Nook and the other platforms, which is what we are recognizing for trade in the quarter that we just discussed.

Drew Crum – Stifel Nicolaus

Dick, are you guys changing your approach with your retail partners given some of the challenges and changes notably at Borders and Barnes & Noble which is an important part of your trade channel?

Richard Robinson

I will ask Ellie to answer that. We obviously continue to have very good relations with all of the major trade retail chains including the two you mentioned. Let her give some color to your question.

Ellie Berger

Yes, I would say that we do continue to have and cultivate our relationships with all our major customers and as they have ebook initiatives, we are learning about it and cautiously entering that market.

Drew Crum – Stifel Nicolaus

Okay, and shifting gears to Educational Publishing, you are reaffirming the guidance for essentially flattish revenue. Just given the mix of revenues, what are you assuming for profitability or margins for that segment?

Richard Robinson

Maureen, why don’t you tackle that and then Margery if you are able to hear all of this and can talk from the airport, we will –

Margery Mayer

Yes, yes.

Richard Robinson

We hear you fine, that’s great. We are delighted. So, Maureen will tackle the profitability and margin question.

Maureen O'Connell

Drew, you are correct. We are not changing our guidance for the Educational Publishing division and that guidance is flat revenue with some pressure on margins, because there will be a larger proportion of service sales this year, because we grew the installed base so much last year, those people continue to buy more tech services, more implementation services to our service revenues are very strong as they are this quarter, and that will put a little bit of pressure on margins.

Richard Robinson

Okay. Margery, we can hear a little background from the airport or –?

Margery Mayer

I am sorry.

Richard Robinson

You want to tackle that question from Drew?

Margery Mayer

Drew, you want me to talk about the profitability. Is that the part you would like me to speak about, Drew?

Drew Crum – Stifel Nicolaus

That was the gist of the question.

Margery Mayer

Yes, one of the things that we are getting a little less profitability because as Maureen said, because of the mix of services, but one of the things that we are doing is we have created a really effective flex organization where we can flex up and flex down our service deliverers, because that’s always a risk when your service business is growing as fast as ours is. So, we have an eye on profits. It’s really important to our business model to have that service business not only because it’s very in line with what the initiatives are that are coming out of a Race to the Top, the Obama administration’s improvement, but also because it really reinforces the strength of our materials and districts where we are supporting teachers in knowing how best to use them.

Richard Robinson

Margery, while you are on the line, I might want to talk a little bit about your view of the funding and how it’s flowing and what you believe will happen to the rest of the year simply to assure Drew and others on the line of our commitment on outlook that we will reach our budget plan for last year’s sales or approximating last year’s sales.

Margery Mayer

Yes, okay. So, we had a very strong pipeline this summer, but we saw some delays in purchasing because of the timing on School Improvement Grants and I think people watched the market know that Race to the Top is likely to come in our last three quarters, and we didn’t expect any in our first quarter. So, just to give you an example, a material example of how this has been working, we have a very large order this week from Tulsa, Oklahoma.

It was School Improvement Funds that were used for that order and that was something that we had expected to get in this summer, but instead it came in this week. And we have a lot of that kind of business lined up, and we are very much hoping that it’s going to materialize in the second quarter. We think that we are extremely well positioned for School Improvement Grant money, and we are doing, I think lot of good work around Race to the Top. Our acquisition of ICLE a few years ago was fortunate. They are doing quite a bit of work with the SEAs, which are the State Education Agencies, and we are optimistic that we are going to do well.

Just a quick comment on Math Solutions, Math Solutions really boost our ability to expand our service business and get contracts for school districts and states that are looking for more stem, and we think that it brings important talent and intellectual property into our mix for expanding our overall math business.

Richard Robinson

Thank you, Margery.

Drew Crum – Stifel Nicolaus

I guess just two follow-ups related to your comments, Margery. One is what is the total pot of money from the School Improvement Grant and secondly, I guess for anyone, is there any assumed accretion or revenue generation from your Math Solutions acquisition for fiscal ‘11?

Margery Mayer

So, school improvement grants, $3.5 billion are being awarded, and those funds can be used over a couple of years, and there is another $4 billion in Race to the Top. Also, one of the nice infusions in the schools that came late in August, and so we weren’t able to see much effect in the summer was the jobs bill that provided another $10 billion for jobs preservation in schools. What was the second part of your question, Drew, about revenues for Math Solutions? I think that those revenues will be fairly modest and they are somewhat seasonal like we are. So, our acquisition occurred a couple of weeks ago. So, we missed the first quarter, fairly modest but growing.

Drew Crum – Stifel Nicolaus

Okay, and then two, just last housekeeping questions for me. Just the timing of the launch of the six 39 Clues books and the rollout of your point of sale technology in the fairs business.

Richard Robinson

On point of sale, we are – now every fair will have a point of sale device in the fair. So, we have those in all regions and all fairs, all case fairs as we call them which go into schools will be accompanied by a point of sale device, which is like an automated cash register that also keeps, takes credit cards, gives receipts and keeps inventory information, and it’s been very, very helpful to the people who run the fairs, but also helpful to us in keeping track of information and knowing what people are ordering. Ellie, do you want to talk about the 39 Clues series?

Ellie Berger

Sure. We have two new Bridge books to be published this year. We have one Big Black Book coming out in October and the following next Bridge book which really sets up the new launch comes out in April of this fiscal, and then we will launch the new series in August of next year.

Drew Crum – Stifel Nicolaus

Okay. And Ellie, the new series you alluded is the additional six books?

Ellie Berger

Correct.

Richard Robinson

Yes, that’s fiscal 2012.

Drew Crum – Stifel Nicolaus

Got it. Okay, thanks guys.

Richard Robinson

Thank you Drew. Next question?

Operator

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

Richard Robinson

Good morning Barry.

Barry Lucas – Gabelli & Company

Good morning, Dick. Let me congratulate you first on the tender and returning value to shareholders, but maybe you could just touch base on the decision-making process since you have been active in the open market, buying back stock, the dividend remains unchanged, so just sort of what went into your or the Board’s decision to go with the tender which we loved.

Richard Robinson

Barry, our General Counsel is sitting here looking at me with very dark looks, because he’s been – we have been told that because we are about to make an offer for shares that we are not really able to comment on any of the backgrounds going into the decision-making process or the offer itself. So, I will have to bail out of answering that question for you. Sorry about that.

Barry Lucas – Gabelli & Company

All right. That's okay. I think in the past you have shared some discussion of improvement in either average ticket size or number of books ordered through New COOL or with POS system at the book fairs. Could you sort of refresh our memories on what sales did with the new technology?

Richard Robinson

Well, the POS sales was a slight increase with credit use in revenue per fair. However, it’s really too early to comment on that for this year, but it was a relatively small increase, the customer satisfaction has improved, and some softer metrics. And of course our information about inventory is substantially clear, because we know every day what’s selling in those fairs where people are using credit cards and point of sale data. So, in terms of impact from credit cards and from the New COOL, I will ask Judith if she will answer that question.

Judith Newman

Yes, Hi Barry. The thing about New COOL is that now with Parent COOL, we have the potential to get many more parents directly online, and of course it’s too early on schools just opening, but that is the intent of New COOL and of course what our early results are showing is that parents are coming online and the more parents that order, of course there is a potential for more revenue with each teacher order.

Barry Lucas – Gabelli & Company

Great. Last time and I will come back with something we have talked about before. The speculation is Research in Motion will have a new reader announcement next week. I think Dell announced it something in the tablet this week and the Korean Samsung and others will probably be in the market. So, how important is a kids tablet to really driving both front list and back list sales of children's titles?

Richard Robinson

We are really looking forward to the large number of Android tablets that we expect would come out. Some will come out and some will be announced early next year. At this moment, our ereader software, which I will ask Deborah Forte to describe to you will function on COOL and will connect with many devices, not ours, that is we don’t have a kid’s device, but we will – I will ask Deborah to speculate a little bit on what or how kids might react to the new Android tablets and what a kid’s tablet might look like?

Deborah Forte

As you know, our business is children’s books. And so, we have concentrated and focused on software that will power children’s books well and to do that across all platforms. So, we are looking forward to launching our software, which will power our books on all the new devices, because we want to be where the kids are. And the jury is still out on whether or not kids are going to embrace the new tablets coming out, exactly how they are going to access their books, which is why since we don’t know that yet, and there is no true kids dedicated device, we need to evaluate whether that is the right option for us, at the same time making our software available everywhere.

Barry Lucas – Gabelli & Company

Terrific. Thanks very much and congratulations.

Richard Robinson

Thanks Barry.

Operator

I would like to turn the conference back over to Dick Robinson. Please go ahead.

Richard Robinson

Thank you all for joining us today. We had a good outlook for the year. We are delighted to be able to return value to shareholders. We thank you for your continued support and we will look forward to telling you more about our ecommerce, ebooks, book fairs and ereader in subsequent calls. Thank you all.

Operator

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

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