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Scholastic Corporation (NASDAQ:SCHL)

F2Q2011 Earnings Conference Call

December 16, 2010 8:30 am ET

Executives

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

Richard Robinson, Chairman, President and CEO

Maureen O'Connell, Executive Vice President, CAO and CFO.

Margery Mayer – EVP and President, Scholastic Education

Judith Newman – President of Scholastic Book Clubs

Ellie Berger – President of Scholastic Trade

Deborah Forte – EVP and President, Scholastic Media

Hugh Roome – President of Scholastic Consumer and Professional Publishing

Analysts

Drew Crum – Stifel Nicolaus

Barry Lucas – Gabelli & Company

Operator

Good day ladies and gentlemen, and welcome to the Scholastic Q2 2011 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 Web site, Scholastic.com, clicking on Investor Relations, and following the links on that page.

I would also like to note that this presentation contains certain forward-looking statements, which are subject to various risks and uncertainties, including the conditions of the Children’s Books and Educational Materials markets, 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.

Our comments today also includes references to certain non-GAAP financial measures as defined in Regulation G. Reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in our earnings release which is posted in the Company's Investor Relation Web site at Investor.Scholastic.com.

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

Richard Robinson

Thank you, Jeff and good morning and thank you everyone for joining us on our fiscal 2011-second 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.

Last quarter we celebrated Scholastic's 90th birthday with the launch of Read Every Day, Lead a Better Life, a global literacy campaign underscoring the importance of reading as the pathway for young people to succeed in the 21st century. We believe our mission of helping kids read and learn has never been more relevant at a time when reading and learning is becoming more digital and more global.

Even as we launched New COOL, our completely revamped e-commerce system to all of our club customers this fall and as we prepared to beta test a major online eBook store in early Spring, our print children’s book business is alive and well and thriving.

School Book Fairs and trades hit strong growth and in Clubs, we sustained last year’s revenue levels. We also achieved significant revenue gains in International driven by positive results in Canada, Australia, Asia and Export. In Scholastic Education, we held much but not all of the revenue gains, we achieved last year when the 2009 federal stimulus program contributed to record growth.

Finally, we returned 156 million to shareholders through a successful tender offer funded by cash to free cash flow during the quarter only temporarily drawing down our credit facility. We remain committed to using our strong free cash flow to return capital to shareholders and have approximately 44 million still authorized for open market repurchases.

In addition, yesterday Scholastic Sport increased their regular dividend to $0.40 annually. While revenues were positive overall last quarter, operating profits were below expectation in education and clubs, we have lowered our full year outlook as Maureen, and I will discuss in more detail.

But first, I'd like to turn to our operating results.

In the Children's Books segment last quarter revenue grew 5% overall showing the continued resilience of the print children's book market as well as the strength of Scholastic's channels and publishing.

In School book fairs, revenue rose 8% from higher revenue per fair. Fair count also rose last quarter and we are on plan to hold 125,000 fairs in the U.S. this year up modestly from fiscal 2010. Strong growth and higher profits in fairs are driven by our successful multi-year plan to streamline operations, strengthen our sales and merchandising, bring more parents and grandparents to our fairs, revamp our loyalty program for schools and celebrate the importance of reading in the schools, which hold fairs.

In trade, sales increased 8% from a year ago driven by bestselling series publishing including Suzanne Collins' Hunger Games trilogy, the multi platform adventure series 39 Clues and Harry Potter. New titles and series from David Shannon and Dave Pilkey also made the New York Times best-seller list. We anticipate trade sales this spring will be below last year when we benefited from multiple new 39 Clues titles but exciting new publishing project, including the re-launch of the hugely popular Adam [ph] series, as well as the second wave of the 39 Clues called Cahill's versus Despers [ph] should drive growth next summer.

In Clubs we held revenue and teacher participation level with last year. The rollout of New COOL was successful with Clubs online sales growing by 65 helped by a 30% increase in direct ordering by parents online. Last year we also increased promotion and service levels to engage teachers more fully. This resulted in earlier participation by teachers and particularly in September and higher order volumes for the quarter however order size declined as richer incentives affected purchasing patterns and Club sales were flat in the second quarter.

For the remainder of the year e-commerce improvements and the benefit of higher customer engagement from the fall increased promotion should result in modest growth in Clubs. Overall segment profitability declined 11 million in the second quarter reflecting the higher promotion spending in Clubs as well as six million planned incremental spending on e-commerce in our eBook store. This was partially offset by higher profitability in both sales and trade. We expect last years profit decline to moderate in the second half based on expected improvements in Clubs.

With our print business thriving this year we have invested more to build our digital sales and delivery systems. We expect that eBooks could make up more than 25% of our Children's book revenue over the next several years and we're building out our online eBook store on top of our COOL e-commerce platform.

Last quarter we continued to develop and test our online ordering and back and delivery platform for eBooks. We tested our eReader application with children generating strong positive feedback. We're also previewing our eBook platform with publishers and authors to enthusiastic response as we develop our selection of quality children's titles for testing and launch. And all of this progress positions us well to beta test our eBook offering in the spring with a full scale launch next fall.

Fiscal 2010 last year was a wonder year for Scholastic Education, the Education Technology and Services division of the educational publishing segment. Compared to fiscal 2009 this year sales grew over 50% and compared to 2009 sales last year grew over 50% for the year. And over 100% in the second quarter, as we benefited from the initial surge of federal stimulus funds and new products.

As we made our original plan for fiscal 2011 we were optimistic that the level of funding available for our products, especially remaining ARRA funds as well as Title 1 and IDEA and new programs such as Race to the Top and School Improvement Grant. Combined with our sales momentum and expanded customer base would allow us to sustain revenues for the year. Instead last quarter, we saw uncertainty about state and local budgets, caused school districts to decrease or delay purchases even if federal funds were still available.

While last years revenue in Scholastic Education was still up, well last quarters revenues in Scholastic Education was still up over 50% compared to fiscal 2009, showing that we have held a significant portion of last years record growth, revenue was down 16 million or 25% compared to fiscal 2010.

Product sales declined but revenue from tech support staff, development and consulting was up 50% as we serviced an expanded customer base. Looking forward we see a slightly more positive outlook. First the funding environment should improve as deadlines approach for states and school districts to spend remaining federal stimulus funds.

Also, for the remainder of the year we have less challenging comps than we did in the first half.

Second, even in a difficult market we are selling more tech support professional development and consulting services to our expanding customer base. In addition to being solidly profitable services have also strengthened our relationship with customers and our ability to sell additional products. Based on the value of existing service contracts we are confident in delivering at least $5 million in incremental service in the second half of fiscal 2011.

Third, we are launching a major enhancement to READ 180, our flagship program in March, which we are previewing to our key customers next month. The next generation READ 180 provides advanced new tools and intelligence to engage students and empower teachers and administrators, which we believe, will drive long-term growth in this hugely valuable franchise beginning in the fourth quarter.

Based on these three factors our plan is to match revenue and performance in Scholastic Education and in the segment in the second half of fiscal 2011 are level with fiscal 2010, reflecting a greater percentage of services, the segment profit margins will decline modestly as we stated in July.

And beyond fiscal 2011 we continue to target robust growth driven by the continued success of READ 180, the launch of new products under development and the further growth in services. In short our industry leading educational technology business, which has been a major driver of our growth and profitability, continues to be a juggernaut. It is driving reading and learning improvement in many of our major cities where students need help in developing the reading ability so necessary for success and even survival in the 21st century.

This business has won respect and support from school people for its power to intervene in the lives of struggling readers on a broad scale and improve their ability to succeed in school and in life.

Now, I'll ask Maureen O'Connell to review our second quarter financial results and our revised outlook for 2011.

Maureen O'Connell

Thanks Dick and good morning everyone. Looking at the second quarter results, revenues rose 2% primarily reflecting higher sales in children’s books and international, partially offset by a decline in educational publishing.

Costs of goods sold increased in absolute dollars and is a percent of sales reflecting increased incentives and enhanced service in book clubs as well as lower sales of higher margin educational technology products.

SG&A increased relative to a year ago, primarily due to higher Club promotion and planned spending on digital initiatives. This was partially offset by lower corporate overhead due to lower bonus and pension expense. The prior year period also included one-time severance expense of 1.9 million associated with restructuring in the U.K.

In the prior year period, we recorded a one-time non-cash, asset impairment charge of $40.1 million. Excluding approximately $42 million of mostly non-cash one-time items in the prior year operating income declined by $18.9 million in the second quarter. This decline was primarily the result of a lower educational sales base. Higher promotion spending in clubs and planned increase in investment on digital initiatives of approximately $6 million. Overall, earnings per diluted share from continuing operations were $2.19 compared to adjusted earnings per share of $2.29 a year ago. Last quarter's EPS included approximately $0.10 per share of accretion associated with the company's share repurchase program.

Free cash flow for the quarter was $132.8 million compared to $141.3 million last year, reflecting non-cash charges in the prior year period partially offset by strong working capital management last quarter.

Accounts payable increased as we secured more favorable terms from our largest vendors. As Dick described last quarter we returned $156 million to shareholders through a successful tender offer buying 5.2 million shares of common stock as $30 per share. We were able to fund a significant buyback with cash and free cash flow during the quarter, only temporarily drawing down on our credit facility.

We remain committed to using our strong free cash flow to return capital to shareholders and have 44.5 million still authorized for open market share repurchases. In addition, we have raised our regular dividend by 33%.

Last quarter we also exercised an option to purchase land we had previously leased for our corporate headquarters for approximately 24 million using cash holdings. This did not impact free cash flow as defined.

Cash and cash equivalence declined to 54.4 million from 178.3 million a year ago, as a result of stock buyback, land repurchases, as well as the acquisition of Math Solutions in September, partially offset by strong free cash flow over the past 12 months.

Total debt declined as well to 231.2 million at quarter end from 279.6 million a year ago as we repaid a portion of the amortization term loan. Net debt was 176.8 million compared to 101.3 million a year ago.

Based on our year-to-date results and our current outlook we now expect fiscal 2011 earnings per diluted share from continuing operations of $1.80 to $2.05, which corresponds to operating income of 125 million to 140 million before the impact of one-time items.

Revenue is now expected to be between 1.9 and 1.95 billion. This revised full year outlook reflects year-to-date results as well as the following key assumptions about the second half.

Continued solid growth in book fairs, modest growth in Clubs based upon increased customer engagement following our expenditures on promotion and service as well as continued enhancements to our e-commerce and customer service. Guided by our experience in the first half. Level sales in educational publishing based on new products, higher service revenue and a modest improvement in the funding environment as deadlines to spend remaining federal stimulus funds approach.

Our revised EPS guidance includes the full year benefit of approximately $0.15 per diluted share associated with the company's share repurchase.

We have maintained our outlook for free cash flow of $90 million to $100 million given our successful year-to-date managing working capital.

Now with that, I'll turn the call back over to Dick.

Richard Robinson

Thank you Maureen. We believe second quarter results illustrate the solid foundations of Scholastic's businesses as well as our progress investing in their long-term growth. Our traditional children’s book business is growing strongly as we mix significant progress in our top digital growth opportunities, e-commerce and eBooks.

Scholastic Educations long-term growth fundamentals are sound as reflected in the growing number of school districts who rely on us everyday as a key partner. The long-term positive funding environment and pipeline of major new products and enhancements should drive growth over the next two years.

Our financial management cost controls and cash discipline remain very strong. As a result we continue generating strong free cash flow allowing us to both invest in the business and return capital to shareholders.

While we have modestly lowered our outlook for the year we continue to believe that these three legs of our strategy represent a powerful formula to pursue our mission of improving reading and learning whether in print or digitally to grow our business and create shareholder value.

With that I will moderate a 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; Margery Mayer, President of Scholastic Education; Judith Newman, President of Scholastic Book Clubs; 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. Thanks. Good morning, everyone. Maureen, I think you answered this question but I just want to make sure I understand. The educational publishing guidance for fiscal '11 or I guess the second half is expected to be level, not fiscal '11, is that correct?

Maureen O'Connell

That is correct Drew. We're expecting the second half to be level -

Drew Crum – Stifel Nicolaus

Got it.

Maureen O'Connell

with the prior year to do our growth and service business, our new product launches and we also believe they'll be a slightly improved funding environment as the deadline reaches to spend the funds that the government [indiscernible].

Drew Crum – Stifel Nicolaus

Okay and then maybe more intermediate to longer term question as it relates to educational publishing, maybe Margery you can answer this? How has the outlook for the firm changed given the mid term election results?

Margery Mayer

Hi Drew, it's Margery. The one area there seems to be consensus between the Democrats and the Republicans is around education and we hear both sides of the aisle talking about and continued focus on accountability, continued drive to getting even our most challenged students ready for college and career. So we remain optimistic that education is going to be a priority for both parties and that a lot of the conversation that's going on about the kind of change we need in education where it's more personalized, more data driven. We think that those are trends that are going to really positively affect our business going forward.

Drew Crum – Stifel Nicolaus

Okay and Margery, you guys issued a press release a couple of weeks ago about your participation in proclamation 2011, the Texas Pre-K reading adoption, when is that happening? Is that a fiscal '11 event for you guys or is that fiscal '12 and how big is the market opportunity for the company?

Margery Mayer

Yes. It's fiscal '12. The revenues really come in the summer. We're going to start hearing decisions about the proclamation adoption probably in February and March so we'll be able to tell you more about what's going on there. And the opportunity is north of $40 million. There's five or six programs that are competing for the fund and that's an adoption where we've done well in the past and we think we have a really strong program and a strong team. So we believe we are going to do well there.

Now we are having to spend money right now on that adoption and that excelling and marketing expense is in our numbers in the second quarter and there will be some more in the third quarter.

Drew Crum – Stifel Nicolaus

Okay. That's very helpful. Shifting gears to the trade business, you guys have had a really good start to fiscal '11. Could you comment on the performance in some of your international subsidiaries and generally speaking what are you seeing in terms of pricing and inventory levels of retail? And then the final question as it relates to trade is, how are you guys managing your exposure to Borders and Barnes & Nobles, where it seems those two businesses are continuing to struggle?

Richard Robinson

Internationally our trade is great. It's partly driven by our great U.S. trade list and reselling those books extremely well in Canada where we are the number one children’s publisher in Australia and in the U.K. And our trade business in everyone of those countries is up. Our trade business in export is also quite strong and then we have a growing English language, trade distribution business in Asia.

So the trade picture for print children's books right now around the world is strong and perhaps even stronger than it is in the United States. Do you want move on to the question of Borders and Barnes & Noble?

Margery Mayer

Yes, for some time now both Barnes & Noble and Borders, we've been watching the level of current payments against the age payments and making sure that we manage our receivable outstanding so that it stays within acceptable limits that we're comfortable with. Of course we have increased our bad debt reserves. We did that last year relative to the company's given their performance but we have carefully managed what we shift based on what is being paid for. And so we're comfortable with our position for both those companies.

Drew Crum – Stifel Nicolaus

Okay. Two last questions from me. The digital investments you guys are making for fiscal '11. I think it's $11 million year-to-date? Is the guidance still 20 million and the cost of goods sold was up considerably in the quarter, is that a trend we should expect going forward?

Richard Robinson

Let me try the digital one. I think we're right on target with the spending as you point out. These are primarily e-commerce improvements relative to our COOL platform, as we broaden the COOL platform to sell eBooks and other things, plus some significant investments in developing our eBooks system, which I referred to earlier and in enhancing several hundred titles for eBooks, so that we were able to deliver a really strong experience through our eReader applications, when we beta test this in the next couple of months. So we're right on target with that. This doesn't include any marketing investments for the fall launch, which will probably come in the summer.

Margery Mayer

And then Drew, your question about costs to goods sold and the rate decline. Really the decline in the quarter was related to the enhancement centers and service that we're offering in Clubs as well as the mix in business toward service versus product within education, and so we will still have an enhanced service going forward. We'll have less promotional activity in Clubs and less incentives and rewards and free books. So it will be less of an impact in the second half but there will be some impact here year-over-year when you include the service, higher service component as education as well as continued service enhancement in our Club business.

Drew Crum – Stifel Nicolaus

Okay. Thanks guys.

Richard Robinson

Thank you.

Margery Mayer

Thank you.

Operator

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

Barry Lucas – Gabelli & Company

Thanks and good morning. Dick, if you could maybe drill down a little bit deeper on the Club business. I really was a bit surprised given the absence of teacher dislocations and the new, what seemed to be early success selling on the new platform, parent involvement, et cetera et cetera? What do you think went wrong there?

Richard Robinson

Well I think most broadly Barry is a transition for our customers as well as for the company in moving to more sophisticated e-commerce and eventually into the sale of digital products. So we launched New COOL, which was a different and much richer, and more enhanced platform to all of our 900 and some thousand teacher sponsors who in term will offer this to the parents who ordered by credit card and through our e-commerce system. So this is a pretty major change in the way our business is conducted. And of course it's a very favorable change long-term because it's building our relationships with our customers in a more expanded e-commerce format leading to digital sales.

But the growing pains on this are real and we also, the way people are ordering has changed. So, they're being more efficient in ordering in some respects and are using their bonus points up front. Because you can see on our Club ordering platform. It's just exactly what number of bonus points you can spend right now and so some of there were moving towards a bonus point used right up front instead of paying cash. So we're using their credit card.

In addition we offer expanded service and we took off some of the restrictions on size of orders so we got a lot more small orders, which increased our cost. And also teachers spent less when they just ordered periodically and they didn't sort of accumulate their order. So this had an effect on our cost base and I think also affected the size of the order and the amount of total cash we received. So these are all growing pains from our Club with strategy change and the use of more e-commerce. We're learning from it and we believe we'll have stronger growth in the second half and of course as we continue with this platform we'll have, we'll be much more knowledgeable about how our customers are responding.

Judy, do you want to add some thoughts to that?

Judith Newman

Sure. Hi, Barry. As Dick said we are making this strategic conversion online and what we're excited about is, as you know the increase we're seeing in teacher sponsors using COOL. As we said, up 6% and also much more engagement with parents ordering directly online which we know is our big opportunity. So for the very first time we're really having a direct relationship with parents and we can recommend books and have a much more targeted experience for them, which we believe, will really result in much higher shopping carts. And we're very excited about the engagement we got in the fall and our teachers are loving us. As Dick said, they're using their points, they're ordering like crazy and on the second half of the year we'll be applying some of those learning’s to really focus on increasing the size of each order and modifying the costs as best as we can.

Barry Lucas – Gabelli & Company

One follow-up on kind of the longer term. Margery, maybe you could expand a little on the enhancements or differences in this new generation, READ 180 and maybe you could touch on some of the other new products in math and what have you? [Indiscernible] that can provide a list for next fiscal year?

Margery Mayer

Hi, Barry. Well READ 180 Next Generation is our first major new release of READ 180 since our Enterprise edition, which came out in 2005. Every year we've made enhancements to READ 180 to keep it current on new technology to add new features for customers but this is really a major new release. Now what we've done here is we wanted to stick with the basic model and the technology that works so well because we have over 40 studies that prove that READ 180 works. We've been cited in the What Works Clearinghouse. We have a very large footprint throughout the country where there's great success.

So the fundamental premise of the program, the science behind the program, we have kept in place. And we really have to look at a new set of companies to think about what this revision should look like. So, we've been studying the practices of company's like Johnson & Johnson, Apple, Nike, places like that rather than traditional publishing models for revision.

What we've done though is really re-engineer the experience of the user so that the program is more effective, smarter. We're going to empower teachers in a more powerful way, make their jobs easier by doing, using algorithms to help them group students in new ways. So there's a lot of new things in the program that we're not going to talk about right now but basically the focus on the program is to keep the great science and the great effectiveness, the engagement the kids have, the power of data and technology but to make it all that much better.

Barry Lucas - Gabelli & Company

Great and other -

Margery Mayer

Oh and on the other products going forward, we have a lot of activity going on right now with, in Math and more literacy programs. I'd rather not talk about those too specifically because they're competitive but we are very geared up and we've got lots of interesting stuff going on.

Richard Robinson

Great, thanks very much Margery.

Richard Robinson

Thank you, Barry.

Operator

I'm showing no further questions at this time and would like to turn the conference back over to Dick Robinson.

Richard Robinson

Thank you all for your attention and support. We look forward to the rest of the fiscal year and unveiling our plans for the following years so we'll talk to you again in March. Thank you very much.

Operator

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

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