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Scholastic (NASDAQ:SCHL)

Q3 2011 Earnings Call

March 24, 2011 8:30 am ET

Executives

Maureen O’Connell - Chief Administrative Officer, Chief Financial Officer and Executive Vice President

Judith Newman - Executive Vice President and President of Scholastic Book Clubs and E-Commerce

Richard Robinson - Chairman, Chief Executive Officer, President and Chairman of Executive Committee

Margery Mayer - Executive Vice President and President of Scholastic Education

Jeffrey Mathews - Investor Relations

Analysts

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Dennis Barrett - Sidoti & Company, LLC

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q3 2011 Earnings Conference Call. [Operator Instructions] I'd 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.

Jeffrey Mathews

Thanks, Allie, 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 book and educational materials markets, and acceptance of the company’s products in those markets, and other risks and factors identified from time to time in the company’s filings with the Securities and Exchange Commission. Actual results could differ materially from those currently anticipated.

Our comments today also includes references to certain non-GAAP financial measures as defined in Regulation G. The reconciliation of those non-GAAP financial measures with the relevant GAAP financial measures and other information required by Regulation G is provided in the company's earning release, which is posted on the company's Investor Relations website at investor.scholastic.com.

Now I'll 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 all for joining us on our fiscal 2011 third quarter conference call. This morning, I'm joined by Maureen O'Connell, Chief Administrative Officer and CFO, who'll review our financial results and outlook. Other members of the executive team are available to answer questions at the end of prepared comments.

Last quarter, Scholastic invested in growth opportunities in e-books, e-commerce and educational technology as we moved ahead with new digital applications in our Children's Book business while sustaining the long-term growth of Scholastic Education. Company-wide revenue was solid but profits declined. Three key factors contributed to this. First, following the decision to accelerate our e-book and e-commerce initiatives, we spent $10 million in the quarter. We now expect to spend $30 million in these areas for the full year compared to our original plan of $20 million.

Second, continued pressure on school funding resulted in lower Education sales and profits. Third, we recorded a one-time bad debt expense of $3.5 million related to Borders' bankruptcy filing. Based on these factors, we have also revised our fourth quarter outlook. While these results are disappointing, we remain optimistic about the fundamentals of our business and the long-term growth opportunities in both Children's Books and Education.

As the world's largest publisher and distributor of children's books, Scholastic has the significant opportunity to expand our reach through e-commerce and e-books, technologies which will continue to reshape our market over the next three to five years. Last July, we announced we're accelerating key digital initiatives in Children's Books. As I just indicated, including last year's -- last quarter's expansion, we now expect to spend $30 million in two areas. First, we are moving towards the launch of our ebookstore next fiscal year. The Scholastic children's ebookstore will bring together a downloadable kid focused e-reader software application and a curated catalog of e-books. It will initially be launched through new COOL, the Book Club's new online ordering platform, and later expanded to other channels. Last week, we began beta testing with our first pilot group of teachers. We will continue expanding the test group and release new features and functionality throughout the summer. In parallel, we're developing a robust catalog of quality children's e-books and enhanced e-books using our own content and working with other publishers.

Second, we are leveraging our brand marketing scale and book channels to expand our online reach to kids, parents and teachers, both through new COOL, as well as Scholastic's other e-commerce channels. Last quarter, we accelerated our digital investment to expand features and functions for our e-bookstore and the related COOL platform, including enhanced search capabilities, personalization and parental controls.

Turning to operating results in the Children's Book segment, revenue held flat last quarter compared to a year ago, demonstrating the category's resilience and the continued strength of our Publishing and Distribution channels. Scholastic's content in particular, best-selling series like Harry Potter, as well as The Hunger Games, which is performing particularly well in both e-book and print format, led to double-digit gains in Trade Publishing last quarter. As noted in our second quarter call, School Book Fairs experienced solid gains in revenue per fair in the fall, following investments in point-of-sale technology and improved marketing. Last quarter, adverse winter weather caused some fairs to be canceled and reduced traffic and others, causing revenue to decline slightly. We have rescheduled the majority of affected fairs in the fourth quarter and our full year outlook remains for solid revenue growth in this channel.

School Book Clubs is undergoing a major transformation this year following the full launch of new COOL. We're already achieving higher levels of engagement from teachers and parents, as well as significant increases in online ordering by parents, which are top strategic goals. The Club's e-commerce transition has affected customer behavior in other ways. While teachers are ordering more frequently, revenue per order has declined as teachers use new COOL to redeem more bonus points and buy more discounted and lower-priced items. In response, we continue to improve the user experience and to test new promotional and pricing models to drive growth and profit online. Combined with the challenging economy, these factors led to a modest revenue decline in Clubs last quarter, which is expected to continue in the fourth quarter. However, we are confident that our e-commerce strategy and the increased choice personalization and convenience that offers our customers, will yield profitable growth in the coming fiscal year.

Scholastic Education, the Education Technology and Services division of the Educational Publishing segment, had a remarkable fiscal 2010 as we have previously reported. With the initial surge of federal stimulus funds and the benefit of new products, last year's sales grew over 50% for the year and for the third quarter compared to fiscal 2009. In the third quarter of fiscal 2011, uncertainty about state and local budgets continue to cause school districts to hold back purchases. In addition, a significant number of opportunities, many related to school improvement grants and other remaining stimulus funding sources, have been delayed. We continue to believe that as school budgets firm up, we will receive these orders in the fourth quarter of this year and the first quarter of next year. In total, sales of Educational Technology and Services declined approximately 10% last quarter, primarily due to lower product sales, partly offset by higher recurring revenue from our expanded customer base.

Compared to fiscal 2009, Technology and Service sales were up more than 30%. Classroom and Library supplemental sales also declined modestly in the quarter, reflecting the tough funding environment. Despite the near-term funding challenge, we believe this business has held its market position, leading market position in Educational Technology and has a promising long-term trajectory, driven by new products and services, as well as an expanding customer base.

Following a number of very positive customer previews, we recently announced the upcoming release of READ 180 Next Generation. Next Gen incorporates new technology content and support, including dashboards, artificial intelligence and improved technology architecture, to make teachers more effective, school leaders more empowered and students more engaged. According to customers, Next Gen effectively improves the usability and impact of READ 180, which continues to be, by far, the leading intervention program in reading. This new version of READ 180, which begins shipping in May, should have a modest positive impact on the fourth quarter. More important, we believe these major enhancements to a best-in-class product will provide significant incremental value to educators, driving continued expansion of our customer base and market share over the long term. We also continue moving forward with the development of MATH 180 and look forward to providing an update in the future.

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

Maureen O’Connell

Thanks, Dick, and good morning, everyone. Looking at third quarter results, revenues declined 1%, primarily reflecting lower sales in Educational Publishing and Media, Licensing and Advertising, partially offset by higher revenue in International. Cost of goods sold increased in absolute dollars and as a percent of sales, reflecting increased incentives and enhanced service in Book Clubs, as well as lower sales of high-margin Educational Technology products.

SG&A increased relative to a year ago, primarily due to spending on digital initiatives and higher Club promotion. Last quarter, we incurred a one-time bad debt charge of $3.5 million, recorded in the Children's Book segment related to last quarter's bankruptcy filing by Borders. In prior years, we have reserved for approximately $1.5 million in Borders receivables and are now 100% reserve. Borders represents less than 3% of sales in the Children's Book segment.

Last quarter's results also include a onetime expense of $1.8 million recorded in SG&A related to a previously announced U.K. reorganization. A year ago, we recorded a onetime expense of $2.4 million for U.K. restructuring charges and a $1.5 million loss on investment. Excluding these nonrecurring items, operating income declined by $28.5 million in the third quarter. Overall, the GAAP third quarter loss per share from continuing operations was $0.81 compared to a loss per share of $0.12 a year ago. One-time items represent $0.13 and $0.08 in the current and prior quarters, respectively.

Children's Book Publishing and Distribution revenues were essentially flat, but operating profits declined $16.1 million, reflecting $10 million spent on digital initiatives and a $3.5 million one-time charge related to Borders bad debt. In addition, promotion was higher in Book Clubs, where orders were up but revenue was down due to lower order sizes and a greater use of incentives and bonus points. We expect Children's Book segment to be down in the fourth quarter due to a further $10 million in digital spend and lower revenue in Book Clubs. In Educational Publishing, revenue was down $6.7 million, primarily due to lower Educational Technology product sales, partially offset by higher service revenues.

Education operating profit was down $11.1 million due to sales mix. We expect the fourth quarter for Education to benefit from the introduction of the Next Gen, but we continue to expect a challenging funding environment and longer selling cycles.

International revenue was up $6.4 million in the third quarter due to FX and higher sales in Australia and Canada, partially offset by declines in the U.K. and foreign rights revenue. Operating profit was down, reflecting lower foreign rights income. Revenue in Media, Licensing and Advertising was down due to lower interactive and Back to Basics sales. Lower operating profits of $4.2 million was primarily due to lower sales and higher discounting and promotion at Back to Basics. This business is under review.

Based upon our year-to-date results and fourth quarter outlook, we expect revenues of approximately $1.9 billion and earnings per diluted share of $1.25 to $1.40 before the impact of one-time items. This corresponds to operating income of $90 million to $100 million. This equates to a reduction of our prior guidance of $35 million to $40 million, reflecting third quarter results, higher digital spend and a lower fourth quarter outlook than previously for Book Clubs and Education businesses.

Free cash flow for the quarter was $49.2 million compared to $72.9 million last year, reflecting lower results. Collections improved due to the rollout of point-of-sale systems for Book Fairs. Accounts payable increased, primarily due to inventory purchases and the timing of payments. Cash and cash equivalents were $90.7 million compared to $238.9 million a year earlier, primarily reflecting our significant second quarter stock repurchase, the purchase of land and the acquisition of Math Solutions, partially offset by strong free cash flow over the past 12 months. The company had total debt of $220.1 million at the end of third quarter, down from $265.3 million last year.

Net debt, as defined, was $129.4 million compared to $26.4 million a year ago. We have maintained our outlook for free cash flow of $90 million to $100 million, as well as our commitment to returning cash to shareholders based on a strong balance sheet and tight working capital management. Now I'll turn the call back over to Dick.

Richard Robinson

Thanks, Maureen. While we are obviously concerned about the third quarter results and the further reduction of guidance for the year, we know that we have a solid, strong Educational Technology business, which will continue to grow in revenue and profits. And we are investing in e-commerce and e-book marketing and delivery systems to ensure our leading market position in children's books globally. We are confident that these investments will bring us profitable growth in this industry transforming opportunity.

With that, I will moderate a question-and-answer period. In addition to Maureen, I'm joined this morning by Margery Meyer, President of Scholastic Education and Judy Newman, President of Scholastic Book Clubs and e-commerce. 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.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Maureen, could you address the U.K. business? You took another $0.06 charge in the quarter. You took significant charges with that business in fiscal '10. What's happening with that business? Can you give us an update there?

Maureen O’Connell

Sure. The charge in the quarter was related to truing up our assumptions that we made at the time of the original restructuring. We assumed that we would maintain leases for six months and 12 months out on two of our properties. And we had to extend those because we have not rented them in that period of time. So really, it's just an assumption on how long we'll have to carry leases before we can sublease them, and that was the adjustment in the quarter. As you know, that was a 40% reduction in our footprint, which has been completed. And so right now, it's just truing up our original assumptions.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Okay. And is the expectation on that business feel that it approaches breakeven sometime this fiscal period or next year?

Maureen O’Connell

I think at this point, it is next year that our goal would be towards breakeven.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Okay. And shifting gears, and I think you somewhat addressed this, but just want I get your sense as to what the impact from Borders will be going forward. You guys did a good job managing that business to that account, that relationship. But with the potential for bank -- or the bankruptcy and the potential for additional losses of stores, now what is the revenue forgone with that channel going forward for trade?

Richard Robinson

Well, I think it's about -- our total Borders revenue in the past has been around $20 million annually, which was we said represents 2% to 3% of our total revenues in the Children's Book segment, although a higher proportion of trade. We expect that Borders will continue to operate a smaller number of stores, and that we will be able to find most of the revenue forgone there, Drew, and other areas because there a lots of other opportunities that are opening up in special sales, in supermarkets and other places in response -- as well as online, in response to the opportunity represented by Borders closing some stores.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Okay. And this is for Dick and Margery, I guess. On the Educational Publishing business, you mentioned some uncertainty from the funding environment, the state and local level, but I didn't hear the same commentary around the federal education budget and there's been a couple of key programs cut, and Republicans of the House, I guess, is threatening to reduce expenditures for other programs that I know are important to your business. So I guess my question is what is the updated read on the funding environment, the federal level for your business?

Richard Robinson

I'll ask Margery to answer the second part of that, Drew. But in terms of the recent restrictions or cuts in proposed current federal budget, we expect that, that's going to be -- most of those programs are going to be shifted into block grants into other places in the Department of Education. They won't disappear, they'll simply be categorized in different areas. And that's, of course, is being discussed back and forth between the Democrats and the Republicans right now. But that's our view on that business. In respect to...

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Do you think that, that uncertainty has had any impact on purchasing patterns with your customers?

Richard Robinson

Well, I think in the -- yes. I think the larger federal picture, I was addressing just the smaller one that you brought up about recent activity and the continuing resolution in the Congress. But I think, more broadly, we feel that the uncertainty around state and local budgets have compounded the effect in state Departments of Education of holding back on some of the federal funding because they're kind of waiting to see how the picture clears before they make commitments, even though those federal funds are already obligated. So Margery would comment further on the situation.

Margery Mayer

Yes, I agree with Dick. I think that there is a nervousness out there because there's so much that's unknown. But we believe the President and the Secretary of Education, when they say that they're going to continue to fund education, how that funding comes down to districts and states will likely change when we see the reauthorization of ESEA. But I think that federal funding is essential to running our schools in the United States. I think that in general the federal government gets that. And we're optimistic that funding will be supported by the government.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

And Margery, does Common Core in any way have an impact on your business in the interim as states are adopting and implementing Common Core Standards? Does that in any way impact your business?

Margery Mayer

I think it's good for our business. We are already getting some contracts from school districts to do some consulting and professional development around the Common Core. Some school districts are getting ready for it earlier than others. But I -- but we think that there'll be a lot of interest at the school district level in getting their teams up to speed on what the Common Core is and buying curriculum materials that help their kids meet the Common Core. The new addition of READ 180 Next Generation addresses a lot of the themes in the Common Core, because we want our kids who are getting intervention to be successful with the Common Core. So for example, we did a lot to strengthen the writing in Next Gen. We focused kids a lot on being able to read text, to make an argument about what their opinion is about text, which is just one example of what the Common Core is driving at.

Richard Robinson

And just add to that, Drew. I think the dashboards that Margery has provided in Next Gen are being cited by some of the Common Core assessment people as the kind of thing that they would like to see in the testing program that comes in, in 2014. So we feel we're going to benefit from Common Core, both in Educational Technology and our supplementary educational programs.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

And guys, I would agree with that. I guess, maybe I can clarify the question. In the interim, as you're waiting for Common Core to go into effect, does that in any way impact the business? In other words, does your product, does your service have to be or is it aligned with Common Core? And if it is, does that create any revenue disruptions?

Margery Mayer

I don't think the Common Core is going to create any revenue disruptions. I just think it provides some near-term upside. Not a huge amount, but I think that there is going to be some near-term upside, especially for our Service business. And I think the fact that we worked with some of the authors of the Common Core on Next Generation READ 180 really speaks to the fact that READ 180 is going to be perfectly positioned for the Common Core.

Andrew Crum - Stifel, Nicolaus & Co., Inc.

Okay. Guys, last question for me, a two-part question on the e-book initiatives and I guess the first part's more for Maureen. $30 million of spending in fiscal 2011, what does that number go to in fiscal '12? And then for Dick, just kind of a longer term question for the business, any thoughts or concerns around e-books lowering the barriers to entry and perhaps weakening the competitive advantages you guys have enjoyed through ownership of the proprietary channels, like Clubs and fairs?

Maureen O’Connell

Well, I'll take your question on the spending first. On the $30 million, is primarily related to the build of the software to offer the e-books on COOL and all the related applications on COOL to allow that to happen. So that is a one-time significant spend to build the system. Once the system is built and operating and running, which we expect it to be next year, then you just have the maintenance cost of the file servers and Q&A and those kind of areas. So it would be down substantially. We'll paint that exact number for you when we give you guidance on the plan.

Richard Robinson

And in respect to the longer term, Drew, of course, we are vitally interested in the effect of e-books on our channels. We just had some consumer focused groups yesterday hearing parents and teachers talk about the effect of digital and e-books on their business. And what was very heartening for us is that they expect us to deliver those. In other words, we are their children's book provider as they see it and they're expecting us to deliver their e-books to them, and that's what we're preparing to do. So our challenge of course is to maintain our Children's Book sales and position through our channels in selling e-books, but it's heartening to know that our customers expect us to do that. So it's a matter of our execution and how well we accomplish that goal, which is why we're investing the $30 million that you and Maureen just discussed. We're very optimistic about the long-term effect of e-books on our business. We're already doing well with e-books and trade, but that's a different matter. The distribution channels, as you point out, must respond and offer e-books as customers want to have them. Right now, they're not feeling that the other vehicles for e-books are serving their children's book needs. And so there is an opening for us, which they expect us to fill.

Operator

[Operator Instructions] Our next question comes from Dennis Barrett of Sidoti & Company.

Dennis Barrett - Sidoti & Company, LLC

Just a couple of questions. The first question was regarding, with respect to e-books, is 25%, I think Dick mentioned that in the previous call, the 25% of the Children's Books?

Richard Robinson

We're looking -- yes, we expect over the next three years that at least 25% of our revenues will move to digital sales in both in consumer e-books and also in some of our supplementary school channels.

Dennis Barrett - Sidoti & Company, LLC

Okay. So that's still the number?

Richard Robinson

We're -- I think, whereas we might have said that was a ceiling six months ago. I think we now regard that as perhaps more of a floor. I mean, I think we're seeing digital books move more quickly in the consumer, lives of the consumers, than anticipated. So we're -- that's why we're increasing the amount of investment and speeding up the time-to-market.

Dennis Barrett - Sidoti & Company, LLC

Okay. And with respect to the new COOL platform targeted to the parents, are you -- what kind of add-on revenue projections are you looking for from that? Or is that more just to sort of, I guess, to compensate for the discounts that teachers seems to be taking?

Judith Newman

Dennis, this is Judy Newman. No. We're -- what we're experiencing as ptag COOL [ph] or pCOOL [ph], as we call it, has rolled out this year, is that really increased engagement by parents and the teachers on that part of the platform. So we're able to talk to parents specifically about books that their kids are interested in. We have a direct communication with them. And so we're very optimistic as we build more and more parents coming online that this is really going to be a great opportunity for a much richer and more interesting relationship and growth and of course, improved profitability.

Richard Robinson

In the quarter, the teachers showed an ability to go into our COOL system and find benefits for themselves that we are glad to have them have. On the other hand, it reduced the amount of revenues that we received from them. And so, we're working to make sure that we're offering them a variety of pricing alternatives and incentives that will help our revenues, as well as help them get the benefits of new COOL.

Dennis Barrett - Sidoti & Company, LLC

Okay. And lastly, for me, just as sort of a broader question regarding funding, I know you don't break out federal versus state or local. But I mean, can you give us an idea of, you've mentioned in the past that you think it's more of a timing issue and there are uncertainties regarding future funding. I mean in a broader sense, do you see a 10% reduction in overall funding? Or what are you sort of anticipating there?

Richard Robinson

Well, I think just to start with the federal funding, particularly Title I, does provide a very important part of the total revenues for our Educational Technology business. Margery you want to...

Margery Mayer

Sure. Dennis, we really didn't sized it as being -- I think federal funding, we think, will be flat to up going forward after you correct for the stimulus dollars. So pre-stimulus federal funding, we think, will be flat to up. State and local funding, we think, is going to be under pressure for the next interim period. And we haven't really put a percentage on it. One of the things that tends to happen is that people think it's going to be worse than it turns out actually be. And that happened right here in New York City, where the mayor said that we were going to have to let go more than 10,000, 20,000 teachers, something like that, and now it's down to maybe 4,000. And that's a pretty common thing that we hear that government officials are looking at the budget. They're making big cuts and it gets a little better to much better than they say. Now that's not to say that there won't be cuts and you can't pick up the newspaper without hearing -- reading about cuts in New Jersey and Wisconsin, places like that. So it's a mixed bag out there. And there's the factor of the psychological feeling that educators have where there's a lot of unknowns and there is a nervousness among decision-makers. And the reality that there is a lot of money slashing around in the system, and there's still stimulus money out there. We think that we've seen some loosening up of that stimulus money recently. And our sales force believes that there is business to be had, and we're going out there and getting it.

Operator

[Operator Instructions]

Richard Robinson

Well, thank you very much, and we appreciate your support. We were disappointed in our quarter, but we have a very strong view that both our Educational Technology business and our Children's Book business are going to benefit from the digital future that we're moving toward. 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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