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Scholastic (NASDAQ:SCHL)

Q1 2012 Earnings Call

September 22, 2011 8:30 am ET

Executives

Margery W. Mayer - Executive Vice President and President of Scholastic Education

Maureen E. O’Connell - Chief Administrative Officer, Chief Financial Officer, Principal Accounting Officer and Executive Vice President

Ellie Berger - President of Trade Publishing Division

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

Deborah A. Forte - Executive Vice President and President of Scholastic Media

Jeffrey Mathews - Investor Relations

Analysts

Barry L. Lucas - Gabelli & Company, Inc.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Dennis Barrett - Sidoti & Company, LLC

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q1 2012 Earnings Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I'd now like to turn the conference over to your host, Mr. Jeff Mathews, VP of Corporate Strategy, Business Development and Investor Relations. Please go ahead.

Jeffrey Mathews

Thank you, Ellie, and good morning, everyone. Before we begin, I'd like to point out that the slides for this presentation are available for simultaneous viewing on our Investor Relations website, investor.scholastic.com. 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 include references to certain non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in the company's earnings release, which is posted on the company's Investor Relations website at investor.scholastic.com.

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

Richard Robinson

Well, thanks, Jeff, and good morning. Thank you for joining our fiscal 2012 first quarter analyst and investor conference call. For this morning's prepared comments, I'm joined by Maureen O'Connell, CFO and CAO; other members of the executive team will also be available to answer questions later.

We're pleased to have achieved a strong start to fiscal 2012, putting us on plan to meet this year's financial goals. First, continued robust sales of READ 180 Next Generation, as well as System 44 math products and services, resulted in broad growth and margin improvement in our newly defined Educational Technology and Services segment. Second, Scholastic's other Education businesses now referred to as the Classroom and Supplemental Materials Publishing segment, also saw strong growth last quarter, driven by new product launches and significant district contracts.

Third, best-selling Scholastic books and e-books, including The Hunger Games trilogy, drove double-digit percentage growth in retail sales. And fourth, we continue to move forward with digital growth initiatives in the Children's Books segment. We remain on plan to roll-out our children's eReading app and ebookstore later this fiscal year, while we take steps to reduce costs in non-digital areas to help fund strategic spending on e-books and e-commerce. Last quarter's results also illustrate our progress across the company in developing new digital products and distribution to help children read and learn in new ways. I'll discuss how we expect to drive this long-term profitable growth in a moment.

As I've just said, beginning this fiscal year, we are now separately reporting results for our Educational Technology and Services segment, which provides schools with reading and math curriculum solutions that combine technology, materials and services, with higher priced intervention systems, a separate sales organization and different business model, as well as higher margins and growth rates. Educational Technology and Services is increasingly differentiated from the company's supplemental Education businesses, which provide classrooms and libraries with classroom magazines, classroom book collections, as well as guided reading and summer reading programs to support school literacy. These businesses are now referred to as Classroom and Supplemental Materials Publishing.

This reporting change has no impact on the company's operations or consolidated results because there have been no changes in our internal organization. However, we believe the new segments provide our investors greater visibility into Educational Technology and Services, a key driver of the company's profitability and long-term growth story.

In the seasonally important first quarter, Educational Technology and Services revenue rose 18% versus a year ago, driven by strength in all 3 key areas of the business: reading, math and services. Profits rose faster than revenues, reflecting a favorable mix of higher margin technology product sales. READ 180 Next Generation has now recorded sales exceeding $50 million since we launched the new version of this market-leading reading program in May. Major school districts like Clark County, Nevada, East Baton Rouge, who are already using the program have enthusiastically upgraded to get Next Gen's new features, including management dashboards for administrators, teachers and students. Total district upgrades now stand at 18%, well ahead of our original expectations.

System 44, our tech-based phonics program, which integrates tightly with READ 180 and Big Day, our early childhood curriculum, also contributed to last quarter's growth in reading programs. Stronger math sales were driven primarily by our intervention program, Do The Math. The success of this program underlies much of our strategy for MATH 180 where development continues on pace. We also sustained double-digit growth in services, including professional development and tech support last quarter. These results reflected good renewals among existing customers and strong performance at Math Solutions, the math consulting business we acquired last fall.

In the Classroom and Supplemental Materials Publishing segment, sales grew 25%, driven by major contracts for summer reading and custom book collections. Scholastic's Guided Reading Programs, which provide comprehensive support for guided instruction, assessment and independent practice in the classroom, also showed significant growth, including the launch of Text Types, the new program in the guided reading family. Segment operating results also improved last quarter.

In the Children's Book Publishing and Distribution segment last quarter, positive results included strong trade sales and continued progress on key digital growth initiatives as we prepared the School Book Club and Fair businesses for back-to-school. In Trade, sales increased 10% from a year ago driven by several best-selling Scholastic series. First, The Hunger Games trilogy continues to sell very strongly in both e-book and print formats, partly driven by enthusiasm for the first movie in the series due out next March. Second, Harry Potter sales maintained their momentum last quarter buoyed by the July release of the final film in the series. And third, we released the first title in part 2 of The 39 Clues, our multi-platform adventure series, which continues to be a children's bestseller.

Last quarter's results are particularly impressive because they were achieved without sales from Borders, a major national bookseller which has closed. A year ago, Borders represented approximately 6 million sales in that quarter. We believe the continued success of our best-selling series, our pipeline of new titles, including Wonderstruck by Brian Selznick and The Scorpio Races by Maggie Stiefvater, as well as the release of much anticipated movie versions of War Horse, The Hunger Games and The Invention of Hugo Cabret, will drive continued strong sales over the course of the year. While it is too early to have visibility on sales trends in Clubs and Fairs, these businesses are also positioned for improved results in the new school year. In Clubs, we have taken steps to improve profits by reducing our promotion spend, targeting it to our most profitable customers, both off and online. We expect this to encourage larger order size, which should also improve operational efficiencies. In Fairs, bookings are on track to achieve fair counts approximately level with last year based on stronger marketing programs, higher parent and family attendance at fairs, and the success of point-of-sale equipment deployed across all book fair regions, we continue to target modest revenue per fair growth.

Just as we have grown education sales over the past 10 years with new digital products and solutions, we continued moving forward to profitably grow Scholastic's Children's Books businesses through e-books and e-commerce. We remain on schedule to launch our e-book business in early calendar 2012, as we announced last July. The core of the strategy is the free and easily downloadable Scholastic eReading app, which provides children with a personalized eReading experience designed to help them learn and love to read. Our eReading application augments the rich reading experience found in children's print books with activities, animations and videos that allow a child to engage more deeply with books. Inside the eReading app, children have access to their personal bookshelf and to the Scholastic ebookstore, where they and their parents can choose and buy from a carefully curated selection of quality children's titles. This summer and fall, our development team has been focused on QA and load testing the app. We have also been acquiring quality children's content for both the ebookstore and our print publishing.

Last month, for example, we announced the partnership with Ruckus Media to develop transmedia properties that span print e-books and apps and to acquire a backlist in out-of-print titles. Earlier this week, we announced an exciting deal with SourceBooks, a leading independent children's publisher, to feature their extensive list on our eReader. And of course, Scholastic's own publishing remains a key source of best-selling quality books for our eReader as evidenced by the success of series like The Hunger Games.

In parallel with investments in the children's digital reading platform and ebookstore, we've also expanded our e-commerce experience with last year's roll-out of new COOL, Club's new online platform. As we have described new COOL strengthens our deep relationship with teachers and extends them to parents and kids. We have made key improvements in the COOL user experience this fall. And already this school year, the number of teachers ordering online is up approximately 10% and now represents 80% of all Club orders.

To help fund continued strategic spending on e-books and e-commerce, we have also reduced costs in non-digital areas, including implementing a voluntary retirement program. In total, we anticipate approximately $15 million in savings on an annualized basis.

In International, revenue rose in the first quarter from a positive foreign exchange impact and local currencies. While sales in Australia declined, they are expected to improve as a result of strong new titles available later this fiscal year. This was partially offset by strong growth in Asia, a key international opportunity for Scholastic, given the region's emphasis on education among its growing middle class. Last quarter, revenue from our Asian subsidiaries continued to rise at a double-digit rate, driven primarily by direct-to-consumer sales in Malaysia and the Philippines and higher Book Club and Book Fairs sales in India. Sales also grew in the U.K. in Clubs and Trade, where results were on plan for the quarter.

Maureen O'Connell will now review our financial results for the first quarter.

Maureen E. O’Connell

Good morning, everyone. Looking at the first quarter results, revenues increased 10% relative to a year ago, primarily reflecting higher sales of educational products and services to schools, as well as higher sales of children's books and retail trade channels. Cost of goods sold decreased slightly as a percent of sales compared to a year ago, reflecting product mix. SG&A was approximately flat, excluding one-time expenses of $2.1 million related to cost reductions in the current period and $1.2 million related to restructuring in the U.K. in the prior period. Overall, the loss per share from continuing operations improved to $0.81 compared to a loss per share of $0.94 a year ago. The greater loss from discontinued operations primarily reflects noncash charges associated with the company's decision to exit its toy catalog business.

This slide provides segment results, including the newly defined Education segments. I'd like to point out that typically in the Educational Technology and Services segments, the first fiscal quarter is the largest in terms of sales and operating margin, reflecting summer purchases of technology products by schools. In later quarters, once schools are in session, we typically sold fewer products, though this is partially offset by revenue from low margin -- lower margin services. As a result, operating margins typically decline in later quarters as we expect in the current year.

In the Classroom and Supplemental Materials Publishing segment, first quarter sales were up significantly, driven by new products and significant contracts. For the full year, we expect this business to grow strongly, though at a lower rate than in the first quarter, given the acceleration of sales this year. Segment operating income last quarter was approximately breakeven, as is typical in this segment because classroom magazines generate minimal revenue during the summer and record a loss.

The current slide presents reclassified results for the new Education segment, which had previously been consolidated into Educational Publishing.

Looking at cash and the balance sheet. Free cash flow in the quarter was a use of $68 million, improving significantly from a use of $96.9 million last year. Scholastic typically uses cash during the summer, with schools out of session and the need to build the inventories before the fall. The year-over-year improvement in cash use was primarily related to lower seasonal net loss in the current period, as well as a favorable increase in deferred revenue and the timing of capital expenditures. Accounts receivables increased slightly, reflecting higher sales of Children's Books in Trade, while inventories declined modestly due to delayed purchasing in Book Clubs and Book Fairs. Over the past 12 months, Scholastic returned $167.2 million to shareholders in the form of share buybacks and dividends. As a result, cash and cash equivalents declined to $33.7 million from $124.2 million last year. Total debt declined as well to $200 million from $242.3 million a year ago, as we repaid a portion of the amortizing term loan. At quarter end, net debt was $166.3 million compared to $118.1 million last year.

We are affirming our fiscal 2012 outlook for revenues of $1.9 billion and EPS of $1.75 to $2.10, which corresponds to operating income of $120 million to $140 million. We continue to expect free cash flow of $90 million to $100 million for the year. At the top end, this guidance corresponds to $140 million in operating income compared to $110 million in the prior year. Following last quarter's strong results, we have now achieved $10 million of the necessary improvement. Note that this outlook for EPS and operating income excludes the impact of severance and other one-time expenses associated with restructuring actions, as well as noncash, nonoperating items.

As we committed in July and Dick discussed a moment ago, we have taken steps to reduce costs in non-digital areas of the business to help fund digital growth initiatives. Based on our current plan, we anticipate annualized savings of approximately $15 million. Giving the timing of these reductions, about 2/3 of that benefit will be realized in the current year, which was anticipated in our fiscal 2012 guidance. These actions will result in a one-time severance and other charges of approximately $10 million to $15 million this year, which are excluded from our guidance.

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

Richard Robinson

Thanks, Maureen. We had a strong first quarter with gains in both Education segments, as well as excellent results in Trade, as we move forward with e-books and e-commerce and prepare for a profitable year in Clubs and Fairs, as well as continued growth in international. Our decision to separate results for education, technology and services underlines our confidence in this fast-growing profitable business as a key growth driver for the company.

Now I will moderate a question-and-answer period. In addition to Maureen, I'm joined by these division presidents: Shane Armstrong, Scholastic International; Deborah Forte, Scholastic Media; Margery Mayer, Scholastic Education; Judy Newman, Scholastic Book Clubs and E-Commerce; and Hugh Roome, 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.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Dick, I wanted to ask you about the Trade business. Obviously, a very strong start...

Richard Robinson

Yes, by the way, Drew, I neglected to say that Ellie Berger, the President of Trade, is also here among our -- to supplement whatever questions you ask, would comment on that.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Okay. So obviously a strong start to fiscal '12 with the Trade business. You've got some movie tie-ins later in the fiscal period, and I think some easier comparison. How's the business tracking against the guidance you gave in conjunction with the fourth quarter and which I believe you said would be down modestly for the year?

Richard Robinson

Maureen, maybe you could handle the down modestly question, and then Ellie and I can give some color to how the Trade business is going, which is actually gangbusters at the moment. So thanks for the question, Drew.

Maureen E. O’Connell

We're tracking a little ahead of that right now. We had a strong quarter that exceeded our expectations, particularly strong for The Hunger Games franchise and Harry Potter. But as you realized from our press release, we're not changing any guidance at this point because our important school businesses have not opened yet.

Richard Robinson

I think Trade was a wonderful quarter for us and was good, not a surprise, but it was just -- underlines the strength of our list in the quality of our best-selling programs, Hunger Games. We've mentioned, Maggie Stiefvater. We've got The 39 Clues coming back and the second part of The 39 Clues. And so everything is going extremely well, and the e-book sales for The Hunger Games have been exceptionally strong. Drew, let me ask Ellie to give any further comments on how the quarter is going in Trade and what her feeling is about the year.

Ellie Berger

I think Dick said it. I think we have a pipeline of titles that we're really excited about, still to come. We have the big publication that just happened last week of Brian Selznick's Wonderstruck, which is already tracking very well. And again, as Dick said, I think the e-book sales have been really strong, especially on the titles that have a crossover appeal. So we're very optimistic for the rest of the year.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

And guys, any sense or read on how retailers are managing inventory ahead of the holidays? I think we're getting into that seasonally important period for selling ahead of the holidays and would be interest in your comments there.

Maureen E. O’Connell

Yes. I think that everyone's being conservative. I think they're not ordering perhaps as deep as they have in the past, but we're getting support for our list for the most important titles of our list across-the-board.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Got it. Okay. And then maybe a question for Margery on the Ed Publishing business. Any thoughts on what the conversion rate for READ 180 will be? The Next Gen product for fiscal '12. I think you said 18% year-to-date, and that was tracking ahead of the expectation. And then the follow-on is, was there any pick up of the textbook adoption sales in the first quarter? Is that going to flow in the second quarter?

Margery W. Mayer

Want me to just go ahead, Dick? Well, I think we're tracking better on conversions than we had planned, as Maureen said, and -- but most of those conversions probably are in. We still are expecting to see more of them, especially in the second quarter. But because of the buying pattern that of putting technology into the summer and having it up and running for back-to-school, a lot of that is already in. But we're getting such a great reaction to Next Gen, as Dick mentioned, and our customers are incredibly enthusiastic. In terms of the adoption revenue, as you know, we don't participate in very many adoptions, but we did participate in the early childhood adoption in Texas. And we are going to see some early childhood revenue come in, in the second quarter, not a truck load, but we are going to see some because Texas has been slow on ordering and having those orders go through the depository and back to the publishers. And I'm sure you've heard this from other people as well.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

Okay, appreciate the color. Last question for me, just on the cost cutting. $15 million is planned, is that enough to offset the incremental spend you guys have planned for on the digital side?

Maureen E. O’Connell

Yes, our guidance at the top end is still $140 million, which is $30 million better than we did last year and that includes stronger performance in the business, higher digital spend, as well as the cost-savings reductions which were all anticipated there. We initiated a voluntary retirement program this quarter, so we've really put those cost reductions into action and the results of that will be seen in the remaining quarters.

Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division

And Maureen, you guys showed some nice improvement in terms of reducing the operating loss from the Children's Book business. And if I recall, you had an incremental $5 million in digital spend in the year-ago period. What did that number look like if you can share with us for this current quarter?

Maureen E. O’Connell

Well, it didn't come down. I mean, overall, our digital spending, as we had said before, would be up and it is tracking to be up. However, we did reduce our promotion, as Dick mentioned, to better match our promotion spending against the customers who spend the most. And so you're seeing the benefit of that. So we've changed our strategic merchandising and marketing to reflect really targeting the top customers.

Operator

[Operator Instructions] Our next question comes from Barry Lucas of Gabelli & Company.

Barry L. Lucas - Gabelli & Company, Inc.

Couple of items, Dick. Maybe you could talk a little bit about the funding environment and what do you -- how do you feel about local school districts? And what do you see going forward in this very uncertain period that we're moving through?

Richard Robinson

Well, I'll ask Margery to supplement this, Barry, but I'm much more optimistic based on my very long experience in education about the funding environment. There's money out there. It's a little hard to come by in states. The federal government is certainly not adding greatly to its investment, but it isn't cutting back very much either at this point. And the local schools are -- will adjust their property taxes to get revenue back in the system. So school spending will probably be up in the United States overall. I think that for -- of course, as you know, 80% of that spending goes to teacher's salaries and professional staff. And if you can upgrade the quality of those teachers and help them do a better job and meet their needs for professional development, which they all want, according to a new survey that we're going to be releasing the results of quite soon, along with the Gates Foundation. Teachers want more professional development, and I think we're providing more of it and that's going to make the existing expenditures more effective for schools. So I think that's how I view it as opposed to people who are looking at the difficulties in the states and so forth and so on. In the past, states have recovered. They found the money. They don't cut education and schools move on to try to do a better job. But let me ask Margery to give her view of this, particularly as it relates to our new segment that she's running.

Margery W. Mayer

Well, I agree with what Dick is saying. And I guess I would add to that is a lot of our products and services are purchased with federal earmarked money for -- with Title I, which as you know serves poor children and schools serving poor children and IDEA, which is special ed. So we, as you can see from our results this summer, we've been able to tap into a lot of funding that's out there. I do think when you talk to educators, they're feeling quite a bit of pressure around funding. One thing that I think has benefited us, the past several months, is the tightening up of the screws on funding. It's forcing educators to really focus on supporting the things that are working in their district. And I think our timing on Next Gen gave us a good opportunity to go and reinforce READ 180 in a lot of our best accounts. And it was sort of counterintuitive, but it seems to have worked out really well so far.

Barry L. Lucas - Gabelli & Company, Inc.

Great. Margery, as long as I've got you, maybe you could provide a little bit of an update on MATH 180 timing, how the development project is going.

Margery W. Mayer

Yes. It's unchanged. It's the same that we've been saying, and we're making really good progress in math. We're thrilled with our acquisition of Math Solutions, which is doing really well, and it's helped -- bolstering our capacity within our organization. So we're working on all fronts, not just product development, but also getting our sales force ready, our marketing ready. And yes, I think it's going to be really exciting.

Barry L. Lucas - Gabelli & Company, Inc.

And a target date for when that we might...

Margery W. Mayer

We're going to be -- it's about 24 months away, something like that.

Barry L. Lucas - Gabelli & Company, Inc.

Two more quickies, if I may. Dick, I think you have mentioned or you talked a little bit about the app for -- free app that kids could download to their readers for Scholastic and other titles. How are you positioned now with the other important participants in that pipeline, whether we're talking, in particular, Apple?

Richard Robinson

Well, we are going to -- our app is going to be -- is going to support the Apple systems, as well as Android, PC and Macs. So you'll be able to use this app on iPhones, iPads, Android pad, tablets, et cetera, like Android phones, as well as PC and Mac. So we're supporting all of those platforms because all -- people are buying books -- e-books on all those different -- in all those different ways. Deborah, do you want to enhance that answer?

Deborah A. Forte

I think it's a perfect answer. We created the app so it's platform agnostic. So kids can read anytime, anywhere. And as Dick said, we start with the PC, which is ready and then we go to the IOS, and we'll have the Android early in the winter.

Barry L. Lucas - Gabelli & Company, Inc.

And will product be available in the Apple stores or the iStore? And how -- or is it more the direct sell that you're expecting?

Richard Robinson

Well, as you know, the challenge for us, Barry, is to make e-books available, a wide variety of e-books, including those published by us, but also by other publishers to our Book Club and Book Fair customers primarily, because that's where the parents and the kids are in our customer environment, so that's our major focus for those titles. We're outreaching to our customers and selling and getting them to download our app and get them to order our books from us. Deborah, do you want to go farther with that?

Deborah A. Forte

Yes. No, I think that the creation of this was that we needed to supply the very best experience for kids who wanted to read children's books. And so we made something that we think does that. And certainly, because the app is cross-platform, it can be accessed anywhere. We'll be on each of the operating systems. But as Dick said, our focus is really giving our customers the very best experience and really dedicating ourselves to the best eReading experience for children's books.

Barry L. Lucas - Gabelli & Company, Inc.

Great. Last area for Maureen or -- what would motivate you at this point given the good start to the year to start accelerating share repurchases?

Maureen E. O’Connell

Good question, Barry. We didn't aggressively buy this quarter because we are renegotiating our bank deal. Our bank deal is due at the end of the year, and we felt we'd be in a better negotiation position, not to draw down on our revolver and really focus on generating as much cash as possible and not using it. So we are more than ever committed to our stock buyback program. We have 45 million authorized and available for us, and I think you'll see us back in the market.

Operator

Our next question comes from Dennis Barrett of Sidoti.

Dennis Barrett - Sidoti & Company, LLC

Just as a follow-on, Maureen, on the free cash flow question. Do you have any -- or does the company have any plans to consider acquisitions going forward, especially in the technology educational area?

Maureen E. O’Connell

We have looked at everything in that area, but we do have the market-leading program and so it's very difficult to find something as good as READ 180, something that we want to brand READ 180. So we've really been buying service companies. And as you know, we bought Math Solutions in the second quarter last year and a few years ago we bought ICLE, which was a reading consulting business. Now we have a math consulting business. But we do look at companies as they are available. We just have not seen anything that's the right fit.

Dennis Barrett - Sidoti & Company, LLC

Okay, great. And my other question was just on whether -- is it too soon to start talking about what margins may look like or e-books or how the cost structure changes as the product mix changes?

Maureen E. O’Connell

At this point, we're guiding for margins that are similar to our current margins because we expect that we will save in print, paper, postage, shipping, but we will pay a higher royalty rate. So we're guiding for similar margins.

Operator

I'm showing no further questions at this time. And I'd like to turn the call back over to Mr. Dick Robinson for any closing remarks.

Richard Robinson

Well, thank you all for your support. We're delighted by the first quarter. We have good expectations for the balance of the year, and we'll look forward to talking to you in December. Thanks very much.

Operator

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

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