School Specialty's (SCOO) Management on Q2 2016 Results - Earnings Call Transcript

| About: School Specialty, (SCOO)

School Specialty Inc. (OTCQB:SCOO) Q2 2016 Earnings Conference Call August 4, 2016 9:00 AM ET

Executives

Glenn Wiener – Investor Relations

Joseph Yorio – President and Chief Executive Officer

Ryan Bohr – Executive Vice President, Chief Financial Officer

Kevin Baehler – Chief Accounting Officer

Analysts

Kevin Tracey – Oberon Asset Management

Richard Dearnley – Longport Partners

Operator

Good day, ladies and gentlemen, and welcome to the School Specialty’s Investors’ Conference Call. At this time all participants are in a listen-only mode. Later we will conduct a Q&A and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded.

I would like to introduce your host for today’s conference, Mr. Glenn Wiener, Investor Relations. Sir you may begin.

Glenn Wiener

Thank you, Amanda and good morning everyone. Welcome to School Specialty’s Fiscal Year 2016 Second Quarter Results Conference Call. Today’s call is being webcast from our Web Site, www.schoolspecialty.com, and can be accessed in the investor relations section of the site. We also have a replay available for those who are unable to join us this morning.

We filed our form 10-Q, issued our fiscal second quarter release, and posted the corresponding investor presentation on our website. All documents can be found in the IR and, if you need anything, by all mean just give me a call or shoot me a note, and I can send the documents to you as well.

Before I turn the call over to management, I’d like to remind everyone that, except for historical information contained herein, statements made on today’s call and webcast about School Specialty’s future financial condition, results of operations, expectations, plans, or prospects constitute forward-looking statements. Forward-looking statements also included these preceded or followed by the words anticipates, believes, could, estimates, expects intends, may, plans, projects, should, targets, and/or similar expressions.

These forward-looking statements are based on School Specialty’s current estimates and assumptions and as such, involve uncertainty and risk. Forward-looking statements are not guarantees of future performance and actual results may differ materially from those contemplated by the forward-looking statements because of a number of factors, including the factors described in the company’s transition report on form 10-K for the short year ended December 26, 2015.

Any forward-looking statements in today’s call and webcast speaks only as of the date on which it is made. Except to the extent required under the Federal Securities Law, School Specialty does not intend to update or review the forward-looking statements.

Now, to the matters at hand. Joining us today are School Specialty’s President and Chief Executive Officer, Joseph Yorio, and Ryan Bohr, the company’s Executive Vice President and Chief Financial Officer. Kevin Baehler, our Chief Accounting Officer, is also with us, and will be available for questions following management’s remarks.

I’d like to thank you all for your continued support and, at this time, I’d like to turn over to Joe.

Joseph Yorio

We reported our results on Tuesday, and I trust by now you’ve reviewed our materials and form 10-Q. I’ll begin with a brief recap of our results, and make a few statements regarding our outlook. Ryan will then provide more color and detail around our results and balance sheet before we open the call up for Q&A.

To begin, the second quarter materialized as expected, and results came in slightly ahead of our internal plan. We’re successfully executing on the initiatives we previously discussed, and continue to establish a strong foundation for balanced growth in the years ahead. Revenues came in close to $146 million, almost $5 million or 3.5% increase over second quarter last year.

Both our distribution and curriculum segments grew with distribution up two and a half percent, and curriculum up close to eight percent. Within distribution, furniture continued to lead the way as our highest growth segment. As loose furniture revenues grew by 17% and Projects by Design furniture rebounded from a slower first quarter, as we anticipated, and delivered over 30% growth in the second quarter.

Driving furniture growth is one of our key strategic initiatives, and the investments we’ve made in our infrastructure, assortment, sales, and marketing are having a positive effect. The market is seeing strong demand, but I believe we’re outpacing the market and with significant opportunities that lie ahead of us.

As mentioned on our year-end and first-quarter call, achieving balanced growth within distribution is a key focus for us this year, and we’re making progress. Our core supply business was essentially flat during the second quarter, but is up over one percent year to date. We recognize the competition we’ve faced from the big box retailers, strong regional competitors, and online competitors. And to combat that, we continue to increase our presence with online partners such as Amazon, Wal-Mart, and DonorsChoose, to name a few, as well as our wholesale partners such as SP Richards.

In addition, we continued to look at our leverage – we continued to look to leverage our unique depth, breadth, and proprietary brands to improve the mix within specific product categories and offset price pressures seen in more commodity items. Finally, we believe we can offer a unique level of customer support and subject matter expertise that sets us apart from our larger competitors. With respect to Amazon specifically, we’ve strengthened our relationship and expanded our offering, which is having a solid positive impact on revenues.

The instructional solution category has slowly shown steady growth year to date. In the second quarter, it was up 1.6%. The growth is being seen in early childhood learning and the special needs product category. And we believe this is a direct result of an improved assortment, the expansion of our team of category specialists, and modifications to our catalogue and marketing campaigns.

The balance of the instructional solutions, which is a broad portfolio of supplemental learning materials and teacher resources, has been lagging. This, however, is an area of synergy we see with our reading discs. And while it will take some time to realize the full benefits of this model, we believe we’re positioned to improve the growth trends in this category longer term.

Year to date and in the second quarter we did experience some declines in agendas and the AV tech categories. However, within agendas it’s important to point out that year to date and second quarter results do not tell the full story. Year to date booked orders at the end of Q2 spare to box grew 92.5% of last year. And we continue to work to close this gap.

We recognize that paper-based planner market has declined. However, there remains a meaningful market for our product. And we continue to be among the largest, if not the largest, player in that market. What we have done to address the market dynamics is lower the cost of our production to enhance profitability, transition our sales strategy primarily to an inside sales model, and modify our product offering to lessen the focus on content-rich products with a higher price point, and better promote a lower price point offering, a more basic offering.

We believe these actions will not only slow the rate of revenue decline, but eventually allow us to stabilize the sales by taking market share. As for the AV tech category, some of the challenges we face will not be resolved overnight. Revenues in the early part of 2015 were boosted by headset sales to support the Common Core assessments. And while year to date this category has shown a 29% year over year decline, the results compared to previous year have improved each month.

And through the early August, the year to date decline has been cut to approximately 15%. We have a recognized brand in Califone, and we offer a diversified assortment of products through third-party relationships. However, if we truly want to be player in the AV tech, or more commonly and accurately now called ed tech category, we need to enhance our internal category expertise, expand and improve our assortment. We’ve taken a number of steps to do so, and expect that we can improve the trends in this category, particularly as we simultaneously expand our wholesale relationships and integrate this category into our Amazon relationship.

Now, looking at the curriculum business, revenues grew by close to eight percent. With respect to science, revenues were up close to 10% and, in the second quarter, 17% year to date. And we continue to experience a strong demand for the FOSS Next Generation solutions. We expect growth to continue for the balance of the year, and we could see some upside to our original expectations, based on our current order flow and our pipeline.

Our science team has done an excellent job. And the investments we’ve made in the product line are paying off. We’ve also taken important steps to integrate our science domain experts with our broader distribution sales force, and we believe this will enhance our growth opportunities into the next year and beyond, particularly in our science supply business.

Our reading category declined last year. And we entered fiscal 2016 expecting the category to be flat as we retooled some of our offerings. During the first quarter, revenues were down. And in Q2 we posted growth of over two percent, which turned our year to date results positive.

Our SPIRE reading intervention program has led the way in our reading category, and the new digital version, iSPIRE, has seen early success. We expect to see momentum build with iSPIRE in the second half of the year and are confident we can remain on the plan this year. Further, we are focused on other enhancements to our product offering to improve longer-term growth trajectory in this category. As we look at our overall business, we remain confident in our ability to achieve the two and a half to three percent revenue growth that we’ve provided.

Now a few brief comments on our margin expenses. Gross margins are tracking roughly on line with our plan. Some categories are up and some are down. Higher furniture sales as a percent of our mix will skew margins downward, as pointed out on our last call. Overall, SG&A was down $1.4 million, or 2.6%. As a percentage of growth, it was 36.5%, compared to 38.8% in last year’s Q2.

And we continue to generate savings from process efficiencies and expense controls. But at the same time we are strategically investing in our business to pave the way for future growth and increased profitability.

In our fulfillment centers and supply chain management, we’re making improvements daily. And, if you remember, this was key area of performance for us last year. We’re performing to plan on key operating metrics such as order cycle times, lines processed per hour, order fill rate, on-time orders, and labor and transportation costs, as measured as a percent of revenue. Our fulfillment center performance is important, not only from a cost perspective, but also from a standpoint that we believe that improved service levels and turnaround times are absolutely critical to improving our sales in the non-peak season.

The cumulative impact of revenue and margin increases and lower SG&A has resulted in an operating income of $2 million, which is an improvement of $9.3 million versus last year’s second quarter. And our net loss of $2 million is a $10.4 million improvement. Lastly, EBITDA of $9.4 million for the quarter was $1.7 million or a 22% improvement.

As many of you may recall, our strategy for the past two years has to build a more scalable business with a lower cost structure. As the bulk of our revenues come within a four-month period, we set out to reduce our fixed cost and to reduce the level of losses in the non-peak season. With an ongoing commitment to a 1SSI [ph] model and process improvements, and investments in tools to most cost-effectively management our business, we are well on our way to achieving this.

Notably we feel there are still substantial process improvement and cost reductions that can be obtained, and we have plans in place to further streamline the organization and increase profitability. This will be done mostly by implementing our Lean/Six Sigma comprehensive process excellence initiative that we spoke about earlier. While the initial targeted implementation of Lean/Six Sigma fulfillment centers has driven many of the improvements to date, the initiative, which was now just launched this month, will bring Lean/Six Sigma to processes throughout the entire company, every department and every location.

To summarize the quarter, really our results for the first half of the year, we are on track to deliver within the guidance we provided at the beginning of year. Although we’ve come a long way to return School Specialty to growth, I honestly don’t believe we’ve come close to realizing our full potential, as there are still tremendous opportunity ahead of us.

With that, I’ll not turn the call over to Ryan for some additional comments on our financials and our balance sheet. Ryan?

Ryan Bohr

Thanks, Joe. Joe provided a fair amount of detail around our sales performance, but I’d like to touch on a few additional points. As we’ve stated, we remain very focused on balanced growth. I mentioned in our last call that the supplies and instructional solutions categories are important barometers of our progress as collectively they would be expected to represent an approximately 55% of our overall sales in the distribution segment.

The year to date growth trends of 1.3% and 1.4% in these areas is an indication of good progress, but not an indication of what we believe our potential is in those areas. And within these broader categories, there are some important subcategories worth noting. Within supplies, for example, art, which is an important area of focus and represents nearly 24% of the category, is up over three percent.

Our partnership is SP Richards is driving growth in basic office supplies. This relationship, along with other relationships with online retailers, has been a sound strategy and broadens our reach. While physical education is down and shaving half a percent off our supplies growth rate, it’s more due to limited PEP grant funding. We’re confident changes we are making to our sales strategy will reinvigorate growth and win back market share in this category.

Within instructional solutions, our efforts in early childhood and special needs are beginning to hit stride as these subcategories are up nine and 11.8% respectively. I raise these points as art, early childhood, and special needs, for example, have been called out a year ago as areas of strategic focus for our company. As the results in these categories indicate, as our team systematically addresses the root causes of past performance issues, we’re confident we can develop and execute improvement strategies and we believe we are in the early innings of what we can achieve.

However, we clearly have product categories or subcategories that need to be further addressed, some of which may weigh down our results in the near term, but in the long term also represent opportunities for growth.

On page five of the investor presentation, please note that we’ve provided some additional detail regarding our progress with our safety and security initiative and healthcare. While the results in those areas are not material today, the opportunities that are emerging clearly indicate they have the potential to have a material impact on our growth and profitability going forward.

As Joe’s comments and the materials illustrate, science continues to perform well. And we noted the performance of FOSS Next Generation. In our opinion, the Next Generation science standard supports, if not demands, an inquiry-based program like FOSS. In many districts that were waiting on the sidelines to determine how or when to adopt NGSS, have found FOSS to be a very good solution.

These views are evidenced by not only our success, but also by how much of the growth is being driven by new districts, i.e., districts that have not utilized the FOSS program in the past. Furthermore, we are seeing successes in both adoption and open territory states.

Finally, as it relates to sales, I’d like to address our comments relating to peak orders shifting to later in the season. First of all, this wasn’t really a factor in our year to date results, more of a forward-looking comment as we track and assess our performance in July and early August. Given our very broad base of customers, circumstances can vary materially by region or state, let alone by county or school district.

This being said, we are seeing some broad trends. Fewer orders placed in June, before school ends, for future delivery. And, as a consequence, more orders placed in late July, early August, as staff returns to the schools. Fewer orders placed before school budgets are fully finalized. Budget delays in certain key districts, Chicago, Pennsylvania, being very prime examples.

In customers placing orders closer to consumption, given the service levels we have shown for a sustained period of time, we are seeing this is in our orders as fiscal July overall was weaker than expected early in the month, only to see the end of the month and the first eight days of fiscal August show significant strength year-over-year.

Moving on to SG&A, we continue to reinvest SG&A dollars into the business to support strategic initiatives. Areas of investment include continued expansion of our inside sales team, establishing a new position to better support our product specialists, and implementation of new business tools such as CRM and transportation management systems. We’ve balanced these investments with savings in other areas, and are on track to decrease our full year SG&A cost by 2.5% to a little over 3%, as indicated in our guidance.

Through the end of Q2, our year-to-date SG&A expenses, after adjusting for one-time restructure related costs, were down $1.9 million or 1.9%, versus end of Q2 last year. As a percentage of revenue, year-to-date SG&A expenses, adjusting for one-time restructure related costs, are down 210 basis points. Year-over-year we are seeing modest improvements in direct labor and transportation costs, both measured as a percentage of revenue.

Excluding variable components of SG&A, such as direct fulfillment center labor, commissions, transportation costs, our more fixed operating costs are down year-over-year by $3.4 million or 4.2%. Although decreased depreciation and amortization represented $1.6 million of the year-over-year decline, cost and process improvements throughout the organization have resulted in a lower cost structure that we will be able to leverage with future revenue growth and improve our operating margins.

Our lower cost structure is evidenced in decreased compensation of benefit costs also associated with the continued net reduction in personnel over the past 12 months. Year-to-date our comp and ben costs, excluding variable related costs and performance based incentive comp, are down $1 million or 2.5%. Importantly, this decline was achieved despite adding key positions to support growth initiative.

During the first six months of 2016, we recognized $1.1 million of incremental incentive compensation costs. Although we expect overall costs for incentive compensation to be consistent year-over-year, the timing of the expense in 2016 is less backend loaded, as compared to 2015.

We currently expect that restructuring non-recurring charges will be between $2.5 million and $3 million for the full year. This is slightly higher than our estimate from last quarter, as we continue to identify cost improvement actions which may result in additional non-recurring costs such as severance or contract termination costs.

Moving on to working capital, current assets and liabilities are very much in line with expectations. The one year-over-year variance I’d like to touch on is the increase in accounts payable which, as we stated in the 10-Q, was timing related. Recognizing we do a weekly supplier check run, at quarter end we make payments for items up and – due up until the quarter end. Whereas non-quarter end weekly checks would run up until the next check run, the following week. The prior year comparable period was not at quarter end. This being said, a portion of the increase is the result of ongoing efforts to improve vendor payment terms.

The increase in deferred catalogue costs is not related to an increase in catalogue expenses. It relates to year over year differences in the timing of catalogue mailings. Net catalogue costs are actually down year over year.

Moving on to some tax comments, as we typically generate pre-tax losses in the first six months of the calendar year, we have recorded a tax benefit of $4.4 million through Q2, and an associated refundable income tax receivable. The effective tax rate of 24% year to date through Q2 approximates our full year estimated effective tax rate.

In the second half of 2016, we expect to generate taxable income for which the related tax provision, at approximately 24%, will fully offset the refundable income tax receivable recorded at the end of Q2. We expect cash taxes for 2016 to be approximately seven to nine percent of per-tax income, or approximately $1.3 to $1.7 million.

You will note that our anticipated tax cash rate for 2016 is lower than our previous estimate, as the sale of our interest in Carson-Dellosa, which is described in note 18 of the 10-Q, will trigger the realization of certain deferred tax assets. Beginning in 2017, we expect our effective tax rate and cash tax rate to return to more traditional levels of between 35% and 40%.

As stated in our investor presentation, for the year we expect our leveraged cash flow to be approximately $20 million, which excludes the $10 million of proceeds realized from our sale of our interest in Carson-Dellosa. Please note that the Carson-Dellosa investment was accounted for under the cost method of accounting, and therefore its performance was not included in any of our results.

When you consider the impact of OID accretion, take interest associated with our vendor notes, and the sale proceeds, we expect a debt reduction of approximately $28 million in 2016. Full-year interest expense is expected to decline by approximately $1.5 million.

In closing, while we are focused on delivering results, we are equally aware of the importance of addressing the limited liquidity in our stock and lowering our cost of capital. As we’ve stated, we believe another strong year of performance will not only increase enterprise value, but also expand our options to improve liquidity and attract new investors and financing partners to our business.

We’re off to a good start in 2016, and are squarely focused on delivering the balance of the year. We appreciate your support, and look forward to our further discussions. Operator, we’re now ready to open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] One moment for questions. Okay, our first question comes from Kevin Tracey from Oberon Asset Management. Your line is now open.

Kevin Tracey

The first one I had is on the guidance. The, in the first quarter you said that you are tracking towards the higher end of your guidance. And then this quarter you made a comment about being slightly ahead of plan. So I guess understanding the delay in orders are seen in the peak season, and where the order book stands today, do you still believe that your tracking towards the high end?

Kevin Baehler

The our guidance, if you look at the ranges, are relatively tight ranges, Okay? So as we are ahead of our internal plan, as we exited the quarter and some of the shifting of the timing, it just gives us a little less visibility overall compared to some prior years. But, yes, we still feel very confident that we’re performing in the range. And clearly the upper end of the range is still very achievable. So we just feel very confident to say that we’re expected to perform in the range.

Joseph Yorio

And, Kevin, this is Joe, and I think as we allude to in the comments, these next two, three weeks, as we continue to see the build of orders, we’ll get more visibility into that. You know, as we really get into schools going back into session here at the, the end of August, these next two or three weeks will be critical in seeing that build.

Kevin Tracey

Okay, great. And yes – believe you can pay off your term loan without any pre-payment penalty after October of this year. I’m wondering if you’ve gone any further in your discussions with banks, or established a goal of refinancing this year? I imagine selling your interest in Carson for $10 million is a big help with that.

Kevin Baehler

Yes. I mean certainly the lowering our – the amount of leverage and the refinance certainly helps and our performance helps. You know, we, we are have – we evaluate that and have ongoing discussions regularly. And we’ll are very focused on finding the right time with the right financing partners to address our cost to capital. So we, we actively and kind of ongoing are looking into that.

Kevin Tracey

Okay. I’m wondering if you also could talk a little bit about the outlook for next year and 2018, as far as the science and furniture business goes. I think you had a little bit more visibility in terms of construction plans and stated the options going forward in those two businesses. So can you talk a little bit about what the market looks like over the next couple of years?

Kevin Baehler

Yes we’re certainly not going to provide any specific guidance as it relates to next year yet. But as we’ve stated we believe that these are strong growth categories for us and will continue to be our higher growth categories. We believe that the Next Gen science standards, the alignment we have with that will certainly continue to help us grow that category with our FOSS products.

And our furniture sales, there’s a – the outlook is favorable for new school construction and dollars spent on school refurbishments. You know, there’s public industry information out there on that. So we, we certainly believe we will benefit from that. But we also our proprietary brands are actually growing at a higher rate than our overall furniture category. And, and so, we’re very comfortable with our offering that we can also grow with the market but continue to take share. So there’s a lot of favorability in the outlook in those two categories, and we expect to continue to do well.

Kevin Tracey

Okay.

Kevin Baehler

Well. Great Rob.

Joseph Yorio

Thanks, Kevin.

Operator

[Operator Instructions] And our next question comes from Richard Dearnley from Longport Partners. Your line is open.

Richard Dearnley

Good morning. In your furniture category, you said you proprietary brand is doing better than the category in general. Is – can I suppose the proprietary furniture is coming from China?

Kevin Baehler

Well, we, we actually have an assembly operation in Texas, and a – our, our wood furniture is all manufactured here in Pennsylvania. The components many components of portions of our line, are certainly sourced overseas. They’re assembled in Texas and, as I mentioned, all wood is manufactured here.

Joseph Yorio

And this is Joe. If I could read into, maybe a little bit into your question, one of the reasons that I, that we think that our proprietary business is growing at a higher level is because over the last two years there have been some challenges with suppliers getting the product in on time. And there’s been delays, two, three, four weeks. We hadn’t experienced that.

So as we started to build credibility about 18 months ago, because our products were available and on time, we think that, as we’ve done that, we were able to take some market share. And now the customers are really looking at our product. Because once they had a little taste of it, they’re realizing the quality of it and we do have it available, right.

Richard Dearnley

And as the, as the order cycle compresses continues to compress, does that force schools into buying essentially what, what’s in stock versus slightly more customized?

Joseph Yorio

No, I don’t think that it does. I think that and this really started last year. As we started having conversations with upper management that schools previously could really start to order before their budgets were approved. And last year’s probably as it got more systemically across the entire U.S. that, until they got their budgets approved, they couldn’t, they couldn’t place their orders at all. So I think it’s just putting more planning on them.

What we’ve also seen, though, it seems like they have their budgets last a little longer. So as we saw the numbers in April, in March, and even into May, there was dollars left over in their budget. So I think that they’re just planning their years out more. So they’re using those budgets at the end of the year to buy product that potentially they would have held off or bought earlier in the year previously. And now as they get into being more compressed at the end of the year, they’re just doing a better job in their planning.

Ryan Bohr

And one thing, just another point, when we’re referring to some of the shifts in, in the order patterns, it has a lot to do with the big back-to-school supplies orders. It’s not typically the furniture orders, the larger furniture orders are – have a different planning process associated with them than just your bulk, readily available consumable supplies. Which we, which we have available. Those aren’t lead time items, so it doesn’t really create an issue.

Richard Dearnley

Right. I see. And, and then in your freight revenue, your freight revenues were down. Not, not year to year, 12 months, but in the first quarter and first half. Where in loose furniture was considerably up. And I, I, I’m guessing that a lot of the freight revenue is, is related to loose furniture because it’s big and bulky. So first question is that true? And then, second if that’s true, why, why would freight revenue be, be down when loose furniture is up 17%?

Kevin Baehler

I can answer that question. Actually the – it, it’s true that we do recognize a fair amount of freight revenue associated with our furniture, which is bigger and bulkier, as you indicated. But actually the highest portion of freight revenue is associated with our agenda product. And, as you’ll see, year over year in quarter two, agenda revenue is down roughly 19%.

That is having an impact on the freight revenue that is partially offset by the incremental revenue associated with, with furniture. But it’s just that, again, the weight of the, of the – there, there’s a heavier weighting associated with freight revenue, associated with agendas than any of our other product categories.

Operator

And at this time I am showing no further questions. I would like to turn the call back over to Mr. Joseph Yorio, president and CEO.

Joseph Yorio

All right. Well, thank you everyone. We appreciate your continued support, and we’ll continue to perform, and we’ll talk to you at the end of the third quarter. Thank you. Have a great day.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the program. You may now disconnect.

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