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Executives

Jeffrey Mathews -

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

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

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

Analysts

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

Barry L. Lucas - Gabelli & Company, Inc.

Scholastic (SCHL) Q3 2012 Earnings Call March 15, 2012 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q3 FY 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. Jeffrey Matthews, Vice President of Corporate Strategy, Business Development and Investor Relations. Please go ahead.

Jeffrey Mathews

Thanks, 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 at 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, that accompanies products within 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.

Also, our comments today 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 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

Thanks, Jeff. Good morning, and thank you for joining our fiscal 2012 third quarter analyst and investor conference call. For this morning's prepared comments, I'm joined by Maureen O'Connell, CFO and Chief Administrative Officer. Other members of the executive team will also be available to answer questions at the end of this call.

Obviously, we're delighted by the very strong third quarter and by year-to-year gains across our business. In particular, last quarter we achieved significant improvements in Children's Trade Publishing with buoyant sales of The Hunger Games trilogy in the run-up to next week's movie release. School Book Fairs also achieved double-digit sales growth and along with Clubs saw improved operating profit.

Taking a major step in our Digital strategy for Children's Book, last week, we introduced Storia, our new children's ereading app and ebookstore and began the first stage of the rollout to teachers, parents and kids, through our Book Club and Fair channels.

Meanwhile, our year-to-date results in education have continued strong based on new products backed up by increased sales and service capacity. With substantial help from The Hunger Games trilogy in English-speaking markets, and in our growing Education business in Asia, we boosted revenues and profits in International. Based on the strong momentum, we raised our outlook for profits and for free cash flow in fiscal 2012 as Maureen will discuss in a moment.

Now let's take a look at last quarter's results in more detail. Revenue in the Children's Book Publishing and Distribution segment increased by $73 million last quarter, producing a $33 million gain in operating income. The Trade channel delivered $69 million of the sales growth in the substantial portion of the higher profits. We also achieved the $9 million or 12% revenue increase in School Book Fairs, and profits were up in both Fairs and Clubs as well.

We were especially proud of the success of Suzanne Collins, The Hunger Games trilogy, yet another Scholastic published global phenomenon with this large crossover readership by adults. Sales of the series reached a high point in the quarter, ahead of next week's highly anticipated movie release. This was the primary cause of higher trade results, but other bestsellers also contributed growth, including The Invention of Hugo Cabret by Brian Selznick, and War Horse by Michael Morpurgo, both of which had critically acclaimed film adaptations released in the quarter.

Brian Selznick's second novel, Wonderstruck, performed strongly too, as the new and back list titles in The 39 Clues series. Like Scholastic's previous record-breaking book series, including Harry Potter and Goosebumps, The Hunger Games has become a global sensation, reflecting the incredible talent of Suzanne Collins, whom we have nurtured, published and believed in since her first major book project with Scholastic 8 years ago.

Scholastic's marketing and promotion has further fueled anticipation and word of mouth support through -- for Hunger Games, especially through the social media. The Hunger Games regularly trends is a leading topic on Twitter worldwide. Effective marketing and traditional channels has been critical, too, through point-of-sale displays. Promotion in our Clubs and Fairs and support in the press and in the bookseller education and librarian communities. The Hunger Games has also benefited from the growing market for adult ebooks. A new crossover selling opportunity has emerged with adult readers who might previously not have visited the young adult section of a bookstore or carried away a novel around with them.

Since all 3 titles in the series have already been published and have already been bought by many customers, we expect sales to stabilize over the next several quarters compared to last quarter's movie-related spike. We were pleased that The Hunger Games trilogy has become another classic and bestseller on Scholastic's publishing list. Its successes helped expand the overall market for young adult fiction while further underlying Scholastic's reputation as a consistent creator of bestsellers.

On the distribution side of the Children's Book segment, we also experienced strength last quarter. In School Book Fairs, we substantially increased both fair count and revenue per fair. In School Book Clubs, we continue to pursue a strategy of targeted promotion spending resulting in higher profits. In addition now, over 80% of teacher orders are placed online and many online teachers have enabled direct ordering for parents, both key signs of progress.

Last week, we took a big step toward our digital distribution strategy, officially introducing Storia, the free reading -- free ereading app and ebookstore designed for children. Storia is easy and intuitive, helping kids learn and love to read in a fun, educational and engaging way. The free app is currently available for iPads and Apple's App Store and for PCs on scholastic.com. Later this year, we will release versions for Android tablets, Android smartphones and iPhones. Each Storia download comes with 5 free ebooks with access to an ebookstore with over 1,300 quality children's ebooks, including approximately 250 enriched titles. By next fall, we will offer more than 2,000 ebooks, including 350 enriched titles.

We've begun a stage rollout of Storia to a quarter, 25% of Book Club teachers, sponsors and parents this spring, and we'll also demonstrate the application at approximately 1,000 book fair events. This staged approach will allow us to further test and hone the end-to-end customer experience in preparation for a full launch across our network of Clubs, Fairs and online sites next fall for back-to-school. While we don't expect a material amount of revenue this fiscal year, initial reactions to Storia in the press and by teachers have been very positive. Teacher support is critical to our strategy, and many teachers are already planning to use Storia to introduce ebooks in their classrooms.

The third quarter is the seasonal -- seasonally smallest period for our 2 Education segments. In Educational Technology and Services, year-to-date sales are up nearly 20%, with significantly higher margins, reflecting strong demand for READ 180 Next Generation, which we launched last May. Sales of services have also risen by double-digit percentages driven by an expanding customer base and high renewals. In the third quarter, these trends continued partially offset by a decline in sales of other products. As anticipated, the seasonal change in mix of service and product sales affected margins.

In Classroom and Supplemental Materials Publishing, year-to-date revenue has also risen and margins have improved as a result of strong high-level selling in new products. Given the shift to federal funding toward the first half of this year compared to a year ago, sales of classroom libraries declined in the third quarter versus the prior year. This was partly offset by increases in Classroom Magazine revenue.

In the International segment, profits grew last quarter. In Canada, the U.K. and Australia, sales and profits rose benefiting largely from The Hunger Games trilogy. Sales also improved in Asia partly due to strength in Singapore and in India, where we are focused on education as a growth opportunity, as well as in Children's Books. As we've stated before, we're building out an Educational Publishing operations in Singapore, whose world-renounced school success provides a strong foundation. To enhance the strategy, last quarter, we acquired Learners Publishing, a small Singapore-based developer of supplemental learning materials for English language learners. In addition to broadening our product offering, the acquisition adds a talented team to our product development hub in Singapore.

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

Maureen E. O’Connell

Thank you, Dick, and good morning, everyone. Looking at third quarter results, revenues increased over 20% relative to a year ago, primarily reflecting higher sales in Children's Books and in International, both of which benefited from The Hunger Games trilogy. Cost of goods sold as a percent of sales improved significantly by over 300 basis points, reflecting favorable product mix, including higher ebook sales, as well as lower spending on incentives and Clubs.

SG&A rose last quarter as a result of sales tax accrual, higher benefit costs and increased bonus accruals relative to higher year-to-date results as well as the planned increases in spending on digital initiatives.

Overall, the seasonal loss per share from continuing operations improved to a loss of $0.09, including $0.05 in onetime items, compared to a loss of $0.77 a year ago, which included $0.13 in onetime items.

Turning to segment results. In the Children's Book segment, revenue was up significantly, driven by growth in Trade and School Book Fairs partially offset by decline in Clubs. Higher results in all 3 channels, partially offset by increased digital spending, yielded a substantial improvement in profitability.

In Educational Technology, revenue was up slightly in the quarter but profits declined, reflecting the higher portion of service revenue relative to product sales in the quarter compared to a year ago, as well as increased prepublication amortization following new product launches.

Classroom and Supplemental Material Publishing revenues declined last quarter, reflecting the earlier timing of federal funding. Year-to-date, revenues were up strongly.

In MLA, revenues and profits rose due to higher sales of interactive products, as well as increased production revenue. Finally corporate overhead rose by $4.8 million versus a year ago. The difference, primarily, reflects onetime expenses related to voluntary retirement plan of $2.5 million or $0.05 per diluted share, as well as higher incentive accruals as I just described.

Looking at cash in the balance sheet, free cash use in the quarter was $1.5 million compared to free cash flow of $49.2 million last year. This difference primarily reflects an increase in inventory and accounts receivable related to higher third quarter trade sales. In the quarter, we completed our plan to bring all trade collections and customer service in-house, implementing a comprehensive enterprise order-to-cash system. This is already generating margin and customer benefits, but has impacted the timing of collections in Trade.

Cash and cash equivalents rose to $111.8 million from $90.7 million a year earlier, as a result of strong free cash flow over the past 12 months. All at the same time, we also repaid debt and returned cash to shareholders through dividends and share buybacks. We maintained a strong balance sheet with total debt of $165.3 million at quarter end compared to $220.1 million a year ago. This fiscal year, we have acquired 220,166 shares of common stock on the open market for $5.6 million. We currently have remaining authorization to repurchase up to $38.9 million of common stock.

Based on our significant profit gains in the third quarter, as well as solid results in the first half of fiscal 2012, we have raised our outlook. For the fiscal year ending May, we now expect revenue of approximately $2 billion and EPS of $2.60 to $2.90. This corresponds to operating income of $160 million to $175 million relative to our prior guidance of $120 million to $140 million.

Year-to-date gains and profitability put us in a good position to achieve this guidance, even as we face a difficult comparison against last year's strong fourth quarter results in Educational Technology and Services, when we launched READ 180 Next Gen. A year ago, we also recorded strong sales of Harry Potter in advance of the last movie in the series.

This year in the fourth quarter, we anticipate higher expenses associated with the launch of Storia and increased incentive expense compared to a year ago.

As a result of these factors, we continue to forecast fourth quarter operating income to be level or somewhat below the prior year. Based on higher full year earnings, we now expect free cash flow to exceed $120 million for the year, exceeding net income. We anticipate collecting higher third quarter accounts receivable in late May or early June. The exact timing of collections relative to our May fiscal year end could result in potential upside or downside to this free cash flow forecast, with an offsetting impact on next year's free cash flow.

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

Richard Robinson

Thanks, Maureen. As you all have heard, we're excited and proud to have produced good third quarter results bouyed by The Hunger Games but also showing continued strength throughout the business.

Now I will moderate a question-and-answer period. In addition to Maureen, I'm joined this morning by these division presidents, Shane Armstrong of International, Ellie Berger of Trade Publishing, Deborah Forte of Media, Margery Mayer of Education, Judy Newman of Scholastic Book Clubs and ecommerce, and Hugh Roome of 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

So my first question, Dick, I wonder if you could quantify the contributions you've seen from The Hunger Games either in the third quarter or year-to-date, just trying to understand how that's going to impact your business going forward as you mentioned, Trade, you expect to stabilize going forward.

Richard Robinson

Yes. Maureen, will answer that one, Drew. Thank you for the question.

Maureen E. O’Connell

Yes, the majority of our gains in Trade this quarter was Hunger Games, as well as other bestsellers. We do expect that not to be a significant in the fourth quarter because the movie will be released. And as we said on the call, all 3 books sold ahead of the movie, so we've seen very strong sales in the third quarter ahead of the movie. So we expect that to come down. We do expect, though, the sales will continue to be strong but not as strong as the third quarter. Offsetting that will be Next Gen, which was launched last year in the fourth quarter, as well as higher spending on Storia, and Hunger Games, which was also strong last year in the fourth quarter due to the movie series release.

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

Okay, Maureen, I think you kind of answered this already. But just to maybe expound on your response to Storia and the investment spending there. Where are you with that, should we anticipate sequential increases in the fourth quarter and beyond? I just want to understand how you're thinking about digital investment for the business going forward.

Maureen E. O’Connell

About half of our spending for this year is in the fourth quarter for Storia because that's when we're rolling out to our teacher base, as well as testing in the Fairs and our marketing plan supporting that is in the fourth quarter. So there has been some increase in the first 9 months of the year, but the fourth quarter has substantial increase.

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

Okay, very helpful. And then maybe for Margery, if you can talk about -- we're in a new calendar year here. Just your outlook for the funding environment, what you're seeing in terms of the sales cycle for your product? A lot of your competitors, albeit on the basal side, have suggested calendar '12 is going to be a tough year, but I wonder if you can comment on that.

Margery W. Mayer

Drew, it's Margery. Well, yes. We've heard from other people that they're finding it difficult and -- but we've been doing okay. We grew in the quarter. It's a small quarter for us. We -- because we rely more on Title 1 money and special ed, which are more stable, we've been seeing funding out there. I think you know that some states are actually bringing some funding up. It's not at the 2008 levels, but it is showing some signs of life. We are seeing very strong demand for services with the Common Core coming down the road and new assessments, people are really anxious to get their professional staffs ready for this. So we're cautiously optimistic that we're going to be able to weather and grow over the coming months and years.

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

Good. My last question, guys, any reason there was no buyback during the period?

Maureen E. O’Connell

As we were watching The Hunger Games sales increasing, we didn't think it was prudent to go out in the market and buy until we updated our guidance. Also, we raised our dividend in the quarter.

Operator

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

Barry L. Lucas - Gabelli & Company, Inc.

Drew covered most of the areas. Dick, maybe you could talk about the response that you've seen so far to Storia, what are teachers, what are employees who've been on the site saying, and what's worked and what hasn't worked?

Richard Robinson

Well, teachers loved this app. They're excited about the opportunity to bring something new to their students. When we talk to them, we've talked to hundreds and hundreds of teachers about Storia. They glow with enthusiasm about the app itself, but also the opportunity to introduce their kids to something that everybody's interested in and talking about, and it gives them a new kind of -- a new way to talk about reading, which is so important to build enthusiasm and the love and the support for reading among their students. So I think that characterizes it a lot. They -- the app itself is easy to use. The connection to the bookstores, you have to work out a little bit, but that has been working, too, for the great majority of our people who have tried it so far. Employees have liked it. And we're just feeling very good buzz about Storia all around and a great excitement particularly among teachers and the people supporting the Book Fair events. So it's a good moment, Barry, and this is something new with the people who want to get a hold of to bring new ways of reading and thinking about reading to their kids.

Barry L. Lucas - Gabelli & Company, Inc.

Right. And it's available to the -- I mean, having been on the website for desktop, laptop, iPad, but not for Android powered tablets, is that the case?

Richard Robinson

That's coming later this month or early next month.

Operator

[Operator Instructions] I'm showing no further questions at this time. I'd now like to turn the conference back over to Mr. Richard Robinson for any closing remarks.

Richard Robinson

Thank you. We had a great quarter. We're very excited about the support for The Hunger Games from all parts of the world from adults, from young people. It's just a reaffirmation of what a great story can do to lift people's spirits and give them a new feeling about reading. Similarly, with Storia, we're very excited about Storia. All of the parts of our company did well in the quarter, and we're very, very proud to -- of that fact and look forward to talking to you again in July. Thank you 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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