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Scholastic Corporation (NASDAQ:SCHL)

F3Q08 Earnings Call

March 27, 2008 8:00 am ET

Executives

Jeffrey Mathews - Investor Relations

Richard Robinson - Chairman of the Board, President, Chief Executive Officer

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

Analysts

Peter Appert - Goldman Sachs

Drew Crum - Stifel Nicolaus

Catriona Fallon - Citigroup

Operator

Good morning. My name is Jackie and I will be your conference operator today. At this time, I would like to welcome everyone to the Scholastic third quarter 2008 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to Jeff Matthews, Head of Investor Relations. Sir, you may begin your conference.

Jeffrey Mathews

Thanks, Jackie 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 condition of the children’s book and educational materials market 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.

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

Richard Robinson

Thanks, Jeff and welcome, everyone, to Scholastic's earnings call and presentation for the third quarter of fiscal 2008. There are two main points about our third quarter. First, in our second smallest quarter, where we typically record a small loss, results from continuing operations were solid. Excluding one-time expenses and gains in both periods, net loss from continuing operations slightly improved in the quarter to $0.10 from $0.13 last year. Year-to-date, we have earned $2.01 per diluted share compared to $0.65 last year.

Second, we have moved ahead with our plan to sell our U.S., U.K., and Canadian direct-to-the-home continuities, causing direct-to-the-home to be classified as a discontinued operation. While this move brings with it a non-cash write-down of assets that significantly impacts our third quarter overall net results, we believe that this is a strongly positive move forward for the company. After experiencing increased losses in continuities in the last two years, exiting this business is a necessary step that will significantly improve Scholastic's future profitability.

In continuing operations in the third quarter, profitability increased in school book fairs, reflecting solid growth in improved margins. In clubs, we continued to streamline promotion spending while investing to drive top line growth next year. Trade had a solid quarter too, with continued sell-through of Harry Potter at retail and other Scholastic titles making bestseller lists.

In educational publishing, good sales of print products contributed to top line growth and improved results, while Read 180 and Fast Math continued to achieve solid sales in educational technology. Revenue and profit were also up in many international subsidiaries. The U.K. in particular saw improved profitability, especially from strong sales in The Golden Compass book series.

We managed working capital tightly, with inventories down year over year for a third consecutive quarter and, as we indicated, we moved ahead on our plan to divest direct-to-the-home continuities.

I’ll address the outlook for fiscal 2008 and longer term in a few minutes but first, Maureen O’Connell, Scholastic's Chief Administrative Officer and CFO, will review the accounting for discontinued operations and the balance sheet.

Maureen E. O'Connell

Thanks, Dick and good morning, everyone. We had reported our third quarter results, which were a net loss of $2.14 per share, compared to a net loss of $0.18 per share in the prior year in two components. The first, continuing operations represented a loss of $0.12 per share in the third quarter, compared to a net loss of $0.09 per share a year ago. These results include all our businesses, except the direct-to-the-home business, as well as interest expense and other gains and losses.

Second, earnings from discontinued operations represented a loss of $2.02 per share in the third quarter versus a loss of $0.09 per share a year ago. These results include the revenue and operating losses for our direct-to-the-home continuity business, as well as the associated non-cash write-downs.

As anticipated, the loss from discontinued operations is primarily related to non-cash write-downs. Accounting rules dictate that assets held for sale must be held at current value less cost to sell. Therefore, we recorded a $107.3 million pretax non-cash write-down of certain assets, including deferred promotion and intangibles. Net of tax, the write-downs amounted to a loss of $1.89 per share.

The remaining net loss from discontinued operations of $0.13 per share in the third quarter compared to a loss of $0.09 per share a year ago was due to operating losses in the direct-to-the-home business. Year-to-date, the net loss from discontinued operations excluding the non-cash write-down was $0.39 per share versus the loss of $0.22 in the prior year.

Revenues from discontinued operations in the quarter was $40 million, compared to $51.1 million a year ago. As we move forward with the divestiture, we are in active negotiations and our goal is to have the sale substantially completed by the end of the fourth quarter. As the process continues, we anticipate cash expenses from selling and there may be additional non-cash write-downs. Of course, we also expect proceeds from the sale.

Now, turning to the balance sheet, last quarter working capital levels improved and inventories declined year over year. At quarter end, the company’s net debt, which we define as total debt less cash, was down significantly, primarily due to our strong free cash flow over the last 12 months. Net debt also benefited from higher year-over-year accrued royalties, which will be paid at the end of this month.

Getting affect to the upcoming payment, pro forma net debt to capitalization was approximately 22% versus 23% 12 months ago. Our balance sheet is strong, even after incurring the additional $200 million last summer to finance the accelerated share repurchase. We also have over $325 million in excess debt capacity, in addition to our cash, providing ample liquidity.

Last December, we announced that the board had authorized an open market share repurchase program for up to $20 million. Under this plan, we repurchased approximately 167,000 shares for $5.4 million at an average price of $32.53 per share during the third quarter.

With that, I’ll turn the call back over to Dick to discuss our outlook.

Richard Robinson

Thanks, Maureen. Fiscal 2008 looks like it will be a strong year for continuing operations, led by the tremendous success of Harry Potter and the Deathly Hallows, both in terms of sales and execution. We will generate significant profit growth and cash while improving margins and investing in growth for next year and beyond.

Based on this progress and the decision to sell direct-to-the-home continuities, our updated guidance for continuing operations for this year is to earn $2.50 to $2.85 per diluted share. This is equivalent to the upper half of our original guidance, which had assumed that direct-to-the-home continuities would have no net benefit or drag on earnings. Therefore, while direct-to-the-home continuities have been a disappointment relative to our original expectations, we expect the core continuing businesses to perform strongly.

We are also narrowing our free cash flow guidance to $90 million to $100 million, which is also the top half of its original range. With this outlook, we are sensitive to the fact that difficult economic times may challenge our customers this spring and in the coming year. While we haven’t yet seen any significant impact on our business from the tough economy, we have reduced spending in the third and fourth quarters to protect our profitability.

Looking further ahead, we are making significant progress toward our goal of 9% to 10% operating margins in fiscal 2010. As I discussed on our last call, there is an approximately $70 million dollar operating income gap relative to fiscal 2007 results in order to achieve our fiscal 2010 margin goal. By exiting direct-to-the-home continuities, which is now well underway as we’ve described, we will make up 40% of this amount by eliminating operating losses.

To address the remaining gap, we are focused on three areas. First, we are focused on growing profits in our children’s book business through strategic pricing, operating efficiencies, and modest revenue growth. This growth will come in part from the strong list of publishing properties in trade, including this year Meg Cabot’s Allie Finkle, [Arigolo] and Goosebump series, and innovative products like 39 clues, which links books, websites, and trading cards in a dynamic new cross media format.

In addition, we are further building our major e-commerce platforms, including Cool, our club online ordering system, which will relaunch in a much-expanded format next year, and our teacher’s store. Together, these two e-commerce channels will do over $300 million in business this year.

We also are moving much of our marketing to the web, which reaches young people where they spend much of their entertainment time. Secondly, we are investing in the higher margin, higher growth areas of education technology. Building on the success of Read 180, our market leading intervention program which has recorded more than a $0.5 billion in sales in this decade, we are creating a new sales and service paradigm for educational technology business. Working with school administrators to improve reading scores in their district, we offer both a product, such as Read 180, as well as consulting and implementation services to ensure the program’s success. This new model has paved the way for new programs, like System 44, which we will introduce in the fall. System 44 is a cutting edge technology based phonics program focusing on grades three to 12 that will complement Read 180. We also are moving into math instruction, with Fast Math, which continues to do well and Do the Math with Marilyn Burns, which we are launching this spring.

Third, we are reducing costs. We are on target to achieve our overhead cost savings target this year and are realizing additional cost-saving opportunities in central and back office functions and within the businesses through process standardization and consolidation.

As well as improved margins, we remain committed to strong free cash flow, as Maureen said, of which we have generated nearly $350 million over the past four fiscal years. This has significantly strengthened our balance sheet. Combined with prudent levels of debt, it has allowed us to return over $205 million to our shareholders through share repurchases this year.

Going forward, we will also continue to maintain a strong balance sheet while investing in the growth areas of e-commerce and educational technology. We are now preparing a two-year plan for fiscal 2009 and 2010 to attain an operating margin of 9% to 10%.

Though the economy may provide some headwind to top line growth next year, our investments to drive growth will also help us increase market share in both the children’s books and educational technology markets. We look forward to discussing this further in July when we announce our fiscal 2009 plan.

In summary, it was a solid quarter for our core continuing businesses and we are glad to move toward a resolution of direct-to-the-home continuities. While non-cash asset write-downs related to discontinued operations have impacted our overall net results in the third quarter and for the full year this move, as we have said, will significantly improve Scholastic's profitability going forward.

With that, we’ve ended our prepared comments. Maureen and I would be glad to take questions at this time.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Peter Appert with Goldman Sachs. Please go ahead.

Peter Appert - Goldman Sachs

Thanks and good morning. Dick, the results in the fair business are very impressive. Is there something structural or marketing programs or something that’s changed that’s driving the accelerated revenue growth there?

Richard Robinson

Well, revenue per fair did improve in December, January, and February. It’s not a peak time for fairs, as you know, Peter, which are typically strongest in the second and fourth quarters. But we saw some increased fairs, we saw some very good cost management, which improved profitability and we saw from the combination of fair growth and revenue per fair, some good revenue growth. So it was an encouraging quarter for fairs.

Peter Appert - Goldman Sachs

But probably we shouldn’t then read into the 7% revenue gain -- we shouldn’t extrapolate from that, I guess.

Richard Robinson

I don’t think so because it’s a small quarter and the economy impact will probably be stronger in the current quarter, March through May, so we’re a little cautious. We’re holding down costs in order to protect profitability but we are hopeful about the revenue, but we’re not counting on it.

Peter Appert - Goldman Sachs

Got it. And then, on the club business, I had thought at this point you had cycled through some of the restructuring efforts you had taken in terms of fewer mailings, et cetera, yet you are still posting negative revenue comps. Could you speak to what needs to happen to get the clubs back to positive revenue comparisons?

Richard Robinson

Well, as you know, we are -- it’s just Maureen and myself here this morning, so Judy, who would normally speak to this, is not hear but I will speak on her behalf. This year we have, as we’ve said before and as you have noted, we’ve reduced our promotion mailings and given fewer offers. We have protected profitability on lower revenue growth but our profits are -- actually profitability as an absolute measure has improved. So we are encouraged by that.

The fourth quarter, despite the economic situation, we hope will be stronger in revenues compared to the past three quarters.

The main thing however, Peter, though is that we took a kind of a pass year on revenue growth this year in the club business, as we’ve said before. And we are investing in Cool and we believe that our revenue growth opportunities are really from an improved e-commerce system in the new Cool plus the additional outreach to parents through a vastly improved Parent Cool. This will probably take 24 months before we really see the full impact of it but we are confident and planning and Judy is quite optimistic about a return to revenue growth in ’09, and certainly in ’10, by which time we will have the full effect of the Cool and Parent Cool.

Peter Appert - Goldman Sachs

When does the Parent Cool roll out, Dick?

Richard Robinson

Well, it’s probably going to be largely in a test mode next year, but it will be available in an expanded format during the ’08/09 school year.

Peter Appert - Goldman Sachs

Right, got it. And then just one other thing and I’ll let someone else get on, and that is the Read 180, after some great momentum in the last several years, it seems like it’s stalled a little bit this year. Any specifics you can cite in terms of what’s driving that?

Richard Robinson

Well, I think we -- as we focus a lot on implementation and improve the use of Read 180 in the current installed base, we are seeing and will see some increased sales in our installed base. So that’s our strategy going forward and we believe we will see some renewed sales growth in Read 180 in the coming year. In the meantime, system 44, which people are very excited about in the school districts that we are serving through Read 180, people are asking for phonics programs for their kids who are in middle school and high school who are reading at the first grade level, and there are a considerable number of those kids who will benefit from system 44 and there’s already a modest pipeline of orders for that product, even though it’s not available until the fall. We believe that we are getting -- we’ll see a very encouraging response, and then those kids will be better able to use Read 180 once they’ve been through system 44, so there’s an iterative aspect to that. But I would look for some increased momentum in Read 180 during the next -- probably the latter half of the next year.

Peter Appert - Goldman Sachs

And then actually one just last thing -- do you have what the Harry Potter revenues in the current quarter were?

Richard Robinson

Let’s see -- Maureen, we do have that. Do you want to give that number?

Maureen E. O'Connell

Sure. This quarter it was approximately $10 million versus $5 million a year ago.

Peter Appert - Goldman Sachs

Great. Thanks, Maureen. Thanks, Dick.

Operator

Thank you. Your next question is from Drew Crum with Stifel Nicolaus. Please go ahead.

Drew Crum - Stifel Nicolaus

Thanks. Good morning, everyone. I just wanted to clarify on the guidance for fiscal year ’08, are you assuming the dilution from continuities in the first half of ’08?

Maureen E. O'Connell

No, the guidance has been adjusted to remove the discontinued operating losses, and so that’s our continuing business operating guidance.

Drew Crum - Stifel Nicolaus

Maureen, which was $2 through the first three quarters?

Maureen E. O'Connell

Correct.

Drew Crum - Stifel Nicolaus

So that would assume $0.50 to $0.85 in the fourth quarter, which seems to be down significantly from last year -- and correct me if I’m wrong, if I’m misinterpreting something here.

Maureen E. O'Connell

Well, I think the guidance reflects the current operating environment and where we think we will operate in this environment, but at the high-end -- you’re right, it’s $0.50 to $0.85.

Drew Crum - Stifel Nicolaus

Okay and a $0.35 spread, you’re already one month into the quarter. I mean, it seems pretty wide. What are the variables you are looking at in the quarter? And also along those lines, where have you decreased spending in the business? I think Dick mentioned that.

Richard Robinson

I think first of all, we are holding our overhead very tight. Maureen will give some detail on that, but overhead has been down to budget; except for stock comp, it’s been down to prior year as well.

Book fairs have been very diligent in holding its cost base this spring and as we’ve said, book clubs have reduced promotion plan, which sort of fits the current economic picture and throughout the company, we are being cautious about spending in the quarter, so that should help protect our profitability.

We are bit ahead of ourselves I think on the $2, so we will have to see where the fourth quarter comes in but historically, it has been a very profitable quarter for us.

Maureen E. O'Connell

What we are monitoring as a swing factor right now is really our curriculum publishing business and when the Read 180 sales are in the fourth quarter. And so that’s what the difference is versus the prior year.

And as Dick said, we have had very favourable overhead costs to date. In all our employee areas, we have lower headcount, lower salary expense. We have improved medical and benefit and fringe rates. And other than stock comp, our costs are down across the board.

Drew Crum - Stifel Nicolaus

Okay, and then I want to move to educational publishing; you guys had I think a pretty good quarter there, given where the market is. It looks like you are outperforming everyone. Just kind of give us an assessment as to what macro conditions look like for that business, relative to when you exited the second quarter and just thoughts on the outlook. And I’d also be interested to hear your thoughts on the impact of the reduction to Reading First, how that impacts your business. Thanks.

Richard Robinson

I probably shouldn’t try to do much on the Reading First group, since --

Drew Crum - Stifel Nicolaus

Okay.

Richard Robinson

-- is not here, but let me give you some feeling. First of all, the next 24 months in education are going to be difficult because states like Florida have reduced revenues in the state and this is beginning to roll through the school budgets and operating costs are having to be lowered in California and Florida and other places, especially where the housing market has taken a drop. Usually this is a bit delayed but I think we are seeing a quicker reaction on the part of the states this year. So that will depress on a macro basis educational spending.

However, in our business, obviously we’re in the educational technology business on the one hand and the supplementary publishing business on the other. Supplementary publishing, while it’s a -- the sales have been down this current year on an industry-wide basis. We have just revitalized our sales force and put a bunch of new feet on the street, so to speak, so we are seeing the impact of a new sales operation taking increased market share in this business, both through our classroom book business. We’ve also stabilized our library business in the quarter and the supplementary aspect of our business is also picking up. So we are looking at an increased market share in what will probably continue to be a fairly flat, even down market.

In educational technology, especially with these large system sales, we are working with the superintendents to improve scores. You’re tapping on different budgets. It’s not just the materials budget; it’s also the staff development budgets, the personnel budgets, and so forth because we actually have employees that are funded in part by the school districts in the school districts helping them improve their score. So this is kind of a different niche of educational publishing. It’s not entirely supported by structural materials budgets. It goes into other budgets within the school.

Having said that, we are seeing the overall pressure on schools to reduce their budgets and a lot of wonderful programs will probably be tossed out during the year but not those that are focused on student achievement and student performance, like Read 180 and our upcoming System 44, Fast Math, and other of our educational technology programs.

Drew Crum - Stifel Nicolaus

Thanks, Dick and just one last question on educational publishing -- you were expecting some margin degradation during the year and it looks like year-to-date, it’s only down about $4 million to $5 million on the operating profit line. Has most of the spending on the new technology products and the spending on the reorg for the sales force been incorporated into those numbers, or should we expect more in the fourth quarter?

Richard Robinson

Well, the sales costs will continue and that’s a large portion of it, is the increased sales capacity, both in the supplementary area, which is moved to increase sales, as I pointed out, and was responsible in part for the good performance of education in the quarter. But also the tech sales force -- with the increased amount of implementation that we are doing, we are also seeing some increased expenses, not all of which are being passed along to the school districts. But that’s an evolving process and by ’09 and ‘010, we will have right-sized the investment there and match it to our revenue capabilities.

Drew Crum - Stifel Nicolaus

Okay. Thanks, guys.

Operator

(Operator Instructions) Your next question is from Catriona Fallon with Citigroup. Please go ahead.

Catriona Fallon - Citigroup

Good morning. I was wondering, can you talk a little bit more about Cool and how far along in the development of that is? I mean, you say that its full rollout will come later, but I’m wondering how much more additional investment is needed to get that really rolled out across the board?

Richard Robinson

Well, there’s investment that we’ve been making during this year and will continue to make until the system is up. There will be a beta later in the spring and a soft launch next fall, and we are looking for a full impact launch during the year next year. Most of the spending is capital spending for an upgraded system.

We are installing a remarkably improved e-commerce marketing program there with a lot of bells and whistles that are available from Amazon and others. We have our own version of an upgraded e-commerce system.

Catriona Fallon - Citigroup

Okay, and then also on just additional cost-cutting opportunities, can you talk a little bit about the remaining distribution centers? So I assume then with the discontinued operations, that’s including the distribution centers associated with direct-to-the-home. Could you talk a little bit more about the detail there and if there are any other distribution centers that can be consolidated, or where cost-cutting can be achieved there?

Richard Robinson

Let me move that over to Maureen in a second, but there are three kinds of distribution centers that Scholastic has. The largest one is in Jefferson City, Missouri, where we ship our Club Education and other related materials from. We have 60-plus distribution centers for book fairs, which are located all over the United States and as we’ve said, we are in a longer term consolidation phase for those distribution centers.

Finally we have in Maumelle, Arkansas, a continuities distribution center and Maureen can talk about the plans for that.

Maureen E. O'Connell

As Dick said, that distribution center is completely dedicated to the continuity business, and so as we move forward in our negotiations with our buyers at the moment, we can either sell that as part of the sale or sell that separately, and that’s reflected in the numbers that we wrote down in terms of the assets.

Catriona Fallon - Citigroup

Okay, and then I guess on the Q4 call, will we get an update as to any additional cost-cutting efforts that might be made in an effort to get to the 9% to 10% operating margins?

Richard Robinson

Yes, that would typically be the topic of our July call. It’s our two-year plan for ’09 and ‘010 and we are budgeting that way this year, two-year plan, to get to the 9% to 10% operating margin and typically, we would give more detail by call on that topic.

Catriona Fallon - Citigroup

Okay. Thank you.

Operator

Thank you. Your next question is a follow-up from Drew Crum from Stifel Nicolaus. Please go ahead.

Drew Crum - Stifel Nicolaus

Thanks. Just two questions -- first, the fourth quarter, what is the comp ex continuities that we should be using in our model?

Maureen E. O'Connell

When you say the comp, you’re saying what the --

Drew Crum - Stifel Nicolaus

The earnings comp for fourth quarter of ’07.

Maureen E. O'Connell

Okay, let me get you that. Last year overall, our earnings per share was $0.93 and that included the losses of continuities, which was about a -- let’s see, year-to-date it was $0.22. I think it was $0.07 more on the -- $0.10 more in the fourth quarter, so a $0.32 loss last year.

Drew Crum - Stifel Nicolaus

Okay, and I just want to get an update on the impact from paper, postage, printing, et cetera that you had built into the guidance. Is it still $10 million to $15 million? Is that still a good range to be thinking about for the year?

Maureen E. O'Connell

Yes.

Drew Crum - Stifel Nicolaus

Okay. Thanks.

Operator

Thank you. There are no further questions. I would like to turn the floor over to Dick Robinson for any further or closing remarks.

Richard Robinson

Thanks to you all for listening. Of course, there are two points that we tried to make here. I hope we did, successfully. One is that we had a good quarter on an operating basis, that is on continued operations. And second, we made a significant move forward in moving our plan for the sale of the direct-to-the-home continuity business, now listed as discontinued operations and we believe that will be a platform for improved profitability for the company going forward, although there was a significant non-cash loss recorded in this quarter.

Thank you very much. We look forward to talking with you on the July call.

Operator

Thank you. This concludes today’s Scholastic third quarter 2008 earnings conference call. You may now disconnect.

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