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Executives

Jeffrey Mathews - Vice President, Corporate Strategy, Business Development & Investor Relations

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

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

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

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

Analysts

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

Scholastic (SCHL) Q4 2012 Earnings Call July 19, 2012 8:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Scholastic Q4 2012 results. [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 [ph] Matthews, VP of Corporate Strategy, Business Development and Investor Relations. Please go ahead, sir.

Jeffrey Mathews

Thanks, Allie, and good morning, everyone. Before we begin, I'd like to point out that the slides for this presentation are available for simultaneous viewing by going to our website, scholastic.com, clicking on Investor Relations and following the links on that page.

I’d also like to note that this presentation contains certain forward-looking statements, which are subject to various risks and uncertainties, including the conditions of the children’s book and educational materials markets and acceptance of the company's products in those markets, and other risks and factors identified from time to time in the company’s filings with the Securities and Exchange Commission. Actual results could differ materially from those currently anticipated.

Our comments today also 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 also at scholastic.com.

Now I'd like to 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 Year End 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 at the end of this call.

With solid results across the company, fiscal 2012 was a good year made great by The Hunger Games. Suzanne Collins' wonderful trilogy emerges yet another Scholastic published global phenomenon, regularly taking the top 3 spots on print and e-book bestseller lists across the English-speaking world and helping drive record earnings for the company. On top of our success for The Hunger Games, good execution delivered strong operating performance across the company. At the same time, we accelerated major digital initiatives in Children's Books, Educational Technology and International. Continued financial discipline produced significant free cash flow and we finished the year with our strongest balance sheet in more than a decade. These great results provide a strong foundation for the future.

Although we will not repeat our record earnings from fiscal 2012, our goal for fiscal 2013 is to sustain last year's momentum while generating strong free cash flow. We have also taken major steps forward in the fast-paced digital transition of our businesses. We expect our substantial investments in e-commerce, e-books and new digital programs and education will generate strong profit growth, largely in fiscal 2014, though earnings in the year ahead will be lower than fiscal 2012's record level.

Now I'd like to discuss our results and our plan in more detail.

In Children's Books, we had a tremendous year in fiscal 2012. Continuing a record of high quality, best-selling Publishing and Trade, and strong results in fairs. At the same time, we successfully introduced Storia, our ereading app and e-book system, which is the central pillar of our digital strategy for this business. These results and investments position our Children's Book business well to grow and maintain market share as more schools and families buy e-books from us.

During fiscal 2012, The Hunger Games trilogy reached new peaks each fiscal quarter driven by tremendous word-of-mouth among fans, supported by smart marketing and social media campaigns. Later in the year, this accelerated with the buildup and release of the movie. The Hunger Games has emerged as the top e-book in the U.S. in 2012 as the trilogy gains widespread adult readership.

We also had great results with other Scholastic authors and series including The Invention of Hugo Cabret and Wonderstruck by Brian Selznick, as well as new and backlist titles in the 39 Clues series. With over 50 million copies now in print and digital in the U.S. and many more millions internationally, The Hunger Games is a true global phenomenon, the product of remarkable storytelling and great publishing.

All 3 titles in the series have now been bought by many customers, and as a result, sales have begun to ease in June and July, as fiscal 2013 begins. For the year, we expect sales to return to pre-movie levels as The Hunger Games becomes a cornerstone of our backlist.

In the coming year, we have a number of exciting new releases, including 2 new Captain Underpants titles by Dav Pilkey and a fantastic new Star Wars pop-up book by Matthews Reinhart. Scholastic Series Publishing continues to expand with The Raven Boys, the first book in the new young adult quartet from award-winning and best-selling author Maggie Stiefvater. We also are publishing 3 new titles in the best-selling 39 Clues series.

Building on that series' groundbreaking success, we are launching the Infinity Ring, a highly anticipated multi-platform series whose lead author is the popular James Dashner. In addition, major campaigns are planned for the 20th anniversary of Goosebumps and the 50th anniversary of Clifford, The Big Red Dog. And of course, we look forward to working on future projects with long-time Scholastic author Suzanne Collins.

School Book Fairs finished 2012 solidly with continued growth in revenue per fair, driven by strong participation from parents, grandparents and kids. In fiscal 2013, we are expanding our successful programs to drive more family participation in school book fair events. This should result in further growth in revenue for fair as well as we also modestly grow fair count.

In School Book Clubs last year, we continue to pursue a strategy of targeted promotion spending, resulting in higher profitability on lower revenue. For back to school, we are increasing incentives and mailings to our most productive customers. With over 80% of our teachers now online, we continue to make online ordering easier and more rewarding for our customers. This plan should hold revenue approximately level.

This spring, we introduced Storia, our fee ereading app and e-book system designed for children, an important step in our digital distribution strategy. Storia has already received strong praise from teachers, parents and reviewers at the New York Times and School Library Journal. Children's Technology Review gave Storia an Editor's Choice award noting, “Scholastic's Storia comes out on top.” The free app is available for download in Apple's App Store for the iPad and the scholastic.com for PCs. This fall, we will release versions for Android tablets and smartphones, as well as the iPhone.

As we launch our back-to-school program, we have more than 2,000 Storia e-books available, including 350 enriched titles. We will also offer Harry Potter e-books this fall, while other best-selling Scholastic series are already available on Storia, including The Hunger Games, 39 Clues and Shiver.

For back to school, we're introducing Storia more widely, especially to teachers through school book clubs. Teachers have reacted very positively to Storia as a great way to introduce e-books in their classrooms. As they build excitement for digital reading among students, teachers are also recommending Storia to parents. This fall, we're also expanding Storia demonstrations in school book fairs, where families have reacted enthusiastically when given the chance to experience Storia firsthand.

Although e-book sales to children are still small compared to adult purchases, schools and families are excited about the impact of e-books on children's enthusiasm for reading. Our customers expect Scholastic and our Storia ereading app to lead this transition. In 2013, we are rapidly building new product and expanded digital distribution as we introduce schools and families to digital reading. However, we do not expect to drive significant revenue until fiscal 2014 at the earliest.

Educational Technology and Services had a great fiscal 2012, with strong growth and significantly higher profits following the successful release of READ 180 Next Generation, the #1 reading intervention program used in U.S. schools. Professional development, technology support, school reform and other services also grew by double digits, reflecting a growing base of customers who turn to us for consulting services to help them solve their toughest educational issues. The success of READ 180 Next Gen marks a new phase in the growth and evolution of Scholastic Education, in terms of the power of our products and platform, as well as the sophistication of our sales and service organizations.

Having just returned from our summer sales meeting for Scholastic Education group, our Educational Technology and Services division, I'm struck by the growing power, confidence and strength of this new model for Educational Publishing. It blends innovative technology products, data-driven instruction, research-based teaching and learning, and professional services to support school districts as they strive to increase student achievement. Scholastic Education is redefining the way our industry can support schools by providing great products and a continuous consulting support to ensure that student achievement is improving in every school and classroom.

In addition to our internal momentum, our successful approach to raising student achievement and teacher effectiveness benefits from key external trends, including the upcoming Common Core State Standards. Developed by the National Governors Association and the Council of Chief State School Officers, the Common Core introduces rigorous shared standards for math and English language arts. 45 states have already adopted these and testing will begin in the 2014, '15 school year.

We think teachers and students will benefit from the new standards but will need significant help to meet them. This has already created a great opportunity for Scholastic. Our current math and literacy programs align closely with the Common Core. In fact, many of our authors had a hand in drafting these new standards.

Targeting this emerging need, we have been investing in an extensive pipeline of new products with the following major launches scheduled for fiscal 2014. MATH 180, the groundbreaking research-based math intervention program; and iREAD, a new primary grade literacy program developed with top experts in the field; and we will release a major next generation version of System 44, our foundational reading and phonics program which is a prequel to READ 180. We expect these new products will drive substantial revenue and profits, further accelerating growth in Educational Technology and Services.

Scholastic's other Education segment, Classroom and Supplemental Materials Publishing, also achieved growth in fiscal 2012 with new literacy products and high-level selling. In fiscal 2013, we expect to continue this growth with new Common Core align nonfiction guided reading and middle school programs.

Turning now to International. These results improved dramatically in fiscal 2012. Our Children's Book businesses in U.K., Canada and Australia all experienced strong revenue growth, partly reflecting the success of The Hunger Games trilogy as well as continued operating improvements, especially in the U.K. Sales in Asia also rose reflecting the growing demand for educational products in that region.

Well, in fiscal 2013, we expect lower sales of The Hunger Games compared to fiscal 2012. Revenue and profits in International are expected to rise compared to fiscal 2011 as we increase market share in Children's Book Publishing in each of these countries. To accelerate our growth trajectory in Asia and emerging markets, our new Singapore-based product development team is moving ahead with the comprehensive plan for new print and technology based curriculum with launches beginning in fiscal 2014. This strategy complements our direct-to-consumer and school-based selling channels, which are well established in the region.

Maureen O'Connell will now review our financial results for the fourth quarter and full year and lay out our financial goals for fiscal 2013.

Maureen E. O’Connell

Thanks, Dick, and good morning, everyone. Let me begin with the income statement. For the full year revenues rose 14%, primarily driven by strong sales in Children's Books and International, especially The Hunger Games series, as well as growth in Educational Technology and Services. Cost of goods sold as a percent of sales decreased slightly with an increase in obsolescence reserves for clubs and fairs related to changing sales trends, mostly offset by higher e-book sales in Trade and fewer free book incentives in clubs.

Selling, general and administrative expenses increased in absolute dollars, reflecting onetime expenses of $9.3 million from the company's voluntary retirement program. In addition, the company had higher sales tax accruals for School Book Clubs, increased digital investment and higher selling expenses in both of our education businesses. Operating income increased nearly 80% to $201.8 million, excluding onetime items. And operating margins exceeded -- reached 9.4%. The company's provision for income tax resulted in an effective tax rate of 36.3% in fiscal 2012 compared to 46.1% a year ago. This decrease was primarily due to the reversal of certain valuation allowances based on higher profitability in the U.K. and across the company.

Earnings per diluted share from continuing operations, excluding onetime items, grew to a record $3.70 in fiscal 2012 compared to $1.62 a year ago.

Overall, our results were in line with our raised April guidance on an operating income basis, but was ahead of guidance due to the benefit of the reduced tax rate.

Turning to segment results. In the Children's Book segment, revenue was up significantly for the year and for the fourth quarter, driven by the growth in Trade and School Book Fairs, partially offset by a decline in clubs. Profits increased due to higher sales, partially offset by increased digital spending, sales tax and obsolescence.

In Educational Technology and Services, revenues were up solidly in fiscal 2012, reflecting strong sales of READ 180 Next Generation, particularly in the first half of the year. Revenues from services also grew by double-digit percentages, ramping up during the course of the school year, as is typical. Strong segment sales in particular with a higher-margin educational technology products drove significantly higher profits for the year.

In the fourth quarter, sales and profits declined, reflecting lower sales of READ 180 compared to a year ago when we first launched the new version, partially offset by growth in lower margin services.

Classroom and Supplemental Material Publishing sales grew for the full year but were also front-loaded, reflecting the availability of certain federal funds earlier in the year.

In the segment Classroom Magazine, revenues also grew. Profits were up slightly due to revenue mix and higher selling expense. International sales and profits were up strongly for the year and especially in the fourth quarter, reflecting the benefit from The Hunger Games series in the U.K., Australia and Canada. In addition, Asia experienced strong growth.

In MLA, revenues and profits declined in the fiscal year primarily as a result of an expected decrease in advertising and sponsor sales, as well as an impairment charge taken on a television property.

Finally, corporate overhead expense rose in fiscal 2012, reflecting onetime expenses of $15.5 million from the company's voluntary retirement program, as well as a noncash loss on a sub-lease arrangement. In addition, there were higher bonuses related to the improved results.

In fiscal 2012, we generated free cash flow of $147.6 million, significantly above last year's results and exceeding fiscal 2012 net income, reflecting improved operating results and continued working capital discipline. As a result, cash and cash equivalents at year end exceeded the company's total debt by $35.6 million compared to net debt of $98.1 million a year ago.

This fiscal year, we have acquired 475,000 shares of common stock on the open market for $13.1 million. We currently have remaining authorization to repurchase up to 31.4 million shares of stocks.

Now I'd like to discuss our outlook for 2013. In Children's Book Publishing and Distribution, we expect strong frontlist sales in Trade and modest growth in fairs to partly offset a decline in sales of The Hunger Games to pre-movie levels. As a result, segment profits will decline from fiscal 2012 levels but exceeds fiscal 2011. In addition, spending on digital initiatives in the segment will be front-end loaded, impacting the segment's seasonal first quarter loss.

In Education Technology and Services, sales are expected to be approximately level for the year, with a decline in product sales especially in the first quarter relative to last year's launch of READ 180 Next Generation. Higher service sales and renewals to an expanded customer base are expected to offset these factors later in the year. Profits are expected to decline somewhat for the year, reflecting lower product sales, as well as spending on major educational technology products, which should drive substantial growth in fiscal 2014 when these products are launched.

In Classroom and Supplemental Materials Publishing, revenue and profits should increase for the year driven by launches of new Common Core aligned reading and writing products later in the year. Relative to last year's front-loaded results, however, results for the first half of the year are expected to be down.

In International, continued improvements in the U.K. and strong growth in Asia are expected to partly offset the expected decline in the sales of The Hunger Games. Relative to fiscal 2011 levels, however, revenue and profit in International are expected to rise solidly.

Corporate overhead is expected to decline due to fiscal 2012 higher bonus accruals, partly offset by higher medical expense. In fiscal 2013, we expect an effective tax rate more in line with fiscal 2011, that is in the mid-40s, following last year's tax benefits from the reversal of certain valuation allowances.

On a consolidated basis, we expect total revenues of approximately $1.9 billion to $2 billion, and earnings per diluted share from continuing operations of $2.20 to $2.40. This outlook corresponds to operating income of $130 million to $140 million. Our outlook for EPS and operating income excludes the impact of onetime items. We expect free cash flow of $120 million to $140 million in fiscal 2013, and capital expenditures are expected to be between $65 million and $75 million. We also plan to spend $65 million to $75 million on prepublication and production. Increases in both areas primarily reflect investment in e-commerce, digital product development, including Storia, and our new educational technology programs. With that, I'll turn the call back over to Dick.

Richard Robinson

Well, thank you, Maureen. Now I will moderate a question-and-answer period. In addition to Maureen and Jeff [ph], I'm joined this morning by Ellie Berger, President of Trade Publishing; Margery Mayer, President of Scholastic Education; Judy Newman, President of Scholastic Book Clubs and e-commerce, as well as other members of our executive team who are here to answer any questions that you might have. So with that, let's open the call for 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 I want to start with Hunger Games first. Dick, is there any way you can frame up what the revenue contributions were, the profit contributions were, in fiscal 2012 or in the fourth quarter? And Maureen, maybe you can talk about what your expectations for Trade would be in fiscal '13 ex Hunger Games?

Richard Robinson

Well, Drew, as you know, we're not breaking out individual titles, either on revenue or profit side. So we are saying that we'll return to pre-movie levels. Meantime, Maureen can answer your other question on Trade.

Maureen E. O’Connell

Yes. I mean, we peaked sales of Hunger Games in the April and May period, and as we said, we saw an easing off of those sales in May and June. And so we believe that those sales trends now will be similar to before the movie was launched. As far as your growth rate on Trade, it will be down double digits because of the decline in The Hunger Games sales. The core business, however, will have a single digit growth in the base.

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

Okay, that's what I was looking for, because I think you made a comment about International. Your expectation was that International in fiscal '13, excluding Hunger Games, would be up versus fiscal '11, I was kind of looking for the same type of...

Maureen E. O’Connell

And that would be the same trait on the base.

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

Okay, fair enough. And then on digital, I think you mentioned incremental investments in fiscal '13, can you quantify what that might look like? And then returning to the fiscal fourth quarter of '12, what was the incremental investment you incurred around digital in that period?

Maureen E. O’Connell

Okay, well, our digital investments, as you know, are core to our business now so they're embedded in a lot of our costs. So it was very hard to just break out separately because if you do a marketing promotion that has both a club promotion and Storia promotion, it's very hard to distinguish which is which. But overall, our digital business will increase next year in spending as we launch the program for the back-to-school. So there will be marketing spend, and that's why we said it will be front-loaded because you'll see most of that spend occurring in the first half, whereas last year it occurred more or less evenly through the year, a little higher on the fourth quarter.

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

Are there any other cost reduction programs in place or you're planning for, given the increase spend on digital?

Maureen E. O’Connell

Well, I think since our operating income is up substantially over fiscal 2011 levels, and yet we’re spend to get a much higher rate on digital, embedded in that is a cost reduction efficiencies that we've been achieving throughout the year.

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

Okay. And Dick, as it relates to Storia, I mean, there's been some developments with Apple, the alleged collusion, that price-fixing with various publishers, and if for some reason, their business were to diminish or go away, do you have any plans to make Storia available on Amazon's platforms?

Richard Robinson

Yes. As you know, we plan to have Storia available in many places as we possibly can. I might ask Deborah Forte, who's here with us, to talk a little bit about the applications for each of the various distribution devices, including Kindle.

Deborah A. Forte

Good morning. As Dick said, our strategy for Storia is to make it ubiquitously available and platform agnostic. So we're going out, of course, we've been on the PC and the iPad, and we expect to be on the Kindle this fall and on Android tablets and then roll out with phones. So we'll continue to do that like other sellers, just the way Amazon is on the iOS. And that's our strategy right now. So we're going to continue with that strategy and hope that we can reach as many of our customers as possible regardless of the device and platform.

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

Okay, good. That's helpful. And shifting to ed publishing, the guidance for technology, flattish for fiscal '13. Is it just the tough comparisons you're cycling against or is there anything else macro related that you're contemplating on the guidance there?

Richard Robinson

Margery, you want to talk about that, please?

Margery W. Mayer

Yes, we had such a strong year with the launch of Next Gen and, I mean, we really had a phenomenal year. And as Dick's comments ahead of the questioning, said, we feel like we really are continuing in this evolution of our business where we're getting our sales force even stronger than they've been in the past. We've been hiring some really outstanding people. We've been getting a lot more consistent about how we sell, using data to sell. So we feel like we're doing fantastically. We have 3 great products coming out next year. We just had really high numbers in 2012 and we're continuing to do extremely well in the business.

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

Okay. Dick, last question for me, can you talk about how you're thinking about uses of cash in fiscal '13? You generated healthy cash flow in fiscal '12, you mentioned the balance sheet's strongest it's been in the last decade or so and you're expecting strong cash flow in '13. How are you thinking about uses of cash going forward?

Richard Robinson

Well first, we are, of course, investing considerable amount in digital side, as Maureen suggested. That, of course, is baked into our operating profit numbers. So we're accommodating that investment within the context of improving our free cash flow. As we have in the past 5 years, Drew, as you know, we've had a dividend; we've raised the dividend once. We have had several stock buybacks since 2007. We have an ongoing program of reacquiring shares. As Maureen noted, we have 31 million currently authorized by the board for that program. The board always looks at the question of the use of cash and how we can return more cash to shareholders. So that's our theme. As long as we’re able to manage the investment of our digital transition, which is so far we're doing very, very nicely. So I assume the board will continue to review this. We're obviously all very pleased about the cash generation from the current year. And we will undoubtedly be discussing this at all of our board meetings in the future, just to determine as to whether we’re on the best way that we can return cash to shareholders after investing in the business, which is growing so nicely right now, especially in the educational technology and digital side.

Richard Robinson

Well, thank you, all, for attending our fiscal 2012 year end call. We're very excited about the great achievement of the company during this year. We're thrilled to be the publisher of The Hunger Games trilogy which truly transformed publishing in the past year. We're making so many strong investments and transitioning our business to digital, and we're building our educational technology business while maintaining our leadership position in Children's Book Publishing and supplementary publishing for education, so we’re -- and our International business is just booming. So we're very excited. We thank you for your attention and we'll return to talk to you in September. Thanks so much.

Operator

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

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