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Executives

Mark Fleming – Director of IR and Corporate Communications

Dave Vander Zanden – CEO

Tom Slagle – President and COO

Dave Vander Ploeg – EVP and CFO

Analysts

Mark Marostica – Piper Jaffray

Trace Urdan – Signal Hill

Bob Evans – Craig Hallum

Mimi Noel – Sidoti & Company

Luis Sykes – Pennant Capital

Gordon Lasic [ph] – Robert W. Baird

Sabina Bhatia [ph] – Basso Capital

School Specialty, Inc. (SCHS) F1Q09 (Qtr End 07/26/08) Earnings Call Transcript August 21, 2008 11:00 AM ET

Operator

Greetings and welcome to the School Specialty first quarter 2009 earnings conference call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Mr. Mark Fleming, Director of Investor Relations. Thank you sir, you may begin.

Mark Fleming

Thank you, Ryan, and welcome to School Specialty's fiscal 2009 first quarter earnings conference call. Our presenters today are CEO, Dave Vander Zanden; our President and COO, Tom Slagle; and our Executive Vice President and CFO, Dave Vander Ploeg.

Before I turn the call over to Mr. Vander Zanden, I would like to take a moment to read our Safe Harbor statement. Any statement made during this call concerning future results of operations, expectations, plans, or prospects are forward-looking statements. Forward-looking statements also include those preceded by or followed by words like anticipates, believes, could, estimates, expects, intends, or similar expressions. These forward-looking statements are based on School Specialty's current estimates and assumptions, and as such involve uncertainty and risks. These statements are not guarantees of future performance and actual results may differ materially from those contemplated by the forward-looking statements due to a number of factors, including those described in Item 1A of the company's annual report on Form 10-K for the 2008 fiscal year. Those factors are incorporated by reference, except to the extent required under Federal Securities Laws, School Specialty does not intend to update or revise the forward-looking statements.

With that I would like to turn the call over to your host, Dave Vander Zanden.

Dave Vander Zanden

Good morning, everyone. Thanks Mark. This morning I want to start out with just a couple of quick high-level comments on how the season is shaping up and what we are seeing and then I'll turn the call over to Tom Slagle and Dave Vander Ploeg for more detail and color.

So, let me get started. On revenues, state funding for the most part has unfolded pretty much as we expected. There may be some minor pluses or minuses from state to state, but no real significant surprises. And I just want to remind you as I go through the revenue comments that we kind of look at the business in two seasons, two six-month periods, and at this point in time, most of our comments will be on the busy season.

We are seeing the revenue bookings for the business, both Essentials and Specialty, to be on track at this point even though what you saw in the reported results were that shipments were a little bit light. So you'll see the volume catch up as we get into the second quarter. The movement of those shipments is a bit related yet to the later school starts from last year. We think customers are still shifting and getting their timing right on when they place their orders. Budgets were passed just a little bit later this year, so we saw a little bit of a hold up in cutting POs, waiting for the final budgets to be approved. Then there is some cautiousness in the marketplace from customers that are nervous about rising fuel costs, and so we think they're a little more cautious in their spending patterns this year.

From a macro standpoint, we're keeping an eye on the fuel prices. Even though they've come down recently, there is some nervousness in the schools about where they will peak if they go up again and what's going to happen. Even though we saw the peak in the summer months when schools aren't in session, so they haven't really experienced the $4 plus prices that we all saw at the pumps, they're still a little bit nervous out there. So oil has pulled back a little bit and we're happy to see that, but this is probably the only area that is left from a macro standpoint that we're keeping an eye on.

From a gross margin standpoint, Dave and Tom will give you a little more color here; we looked really at three issues in the quarter and for the season. First one is delayed volume, which we talked about, which we expect to catch up in the second quarter. We're getting unexpected price increases from some suppliers in areas that we normally don't see price increases in because we have agreements that keep them pretty well controlled until we have the opportunity to pass them on to customers, but that is not holding true this year. An example in the furniture area, where steel went up 50% for our suppliers and polypropylene 70%, the cost of producing some of the furniture in our industry, raw material costs are 50% to 60% of that product cost. So with steel and polypropylene going up that much, those are very significant increases.

Most of these furniture companies we buy from are fairly small with revenues from maybe $30 million to $60 million and gross margins in the low $20 millions. So when they get price increases that reduce gross margins 20%, in some cases, they're passing them on and there is not a lot of negotiation. They're just pushing them through. Now, we are still talking with some of these folks and trying to be sure that we are approaching this in a healthy manner with them. But, we are revisiting some of the agreements that we had in place as we roll through the second quarter.

So, as a result of that, we're getting squeezed a little bit on the contract fixed prices that are out there in furniture and some of the supply areas. It's going to take us about six months to be able to touch each one of these contract bid areas and catalog prices where we can adjust prices to our customers and balance this back out. Again, Tom and Dave will give you a few more details in this area.

The third area is really around system integration issues. We had the Oracle conversions for the essential side of the business occur last November. And we're – the system is operating really well. One of the tests we wanted to accomplish during the summer months was to make sure that we had designed it from a capacity standpoint correctly and we really had no issues there.

From an integration standpoint, we had spotty issues in a number of different areas and I'll give you a quick example. In accounts payable, we had some system-matched vendor invoices with purchase orders that were kicking out of the system. It had to do with the discrepancy in the way it was set up. In the early months of running Oracle, it didn't cause us any trouble because volumes were low. As the volumes built, we kicked out a lot of invoices in those spring time May/June time frames, as deliveries increased and we just had a bottleneck cleaning them up. And as a result of that, we missed some early pay discounts with vendors. So that kind of thing that caused us a little trouble in the quarter and added some margin pressure. In that particular example, those things are fixed today and operating well. Again, Tom and Dave will comment a little bit more as the call goes on.

From an SG&A standpoint, we have been really cautious since the year began, concerned about macro issues, trying to make sure that we keep things under control. And Q1 you generally aren't going to see much SG&A gain anyway, just due to our focus on taking care of the customers and the spending levels, we need to serve the marketplace and get the job done. But we are well positioned for reductions in the balance of the year, while still retaining some of the important initiatives we have talked about in the past.

We also announced that we are closing a distribution center. That's a result of some great productivity gains we've had the last couple of years in DCs and supply chain. We had eight that will take us down to seven in this DC, and Lyons, New York will close at the end of October. Next year in the summer months, you'll see a more smoothed out delivery pattern as a result of this and you'll see some more shifting of business from Q1 to Q2. We'll talk about that next spring as we start looking at the next busy season to remind you those shifts are going to occur.

So at this point, I'll turn the call over to Tom and he can give us some more details on the operations. Tom?

Tom Slagle

Thank you, Dave. Good morning, everyone. I would like to spend a few minutes just giving you my perspective on the quarter and the year. From an operational standpoint, I believe we had a relatively good quarter. We've made progress in a number of areas and I do think we set the stage for what we think will be a very good second quarter and a solid second half of the year. We delivered good growth in several of our specialty businesses including physical education, our reading intervention business, and our mass merchant publishing business delivered some positive results for the quarter. While expected, our science business was down from last year's strong adoption cycle.

We did see good momentum in the markets where state adoptions have occurred, as well as good growth in what we call our base business or those non-adoption states. Specifically in science, we just started the much smaller year two of the California science adoption. Our first quarter highlights involved activity in San Diego and New York City. Orders came in better than expected in San Diego and we picked up three additional elementary grades in New York City. So aside from the adoption states, it's important to emphasize our success in New York, as well as some of the other non-adoption areas.

In fact, in the first quarter, our non-adoption science revenue grew 4% over last year's first quarter. We see that open territory strength continuing as the popularity and uptake of our hands-on instructional model grows and we introduce new product versions that cater specifically to meeting national science requirements.

The physical education and health category, again, had a good first quarter with continued strength in several state budget grants. We're also seeing some strong federal support for promoting a coordinated health approach nationwide in our schools and communities. Our physical education products and our SPARK program, which is focused around the continuing education and health curriculum, is benefiting from that added funding, specifically from the PEP grant fundings that were recently announced.

Our SPARK model has gained significant endorsements from organizations like the Alliance for a Healthier Generation and the North Carolina Alliance for Athletics, Health, Physical Education, and Recreation, both of which have endorsed SPARK as a program to help advance their objectives and we're delighted to have the opportunity to strategically align ourselves with organizations like this to improve the physical fitness of young students.

Our reading intervention business continues on a growth track and we're successfully carving out what we believe to be a solid position in that space. The market is searching for innovative solutions that can continue to provide educators means to provide improved proficiencies of student performance to standards and our value proposition is filling an important need in this space.

We're making very good progress in our Canadian initiative in that market space. Two years ago, our presence in Canada was mostly around student agendas. Today, we have a new general manager for our Canadian sector and a team of sales professionals that are really beginning to leverage the full capabilities of School Specialty in this market. So we feel we have good momentum up there and view this market as an excellent growth opportunity for the organization going forward.

Our furniture and equipment category is also well positioned for growth. Particularly, our Project by Design business model is filling a critical need in the marketplace by helping schools eliminate the time and frustration of building projects to include new building designs, remodels, et cetera. Our turnkey offering provides capabilities that range from design all the way to installation with particular focus on aligning with the school's objectives of learning environments and efficiencies. This approach we believe provides us a differentiated edge from where we see our competition and it's growing, not only within the traditional classroom, but also outside that into areas like science labs, fitness areas, and other spaces which we believe our model adapts very well to and also fits in with some of our specialty businesses.

The strategy has built a good backlog for us. Our pipeline's encouraging and we believe that will perform well in Q2 and the remaining part of the year. The expansion of the strategy to those areas outside of that general classroom, again, is providing what we think are some unique cross-selling opportunities that are going to provide us incremental growth into the specialty units like physical education and science. Within that category, we again expect a good second quarter.

Let me speak now a little bit around our performance with our Essentials segment. I would say that, overall, it fell a little below our expectation around shipments for the first quarter, but as mentioned by Dave, we are very pleased that our booked order patterns through Q1 and into August are very encouraging. All indications are that we will see growth in the second quarter.

In the first quarter, orders and shipping requirements from customers came in a little later than what we had planned. We saw several larger districts delaying orders as they were negotiating their own internal budget. But while this shift will cause some movement of volumes from Q1 to Q2, these order receipt requirements actually bode well for us as we look to provide a more level operational schedule for our distribution centers in the upcoming years. As we're seeing the order flow materialize into Q2, we've been very proactive in planning our workloads within our operations and to date we've had a very good on-time performance and we do not anticipate any challenges in meeting the customers’ needs through Q2 and the remaining part of this year.

Dave mentioned in his comments some of the gross profit shortfalls across our businesses in the first quarter and I'd like to, again, bring a little more color to that for you. Part of this is driven by the volume shortfalls that were realized in the quarter, but as significant are some of the cost increases both from vendors as well as the transportation costs, which you know are a large part of our business model.

As I'm sure you're all aware, many sectors of the economy are facing similar pressures from rising raw materials and energy prices. We'd like to think we are immune to that, but we're not and this definitely had an impact on our performance in Q1. Our main challenge is that we did have limited ability to raise prices in some of our contract and bid business, for which the most part we're contracted some eight to nine months ago with firm pricing requirements that run through a typical 12-month cycle, some of them a bit longer than that. The impact from transportation costs and vendor cost increases both domestically, which are primarily around paper-related products that typically we cannot lock into because of the fluctuation of those commodities, but also international products put pressure on us, particularly as the volume demand ramped up in Q1.

Finally, as we're operating with the new enterprise business system for the first busy season with many of these highly transactional entities like Essentials, we're experiencing some issues that impacted margin related to some vendor discounts, but also things like pricing applications that caused us to actually apply into the system, inadvertently, discounts in broader areas of contracts than were originally defined based on the definition of the business rules we wanted to load. These issues are being aggressively attacked, and while some of the gross profit issues related to fixed-price contracts will remain until those are renegotiated, many of these other issues can and will be mitigated in the short term and the team is very focused on doing so.

Some specific actions that we are taking, in the area of transportation costs, these have been heavily impacted by surcharges based on carriers' incremental fees which have been traditionally absorbed in our businesses. This will change as we go forward as we're implementing new policies and several of our units have already put these policies into place.

Many of our units have a frequency of drops around their catalogs that do allow us to adjust pricing and terms, which will have an impact at the beginning of the back-to-school season and into the fall campaign. So, my point there is that we are already making adjustments in several areas where cost increases, commodity changes, and terms have changed with transportation where we can actually begin to reflect that into our pricing schedules with customers.

We believe that we can recover some of the vendor cost increases by revisiting clauses in some of our contracts. Dave mentioned this on the furniture side and that's where it primarily exists. Steel, polypropylene, as he mentioned, has risen dramatically and these vendors have been forced to pass cost increases through. But this area is one where what happens is we provide a customer quote several months ahead of a purchase. Typically, that's how the cycle works within the school, where they need a quote and then they have to get budget approval to then actually issue the purchase order.

We typically get vendor cost locked in through that quote-to-order period and in many cases this past quarter, we found that costs have changed within that period due to the pressures on these commodities, which we do believe can be partially recoverable and we're in conversations right now with those vendors.

On the bids and contracts, many of them are up for renewal early next calendar year. During that time, we will address the profitability of these contracts, factoring in both vendor costs as well as transportation elements at that time. The system issues, the things that were affecting some of those pricing applications as well as AP and some other areas that we've identified are being worked, have been worked, and we're putting the changes in place to ensure that we get those processes back on track.

While we're not – and I wasn't pleased with the gross profit performance in the first-quarter, we do have aggressive plans in place that will have a positive impact on our performance for the remaining part of the fiscal year. This also includes an aggressive and planned reduction in our SG&A budget, which implementation is already underway. I will tell you I believe the team is very squarely focused on these issues. We are very committed to driving the improvements in the areas that I've specified above.

So, in summary, what I would like to just recap for you is I believe the first quarter was a good start to the fiscal year. Our order trends have indicated a shift to volume into the second quarter for consumables and some real positive performances for many of our other categories.

The school budgetary challenges have played out consistently with our expectations as we had entering the year. Our working capital focus continues to drive progress through the first quarter. Inventories were down by $28 million year-over-year, helping us to achieve a $9.7 million improvement in free cash flow during the quarter.

Progress continues to be made on all of our corporate initiatives. Things that I've talked to about in the past such as category management, lean database marketing, and campaign management, as well as some of the strategic focus areas that we've invested in with Canada and several of our other units, they're beginning to show results and I believe they're beginning to allow us to leverage some of the capabilities we have to continue to drive better organic growth.

Our decision to close our Lyons distribution center this fall will further improve the productivity of our network. The labor productivity gains that Dave referenced, as well as the focus on working capital reductions and the ability to take inventory out of our system has allowed us to continually rationalize our DC network and drive the resulting efficiencies that come from these types of consolidations. The challenge that we had in the quarter clearly revolved around gross profit, which I have reviewed, hopefully given you some confidence that we've taken very aggressive action to resolve and improve. I'm confident that we will deliver on these improvements. The team is very committed to doing so, and I look forward to Q2 and the remaining part of the fiscal year.

So, at this point, I will turn the call over to Dave Vander Ploeg.

Dave Vander Ploeg

Thank you, Tom, and good morning everyone. I will spend a few minutes and add some additional context to the press release and the related financial schedules, which were issued this morning. I would like to start by talking about the income statement and both the top-line and bottom-line performance.

First quarter consolidated revenues declined 2% year-over-year with both of our segments reporting declines in sales. As we discuss regularly when we talk about the Specialty Unit, adoption revenues play a big role in our year-over-year comparisons. Going into this fiscal year, we had anticipated a $32 million full-year reduction in revenues related to science adoptions. As you have heard this morning, sales of the science curriculum are stronger than we had anticipated.

Despite being ahead of our internal plans, the adoption revenues were approximately $10 million less than last year. So if you exclude adoptions, organic growth in the Specialty unit was 4% year-over-year. We continue to see solid growth in the areas of reading intervention, physical ed and publishing, as Tom just got done talking about. Revenues in the Essentials segment declined $4.7 million or 2.8% during the first quarter as we saw strong furniture and project activities offset by slower than anticipated school supply shipments.

As both Dave and Tom talked about, all indications are that the orders and shipments for school supplies are arriving later than past busy seasons and current order velocity is showing strong increases over comparable weeks in August of 2007. So, as we look forward, we see a solid busy season from a revenue standpoint and are maintaining the guidance range on the full-year revenues of $1.077 billion to $1.11 billion.

Gross profit declined $9.4 million year-over-year in the first quarter, and as Dave mentioned in his opening comments, the reasons really fall into three broad categories. About one-third of the shortfall is directly tied to the volume situation, which was explained a moment ago. Another third is tied to the unexpected raw material price increases from suppliers, mostly in the furniture and consumables side of the business. The final third is related to impacts we saw regarding our system integration efforts, which you just heard Tom talk about.

I will expand a little bit more on these last two through my comments on gross margin. When you look at the gross margin change year-over-year, you see the first-quarter decline of 160 basis points across the company. There are really four primary reasons for the decline during the quarter.

First, as it relates to the Specialty segment, which saw a gross margin decline of 80 basis points, mix of product was the real driver of the variance. With a few science – with fewer science adoptions, revenues were replaced with lower gross margin Specialty Products. So, on a consolidated basis, this accounted for about 30% of the total gross margin decline I mentioned earlier.

Second, within the Essentials segment, which saw a gross margin decline of 260 basis points, unanticipated supplier cost increases were absorbed across a wide array of furniture and supplies categories. These increases were taken after the catalogs were dropped or specific district fixed-price contracts were put in place for the year. Furthermore, these increases were largely tied to commodity price escalations, which Tom just alluded to, such as with steel, paper or other raw materials tied closely to oil. This accounted for about 100 basis points in gross margin degradation in Essentials, which on a consolidated basis represented another 27% of the overall decline.

Third, the freight costs on the procurement side were up sharply and this accounted for about 35 basis points of reduction and represented about 10% of the overall decrease. Finally, as we entered the heavier ordering and procurement season in early Q1, certain system integration issues surfaced, which both Dave and Tom have added some color to, around information flow, purchasing, and pricing calculators.

These integration issues, once identified, were proactively addressed and in many cases have been resolved. In some cases, business processes are being modified to incorporate the new discoveries. These items accounted for the balance of the gross margin decline and they should not repeat in the future as the issues are addressed and corrected.

Taking a look at the selling, general, and administrative costs, overall expenses increased $900,000 year-over-year in quarter one. A major component to this category is our outbound transportation costs, which were up $1.5 million year-over-year. This increase was partially offset by variable selling-related expenses, which did decrease consistent with the revenues.

In addition, the company also continues to invest in e-commerce and database marketing initiatives, which are being funded by productivity gains in other back-office and administrative functions. For perspective, at the end of quarter one, the company had about 30 fewer employees than the year prior after adjusting for discontinued operations. As Dave mentioned, we have been very careful and cautious in this area in light of the uncertain economy and will take steps to further reduce spending in this area as we move out of the busy season in the next few months.

Moving on to interest expense and other, these categories declined $1.2 million in the first quarter, reflecting an overall 335 basis point reduction in our overall effective borrowing rate as compared to the same quarter last year. This decrease in rates was offset by a slight increase in overall debt levels. As we have mentioned in our past calls, the other expense, which is broken up separately on the income statement, primarily is our discounting on our accounts receivable securitization program.

Looking at the income taxes, the effective rate for the first quarter was 39% versus 39.2% last year. Income from continuing operations declined $5.4 million or 13% over the same period last year. Earnings per share from continuing ops were $1.84 versus $1.87 last year or a decrease of 1.6%.

As we indicated in the press release, the percentage decline in fully diluted earnings per share is less than the decline in income from continuing operations, due to the reduction in the share count over the past year tied directly to our repurchases. The incremental net effect of the share repurchase program was approximately $0.19 per share.

I will quickly transition to covering cash flow and the balance sheet before I wrap up. During the first quarter, free cash flow performance improved nearly $10 million as the lower cash from earnings was more than offset by working capital improvement. The majority of this improvement came from an $8 million income tax refund received during the quarter. Product development and capital spending are both down slightly year-over-year, mostly due to timing. For the full year, we are maintaining our guidance on free cash flow.

With regard to the balance sheet, this is the time of the year where working capital is peaking, and we will start converting inventory buildup into accounts receivable. On a year-over-year basis, many of the current asset and liability accounts are down slightly due to the media sale, as these net assets were part of the fiscal '08 quarter-one balances. So real quickly, customer receivables are down $2.2 million, primarily due to media.

The decline in revenues that we saw is offset by an increase in days sales outstanding of about five days. We continue to train associates on the new collections platform and will be installing advanced collection software to aid in the workflow design in quarter two.

As Tom mentioned, inventories are down $28 million year-over-year as we continue to focus on this very important working capital component. Total debt levels are up approximately $5 million year-over-year, as our fiscal 2008 stock repurchases were slightly higher than the total free cash flow from last year.

And a quick comment on share repurchases. As the press release highlighted, there is a positive $0.19 per share effect over the past year on current EPS due to share repurchases. As you recall in fiscal '08, we repurchased about 2.8 million shares for a total of $95 million. And in the first quarter of fiscal '09, we have repurchased an additional 497,600 shares for $15.3 million.

Finally, as Dave and Tom mentioned earlier, we will be closing Lyons Distribution Center, and we have estimated the cost of this closure to be approximately $1.2 million or $0.04 per share. So while we are maintaining our revenue and cash flow guidance, we have adjusted our EPS range for fiscal 2009 to reflect upon this closure.

With that, I will turn it back over to Dave Vander Zanden.

Dave Vander Zanden

Thanks, Dave. Ryan, I think we're ready for questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from the line of Mark Marostica with Piper Jaffray.

Dave Vander Zanden

Hi Mark.

Mark Marostica – Piper Jaffray

Yes, thank you. Good morning. My first question is related to the order flow that you commented on. I just want to get a sense, with the orders that you have in hand busy season to date, if you compare that to your typical busy season, are you ahead, behind? Just give us a sense of where you feel you are related to a typical busy season at this time. I'm just trying to get a sense of the visibility on the remainder of the busy season.

Tom Slagle

Yes, Mark, this is Tom Slagle. If we look at what we call the open and the booked orders, we see that running ahead of where we were at this point prior year, which is again what builds our outlook, if you will, on to Q2. But as I think we mentioned during the call, we saw some of those orders shifting, some of the shipment dates shifting. So, it is clear to us that we have those in the bucket. It's a matter of now getting them out the door, which we are beginning to do here in August and will through the remainder of Q2.

Mark Marostica – Piper Jaffray

Got it. Moving on to the headwinds on the gross margin, as we look into Q2, would you expect to see a similar gross margin headwind that you saw in Q1? And specifically, do you expect to get any relief in Q2 from being able to adjust furniture pricing or consumables pricing relative to the increase in raw material costs?

Dave Vander Ploeg

Yes, this is Dave Vander Ploeg talking. We have obviously spent a lot of time studying that headwind question to really understand what drove the 160 basis point reduction in gross margins in the first quarter. We do believe with the analysis we have done and the steps that we have taken really in a number of areas that we will begin to see gradual improvement in the gross margin. Certainly won't make up the entire delta by any means, but we will start to see improvement in really each of the subsequent quarters going forward.

Mark Marostica – Piper Jaffray

And then specifically on transportation costs, can you remind us what transportation costs are as a percentage of revenue?

Dave Vander Ploeg

Mark, are you interested in just SG&A or inbound transportation total, what are you kind of looking for there?

Mark Marostica – Piper Jaffray

Yes, I was interested in your freight charges.

Dave Vander Ploeg

Okay, cost to ship to the customers generally accounts for a little more than half of our total freight. The other half, the other balance would be inbound and as a present of total revenues that generally runs in the 7% to 8% range.

Mark Marostica – Piper Jaffray

Okay, and the portion of that cost is shipped to customer, I understand that is where you are seeing some pressure from customers that are not willing to take those charges, is that correct?

Dave Vander Ploeg

Actually, what we are seeing there is that we have got pricing scenarios on the street that we are offered with the catalog drops. Until we can get back to adjusting those, we are kind of stuck with them. On the Specialty side, we dropped catalogs three times during the year and on Essentials only once. But now on the Essentials side, as we do the furniture and large shipments direct from vendors, we do pass that cost on to customers and there we can make quicker recoveries. So there is a bit of a balance in there and it just takes a little time to work through (inaudible).

Mark Marostica – Piper Jaffray

I see. Thank you, I will turn it over.

Operator

Our next question comes from the line of Trace Urdan with Signal Hill Capital Group.

Trace Urdan – Signal Hill

Thanks. Good morning. You guys are maintaining your guidance range despite the description of some areas of pressure. I think also, Dave, if I recall correctly last time when you were discussing the outlook, you were sort of cautiously optimistic about California. Now, it looks like maybe California could be coming in a little bit under where in the last conference call you maybe thought it could come. So, my question is that you are maintaining the guidance range. Are there pockets of strength that are offsetting this weakness that leads you to feel good about the overall number? I guess I am really asking about the top-line number more than the bottom-line number.

Dave Vander Zanden

Trace, I think we are doing okay in California, in spite of those budget changes, they are not disturbing our activity out there and things are going fine. We do have – and it's pretty typical in the business pockets that do outperform. Tom talked a little bit about physical education and we are pretty successful with some of the PEP grants that came in and so we see upticks there. So there is some pockets of good news here, too.

Trace Urdan – Signal Hill

Okay. And then following up on the physical education discussion, you guys talked about SPARK. How big a business could SPARK really be for you and what is your estimate of how much we will spend in this area now? Are we talking about them sort of carving out new spending to address this issue or are you gaining share from other places that are spending that money now?

Dave Vander Zanden

Trace, it's a great question. SPARK is actually kind of plowing some new ground out there with the coordinated school health programs. We have seen pretty basic programs that are focused on increasing physical education or physical movement. SPARK is more well rounded, where it involves nutrition, understanding and learning. We also teach the staff in the schools about wellness, so eight different parts to coordinated school health that SPARK is pursuing. The schools are all focused on this area and there are a number of states that are putting dollars aside to fund this. So we think it's a great position for us to be in and we are continuing to invest in product development around SPARK. We think it will be a great product for us down the road.

Trace Urdan – Signal Hill

Okay. And then, Tom, you were talking about I think some – being optimistic about what your furniture business could do in the balance of the year. But it also sounds like your customers aren't really experiencing the full price of those furniture products right now. Do you not expect that as you get to the place where you are passing through some of those higher costs that that might dampen their ordering in the furniture area, or how are you thinking about that?

Tom Slagle

Yes, Trace, I think if you look at what is going on in the market, competitors, some of the folks that are actually selling direct are already pushing those price increases through. So, I don't think that that is going to dampen, particularly around the project side of the business, where these are rebuilds, these are remodels where the budgets have already been formulated. There is always some variances to those, but I am not sure it's going to make their decision change relative to that pipeline. Frankly, in many cases, we have got a number of those contracts already booked in the backlog. So, we feel pretty good about what we see that outlook to be.

Trace Urdan – Signal Hill

Okay. And then also, Tom, in this – what appears to be sort of a more inflationary environment, do you guys think you might be inclined to back away from that kind of fixed contract pricing with customers that you operated on before, or is that just the reality of the marketplace that you have to have those fixed contracts?

Tom Slagle

Well, I think there is going to be a percentage of your large districts, that they are going to bid to very specific specifications then you are going either choose to participate or not participate. Obviously, in a lot of these large contracts that we bid, we like to get our foot in the door because we also then have the opportunity to pull through business in many other categories.

So, there is some strategic value to getting in there. We would like to, obviously, work in as much flexibility as we can into some of the terms and conditions so that we can try to make sure we can respond to some of the market conditions. I am sure there is going to be some of your largest districts that are still going to be able to demand very strict specifications in these bids. Some of the other districts where we have that flexibility we will push it to the best of our ability.

Trace Urdan – Signal Hill

Okay, and then last small question for Dave Vander Ploeg. The tax refund, does that bear on where the tax rate actually came in on the prior year? Meaning was the tax rate overstated in the prior year, given the $8 million refund or is that apples and oranges?

Dave Vander Ploeg

No, it had no bearing on that. It was really tied to media and the late end of year donations that we made that kind of put us into a refund position.

Trace Urdan – Signal Hill

Okay, thanks, gentlemen.

Operator

Our next question comes from the line of Bob Evans with Craig-Hallum Capital.

Bob Evans – Craig Hallum

Good morning every one. First, Dave Vander Zanden, can you comment – you said your view, current view of the market really hasn't changed. But could you do a bit of a review of what that is?

Dave Vander Zanden

Yes, in general terms from the state funding standpoint, Bob, specifically, are you thinking there?

Bob Evans – Craig Hallum

Yes.

Dave Vander Zanden

Yes, we see that the states in a lot of cases have fewer dollars available, but they are not taking it out in a major way on the district spending that they are doing. So the funds going to the districts are holding up just fine, maybe a hair lighter, and that is kind of what we anticipated. I think the reason they are able to do that given the environment right now is that they had enough reserves on the balance sheet they carried into the year. And they are also looking at a number of fee areas and things like that. So it is clipped a little bit, if you think of it that way, kind of on average out there. But that is kind of what our thought was going in.

Bob Evans – Craig Hallum

Okay, and how much do you think is being held back in reserve due to higher energy costs or –?

Dave Vander Zanden

Yes, it's a great question. We are having a difficult time quantifying that. It's a bit of building by building discussion out there, where superintendents are nervous about fuel prices. We know they are being fiscally responsible in the discussions we are having with them, but we have a difficult time putting numbers on it.

Bob Evans – Craig Hallum

Okay. Can you comment on Canada? You said you are taking a number of steps to grow that market. How big is that market now and how big can it become?

Dave Vander Ploeg

We don't break that market out relative to reporting, Bob. But right now, if you look in terms of identifying what we think Canada could be valued at, you can typically look in the ranges of 10% of the US market. Obviously, we are considerably under-penetrated in that respect. As I mentioned, most of our volume up there had centered around our agendas business, which had participated in Canada for quite some time. But with that, they had an established organization, some very experienced and knowledgeable representatives that have tremendous relationships with the districts and the schools up there. So as we are now beginning to approach that market with a much more disciplined view of how do we build the One School Specialty strategy up there, we are seeing double-digit growth and we expect that that is something that we can continue to accelerate as we really target the market in a much more unified way.

Bob Evans – Craig Hallum

Okay. I know you guys don't give specific quarterly guidance, but can we just broadly think Q2 versus Q1 this year? If I have heard correctly, Q2 should be growth, obviously sequentially, but year-over-year versus Q2 a year ago from what I have discerned. Also we would expect some level of margin improvement year-over-year as it relates to Q2 this year versus Q2 last year. Is that a fair statement?

Dave Vander Ploeg

No, I think you may have misunderstood my earlier comments. We do believe that the hole that we have dug in our gross margin will improve from first quarter to second quarter. But we do expect to be down year-over-year.

Bob Evans – Craig Hallum

Okay, first quarter – are you saying from an annual basis? Again, I am just trying to understand the comment, are you saying sequentially up or are you saying year-over-year?

Dave Vander Zanden

Bob, I think what Dave was commenting on was from the decline that you saw, the change year-over-year in Q1 should be lessened in Q2 and then Q3 would be less than that as we work our way through. Year-over-year on the quarters you should expect Q2 to come in less than Q2 last year.

Bob Evans – Craig Hallum

Okay, so the amount of decline will be less?

Tom Slagle

There you go.

Bob Evans – Craig Hallum

Right, but from a – on an annual basis, it will be a lower margin?

Dave Vander Ploeg

That is right.

Bob Evans – Craig Hallum

Okay, just wanted to clarify. How about as we look at revenue in terms of Q2 versus – given the timing differences, should we expect some level of modest growth versus last year?

Tom Slagle

Yes, I think what we are saying is that the shortfall in shipments in Q1 will be made up in Q2 and we expect to achieve the revenue guidance. So you should expect some growth there for the six-month period.

Bob Evans – Craig Hallum

Okay, all right. And then, also when you had talked about your orders thus far and visibility, how much visibility, if you will, sitting here today do you have as it relates to Q2 revenue? I mean, do your orders that you have account for 70% of that revenue thus far, 90%? I am just trying to get a sense of order flow versus actual revenue visibility.

Dave Vander Zanden

I am not sure we have – can pinpoint a specific number or volume that we can say contributes to the quarter. We have obviously got August is coming to a close. We have pretty good visibility as to where we stand there and we continue to see the order flow coming in strong. As we look at it on a daily basis compared to where we have prior year, the one area that we have a little longer-term view to is the furniture and equipment backlog, which looks, again, very positive for us. Again, right now, all indications for us, Bob, are pointing to second quarter order volumes coming in very well for us.

Bob Evans – Craig Hallum

Okay, and just can you describe a ballpark sense? I am just not sure – I am just trying to get some sense of magnitude of visibility.

Tom Slagle

Bob, I would say at this point in rough terms there is about 55% to 60% of the annual volume booked, so we key off of what is in so far. Now, that doesn't all ship in the second quarter, so you have to be a little bit careful.

Bob Evans – Craig Hallum

Okay, fair enough. Thank you.

Operator

Our next question comes from the line of Mimi Noel with Sidoti & Company.

Mimi Noel – Sidoti & Company

Good morning, just a handful of questions from me. In looking at the balance sheet anticipating an increase in volume in the second quarter, is it the absence of the Delta science initial adoption revenue that would account for the reason why your inventory is actually lower than last year?

Tom Slagle

Actually, there is some impact there, Mimi, but – this is Tom by the way – but all in all we have been making constant and steady progress relative to the working capital inventory reduction in all of the units. So I don't think that you can contribute all of that to that piece of it.

Mimi Noel – Sidoti & Company

Okay and if not for the working capital – the discipline on the inventory, and if not for adoption revenue being lower, would inventory be up versus last year? Are you able to look at it that way? Just trying to get a read through on the balance sheet and connect that to your commentary regarding your outlook for the October quarter and current order flow.

Tom Slagle

I think if you looked at it in terms of the way you described it, I would think you would suggest inventory may be down slightly, mainly because of the adoption change. But other areas probably would have remained somewhat unchanged would be my take.

Mimi Noel – Sidoti & Company

Okay.

Dave Vander Zanden

Mimi, this is Dave Vander Zanden. We are really focused on getting permanent inventory reduction in the fiscal year, so you are starting to see some of that come through.

Mimi Noel – Sidoti & Company

Okay. Also had a question on SG&A, there was a comment made about some improvement either second half of the busy season or second half of the year. Could we anticipate that we will see year-over-year declines perhaps reflecting lower staffing to support ERP transition?

Dave Vander Ploeg

This is Dave Vander Ploeg, I think we will – you can expect to see continued efficiencies in the back office parts of the company due to the ERP initiatives. I think what will be somewhat masking that, however, is that the outbound transportation costs as part of our overall SG&A and just given the price of steel, that is going to be up 10% to 12% year-over-year. And so you may not see the benefits of our productivity because of the transportation spend.

Mimi Noel – Sidoti & Company

Okay. And then the last question for Dave Vander Zanden, I think you said top line you should expect to see growth for the six-month period. I assume that excludes or that backs out the influence of adoption revenue.

Dave Vander Zanden

Yes, Mimi, thank you for pointing that out. That is correct.

Mimi Noel – Sidoti & Company

Okay. That is all I have. Thank you.

Dave Vander Zanden

Thanks.

Operator

Our next question comes fro the line Luis Sykes with Pennant Capital.

Luis Sykes – Pennant Capital

Hi, good morning. I wanted to try to complete my understanding around the state adoption revenues. I think you previously said that you will expect that to decline $32 million relative to last year, but then it looks like you are coming ahead of plan. What is your current expectation for that for the year?

Dave Vander Ploeg

A $29 million reduction.

Luis Sykes – Pennant Capital

I couldn't quite follow your math with regards to the organic revenue growth in Specialty excluding state adoption, where you go to this 4%, I get to somewhere around 2% to 3%. Is there something else I am missing? I mean, if you just take the $10 million and deduct it from this year's number, you wouldn't get to 4%?

Dave Vander Ploeg

I think the difference is you can't just take the $10 million out. You really have to restate both last year and this year to exclude adoptions. Since we don't disclose how big our science business is, we don't disclose those two numbers. But if you remove the adoption from both last year and this year, it will compute out to a 4% growth rate.

Luis Sykes – Pennant Capital

But this is taking out the entire science business or this is just taking out the state adoption fees?

Dave Vander Ploeg

State adoption revenue from the specialty business unit.

Luis Sykes – Pennant Capital

Okay. I thought last year you said it was $14 million or $15 million, so even if I take that out from last year and take out I guess $4 million or so this year, I wouldn't get there.

Dave Vander Zanden

We have never disclosed what the specific –

Luis Sykes – Pennant Capital

What the absolute level of revenues were. Last question, just trying to get a sense for what kind of fully diluted share count you are baking into the guidance.

Dave Vander Ploeg

It would be consistent with what you see in the first quarter.

Luis Sykes – Pennant Capital

Has that changed relative to what you guided last quarter?

Dave Vander Ploeg

No.

Luis Sykes – Pennant Capital

Okay, and is that – does that reflect your expectation? Do you not expect to continue to buy back stock?

Dave Vander Zanden

We really don't comment on the future periods on the stock buybacks. We try to share what we know today and leave it at that.

Luis Sykes – Pennant Capital

Okay, thank you.

Operator

Our question comes from the line of Gordon Lasic [ph] with Robert W. Baird.

Gordon Lasic – Robert W. Baird

Hi guys. I just wanted a little bit – wondered if you could provide a little bit more color on – the cost savings you expect to realize in fiscal 2009 and 2010 from these category management initiatives that you have been investing in, any additional comments there?

Tom Slagle

Yes, we have stated – this is Tom, we have stated in prior calls that in '10 we expect to see minimum $0.10 to $0.15 per share in value that we can create through this alignment. We have got a tremendous amount of work that is being done right now. There are becoming a lot of obvious, if you will, efficiencies are going to be driven by the integration of the unit that we have within this category management scenario. Simple things like, again, consistent item categorization and how that relates to vendor management, our ability to consistently rationalize SKU count, integrate around a few sets of vendors versus the multiples that we do in dealing with them in one fashion, not to mention then the channel strategies, marketing efforts. There is a whole host of areas that I didn't get into a lot of detail here, but certainly can do that in the future to help bring a bit more color to that. But we are comfortable that that $0.10 to $0.15 is clear in front of us.

Gordon Lasic – Robert W. Baird

Okay, thanks. Can you provide any comments on acquisitions that are coming across your desk? I know you have talked about you are willing to do that during the busy season if something rights comes along. But given that your focus seems to be more on fixing operational initiatives, does – have you kind of pushed out your appetite for acquisitions going forward?

Dave Vander Ploeg

We did do some of that in the past with everything we had going on in convergence to Oracle and so forth. But, I think we are starting to catch up on initiatives. In spite of initiatives on hand, if something came along that we felt was really important to our strategy in the future, we would act anyway. The only other comment I would share with you on that, because we really don't talk much about specifics around acquisitions, is we are seeing a lot more activity in the marketplace. Things are heating up and just as a general rule, we are also seeing lower multiples than what we had in the past as well on the purchase price.

Gordon Lasic – Robert W. Baird

Okay. Great, thanks for that. Just a housekeeping item, what are your expectations for CapEx for the year? You had said $18 million, but I think this quarter came in a little light according to our estimates. So is that the same? Are you keeping that the same for the remainder?

Dave Vander Ploeg

Yes, we are still projecting something in the range of $17 million to $18 million.

Gordon Lasic – Robert W. Baird

Okay. Thanks a lot, guys.

Operator

Our next question comes from the line of Sabina Bhatia [ph] with Basso Capital.

Sabina Bhatia – Basso Capital

Hi. Thanks for taking my question. Most of my questions have been answered. I just had a quick question, the $350 million credit facility that you have, what is outstanding on that? I think last quarter it was about $98 million or so.

Dave Vander Ploeg

Hang on a second, we are looking.

Sabina Bhatia – Basso Capital

Yes, sure.

Dave Vander Ploeg

We believe it's around $200 million as of today, but we don't have it right in front of us.

Sabina Bhatia – Basso Capital

$200 million availability or outstanding?

Dave Vander Ploeg

$200 million is outstanding.

Sabina Bhatia – Basso Capital

$200 million is outstanding, and so $350 million facility?

Dave Vander Ploeg

Yes, we are reaching kind of the peak of our working capital season, if you will. So it will crest in another month. And then, as the busy season subsides and we collect on the receivables, it will work its way down to its low point in February.

Sabina Bhatia – Basso Capital

It will? Okay, great. Thanks a lot.

Operator

Seeing as there are no further questions, I would like to turn the call back to management for concluding remarks.

Dave Vander Zanden

Great. Thanks, Ryan. Well, thank you all very much for listening to the call today. The next call is on November 20 when we will report the second quarter results and we will see you then.

Operator

Ladies and gentlemen, this concludes today's teleconference. Thank you for your participation.

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Source: School Specialty, Inc. F1Q09 (Qtr End 07/26/08) Earnings Call Transcript
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