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Scholastic Corporation (NASDAQ:SCHL)

F1Q09 Earnings Call

September 25, 2008 8:30 am ET

Executives

Jeffrey Mathews - Investor Relations

Dick Robinson - Chairman, President, Chief Executive Officer

Maureen O'Connell - Chief Administrative Officer and CFO

Deborah Forte - Executive Vice President and President, Scholastic Media

Ellie Berger - President, Trade Publishing

Margery Mayer - Executive Vice President and President, Scholastic Education

Judith Newman - Executive Vice President and President, Book Clubs

Hugh Roome - Executive Vice President

Analysts

Drew Crum - Stifel Nicolaus

Peter Appert - Goldman Sachs

Catriona Fallon - Citigroup

Operator

Welcome to the Scholastic quarter one 2009 earnings conference call. (Operator Instructions) It is now my pleasure to turn the floor over to your host, Jeffrey Mathews, head of Investor Relations.

Jeffrey Mathews

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 would 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.

Dick Robinson

This morning I am joined by Maureen O’Connell, CAO and CFO; Margery Mayer, President of Scholastic Education; other members of the executive team are available to answer questions at the end of our prepared comments.

In the first quarter, Scholastic’s smallest revenue quarter, we made progress towards our fiscal 2009 financial targets. We took aggressive steps to reduce costs and salary expense. We laid the groundwork for margin and revenue growth in the children’s book segment and are encouraged by this fall’s early results. We improved sales execution and prepared to launch major new products in our education business. We ended the quarter with a strong balance sheet and ample liquidity.

Based on these factors we believe Scholastic is well positioned to deliver steady, profitable growth even in today’s uncertain climate. In a moment we will talk about the outlook for children’s books as we head into our big season. But first let me comment on Scholastic Education and our actions to improve margins there.

In Scholastic Education, educational technology sales were down last quarter. This was partly anticipated but it was also an opportunity to improve sales execution as we continue to pursue the strategy we began a year ago to ensure long-term growth in this key area. These changes including the separation of the print and technology sales forces more quickly benefited our print business given its shorter and simpler sales cycle.

On the technology side the sales cycle is longer and more complex. However, as Margery will describe in a moment we have made significant change in our sales process as we enter the second quarter and a new sales year. We also have major new product launches. Overall, we remain confident in the long-term growth and margin prospects of Scholastic’s market-leading education technology business.

As for margins, in July we described two levers; cost reduction and price increases. After the first quarter we are on track to reach a goal of $25-35 million in annualized cost savings in this fiscal year. We have been attacking supply chain and manufacturing costs as well as postage, shipping and freight. In addition, we are making progress with plans to reduce headcount and streamline certain areas of the business. We have also implemented price increases in our children’s book business which will offset higher commodity costs as these businesses begin ramping up in the new school year.

Both cost reduction and pricing are important parts of our plan to improve profitability and reach 9-10% of our operating margins next year. Maureen will provide more details in a moment.

With schools out in the U.S. the first quarter was a small one for the children’s book segment especially compared to a year ago when we benefited from the record-breaking publication of Harry Potter and the Deathly Hallows, the last book in the now classic seven book series. Still during the summer period we laid the groundwork for modest growth and improved margins in children’s books and were encouraged by how things are going so far.

In one of the most successful summers in recent years X Harry Potter, Scholastic Trade Publishing launched a broad range of exciting new franchises while strengthening existing ones. We published The Maze of Bones, the first title in the 39 Clues, our innovative new franchise that combines books, an interactive website, prizes and collectible cards. There has been an enormous amount of buzz about this and the book has already reached the top of the NY Times Bestseller List after two weeks of being on sale.

We are also moving forward on development of a film with DreamWorks, hiring a high-profile screenwriter. Web traffic and sell through books and cards have been strongly positive. We publish the second title in the series called One False Note on December 2.

Last month we released the Hundred Games by Suzanne Collins, the first in the trilogy. It has received great reviews including one from Stephen King and debuted on this week’s NY Times Bestseller list at number nine. We have begun shipping Ink Death, the eagerly awaited final installment in Cornelia Funke’s trilogy. The first two books in this series have sold nearly 3.5 million copies in English worldwide.

Momentum is building with the Goosebumps franchise with the fourth Horrorland book a top seller for us last quarter and writers announced for the Goosebumps movie. We will introduce new Goosebumps games for Playstation 2, Nintendo DS and Wii platforms in time for Halloween.

As for Harry Potter, we are building the franchise ahead of the holiday season. This week we launched a special 10th anniversary edition of Harry Potter and the Sorcerer’s Stone, the very first book in the series with hopes of attracting new readers. In December we will launch the Tales of Beetle the Bard, a book of wizard fairytales written by J.K. Rowling and mentioned in the Deathly Hallows. Sales of the book will benefit Rowling’s charity so they will not have an impact on our bottom line but we expect lift for Harry Potter backlist sales.

Overall we have started strong in Scholastic Trade this year. In School book clubs we are optimistic about modest revenue growth and improved margins based on the launch of new Cool and updated marketing and pricing. New Cool as we have said in prior calls is the revamped online selling and marketing platform which expands our direct reach to parents and kids and improves the club experience for teachers. We plan to go live with the first group of classrooms in November in a staged rollout. This should begin driving incremental leveraged growth starting in the second half of fiscal 2009.

Club customers are reacting positively to enhancements in our print promotion strategy such as rounded pricing and information about book reading levels. It is still early in the school year of course, but we are seeing strong order volumes offset by a shift towards lower priced items. This enthusiasm among customers looking for value is encouraging and a reflection of club strength in a tight economy.

In school book fairs our plan is to drive higher revenue per fair and prices to grow revenue and profits. We continue to improve merchandising and we have developed tools to help fair chair people increase family involvement, both key revenue per fair drivers. This summer we instituted new strategic pricing for fairs while adding a fuel surcharge for fair deliveries. The latter provides a significant offset to higher fuel costs in the business without adversely impacting fair bookings with are on plan and in line with the prior year. Rebooking rates are strong, especially among the larger and more profitable fairs.

While August and September are small months for fairs and clubs so there are few earlier results to report, we remain optimistic about fair’s prospect for modest revenue growth this year even in an environment that is proving difficult for traditional book sellers.

Finally, last quarter we closed the sale of the U.S. Direct-to-the-Home continuities business. This allows us to focus on building relationships with our parent and child customers through the profitable school book club fair and online businesses.

In summary, we are on track to achieve our cost reduction targets. Scholastic’s children’s book businesses are well positioned to drive modest growth in revenue and profits in the remainder of this year. Now Margery Mayer will provide our outlook for the Educational Technology business which continues to be a key part of the company’s growth plan.

Margery Mayer

Scholastic Education has emerged as the fourth largest educational publisher in the U.S. and a leader in educational technology. The tremendous success of READ 180 was almost $600 million in sales to date has driven this growth. With Scholastic’s unique end-to-end approach to selling technology solutions to school districts has also differentiated us from the competition and helped us grow.

To reinforce this strategy and seize long-term opportunity, last September we split the print and technology sales forces apart. We beefed up our service and support staff and we accelerated product development. This impacted short-term results during the first year under the new strategy including the last quarter when technology sales were down.

Now we anticipated much of this decline. A large sale a year ago left us with a challenging comparison. We knew we faced a tough selling environment especially in a couple of key states. In general we are seeing medium to large districts delay purchases as they face the largest deficits they have seen in years.

However, this summer’s performance also made it clear we had opportunities to improve execution. As we discussed in July, technology based solutions require distinct sales planning and tracking practices. To address a capability gap this summer we improved our hiring process, consolidated sales management, centralized field marketing and changed how we align account executives with opportunities. Additionally, we put new management into our implementation organization.

We are already seeing the benefits of these measures in improving sales productivity. For example, we hope to announce soon our largest ever single contract for READ 180 after being selected as the single-source provider in a reading intervention RFP for one of the country’s major urban school districts.

Service revenue was up 30% last quarter, evidence of our customer’s commitment to READ 180 specifically and Scholastic in general as a partner in raising achievement. We are building a growing consulting business helping build leadership capacity in challenged schools. For example, we have had good success with that in Louisiana and California.

In addition, we have a strong READ 180 customer base and franchise which we are leveraging with key product enhancements and new programs. In November we officially release System 44, our prequel to READ 180. We have a lot of excitement about that among our customers and nearly $3 million in pre-sales. Also in November we release a new hosted version of READ 180 for customers who haven’t had the infrastructure to support READ 180 on their own. Next spring we are looking forward to early sales of our new California edition of READ 180 which we are hopeful will be approved by the state board for adoption in November.

We are also excited about our burgeoning math intervention business. Following on the success of FASTT math, Do The Math is on plan to achieve substantial growth this year.

In summary, we are more committed than ever to growing our technology and curriculum business for the long-term. We believe that as school’s demand for innovation continues to rise along with the urgency in raising children’s achievement we will continue to benefit and grow.

I think now Maureen you are next.

Dick Robinson

Maureen O’Connell will now discuss our progress reducing costs last quarter as well as our results and our outlook.

Maureen O’Connell

In addition to revenue growth, as Dick and Margery just discussed, cost savings are a key lever to help us reach 9-10% operating margins in fiscal 2010. We made significant progress with our cost reduction plan in the first quarter and are on track to achieve savings of $25-35 million on an annualized basis.

Our first quarter focus has been on external costs and renegotiating with our vendors. For example, we have worked with our key suppliers to manage rising paper costs by pre-buying, reducing paper specification and setting pricing caps. We have negotiated new manufacturing contracts. For example, reducing pricing on common formats and eliminating inflation paid pricing on some contracts.

We are increasing our bundling and co-mailing of catalogs, magazines and promotions to reduce postage expense. We have renegotiated and consolidated our local delivery contracts yielding substantial savings. We have successfully reduced our rates for temporary labor under new contracts. We are in the process of renegotiating and standardizing our fleet of book fair trucks as well as sales force cars. We are implementing new travel and entertainment policies, renegotiating vendor contracts and instituting new reporting tools to increase compliance and reduce expenses.

We are closely examining our existing IT vendor relationships, exploring new relationships and consolidating cross-company purchases to lower costs. These are only some of the examples of efforts across the company to reduce spending strategically which has been our first priority before turning to salaries and headcount.

On the latter front we have made some very difficult decisions. We have suspended annual salary increases normally made in October for most staff and management. We have implemented a voluntary retirement program for employees over 50 years of age with at least 10 years of service. Qualifying employees must decide by October. We have frozen hiring. Finally, we are working on plans to streamline other areas of the business and find synergies among them.

We expect to accomplish much of this work by the end of the calendar year with savings beginning in the second half of the fiscal year. We currently expect associated severance and one-time expenses to be comparable with this year’s realized savings. We will update you as we know more.

Turning now to the first quarter results. Revenue and earnings fell relative to a year ago when we released the last book in the Harry Potter series and benefited from approximately $240 million in incremental revenues. Cost of goods sold declined in absolute dollars and as a percent of sales compared to last year’s higher Harry Potter related expenses.

SG&A declined in absolute dollars in the first quarter for the same reason. However, as a percent of revenue SG&A increased reflecting the higher operating leverage of Harry Potter sales a year ago.

We typically use cash during the summer with schools out of session and the need to build inventories before the fall. Free cash flow use last quarter was somewhat higher than a year ago. A year ago Harry Potter had minimal impact on free cash flow due to the timing of collections and payments. Consequently, the year-over-year difference was primarily due to inventory buying in school book fairs where we bought earlier to avoid a potential strike in West Coast ports as well as the timing of payables.

Net debt declined by over $150 million at quarter end compared to a year ago reflecting strong free cash flow in the intervening 12 months. At our point of seasonally high cash usage we had over $325 million of cash on hand and cash available under existing credit lines. Ample liquidity positions us well to take advantage of opportunities even in uncertain markets. As Dick noted last quarter we completed the sale of the U.S. Direct-to-Home business. As expected, initial cash proceeds from the sale were modest offsetting severance and other liabilities.

Finally, last quarter we bought back approximately 425,000 shares of our stock for $11.7 million leaving $8.3 million in current repurchase authorization. Also, earlier this month we paid our first dividend since going public in 1992, returning additional cash to our shareholders.

Now to review the outlook for the rest of the year. In children’s book publishing and distribution we continue to expect modest revenue growth and improved operating leverage excluding last year’s Harry Potter benefit. Based on early results we believe clubs will grow modestly from steady print promotion results, new pricing and the staged rollout of New Cool.

Likewise, based on very early results we expect revenue per share and pricing to drive modest growth in fairs. We are also encouraged by trade’s full front list and the tremendous reception it is receiving.

In education, as Dick and Margery described, we continue to believe that higher sales productivity combined with new product launches and growth of services will help us achieve our goals. A number of factors such as continuing improvement in sales execution, the speed of System 44 adoption by current READ 180 base, the inclusion of READ 180 in the California reading adoption are important to this outlook.

In international, with the first quarter’s difficult Harry Potter comparisons behind us, revenue and profits should be up modestly for the rest of the year reflecting growth in Australia, Canada and Asia, partially offset by tough comparison for the U.K. where we sold Golden Compass a year ago.

In media, licensing and advertising revenue and margins are expected to continue to improve driven by sales of interactive products in our retail channels. Corporate overhead is still expected to increase modestly from higher stock based compensation and severance as well as higher facility and medical costs. This will be partially offset by lower salaries and spending in consulting.

Overall, we continue to expect solid profit and margin growth including Harry Potter in fiscal 2009 with revenue of $2 billion to $2.1 billion, earnings per diluted share of $1.75 to $2.10 and free cash flow of $90-100 million.

Dick Robinson

Even with today’s tough economic environment and last year’s extraordinary comparisons we do feel positive about the first quarter results and our outlook. Scholastic remains unparalleled in its ability to reach teachers, parents and kids with the best, most trusted products and services for their learning growth and entertainment.

We are unique in our ability to communicate directly with our teacher, parent, student and school customers to help them make the choices that are right for them. We continue to deliver extraordinary customer service every day.

In a difficult economic environment our products and services remain an important part of the lives of our school and family customers. This ensures our continued value as a company that people need in both good and difficult economic times. We remain focused and committed to improving profitability and growth. To ensure this in the short-term we are concentrating on execution in all of our businesses through reduced costs and gross sales and for the long-term we will grow the company in children’s books, educational technology, international especially in Asia and broader use of e-commerce to sell more books and digital products to our school and family customers.

The school year is now beginning; an exciting time for some of our largest businesses and we look forward to reporting on the results and progress in December.

Now I will moderate a question-and-answer period. In addition to Maureen and Margery I am joined this morning by Ellie Berger, President of Scholastic Trade Publishing; Deborah Forte, President of Scholastic Media; Judy Newman, President of Scholastic Book Clubs and Hugh Roome, President of International.

With that let’s open the call to questions.

Question-And-Answer Session

Operator

(Operator Instructions) The first question comes from Drew Crum - Stifel Nicolaus.

Drew Crum - Stifel Nicolaus

A couple of items on your guidance for fiscal year 2009. Number one, any change in view in the contributions you are expecting from Harry Potter given Time Warner’s decision to move the movie from the fourth quarter of this year into 2009? Secondly, any impact you are anticipating from the hurricane down in the Gulf region? I wanted some additional clarification on the severance costs. I think originally it was $0.11 and Maureen you made some comments on that. I just wanted some additional color there.

Dick Robinson

I think on the move of the movie we didn’t budget a lot of impact from the movie and I don’t think it will make a great difference to us. Obviously we will be looking forward to the summer when the movie comes out. So on that one I don’t think it will have a big impact.

Ellie Berger

The only thing I’d add to that is because we have sent the movies where we do have [inaudible] that we will be publishing we expect that stores will merchandise the backlist against the sales of that new title in December.

Dick Robinson

That is an important fact. On the hurricanes it is really too early to tell. We have had some cancellations around Houston and so that has had some small impact. Do you want to comment further on that Maureen?

Maureen O’Connell

Yes. We had some cancellation in our fair business but as Dick said that was a minimal impact. As to your question as far as severance we guided for $0.11 in severance this quarter. As you saw, it was $0.05 per share. Our guidance, we haven’t updated yet for the actions we just announced in terms of voluntary retirement and the streamlining of the organization but we expect that severance will equal the benefit in the year and we will realize the full benefit of $25-30 million in savings next fiscal year.

Drew Crum - Stifel Nicolaus

Maybe I can follow to that point. Is there any way to quantify the cost savings you recognized during the first quarter? I understand you are still targeting $25-35 million for the fiscal period.

Maureen O’Connell

Well the actions we have put in place represent about half of the savings so far. So as far as freezing headcount and eliminating the annual increases we don’t yet know how many people will opt into the voluntary retirement program so we don’t have numbers for that and we are working on activities to streamline our organization and so those plans will be finalized by the end of this calendar year. So we don’t have those yet.

But the first quarter really had minimal realized savings. We did have strong cost management performance in overhead, clubs and fairs but that was offset by the higher severance, higher FASB123 expenses and higher rent costs.

Drew Crum - Stifel Nicolaus

Maureen, your view on paper postage printing I think was originally $15-20 million for the year. Does that still hold true?

Maureen O’Connell

Yes, but we have been mitigating those costs by actions that we described such as co-mingling our mailings, reducing our paper weight in some areas, changing the paper to lower cost options and we also pre-bought this year and entered into some longer-term contracts to get paper discounts. So that is the aggregate amount that we have increased our costs by but we have mitigation strategies in place and as Dick described we have also increased our prices in our book business.

Drew Crum - Stifel Nicolaus

Any early indication in terms of the recent activity to the pricing increases from your customers?

Dick Robinson

Well it is quite early to tell, as we said in respect to our clubs we see some shift to value buying. Judy do you want to amplify that?

Judy Newman

Yes, obviously it is too early to say anything about clubs because I could say it would be pretty anecdotal but I can say a couple of things. First of all we are seeing very strong orders. Customers are enthusiastically placing orders across all of our 13 September booklet catalogs. As Dick said this was offset somewhat by a shift towards lower-priced items. Customers are searching for good value so they are kind of seeking out the lower priced and often good margin, lower priced items. Secondly, the teacher customers are very happy about our rounded pricing strategy where we went from $3.95 to $4.00 to avoid the teacher having to make the change and my in-box is actually bursting with thank you notes from teachers who are complimenting us on that. Thirdly, I’ll just get this in that we are moving forward on our Cool rollout as we said for November.

Drew Crum - Stifel Nicolaus

Just expectations on CapEx and pre-pub for the year. They were relatively flat with the year-ago period.

Maureen O’Connell

At this point our expectations remain as we guided last quarter. No change although spending will be more geared towards the second half of the year than the first half of the year.

Operator

The next question comes from Peter Appert - Goldman Sachs.

Peter Appert - Goldman Sachs

Can you just give us an assessment of how you see the competitive dynamics or the reading remediation market? How much is that a factor do you think in the revenue progression? A second one Margery, just a little bit more about System 44 in terms of how you see the scale of the market opportunity for that product?

Margery Mayer

In terms of competition there is definitely more competition than there was five years ago. So there is, but we don’t see anybody coming up all the time in a head-to-head competition on a universal basis. So it is kind of geographical and spotty. There are several companies that are likely to be approved for adoption in California. Call us crazy but we still believe we are not the gold standard but the platinum standard in intervention. We have had more studies this year that our program works. We had expansion of our product. Yes, it is more competitive than it was but we still feel that we are the clear leader in our space.

In terms of System 44, there are two very nice things about the market for System 44. First of all, it fits right in and tucks right under READ 180. So our base, we have over 10,000 classrooms using READ 180. System 44 can be sold right into that base. The other thing about System 44 is there is an existing market for foundational reading programs and there are a number of companies in it. None of them really use technology in a medium way. We are using it in a very sophisticated, exciting way. So I think it is a break through program for foundational reading. We can sell it a little bit younger than we have been selling READ 180. We can take it down to grade 3 and we already have $3 million in pre-sales without anybody having even actually seen the product.

Peter Appert - Goldman Sachs

But in terms of the revenue opportunity then, probably not as big as READ 180 in terms of the narrower focus?

Margery Mayer

No. I think it is going to be smaller than READ 180 but it is material.

Peter Appert - Goldman Sachs

The existing sales organization sells it, correct?

Margery Mayer

Yes.

Peter Appert - Goldman Sachs

And from a technology standpoint it is the same as READ 180? There is no incremental investment by the school district?

Margery Mayer

Well our products have two parts to them. One is the management system where students are enrolled and data is generated. That is the same management system as READ 180. The other part of our product is Student Client and it has a new Student Client with a new interface and some features that READ 180 doesn’t have. It is very updated and exciting. So for schools that already have READ 180 and are using SAM to run READ 180, which they need to, that is our management system, all they need to do is pretty much drop the Student Client on top.

Peter Appert - Goldman Sachs

The point was no capital investment required by the school other than…

Margery Mayer

No capital investment. Just product purchase investment which we look forward to.

Peter Appert - Goldman Sachs

You are selling System 44 now, correct?

Margery Mayer

We are pre-selling it to customers. We have done some mailings and some limited presentations. We already have several of our READ 180 customers who have been lining up to order it. So yes we are talking about it but we haven’t started physically shipping it until November.

Peter Appert - Goldman Sachs

Lastly, in the context of the contribution from System 44 do you think the educational technology can end the year with up revenues even in the context of schools’ financial pressures?

Margery Mayer

Yes, we have a path to meeting our goal for the year. It is based on 44. It is based on the order we know is coming in and other orders we are looking forward to. It is based on our service revenue being up and it is also based on some early sales in California. So yes we definitely have a path to get us there.

Peter Appert - Goldman Sachs

Dick or Judy, can you give us more data on the pricing stretch in terms of what kind of percentage increases in pricing on average are you implementing? And I was just interested in your comment Judy about the shift to lower price points. Does that effectively neutralize the impact of the price increases?

Dick Robinson

We increased prices throughout our children’s book business based in part on our drive for improving margins but also on the increase in paper costs and shipping costs. So we have done that throughout. Judy can comment in particular how that plays out in the clubs but it is rather early in the clubs to really know exactly what the mechanics of how this is all working. But she can give you some impressions.

Judy Newman

Yes Peter, it is early and as you know we offer a portfolio of products all the way from lower prices all the way up. So we are watching what the teachers, parents and kids are taking. So we made sure to sort of protect the margin at each price point and make sure we do offer the customers a wide-range of products. We anticipated coming into this season, this back-to-school season, that there would be a lot of pressure on customers’ pocketbooks so we wanted to make sure the book club kind of protected its value proposition and really was there for customers who were looking for good value for books. So we brought forward some of our merchandising on our regular, paperback books as opposed to some of the worse margin, non-book items if you will.

So we really expect the price increase overall to be better margins, to keep the excitement and the engagement which is our main thing. We didn’t want people to look at the club flyers and go, “Oops, too expensive. This is discretionary. I’m not going to buy.” So we are very happy to see that engagement and enthusiasm is really working for us right now. Because we have this wide-range of products, we are just really digging in to see what it is that they are buying.

Peter Appert - Goldman Sachs

So what is the average price increase?

Judy Newman

The average price increase is about 5%.

Peter Appert - Goldman Sachs

Is that, Dick, across fairs, trade and clubs?

Dick Robinson

Yes, it could be higher in some fairs and trade than in clubs.

Peter Appert - Goldman Sachs

You mentioned a surcharge for shipping in fairs. How big is that? I assume that just comes out of the profit of the organization running the fair. Is that correct?

Dick Robinson

You know a lot about this business, Peter. It is $30 per fair. We run over 100,000 fairs so it comes right out of the first $30 of substantial commissions that the fair operators get from the schools.

Peter Appert - Goldman Sachs

You haven’t changed the commission structure have you?

Dick Robinson

No. It is about the same as it always has been and it is very satisfactory to the schools. Of course a driver with why they run fairs and the impact of families and reaching out to the school population.

Peter Appert - Goldman Sachs

Maureen you are almost out of share repurchase authorization. Do you re-visit that or do you step back on share repurchases in terms of other uses for cash in the near-term?

Maureen O’Connell

Peter, we not only have share purchase another $8 million to go but we are also initiating the first dividend since going public. So we are returning money to shareholders and we will continue to look at our cash as we generate it and we are happy to be generating strong cash flow and look at the opportunities to reinvest that cash first in our business through pre-pub in our education segment and interactive as we develop new products there and also in our trade area. Then we will look at whether there is still excess cash left after we have fulfilled our pre-pub needs and capital needs and we decide what to do with it. We have ongoing discussions with our board about how to reinvest our cash.

Peter Appert - Goldman Sachs

I’m assuming from what you said earlier that pre-pub capital spending numbers are pretty well set and should not be taking a significant step up in the next couple of years, correct?

Maureen O’Connell

They are not changing from our guidance which was $65-75 in capital and $80-90 million in pre-pub which is up from last year because we had some delays last year but that spending is predominately in the education segment. As Margery described the System 44 and other products we are developing there as well as in our interactive segment as we launch new products there.

Operator

The next question comes from Catriona Fallon – Citigroup.

Catriona Fallon - Citigroup

I was wondering if I can get a little bit more detail on how you are renegotiating some of the printing and paper contracts and how much you expect to save from each of those efforts.

Maureen O’Connell

Renegotiating the contracts and all the activities I described that were non-salary related are about 1/3 of our savings so all of those activities cumulatively represent 1/3 of the savings in the $25-35 million goal. What we are doing is we are shifting work, common formats to vendors who will offer us better price concessions and we will get more volumes to do that. So we look at our vendor universe and as we talk from one vendor to the other and whomever will give us the best price at delivery times we will move the business to them. The paper area we did pre-buy some paper. We did consolidate our contracts so that we could go to one vendor and get better buying because we are buying at larger volumes.

Catriona Fallon - Citigroup

So, let me just understand there is also the $15-20 million increase in costs this year that you anticipate for paper and postage. So you are finding other ways to save. So the real annual cost savings you are looking for is more like the $25-35 million plus the $15-20 million increase in paper and postage so you are really looking for cost savings of $40-55 million?

Maureen O’Connell

No, actually the $15-20 million in commodity pricing we expect pricing will offset that across our book business. Then we have a plan to increase our cost savings $25-35 million. So right now our plan is that the commodity pricing will be offset by pricing increases across our business. We are a low-cost offering and so we have a big value gap between other competitors and ourselves and so we just shrunk that value gap a bit so where we were 30% lower than the nearest competitor now we are maybe 25% lower. Still a great value. So that is why we feel like we could increase prices if commodities went up.

Catriona Fallon - Citigroup

Then you mentioned the large deal at the urban school district. When do you expect that revenue to be recognized and how should we be thinking about modeling that over the course of the year? Is it more of a one-time or more of a subscription fee we will see?

Margery Mayer

It is a three-year contract. We expect it to come in the second quarter but there could be a delay because we are dealing with a big city and sometimes those happen. I think that is pretty much what we can say about it right now. Maureen do you want to say anything else?

Maureen O’Connell

Well to the point that it is service revenue we recognize that revenue as subscription so some of the service revenue growth doesn’t show up in the quarter that we said because we recognize it over the life of the contract.

Catriona Fallon - Citigroup

Typically for the education contracts if I just look back at the last several years, Q1 tends to be essentially the largest quarter for education and publishing This quarter it looks like it was kind of I think a little weaker than last year and the year before. Is there some change in the seasonality that we should be expecting for education and publishing? Then also when do the school districts make their purchases of something like a System 44 or a READ 180? Is it typically in the summer months? Or would we also see that into November and February quarters?

Dick Robinson

We did say that we would have a lower than normal first quarter this year because of comparisons with last year but also how our sales force was operating and how the new product flow was coming. So we budgeted at a lower level for the first quarter this year than the previous two years. On the other hand we still fell a little bit below what we had hoped. The System 44 revenue which Margery just talked about will flow through the school year. READ 180 tends to be heavier in the last quarter of the year and the first quarter of the year. Margery do you want to make further comments about that?

Margery Mayer

I think what Dick said is right. We think System 44 could be less seasonal than READ 180. It is really something that can be started at any time in the year. So we are expecting to have good sales of System 44 over the next three quarters.

Dick Robinson

I think the main point is we have a plan. We are very focused on the next three quarters and how we can increase the revenue in those quarters. So for this year we think we can outperform where we have been in previous years in those quarters.

Catriona Fallon - Citigroup

Any change in the timing of fairs this year? I know that in the past you have benefited when sales have been pulled forward or pushed back in different quarters.

Dick Robinson

The pattern is pretty much the same this year. I think they may be starting a little bit later although many schools because of the early Labor Day schools may have on the average opened a little bit earlier.

Catriona Fallon - Citigroup

My last question was on the Direct-to-home Continuities Program. I saw on the press release it said free cash flow use from discontinued operations was basically $3.5 million. Is that basically all from the sale of the business in this quarter?

Maureen O’Connell

That is their operating cash flow prior to selling it. So that is their use of cash flow that was their operating results for the first quarter while we owned them.

Catriona Fallon - Citigroup

Even for the first quarter of this year?

Maureen O’Connell

Yes.

Catriona Fallon - Citigroup

Okay. Any more details on the sale of that business?

Maureen O’Connell

As you know we sold the direct-to-home U.S. business. At this point we received a minimal amount of cash which covered liabilities we had. We will continue to collect cash which is based on their cash collections with guaranteed rates and we expect to be paying liabilities at the same time. So it will have minimal impact on cash.

Operator

At this time there appear to be no further questions.

Dick Robinson

Thank you all for listening to our first quarter call. Obviously we are heading into our heavy period for school clubs and fairs. We are very encouraged by the terrific summer we had in trade. We are working very hard to improve our sales execution in educational publishing and to control costs and reduce expenses throughout the company. Thank you very much for your support of Scholastic.

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Source: Scholastic Corporation F1Q09 (Qtr End 08/31/08) Earnings Call Transcript
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