Scholastic Corporation (NASDAQ:SCHL) F4Q09 (Qtr End 05/31/09) Earnings Call Transcript July 23, 2009 8:30 AM ET
Jeff Matthews - IR
Dick Robinson - Chairman, CEO and President
Maureen O'Connell - EVP, Chief Administrative Officer and CFO
Margery Mayer - EVP and President, Scholastic Education
Drew Crum - Stifel Nicolaus
Good day, and welcome to the Scholastic 2009 earnings conference call. Today’s call is being recorded. For opening remarks and introductions, I would like to turn the conference over to Mr. Jeff Matthews. Please go ahead, sir.
Thank you, Lory. Good morning, everyone. First, I would like to apologize for the technical delays. Then, I’d like to say that before we begin, the slides of this presentation are available for simultaneous viewing by going to our Web site, scholastic.com, clicking on Investor Relations, and following the link from that page.
I’d also like to note that this presentation contains certain forward-looking statements, which are subject to various risks and uncertainties, including the conditions of the children’s book and educational materials market, the 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.
Thanks, Jeff. Good morning, and thank you everyone for joining us on our fiscal 2009 year-end conference call. I’m joined by Scholastic’s CAO and CFO, Maureen O’Connell, and by Margery Myer, President of Scholastic Education. Other members of the executive team will be available for Q&A at the end of this call.
This morning we will present our plan to grow profit and free cash flow substantially, which if realized will enable us to reach our long stated goal of 9% operating margins in fiscal 2010. Before that, we will review our solid fiscal 2009 results.
First, Scholastic held revenue approximately even with prior year, excluding fiscal 2008’s extraordinary benefit from the final book in the Harry Potter series and the negative impact of foreign exchange. Solid sales demonstrated the continued support of our customers in a difficult economic environment. And children’s book sales declined just 2%, compared to larger declines for the major booksellers. We achieved these results by driving strong customer participation and engagement, which mostly offset lower order in transaction sizes in clubs and fairs. This pattern held in the fourth quarter.
In education, our successful strategy of partnering with schools to raise student achievement helped us significantly outperform a challenged market, where industry-wide sales declined by double digit percentages in the quarter due to continued pressure on state and local education funding. After a weak start last summer when we concluded a major reorganization of our sales force, revenue from educational technology held even for the remainder of the year, with strong sales of services and the successful launch of System 44 and other programs such as Do The Math.
In the fourth quarter, Ed Tech and Services continue to outperform the market. As we’ll discuss in a moment, we did not see any material benefit from Federal stimulus funds until the first quarter of 2010. We also had areas of strength in other segments, including in Asia consumer magazines and Scholastic entertainment, each of which had strong revenue and profit increases.
Second, we substantially reduced costs and overhead as well as in manufacturing and supply chain. We took steps to reduce salary expense and headcount, eliminating over 500 positions last year. Though much of this benefit was offset in fiscal 2009 by one time severance costs, we began fiscal 2010 with annualized salary expense reduced by more than $30 million from a year ago.
Third, we exited unprofitable and non-core businesses. We completed the sale of Scholastic at Home, and have now discontinued 10 non-profitable divisions in the last six quarters.
Fourth, in fiscal 2009, we reduced net debt by $74 million to just $160 million, our lowest year-end level in more than ten years. In addition, we took the non-cash asset rate write-downs, including goodwill and investments in the UK to reflect the current market environment.
Overall, these accomplishments enable us to deliver fourth quarter earnings level with the prior year, and to achieve guidance for EPS, and to exceed free cash flow guidance for the year. We now begin fiscal 2010 with the reduced cost structure, a leaner portfolio, and a stronger balance sheet. To achieve our strong earnings outlook for $1.80 to $2.30 per diluted share from continuing operations before one time and non-cash items, we have a three-point plan to improve operating income by $30 million to $70 million, which includes and equates to 9% margins if we reach the upper end.
In children’s books, our largest segment in terms of revenue, we have taken steps to improve margin and drive a modest revenue growth. First, following last year’s gross margin improvements, we continue to raise prices slightly in school book clubs and fairs, while maintaining our strong value proposition. If done carefully, price increases continue to be feasible even in the current economic climate because our books have historically been under-priced relative to retail.
Second, we’ve also improved gross margins by producing more Scholastic titles for use in our clubs and fairs while consolidating the purchase of books from other publishers. This should reduce our cost of products beginning in the fall, and in the long term increase the share of Scholastic products sold in our channels, generating further costs and strategic benefits.
Third, the strong support of our customers last year sets the stage for modest growth in fiscal 2010. In clubs, to increase classroom order size, a strong marketing campaign directed at teachers and parents is expected to drive more parent ordering online through the existing COOL platform. Meanwhile, we’re continuing to improve new COOL, our enhanced ordering system, which is currently being tested 80,000 active customers and will be rolled out over the next year.
In fairs, we plan to maintain revenue for fair growth with further improvements in merchandising and participation, most likely increasing the number of fairs held. One contributing factor is new point-of-sale technology, which will be rolled out in two regions in the fall after a successful large scale pilot this spring. This technology provides timely sales data and automates the sales process permitting more credit card ordering. Long term benefits of POS include better merchandising and inventory process, in improvements in loyalty programs and gift cards as well also reducing shrinkage.
In trade, we have a strong publishing list including, additional titles in the 39 Clues series, which I’ll speak about in a moment. The release last week of Harry Potter and the Deathly Hallows in paperback coincides with the new Harry Potter and the Half-Blood Prince movie, boosting HP sales this year. Together, these initiatives in children’s books will provide a key portion of the $30 million to $70 million profit improvement in our fiscal 2010 plan.
I’ll now ask Margery Mayer, President of Scholastic Education, to comment on the second key element of our fiscal 2010 plan, which is to drive substantial growth in educational publishing with the help of stimulus funding.
Thanks, Dick, and good morning, everyone. The passage of the American Recovery and Reinvestment Act in February was cause for great excitement in the education community, and among those, like Scholastic, can serve that community. Although there are some companies who worry about just how much of the almost $100 billion is going to flow in the districts for new products and services, we are not among them. ARRA basically doubles available funding for our key products through increases to IBA and Title-1. Additionally, the fact that schools know they will be receiving stabilization money and other additional funds has led them to loosen the purse strings, which they held so tightly at this time last summer.
We are tracking sales that we believe are tied to ARRA and have already seen good results. Between June 1st and July 17th, the first seven weeks of fiscal 2010, sales of educational technology in classroom books, which are the key areas we expect to benefit from ARRA, increased more than 40%, compared to last year.
We can link much of this increase to stimulus funding and the further improvements in our sales capability. In fact, we are seeing particular growth among larger contracts as our sales force expands existing opportunities with stimulus funding. Because of this, we believe we are well positioned to take advantage of the direction laid out by the Obama administration. They have told schools to use stimulus funding for programs and services that support innovation, that encourage data-driven instruction, and help develop human capital. All of which matches the business we have established with Read 180 at the center.
Our research-based products, including Read 180, System 44, and FASTT Math, and our ability to partner with school districts have already made us the market leader in curriculum technology. Traditional programs have difficulty moving the needle at scale, and the educators largely recognize this. They realize that technology based on research and implemented well is essential for providing students with the individualized learning that meets their needs and engages them. And our programs, proven to work in numerous third party studies, are recognized for their effectiveness.
Early on, we’ve realized that technology cannot be sold the same way text books are. To use technology effectively, school districts require extensive service, technical support, and professional development. And we have evolved a unique solutions selling approach to support districts. Hence, the new administration’s guidelines are things we’ve been promoting for some time, and we firmly believe that our new products, services, and enhanced selling strategy should enable us to achieve our goal of $100 million in sales from the stimulus funds over the next two years, and approximately $50 million of that will come in fiscal 2010.
Well, thanks. As Margery’s described, we already have a strong start in the first seven weeks of this year with 40% gains over last year. This gives us confidence we can achieve our $50 million goal in fiscal '10 for incremental sales of higher margin educational technology, consulting services, and classroom books. This is the second key element of our plan to improve operating income by $30 million to $70 million.
The third component of our fiscal 2010 plan is further operating improvements and costs reductions. We began this year with salary expense reduced by $30 million from a year ago. Approximately half of this was realized last year, giving the staging of headcount reductions, but offset by severance and one time expenses. In fiscal 2010, we expect the full year benefit of these savings. In addition, we have taken further steps to improve efficiencies.
In school book fairs, we've reduced the number of regions from 14 to 7, and are moving to a hub-and-spoke model, where hubs will handle centralized activities including re-stocking, labor planning, and scheduling and inventory management. Branches will focus on sending and receiving fair cases to schools. This has already resulted in headcount and salary savings, and over time, will improve labor efficiencies and reduce inventory levels.
In clubs we are reducing promotions spending relative to higher fiscal 2009 levels, when we increased investment in customer retention. Fiscal 2010 promotion spending should be approximately in line with two years ago, fiscal 2008.
In the UK, we will expand revenues in clubs and reduce operating costs in fairs, in response to a soft market in that country and disappointing fiscal 2009 results. Further consolidation of facilities and staff will result in additional savings that we expect will involve a one-time charge in fiscal 2010. We've also consolidated Internet backend operations to lower costs, as well as outsourcing some overhead functions.
Finally, we have moved to reduce SG&A costs, including overhead salaries and marketing across our business. Cost savings we've already achieved, plus additional actions in place for 2010, are the third lever that should allow us to achieve our target for $30 million to $70 million in incremental operating income this year.
The 9% to 10% operating margins are a long-stated goal for the company and the number one focus of our fiscal 2010 plan. However, we continue to pursue key strategic opportunities, which will help drive long term growth on this year's more profitable base business.
First, we continue expanding our sales online where we had over $370 million in revenues last year, and ranked as the third largest Internet book seller. In addition to being the channel for selling print and physical products, the strong online relationship with our customers also positions Scholastic to distribute digital content and to become a leader in children's e-books.
As of today, however, this market is still nascent compared to the recent activity and buzz surrounding e-books for adults. This reflects differences between the adult and children's book market, and especially how kids, with the help of their parents and teachers, read and use books. Right now, we are building on our 15 years of experience as a provider of digital content and as a marketer of -- through the Internet to create a children's e-book business, which will be important to our long term growth. We will begin market tests in calendar 2010, and we'll discuss our strategy further in the upcoming quarters.
Second, we're already the leader in a new form of publishing that combines traditional print and online, leveraging other media, gaming, and online communities. The multi-platform The 39 Clues remains a New York Times bestselling series following last years' successful launch. So far, sales of each new title have outpaced prior ones as the community for this multimedia franchise continues to grow in print and online. Six titles remain to be published in the series over the next 13 months.
Third, we continue investing to strengthen and broaden our portfolio of market leading educational technology and services, as Margery just got through explaining to you. This expands our opportunity to serve schools with ARRA funding today, and will drive growth on a significantly larger customer base post stimulus. We launched two significant new products, System 44 last December and Expert 21 will come later this summer. Combined with our flagship reading intervention program, READ 180, this prequel and sequel programs make up a comprehensive tiered literacy solution, which we round out with consulting services and assessments. We’re making investments to in new web-based programs and expanded services in consulting, and increasingly in Math where we show growing strength.
Our fourth strategic growth opportunity is serving middle class families around the world, who want their children to learn English. Asia, including India, was a bright spot for us last year in spite of currency declines and economic difficulties for consumers in that part of the world. We’re expanding on our strong base in this region, including building our English language schools in China.
So online selling, more digital products for consumers and schools, continued leadership in educational technology, and growth in Asia, these are four major growth opportunities for Scholastic. We are pursuing these vigorously, as we remain focused on margin and profit growth in 2010.
Now, I’d like to ask Maureen O’Connell to discuss a further element of our plan, maintaining tight controls on cash and working capital to maximize free cash flow and further improve our already strong balance sheet. She’ll then review fiscal 2009 results and provide a detailed outlook for 2010 before I conclude the morning’s comments and open up the call to questions.
Good morning, everyone. As Dick has discussed, we have a three-point plan to increase operating income by $30 million to $70 million and to achieve our long term goal of 9% operating margins if we reach the high end of our guidance range. We are also committed to maximizing the conversion of income into free cash flow. In fiscal 2010, we continue to strictly manage working capital and our focused on reducing inventory levels, especially in book fairs. This will be aided by the region consolidation that Dick discussed.
We will also continue to tightly control cash spending with capital, pre-publication, and production spending expected to be flat in fiscal 2010, while we maintain investment and strategic growth areas, including educational technology and e-commerce. We entered the new fiscal year with $325 million in uncapped liquidity under our revolving credit agreement, and are projecting another strong year of free cash flow in fiscal 2010. This will enable us to further reduce debt, pursue opportunities, and enhance shareholder value.
Before going into our fiscal 2009 results from continuing operations, I want to detail a number of items last year that affected the comparison with 2008, as detailed on this slide.
First, in SG&A, we incurred $19.9 million in net one-time expenses and gains. This primarily reflects $20.3 million in non-reoccurring severance and expenses related to our cost reduction programs this year. On a segment basis, these expenses show up in corporate overhead. Additionally, there was a small net non-cash benefit related to pension accruals and SG&A. Second, as a component of operating expenses, we impaired certain assets by $18.4 million, primarily UK goodwill, as we discussed on our third quarter call. Third, below the operating line, we recorded a non-cash unrealized loss on a minority investment in the UK book distribution business of $13.5 million, reflecting the difficult climate in UK publishing. Fourth, in the tax line, we backed out tax benefit of these one time adjustments.
Now, looking at adjusted results, revenue was approximately flat, excluding year-over-year differences in Harry Potter sales and $62.5 million in negative foreign exchange impact in fiscal 2009. In fiscal 2008, when we published Harry Potter and the Deathly Hallows, we broke records with sales of $270 million. In comparison, in fiscal 2009, we had Harry Potter sales of $35 million, half of which were from the Beedle the Bard, a Tale by JK Rowling, whose profits went to her charity.
Cost of goods sold declined as a percent of revenue in fiscal 2009, reflecting higher Harry Potter related expenses in the prior year. SG&A also declined last year by approximately $44 million, excluding non-reoccurring severance. This reflects higher Harry Potter related expenses a year ago and lower salaries, outside services, and T&E Expenses following our cost-reduction programs in 2009. Improved selling efficiency in the education businesses also helped SG&A.
As Dick discussed last year, over 500 positions were eliminated. And by the fourth quarter, salary and benefit expenses were down $8 million, with $30 million on an annualized basis. Because most headcount reductions occurred in the second half of the year, we achieved approximately half of this yearly benefit in fiscal 2009.
Bad debt expense increased year-over-year, reflecting both higher bad debt reserves in the trade business and in book fairs, as well as a favorable prior year collection in classroom magazines within education.
On an adjusted basis, the company’s tax rate in fiscal 2009 was approximately 45%, compared to 37% in the prior year, primarily reflecting losses in foreign operations, for which we do not expect to realize benefits.
Overall for the year, adjusted earnings from continuing operations were $47.9 million or $1.28 per diluted share compared, to $117.3 million or $2.99 per diluted share a year ago. Again, this primarily reflects the extraordinary benefit of Harry Potter in the prior year, which was the company’s most profitable Harry Potter release. The current year was also affected by negative foreign exchange impact and greater losses in the UK.
Now, turning to discontinued operations, last year we continued to review our portfolio businesses and exited several unprofitable non-core businesses, including the Australian continuity business in the fourth quarter. These businesses were all reclassified as discontinued operations. We recorded $30 million in non-cash asset write-offs, in addition to $32 million in operating losses from these businesses in fiscal 2009. This compares to non-cash asset write downs of $153 million and operating losses at $53 million in fiscal 2008. In fiscal 2009, we also sold a non-course school marketing company for $29 million in cash, and recorded a $22 million gain, partly offsetting these losses in discontinued operations.
Now, let’s discuss cash. Free cash flow for the year was approximately $84.9 million. We exceeded our guidance at $55 million to $80 million due to tight working capital management and conservative spending. This compares to $185.6 million in the prior year period, again as a result of that year’s Harry Potter sales. Total debt was $303.7 million at year-end, down from $349.7 million 12 months earlier. In fiscal 2009, we made $42 million in principal payments towards the company’s amortizing term loan and repurchased $2.5 million in public debt.
Cash and cash equivalents at quarter end was $143.6 million, compared to $116.1 million a year earlier. As Dick stated, the company’s net indebtedness was at the lowest level in over ten years at the end of fiscal 2009.
Now, to recap our fiscal 2010 plan. We are targeting $30 million to $70 million in incremental operating income from, one, improved gross margins and modest revenue growth in children’s books; two, $50 million in incremental high-margin sales of educational technology consulting services and classroom books due to the stimulus funding; and three, cost reductions and efficiency improvements in book fairs, book clubs, UK, and overhead functions building on the $30 million in salary reductions achieved last year.
On a continuing operation basis, this plan is expected to yield total revenues of approximately $1.8 billion to $1.9 billion, and earnings per diluted share of $1.80 to $2.30. At the top end of our range, this outlook corresponds to an operating margin of 9%.
Note that the EPS outlook excludes the impact of any severance or one time items associated with cost-reduction or non-cash, non-operating items. We expect to incur one time costs related to restructuring the UK, including reducing footprint and staff reductions. We will provide further updates in the coming quarters. We expect free cash flow of $90 million to $120 million in 2010, capital expenditures will be between $45 million and $55 million, while pre-publication and production spending is expected to hold at $50 million to $60 million.
Our outlook currently includes normal course severance of approximately $0.15 per diluted share or $8 million, in line with last year. Stock based compensation expenses expected to be approximately $0.20 per diluted share after tax next year, compared to $0.16 per diluted share in fiscal 2009. Based on our share repurchases with fiscal 2009, our forecast is to have approximately $37 million shares for the year on a fully diluted basis.
With that, I’ll turn the call back over to Dick.
Thanks, Maureen. We have a solid fiscal 2010 plan which we expect to execute well, delivering $30 million to $70 million in incremental operating income and reaching our long-term goal of nine percent margins, while significantly growing free cash flow.
Now I will moderate a question-and-answer period. In addition to Maureen and Marjery, I’m joined this morning by Ellie Berger, president of Scholastic Trade; Deborah Forte, president of Scholastic Media; Judith Newman, president of Scholastic Book Clubs; and Hugh Roome, president of Consumer Magazines export in Asia. With that, let’s open the call for questions.
Thank you. (Operator instructions) And we’ll go first to Drew Crum with Stifel Nicolaus. Please go ahead, sir.
Drew Crum - Stifel Nicolaus
Great. Good morning, everyone. I wanted to start with those fourth quarter earnings number. Just want to get some clarification on the $0.82 you reported. Does that not or does it include the $0.17 tax benefit that was noted in the press release?
Maureen? You’ll take that one from Drew?
Sure. When we estimated our UK -- when we rode off the Goodwill and the UK and the investments in the UK, we estimated tax benefits in the third quarter. It turned out we can deduct more of that and so we took that as a deduction to our EPS this quarter. So it’s actually a reduction of our benefit in this quarter. So we had higher earnings from continuing operations before that tax adjustment.
Drew Crum - Stifel Nicolaus
Okay. And Maureen, looking to 2010, which would we be using for an effective tax rate?
I’d say between 43% and 45%.
Drew Crum - Stifel Nicolaus
Okay. And it looks like you guys are really getting some traction with the federal stimulus year-to-date, some encouraging result. I wanted to ask you what your assumptions are outside of revenue from a federal government. There’s some concern at the state in local level and I know that’s a piece of your business as well. How do you factor that in to your outlook for fiscal 10?
Well, it’s a good question, Drew. I’ll ask Margery to answer it more detailed. Our plan here was always to have a level of growth in our core business in fiscal 2010. On top of which, the incremental $50 million that we discussed for ARRA and aid stimulus. However, Margery can give you a little more color on that particular issue which you raised, the local budget’s weakening.
So Drew, good morning. How are you?
Drew Crum - Stifel Nicolaus
Good morning. Good.
Well, I’d have to tell you that I have to contain myself because we’re pretty excited about what we’re seeing in the education market right now. We are tracking our opportunities by whether or not we feel that there’s stimulus or whether we feel that they’re what we call our core based business and both of those categories are up. And what we’re seeing, I think, is that even if school districts don’t have their stimulus money already, they see it coming. And so they’ve loosened up their money and they are spending.
So with every indicator we’re looking at right now is in a positive direction. We’re seeing more large orders. Our large orders are larger than they were last year. We’re just really, really honestly excited about the opportunities out there.
Now, a lot of this reflects the work that we’ve been doing in terms of building our businesses, a technology business with a complete set of services that come with it. Many of our large orders have a large percentage coming from services and we have a lot of renewals of services. We just -- we’re thrilled, so far. But we’re always got our fingers crossed that it keeps going.
Drew Crum - Stifel Nicolaus
Okay. And somewhat related to that, what is your exposure to California, is there a way to quantify that?
Actually, one of the good things going on for us right now is California. We’ve got a lot of large orders from California in the last few weeks. Read 180 is listed in their intervention adoption, which puts it in the category of categorical funding that isolates it somewhat from the budget woes. And we see more business coming in from California this summer than we’ve seen in a long time.
Drew Crum - Stifel Nicolaus
Okay. And given the budget crisis there and the cuts to education, would that in any way impact the book fair events that you hold in the state?
Well, actually, in some ways it’s counter -- it goes counter to the funding trends. If the school gets cut back, often the parents will come in and want to spend a little bit more of their own money to help support the school, which is a book fair of course, where it helps the child to get more reading through the clubs and our fairs. So there really is no direct correlation between school spending and revenues from clubs and fairs.
Although, there is probably a positive correlation in that we do better often when schools are having more difficulty because they seek more opportunities for fund raising to develop school-based funds and the parents want to contribute a little bit more to their child’s education.
Drew Crum - Stifel Nicolaus
Okay, great. And then just one more question, the margin target for 2010 looks to be a range of 7% to 9%, previously it was 9% to 10% which obviously, 7% to 9% would be a significant increase over the fiscal year 9. But just want to get a sense as to what the change agent is there driving what seems to be a lower EBIT range for you guys?
Well, we laid out our three-point plan, Drew, which shows three buckets of profit improvement which at the top end of the range would lead us to 9%. So it’s a difficult economic time and we don’t see any great change in parent purchasing capability this fall from last year.
So we’re obviously being conservative in the range. Our goal remains to hit the top end of the range but the economics are not altogether favorable and we’re -- we believe that there could be some shortfall on that. But our goal remains at 9%.
Drew Crum - Stifel Nicolaus
Okay. Thanks, guys.
(Operator instructions) And that does conclude our question and answer session. At this time I’d like to turn the conference back over to Mr. Dick Robinson for any additional or closing comments.
Well, we thank you all for your support during fiscal 2009 which we believe we did some very good things to position the company for our 2010 plan. We outlined the ways that we are expect to add $30 million to $70 million of operating income and we’re on the way to executing that plan. We appreciate your continued support and interest in Scholastic, and we will be working for you for this school year. Thanks so much.
And that does conclude today’s conference. Thank you for your participation.
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