Scholastic Corporation (SCHL) Q2 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Scholastic Quarter 2 Fiscal Year 2012 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to turn your conference over to your host for today, Mr. Jeffrey Matthews, VP of Strategic Planning, Business Development and Investor Relations. Sir, you may begin.

Thank you, Ben, and good morning, everyone. Before we begin, I'd like to point out that the slides for this presentation are available for simultaneous viewing on our Investor Relations website, investor.scholastic.com. I'd also like to note that this presentation contains certain forward-looking statements, which are subject to various risks and uncertainties, including the condition of the children's book and educational materials markets and acceptance of the company's products in those markets and other risks and factors identified from time to time in the company's filings with the Securities and Exchange Commission. Actual results could differ materially from those currently anticipated. Our comments today also include references to certain non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in the company's earning release, which is posted on the company's Investor Relations website, investor.scholastic.com. Now I'd like to introduce Dick Robinson, the Chairman, CEO and President of Scholastic, to begin our presentation.

Thanks, Jeff, and good morning, and thank for joining our fiscal 2012 second quarter analyst and investor conference call. For this morning's prepared comments, I'm joined by Maureen O’Connell, CFO and Chief Administrative Officer. Other members of the executive team will also be available to answer questions at the end of the call. We had a strong second quarter, and remain on plan to achieve our fiscal 2012 goals. The Educational Technology and Services division recorded another quarter of double-digit growth on the strength of multiple programs including READ 180 Next Generation. This led to higher profits. In classroom and supplemental materials, solid execution in selling our reading programs led to improved results with broad sales gains and increased margins. In Children's Books, multiple best-selling Scholastic titles in print and ebooks drove higher results while we move forward with our plan to introduce the Scholastic Children's ereading app and ebookstore in early March. And we continue to generate strong free cash flow, allowing us to maintain a solid balance sheet while returning cash to shareholders. Yesterday, the board raised Scholastic's dividend by 25% to $0.50 per share annually. Now I'd like to discuss last quarter's results in more detail. In Educational Technology and Services, revenue rose more than 30% versus a year ago, driven by continued strength in all 3 key areas of the business: reading, math and services. Profits and margins rose even faster, reflecting operating leverage and a favorable mix of higher-margin technology product sales. READ 180 Next Generation continues to perform extremely well since we launched it in May with over $60 million in sales to date and more than 20% of existing district customers have now upgraded from previous versions of the program. This version gives educators greater access to powerful data on student achievement, a key factor in the high conversion rates among existing customers. More broadly, READ 180's success in the marketplace stems from the proven -- the program's proven ability to raise reading achievement for at-risk students. For this reason, we are gratified by the results of the U.S. Department of Education's 4-Year Striving Readers program published last month. The rigorous study demonstrated READ 180's ability to improve reading scores in very challenging school districts including Newark, New Jersey and the Ohio Department of Youth Services, as well as in suburban districts such as Chicopee, Mass. These carefully researched results build on positive outcomes in more than 40 other studies over the past 12 years, making READ 180 the most fully and favorably research reading intervention program on the market. Also last quarter, System 44, a tech-based phonics program, which integrates tightly with READ 180 as well as Big Day for pre-K and early childhood curriculum and Do The Math, our math intervention program, all continue to perform well with double-digit growth. In Services, too, we sustained double-digit growth last quarter including professional development and tech support. These results reflected good renewals among existing customers. In the Classroom and Supplemental Materials Publishing segment, new products and strong sales execution drove a 12% gain in sales and higher profits last quarter. In particular, we saw a strong spending by schools on paperback collections, especially guided reading program as well as sales to nonprofit literacy programs. Classroom magazines also showed strong profit gains as we successfully introduced new digital editions of our publication. In the Children's Book Publishing and Distribution segment, we achieved double-digit profit growth. In Trade, The Hunger Games is performing particularly well in print and in digital, ahead of the March 2012 movie debut. Wonderstruck by Brian Selznick has also been a seller, in addition to The Invention of Hugo Cabret, his previous book, which Martin Scorsese recently adapted as the award-winning film, Hugo, which opened on Thanksgiving. A number of other titles also are performing very well, including Walter Wick's Toyland Express, a new title in the Can You See What I See series, War Horse by Michael Morpurgo, which Steven Spielberg has adapted as a film opening on Christmas Day, and The Scorpio Races by Maggie Stiefvater, the best-selling author of the Shiver trilogy. These strong results give us optimism about Trade's outlook for the remainder of the year. In School Book Clubs last quarter, revenue declined but profits rose significantly as we reduced spending on promotion, better targeting our profitable customers. We also reduced costs in other areas including postage and distribution while continuing to provide outstanding customer service. A year ago, we offered broad incentives to support the rollout of new COOL, the company's online platform. Further refinements to new COOL over the summer yielded a better online customer experience this fall, with online ordering rising to nearly 80% of transactions. In School Book Fairs, revenue held level with the prior year with fair count and revenue per fair in line with prior. Based on current fair bookings and the spring selection of titles, we expect modest growth in the second half of the year. A key focus for the company over the past 18 months has been the digital transition of Scholastic’s Children's Book business where we have an opportunity to leverage our position as the world's largest children's book publisher and distributor to become a leader in e-commerce and ebooks. Scholastic is already a major online bookseller to teachers and students in their classrooms through Book Clubs, and new COOL has fortified this position. We are also moving forward with our plans to be a major provider of ebooks and are on plan to introduce the unique children's ereading app and ebookstore in our school channels in March 2012. Last quarter, we built a marketing plan, which leverages Scholastic's deep relationship and multiple touch points with teachers, parents and kids through Book Clubs, Book Fairs and our extensive online services. A particular focus of this plan is teachers whom we believe will be early adopters and key influencers of parents and kids. We also have completed the mobile versions of the free eReader app, which can be downloaded to iPad and Android devices in addition to the PC version. Also this fall, we continued extensive demonstration testing of the app with Book Club teachers and parents at Book Fairs. These tests have reinforced the high marks and enthusiasm we have been receiving for the software. In March, we will introduce our ereading app and ebookstore to a significant portion of our school market, leading to a broad ebook launch to our teacher and parent customers for back-to-school 2012. As we've said in the past, sales of children's ebooks are still small relative to the growing adult ebook market. We are investing ahead of the demand to stake out a leading position in a market that we believe will grow substantially in upcoming years. To partly offset our investments in these digital initiatives, we are reducing costs in non-digital areas of the company. For the full fiscal year, we expect to achieve approximately $15 million in annualized savings. In the International segment, profits increased last quarter on slightly lower sales. In Australia, sales declined following the discontinuation of low-margin product lines, but profits improved due to cost reductions. Improved performance in the U.K. also contributed to segment results. Last quarter, we moved forward with our growth plans in Asia, which remains a top opportunity given the region's emphasis on education among its expanding middle class. In addition to expanding our direct-to-consumer and school-based selling channels there, we're also building out an educational publishing operation in Singapore, which is an ideal base for this activity given the country's world-renowned education system and reputation. This team is developing print and technology-based curriculum programs with a focus on English language learning and math for sale throughout Asia and other global growth markets. Maureen O’Connell will now review our financial results for the second quarter. Maureen E. O’Connell: Thanks, Dick, and good morning, everyone. Looking at second quarter results, revenues increased 3% relative to a year ago, primarily reflecting higher sales of educational products and services to schools, as well as higher sales of children's books in retail trade channels. Cost of goods sold as a percentage of sales improved significantly by almost 200 basis points, reflecting favorable product mix, including higher ebook sales, as well as lower spending on incentives and clubs. SG&A last quarter included onetime expenses related to our cost reduction plan of $4.7 million for a voluntary retirement program. Excluding these onetime factors, SG&A in the quarter remained relatively flat reflecting lower promotion spending in Clubs, offset by higher spending on digital initiatives and sales commissions in both our education businesses. Last quarter, we also successfully sublet a significant amount of space in New York as part of our plan to streamline our real estate footprint and reduce costs. These actions will positively impact future free cash flow and earnings. However, in accordance with the relevant accounting literature, we incurred a noncash charge of $6.2 million as a result, recorded as a separate item on the income statement. Overall, earnings per share from continuing operations improved to $2.62 on a GAAP basis or $2.83 excluding onetime items, compared to $2.20 a year ago. Turning to segment results. In the Children's Book segment, revenues were relatively flat, with growth in Trade offset by a decline in Book Clubs. Our strategy for Clubs is to reduce and focuses promotion dollars on the most profitable customers. This, along with operational efficiencies, drove up Club profits. As a result of this and higher Trade results, segment operating profit was up $11.3 million. Book Fair revenue and profits were in line with last year due to timing. The outlook for the remainder of the year is positive with spring fair bookings ahead of prior year. In Educational Technology, revenues were up strongly, as were margins, as we continue to have strong product sales. Per the normal seasonality and selling cycle in this business, we expect Service revenues to be higher in the second half, reducing margins. Classroom and Supplemental Materials Publishing also had a strong quarter due to product launches and sales successes with nonprofit literacy organizations. In MLA, revenue and profits were lower due to a planned decrease in custom marketing programs for third-party sponsors. Finally, corporate overhead in the quarter included onetime, mostly noncash expenses associated with cost reduction programs of $10.9 million. Excluding these items, corporate overhead was $11.8 million versus $9.7 million a year ago. The remaining difference primarily reflects the timing of stock-based compensation in the quarter, which on a year-to-date basis, was modestly below the prior year. Looking at cash and the balance sheet. Free cash flow in the quarter was $129.6 million compared to $132.8 million last year. Cash and cash equivalents rose to $114 million from $53.2 million a year earlier, as a result of strong free cash flow over the past 12 months while at the same time we also repaid debt and returned cash to shareholders through dividends and share buybacks. We maintain a strong balance sheet with net debt of $44.4 million, compared to $178 million a year ago. Last quarter, we successfully extended our committed $325 million revolving credit facility for another 2 years until June 2014. At quarter end, we were undrawn on the credit facility. The company has opportunistically repurchased stock under our current share repurchase program. This fiscal year, we have acquired 220,166 shares of common stock on the open market for $5.6 million. As of today, we have remaining authorization to repurchase up to $38.9 million of common stock. We have also raised our regular dividend by 25% to $0.50 per share annually. Looking at the rest of fiscal 2012, we are affirming our outlook for revenues of $1.9 billion and EPS of $1.75 to $2.10, which corresponds to operating income of $120 million to $140 million. Year-to-date gains and profitability put us in a good position to achieve this guidance. This outlook assumes profits hold level or decline slightly in the second half, with higher spending on the introduction of our eReader app. We also continue to expect that this year's gains in both education businesses were largely front-end loaded. Note that our EPS and operating income excludes the impact of severance and other onetime expenses associated with restructuring actions, as well as noncash, nonoperating items. Based on our strong year-to-date improvement in free cash flow driven by working capital management, we now expect free cash flow to exceed $100 million for the year, the top end of our original guidance. With that, I'll turn the call back to Dick.

Thanks, Maureen. Obviously, we feel good about this quarter and our performance, and we're excited about the opportunities in the ebook market that we're uncovering through our testing and through our planned expansion of our ebook app and ebookstore in March. Now I will moderate a question-and-answer period. In addition to Maureen, I'm joined this morning by these division presidents: Shane Armstrong, Scholastic International; Deborah Forte, Scholastic Media; Margery Mayer, Scholastic Education; Judy Newman, Scholastic Book Clubs and E-Commerce; and Hugh Roome of Consumer and Professional Publishing. With that, let's open the call to questions. And Ellie Berger of Trade, naturally, with her good quarter. We're very happy to have her here, too.

[Operator Instructions] Our first question today comes from the line of Drew Crum from Stifel, Nicolaus. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: I want to start, Maureen, with the gross margin. It was up pretty significantly in the quarter. Is that the new run rate we should think of for the business going forward as you move more into digital and the READ 180 continues to trend higher, or should we see some degradation going forward? Maureen E. O’Connell: Drew, there was a number of things that impacted gross margin in the quarter. One was less incentives in Book Clubs and that would be largely front-end loaded because, as you know, we recruit new teachers in the early part of the year. So that will not continue through the rest of the quarters. But we did have also a benefit of product mix, which was higher educational technology sales. Again, that's product sales. And as we said in the second half of the year through the normal cycles, it'll be more service sales so it'll be less of an impact on gross margin. And then finally, ebook sales, which we expect will continue. So there will be improvement, but it will not be as significant as it was this quarter. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Got it, okay. And then moving over to the Trade business. Maybe for Dick or Ellie, the business was up 19% year-to-date. And if I recall correctly, you guys were guiding to down modestly for fiscal '12. That would imply about a 30% decline in the second half. Is there any updated revenue guidance you can share with us for that business?

Well, we're doing well in Trade and as we indicated in our preliminary remarks here, we are expecting a good second half in Trade. Ellie, would you like to amplify on that?

Sure. We're looking forward to the Lionsgate release of The Hunger Games movie in March. We have several new tie-in books coming out as well as continued publicity that’s driving the core trilogy sales, both in print and E. We also are publishing a new novel that's got an incredible prepublication buzz called The False Prince by Jennifer Nielsen that we're very excited about publishing in March or April of this spring. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: And Ellie, can you remind us the timing on The Hunger Games tie-ins? Is that a fiscal third quarter event and the number of titles you're going to be releasing?

We're publishing 3 tie-in titles in February 7. And then, we'll be publishing a fourth title that will be simultaneously released with the movie on March 23. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Got it, okay. And you guys alluded to some investments you're making in Asia, specifically to educational publishing. Any hit to margin from that, and when would you expect to see some benefit on the top line from those investments?

Well, this investment is relatively small. We’re building a dynamic, but not huge publishing operation in Singapore focusing on curriculum products, textbooks and supplementary materials as well as digital. That team is at work. We expect the results of their activity to be coming in the end of the next fiscal year. But there won't be a material impact on our profitability from this operation. But it's an exciting thing because we -- there's tremendous growth in education in Asia. We've been adapting our own U.S.- and U.K.-based material there, but there's a strong appetite for locally produced, locally conceived Asian-relevant material with a particular focus on math and language arts that we see increasing. And we're very happy to be investing modestly, but with real focus on building this capability in Singapore. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Dick, how did Asia perform in the quarter?

Shane, do you want to talk about that?

Yes. Shane Armstrong here. Asia had -- Asia performed -- has performed well over the past 6 months. The quarter was quite flat. This was partly due to floods that we had in Thailand, which were very significant. And also we had other natural disasters in the Philippines where we had multiple typhoons. Having said that, we continued to see some great sales from our direct sales business and also from Book Fairs and strong sales in India in both Book Clubs and Book Fairs. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Got it, okay. Last one for me, guys. You guys were guiding to, I think, 30% conversion rate on the READ 180 Next Generation product, is that still the guidance for fiscal '12? Maureen E. O’Connell: We haven't set a specific guidance. I think right now, we're very happy, we’re at 21% conversion and we're ahead of, I think, previous edition of READ 180, but we haven't guided for a specific number this year.

Our next question comes from the line of Barry Lucas from Gabelli & Company. Barry L. Lucas - Gabelli & Company, Inc.: Couple of items, Dick. Maybe you could just provide a little bit more color if you're 90 days away from really having the release of the eReader app. I'm sure it's been in beta test. What have you seen, what's worked, what hasn't worked and what's providing the optimism?

Well, we're optimistic because we have a great position in long-term sales of ebooks. On the Trade side, obviously, we're selling our ebooks through -- largely through Kindle, NOOK and iPad but those are consumer sales that we're not participating in the distribution of. And as you know, Barry, the key for us is our Club and Fair channels, which provide a significant amount of revenue for Scholastic that we need to sell direct to our Club and Fair customers, the ebooks that they're looking for and they're looking to us to provide. So our tests continue to focus on the school channels and our launch is going to be a very significant expanded test to a large portion of our market. But we're -- it's not an all-out consumer test or launch that we're providing. What we've learned is that the teachers love our ereading app. They want to bring it to their children and to their parents. We've learn that the parents, through Book Fairs, are expressing great excitement about ebooks, but not very much knowledge of exactly how they want to get those ebooks. So they're looking to us to provide them with the guidance, direction and the application that's going to enable them to download ebooks to their current devices. Obviously, there's a lot of interest in the new devices, the Kindle Fire, the Color, the NOOK tablet, et cetera. But the market, as has been pointed out by others, for children's books is developing rather slowly and it's somewhere between 1% and 4% of the total of children's books sold right now, so we believe we have some time to further refine and test our ebook application and the ebookstore and then point to a launch in the back-to-school fall of 2012. Barry L. Lucas - Gabelli & Company, Inc.: Okay. Anything further you can say about MATH 180? I know it's -- we're still a ways away, but how's the development going?

Well, Margery’s been doing -- has had a great 6 month here, so I'm sure she'd be -- love to tell you about what she's doing and including a comment on MATH 180, Barry.

Barry, it's Margery. So MATH 180’s coming along really, really well. We have, I think, a very exciting product that's under development. We've been spending time with doing some testing with kids of the ideas and a lot of interfacing with teachers and also our authorship team. And our math business, overall, is doing extremely well. Our acquisition of Math Solutions has been -- exceeded our expectations in terms of the strength it's brought us in terms of our math knowledge and math depth. And our overall -- and our math products that we have now are selling well. Do The Math now has had tremendous growth for us. We've sold it in every -- all 50 states now. And we've also added math specialists in all of our regions. So we're -- we not only have the product under development and feel good about it, but we also feel good about the capacity we're building in the field to sell and support math. Barry L. Lucas - Gabelli & Company, Inc.: Great. One last area, Dick, and not to beat this to death, but you've increased the dividend 25%. You've started to nibble back at the stock in open market purchases and you've raised the free cash flow guidance to north of $100 million but not willing to budge on either revenues or earnings guidance. So you're optimistic in a lot of ways except for a few, so maybe you could explain that a bit.

Well, we're happy that we're returning cash to shareholders and we're continuing to do that, and we expect to continue to do that. Obviously, Barry, the cash, we're doing extremely well with it. There are 2 areas where we could expect to need cash. One is in our ebook expansion of selling directly to our customers. The other would be any acquisitions that might appear that we think are relevant to the educational technology sector. We've talked about those before. I'll ask Maureen to talk a little bit about the working capital. But obviously, we're excited about what we're doing. We've got the resources to move ahead on a number of fronts. We're being sensitive to returning cash to shareholders, but we don't -- we're basically wanting to expand the company as well. So I think that's our outlook. We're feeling good about what we're doing. We don't want to raise the guidance at this point because we have – well, we're happy with where we are. We know that a lot of things are changing in our marketplace, and we don't want to be overly optimistic. But we do believe we can make our current targets nicely. Maureen E. O’Connell: And as far as our cash guidance, we're raising it because we have done extremely well in working capital management. In the first half of the year, we've benefited significantly from the growth in Margery's service businesses and we collect that cash, as you know, ahead of revenue. So that is front-end loaded. In the second half of the year, we will have to increase our purchases of inventory for our Book Fairs because we were particularly low in inventory last year in the spring quarter and we feel it was a disadvantage. And so we're going to increase our inventory and our selection in the spring fairs and so we will be spending more in inventory in the second half. But we are benefiting in working capital and that's why we're confident in both raising the dividend, buying back significant amount of shares in the quarter as well as raising our guidance.

But Barry, I don't often have to enhance what Margery says but I wanted to underline the fact that MATH 180 is moving very nicely right now. We've really got a team together. She's pushing them pretty hard to develop MATH 180 and its book’s shaping up to be a really exciting product that we're very, very proud of. So that’s just a progress report, I know you care about this. But we care just as much as you do, and we're excited about the progress we're making.

[Operator Instructions] Our next question comes from the line of Dennis Barrett from Sidoti & Co. Dennis Barrett - Sidoti & Company, LLC: I just wanted to ask about funding and how you see the landscapes, both at the state and federal level especially in 2013 with the threat of across-the-board cuts. Do you consider Title I and IDEA to be at risk in any way?

I'll turn this over to Margery, Dennis, but we're pretty positive about funding for education. It’s been expanding. If you look back over the past 12 years, there's significant expansion of both federal and state spending on education. This is a long-term deep trend for our country. We have to do it. We have to prepare those kids. We're committed to it as a country, and I know we're going to find the money to be able to continue that investment despite the ups and downs of the political scene. But Margery can address this more specifically.

So obviously, we have our eye on what's going on with funding. But it's our belief that because we focus on intervention and we focus on children who are in most need of support from school, that funding will be focused on those schools no matter what happens with the Presidential race. So we feel that we're in a good position to continue to get federal funding for our products. I just want to say, in addition, that we think that our business continues to gain share overall and that, that's going to be important for people going -- for successful companies going forward. There's both physical funding issues and there’s psychological funding issues. And if you talk to educators, they are feeling pressure. So our message to our sales force is that we need to be sure that there's money in the schools. There's no question about it. There's funding to support children in need and that we need to get increased share of it, if that's what it takes.

And with no further questions in queue, I would like to turn the conference back over to Mr. Robinson for any closing remarks.

Well, thank you, all, for your support. We're very proud of what we have done in the quarter. But more important, there are long-term trends that we're addressing in our Educational Technology business, in our ebook expansion and in our core supplementary and Children's Book businesses. We've had a great quarter in Trade, we expect to continue that. We're happy for your support, and we expect a good performance in the balance of the year. Thank you so much.

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program, and you may all disconnect. Have a great rest of the day.