Scholastic Corporation (SCHL) Q1 2013 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Scholastic's First Quarter Fiscal Year 2013 Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Jeff Matthews, Vice President of Corporate Strategy, Business Development and Investor Relations. Sir, you may begin.

Thank you very much, 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 at 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 include certain references to certain non-GAAP financial measures, as defined in Regulation G. The reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in the company's earnings release, which is posted on the Investor Relations' website at investor.scholastic.com. Now I'd like to introduce Dick Robinson, the Chairman, CEO and President of Scholastic, to begin our presentation.

Thanks, Jeff. Good morning, and thank you for joining our Fiscal 2013 First Quarter Analyst and Investor Conference Call. For this morning's prepared comments, I'm joined by Maureen O'Connell, CFO and CAO. Other members of the executive team will also be available to answer questions at the end of this call. In line with our fiscal 2013 plan, we addressed 2 key growth initiatives last quarter. We moved forward with Storia, which is our platform for ereading and ebooks and more broadly, for delivering digital content to classroom teachers and their students. We also accelerated the development of 3 major educational technology programs, which will be launched next summer, generating sales in fiscal 2014. These investments will drive long-term profitable growth beginning next fiscal year. As expected, revenue and profits declined this summer compared to last year's very strong first quarter when we benefited from new product launches and substantial sales through Reading Is Fundamental before its funding was substantially reduced. This year faced with uncertainty about federal funding and the upcoming Common Core, school districts, delayed product purchases, I'll discuss shortly. Nevertheless, free cash flow was considerably stronger than a year ago, as we continued to collect on last spring's very strong trade sales. We ended the quarter with an exceptionally strong balance sheet. In the second quarter, which we're in now, the key period for our School Book Clubs and Fairs, we remain focused on carrying out our marketing and sales plans, and based on our current outlook, we are affirming our fiscal 2013 guidance. Now I will discuss our operating results, investments and outlook in more detail, beginning with Children's Books. Last quarter's Scholastic's Trade Publishing continued its record of critical and commercial successes, as we prepared the School Book Club and Fair businesses for a strong back-to-school season. After a phenomenal run last fiscal year, all 3 titles in Suzanne Collins masterful trilogy of The Hunger Games, continued to top best seller list throughout the summer. U.S. sales of the series held level compared to a year ago, and grew abroad and in audio formats, contributing to higher profits in international and media segments, respectively. We moved forward with an exciting new multi-platform series called Infinity Ring, and launched the latest book in the best-selling Captain Underpants Series, Captain Underpants and The Terrifying Return of Tippy Tinkletrousers! which has already hit best seller list in the first week of publication. And looking ahead, we have great new publishing coming, including this week's release of The Raven Boys, the first titled in a new series by best-selling scholastic author, Maggie Stiefvater. Later this fall, we publish new titles in both 39 Clues and the Infinity Ring series. While it's too early to have visibility on sales trends in Clubs and Fairs, we believe these businesses are also positioned for solid results in the new school year. In Clubs, we have taken steps to improve profits with additional promotion spending, targeted to our most productive customers both off and online, and more than 80% of our customers are now ordering online in Clubs. In Fairs, bookings are on track to achieve Fair counts above last year, and based on successful programs to drive family participation, we continue to target modest revenue for Fair growth. Over the summer, we also prepared to launch Storia, our children's ereading app and ebook system through Clubs and Fairs, which are now underway with the fall school openings. Having built Storia as a platform for distributing ebooks and classroom materials, we're using our position in the classroom to help teachers introduce ebooks and ereading to their students and to provide them with the support that will enable them to make ereading successful. In addition to Storia's age-appropriate dictionaries and ebook enrichments, which provide an engaging and interactive reading experience for kids, both teachers and parents want Storia to help track what and how kids are reading. We have incorporated their feedback into our new reading progress dashboards, which will be rolled out in Storia later this fall. In our early test of Storia, teachers are truly excited to bring Storia to their students, where they believe they are bringing a new medium for reading, which kids find easy to use, is fun and motivating. As we help teachers use Storia with their students in the classroom, children also want to have Storia ebooks available for use at home. So they are showing their parents how the Storia app and ebooks can be downloaded through Clubs and Fairs. Storia also offers teachers and parents an easy way to communicate around children's reading as the ebook and the information in Storia can easily be shared by both teachers and parents, as well as with the children themselves. The free Storia app is now available for the iPad, PCs and Android tablets, with over 2,000 Storia ebooks available, including Harry Potter, The Hunger Games and 39 Clues, as well as about 350 enriched titles. For back-to-school, we are promoting Storia broadly to teachers through School Book Clubs, expanded demonstration in School Book Fairs, where families have been reacting enthusiastically after experiencing Storia first hand. Our salespeople are also introducing Storia as a platform for school-wide purchases of ebooks. As we have said before, there currently is a great opportunity for Scholastic to leverage our leading position as a distributor of children's print books through Clubs and Fairs, and to expand our position in the emerging children's ebook market. For this reason, we continue to invest in product development and marketing for Storia in fiscal 2013, but we do not expect to drive significant revenue until fiscal 2014 at the earliest, but kids and teachers are loving Storia. In Scholastic's education businesses last quarter, we accelerated our expansion of new products and services while results declined, reflecting tough prior year comparisons and lower spending by school district. In Educational Technology and Services in the summer of 2011, we achieved significant sales of the then newly released READ 180 Next Generation, which aren't expected to recur in this year's first quarter. Many school districts are also concerned about potential cuts in the federal budget and the upcoming Common Core State Standards, and held back funds this summer, delaying purchases of products. Higher demand last quarter for educational service offerings, both supporting the installed base of READ 180 customers and helping school districts prepare for the new standards indicates that Scholastic is well-positioned to grow product sales, as schools gain more clarity around federal funding for the current school year, and also begin implementing the Common Core. We are responding to these needs with more messaging and outreach around how our products and services will support the Common Core and more investment in national and state-level sales efforts. We are confident that these actions will help drive growth and even in the current environment. Building on our success with new product launches last year, we have accelerated development and expanded marketing plans for 3 new Common Core align programs, which we launched in fiscal 2014. First, there is MATH 180, a groundbreaking research-based math intervention program that builds on the strengths and success of READ 180, highly adaptive and data-driven, it incorporates compelling content to engage students, as well as extensive professional development in classroom support to make teachers successful. We believe this long-awaited program will meet a critical need among the many middle and high school students who are struggling with math. Second, next summer, we'll launch iREAD, a technology-based literacy program for primary grades. We are developing iREAD with some of the best experts in the field of early childhood literacy, which is a growing focus in U.S. schools. Third, we will launch a major new next-generation version of System 44, our foundational technology-based reading and phonics program as a prequel to READ 180 Next Generation. Last quarter, the Classroom and Supplemental Materials publishing segment also faced delayed spending by school districts on products. However, the year-over-year declines in sales principally reflected the strong prior year when we closed significant contracts with Reading Is Fundamental prior to the expiration of federal funds for that program. Looking ahead, we are optimistic about new Common Core align nonfiction, guided reading and middle school programs that we are launching this year. With that, Maureen O'Connell will now review our financial results for the first quarter. Maureen E. O’Connell: Thanks, Dick, and good morning, everyone. Let me begin with the income statement. For the first quarter, revenues decreased 8% relative to a year ago, primarily reflecting lower sales in Educational Technology and Services and Classroom and Supplemental Materials. Cost of goods sold increased as a percent of sales due to a decline in higher-margin educational products. SG&A was approximately flat, excluding onetime expenses of $2.1 million related to a cost reduction program in the prior year. Bad debt improved due to higher collections. Our income statement -- our income tax benefit improved, reflecting lower valuation reserves in the current period related to U.K. profitability. Overall, the loss per share from continuing operations was $1.02 compared to a loss per share of $0.81 a year ago. Turning to segment results. In Children's Books, first quarter sales decreased, reflecting a decline in trade sales of the Harry Potter series compared to a year ago when retailers restocked before the release of the final movie in the series. U.S. sales of the Hunger Games held level, though decreased substantially from the fourth quarter of 2012 as expected when the sales of the series reached their peak. Results are not meaningful for Book Clubs and Fairs this quarter since schools are not in session. Profits in Children's Books decreased due to increased spending on digital initiatives, including Storia and e-commerce. In Educational Technology and Services, revenues and profits declined in the first quarter, reflecting strong sales of new products in the prior year and delayed spending on products by school districts in the current quarter, partially offset by higher service sales. Classroom and Supplemental Material Publishing sales and profits declined as expected due to the expiration of RIF funding, which benefited the prior year. International revenues were up in the first quarter due to higher sales in the U.K., Canada and foreign rights, partially offset by a decline in Asia and an unfavorable FX impact. Operating profit was up, reflecting the quarter's strong sales. Revenue in Media, Licensing and Advertising was up primarily due to strong audio sales of the Hunger Games. As a result of higher sales and lower pre-pub amortization, operating profits increased as well. Overhead, excluding VRP [ph] charge in the prior year, was flat. Looking at cash in the balance sheet, free cash flow in the quarter was $4 million, improving significantly from a use of $68 million last year. The year-over-year improvement in cash used was primarily related to receipts from last spring's sales of the Hunger Games and lower inventory purchases. As a result of strong free cash flow in the quarter, cash and cash equivalents increased to $193.1 million from $33.7 million last year. Total debt declined as well to $153.4 million from $200 million a year ago. At quarter end, cash exceeded total debt by $39.7 million compared to net debt of $166.3 million last year. Our public debt of $153 million is due in April of 2013, and we currently plan to draw on our $325 million credit facility to redeem those notes. We are currently in discussions with our Board of Directors regarding appropriate leverage targets for the company. We are affirming our fiscal 2013 outlook for revenue of $1.9 billion to $2 billion and EPS of $2.20 to $2.40, which corresponds to operating income of $125 million to $135 million. We continue to expect free cash flow of $120 million to $140 million for the year. Note that this outlook for EPS and operating income excludes the impact of severance and other one-time expenses associated with restructuring actions, as well as non-cash, non-operating items. With that, I'll turn the call back over to Dick.

Thanks, Maureen. Now I will moderate a question-and-answer period in addition to Maureen and Jeff, and I'm joined this morning by Ellie Berger, President of Trade Publishing; Margery Mayer, President of Scholastic Education; Judy Newman, President of Scholastic Book Clubs and e-commerce, as well as other members of our executive team. With that, we'll open the call to questions.

[Operator Instructions] Our first question comes from the line of Drew Crum. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: So I had a couple of questions on the Educational Publishing business and some of the macro issues you addressed in your preamble. Can you talk about Common Core in more detail and when it becomes a bigger opportunity for the company? When do you start seeing purchases aligned with Common Core? Is it a fiscal '13 event? Or does it become more meaningful in fiscal '14 in conjunction with the new products you're rolling out? And then also, as it relates to the federal budget cuts and sequestration, how big of a risk is that for your business? I know you source significant amount of revenue from the federal government. How are you thinking about that? Does that, in any way, change your outlook for fiscal '13 as it relates to revenue and profit growth for the business?

Drew, thanks for the 2 very good questions. I'll ask Margery to address the Common Core issues and some of the other funding issues. I think on the sequestration and the federal budget, we believe that this is primarily psychological. It's a sort of an overhang among these administrators who are trying to plan their budgets for the current school year. And in the summer, which is usually the beginning of the budget year, there are these dire comments from Washington about sequestration of federal funding, and there's -- some people are just saying, "Look, until this gets clarified, we're not going to open up and spend". And that, we believe, really permeated an awful lot of the schools, slightly supplemented by the focus on Common Core, people asking what are we going to do about Common Core, somewhat diverted their attention away from product purchases. Although, as was noted, we did have excellent service and consulting revenues, much of it based around Common Core. But in terms of how it relates to our products and Common Core's impact on -- will impact all parts of the company. For example, our Classroom Magazines are enjoying a terrific summer and renewal rate this year, and circulation is up substantially because we believe that the Common Core is causing people to want more nonfiction, which is what's primarily in our classroom magazines. So we're seeing a substantial increase in the circulation of the magazine. But in terms of the impact on Scholastic Education in our core solution products, I'll ask Margery to comment further. Margery?

Hi, Drew. Well, I think Dick gave you a really good overview there. So here's how we view Common Core. We think it's a gigantic opportunity for our business because it's raising the rigor of school, and we know that there -- it's not going to just magically happen that as we raise the rigor, the kids that need intervention are going to be raised up with the rigor. They're going to need extra help and support. So we're super confident about what Common Core is going to do for our business over time, and we built a lot of bridges to Common Core into READ 180 Next Generation, which our customers see and appreciate. But when we look at Common Core, we think of it as coming in phases. So we believe, right now, we're in Phase I, which is an awareness phase. Administrators are having to introduce the idea of Common Core to their entire professional staff. They're having -- they're in educational mode. We saw the lift in our service business from doing professional development around Common Core in that phase of education. We think the second phase of it is going to be around putting the right programs in place, and we're totally confident that READ 180 and next summer, with MATH 180, iRead and System 44 next-gen, that our programs are going to be essential to achieving what Common Core is asking schools to do. So we're supportive of Common Core. We think it's going to be good for us, and we think we're going to start seeing some of that very soon. What Dick said, I really don't have anything to add about sequestration other than what Dick said. I guess, the one thing I would say is that we have more and more poor children in the country, not less and less. And when we look at the federal formulas for how Title 1 and special ed support our children who are in need, they're actually deficient. So we're confident that the federal government is not going to abandon our poor and needy children, and we just need some time. I think the election is also something that's created a little uncertainty in some of our -- in some districts. So we think after the election, whoever gets elected, there will be more certainty, and we also are confident that we're not going to not support our schools serving our poorest children.

Okay, good. That money will probably be released and people -- the threat of sequestration will go away, and people will go back to working and spending money on programs, and we -- it's in our plan, but we're also intensifying our sales efforts to ensure that we get those sales when that money becomes available. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Okay. Just shifting gears, Dick, can you comment on the performance of Hunger Games in the quarter relative to your expectations? There's a DVD release in the U.S. and I would have thought that, that might provide a catalyst for additional sell-through, and maybe it did. But I just want to get your thoughts or comments around the performance relative to your expectations and what inventory levels look like for Hunger Games as you enter the second quarter?

We were -- we thought that Hunger Games did well in the quarter. We were happy that we achieved the same level as last year. Maureen or Ellie Berger may have some further comments on the inventory and the sell-through, so I'll ask them to talk about that. Maureen E. O’Connell: Well, we did experience a nice bump from the sales again when the DVD was announced the weeks before and the couple of weeks after. We saw increased sales, especially of the ebooks, and we have good inventory. We're well-positioned for the upcoming movie next fall, and have marketing prepared along the box set for the fall.

We've closely monitored our inventory around Hunger Games, and we feel very confident that we have adequate reserves against whatever we think will be returned, and that we'll see strong sell-through through the holiday season. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: What's the timing on the box set, Ellie?

The box set has been out for about 1 year. It's in hardcover, and we'll be re-promoting it this fall for gift-giving. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Got it, okay, okay. I'll just ask one more question, and jump back into the queue. Just, Margery, can you give us some updated thoughts on how you're thinking about uses of cash? I know the balance sheet looks very strong. The free cash flow improved drastically year-on-year. What are the company's updated thoughts in terms of redeploying cash?

Well, that is something that we're in deep discussions right now with our Board of Directors regarding what's an appropriate leverage ratio for the company. As always, our focus on cash is first to invest in our business, product development, CapEx, and we feel we're adequately doing that both in all the new products we're developing in educational technology, as well as our Storia launch. And then, next, we look at whether there's any acquisition possibilities or to return cash to shareholders, and those are the discussions that we are in process of having.

[Operator Instructions] And our next question comes from the line of Barry Lucas. Barry L. Lucas - Gabelli & Company, Inc.: Couple of housekeeping questions, and then maybe some stuff with a little more meat. Any way to size, even though it's brief, the impact of the teachers strike in Chicago?

Good question. I think, as Margery indicated, there's -- you would have expected a more public outcry on teacher strike in Chicago. But one side note here, and which we think is very important, is that I think the public is supporting the teachers again all over the United States, following a period where teachers have been criticized by everybody for contributing to the poor performance that people perceive the schools are delivering. So I think we're seeing an end to that, as people realize that the frontline of education is teachers, and teachers are trying hard. They're doing a good job. They're dealing with 57 million kids every single day, and trying to teach them more skills and more excitement about reading and learning. The impact of the Chicago teacher strike itself is probably minimal on our instructional materials. The schools that are using Clubs and Fairs, we did experience a little bit of cancellation of Fairs in the Chicago public schools, but those are usually delayed and they're rescheduled further downstream in school year. So we're not expecting any dramatic impact, although, obviously, it's always a concern when some 350,000 kids or more are not in school for a week. Barry L. Lucas - Gabelli & Company, Inc.: Right, got it. Maybe you can just kind of refresh our memory. I think you quantified the incremental sales for Hunger Games that came out of the movie in the last couple of quarters. Is there a level that you could describe that would be, I would say, the evergreen piece of Hunger Games, particularly now that with the movie support and what have you versus the spike that you got in the last fiscal year?

Well, of course, last year was amazing, and people all over the world embraced The Hunger Games, particularly in the spring and what was our fourth quarter. Sales continue to be very strong. It's because it's listed on the Children's Book Best Seller list in New York Times. Not everyone sees that it's at the top of national sales for most title in the United States, but I think Ellie might have some thoughts on the trajectory on what we see as the future steady-state of Hunger Games.

As Dick said, it does remain at the top of many best sellers, and it's been at the top of book scan, which tracks the point-of-sale in most of our accounts. So it remains the best-selling kids book. Trilogy, the 3 books are there, as well as the boxed set. So again, our retailers are very supportive, continue to be promoting the book surely through the fall and into next year when they look forward to even more attention on the property driven by the movie. Barry L. Lucas - Gabelli & Company, Inc.: Okay, that's helpful. Storia, Dick, any -- what are the benchmarks or hallmarks we should look at, or think about or how will you describe the success of Storia as we roll into the next couple of quarters?

Well, I think right now, it's really getting teachers to use it, getting them familiar with it, getting them to download it, and getting them to use it in their classroom, getting them to show kids books on Storia, on their interactive whiteboards and on their tablets in the classrooms. So it's more of an introductory phase where people are using it and getting used to it. I think it will take, at least, this school year before we'll see any impact of Storia of going home and being -- purchase being made by parents at home through Storia of ebooks for their kid. So we're looking more at the number of downloads, the conversions to registration and ordering and use of the ebooks, and other kind of metrics like the number of schools in which Storia is used, the number of teachers using it. So we will -- I think we will not see a strong revenue until 2014, but we will see teachers using it excitedly and broadly in the classrooms, and we'll see what the strong and weak points of it are, and how we can add to it and keep evolving it to make it more effective, but we do see Storia as the way for teachers to bring ereading into their classrooms. They're very excited about it. It's something they can bring to their kids, and it makes their kids excited, and it's kind of a new way of talking about reading in the 21st century for teachers, and that's what drives their interest and enthusiasm. In terms of sales metrics, we have established, as you know, 2 years ago, the goal of 30% of our sales being digital in this area of our business by 2015. And we have a plan that will get us most of the way there, which is very much dependent on how we build the Storia in a whole variety of ways through the schools and through the parents and through the Fairs, and how many books the parents and the teachers will wind up buying through Storia over that period of time. Barry L. Lucas - Gabelli & Company, Inc.: Helpful. Two more items, Dick. One is Common Core, which I think you've adequately described the opportunity, but how do you think about the risk of Common Core? I mean, as we get kind of -- I would say more standardized requirements across the country, doesn't it make you a little bit more vulnerable to the big guys, let's say, McGraw-Hill and Pearson, coming down from the top, and maybe the barriers to entry to the business become lower, and others who are not necessarily in Educational Publishing, but are somewhere aligned or close to that nip away at the bottom. So how do you think about the risk part versus the opportunity?

Well, it seems to me that people really don't understand, Barry, you do, but most people do not, that the kids in the schools are relative to grade level, are not performing very well. You know that only 30% of kids are on grade level. 70%, therefore, are below grade level in reading and math through the NAEP scores. The standards ratchet up the expectations even higher than the current testing. It's going to expose the weaknesses that the kids have in being able to reach the new standards. The key here is whether the schools will put in the scaffolding that will help the teachers help the kids get from where they are, which is already below level and get them above to the new more complex standards, it's going to require a huge amount of professional development, of communication, of careful support for every skill that's going to be required in the Common Core. I don't think this gives any advantage to any particular person, particularly, the people who are coming in from outside, who really seldom understand that reading improvement and school improvement and student achievement are actually done right in the classroom by teachers and by kids, and has very little to do with reform and use of technology from -- other than the theory that every kid can learn just by turning on the computer. So it really advantages our programs because our programs are the ones that build the skills that the kids' need. I'll ask as Margery to amplify that if you got any more time to listen to us on this point.

So Barry, I do think that there is some risk in Common Core to people who are publishing traditional curriculum because I think it does offer -- it is commoditized under Common Core. The advantages that the basal companies have, where they did stated additions to go with state standards, all that gets wiped out when you're talking about just purely meeting the curriculum goals of Common Core. But the reason why we're totally confident that we are not going to be commoditized is because our products are so adaptive, personalized and targeted on the kids that most need help, and that cannot be achieved by just pulling free material off the web. So we think about this a lot. We want to be sure that we stay on our toes, but it's going to take more, not less, from us going forward. Barry L. Lucas - Gabelli & Company, Inc.: Terrific. Great, Margery. The last item, really, for Maureen, and since you talked a little bit about the board and looking at the balance sheet and appropriate leverage, can we infer from those comments, Maureen, that part of the reason why there were no additional share repurchases or anything else on the capital structure really has to do with whatever refinancing or financial strategy you look to apply in the next couple of 6 months or whatever? Maureen E. O’Connell: Yes, I mean, we do not believe that we should be debt-free, and as we pay off our bond, we will be. So we are looking at alternatives, including increasing the size of our bank deal or amending our bank deal, and so we wanted to be in the strongest possible position, and that's why we did not buy shares this quarter.

[Operator Instructions] I'm not showing any further questions at this time. I would like to turn the call back over to Mr. Richard Robinson for closing remarks.

Well, thank you, all, for your support. We look forward to talking with you in December.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a great day.