Scholastic Corporation (SCHL) Q2 2014 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Scholastic Second Quarter Fiscal Year 2014 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, Gil Dickoff, Senior Vice President and Treasurer and Investor Relations. Please go ahead.

Thank you very much, Kate, and good morning, everyone. Before we begin, I would 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 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 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 SEC. Actual results could differ materially from those currently anticipated. Our comments today 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 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.

Thank you, Gil. Good morning, and thank you for joining our second quarter 2014 analyst and investor conference call. For this morning's prepared comments, I'm joined by Maureen O'Connell, CFO and CAO. Before I review our second quarter, I want to point out that we filed an 8-K this morning related to our intention to purchase our headquarters property here at 555 Broadway in New York City, which contains unique retail space as well as our offices. This purchase will give us complete ownership of our 325,000 square feet headquarters location, which includes 557 Broadway. This will increase our cash flow and will also provide us with the flexibility to further monetize this valuable space in the SoHo neighborhood. We expect to fund the $255 million purchase with cash on hand and borrowings under our committed credit facility. Maureen will talk more about this later. We had very strong second quarter results driven by profit improvement in each part of our Children's Book business and excellent sales in our Education businesses. These operating results were offset by a onetime noncash charge in the amount of $13.4 million related to goodwill from 2 acquisitions made in the Children's Book business more than 10 years ago. This charge, which has no impact on the operations of our business, almost completely offset the 19% improvement in operating profit in our Children's Book business, which was driven by higher sales in Trade and Fairs and reduced cost in Clubs. The power of Scholastic lies in our content distribution and relationship to the schools and our customers. We have 3 strong business areas which are all on track for growth. The Children's Book business, Trade, Clubs and Fairs, which comprise 50% of revenue, had a 19% rise in operating income in the quarter before the noncash charge. Our Education businesses, representing about a quarter of our company sales, continue to turn out double-digit revenue and profit growth. In our International business, which represents another 25% of our company, revenue declined over one quarter due to unfavorable foreign exchange rates, but we have continued to realize double-digit growth in our Asia markets. We have industry-leading competitive positions in our Book and Education business and, as we successfully navigate the Digital transition, we're continually innovating to keep developing new products and new marketing approaches to maintain our relevance and access to our teacher, parent and child customers. Because we're a trusted brand in our deep partnerships through the schools, our Clubs and Fairs are a powerful channel. Teachers and parents depend on Scholastic Clubs and Fairs for low-priced, high-quality books to motivate children and satisfy their individual reading interests. As access to bookstores shrink and more sales are made online, our school channels have become an even more critical place for children to discover great books, and where teachers and parents can guide them to becoming lifelong readers. This is increasingly relevant in the Common Core era, when daily independent reading is necessary to help children meet the new higher standards and when screen-based media competes for children's time and attention. Storia also continues to be an important vehicle for making ebooks more accessible and exciting for children in classrooms and at home. As planned, our investments in Storia are now focused on maintaining our platform while adding content. And revenue is growing in line with the ebook market as a whole. To help our customers and to continue to grow our share of the children's book buying market, we're linking the marketing product offerings and operations of our Clubs and Fairs businesses. This will improve our ability to address these growing opportunities with teachers and students, where reading, always a top priority, has taken on an even greater importance. This was also an exceptional quarter for our Trade sales, after the Catching Fire film premiered in November. We had a strong performance from The Hunger Games with our deluxe box set and through ebook sales. During the quarter, we also finalized an agreement with Apple under which our ebooks, including The Hunger Games trilogy, are now available in the iTunes store in the U.S. and Canada. This provides us with another important channel to offer this trilogy and other ebooks to readers of all ages. We had a number of additional standouts in our Trade division this quarter, including core backlist titles such as Harry Potter, The Magic School Bus and Goosebumps; as well as newer titles such as Spirit Animals, our innovative multi-platform series; Star Wars: Jedi Academy; and The Adventures of Captain Underpants, which was published in color for the first time. In Education, our comprehensive suite of programs and services are well positioned to raise language and math achievement of students, develop the professional skills of teachers and employ technology that ensures results. During the quarter, we combined our complementary Educational Technology and Services and Classroom and Supplemental Materials Publishing organizations. This new larger group improves our ability to serve schools and districts at a time when customers are turning to Scholastic for broader solutions to their need to improve student achievement. Each of our now 110 field sales reps is now offering our full range of Educational Technology programs, professional development services and classroom materials. This includes Read 180, System 44, Math 180, Common Core Code X and iREAD; and our guided reading programs, classroom book collections, Classroom Magazines as well as a range of professional development and related consulting services. Our combined field sales team gives us more opportunities to respond to RFPs to package a complete English Language Arts block of product, aid in math intervention and significantly grow the business. Innovative product development and the services we provide to effectively implement these programs is why Scholastic has a reputation for helping drive significant improvement in student achievement. This is particularly evident with Math 180, our newly launched program. There's a vast need for a program that effectively helps students who are falling behind in math. And we think, and teachers agree, that Math 180 is the game-changing foundational program for math, just as Read 180 has been for reading. Increased interest and need for nonfiction and complex informational and literary text has resulted in higher sales of our classroom book collections and growing circulation for Classroom Magazines, which is now over 12.6 million copies. This drove 11% revenue and 45% operating income increase in the Classroom and Supplemental Materials Publishing compared to last year. Our rich content and the strength of our technology programs have also been instrumental in the strengthening of our global educational platform. The rise of English language learning worldwide is driving higher sales internationally. In fact, there are 2 million children using Scholastic Reading Inventory, our computer-based reading assessment program, in the Philippines. India also continues to be a great story for Scholastic, with strong growth in our traditional businesses and the added success of new education products created in our Singapore publishing center. As we continue to expand and deliver our region-specific products and programs for English Language Learners, we remain well positioned for growth throughout Asia and other emerging markets in 2014. Each of our business segments is on track for growth, and our results this year will be driven by our new products and increased demand for customized learning solutions in Education and our Trade franchises in Children's Books. Our collaborative marketing, sales and publishing in our Children's Book channels improve operating efficiency and ability to serve our customers. We are affirming our fiscal 2014 guidance and continue to expect improvements in profitability and strong free cash flow in fiscal 2014. With that, I will turn the call over to Maureen to review the second quarter financials in detail. Maureen E. O’Connell: Thank you, Dick, and good morning, everyone. I will begin with the income statement. In the second quarter, revenue increased by almost 2% to $623.2 million, driven by higher sales of Children's Books in our Trade and Fair channels, continued growth with our new Educational Technology products, better results in our classroom paperback collections and increased circulation of our Classroom Magazines. This was partially offset by unfavorable foreign exchange in our International businesses. Results for the second quarter of the current fiscal year include onetime expenses of $0.35 per share related to cost reduction and restructuring programs, including a goodwill impairment charge of $13.4 million in the Children's Book Publishing and Distribution segment. This onetime, noncash charge is related to the Trumpet and Troll Book Club acquisitions made over 10 years ago and has no impact on the actual operations of our businesses. Cost of goods sold as a percent of sales decreased by approximately 20 basis points this quarter, as favorable sales mix resulted in lower cost of product. SG&A decreased by $2.4 million, excluding $5.5 million in onetime severance costs compared to the prior year. Income per share from continuing operations was $1.80 compared to $1.91 a year ago, including onetime expenses for severance and restructuring programs, as well as the previously mentioned write-off of goodwill. The consolidated income per diluted share was $1.80 compared to $1.89 last year. If you exclude the onetime expense of $0.35 per diluted share, second quarter 2014 income per diluted share from continuing operations was $2.15 versus $1.91 a year ago, an increase of 13%. This was primarily from margin improvement in Children's Books, increased sales of high-margin classroom books and Education Technology, and higher circulation of Classroom Magazines. In the Children's Book Publishing and Distribution segment, revenues were $352.1 million versus $347.4 million last year. The Hunger Games trilogy, including the new paperback box set and movie companion edition, performed well following the release of the Catching Fire film in November, and we expect sales to level off in Q3. We also had continued strong performance of Spirit Animals and the new Harry Potter paperback collection, which was released at the end of August. Book sale revenues increased 3% compared to one year ago, reflecting higher revenue per Fair. In Book Clubs, operating profits improved on a modest revenue decline of approximately 3% as a result of significantly lower selling, general and administrative expenses compared to the prior year period. The operating income for the segment was $82.3 million, excluding the onetime goodwill write-off, compared to $69.4 million a year ago. The $12.9 million or 19% operating income increase was driven by improvements in each part of the Children's Book business, higher sales in Trade and Fairs and cost improvements in Clubs. In Educational Technology and Services, segment revenue increased 17% to $60.9 million compared to $52.2 million last year. This was driven by the performance of our outstanding new technology products. Segment operating income increased 30% to $6.9 million due to higher revenues from high-margin Educational Technology programs in the current period, partially offset by higher prepub amortization on these new products. Segment revenues in Children's and Supplemental Material Publishing was $59.1 million, an 11% increase, compared to $53.2 million last year. Segment operating income improved to $10.7 million compared to the prior year operating income of $7.4 million, an increase of 45% due to higher sales of our high-margin classroom books and Classroom Magazines in the current quarter. In our International segment, revenues fell to $135.6 million from $143.7 million last year, primarily the result of unfavorable foreign exchange and slightly lower Trade sales in the major markets. Foreign currency exchange rates adversely impacted revenue by $7.5 million in the quarter. This was partially offset by high direct-to-home and educational sales in Asia, where we continue to see benefits of a growing middle class and their focus on English language learning. Segment operating income was $22.2 million compared to income of $24.7 million last year. In Media, Licensing and Advertising, revenue was $15.5 million, down from $17 million last year, primarily due to lower interactive sales. As a result, segment operating loss was $0.4 million compared to operating income of $2 million last year. Corporate overhead was $8.1 million, excluding $5.5 million in onetime expenses related to severance and restructuring programs, compared to $6.8 million last year. This year-over-year change is from the reinstatement of bonuses and stock comps. Free cash flow in the second quarter was $129.4 million compared to free cash flow of $60.4 million last year, primarily the result of lower royalty payments and improved working capital as compared with the prior year period. We maintained a strong balance sheet with no net debt, and cash and short-term investments exceeded small International local currency credit balances by $107.6 million. The company has ample headroom for borrowings under its unused $425 million committed credit facility due in 2017. During the quarter, we repurchased approximately 203,000 shares in the open market transactions and had approximately $13.4 million remaining under our current board authorization for share repurchases. As previously announced, yesterday, the Board of Directors declared a regular quarterly cash dividend of 15% -- $0.15 per share in common stock. As Dick mentioned, we also announced our intention to purchase our headquarter property at 555 Broadway in New York City's SoHo neighborhood for $255 million under a right of first offer contained in our master lease agreement. We expect to close this transaction prior to the end of the current fiscal year. We believe that this is a unique opportunity to acquire an accretive property, which has already been combined with our property at 557 Broadway, creating one of the largest modern office buildings and unique retail space in Soho. In addition, converting a long-term lease obligation into an owned asset with higher annual depreciation will improve our free cash flow and provide further options for potential monetization of the combined property. We expect to fund the purchase with cash on hand and borrowings under our committed credit facility. Our net debt, including capital leases, is expected to increase by approximately $100 million. In conclusion, as Dick said, we are pleased with our results to date and remain on track to deliver our fiscal 2014 outlook for revenue of approximately $1.8 billion, and earnings per diluted share from continuing operations in the range of $1.40 to $1.80, before the impact of any onetime items associated with cost reduction programs or noncash, nonoperating items. We continue to expect free cash flow in the range of $60 million to $80 million. This outlook includes capital expenditures of between $55 million and $65 million and prepublication and production spending of approximately $65 million to $75 million. And now, I will turn the call back to Gil to moderate the question-and-answer session.

Thanks, Maureen. Before our operator provides queuing instructions for the Q&A session, I wanted to address a few questions that we received from investors and analysts earlier this morning. The first question that we received was what efficiency initiatives have we employed to achieve margin improvement in Children's Books that we realized this quarter? And how should we expect profitability to trend in the second half? I think I'll turn that question over to Judy Newman, Head of our Book Clubs unit.

Thank you, Gil, and good morning, everyone. So Clubs and Fairs have been working very closely together to align our front-end marketing, our product development and pricing between the 2 channels. We've been developing specific content for these channels and really targeting our promotions much more strategically. We believe that this collaborative effort in schools, where Clubs and Fairs are both very strong, is really going to help grow our share of the children's book buying market much more profitably. At the same time, as we're growing sales and focusing on customer activation, we're also looking to lower our technology spend, reduce some of our infrastructure costs, including operational efficiencies in distribution, manufacturing, customer service and supply chain. So there's many initiatives that have begun this quarter and will be continuing all year, and we expect really great, continued progress throughout the year.

Thanks very much, Judy. Second question that we received earlier has to do with our Education businesses and if we expect any cost savings related to the combination of our 2 Education businesses, and how we expect the combination to impact Ed Tech product sales in the second half. And to answer that question, I'll ask Margery Mayer, who heads up that group, to respond.

Thanks, Gil. So the combination of our 2 groups is really about growth, where we have 2 product lines we're putting together that are very much in harmony with each other. Our Classroom Books and Supplemental group has been focused more on K-5, and, of course, we have such a strong position at middle school and above. And we're also, most excitingly I think, putting together our sales forces, both of which have been incredibly effective at what they're doing. So we've essentially doubled our coverage of our solutions. In terms of savings, we're going to always be looking for greater efficiencies and we think we will find some going down the road. But as I said, this is about growth. In terms of the second half, we're staying constant with what we've said in the past.

Thanks very much, Margery. And operator, we're now ready for you to provide instructions for the Q&A session.

[Operator Instructions] Our first question comes from the line of Drew Crum with Stifel. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: So just a couple of housekeeping questions to start. The CapEx is down about $16 million through the first 6 months. I believe the guidance was $55 million to $65 million for fiscal 2014, which would imply growth year-on-year. Should we anticipate some catch-up in the second half? Was there a change to guidance there? And then the second item is just on the cost reduction restructuring of $5.5 million this quarter. Should we anticipate more restructuring or savings, cost-related savings to hit the P&L in the second half? Maureen E. O’Connell: So to the first question about CapEx, we are maintaining our range of $55 million to $65 million, it's just the timing of the spend is skewed more towards the second half. And the restructuring charge we took in the quarter of $5.5 million, a significant part of that, more than half of that, was due to our distribution operations, where we are realigned to achieve more maximum efficiencies in the Club operations. We do expect that there will be more charges going through the year as we continue to look at the Book Club and Book Fair operations together and seeing where we can leverage those 2 footprints to reduce costs. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: And moving over to the Ed Publishing business, Margery, maybe you could comment on the impact from Common Core? What you're anticipating in the second half earnings? Update or thoughts around timing of implementation?

So I think Common Core is definitely feeling the market to some degree. We have really good work going on in our Services business around Common Core. And we're also -- think, Common Core is a very important message around our products. So when we talk about Math 180, one of the pillars of our product is that we are rebuilding the foundations that kids need to be successful with Common Core. In terms of timing, we're seeing school districts all along the spectrum of implementation of Common Core, from school districts that are literally just getting started to school districts that feel like they're well along. For example, New York City, very well along; Code X, our middle school Common Core program, is in probably 2/3 or more of schools right now being used. In terms of the second half of the year, we expect to be over last year and we see good momentum in our business. Andrew E. Crum - Stifel, Nicolaus & Co., Inc., Research Division: Okay. And last question, just on the Clubs business, any update on how you're thinking about revenue for the second half and just any impact that Common Core is having on that business? I think going into the year, you thought that Common Core would drive sales for Clubs. You had an easier comparison in the second quarter, and yet the business was still down. I just want to better understand how you're thinking about revenue going forward. And on a related note, any update on consolidating Clubs with the Fairs operations?

I think on revenue, Drew, we've got more new sponsors, which is great, so that's been an important win for the fall. Common Core, while I think it's increasing the amount of focus on nonfiction in the schools and the need for nonfiction, that's showing up extremely well in the sales of our Classroom Magazines and also increasing amount of nonfiction, both in Book Fairs and Book Clubs. But it's not a -- it hasn't proved to be a driving force in the kids' purchase of books, which continues to be things that they love, things that they -- the stories and so forth and so on. The combination of Clubs and Fairs, we're certainly working very hard on the back end of distribution, as Maureen said. And we're combining and unifying our marketing messages around the importance of independent reading in the Common Core period, where it's well known in schools that the children who read more fluently, more widely, are -- develop the higher-level thinking skills that they need to be successful on the Common Core test, which remains the drive of teachers. We also note that as kids spend more time on devices, the teachers are really focusing on reading and pouring it on in terms of getting kids to be excited about reading to want to read more. We believe that will show up as we get more sponsors in the second half, and that we are -- our revenues will probably remain flat or a little bit up in the second half. I'll ask Judy to add her thoughts to that comment.

Drew, I think that we're feeling very good about Clubs this year. There's been a lot of positive enthusiasm to our grade-specific catalogs and some of our products. And as Dick said, as maybe kids and parents are sort of less interested in reading in the recreational space, in schools, it's much more important than ever. So Common Core is there just shining this light on the need for kids to read books as much as they can. And Clubs and Fairs are right there positioned in schools to do that. And so we're very encouraged by this. As Dick said, the fact that we have more new sponsors coming into our mix is a great sign of support for this business. So overall, we're very positive. We're feeling really good about things. And the Clubs and Fairs working together to have that consistent message everyday that we're both in the same schools is really a powerful tool. And as both Maureen and Dick have said, we're working very hard to target our reward systems more strategically and our product and all our back end to create much more efficiency. So we're all -- we're feeling pretty good about these businesses working together in this really important time to get great books into kids' hands.

I think we also have Book Fair field reps out there, Drew, more -- well, over 100 of them, who work to improve revenue per Fair. But they're adding -- they're talking to teachers about the importance of independent reading and how to match Clubs and Fairs together and use more Clubs with the Fairs and vice versa. So that's also -- will help over a period of time. Thanks for the question.

[Operator Instructions] Our next question comes from the line of Barry Lucas with Gabelli & Company.

Dick, I've got 3 areas I'd like to touch upon and one would be on the Educational Technology side, the other in Clubs and Fairs and the other, capital allocation. So maybe you or Margery could, I don't know, size the opportunity at this point with -- either with Common Core, also Math 180? And potentially, if you can compare the launch of Math 180 to Read 180, how has the new product done relative to the other? And just some more color in that area to get a feel for how it's progressing, the tail on the business, that sort of thing.

I'll ask Margery to answer that more fully, Barry, but I think the main thing that we see overall, which is why we merged our operations in Supplementary and Educational Technology, which is more Core material, is a tremendous drive in schools to improve achievement. There's huge concern for improving achievement as the Common Core tests near. And this has made schools turn to Scholastic and other publishers, too, for a broader range of services. I know you know the story, but that -- this is the key point where we're moving away from just the instructional materials budget into the human capital budget, which is more than 100x larger than the instructional materials budget. So it's that area which promises so much growth for our education businesses working together. And together, they can talk about the combined solutions everywhere, K-5, print, digital, et cetera, Educational Technology, so that's terrific. Let me be immodest about Math 180 because since Margery and her team developed it, it would be unbecoming of her to get to say the things that I'll say. But I think this program is really a monster winner. We have an immediate response from kids and teachers about how excited they are about using Math 180. It's beautifully designed, it's very well focused, easy to use, kids are responding to it dramatically, there's lots of word-of-mouth about it. And I think, in effect, it's a more successful launch than Read 180, which took a longer time to develop, of course, in a different era, more than 15 years ago. But in any event, it's great and it's working for kids and it's going to sell. So having prefaced that comment, let me ask Margery to expand.

Yes. Barry, we're really excited about how Math 180 is going. We're in well over 100 districts already. We only brought the product out in August. And even though there's other math programs out there designed to meet the needs of the students that we're treating, they just don't do what Math 180 does, in our immodest opinion, as Dick said. We -- a couple of things that Math 180 really focuses on that's really working well, first of all, when we think about -- when we were building Math 180, we did our research on it, one of the things that kept coming back to us is how difficult it is for teachers to teach math in middle school. A lot of them are not certified math teachers. We're asking them to teach the kind of math in the Common Core that they're not used to teaching. So there's a huge amount of attention in Math 180 on how to support the teacher. Now not only is that in the program, but our acquisition of Math Solutions a few years ago really enhanced our ability to not only get it right for the teacher inside the program, but also to get it right when we're going into schools and working with teachers teaching Math 180. So every single one of our customers, more or less, is also working with our consultants to get the right kind of professional development to go with Math 180 which, as Dick said, allows us to tap into both materials budgets and in the human capital budgets. And there's just a lot of other really great things going on in Math 180. One of the ideas that people are really resonating to is the program is built around the idea of a growth mindset. And that idea is around having kids approach math, not whether they're good or bad at it, not whether they like or hate it, but the idea that if you work at it, you can get it. And we're getting a great response to that. The technology is really engaging. All the math is grounded in real life applications. These things are things that when people see it, there's like a big aha moment with it. I'm sorry, I think I went on a little bit too long. But anyway, I'm excited about it and so is our market.

Yes. On the Book Fairs and Clubs working together, I think we've probably said it all, Barry, in our earlier response. I don't think there's a lot to add there right now in terms of -- we're pretty excited about the fact that we have the sales group that's kind of -- is going out and talking about independent reading in the schools. In the era of the Common Core, we think that will have an impact because a school only can have 2 to 3 Fairs lasting 2 to 3 weeks out of 35 weeks of school operation. And in between those times, the Clubs can fill in and give kids access to low-cost, high-quality reading. And we think that can be sold through our field reps to get the principals, teachers and parents more involved. We also are working with reading club coordinators like our Book Fair volunteers who can help the teachers put in the orders and manage the programs. So I -- but I think that's about all that we can offer at this point. On the capital allocation, I think Maureen can handle that one, I'm sure. Maureen E. O’Connell: Did you have a specific question, Barry?

Yes. Actually, goes to 2. The decision on the real estate purchase versus share repurchases at this point, your stock kind of languishing where it's been, and 3 years since the Dutch Auction. So what were kind of the elements that went into the decision-making process? Maureen E. O’Connell: Well, frankly, it was to be opportunistic. We own the building at 557, we had the opportunity to buy 555 at what we believe is an attractive price, particularly considering the retail values here in SoHo and the uniqueness of this property being on Broadway and of the size that it is. So we felt it to be very opportunistic to spend $100 million in incremental debt, allowed us to control this whole facility and have control of our own destiny. And so, that's what led us to make that decision. And when we model the cash flows on this, over the next 10 years, it's a positive cash of $60 million. And that assumes that we never pay off the debt and we just pay interest through the whole period. So I think it was very attractive from a cash flow standpoint as well. And now, we have the flexibility and the options to monetize the retail or any part of this building if we want to. So it wasn't stock buyback versus retail, it was the -- or versus our building. It was in the opportunity to have such flexibility in our destiny regarding the building. As far as stock buybacks, we are continuing to be in the market. We bought over 200,000 shares this quarter. We still have $13 million under authorization from our Board of Directors, and we'll continue that program. And then, as you know, our dividends have increased over the period of time since we launched dividends, so we continue to look to return cash to our shareholders.

I'm not showing any further questions at this time. I'd like to turn the call back over to Dick Robinson for closing remarks.

Thank you, all, for your attention. We had a great quarter. We're excited about a lot of what we're doing. Please follow us, we'll be back with you in March. And we're expecting that we're going to achieve our goals for the year. Thanks so much. Happy holidays.

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

Thank you very much.