Scholastic Corporation (SCHL) Q2 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to the Scholastic Reports Fiscal 2016 Second Quarter Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today’s conference, Mr. Gil Dickoff, Senior Vice President and Treasurer. Sir, you may begin.

Thank you very much, [Tanya] [ph], and good morning, everyone. Before we begin, I would like to point out that the slides for this presentation are available on our Investor Relations website at investor.scholastic.com. I'd also like to note that this presentation contains certain forward-looking statements, including information concerning the company's intention to commence a modified Dutch auction tender offer. Such forward-looking statements are subject to various risks and uncertainties, including the conditions of the children's book and educational materials markets and acceptance of the company's products in those markets, and other risks factors that we identify from time to time in our 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. A 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 also 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 today's presentation.

Good morning and thank you for joining us today. By now I hope you have seen both press releases that we issued this morning. The first was our second quarter financial results press release. We also announced the two-pronged plan to return significant value to shareholders and increase annual operating income. First, the Board of Directors has proved to share repurchase of up to $200 million of our common stock. Owners of Scholastic common stock will have the opportunity to tender some or all of their shares through the proposed modified Dutch auction tender offer at a specified price range to be determined. The buyback will be funded with cash on hand and we plan to launch by the end of the month, at which time further details will be provided in our filings with the SEC in connection with the tender offer. We also plan to increase annual operating income by retaining full ownership of our headquarters property of 555, 557 Broadway and converting the lower floors for additional retail operations, including Broadway facing retail of 557. We will convert the space this fiscal year and expect the new leases to begin in fiscal 2017. Leases with high-quality tenants will provide reliable recurring revenue streams and the increased annual rental income will be accretive to operating income overtime. Of course, should it make financial sense down the line, we also retain the flexibility to consider a further real estate transaction. With this approach we can return meaningful value to Scholastic shareholders, while also retaining ownership of a valuable real estate asset. In addition, we will increase future operating income with a predictable stream of rental income, while avoiding any tax liability related to a sale. Also by boosting annual operating income, we can maintain considerable flexibility for continued capital returns to shareholders via dividends and share repurchases, while also making targeted investments in our core print and digital publishing businesses, including technology. We remained well-positioned to capitalize on the opportunities ahead and continue to drive both strong financial performance and value for our shareholders as the children's books segment continues to grow faster than any other segment in the Trade category and schools and districts turn to us for support and building their classroom curriculums and library collections. Now I will turn to our second quarter performance in detail. Revenue was $601.8 million, a decrease of less than 2% versus last year, and second quarter earnings per diluted share were $1.85 versus $2.02 last year. The declined in reported results are largely driven by two factors. The first is the impact of foreign currency exchange rates on our International business both in revenues and profits. The second was the impact of the labor action schools in Ontario, Canada, which incurred during back fall back-to-school months and substantially reduced book club and book fair revenue in the second quarter. While we are pleased that this action was resolved in November, we have experienced reduced results for the important second quarter, which we will not recover in future quarters. We have therefore revised our outlook based on the expected impact of these two items. Performance remained strong for Trade Publishing Globally with solid results from local publishing and English language titles in the International business and strong sales of our most popular series in the U.S., including Captain Underpants, Star Wars, Jedi Academy, Wings of Fire, Harry Potter, The Baby-sitters Club graphic novels and Goosebumps books are released in connection with the Goosebumps film. In children's book publishing and distribution trade results were also bolstered by strong interest in our books for early readers. We have helped millions of children learn to read and our expanded robust selection of early childhood books, resources and programs are helping to bridge the learning and literacy gap, and ensure that all children have the opportunity to discover the power and joy of reading at an early age. Our school-based distribution channels performed well with school book fairs revenue up 6% on higher revenue per fair and an increase in the number of fairs held. In school reading clubs the year-over-year decline in revenue was driven by the late Labor Day holiday and a week delay in school openings this year, as well as a decline in Minecraft handbook sales. We expect a positive environment for club and fair products, and offers will fuel improved performance in the second half. The focus on independent reading that is driving performance for children's books also provides compelling growth opportunities in our Education business. We are investing for growth in Education, which includes our comprehensive literacy solutions for pre-K to 8 through our classroom books curriculum offerings such as guided reading and rented classroom libraries, as well as classroom magazines, all supplemented by growing service business and professional development and family and community engagement. This business is well calibrated to support the new ESSA Act, which became law last week. With the new standards emphasis on higher-level thinking skills in the schools and districts move away from big traditional basal textbook. Demand for our comprehensive literacy solutions continues to grow. Our classroom magazines contribute steady high-margin revenue, and we have doubled our subscriber base in the last four years to over 14.5 million circulation. This growth is mainly tied to the strength of the print magazines digital supplements, which we plan to grow further through product extensions. Our comprehensive literacy solutions include customized curriculum for school districts, meeting local needs for pre-K to 8 curriculum and literacy for major school districts such as Palm Beach and Houston. These programs include professional learning for teacher's and expanded resources with customized libraries in every classroom. We see significant growth in this area over the next several years. The schools turned to Scholastic for help in expanding their literacy programs for every child. For our international business, we continue to see strong performance and trade in local currencies led by Canada, Australia, New Zealand and U.K. and Asia, as well as India. In developing markets, in Asia, in particular, the growing middle class is continuing to drive demand for English language books and instructional materials. The Scholastic brand is one that teachers and parents know they can trust and we are therefore making great inroads in our consumer business. We’ve built our business and strong brand based on our ability to motivate kids to learn and engage them in the classroom and at home. As the focus on independent reading is the key way to develop higher-level of thinking skills, especially in this time of increasingly rigorous standards, our opportunities have never been more compelling in children's books, U.S. education and international as the global commitment to children's learning continues to fuel personal and economic success. Now I’ll turn the call over to Maureen. Maureen O’Connell: Thank you. I will review our second quarter results and will refer to our adjusted results from continuing operations only unless otherwise indicated. Revenue net of currency for second quarter revenue increased by about $8 million to $619 million. Diluted EPS from continuing operations was $1.85 versus $2.02 last year with operating profit of $105.1 million, which was down 5% versus last year. This includes one-time expenses of $1.5 million associated with last year's media restructuring, $0.5 million from the book fairs warehouse optimization project and $0.4 million for one-time transaction related expenses. As Dick said, second quarter reported results were largely driven by the effect of foreign currency exchange rates on sales and operating profits in our international operations and the labor action in Ontario schools in the second quarter. Together these items impacted our bottom line by $8 million in total and all the factors behind our revised guidance, which I will discuss in a moment. In children's book publishing and distribution, revenues increased 1% to $414 million driven by a very strong front lift. Trade publishing sales were up 7% for the quarter. This strong growth was tempered by a decline in production revenues in media and entertainment which are now reported within the trade division. School book fairs revenues grew 6% with increases in revenue per fair and a number of fairs held. These gains were balanced somewhat by school reading clubs, where the latest chart to the school year had an impact on sales for the quarter and Minecraft handbook sales declined versus a very strong fiscal 2015. Overall, segment operating income was $108.9 million, about even with last year. And education revenue grew 3% to $72.1 million as a result of higher classroom magazines circulation, which now exceeds $14.5 million subscriptions, increased sales in custom publishing programs and higher teaching resource workbooks sales. We did see several significant literacy curriculum and classroom book orders shift to third quarter pipeline. Higher sales in our classroom magazines and custom publishing channels also had a positive impact on our operating income, which was partially offset by increased investment in educational salesforce and new marketing programs. In our international segment, revenues in the quarter decreased by $16.9 million to $115.7 million, including the adverse foreign exchange translation of $17.2 million. Operating income was $11.5 million versus $19.8 million last year. While trade was strong across most of our international markets and favorable results were driven by FX, especially the dollar-based cost of product on operating margins as we have covered and the labor action in Ontario schools. We expect to resume normal ordering patterns in our Canadian clubs and fairs in the second half. We are continuing our strategic investment in technology, which drove off corporate overhead to $25.3 million compared to $18.6 million last year after one-time items. Our target investments in technology platforms are enhancing our customer relationship and content management capabilities and are making our product development, sales and marketing more efficient and effective. As a result of this initiative, we can collaborate more easily as a company using the customer data collected across segments to create products and service offerings that are relevant and attractive across all channels. We generated free cash flow of $101.8 million versus $125.7 million last year, which included a positive cash flow contribution from EdTech. Regarding our balance sheet in real estate assets, as announced earlier today, we plan to repurchase up to $200 million of our common stock through a modified Dutch Auction tender offer, which will launch by the end of December. In addition, approximately 60 million remains will be available for open-market share repurchases under our existing authorizations. Further details on the tender offer, including terms and conditions, will be filed with the SEC later this month. Accordingly, we cannot answer any questions beyond what we already told you in the press release. We will also increased annual operating income by retaining ownership and the future value of our headquarters property and leasing additional high demand retail space. As we previously announced, we expect to invest approximately $10 million in fiscal 2016 to create modern Broadway-facing retail space. We will work with every of the state manager to secure leases with high-quality tenants and we expect a new space to generate significant increase in recurring lease revenues starting in fiscal 2017, which will be accretive to operating income over time. More specifically, on an annual basis, we expect our current $6 million in rental income to increase by $10 million, with the new retail space for a total of $16 million. This should increase further as existing leases come up for renewal. We believe this is the best approach for our shareholders, allowing us to both, return significant value immediately through share repurchases, retain ownership of our attractive real estate asset, increased operating income, maintain flexibility and avoid the significant tax liability that would come with the sale of the company's asset. We will also retain the depreciation tax benefit. Now turning to outlook. We have revised our revenue and earnings per diluted share outlook to account for the impact of foreign currency exchange rates and the impact of the labor action in Ontario during the second quarter. We therefore expect total revenue to be approximately $1.65 billion and earnings per diluted share from continuing operations to be approximately a $1.35, before the impact of one-time items associated with cost reduction programs or non-cash, non-operating items. We continue to expect free cash flow in the range of $35 million to $45 million, excluding taxes paid as a result of the sale of EdTech. Our outlook includes CapEx of $40 million to $50 million compared to $30.7 million last year and pre-publication spending of approximately $30 million to $40 million compared to $62.5 million in fiscal 2015, which included the EdTech business. I would remind you once again that EdTech had a significant amount of pre-pub expenses and very little CapEx. I will now turn over the call to Gil to moderate a question-and-answer session.

Thank you very much, Maureen. Operator, we're now ready to open the lines for questions.

[Operator Instructions] Our first question comes from the line of Drew Crum of Stifel. Your line is now open.

Okay. Thanks. Good morning, everyone. So, Maureen, I have a couple questions on guidance to start, that’s kind of a housekeeping item. Can you reconcile why you're reducing the earnings guidance but free cash flow guidance remains unchanged? And then as you look at the second half of fiscal ’16, I believe the Chicago teachers are planning a strike at some of the larger school districts in United States. Is that going to have any impact on your clubs and fairs businesses? Thanks. Maureen O’Connell: Regarding guidance, we did not reduce cash flow because we're actually seeing positive working capital trends right now. Receivables, we've seen strong collections. We continue to monitor our inventories and although areas like trade that had very strong growth, we've not increased inventory. So, we are pleased with our inventory performance. In our guidance, we really changed it to reflect the Ontario action, which is already occurred and resolved itself on November 3rd and with changes reflect the impact of foreign currency on our margins in the international markets. We believe in the second half that currency is already hit the low point and we should not have such an currency impact and we also believe that we will resume normal ordering levels in Canada once the teachers and everyone has return to work administrative functions.

Well, we would be concerned. We would be concerned about Chicago, of course or any major school system where there is a strike. In Canada, there were -- our clubs and fair business was affected for the entire quarter. Normally, we don't expect those strike -- and it was not a strike but it wasn’t an action that called work to rule, where the teachers didn’t do and the janitors didn’t do any extracurricular activities, which affected our clubs and fairs. So while we would be concerned about Chicago, we probably wouldn't have the same impact on our business where it’s a current likely strikes or much shorter when they happen in Chicago or other places in the United States.

Okay. Make sense. And then just lastly on the real estate two questions. Currently, you said in terms of the rationale but I would love to get your just additional thoughts on the rationale, not to enter in the large real estate transaction. And then separately for Maureen, you offered some guidance in terms of the expectations for additional rental income. What is the conversion to free cash flow and should we expect that incremental $10 million in fiscal ’17, or is that something that we will see beyond ’17? Thanks. Maureen O’Connell: Okay. I can take the rental income question first. We are building out the space starting in February to convert it to a Broadway-facing retail property and the next step would then be to work with the manager to lease out that property. So, our goal is to have that available starting in 2017. It really depends on when the tenant is identified and moves into the property and then amount of free rent that we may have to give when we start out to determine when the rental income becomes accretive. But we do believe we’ll pay the $10 million to restore the property this year and then there should be accretion next year in fiscal ’17.

Yeah. We have a great property here, Drew. We decided we would -- the best way for us to realize value from it was to operate it and get the increased lease income and retain the asset.

Okay. Thanks, guys.

Thank you. Our next question comes from the line of Barry Lucas of Gabelli & Company. Your line is now open.

Great. Thanks and good morning. I have several as well on the real estate that I’d like to start there. Roughly, how many square feet of rental space do you expect to have available? Maureen O’Connell: That’s fairly subject to the tenant. So right now, we're considering the first, second floor and maybe part of the second floor, maybe all of it. It really depends on the tenant and their needs. So it’s difficult to put a number on it until we really have the tenant in mind.

Okay. And has any money been spent thus far in the conversion, or whatever renovation, however you want to describe that? Maureen O’Connell: That will start in February. So, we won’t be seeing spending until later in the year or fiscal year.

Okay. And just more, again, coming at -- they are trying to come at this in other way. How much did the potential tax liability weigh on the decision to retain the real estate? Maureen O’Connell: Well, the tax liability wasn’t very substantial, as you know that we entered into a long-term lease many years ago when we had a favorable option to purchase under that lease. And as a result, we have a very low basis and so the tax liability would've been quite substantial.

Okay. And last item on the real estate. Is there any idea what the air rights to the building might be worth, and is there any way to monetize that while retaining ownership of the actual property?

We’ve explored that considerably better as you might expect and there is no remaining air right availability.

Okay. Thanks, Dick. Maybe we will talk about the business a little bit.

That would be a pleasure.

Okay. We haven’t talked about e-books for a while but any change in trend, or maybe you could just describe the trend post the Hunger Games, which carried a meaningful proportion of e-books sales. But it feels like overall sales for the industry for e-books have flattened to say the least. So just wondering what you’re seeing in your side of business?

Right. Well, as you know, adult or -- and total adult sales of e-books have topped out at 20% and are now declining, and they’re largely best seller front-list related. In the children's books area, never really got over 5% except for occasionally and not include the young adult Hunger Games, which did as you point out have a very substantial amount of e-book sales during the high point of Hunger Games. We see here and there a series in middle grades or young adult where there is a spike in e-books or we create the e-book opportunity by doing unique and original publishing in e-areas, which increases the amount of volume. But, in general, it's just -- this is a print world right now and publishing globally. A great surprise to many and but it’s certainly we see that there is a strong trend that will continue.

Okay. I think in the release there was some commentary on investment -- technology investments and shifting to software-as-a-service and I was just hoping you could kind of quantify that as we look into the corporate line? Maureen O’Connell: Well, we -- Barry, we have spent about $10 million increment year-to-date and that’s about what we will be spending in the second half. And those investments are really already beginning to payoff because we're able to now look for opportunities across our businesses where -- what we are calling headroom or the availability to have one business lead another business and to increase sales and we're already seeing momentum from that build. So it’s a three-year project. It started last year. Last year we were able to offset all the incremental spend by reducing cost in the businesses proportionally. So it wasn’t a significant increase last year. It will be about a $20 million increase this year and then we will guide to next year but it is a three-year program.

And preliminarily, would you think the spend next year is all of that… Maureen O’Connell: Probably about -- more or less, maybe slightly up from where we are now.

Okay. Maureen O’Connell: Because of inclusion and it would be going live. So we would be running parallel in a lot of systems and as a result of the running parallel, I think there will be incremental expenses. But give me time to give you guidance on that.

Okay. But it sounds like something on the order of magnitude $45 million, $50 million over the three years? Maureen O’Connell: It was neutral really last year, it’s 20 million this year, so that that would be a high-end of the range.

Great. Last one for me and Drew, asked this just a moment ago. But the Goosebumps movie did it pull-through, meet, exceed your expectations or was it disappointing? Maureen O’Connell: Hi, Barry. I think it actually -- it is started earlier in the summer and peaked around the movie and it really met our expectations and we continue to see nice backlog sales continuing.

Great. Thanks very much.

Thank you, Berry.

Thank you. Our next question comes from Ian Zaffino of Oppenheimer. Your line is now open.

Hi. Great. A lot of question has been answered already, so just a kind of a couple of other questions here is the $200 million buyback. How did you arrive at that number? It's obviously less than your cash balance, you have no debt? How did you arrive at that? And then also as you start getting this rental income, free cash flow is going to be the higher than it is currently. What are the plans there and how do you look at that as far as use of cash flow? Maureen O’Connell: So regarding the $200 million, we currently have about the cash balance of $350 million, with the 200 million that's a total authorization or share buyback of $260 million, once we complete all of that buying. And we really considered giving as much cash back if possible at the same time looking at the liquidity of our stock and trying not to affect that. And so we felt that this was a significant buyback overall and that's how we arrived at the $200 million range. As far as future, we always look to balance investment in the business with return of cash to shareholders. And I think by retaining the building and the strong balance sheet we have, we continue to have that flexibility into the future. And so I think that we've done this. This will be our third major structured transaction in terms of buyback. We started with an accelerated share buyback of $200 million. We did a -- following that, we did a Dutch Tender the lifetime of $155 million. And now this is the third structured transaction at $200 million plus authorization that the board has approved in the open market of $60 million. So, I think that we have shown our willingness to return to shareholders and we expect over time, we’ll continue to invest in the business and do that.

Okay. And then on the rental income, what type of tax bracket should we assume? Is there any type of NOLs that you could use to offset some of that? Maureen O’Connell: One thing that I think is surprising to many of our investors is that since this is the corporate asset, it is not a capital gain. It is taxed at corporate rates. So it’s 40% or more tax rate plus there is transfer taxes, which are quite significant in New York City. So the tax rate is much higher than I think most investors anticipate.

Right. That would be in a sale, so what would be as far as rental income? Maureen O’Connell: As far as rental income, it would not be significant.

Okay. Okay. Is there anyway -- go on. Maureen O’Connell: It would be part of our operating income. So it would be our normal tax rate on our operating income.

Okay. And I guess from there, we could probably assume, let’s just say of 45% tax bracket, take the difference and figure out MPV at the tax savings are or the tax avoidance by doing… Maureen O’Connell: Right. Our tax rate currently is about 40.5%.

Okay. Okay. So, when you look at that maybe the MPV of the tax savings during this round as suppose to the other. Did you come up with a number or could you tell us what that might be or what you're thinking there? Maureen O’Connell: Well, we felt that this was the best MPV because we retained the asset which continues to add value as well as increasing our operating income. As far as specifics on each alternative, we can go into those numbers.

Okay. All right. Thank you very much. I appreciate your help. Maureen O’Connell: You’re welcome.

Thank you. And at this time, I’m showing there are no further participants in the queue. I would like to turn the call over to Mr. Richard Robinson for any closing remarks.

Thanks for all your support. We appreciate your attention to our second quarter call. We wish everybody happy holidays and we’ll talk to you again in March. Thank you.