Scholastic Corporation (SCHL) Q3 2016 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen. And welcome to the Scholastic Reports Fiscal 2016 Third 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, today's conference is being recorded. I would now like to introduce your host for today’s conference call, Mr. Gil Dickoff, Senior SVP and Treasurer. You may begin, sir.

Kevin, thank you so much, and good morning, everybody. Before I begin, I would like to point out that the slides of this presentation are available on our investor relations website, that can be found 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 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 those 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.

Thank you, Gil. Good morning, and thank you for joining us today. We had a solid third quarter, with strong execution in our global children's book and education businesses. Our leading position in children's books, combined with current market trends that are well aligned with our strength both in distribution and publishing, has continued to be a key driver of growth. The marketplace for children's books from early childhood to young adult has grown over the past 5 years, even as the adult trade business has softened. This growth has stemmed in part from the strong focus in schools on the importance of children's literature and improving children's reading, both in instruction, and through independent reading. In addition, parents are buying more books for the very youngest children from zero to four, driving expansion of the market in the earliest years. As a result of this new market dynamic, retailers are now dedicating more space to children's books. Similarly, where Scholastic is making reading available in more than 80% of the schools, our opportunities continued to increase for pre-K to 8 literacy curriculum and services. More and more schools and district administrators are turning to us for help in assessing their specific literacy needs, and partnering with us to help them with customized solutions, including professional development. As reported, revenue for the third quarter was $366 million, an increase of 6% from last year. Excluding one-time items, our operating loss was $8.1 million, a 51% improvement compared to an operating loss of $16.5 million last year. The loss per share, excluding one-time items was $0.06 versus $0.33 in the prior year period. As you know, the third quarter is a seasonally low revenue quarter, and one in which we typically report a loss. In children's books, our third quarter trade publishing performance was driven by our front list, with strong demand for the full color illustrated edition of Harry Potter and the Sorcerer's Stone, Harry Potter themed coloring books, The Baby-Sitters Club and Amulet Graphix novels, as well as the Whatever After and Wings of Fire series, just to name a few. Looking ahead, we're excited about Harry Potter and the Cursed Child, the script book co-authored by JK Rowling, which we will publish on July 31st in the US and Canada. While anticipation for this script book is high, we do expect market reaction to be somewhat different from the 7 original Harry Potter novels, as this is a book based on a play and presented in script format. We also recently announced a multi-year global license publishing deal with Warner Brothers for books based on the 8 Harry Potter films, as well as on the new movie, Fantastic Beasts and Where to Find Them, which will launch on November 18th of this year. The extensive agreement includes world all language rights for new movie tie-in books for children in multiple formats. Our school distribution channels continue to be an important part of the market growth in children's books. In book clubs in the quarter, revenue growth of 4% was driven by increased order volume and strong product, including Star Wars titles. In book fairs, we had higher revenue per fair, but due to a shift of some fairs to the fourth quarter, revenue declined slightly year-over-year. Nonetheless, we expect to have a good revenue quarter in the March to May period in fairs. We expect the children's book market to remain strong and are therefore making additional investments to capitalize on the favorable market dynamics and support for independent reading in schools and at home. We're investing in our strong line-up of authors, licenses and trade titles to grow our front list, and we have adjusted our free cash flow guidance for this fiscal year to reflect these investments, as well as additional investment in our SoHo building's headquarter office space to maximize its long-term value. In education, revenue in the quarter increased by 17%, driven by classroom books and classroom magazines and our success in broadening our partnership with schools and district administrators throughout the country. For example, in Alabama where the state superintendent has committed to an integrated learning support system to address barriers to learning for all children, Scholastic education experts now provide coaching and professional learning, as well as pre-K to 8 literacy programs in 49 counties throughout the state. With innovative in-person coaching and webinars from Scholastic, school districts are improving student attendance, classroom engagement, and graduation rates. This focus on student achievement presents a significant opportunity for Scholastic to expand the market for education products and services, including our classroom book instructional programs, which have grown significantly over the past several years. Further, we expect continued growth in our print and digital classroom magazines, already a strong and profitable operation, where circulation exceeds 15 million copies. We believe the digital supplements to our magazines are among the most widely-used digital learning programs in classrooms today. In our international business, revenue growth was 6% on a consistent constant currency basis, was driven by strength in trade publishing and book fairs. Despite local currency sales growth in many countries, the strong US dollar and weaker economic growth in Asia have continued to challenge our international business. We reported local currency growth in each of our major international markets, Canada, Australia and the UK. In Asia, however, where revenues were approximately even with last year growth has slowed based on more cautious consumer spending. Meanwhile, we expect the situation to improve in coming months, but we are making strategic investments to reduce overhead cost, including the transition to a shared services financial model for certain back office functions and a new efficient ERP platform for finance and warehouse operations. As you know, we have decided to monetize our valuable headquarters building in SoHo through expanding the retail space. We are now beginning to build out this new retail space and are working with a broker to lease out the ground and second floor for retail. This will entail the construction of a new employee entrance way on Mercer Street, allowing us to free up the premium Broadway-facing retail. We have also started a 2 year investment project to modernize our headquarters offices, to make more efficient use of our space, by adding approximately 25% more occupancy in the building, enabling us to house virtually all of our New York staff in this one building. This will lead to cost savings over the long-term, including costs for current leases outside our headquarters. We expect that these investments in both the retail and office components of our company-owned real estate will add significant value long-term, through increased rental income and reduced outside rent costs. I want to address our decision to terminate the $200 million tender offer in the third quarter. As you are aware, major stock indexes slid more than 10% in January and we did not believe it was prudent to buy shares during a period of such volatility. Although stock prices appear to have stabilized, there is still a concern about the strength of global markets. Meanwhile, our board continues to review opportunities to return capital to shareholders, and we have recently begun to repurchase shares in the open market. With that, I will ask Maureen O'Connell, CFO and CAO, to review our quarterly results in more detail.

Thank you, Dick. And good morning everyone. Revenue for the quarter increased 6% or 8% net of currency translation, driven by our children's books, trade and book clubs in particular and classroom books and classroom magazines. As you know, the third quarter is a seasonally lower revenue quarter and one in which we typically report a loss. Excluding one time items, operating loss this third quarter was $8.1 million or $0.06 per share, compared to an operating loss of $16.5 million or $0.33 per share last year. One time expenses for the quarter amounted to $0.15 per share, which included non-cash impairment charges for certain legacy pre-publication assets in our children's book and education segments, as well as severance associated with our cost reduction programs. As a reminder, we had one-time expenses of $0.15 per share last year. In children's book publishing and distribution, revenues grew year-over-year by 7% to $220.2 million and operating income, excluding one-time items, was $6.5 million versus a loss of $2.8 million last year. Book clubs grew by 4% due to higher order volumes, book fairs was down by 1%, as some fairs shifted to the fourth quarter, although we did have higher revenue per fair held. Operating income also benefited from lower product and promotion cost in book clubs. As we look ahead, we are very excited about the upcoming trade releases including Everland, a new young adult title coming in May and the ninth book in Wherever After series, which will be released in April. In education, Q3 revenue increased 17% to $63.5 million and operating income rose by 88% to $6.2 million, excluding the previously mentioned impairment charge. Higher sales volume in the quarter was partially offset by investments to expand our sales force, to accelerate growth in this segment. Performance in the classroom books and print and digital classroom magazines demonstrates the importance and the potential of the education business, which continues to be a growth area for the company. In our international segment, revenue was $82.3 million, a decrease of 4%. If you exclude the $9 million impact to foreign currency, revenues increased year-over-year by 6%. In local currency, each of our major markets grew, Canada, Australia, and the UK and our results in Asia in the aggregate were on par with last year. Excluding one-time items, the operating loss in the quarter was $1.5 million, compared to operating income of $2.3 million last year, due to an insurance recovery for a warehouse fire in India in the prior-year period, as well as higher bad debt and product cost in Asia. Third quarter corporate overhead, excluding one-time items of $1.2 million was $19.3 million, even with the prior year period, also excluding one time items. Incremental facility costs were offset by cost savings in other departments. We are conducting a comprehensive company-wide review of our overhead and operating cost across all our business segments, which will benefit next year. We will provide additional details when we issue our fiscal 2017 outlook in July. Our strategic technology investment project remains on track. As a reminder, these investments are focused on e-commerce, customer relationship management, content management, and creating a single platform for all of our operations. These investments will continue through 2018 and are expected to bring widespread benefits, helping to bring us closer to customers and improve product inventory and content management, so that we can better target our markets, improve processes and lower costs. As we reviewed last quarter, our capital investment plan, which will total approximately $10 million to create new premium retail space at our SoHo headquarters has commenced. This new retail space is expected to generate approximately $10 million per year in incremental rental income. Also, as Dick mentioned, we are preparing to upgrade the office component of our SoHo location, which was last renovated 25 years ago. Over the long-term, the new office design will reduce our reliance on external leases here in New York. However, in the near term, as this work is being performed, we will have higher short term lease costs for swing space, to accommodate employees during construction. We are finalizing plans and cost estimates for the new, more modern and flexible office layout and will provide additional details related to this work when we announce Q4 2016 results and issue our outlook for fiscal 2017 in July. Year-to-date free cash flow use was $191.8 million or $5.8 million if you exclude the impact of taxes paid on the gain of the sale of our education technology business, versus free cash flow of $44.2 million last year. The $50 million year-over-year negative cash flow variance, excluding the one-time tax payment, is primarily the result of EdTech transaction-related expenses paid in the current year, as well as the absence of positive cash flow contribution from the EdTech business last year. Note the positive contribution from EdTech cash flow in the prior year reverses in the fourth quarter. During the third quarter, we resumed our share buyback program and repurchased approximately 336,000 shares of common stock for $11.5 million in the open market as of March 18, and we have $48.4 million remaining under our current repurchase authorization. As we announced yesterday, the Board of Directors declared a quarterly cash dividend of $0.15 per share on Class A and common stock for the fourth quarter of fiscal 2016. Now turning to outlook. While we continue to face headwinds related to the relative strength of the US dollar, which has adversely impacted our reported revenues by $37.9 million year-to-date, we are affirming our fiscal 2016 outlook for total revenues of approximately $1.65 billion. We continue to expect earnings per diluted share from continuing operations of approximately $1.35 before the impact of one-time items associated with cost reduction programs, and non-cash non-operating items. We have adjusted our free cash flow guidance for the current year to $25 million to $35 million from the previous guidance range of $35 million to $45 million, to reflect higher royalty advances and other investments in new Trade titles, authors and licenses, as we look to leverage the success of our front list, as well as higher capital spending levels for improvements to our corporate headquarters. As a reminder, the free cash outlook excludes one-time taxes paid on the gain from the sale of our educational technology business. We expect our continued strong execution and our positioning in the robust market for children's books and educational materials to continue to drive our results. As we deepen our relationship around the world by providing the tools and the support that teachers, families and communities need, to successfully teach each and every child to read, and to learn. I will now turn the call over to Gil to moderate a question-and-answer session.

Kevin, thanks, we are now ready to open the lines for questions.

[Operator Instructions] Our first question comes from Drew Crum with Stifel.

Okay. Thanks. Good morning, everyone. So Maureen, want to better understand how you are thinking about free cash flow going forward and I guess I'm looking beyond fiscal 2016. It sounds like the investments you're making in the corporate headquarters may run past fiscal '17. And I'm not sure what you're anticipating in terms of royalty advances beyond this fiscal period, but it sounds like you've got a very strong pipeline of content coming next year. So just want to better understand how you're thinking about normalized free cash flow for this business, over the intermediate to longer term. Thanks.

Well, you're correct, we have had royalty advance increase this year and we may have some next year. We'll figure – we'll define that as we release our guidance for 2017. As far as the corporate investment, that is a 2 year investment. So I think you can assume our cash flow returns to the historical levels after that two-year investment period is over.

Okay. And then you also mentioned in your preamble the investments you're making in technology, and that would run through fiscal '18. Should we anticipate a flat line spending level the next two fiscal periods, or should we anticipate a step up in investments there?

It should be comparable to the current year investment spending.

Okay. And then Dick, you made a comment on the Harry Potter release in July, any thoughts on the movie tie-in books that you have coming in the next couple quarters? And just taken all together put some perspective around how collectively the content strategy looks, compared to some of the big releases you had in prior years?

Well, Harry Potter remains a tremendously strong franchise, and it's the renewed interest in JK Rowling in the franchise has begun to up-tick now with the announcement of the play coming in July, and the new Fantastic Beast film in November. I'll ask Ellie to detail the sequences of these publishing releases, because there's quite a few of them coming over the next 12 months.

Hi. Even in anticipation of the play that is opening at the end of July, we have seen tremendous interest in the back list. Of course, this year, we published the illustrated edition of Sorcerer's Stone, which exceeded our expectations and we have the coloring books, which are driving tremendous sales, and again renewed interest in Harry Potter. So in July, the end of July 31, we will with publishing the script book, tying into the play that is opening in London's West End. There's a lot of excitement starting about that and we're working closely with our retailers to see how - to laying down that product. And after that does come the movie release in November of this year, and we will be publishing a rich program of tie-in books, movie handbooks, sticker books, a wide range of things, to appeal to a wide audience. We will also later in the fall, have the next illustrated edition, Chamber of Secrets, which again we're very excited to be publishing, and again we'll be tying - doing tie-ins for the three movies coming up over the next six years.

Okay. Do guys - Ellie, do you have both print and digital rights for those movie tie-ins?

We have digital rights to the first movie tie-ins.

Okay. And the script book, is that a digital right as well?

No, we only have the print rights for that.

Okay. I'll jump back into the queue. Thank you.

Our next question comes from Barry Lucas with Gabelli & Company.

Thank you, and good morning. A little bit of nuts and bolts related to the guidance. This quarter, seasonally small, was probably better, much lower loss than last year, and less than I would have anticipated. You had discussion about some fair business being shifted into the fourth quarter, and at the same time, you're generating higher revenues per fair. So why wouldn't the guidance have been a little bit better for fourth quarter and full year?

Well, I'll let Maureen detail that. Remembering, Barry, most of our profits come from the fourth quarter. We're highly leveraged on the fourth quarter, particularly in the education business, but really in all our businesses for the profits. So we're hesitant to change the guidance at this point, even though we had a good quarter, and we do have some continuing cost issues that we're keeping our eyes on. Plus the international business continues to be rocky with the - we flattened out a bit in Asia as we indicated, and the impact of currency has been really very strong on our revenues this year. As we've announced we're $38 million of currency impact on our revenues in international for the first nine months, and we expect that to continue in the quarter, fourth quarter. Maureen, would you want to detail any more about this fourth quarter, and Barry's interest in the guidance?

Yes, I think as Dick mentioned, we had a very large quarter in our children's book business last year, and we are expecting growth again on that this year, so that is something that is anticipated in the fourth quarter. And the fairs moving to the fourth quarter, we're expecting growth from that as well. I think if you look at our year-to-date numbers, because of our results, particularly in international due to FX, as well as the impact of buying the US dollar product, you look at the year-to-date results, although we're up in revenue, there has been an impact on our margins, and also the strike in Ontario affected our results in the year-to-date period. So on a year-to-date basis if you look at our operating income, it is still down from the prior year. So we need to increase our operating income in the fourth quarter to meet our guidance.

Okay. One question about the real estate and the investment that you are making in the building, currently. If I were a high-end retailer, such as many of the tenants in and around the neighborhood. I would probably want to have some meaningful input into the renovation, reconstruction, and the look of my selling space. So you're putting money into the building ahead of a tenant being signed up. I'm just wondering how you balance that.

Well, there are two parts of this, Barry. First, we're simply clearing out the retail space on the first floor, which as you know, having come into the building, we have to take out the escalators, the elevators and so forth and so on in that space, as well as preparing the box for the retailer. Our discussions with retailers have already begun, so as we make the basic adjustments, we're already in touch with them and also our current tenants, Sephora and Hugo Boss, about what we are doing in the building. So both new retailers that we would be talking to, as well as our existing tenants, are very much aware of what we're doing in the building, and have input into it. It's a good question. But I think we are covered for our partnership with the new retailer coming into the building. We're not going to create a space that they don't want, and we've given a great deal of thought to that already, as we have thought about our second floor, and how that might work.

Great. Thanks, Dick.

[Operator Instructions] And I'm not showing any further questions at this time.

In that case, we want to thank you all. We had a strong third quarter. We look forward to our fiscal year-end call in July, and we will talk to you further again. Thanks so much for your interest in Scholastic.

Ladies and gentlemen, this does conclude today's presentation. You may now disconnect, and have a wonderful day.