Scholastic Corporation (SCHL) Q2 2018 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the Scholastic Reports Fiscal 2018 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 call may be recorded. I would now like to introduce your host for today’s conference, Mr. Gil Dickoff, Senior Vice President, Treasurer and Head of Investor Relations. Please go ahead.

Thank you, Crystal, and good morning, everyone. Welcome to Scholastic's Second Quarter 2018 Earnings Call. Joining me here today are Dick Robinson, our Chairman, President and Chief Executive Officer; and Ken Cleary, the Company’s Chief Financial Officer. We have posted an investor presentation on our IR website at investor.scholastic.com, which we encourage you to download if you have not already done so. I would like to also point out that certain statements made today will be forward-looking. These forward-looking statements by their nature are uncertain and may differ materially from actual results. In addition, we will be discussing some non-GAAP financial measures, as defined in Regulation G and the reconciliations of those measures to the most directly comparable GAAP measures can be found in the Company's earnings release filed this morning on a Form 8-K, which is also been posted to our Investor Relations website. We encourage you to review the disclaimers in our press release and investor presentation and to review the risk factors contained on our annual and quarterly reports filed with the SEC. And now, I would like to turn the call over to Dick Robinson.

Good morning everybody and thank you for joining us today. I look forward to introducing you to Ken Cleary, our new CFO in just a few minutes. Ken has been with Scholastic for ten years, most recently as Chief Accounting Officer and he is entirely familiar with all our financial and business operations. He has quickly moved ahead in his new role bringing excellent analytical skills and hands-on approach to working with the business units to improve profitability. As you know, the 2018 fiscal year is a swing year between 2017 when we had significant additional revenues from Harry Potter and the Cursed Child and the 2019 fiscal year when the effects of our Scholastic 2020 plan will begin to kick in. Second quarter results demonstrated progress in our core businesses and were solidly in line with expectations including holding profitability for the corporation, even though we were down almost $18 million in trade revenues based on the comparison with the Fantastic Beasts Screenplay released in November 16, - November 2016, which led to strong revenues in the second quarter last year. Cost savings throughout the organization including overhead resulted in only a slight decline in profits versus last year and kept us on pace with our forecast for 2018. We are therefore affirming our guidance for the full year. Our core Children's Book Publishing showed resilience in the quarter underlining the many reasons why Scholastic is the world’s largest publisher and distributor of children’s books. While Book Clubs and Book Fairs both lost revenues in September from the hurricanes in Texas and Florida, we were able to end the quarter with increases in profitability for both Clubs and Fairs. We also had improved trade results compared to our plan through the strong performance in such new titles as Dav Pilkey's Dog Man. As you know, Education is a major growth area for the company, especially in K-6 core reading, as schools move to balanced literacy and reading solutions which are strongly identified with Scholastic. In the quarter, we added sales and marketing positions which will bring incremental costs, but will lead to greater sales later in fiscal 2018. We were highlighted in the 2017 EdWeek Market Brief survey in which teachers and the district leaders ranked Scholastic as the highest quality producer among four major educational companies with 85% expressing positive support for Scholastic compared to the mid-60s for the next ranked company. In the quarter, we made some significant changes in our Asia operations while also pushing forward with our 2020 plan and nearing completion of our office build out in Soho as our staff has relocated back to the building after 18 months of renovations. I will address these topics in turn. In Children’s Book Publishing and Distribution in addition to the Dog Man series and its predecessor Captain Underpants, best-selling titles in the quarter included tie-ins to best-selling Five Nights at Freddy's video games, as well as Harry Potter and the Prisoner of Azkaban: The Illustrated Edition, and Harry Potter: A Journey Through a History of Magic. Alan Gratz’s highly acclaimed Refugee also continued to sell strongly. We are eagerly awaiting sales of the fourth title in the Dog Man series, Dog Man and Cat Kid, which is scheduled for release on December 26th. We have a strong upcoming list for spring including titles from Super Bowl champion and literacy crusader Malcolm Mitchell, who debuts with his picture book Magician’s Hat. Also The Traitors Game by New York Times and USA Today best-selling author Jennifer Nielsen, James Swanson’s Chasing King’s Killer, The Hunt for Martin Luther King, Jr.'s Assassin, and The Word Collector, new picture books by Peter Reynolds, all scheduled to be released in early 2018. Throughout the 2018 calendar year, we will celebrate the 20th anniversary of the U.S. publication of Harry Potter and the Sorcerer's Stone with major events in July and September. Book Club sales began slowly this fall as teachers took time to adjust to a new sequence of Club offerings. However Club sponsors came back strongly in November with sales in the month increasing compared to the prior year. Profitability improved on lower revenues as we realized cost savings through process improvements including digital marketing initiatives and more services provided online. Book Fair showed sales growth and improved profitability in the quarter. Our focus on revenue per fair growth is driven by matching our fairs more closely to the needs of each school in terms of book selection, fair mix and number of titles. In Education, as earlier stated, we are expanding our efforts to increase new publishing and sales capabilities as customers shift to customizable core literacy curriculum and away from basal readers and textbooks. We were incurring some near-term cost for this expansion, but we are confident that these expenditures will position us very well for next year with a broader product range. We are on plan for the spring launch of Scholastic EDGE, an extension of our – the company’s guided-reading core literacy curriculum offerings. EDGE provides a larger range of high interest and age-appropriate titles at lower reading levels, enabling striving readers to build their skills and capability to read a wider range of books. We also expect sales gains in the second half of the year in our summer reading programs and Level Bookroom 4.0 introduced in April 2017 with over 6200 texts and professional learning support. In addition to these, we are developing more print and digital products aimed at providing a full curriculum – core curriculum to address the complete range of literacy solutions for classrooms including new grammar, writing and usage programs, as well as a new digital phonics program. We recently appointed three outstanding professionals to advance the division’s strategic growth plan by providing districts with core literacy curriculum for pre-K to Grade-6 expanding the Services business, including professional development and family engagement, while increasing sales and marketing capacity. In International, strong trade publishing businesses in the major markets, Canada, UK and Australia and New Zealand continued to drive results, while we were also focusing on the increasing needs for English language learning products for expanding markets in Asia. In Asia, we have also initiated several strategic changes in our Direct-to-Consumer Book business with new leadership in India, Thailand and Indonesia with deep direct selling experience in these markets. We’ve also recently appointed a new Regional Marketing Head to leverage proven programs across all markets. To accelerate sales growth, we are refocusing our sales teams from door-to-door selling to high traffic malls allowing us to promote in advertising large-scale events and demonstrations using well-known local characters as a draw. Coupled with this new selling strategy, we are developing new learning products including some more digital programs that will launch in 2018. Let me now turn to Scholastic 2020, the three-year plan we launched earlier this year to substantially increase operating income and improve our organizational effectiveness as we approach our 100th year in October 2020. We believe this comprehensive plan will position the company to operate more effectively across business groups with better information about product, content, customer data that will not only support more effective marketing including cross-selling opportunities, but will also result in more efficient business processes, especially in the labor and freight-intensive distribution operations. This will lower costs along with a management process that aligns our 2020 activities with the company’s strategic objectives with clear targets and accountabilities. As a result of our Scholastic 2020 plan, we expect significant double-digit operating income improvements in 2019 through 2021. We are already starting to see elements of this plan deliver increasing value to our business units. I already discussed how marketing, automation and e-commerce improvements in our Book Club division helped improve profitability this quarter. In Book Fairs, we are piloting a new POS system this month along with a new digital wallet feature that will allow parents to safely create a digital account to fund their children’s Book Fair purchases. We expect this to improve both participation in fairs and revenue per fair. We have also introduced a new CRM platform in Book Fairs and Education enabling sales and support teams to access customer data, manage pipeline opportunities in sales territories, and administer field service functions on mobile and desktop. In Classroom Magazines, we have completed the migration of all 24 digital magazines to a single platform. Our Digital Education and Subscription products are now all operating on a new digital manager platform allowing teachers to set up classrooms and enabling our sales teams to packaged digital products in response to district needs. On the operations side, new fleet management and inbound freight modules went live on the new Oracle Transportation Management platform this quarter. Finally, on our real estate project, Scholastic employees have been relocated back to our corporate headquarters in Soho, out of leased space and we have now hired the country’s leading independent real estate specialist firm to market the 42,500 square feet of retail space at our 557 Broadway location. With that, I will pass the call to new CFO, Ken Cleary.

Thank you, Dick and good morning. This morning I will refer to our adjusted results from continuing operations for the quarter excluding one-time items unless otherwise noted. Revenues were $598.3 million versus $623.1 million in the second quarter last year. Operating income for the current quarter was $110.9 million, compared to $116 million in the second quarter of fiscal 2017, a period that saw the successful release of Fantastic Beasts and Where to Find Them: The Original Screenplay. Earnings per diluted share was $1.92 versus $1.99 in the prior year period, excluding one-time items in each period. We had $19.1 million in non-recurring items in Q2 including a $15.4 million non-cash partial settlement charge taking below the operating line associated with the termination of our cash balance-defined benefit pension plan here in the U.S. and $3.7 million of one-time severance and stock comp charges. Overall profitability improved in the quarter on lower sales, as the company realized savings in cost of products, fulfillment and catalog and promotion costs, a key focus of ours as we look to achieve a significant increase in operating income by 2020. We have now cycled 12 months of last year’s wage adjustment program in our warehouse fulfillment and customer support operations in response to the competitive seasonal labor markets. Catering the increase in more wages we have revamped training programs that engage our seasonal workforce and produced a 13% year-over-year supply chain improvement in the second quarter. We also implemented improved and highly predictive staffing models that put trained resources in the right place at the right time in order to meet customer demands. Now turning to our segment results. Children’s Book Publishing and Distribution segment revenues were $411.8 million, compared to $432.5 million last year. Segment operating income was $115.1 million versus $121.1 million in the prior year period, primarily result of the lower Harry Potter sales in trade channel as expected. Education segment revenue was $70.9 million, compared to $71.1 million last year with solid results in our target Core Literacy and Supplemental Instruction lines of business, Classroom Libraries, Professional Learning, and Classroom Magazines, all offset by declines in the segment’s Consumer Magazine and Teaching Resources channels. Segment operating income of $3.8 million was down $4.9 million year-over-year, primarily as a result of higher employee expenses from an expanded sales and marketing force with expertise in solution selling of Core Literacy Instruction programs, a key element of the Scholastic 2020 plan. International segment revenue was $115.6 million versus $119.5 million last year. Segment operating income was $14.7 million, compared to $16.9 million in the prior year period, which exclude a one-time charge of $200,000 for restructuring severance. The decline was primarily the result of lower Harry Potter sales in Canada and the export market as expected, as well as softness in the company’s Direct-to-Consumer selling business in Asia. Corporate overhead expenses were $22.7 million versus $30.7 million last year. The lower overhead expense was primarily the result of lower employee-related expenses in the current quarter, as well as some timing-related to moving expenses in the prior year period. Net cash provided by operating activities was $120.8 million versus $179.7 million last year and free cash flow as defined by the company was $90.7 million compared to $164.1 million last year when we realized a higher level of customer remittances from the significant sales of Harry Potter Publishing in the first half of 2017. We distributed $5.3 million of dividends and repurchased $8.6 million of common stock during the quarter leaving outstanding authorization of $25.3 million for future buybacks. At quarter end, cash and cash equivalents exceeded debt by $376.5 million, compared to $435.6 million a year ago. The reduction in cash balances was mainly due to our previously announced capital spending programs. As you know, we have projected to use cash this fiscal year for the first time in many years due to the redevelopment of our headquarters building along with higher levels of spending on technology upgrades. We expect to return to positive free cash flow next fiscal year as the work on the building is completed. In the second quarter, we had $21.3 million in capital expenditures including $9.1 million in connection with our headquarters renovations. We remain on schedule to complete the majority of the office upgrades by the end of calendar year 2017. We also used $7.8 million in capital for a strategic technology transformation program. Before I discuss our outlook, let me take a minute to provide some perspectives on the financial statement impact of our investments in Scholastic 2020 growth and productivity initiatives including upgrades to our office workspace and continuing development and deployment of strategic technologies. These investments include both operating expenses that are reflected in the income statement in the period they are incurred and capital expenditures that will be reflected in subsequent periods as incremental depreciation. When initials are complete in 2018 for the building and 2020 for the technology, capital spending will decline and we expect a net positive impact to earnings as a reduction in Scholastic’s 2020-related operating expenses along with the benefit to the plan itself will be partially offset by higher depreciation as the building improvements and technology deployments are placed into service. Now turning to outlook. We are reaffirming fiscal 2018 outlook of $1.65 billion to $1.7 billion in revenue and earnings per diluted share in the range of $1.20 to $1.30 excluding one-time items and non-cash charges resulting from the previously announced termination of our domestic defined benefit plan. Fiscal 2018 free cash flow is expected to be use of $10 million to $20 million, and includes capital expenditures of $90 million to $100 million, and pre-publication and production spending of $30 million to $40 million. With that, I will hand the call back to Gil for follow-up questions.

Thank you, Ken. Crystal, we are now ready to open the lines for questions.

[Operator Instructions] And our first question comes from Drew Crum from Stifel. Your line is open.

Thanks. Hi, guys. Good morning.

Good morning.

So, Harry Potter has been a headwind during the first half of fiscal 2018. Do you expect that to reverse in the second half and the franchise to grow? Anything you can share in terms of the events that you referenced in July and September of calendar 2018?

I’ll ask Ellie to answer that question, Drew.

Hi, Drew.

The question being…

Hi.

The trajectory of Harry Potter, yes.

Again, we have a lot of excitement coming out in the market with play opening on Broadway in April and the exhibition opening at the New York Historical Society in the fall and against that we have additional tie-in publishing coming out this summer and a tremendous 20th anniversary marketing campaign that we are kicking off starting in the next few months and continuing throughout the year. So we have a lot of key marketing and promotional moments coming up. So we expect sales to remain strong.

So I think the headwinds are probably somewhat over at this point, Drew, but the second quarter there were still considerable Harry Potter revenues in 2017 from Fantastic Beasts not to mention in the first quarter where we had very significant revenues for Harry Potter and the Cursed Child.

Got it. Okay. And then, Dick, can you expound upon what you are doing as far as digital marketing is concerned with the Clubs business? Is this something that’s new and something you expect to use going forward?

Yes, I’ll ask Judy to fill you in on that one, Drew. Thank you.

Hi, Drew.

Hi, Judy.

This year – how are you? This year, in Clubs, goes up and running on demand well and we have a lot of data about our customers. So we were able to really eliminate a lot of print marketing expenses, posters and mailings and direct marketing. So we’ve done in print before and now we are able to do that online. So we can talk directly to our customers. They can identify that we know who they are. We can upsell to them. We can encourage them to place the next order. So now that our site is robust and working, we have really good access to our data. We can take all that targeted marketing for our 700,000 teachers across the country and do a lot of one-to-one digital marketing online, which is both reducing cost, much more personnel, state-of-the-art e-commerce and really improves profitability of the business.

Okay, great. And then, just maybe one last question for Ken. You mentioned the purchase of an annuity contract from a third-party insurance company for the remaining pension liability. What is the cash flow impact you are anticipating from that if there is any? And then, you also referenced the non-cash settlement charge, I think you are going to take in the third quarter. Can you quantify what that will be? Thanks.

Sure, sure, Drew. So, the plan is fully funded at this point in time as per our actuary valuations. So, actually it’s funded to about a 105% right now if you look to both year-end and where we are today. So we don’t expect any cash flow – any cash flow impact to the company, it will all be out of the planned assets.

Got it. Okay, okay, and the charge, the non-cash charge you are anticipating…

Yes, so, we still have a non-cash charge that comes out of the comprehensive income. It has no impact to equity. It is probably - if we probably recognize the third of it, and probably have two-thirds to go. So, probably, roughly, $30 million to go.

Okay.

Pretax.

Okay guys. Thank you.

Thank you. [Operator Instructions] And our next question comes from Barry Lucas from Gabelli & Company. Your line is open.

Thank you, and good morning. Anyway to size the hurricane impact on Clubs and Fairs either in revenues and operating income?

I’ll ask Ken to deal with that one, Barry. Good morning.

Sure.

Good morning.

Sure, so it did have an impact on us. It’s tough to say exactly. We did had some Fair cancelations, but really it was traffic flow that slowed down in some of the Fairs, probably single-digits millions, maybe 4, maybe 4 plus, maybe $4 million to $5 million.

Okay.

On the top-line.

And Judy, I think was good enough to speak about where the benefits come from when you look at the – I would say the profit improvement or the efficiency that you gained. But as I look at in round numbers, $800 million or so of cost to goods and it’s somewhat comparable amount of SG&A, where do you think the big benefits come from in these efficiency actions that you are taking? And I’ve got one more follow-up on this subject.

I mean, in respect to the 2020 plan…

Yes, exactly.

Where the cost reduction is going to come from – they are profit improvements, let’s put it that way. This is all profit improvements including cost reductions. I think we can – I’ll ask Ellie to supplement these comments. But first piece would be the CRM, which will enable us to market more effectively to our Book Fair and Book Club customers as well as our Education customers and this will be able to pinpoint our marketing more effectively to revenue per fair and various Book Fair schools for example, or of teacher customers for the Book Clubs and Magazines and that should improve both the top-line and the cost of marketing. On the process improvement side and the cost reductions, we are really looking at business process improvements that will reduce our cost base and particularly in the heavy fulfillment operations that we have in our Clubs and Fairs programs. So, I’ll ask Satbir, our Chief Technology Officer to expand a little bit on those comments, Barry. This is our three year Scholastic 2020 plan leading to double-digit operating improvements over the next three years. So, over to Satbir Bedi, Chief Technology Officer.

Hi, Barry. Excuse me, this is Satbir. We are obviously in the early stages of what Dick outlined as the three year plan for us. But the cost impact which is specifically addressed are going to be across the board, certainly in the fulfillment area and every area which is process heavy in the company and we also mentioned this has impact on the top-line since we – one of the focuses is to provide better data to the marketers and the sales people in the company to reach our customers and better market and sales blend.

Great, thank you. Thank you for that. So, if I try to roll this up Dick, and look at the whatever – however you want to describe the stretch goal of, call it, $2 billion in revenues, can we see a period toward the end of this that you would have slightly north of 10% EBITDA margins?

On an EBITDA basis, perhaps, that will be a good goal. But the issue with this and the benefit of this program, Barry is that, we keep planning, we keep articulating and implementing this plan on a, kind of a daily, weekly, quarterly basis. So that, as we have a goal and we are progressing towards the goal, but we are doing this in increments. So, we’ll feel more comfortable about offering achievements on the goal as time goes by and we have more concrete things to report about the savings improvements and the goal toward a higher operating margin.

Great, thanks for that, Dick.

But your goal is, it would be fine and we have it on a – basically on an EBIT basis rather than a EBITDA basis. But, we will accept your goal as optimistic and thing that we would like to achieve for the company and for the shareholders.

Great. And if we can just shift gears, maybe a little bit to education, again acknowledging that this is going to be really fourth quarter loaded, but as you look into something a little bit more firm than a crystal ball, what’s giving you the confidence as you described this as a growth area that, whether it’s enquiries from school districts or – say, orders on the books or teach enquiries. What’s providing the support there that has convinced you to put more money into sales and marketing and product development?

Well, Barry, as you know, as well as, or better than anybody else, there is $3 billion to $4 billion instructional education budget in the United States for K-12 schools and that’s more if you include technology. The – so it’s a big market and there are multiple competitors which we are a significant one. This market is moving away from core – from basal textbooks to balanced literacy solutions. And every day, our hundreds and hundreds of people that are out in the field are talking to school districts are confirmed by their conversations, this is the direction that school districts want to go. They’ve got no results from using the textbook day-after-day, year-after-year, and they are trying to be more innovative and to improve teacher professional development and learning as well as improving and making more interesting the books and materials for K-6 literacy. So this is a market that – it’s moving in our direction and we – this encourages us to have a rather high target for our growth in this business looking at the $3 billion. We are not going to get all of that. We are going to get more than the $300 million that we now have. So, we are very, very confident that this is a growth area for the company. We are investing, I think wisely and carefully in it. We are expanding our product as well as our sales and marketing capabilities and I think you will see this business growing significantly over the next three years and it’s certainly a key element in our 2020 growth plan.

Thanks for that color, Dick.

Thank you.

Thank you. [Operator Instructions] And I am showing no additional questions from our phone lines. I would now like to turn the conference back over to Richard Robinson for any closing remarks.

Well, thank you all for listening to our second quarter call. Happy holidays to all. We are looking forward to a strong fiscal 2018, but also 2019 to 2021 as we get the effects of our 2020 plan in going strong. Thank you all for your support and we’ll look to talk to you in the New Year.

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