Scholastic Corporation (SCHL) Q3 2019 Earnings Report, Transcript and Summary

Good day ladies and gentlemen and welcome to Scholastic Reports Fiscal 2019 Third Quarter Financial Conference Call. At this time all participants are in a listen-only mode. Following management's prepared remarks, we will host a question-and-answer session and our instructions will be given at that time. [Operator Instructions] As a reminder today's conference call may be recorded. It is now my pleasure to hand the conference over to Gil Dickoff, Senior Vice President, Treasurer and Head of Investor Relations.

Thank you and good afternoon everyone. Welcome to Scholastic's third quarter 2019 earnings call. With 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 Web site at investor.scholastic.com, which we encourage you to download, if you have not already done so. I would like to 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'll be discussing some non-GAAP financial measures as defined in Regulation G and the reconciliation of those measures to the most directly comparable GAAP measures can be found in the company's earnings release filed this afternoon on a Form 8-K which has also been posted to our Investor Relations Web site. We encourage you to review the disclaimers in our press release and Investor presentation and to review the risk factors contained in our annual and quarterly reports filed with the SEC. And now, I would like to turn the call over to Dick Robinson.

Good afternoon and thank you for joining our call. We had a solid third quarter with strong results globally in trade publishing and are on plan for book fairs and education in the U.S. As reported, third quarter sales increased by $15.4 million or 4% higher year-over-year. Year-to-date, revenues are up $51 million or 5% primarily driven by outstanding trade publishing results worldwide. This quarter's results reflect three major themes. First, continuing strength in children's book publishing and distribution. Business in this segment remains strong with an 8% gain overall, and a 25% gain in trade, which includes a significant jump in revenue from media. Scholastic continues to excel in brand and series publishing including the global bestseller Dog Man by Dav Pilkey which tops children's bestsellers every week and is currently led by Dog Man: Brawl of the Wild, the sixth title in the series. The Wings of Fire series expanded its success with the release of its 12th book, The Hive Queen; and The Baby-Sitters Club now with smashed success in graphic novel format saw its latest title Kristy’s Big Day entered the list of top sellers. The Harry Potter World continues to capture audiences' attention most recently with Fantastic Beasts: The Crimes of Grindelwald. Owl Diaries now including 10 titles continues to be a top series and just reaching the list of best sellers is I Need a Hug. The new award-winning picture book from Aaron Blabey, our author, illustrator best known for the Bad Guys series originally published in Australia. Expanding the impact of our publishing program, Scholastic Entertainment has exciting momentum as our iconic brands are brought to new life on streaming platforms. Our Evergreen Clifford programming library recorded significant sales in the quarter through license to Amazon Prime Video, while anticipation continues to grow for the launch of the new Clifford TV series this fall on Amazon and PBS Kids, accompanied by new book publishing and licensing programs. Book Fairs had a 6% gain in revenue on the recognition of additional revenue based on the timing of fairs at the end of the quarter and the higher redemption of Scholastic dollars. Our salespeople are now marketing fairs more efficiently using the predictive analytics available from the successful integration of salesforce.com. Based on positive feedback, we also expanded the use of our new POS devices in February offering improved connectivity and enabling broader use of E-wallet to allow parents to deposit money in their child's book fair accounts. The second theme reflected in the quarter is also connected to our children's book segment: Our response to the Supreme Court's Wayfair decision regarding sales tax collection. In response to the Supreme Court decision last summer, we introduced sales tax collection to our Book Club customers in February with good results. We have reprogrammed our customer facing ordering platforms for the efficient collection of state and local sales tax, although we still expect some continuing incremental tax-related expense in the current fiscal year. Ken Cleary will have more details on this later on. We are set up well for future quarters now because our online teacher and parent customers are paying sales tax, and we are running several tests to measure the impact of sales tax on the Book Club business overall. The third theme reflects the importance of the Scholastic Literacy launch. In February, we began presenting Scholastic Literacy to customers across the U.S., an important step for the long-term growth of the company. This K-6 core curriculum reading program builds on guided reading techniques and collections of motivational authentic text combined with digital programs that will help students learn the skills they need to master the reading tests they will face throughout their elementary education. With strong authors and tested curriculum applications, Scholastic Literacy has received very positive response from the market, and we are already finalists in several district reading adoptions. We will deliver the program and the professional learning services this summer with revenues recorded in the first quarter of 2020. As you know, we already have a large share of the 500 million supplementary classroom books and classroom magazines market as estimated by Simba Learning. While our supplementary business remains strong and is a key source of high quality books for classrooms, Scholastic Literacy positions us as an important player in the $1 billion plus core reading market, and arena where we currently have little share. As we expand Scholastic Literacy sales, we will add significant revenue and profit over the next several years. Our sales team is geared to sell the new core program, while also maintaining and expanding our position in the supplementary business. To support them as they expand their selling strategy, we have launched a suite of analytics tools to provide predictive and diagnostic capabilities around the sales pipeline. This allows sales managers to focus resources on areas of opportunity across districts and schools. Technology enhancements have also improved our efforts to market and sell through digital and social media platforms. In fact, our teacher store online which supports education has seen a 16% increase in revenue year-over-year and a surge of new customers. Here are some additional notes on this quarter's performance. Our international revenues continue to track ahead of prior year excluding the impact of the strong U.S. dollar. In addition to the success of trade publishing, we saw a strong performance in our multiple distribution channels in China, which deliver English language learning to young children through franchise schools and sales of our print and digital books to families through local Internet marketers. These channels both in China and other areas of our expanding Asian market, along with our growing list of new digital product offerings will drive international growth going forward. I would like to take a moment to highlight key corporate initiatives around Literacy Thought Leadership. Our investors and anyone concerned with children's reading will be interested in the release this week of the seventh edition of the Scholastic Kids and Family Reading Report. This year's findings reaffirm the strong support for reading voiced by children of all ages and their parents including the benefits of reading aloud. It also highlights the need for Scholastic and all of our partners in schools across the country to continue to motivate independent reading for children ages 9 and above when interest can often begin to wane. To this end, Scholastic is about to launch its annual Summer Reading Program, which engages tens of thousands of teachers, families, community partners, retailers, and kids in independent reading. The goal of our efforts is centered on offsetting the summer slide which is noted in research as the decline in academic progress that can occur when school is not in session. In anticipation of the program's launch, we are already receiving enthusiastic support from independent booksellers across the country. With respect to our retail leasing situation in the 555-557 Broadway building, as referenced in our last quarter call, Sephora moved into their new location at our newly developed retail space at 557, and they tell us that their new store is an unqualified success. Meanwhile, we have received strong interest in the retail space vacated by Sephora, and we expect to be able to announce a tenant by the time of our July call. I will now turn this call over to Ken to give you details of our program to achieve our year end results.

Thank you, Dick. Good afternoon. This afternoon, I will refer to our adjusted results from continuing operations for the third quarter excluding one-time items unless otherwise indicated. As discussed last quarter, we have adopted the new revenue recognition guidelines under ASC 606 this fiscal year. Prior periods results have not been restated. As we review the quarter sales and operating income, I will highlight the impact of these new standards on the period's results. Revenues were $360.1 million versus $344.7 million in the third quarter last year an increase of 4%. The current quarter's reported revenue was $9.4 million higher through the impact of ASC 606 basically awash with the unfavorable impact of ACS 606 on our second quarter sales. Operating loss in the seasonally low quarter improved to $18.7 million versus a loss of $19 million a year ago. We had $2.7 million in one-time items impacting our operations in the quarter, which included $2.2 million of onetime severance taken in connection with our cost improvement programs in $500,000 related to a warehouse consolidation in Canada. In the third quarter of fiscal 2018, we had $4.7 million in onetime charges above the operating line. While not components of operating income, the prior periods results included a non-cash pre-tax charge of $39.6 million or $0.76 per share related to the termination of our defined benefit pension plan in the U.S. and an $8.3 million or $0.24 per share charge for the re-measurement of our U.S. deferred tax balance in connection with the passage of the Tax Cuts and Jobs Act of 2017. Adjusted EBITDA for the third quarter was $1.4 million compared to a loss of $2 million last year. For the first nine months of the year our EBITDA is up 29% as adjusted EBITDA continues to improve at a rate greater than operating income as we leverage our recent investments in our building and new technologies and recognize higher depreciation and amortization expense. Turning to our segment results, Children's Book Publishing and Distribution segment revenues were $280 million versus $201.6 million in the prior year period, an increase of 8%. We continue to see strength in our trade publishing in both our front list and new titles and long tail perennial favorites, which in addition to a significant sale of Clifford programming from our evergreen media library to Amazon helped propel in trade group sales of 25% versus the third quarter 2018. The third quarter is a relatively small quarter for a school-based distribution channels Clubs and Fairs. While clubs revenues were down in the quarter, book Fair sales were up 6% with higher redemption levels of Scholastic dollars recognized as revenue under ASC 606. Segment operating profit was $4.4 million versus an operating loss of $1 million last year reflecting the contribution of the higher trade and media sales partially offset by additional sales tax expense in clubs and higher wage and distribution costs in fairs. Education revenues were $60.3 million up 1% versus $59.5 million last year with higher sales of Scholastic Edge and other supplemental print products as well as higher dealer trade sales of our teaching resource product line. Segment operating profit was $300,000 versus an operating loss of $100,000 last year. International third quarter revenues were $81.8 million versus $83.6 million in the prior year period. Foreign exchange had a negative impact on sales of $4.6 million. On a constant currency basis excluding the impact of foreign exchange, international revenues were up 3% year-over-year on strong trade publishing sales in the U.K. and Australia, New Zealand and through the international export channel. The segment recorded operating loss of $2.5 million versus operating profit of $700,000 last year which benefit from a realized gain on the unwind of a foreign currency hedge position. Third quarter corporate overhead expense was $20.9 million versus $18.6 million in the third quarter of 2018 primarily due to higher levels of depreciation for the building and technology upgrades now in service. Net cash provided by operating activities was $21 million in the current fiscal quarter compared to $36.5 million in the third quarter of fiscal 2018 and free cash use was $10.4 million in the current quarter compared to a free cash use of $9.6 million a year ago. In response to certain capacity constraints and longer lead times with strategic printers and suppliers were utilizing our balance sheet more to improve vendor relations and optimize procurement opportunities. To that end, we will see higher levels of inventory and quicker payment terms which in combination will have a near-term impact on our working capital utilization and result in free cash use for the fiscal year. At quarter end, we had $338.1 million cash and cash equivalents compared to $362.6 million a year ago as we continue on our plan spending program of technology and facilities upgrades aligned to our multi-year Scholastic 2020 initiatives as well as the investment in new digital subscriptions and print products in connection with this quarter's release of Scholastic Literacy. The company spent $19.7 million on capital projects in the third quarter including the near final stages of work performed on our headquarters building and the execution of our technology transformation plan including continued rollouts of our new Oracle and Netsuite platforms in North America and internationally respectively. The company also funded $11.7 million in pre-publication and production costs in the quarter. The new cash investment in capital projects and products was partially offset by $20.5 million in depreciation and amortization up from $17.2 million in the prior year period. We are affirming our 2019 fiscal year revenue goals in the range of $1.65 billion to $1.7 billion with continued gains in our trade publishing operations worldwide. We're working hard to deliver our fourth quarter education sales targets which typically skew to the end of the school calendar in May. The timing of fiscal year and education sales may also be influenced by the recent introduction into the market Scholastic Literacy, core curriculum product with longer selling cycle customarily aligns with our fiscal first quarter. We're also affirming our target for adjusted EBITDA a non-GAAP performance measure defined the accompanying tables and reconcile to net income of $160 million to $170 million. As we said before, we believe that adjusted EBITDA is a more meaningful measure of operating profitability and useful for measuring returns on capital investments over time as not distorted by unusual gains, losses or other items. The company's planning capital investments in technology and facilities upgrades remain on track with capital expenditures now projected to be approximately $80 million in the fiscal year, the high-end of our previous range. We are affirming our fiscal year 2019 EPS target although management now expects that earnings per diluted share excluding one-time items will be at the low-end of our previous guidance range of $1.60 to $1.70 as a result of rising labor product and fulfillment costs as well as incremental sales tax expense in our book clubs operations. As discussed with you last quarter, we have incurred on budget administrative costs in the current fiscal year to develop effective and efficient marking programs and customer facing technology that allows our book clubs operations to calculate invoice, collect and remit sales and use tax as a result of the Supreme Court's Wayfair decision that was issued this past summer. There has also been other administrative costs as we work through the ramifications of the sales tax law changes by state including the various state registration processes. Lastly, states that have implemented sales tax thresholds have announced different effective dates for the changes, so we have had to recognize sales tax expense in some jurisdictions in advance of our going live with our collection efforts this quarter. The new customer facing technology and marketing programs have now been successfully rolled out and we are now collecting sales tax on all online book club sales. In the face to continuing wage inflation and distribution transportation and higher costs incurred with our paper and printing vendors due to capacity constraints. We continue to operate a comprehensive program to lower our operations costs by driving efficiencies in procurement, fulfillment and logistics. Many benefits are being derived from our recent investment in data and technology. Specifically, our prior year investment in Oracle Transportation Management continues to yield efficiencies in inbound logistics. We have also upgraded our contact centers to a best-in-class unified communications platform that is anticipated to reduce inbound call volumes and handling times through more self-service options. Efforts to better leverage our buying power and rationalize spend starting with software and hardware expenditures, travel and office supplies are beginning to produce opportunities to bring down costs in future periods. As we look to Q4 and FY'20 we'll be focused on cross divisional inventory and procurement and warehouse efficiencies enabled by better analytics, technology solutions and process changes. With that, I will hand the call back to Gil for the Q&A session.

Thank you. We are now ready to open up the lines for questions.

Thank you, sir. [Operator Instructions] Our first question will come from Andrew Crum with Stifel. Your line is now open.

Okay, thanks. Hey guys. Good afternoon. So, as you addressed the inflationary pressures on input costs and the Wayfair decision, how do you see that impacting fiscal '20? Is it margin dilutive or do you feel like you have a handle on it where it's not going to be a drag on operating results?

Hi, Drew. This is Ken. So, yes, in terms of the sales tax, we've put a comprehensive program in place and we've just rolled that out this quarter. So, our intent is to cover the sales tax expense fully. That may take some time, but we did have a drag on our P&L previously. So, the goal for FY'20 would be really to get back to sales tax neutral to where we were previously. And then ultimately, we think we have an opportunity to fully recover any sales tax leakage we had in prior years.

Okay. And on the input costs?

Oh, I'm sorry. Yes. And in terms of the inflationary pressures, a lot of that has come through already, and as we continue to deploy different technology and really try and leverage our operations across the organization, we do have efficiencies in place. So, we do have -- we have a substantial efficiency program this year, which -- some of which was offset by those inflationary pressures, and we again have a continuing program that you should try and get back even more of the cost next year.

Okay. I guess shifting gears, very good quarter for the trade business. How are you thinking about the frontline, the front lift for the fiscal fourth quarter? And are there other opportunities to monetize the portfolio through streaming deals similar to the Clifford deal that you referenced with Amazon?

We've had a terrific trade year so far, Drew. This is Dick answering your question, and we've done really extremely well. We had a 25% increase in sales in the quarter that included the sale to Amazon of our Clifford programming library for certain uses for Amazon and was part of a larger deal that included some future Clifford programming that we'll start on Amazon in the fall. That of course will help our whole Clifford enterprise in terms of marketing, merchandising, branding, new publishing and so forth and so on. So, we see significant opportunities from the expansion of the Clifford franchise through streaming. There's a lot going on in the streaming world as I don't need to tell you, and we have lots of activity with Netflix where we've got -- Netflix in particular where we have several programs going forward. We've got other deals in the works with other players. And we've got about 15 different projects going on right now in combination of our own production or outside production being financed by various of the streaming services. It's great -- in children's programming presents itself extremely well to helping the people who are trying to get their subscriptions purchased for the whole family. So, there's terrific opportunities for us. The main benefit to the company overall, of course is in increased book sales as well as in merchandising opportunities. So, it's a very good time for our media business. We have a great new small staff that is doing a terrific job working with a whole range of program creators and developers and streaming services.

And just to follow up the front lift for the trade business for the fourth quarter?

For the fourth quarter, yes, we've had such a good quarter. We're a little -- we're not forecasting a significant lift compared to last year in the fourth quarter. We hope we'll get it, but we're not counting on it in this quarter, but the trade list going forward and the momentum we have in the business is really quite striking, and it's also global because our Australia and Canada and U.K. trade businesses are all up. We're selling more in China. So, we've really got a very robust program ahead and some great new titles including the ongoing Pilkey titles, which have been bestsellers every time across the board for Dog Man in particular.

Okay. And then, can you remind us what your expectations are for Education revenue growth in the fiscal fourth quarter. Obviously, it’s seasonally very important, what are some of the puts and takes around exceeding that objective. And I guess looking ahead to fiscal '20, remind us what reading adoptions you're competing in and any willing to size what the opportunity is there?

Sure. Well, we've actually been quite surprised by the extremely positive -- not that we're -- not that we think we had a bad program, but we had a wonderful program. But, we were kind of unprepared for the way the market has responded to it. It's really been amazing. And so, we've got -- we already have some sales that we have made during the spring which will be turned into revenues in the summer as you know. We do have to focus on selling our supplementary backlist product, backlist and front list product in the fourth quarter. So that's still something we are very, very focused on while our sales team is also introducing Scholastic Literacy. Going forward, I think we will begin to see some impact from this business in the summer of -- in this first quarter of 2020. We are not sure what the size of that will be, but it will certainly be new revenues for us because we haven't been in the core business for quite a while. And we're back in it again with a fantastic program that's meeting the needs of schools in a way that we're happily -- we thought we would do, but we're happily surprised to find out. Just the dimensions of those, for next year we're not sure what it will be, but there will certainly be an increase in the category of core in the summer that should be noticeable.

And then, should we expect to see some margin pressure given the investments there or pretty much through most of the investments and hence you get operating leverage from the sales contributions?

Well, in the first quarter, we will see some profit coming from those sales. We have been investing as you know, we've increased our sales staff. We've increased our pre-pub spending over the past 24 months in education and that certainly hit the P&L this year. We'll continue to have those costs. They shouldn't increase very much, so we should be getting the incremental lift from the profitability from the core sales which will carry of course depreciation and amortization for the pre-pub spend okay.

Okay, guys. Thank you.

Thank you.

Thank you. [Operator Instructions] And I'm showing no further questions over the phone. So, now, it is my pleasure to hand the conference back over to Mr. Richard Robison, Chairman, President and Chief Executive Officer for any closing comments or remarks.

Well, thank you all for listening to our third quarter call. We're optimistic about the future. We feel we've got a great new program in Scholastic Literacy. We've managed to collect our sales tax. And we have a number of other wonderful things going on in our trade business globally. So, we'll hope to report on these in our July call. Thank you very much.

Ladies and gentlemen, thank you for your participation on today's conference. This does conclude our program and we may all disconnect. Everybody have a wonderful day.