Scholastic Corp (SCHL) 2008 Q2 法說會逐字稿

Good morning, my name is Jackie and I will be your conference operator today.

At this time I would like to welcome everyone to the Scholastic second-quarter 2008 earnings conference call.

All lines have been placed on mute to prevent any background noise.

After the speakers' remarks there will be a question-and-answer period.

(OPERATOR INSTRUCTIONS).

It is now my pleasure to turn the floor over to Jeffrey Mathews, head of Investor Relations.

Sir, you may begin your conference.

Thank you and good morning.

Before we begin I'd like to point out that the slides for this presentation are available for simultaneous viewing my going to our website, Scholastic.com, clicking on Investor Relations and following the links on that page.

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 market 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 Securities and Exchange Commission.

Actual results could differ materially from those currently anticipated.

Now I'd like to introduce Dick Robinson, the Chairman, CEO and President of Scholastic, to begin our presentation.

Thank you, Jeff, and welcome everyone to scholastics earnings call and presentation for the second quarter of fiscal 2008.

I'm joined by Maureen O'Connell, Scholastic's Chief Administrative Officer and CFO, who will speak after me.

At the end of our presentation we'll both be available for questions as will members of our executive team.

Scholastic's second-quarter results were solidly on plan.

Operating income and margins rose, working capital management was strong and free cash flow reached nearly $300 million.

Profits also increased in trade, clubs, fairs, international and media, licensing and advertising while corporate overhead declined.

This enabled continued investments in the long-term growth of the education business and offset losses in Direct-to-Home Continuities.

In addition, we completed a $200 million accelerated share repurchase and authorized an open market share repurchase program which will begin soon for up to $20 million more.

Based on these results we are affirming our guidance for fiscal 2008.

We have also made the difficult decision to exit Direct-to-Home Continuities in the U.S.

as well as the UK and Canada divisions.

This business has generated significant revenues, profits and cash since we acquired it in 2000 and it continues to possess valuable brands as well as impressive distribution reached to young families and significant cash flow potential.

Last year however these divisions had a combined pre-tax operating loss of $32 million on total sales of $196 million; such declining results have become a significant obstacle to improving margins and increasing profits companywide.

As we have stated, our strategy to turn around the Direct-to-Home business depended on new Web-based promotions that we launched last summer.

Now with nearly six months of performance we have concluded that despite positive results in some areas Direct-to-Home Continuities will not be meet its financial goals for the year and therefore, as we committed in July, we've decided to pursue a sale of the business maximizing its value for Scholastic as well as for the talented people who work And Continuities.

We have retained Greenhill and Company, with whom we are already working, to prepare the business for sale and to identify potential buyers.

All the same, Scholastic remains committed to building direct relationships with parents and families and we are expanding our reach to parents and families online through our clubs, fairs and Scholastic.com.

As we discussed on the last earnings call, to reach our goal of 9 to 10% operating margin by fiscal 2010 we require approximately $70 million in additional operating income relative to last year's results.

The decision to exit Direct-to-Home Continuities addresses approximately half of this gap.

In addition, we are increasing margins in other businesses while investing in next year's profitable growth.

In fact, operating margins improved by over 85 basis points last quarter excluding Direct-to-Home.

We have four key areas of focus.

First, we will reduce costs and modestly grow revenue in our children's book business.

In our school-based channels we are improving efficiencies and shedding unprofitable revenue.

We also are leveraging the Internet and technology to strengthen customer relationships and to improve our reach to parents and children.

In fairs last quarter expenses declined and profits improved as we implemented standardized processes throughout the fair business.

In clubs, profits also increased as we reduced less productive mailings and managed cost.

With over half of our orders coming in online from teachers today in clubs we are rebuilding our club's ordering online system, or COOL, to update our eCommerce capabilities and to enable parents to order online as well.

New COOL will launch next year.

With five children's books and series currently on New York Times best seller list Scholastics publishing has strong momentum.

The list of upcoming releases is also very promising with titles like Goosebumps Horrorland by R.L.

Stein and Meg Cabot's new tween series, Allie Finkle.

Also as reported in the New York Times earlier this week, next fall we launch the 39 Clues, a fast-paced mystery and adventure series for children ages 8 to 12.

The 39 Clues combines into one storytelling experience both books, collectible cards and an interactive website with online games.

This project combines Scholastic's expertise in publishing children's series with our skills in technology and gaming.

We also own all worldwide publishing and media rights to 39 Clues and we are very excited about this project which will launch next fall as its combination of print, interactive, website and card collecting creates a new model for children's publishing.

Our second key focus is on education and in particular on growing our market leading educational technology business.

Scholastic's strategic focus on learning intervention means that we grow by helping educators in some of the most challenging teaching environments.

For example, the New Orleans Recovery School District is now using READ 180, Scholastics leading reading intervention program, and FastMath, the number one math fluency package, to improve student achievement.

Scholastic's on the ground implementation and support staff help school systems like New Orleans use our innovative technology more effectively which in turn drives revenue growth for the Company.

While this fall's reorganization of the education salesforce, combined with a slightly soft school funding environment, has temporarily slowed educational technology revenue growth, sales nonetheless are up year-to-date.

Under the new structure we have increased tech support and implementation in our sales force while focusing on developing larger accounts.

We already see signs of strengthening sales activity in the third quarter and are confident that this year's investment will contribute to our long-term growth in educational technology.

Similarly this year we are investing in new product development to expand on the installed base of READ 180.

System 44, a cutting-edge technology based phonics program for older students, is targeted at young people who need additional support before they enter READ 180.

This program will be especially helpful for English language learners.

Our third focus is on driving margins and growth internationally where in the last quarter we had strong performance in the UK and Australia helping increased segment profits by over 20%.

In addition, we are targeting more rapid growth and increased scale in Asia, as we have seen so far this year.

The media licensing and advertising segment supports the children's book business while leveraging its content.

Last year profits there rose from strong sales of interactive products including Scholastic produced titles for Leapster and Nintendo DS.

We are also encouraged by the release of the Golden Compass film which is playing very strongly internationally, especially in the UK and Australia where we publish the books.

Scholastic Media produced the film receiving production and merchandising agency fees.

Our fourth area of focus, to improve margins, continues to be on reducing costs.

We are on plan to achieve our targets for overhead cost reductions this year.

We are also exploring other opportunities to consolidate functions, reduce redundancy, and improve efficiencies.

These four areas of concentration will help us achieve our margin goals while building earnings and free cash flow growth.

Maureen will now comment on last quarter's results and this year's outlook.

Thanks, Dick, and good morning, everyone.

Scholastics had a strong quarter both operationally and financially, positioning us well to meet our fiscal 2008 plan.

Profits were up in most areas of the business.

Strong front list sales accounted for higher revenues and profits in trade.

Harry Potter sales in the quarter were approximately $10 million driven by sales of the boxed sets compared to $5 million in the prior year period.

Profits also rose from improve efficiencies in school book fairs on modest revenue growth.

School book club profit growth on a revenue decline reflecting cost management and the elimination of less profitable mailings.

These favorable factors were partly offset by greater losses in the Direct-to-Home Continuity business.

In International revenue and profits were also up reflecting favorable foreign exchange and strong performance in the UK driven by strong sales of Philip Pullman's His Dark Materials series also in Australia.

In media, licensing and advertising we had robust interactive product sales in fairs and in retail which contributed to strong profit growth.

In educational publishing profit was down in the quarter reflecting this year's planned investment in the reorganization of the salesforce and in the development of new educational technology products.

As Dick described, a slightly soft funding environment and the reorganization impacted educational technology revenue which declined 9% in the quarter.

Another factor impacting reported revenue is the growing opportunity to sell technical service and support with our educational technology products.

These contracts typically last from six months to three years and consequently are booked primarily as deferred revenues upon sale.

Paperbacks and teaching resources sales rose strongly in the second quarter.

Because of its shorter selling cycle the educational print business has more quickly benefited from the sales reorganization.

However, as Dick described, we are already seeing sales activity for educational technology strengthen in the third quarter.

Finally, corporate overhead expense also improved in the quarter due to lower headcount and lower benefit expense as we continue to aggressively manage headcount and other costs.

Looking at the consolidated results, total revenue in the quarter rose approximately 2% with solid trade sales and international growth being partially offset by lower sales in clubs and continuities.

Cost of goods sold fell to 42.6% of revenue from 43.9% primarily reflecting the timing of prepublication amortization.

Selling, general and administrative expense rose modestly reflecting investment in the educational salesforce and an increased promotion amortization in continuities partially offset by lower promotion spending in school book clubs.

Bad debt expense declined year-over-year reflecting higher bad debt in the media segment a year ago partially offset by increased continuities bad debt in the current quarter.

Operating income rose 3% in the quarter, or 7% excluding the impact of higher losses in the Direct-to-Home Continuities business, and operating margins improved solidly.

Net income rose slightly, while earnings per diluted share rose 10% to $1.93, primarily reflecting accretion from the $200 million share repurchase completed in the second quarter.

In total, almost 5.8 million shares were purchased at an average price of $34.64.

As Dick said last week, the Board authorized an additional open-market share repurchase program of up to $20 million, using available cash to offset dilution from stock-based compensation.

Free cash flow was very significant last quarter, exceeding last year by almost $200 million.

The year-over-year difference was principally due to large cash receipts from first-quarter Harry Potter sales and the favorable timing of Harry Potter related accrued expenses, which will be paid in the fourth quarter.

Free cash flow also benefited from improved working capital management and the third consecutive quarter of year-over-year inventory declines, which dropped $16 million or 3% compared to the prior year.

In addition, year-to-date free cash flow of $169.5 million has also benefited from the timing of capital expenditure and of prepublication and production spending, which will increase in the second half of the year relative to the first half.

Given these factors, the full-year outlook for free cash flow remains 80 to $100 million.

At quarter-end, the Company had a strong balance sheet with net debt of $226.5 million or 18% of capitalization, down substantially from a year ago.

The decline reflects strong free cash flow in the intervening 12 months and the timing of payables, partially offset by $200 million in debt incurred in the first quarter of this year to fund the accelerated share repurchase program.

As Dick stated, we are affirming our guidance for fiscal 2008, following a solid second quarter.

Momentum in trade, clubs, fares, international and media license and advertising drove higher operating margins, while we continued to invest to grow our educational business.

It also offset lower than expected results in Direct-to-Home Continuities business.

Our decision to pursue a sale of this business will help maximize its value and significantly benefit companywide operating margins and bottom-line profits.

Because of this decision, we expect potentially significant non-cash write-downs and modest cash expenses in the second half of the year.

For accounting purposes, we currently expect to report Direct-to-Home as a discontinued operation in the third quarter.

These factors are not reflected in our guidance, as we have not yet unable to quantify the magnitude of these write-downs.

Of course, we will provide more detail next quarter.

With that, I'll turn the call back over to Dick.

Thanks, Maureen.

I will now moderate a question-and-answer period, and I am joined by most of the executive management team; several are traveling on business.

But those here today include Ellie Berger, our new President of Trade, who took over that assignment in September; Deborah Forte, President of Scholastic Media; Margery Mayer, President of Scholastic Educations; Judy Newman, President of Book Clubs; Seth Radwell, President e-Scholastic and Scholastic at Home; and Hugh Roome, President of International.

With that, let's open the call to questions.

(OPERATOR INSTRUCTIONS) Drew Crum, Stifel Nicolaus.

Thanks, everyone.

Good morning.

Just wanted to get a quick question in on continuities, the decision to divest that business.

What types of cost synergies or potential detriments to the business are there outside of exiting this business?

Drew, we've operated this business relatively independently from the rest of the Company since the acquired it in June of 2000.

It has its own staff, it shares a little bit of IT expense, but even there the IT people are mainly devoted to that business and as such their costs are included in that business.

So there won't be a significant hit to overhead cost, nor is there a lot of untangling of business that has to be done as a result of this both here and in Canada and in the UK.

Okay, great.

As you know, we've separately reported on the Direct-to-Home Continuities in the U.S.

which has its own segment so to speak in the financial reporting or its own identified category.

So those expenses are all included in those numbers which we have been publicly reporting for the last seven years.

Okay.

Just wanted to get your updated thoughts on the outlook for educational publishing.

The guidance at the beginning of the year was modest growth for that division.

Is there any update there?

I mean it sounds like you guys are feeling pretty positive about what you're seeing early on in the third quarter, yet we're beginning to hear some rumblings at the local level that there are some pressures, spending pressures, on various discretionary categories.

Just wanted to get your updated thoughts around that.

Well, there always is pressure on education spending, particularly as the economy slips a little bit.

And the states are reporting some shortfalls of their own revenue.

But we believe the market, while temporarily soft, is particularly strong in the educational technology area and also in the intervention area, Margery can talk a little bit more about that.

You're correct to say that we had modest revenue growth, but we also said that we would have a decline in profitability this year due to the investments in the new salesforce.

But those investments are working extremely well and our paperback side of our business is doing quite well, but the longer lead times, of course, require -- later quarters we'll see some of the results of the changes in the educational technology salesforce.

Margery, would you add to that, please?

Yes, I mean I just underscore what Dick said.

We are seeing some states worried about their overall budgets, states like California and Florida.

But when you get down to the school level, the district level, they're still extremely focused on raising achievement, they are investing in intervention, we are seeing that.

Increasingly we're seeing that schools want to not just buy the product, but also want help in how to use that product well with their teachers and administrators.

So that's been really exciting for us.

And we're very pumped up about not only READ 180 but FastMath which is our new math fluency program.

And we have a new product coming out next year called System 44 that we're just starting to talk to customers about and we're getting an incredibly good reaction.

Thank you, Margery.

Last question.

The share buyback program you're doing, you note that it's to offset expected dilution from stock-based compensation.

Is there a change in view in terms of the amount that will be dilutive in fiscal year '08?

I think it was $0.10 to $0.15 at the beginning of the year.

Do you want to talk about that, Maureen?

Yes.

There's not a change in view, but we did have some significant option exercising which eliminated our overhang and we're looking to offset that dilution.

And so we had the cash proceeds come in during this quarter and we're using that to offset dilution from that.

But our guidance remains the same.

Thanks, guys.

Great quarter.

Thank you.

(OPERATOR INSTRUCTIONS).

Peter Appert, Goldman Sachs.

(technical difficulty) Judy please talk a little bit about the dynamics in the club business.

You've basically had I think modestly declining revenues for a couple of years now.

I'm just wondering how we should interpret that in terms of what it says about the secular growth dynamic or outlook in that business and whether that business is now sufficiently mature that it's basically going to be a flat line in terms of revenue for the foreseeable future.

And if that's the case, can you sustain the profitability in that business?

We'll let Judy answer that, as you anticipated, Peter.

And I think she's ready for you on this one.

Good morning, Peter.

As you well know, for the past 18 months we really have been focused on trimming those catalogs, if you will, including Trumpet and Troll where the costs of creating them and supporting them overwhelmed the incremental revenue that we got from them.

We were very successful with that strategy last year and drove tremendous incremental profit.

And this year we found some additional opportunity to do that where the core club served the needs of the customers and the overhang catalogs, as Dick said, the ones we shedded were unnecessary and the cost of creating those really did overwhelm the additional revenue.

So we've taken those out of our mix and we are seeing that additional profit.

So I think we're kind of stable with that at this point and now we are turning to our revenue of growth strategy again and we have been building -- as we've been doing that trimming we've also been building COOL.

And believe it or not, we have been operating with an Internet ordering system that we built in 2000, and yet we do have 50% of our orders coming in on COOL.

And how we are ready to cut over next year to our new COOL and our new Parent COOL, which we believe will start to drive good revenue growth in this business both for teachers because we can start to market to them more individually as well as to parents which really opens up whole new opportunities for us while retaining the excitement and core values of the book club model, that monthly experience, that validation by the teachers, those monthly book club editorial selections.

So we do believe we're beginning our new phase of growth after we've got our profitability story under control.

Does that answer you?

Yes, that's very helpful.

Thank you.

Are you currently selling to parents, Judy, or is that contingent on the new order system?

It's extremely marginal right now.

Like I said, the system is -- it's literally eight years old.

So I'd say it's [resulted in testing].

Could you share with us any metrics on the core clubs that might give us some added confidence that there's growth in those parts of the business?

Things like average order size or teacher participation rates?

Yes, our customers are really flat.

We continue to get our entire base of customers.

We had very little decline in the number of teachers who participate, which is great news.

We continue to get new teachers into our base as well as retain our old customers.

That's our marketing program so we see no deterioration in the number of teachers who are participating which is our core metric number of sponsors.

Our revenue per order, as we've been saying, is really a function of how we move them to use the scholastic clubs -- and that is really a monthly metric, it goes up and down.

We see it stronger in one month over another.

Year-over-year it's been pretty good and there's been some softness in the economy in September, but we made it up in October, so we really do look at it monthly.

That's all good.

Student participation varies by grade, so we see a lot of strength in the younger kids and our challenge, of course, is with the older kids up at the sixth and seventh grade.

We have to work harder to get them, but overall we're feeling really good about the model, the model remains very strong.

And we do believe, as I say, when we open it up to parents and we can start communicating with them directly that gives us a whole new opportunity.

Great, thank you.

And then a follow-on question for Margery.

It feels like the competitive dynamics in the educational technology business get a little bit more intense every year.

And I'm wondering if the extent to which you think that might be a factor in terms of weighing on the revenue performance this year beyond some of the restructuring items you talked about, Margery.

And then secondly, I'm not familiar with System 44, can you tell us what that product is?

Peter, there's definitely more technology coming from more publishers, but we have not seen any consistent competitive pressure on READ 180.

We just got a group of our salespeople together and we went around the room and we said what's the competitive picture look like?

And from different parts of the country people would name one here, one there, but there was no pattern to any consistent pressure on READ 180.

In terms of System 44, we've always said for READ 180 that kids going into READ 180 should be reading at about end of second grade.

It's never been intended to be a phonics -- an intensive phonics program for kids; it's always supposed to be kids who bring some phonics ability to the program.

And we've told school districts that if you have kids who need phonics before they go into READ 180 they should be using other programs from other companies.

Well, next year we are introducing System 44, the name stands for the 44 sounds in the English language.

And we have added Marilyn Adams, who is the leading phonics educator in the country, to our team and the program will now be able to address the needs of every child in grades four and above who is below proficient in reading.

We will not need to say put them in a phonics program before they come into READ 180.

So we think this is going to really enlarge our footprint, this is something our customers have been asking us to do and we are extremely excited.

So you'll sell this as an add-on to READ 180 or as a stand-alone product?

It can work both ways.

It can drop into the READ 180 classroom or it can be used as a stand-alone.

And we will sell to people who are not using READ 180 if they want to use it that way.

and just in terms of trying to understand the scale of the market opportunity, incrementally how much more does this open to you?

That is both a business question and an intellectual question because if you talk to reading educators they vary about how many kids would fall into this group.

Probably about 5 to 15% of kids fall into this group, especially considering English language learners, a lot of homes do not have those foundational English language skills.

And in terms of the market size, there's a lot of -- there's at least $100 million of phonics programs being sold into the upper grades and it may be way above that.

So we think it's a big extension for us.

Great, thank you.

Good, thanks.

Appreciate it.

Thanks, Peter.

(OPERATOR INSTRUCTIONS).

At this time I would like to hand the floor over to Dick Robinson for any further remarks.

Thank you very much for joining us today.

Thanks for the questions.

We're in a good mood here with an excellent quarter and we are -- obviously we've communicated to our staff the difficult decision to sell the Continuities business and everybody has responded well and understands that this is a business decision and that the business is going on as usual.

We appreciate your support and wish you a wonderful holiday season.

Thank you very much for joining our call for the fiscal 2008 second quarter.

This is Dick Robinson, thank you, and wishing you a happy holiday.

Thank you.

This does conclude today's scholastic conference call.

You may now disconnect your lines.