Scholastic Corp (SCHL) 2016 Q2 法說會逐字稿

Good day, ladies and gentlemen. Welcome to the Scholastic reports FY16 second-quarter results conference call.

(Operator Instructions)

As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Mr. Gil Dickoff, Senior Vice President and Treasurer. Sir, you may begin.

Thank you very much, and good morning, everyone. Before we begin, I would like to point out that the slides for this presentation are available on our Investor Relations website at investor.scholastic.com.

I'd also like to note that this presentation contains certain forward-looking statements, including information concerning the Company's intention to commence a modified Dutch auction tender offer. Such forward-looking statements are subject to various risks and uncertainties, including the condition of the children's book and educational materials markets and acceptance of the Company's products in those markets, and other risk factors that we identify from time to time in our filings with the SEC. Actual results could differ materially from those currently anticipated.

Our comments today include references to certain non-GAAP financial measures as defined in Regulation G. The reconciliation of these non-GAAP financial measures with the relevant GAAP financial information and other information required by Regulation G is provided in the Company's earnings release, which is also posted on the Investor Relations website at investor.scholastic.com. Now, I'd like to introduce Dick Robinson, the Chairman, CEO, and President of Scholastic, to begin today's presentation.

Good morning, and thank you for joining us today. By now, I hope you have seen both press releases that we issued this morning. The first was our second-quarter financial results press release. We also announced a two-pronged plan to return significant value to shareholders and increase annual operating income.

First, the Board of Directors has approved a share repurchase of up to $200 million of our common stock. Owners of Scholastic common stock will have the opportunity to tender some or all of their shares through the proposed modified Dutch auction tender offer at a specified price range to be determined. The buyback will be funded with cash on hand, and we plan to launch by the end of the month, at which time, further details will be provided in our filings with the SEC in connection with the tender offer.

We also plan to increase annual operating income by retaining full ownership of our headquarters property at 557 Broadway and converting the lower floors for additional retail operations, including Broadway-facing retail at 557. We will convert the space this fiscal year and expect the new leases to begin in FY17. Leases with high-quality tenants will provide reliable, recurring revenue streams, and the increased annual rental income will be accretive to operating income over time. Of course, should it make financial sense down the line, we also retain the flexibility to consider a further real estate transaction. With this approach, we can return meaningful value to Scholastic shareholders while also retaining ownership of a valuable real estate asset. In addition, we will increase future operating income with a predictable stream of rental income while avoiding any tax liability related to a sale.

Also, by boosting annual operating income, we can maintain considerable flexibility for continued capital returns to shareholders via dividends and share repurchases while also making targeted investments in our core print and digital publishing businesses, including technology. We remain well-positioned to capitalize on the opportunities ahead and continue to drive both strong financial performance and value for our shareholders, as the children's book segment continues to grow faster than any other segment in the Trade category, and schools and districts turn to us for support in building their classroom curriculums and library collections.

Now, I will turn to our second-quarter performance in detail. Revenue was $601.8 million, a decrease of less than 2% versus last year, and second-quarter earnings per diluted share were $1.85, versus $2.02 last year. The decline in reported results are largely driven by two factors. The first is the impact of foreign currency exchange rates on our international business both in revenues and profits. The second was the impact of a labor action in schools in Ontario, Canada, which occurred during fall back-to-school month and substantially reduced book club and book fair revenue in the second quarter. While we are pleased this action was resolved in November, we have experienced reduced results for the important second quarter, which we will not recover in future quarters. We have, therefore, revised our outlook based on the expected impact of these two items.

Performance remains strong for Trade Publishing globally with solid results from local publishing and English language titles in our international business and strong sales of our most popular series in the US including, Captain Underpants, Star Wars: Jedi Academy, Wings of Fire, Harry Potter, the Baby-Sitters Club graphic novels, and Goosebumps books that released in connection with the Goosebumps film. In children's Book Publishing and Distribution, trade results were also bolstered by strong interest in our books for early readers. We have helped millions of children learn to read, and our expanded robust selection of early childhood books, resources, and programs are helping to bridge the learning and literacy gap and ensure that all children have the opportunity to discover the power and joy of reading at an early age.

Our school-based distribution channels performed well, with School Book Fairs revenue up 6% on higher revenue per fair, and an increase in the number of fairs held. In school reading clubs, the year-over-year decline in revenue was driven by the late Labor Day holiday and a week delay in school openings this year, as well as a decline in Minecraft handbook sales. We expect the positive environment for our club and fair products and offers will fuel improved performance in the second half.

The focus on independent reading that is driving performance for children's books also provides compelling growth opportunities in our Education business. We are investing for growth in Education, which includes our comprehensive literacy solutions for pre-K to 8 through our classroom books curriculum offerings, such as guided reading and branded classroom libraries as well as classroom magazines, all supplemented by a growing service business and professional development and family and community engagement. This business is well calibrated to support the new ESSA Act, which became law last week.

With the new standards and emphasis on higher-level thinking skills and the schools and districts move away from traditional basal textbooks, demand for our comprehensive literacy solutions continues to grow. Our classroom magazines contribute steady high-margin revenue, and we have doubled our subscriber base in the last four years to over 14.5 million circulation. This growth is mainly tied to the strength of the print magazine's digital supplements, which we plan to grow further through product extensions. Our comprehensive literacy solutions include customized curriculum for school districts, meeting local needs for pre-K to 8 curriculum in literacy for major school districts, such as Palm Beach and Houston. These programs include professional learning for teachers and expanded resources of customized libraries in every classroom. We see significant growth in this area over the next several years as schools turn to Scholastic for help in expanding their literacy programs for every child.

For our international business, we continue to see strong performance in Trade in local currencies, lead by Canada, Australia, and New Zealand, and UK and Asia as well as India. In developing markets, and Asia in particular, the growing middle class is continuing to drive demand for English language books and instructional materials. The Scholastic brand is one that teachers and parents know they can trust, and we are, therefore, making great inroads in our consumer business.

We have built our business and strong brand based on our ability to motivate kids to learn and engage them in the classroom and at home. As the focus on independent reading is the key way to develop higher-level thinking skills, especially in this time of increasingly rigorous standards, our opportunities have never been more compelling in children's books, US Education, and International, as the global commitment to children's learning continues to fuel personal and economic success. Now, I'll turn the call over to Maureen.

Thank you. I will review our second-quarter results and will refer to our adjusted results from continuing operations only unless otherwise indicated.

Revenue net of currency for second-quarter revenue increased by about $8 million to $619 million. Diluted EPS from continuing operations was $1.85, versus $2.02 last year, with operating profit of $105.1 million, which was down 5% versus last year. This includes one-time expenses of $1.5 million associated with last years media restructuring, $0.5 million from the Book Fair's warehouse optimization project, and $0.4 million for one-time transaction related expenses.

As Dick said, second-quarter reported results were largely driven by the effect of foreign currency exchange rates on sales and operating profits in our International operations and the labor action in Ontario schools in the second quarter. Together, these items impacted our bottom line by $8 million in total and are the factors behind our revised guidance which I will discuss in a moment.

In Children's Book Publishing and Distribution, revenues increased 1%, to $414 million, driven by our very strong front list. Trade Publishing sales were up 7% for the quarter. This strong growth was tempered by a decline in production revenues in media and entertainment, which are now reported within the Trade division. School Book Fairs revenues grew 6%, with increases in revenue per fair and the number of fairs held. These gains were balanced somewhat by School reading clubs, where the later start to the school year had an impact on sales for the quarter, and Minecraft handbook sales decline versus a very strong FY15. Overall, segment operating income was $108.9 million, about even with last year.

In Education, revenue grew 3%, to $72.1 million, as a result of higher classroom magazine circulation, which now exceeds 14.5 million subscriptions, increased sales in custom publishing programs, and higher teaching resource workbook sales. We did see several significant literacy curriculum and classroom book orders shift to third-quarter pipeline. Higher sales in our classroom magazines and custom publishing channels also had a positive impact on our operating income, which was partially offset by increased investment in educational sales force and new marketing programs.

In our International segment, revenues in the quarter decreased by $16.9 million, to $115.7 million, including the adverse foreign exchange translation of $17.2 million. Operating income was $11.5 million, versus $19.8 million last year. While trade was strong across most of our international markets, unfavorable results were driven by FX, especially the dollar-based cost of product on operating margins, as we have covered, and the labor action in Ontario schools. We expect to resume normal ordering patterns in our Canadian clubs and fairs in the second half.

We are continuing our strategic investment in technology, which drove corporate overhead to $25.3 million, compared to $18.6 million last year, after one-time items. Our target investments in technology platforms are enhancing our customer relationship and content management capabilities and are making our product development, sales, and marketing more efficient and effective. As a result of this initiative, we can collaborate more easily as a Company, using the customer data collected across segments to create products and service offerings that are relevant and attractive across all channels. We generated free cash flow of $101.8 million, versus $125.7 million last year, which included a positive cash flow contribution from EdTech.

Regarding our balance sheet and real estate assets, as announced earlier today, we plan to repurchase up to $200 million of our common stock through a modified Dutch auction tender offer which will launch by the end of December. In addition, approximately $60 million remains available for open-market share repurchases under our existing authorizations. Further details on the tender offer, including terms and conditions, will be filed with the SEC later this month. Accordingly, we cannot answer any questions beyond what we already told you in the press release.

We will also increase annual operating income by retaining ownership and a future value of our headquarters property and leasing additional high-demand retail space. As we previously announced, we expect to invest approximately $10 million in FY16 to create modern Broadway-facing retail space. We will work with the real estate manager to secure leases with high-quality tenants, and we expect the new space to generate significant increase in recurring lease revenues starting in FY17, which will be accretive to operating income over time.

More specifically, on an annual basis, we expect our current $6 million in rental income to increase by $10 million with the new retail space, for a total of $16 million. This should increase further as existing leases come up for renewal. We believe this is the best approach for our shareholders, allowing us to both return significant value immediately through share repurchases, retain ownership of our attractive real estate asset, increase operating income, maintain flexibility, and avoid the significant tax liability that would come with the sale of the Company's asset. We will also retain the depreciation tax benefit.

Now, turning to outlook. We have revised our revenue and earnings per diluted share outlook to account for the impact of foreign currency exchange rates and the impact of the labor action in Ontario during the second quarter. We therefore expect total revenue to be approximately $1.65 billion and earnings per diluted share from continuing operations to be approximately $1.35, before the impact of one-time items associated with cost-reduction programs or non-cash, non-operating items.

We continue to expect free cash flow in the range of $35 million to $45 million, excluding taxes paid as a result of the sale of EdTech. Our outlook includes CapEx of $40 million to $50 million, compared to $30.7 million last year, and pre-publication spending of approximately $30 million to $40 million, compared to $62.5 million in FY15, which included the EdTech business. I would remind you once again that EdTech had a significant amount of pre-pub expenses and very little CapEx. I will now turn over the call to Gil to moderate a question-and-answer session.

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

(Operator Instructions)

Our first question comes from the line of Drew Crum of Stifel.

Okay, thanks. Good morning, everyone. So Maureen, I have a couple questions on guidance to start. Just a housekeeping item, can you reconcile why you're reducing the earnings guidance but free cash flow guidance remains unchanged?

And then as you look at the second half of FY16, I believe the Chicago teachers are planning to strike. It's one of the larger school districts in the United States. Is that going to have any impact on your clubs and fairs businesses? Thanks.

Regarding guidance, we did not reduce cash flow because we're actually seeing positive working capital trends right now. Receivables, we've seen strong collections. We continue to monitor our inventories, and although areas like Trade that had very strong growth, we've not increased inventories, so we're pleased with our inventory performance.

And our guidance, we really changed it to reflect the Ontario action which has already occurred and resolved itself on November 3, and we changed it to reflect the impact of foreign currency on our margins in the international markets. We believe in the second half that currency has already hit the low point and that we should not have such a currency impact, and we also believe that we will resume normal ordering levels in Canada once the teachers and everyone has returned to work -- administrative functions.

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

Okay, makes sense. And then just lastly on the real estate, two questions. Heard what you said in terms of the rationale, but Dick, I'd love to get your additional thoughts on the rationale not to enter into a large real estate transaction.

And then separately, for Maureen, you offered guidance in terms of the expectations for additional rental income. What is the conversion to free cash flow, and should we expect that incremental $10 million in FY17, or is that something that we'll see beyond FY17? Thanks.

Okay, I can take the rental income question first. We are building out the space starting in February to convert it to a Broadway-facing retail property, and the next step would then be to work with the manager to lease out that property, so our goal is to have that available starting in FY17. It really depends on when the tenant is identified and moves into the property and the amount of free rent that we may have to give when we start out to determine when the rental income becomes accretive, but we do believe we'll pay the $10 million to restore the property this year and that there should be accretion next year in FY17.

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

Okay. Thanks, guys.

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

Great, thanks and good morning. I have several as well on the real estate, Dick. I'd like to start there. Roughly, how many square feet of rental space do you expect to have available?

That's fairly subject to the tenant. So right now, we are considering the first, second floor, and maybe part of the second floor, maybe all of it. It really depends on the tenant and their need, so it's difficult to put a number on it until we really have the tenant in mind.

Okay. And has any money been spent thus far in the conversion or whatever, the renovation, how ever you want to describe that?

That will start in February so we won't be seeing spending until later in the year -- our fiscal year.

Okay. And again, trying to come at this another way. How much did the potential tax liability weigh on the decision to retain the real estate?

Well, the tax liability was very substantial, as you know, that we entered a long-term lease many years ago, and we had a favorable option to purchase under that lease, and as a result, we have a very low basis, and so the tax liability would have been quite substantial.

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

We've explored that considerably, Barry, as you might expect, and there is no remaining air right availability.

Okay, thanks, Dick. Maybe we can talk about the business a little bit.

That would be a pleasure.

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

Right, well, as you know, adult or -- and total -- adult sales of e-books have topped out at 20% and are now declining, and they are largely best-seller, front-list related. In the children's books area, it never really got over 5%, except for occasionally, and that included the young adult Hunger Games, which did, as you point out, have a very substantial amount of e-books sales during the high point of Hunger Games.

We see here and there a series in middle grades or young adult where there's a spike in e-books, or we create an e-book opportunity by doing a unique and original publishing in E areas, which increases the amount of volume. But in general, this is a print world right now in publishing globally, a great surprise to many, but it's certainly -- we see that as a strong trend that will continue.

Okay. I think in the release there was some commentary on technology investments and shifting to software as a service, and I was just hoping you could quantify that as we look into the corporate line.

Well, Barry, we've spent about $10 million incremental year to date, and that's about what we will be spending in the second half. And those investments are really already beginning to pay off because we are able to now look for opportunities across our businesses where what we are calling headroom, or the availability to have one business lead another business in to increase sales, and we're already seeing momentum from that build.

So it's a three-year project. It started last year. Last year, we were able to offset all the incremental spend by reducing cost in the businesses proportionately, so it wasn't a significant increase last year. It will be about a $20-million increase this year, and then we'll guide to next year, but it is a three-year program.

And preliminarily, would you think the spend next year is more or less?

Probably about -- more or less, maybe slightly up from where we are now because that would (technical difficulty), and it would be going live. So we would be running parallel in a lot of systems, and as a result of running parallel, I think there will be incremental expenses, but give me time to give you guidance on that.

Okay. But it sounds like something on the order of magnitude $45 million, $50 million over the three years?

It was neutral, really, last year. It's $20 million this year, so that would be a high end of the range.

Great. Last one for me, and should have asked just a moment ago, but the Goosebumps movie, did it pull through, meet, exceed your expectations, or was disappointing?

I think it actually -- it started earlier in the summer and peaked around the movie, and it really met our expectations, and we continue to see nice back-list sales continuing.

Great. Thanks very much.

Thank you, Barry.

Thank you. Our next question comes from Ian Zaffino of Oppenheimer.

Hi, great. A lot of questions have been answered already, so just a couple of other questions here. Is the $200-million buyback, how did you arrive at that number? It's obviously less than your cash balance. You have no debt. How did you arrive at that?

And then also, as you start getting this rental income, free cash flow is going to be even higher than it is currently. What are the plans there, and how do you look at that as far as use of cash flow?

So regarding the $200 million, we currently have about a cash balance of $350 million. With the $200 million, that's a total authorization or share buyback of $260 million once we complete all of that buying. And we really considered giving as much cash back as possible, at the same time, looking at the liquidity of our stock and trying not to affect that, and so we felt that this was a significant buyback overall, and that's how we arrived at the $200-million range.

As far as future, we always look to balance investment in the business with return of cash to shareholders, and I think by retaining the building and the strong balance sheet we have, we continue to have that flexibility into the future. So I think that we've done this.

This will be our third major structured transaction in terms of buybacks. We started with an accelerated share buyback of $200 million. Following that, we did a Dutch tender the last time of $155 million.

And now, this is the third structured transaction at $200 million, plus an authorization that the Board has approved in the open market of $60 million. So I think that we have shown our willingness to return to shareholders, and we expect over time, we'll continue to invest in the business and do that.

Okay. And then on the rental income, what type of tax bracket should we assume? Is there any type of NOLs you could use to offset some of that?

Well, one thing that I think is surprising to many of our investors is that since this is a corporate asset, it is not a capital gain. It is taxed at corporate rates, so it's a 40% or more tax rate. Plus, there's transfer taxes, which are quite significant in New York City. So the tax rate is much higher than I think most investors anticipate.

Right, that would be in a sale, so what would it be as far as rental income?

Oh, as far as rental income?

Yes.

It would not be significant.

Okay. So is there any way you could maybe (multiple speakers) -- go on.

It would be part of our operating income, so it would be our normal tax rate on our operating income.

Okay. And from there, we could probably assume, let's just say, a 45% tax bracket, take the difference and figure out what the NPV of the tax savings are or the tax avoidance by doing--

Right, our tax rate currently is about 40%.

Okay. So when you looked at maybe the NPV of the tax savings doing this round as opposed to the other, did you come up with a number, or could you tell us what that might be or what you were thinking there?

Well, we felt this was the best NPV because we retained the asset, which continues to have value as well as increasing our operating income. As far as specifics on each alternative, we can't go into those numbers.

Okay, thank you very much. I appreciate your help.

You're welcome.

Thank you. At this time I'm showing no further participants in the queue. I would like to turn the call over to Mr. Richard Robinson for any closing remarks.

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

Ladies and gentlemen, thank you for your participation on today's conference. This concludes your program. You may now disconnect. Everyone, have a great day.