SCHL

Scholastic Corp. 10-Q Summary: Quarter Ended August 31, 2007

Business Context and Reporting Period

This Form 10-Q covers the first fiscal quarter ended August 31, 2007. Scholastic Corporation operates in four segments: Children's Book Publishing and Distribution, Educational Publishing, Media/Licensing/Advertising, and International. The business is highly seasonal, with the first quarter typically recording a loss due to schools being out of session. This quarter was significantly impacted by the July 21, 2007 release of Harry Potter and the Deathly Hallows.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Surge: Revenues increased 75.2% year-over-year, driven primarily by approximately $240 million in Harry Potter sales (compared to ~$5 million in the prior year).
• Profitability Improvement: The company swung from an operating loss of $66.1 million to an operating income of $5.2 million. Net loss narrowed significantly to $2.8 million.
• Segment Performance:
  • Children's Book Publishing: Revenue jumped from $112.6M to $342.5M; operating loss improved from $(67.3)M to income of $2.7M.
  • Educational Publishing: Revenue remained flat ($127.8M vs $127.4M) due to weak school spending on supplemental materials, though technology sales rose.
  • International: Revenue grew 25.8% to $99.6M, aided by favorable currency exchange rates.
• Debt Structure: Total debt increased to $589.5 million due to a new $200 million Term Loan drawn in June 2007 to fund an Accelerated Share Repurchase (ASR). The company repaid $258 million of 5.75% Notes at maturity in January 2007.
• Working Capital: Accounts receivable increased significantly, using $215.2 million in cash, reflecting the timing of the Harry Potter sales. Accrued royalties provided $111.3 million in cash.

Guidance, Outlook, and Risks

• Outlook: Management indicated solid initial progress toward fiscal 2008 goals, focusing on investments to drive long-term revenue growth and margin improvement in Children's Book and Educational Publishing segments.
• Share Repurchase: The company executed a $200 million ASR. As of August 31, 5.1 million shares were received initially, with a potential for up to 6.2 million shares upon settlement in October 2007.
• Accounting Changes: The company adopted FIN 48 (Accounting for Uncertainty in Income Taxes) on June 1, 2007, resulting in a $34 million increase in liability for unrecognized tax benefits and a $6.4 million reduction in retained earnings.
• Legal Proceedings: Two class-action lawsuits were filed in August and September 2007 alleging false statements regarding operations between 2005 and 2006. The company intends to vigorously defend these suits.
• Market Risk: Approximately 71% of debt is variable-rate, exposing the company to interest rate fluctuations. Foreign currency fluctuations also impact earnings, though management does not view this as a significant risk.

Investor Verification Checklist

• Sustainability of Revenue: Verify the extent to which Q1 2007 revenue growth is attributable to the one-time Harry Potter release versus organic growth in other segments.
• Debt Servicing: Confirm the company's ability to service the new $200 million Term Loan and $175 million Revolving Loan, noting the shift to 71% variable-rate debt.
• Share Count Impact: Monitor the final settlement of the ASR in October 2007 to determine the final reduction in share count and impact on future EPS.
• Legal Exposure: Track the status of the class-action lawsuits filed in late 2007 regarding prior financial disclosures.
• Seasonality: Assess whether the Q1 operating income of $5.2 million is an anomaly or a sign of improved operational efficiency, given the historical trend of Q1 losses.