SCHL

Scholastic Corp. 10-Q Summary: Quarter Ended August 31, 2005

Business Context and Reporting Period

This Form 10-Q covers the first quarter of Scholastic Corporation's fiscal year 2006, ended August 31, 2005. Scholastic is a global children's publishing and media company with operations in four segments: Children's Book Publishing and Distribution, Educational Publishing, Media, Licensing and Advertising, and International. The company's business is highly seasonal, with the first quarter typically being the smallest revenue period due to schools being out of session. This quarter was significantly impacted by the July 2005 release of Harry Potter and the Half-Blood Prince.

Key Financial Metrics

Margins: Cost of goods sold increased to 58.8% of revenue (from 54.5% prior year) due to Harry Potter costs. Selling, general, and administrative (SG&A) expenses decreased to 40.6% of revenue (from 57.1%) due to revenue leverage and the absence of prior-year severance charges.

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 54.0% ($174.7 million) year-over-year. The Children's Book Publishing and Distribution segment drove this with a $153.5 million increase, primarily attributed to approximately $185 million in Harry Potter trade revenues.
• Profitability Improvement: The operating loss narrowed by $44.2 million to $25.2 million. The net loss improved by $29.3 million to $21.2 million.
• Segment Performance:
  • Children's Book Publishing: Operating loss improved from $64.0 million to $19.7 million. Trade revenue surged, offset by a $17.2 million decline in continuity business revenues.
  • Educational Publishing: Operating profit increased 23.3% to $27.5 million, driven by educational technology sales (READ180).
  • Media, Licensing & Advertising: Operating loss narrowed slightly to $5.7 million.
  • International: Operating loss widened to $5.5 million due to lower local currency profits in the UK, despite revenue growth.
• Restatement: Prior year (2004) financial statements were restated due to a review of lease accounting. Certain leases previously classified as operating were reclassified as capital leases, and rent expense calculations were adjusted for escalation clauses. This resulted in a slight increase in the reported prior-year net loss (from $(50.3)M to $(50.5)M).

Guidance, Outlook, and Risks

Management Commentary: Management stated that the results were consistent with the fiscal 2006 goal of expanding margins while growing revenues. The unusually low net loss for a first quarter was attributed to the Harry Potter release and growth in Educational Publishing.

Liquidity and Capital Resources: Cash and cash equivalents decreased from $110.6 million at the end of the prior fiscal year to $18.4 million. This decline is consistent with the company's seasonal cash flow cycle, where negative operating cash flow occurs from June through October. The company relies on seasonal borrowings under its Credit Agreement and Revolver to fund working capital needs.

Risks and Contingencies:

• Seasonality: The company experiences substantial operating losses in the first quarter.
• Debt Covenants: Credit agreements contain financial covenants related to debt and interest coverage ratios.
• Market Risk: Exposure to foreign currency fluctuations and interest rate changes (approx. 18% of debt is variable rate).
• Accounting Changes: The company is evaluating the impact of adopting SFAS No. 123R (Share-Based Payment) effective June 1, 2006, which will require fair value recognition of stock-based compensation.

Investor Verification Checklist

• Harry Potter Sustainability: Verify the extent to which Q1 revenue growth is dependent on the one-time release of Harry Potter and the Half-Blood Prince versus organic growth in other titles.
• Continuity Business Decline: Investigate the strategic rationale and long-term impact of the $17.2 million revenue decline in the direct-to-home continuity business.
• Working Capital Management: Monitor the significant increase in Accounts Receivable ($154.5M increase in cash flow usage) and Accrued Royalties ($87.1M increase) to ensure collection and royalty payment cycles remain healthy.
• Debt Maturity Profile: Review the $301.0 million in 5.75% Notes due in 2007 and the company's refinancing strategy given the current interest rate environment.
• Restatement Impact: Confirm that the lease accounting restatement has been fully addressed and that no further adjustments to prior periods are anticipated.