SCHL

Scholastic Corp. 10-Q Summary: Quarter Ended August 31, 2006

Business Context and Reporting Period

This Form 10-Q covers the first quarter of Scholastic Corporation's fiscal year 2007, ended August 31, 2006. The company operates in four segments: Children's Book Publishing and Distribution, Educational Publishing, Media/Licensing/Advertising, and International. The quarter is historically the company's smallest revenue period due to the school year cycle, typically resulting in a seasonal operating loss.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: Revenues decreased 32.8% ($163.5 million) primarily due to the absence of the Harry Potter and the Half-Blood Prince release, which generated approximately $185 million in revenue in the prior year quarter. The Children's Book Publishing and Distribution segment saw a $162.7 million revenue drop.
• Segment Performance:
  • Children's Book Publishing: Operating loss widened to $67.3 million from $19.7 million, driven by lower trade revenues.
  • Educational Publishing: Operating income improved 18.9% to $32.7 million, aided by a 9% increase in educational technology revenues (specifically the READ 180 program).
  • International: Revenues increased 3.3% to $79.2 million due to favorable foreign currency exchange rates.
• Expense Management: Cost of goods sold as a percentage of revenue improved to 51.3% from 58.8% in the prior year, largely because the prior year included high costs associated with the Harry Potter release. SG&A expenses decreased $5.8 million, offset partially by increased promotional and severance costs.
• Debt Reduction: Total debt decreased by $104 million year-over-year. The company repurchased $35.4 million of its 5.75% Notes due 2007 during the quarter.

Guidance, Outlook, and Risks

• Outlook: Management stated the company is on track to meet previously announced cost savings targets. Growth in non-Harry Potter trade revenues and educational technology was highlighted as positive momentum.
• Accounting Changes: The company adopted SFAS 123R (Share-Based Payment) effective June 1, 2006. To mitigate future compensation expense, the company accelerated the vesting of all unvested stock options in May 2006. Stock-based compensation expense for the quarter was $0.3 million.
• Liquidity: Cash and cash equivalents dropped significantly from $205.3 million at the end of the prior fiscal year (May 31, 2006) to $19.7 million, consistent with seasonal cash burn. The company maintains $230 million in available credit facilities (Credit Agreement and Revolver) and believes it has adequate access to capital.
• Risks: Credit ratings were downgraded during the quarter (S&P from BB+ to BB; Moody's from Baa3 to Ba1). The company faces risks related to the seasonality of its business, foreign currency fluctuations, and interest rate changes on variable-rate debt.

Investor Verification Checklist

• Seasonality Impact: Verify that the reported loss is consistent with historical first-quarter performance and not indicative of a structural decline, given the absence of the Harry Potter blockbuster.
• Cash Position: Monitor the low cash balance ($19.7 million) relative to the upcoming peak borrowing season (September/October) and the company's ability to service debt without further dilution or asset sales.
• Debt Covenants: Confirm continued compliance with financial covenants under the Credit Agreement and Revolver, especially following the credit rating downgrades.
• Stock-Based Compensation: Review the long-term impact of the accelerated vesting of options and the adoption of SFAS 123R on future earnings.
• Bad Debt Trends: Investigate the increase in bad debt expense ($15.7 million vs. $12.6 million), particularly within the continuity businesses, as a potential indicator of customer credit quality.