SCHL

Scholastic Corporation: Q1 Fiscal 2004 Summary (Ended Aug 31, 2003)

Business Context and Reporting Period

This Form 10-Q covers the three-month period ended August 31, 2003 (first quarter of fiscal 2004). Scholastic Corporation is a global children's publishing and media company with operations in school-based book clubs, book fairs, educational publishing, media, and international markets. The company's business is highly seasonal, with the first quarter typically experiencing lower revenues and negative operating cash flow due to the school calendar cycle.

Key Financial Metrics

Margins: Cost of goods sold increased to 59.2% of revenues (from 52.2% prior year) due to higher costs associated with the Harry Potter release. Bad debt expense was 4.4% of revenues (down from 6.0%).

Material Changes vs. Prior Period

• Revenue Surge: Revenues increased 54.9% ($168.5 million) primarily driven by the June 21, 2003 release of "Harry Potter and the Order of the Phoenix," which generated approximately $170 million in revenue compared to $15 million in the prior year.
• Expense Increases: Selling, general, and administrative expenses rose $10.1 million, largely due to $9.1 million in Harry Potter-related costs and higher employee benefit costs. A $2.0 million special severance charge was recorded for workforce reductions.
• Profitability Improvement: Despite higher costs, the operating loss narrowed significantly by $32.3 million, and the net loss improved by $19.8 million, driven by the volume of Harry Potter sales.
• Debt Structure: The company issued $175 million of 5% Notes due 2013 in April 2003. Proceeds were used to retire the Grolier Facility and reduce borrowings under the Loan Agreement and Revolver. Total debt remained relatively flat, but the mix shifted toward longer-term fixed-rate debt.

Guidance, Outlook, and Risks

Management Commentary: Management attributes the financial improvement almost entirely to the Harry Potter release. The company expects to repay the $125 million of 7% Notes maturing in December 2003 using available borrowings under its Loan Agreement and Revolver. Management believes existing cash and available credit are sufficient to finance working capital needs for the fiscal year.

Seasonality: The company notes that cash flow is typically negative from June through October due to seasonal inventory buildup and receivables collection cycles. Borrowings historically peak in September or October.

Risks and Contingencies:

• Market Risk: Approximately 21% of debt is variable-rate, exposing the company to interest rate fluctuations. Foreign currency fluctuations are managed via short-term forward contracts but remain a risk.
• Concentration Risk: Significant revenue concentration in the Harry Potter franchise creates volatility if future titles underperform or if the franchise loses momentum.
• Debt Covenants: The Loan Agreement and Revolver contain financial covenants related to debt and interest coverage ratios.

Investor Verification Checklist

• Harry Potter Sustainability: Verify the extent to which Q1 results were driven by the one-time release of the fifth Harry Potter book versus organic growth in other segments.
• Cash Flow Seasonality: Monitor cash burn rates in Q2 and Q3, as the company historically experiences significant negative operating cash flow during the summer months.
• Debt Maturity Wall: Confirm the company's ability to refinance or repay the $125 million 7% Notes maturing in December 2003 and the $170 million Loan Agreement expiring in August 2004.
• Bad Debt Trends: While the bad debt ratio improved due to high Harry Potter sales, verify if the underlying school-based continuity business (which had a lower pay rate) remains stable.
• Severance Costs: Track the remaining $5.5 million severance liability and its impact on future quarters.