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TMCNet:  SCHOOL SPECIALTY INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operation

[September 04, 2014]

SCHOOL SPECIALTY INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operation

(Edgar Glimpses Via Acquire Media NewsEdge) Quarterly Overview School Specialty, Inc. (the "Company"), is an education company that provides innovative and proprietary products, programs, and services to help educators engage and inspire students of all ages and abilities to learn. Through each of our leading brands, we design, develop, and provide pre K-12 educators with the latest and very best curriculum, supplemental learning resources and classroom basics. Working in collaboration with educators, we reach beyond the scope of textbooks to help teachers, guidance counselors, and school administrators ensure that every student reaches his or her full potential.


Our business is subject to seasonal fluctuations. Our historical revenues and profitability have been dramatically higher in the first two quarters of our fiscal year, primarily due to increased shipments to customers coinciding with the start of each school year. Due to variations in the timing of shipments within this season primarily as a result of changes or delays in the finalization of state education budgets as well as the impact that the bankruptcy proceedings had on last year's quarter one and quarter two revenue, the Company views a year-over-year comparison of the first six months of the fiscal year to be a more meaningful analysis than year-over-year comparative results for quarterly periods on an individual basis.

The six month comparison is especially important in comparing results of fiscal 2015 to the results of fiscal 2014. This is due to the fact that the Company's largest shipping weeks historically straddle the end of quarter one.

Results of Operations Factors Affecting Comparability Fresh Start Accounting Adjustments The Company adopted fresh start accounting and reporting effective June 11, 2013, the Fresh Start Reporting Date. The financial statements as of the Fresh Start Reporting Date report the results of the Successor Company with no beginning retained earnings or accumulated deficit. Any financial statement presentation of the Successor Company represents the financial position and results of operations of a new reporting entity and is not comparable to prior periods presented by the Predecessor Company. The financial statements for periods ended prior to the Fresh Start Reporting Date do not include the effect of any changes in the Predecessor Company's capital structure or changes in the fair value of assets and liabilities as a result of fresh start accounting.

Accordingly, management has provided a non-GAAP analysis entitled "Non-GAAP Financial Information - Combined Results" for the three months ended July 26, 2014. Non-GAAP Financial Information - Combined Results combines GAAP results of the Successor Company for the seven weeks ended July 27, 2013 and GAAP results of the Predecessor Company for the six weeks ended June 11, 2013. Management's non-GAAP analysis compares the Successor Company's GAAP results for the three months ended July 26, 2014 for certain financial items to the Non-GAAP Financial Information - Combined Results.

Non-GAAP Financial Information - Combined Results As a result of the emergence from bankruptcy occurring six weeks into fiscal 2014, management believes that the presentation of Non-GAAP Financial Information - Combined Results for the first quarter of fiscal 2014 offers a useful non-GAAP normalized comparison to GAAP results of the Successor Company for the three months ended July 26, 2014. The Non-GAAP Financial Information - Combined Results presented below are reconciled to the most comparable GAAP measures.

Successor Company GAAP Results for the Three Months Ended July 26, 2014 Compared to Non-GAAP Combined Results for the Three Months Ended July 27, 2013 31-------------------------------------------------------------------------------- Table of Contents Revenues Successor Non-GAAP Successor Predecessor Company Combined Company Company Three Months Three Months Seven Weeks Six Weeks Ended Ended Ended Ended July 26, 2014 July 27, 2013 July 27, 2013 June 11, 2013 Revenues $ 199,469 $ 202,196 $ 143,499 $ 58,697 Revenues for the three months ended July 26, 2014 decreased 1.3%, or $2.7 million from the combined three months ended July 27, 2013.

Distribution segment revenues decreased 3.9%, or $6.7 million, from the combined three months ended July 27, 2013. Approximately $10 million of the decline is related to our student planner and agenda products. We believe schools consider agenda products more discretionary in nature and some schools are de-emphasizing paper-based agendas in favor of digital products. Furniture product lines revenue increased approximately $4 million, partially offsetting the decline in agendas. The furniture product line in the first quarter of fiscal 2014 was more negatively impacted by the bankruptcy due to customer uncertainty and vendor credit limits. The Company has been successful in both re-establishing credit terms with most furniture vendors and gaining back customer confidence in the year following the emergence from bankruptcy.

Curriculum segment revenues increased 13.9%, or $4.0 million, from the combined three months ended July 27, 2013. Approximately $3 million of the increase is related to the adoption of state science curriculum in Texas. The remaining increase is related to other smaller increases in the Company's Science Curriculum.

Gross Profit Successor Non-GAAP Successor Predecessor Company Combined Company Company Three Months Three Months Seven Weeks Six Weeks Ended Ended Ended Ended July 26, 2014 July 27, 2013 July 27, 2013 June 11, 2013 Gross profit $ 78,566 $ 83,376 $ 59,758 $ 23,618 Gross margin for the three months ended July 26, 2014 was 39.4% as compared to 41.2% for the combined three months ended July 27, 2013.

Distribution segment gross margin was 37.1% for the three months ended July 26, 2014 as compared to 39.2% for the combined three months ended July 27, 2013. The decrease is gross margin is primarily related to the Company's agenda product category as agenda revenue has declined, as expected, as schools continue to assess the need for paper-based agenda products and the mix of agendas has trended towards lower margin product offerings. In addition, gross margin declined within the supplies product category as the mix of competitively-bid market basket items was higher in the first quarter of fiscal 2015 as compared to the first quarter of fiscal 2014.

Curriculum segment gross margin was 51.1% for the three months ended July 26, 2014 as compared to 53.3% for the combined three months ended July 27, 2013. The decline is related to increased product development amortization of $1.2 million in the first quarter of fiscal 2015 which has contributed to a decrease of 360 basis points of gross margin. This decline was partially offset by the mix of higher margin curriculum products within the segment.

32-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Expenses Successor Non-GAAP Successor Predecessor Company Combined Company Company Three Months Three Months Seven Weeks Six Weeks Ended Ended Ended Ended July 26, 2014 July 27, 2013 July 27, 2013 June 11, 2013 Selling, general and administrative expenses $ 61,942 $ 63,340 $ 35,867 $ 27,473 SG&A includes selling expenses, the most significant of which are sales wages and commissions; operations expenses, which includes customer service, warehouse and out-bound freight costs; catalog costs; general administrative overhead, which includes information systems, accounting, legal and human resources; and depreciation and intangible asset amortization expense.

SG&A decreased $1.4 million from $63.3 million for the combined three months ended July 27, 2013 to $61.9 million for the three months ended July 26, 2014.

As a percent of revenue, SG&A decreased from 31.3% for the combined three months ended July 27, 2013 to 31.1% for the three months ended July 26, 2014.

SG&A attributable to the Distribution and Curriculum segments decreased $3.9 million and Corporate SG&A increased $2.5 million in the first three months as compared to last year's combined first three months.

Distribution segment SG&A decreased $2.9 million, or 5.8%, from $51.2 million for the combined three months ended July 27, 2013 to $48.3 million for the three months ended July 26, 2014. The segment had a decrease of $1.1 million in its marketing costs primarily associated with a decrease in catalog costs as the Company reduced the number of seasonal catalog mailings and reduced circulation of other catalogs. Compensation and benefit costs for the Distribution segment decreased $1.1 million. Headcount for the Distribution segment has been reduced by approximately 10% compared to fiscal 2014. Depreciation and amortization expense was decreased by $0.4 million primarily as a result of the adoption of fresh start accounting. Distribution segment SG&A decreased as a percent of revenue from 29.5% for the combined three months ended July 27, 2013 to 29.0% for the three months ended July 26, 2014.

Curriculum segment combined SG&A decreased $1.0 million, or 8.1%, from $12.1 million for the combined three months ended July 27, 2013 to $11.1 million for the three months ended July 26, 2014. Depreciation and amortization declined by $0.8 million related to the adoption of fresh start accounting. Curriculum segment SG&A decreased as a percent of revenue from 42.1% for the combined three months ended July 27, 2013 to 33.9% for the three months ended July 26, 2014.

The Corporate SG&A increase of $2.5 million is related to process improvement implementation costs such as consulting fees and warehouse implementation costs associated with transitioning the majority of fulfillment activities to the Company's Mansfield, Ohio distribution center.

Facility exit costs and restructuring In the first quarter of fiscal 2015, the Successor Company recorded a $0.1 million of restructuring charges related primarily to severance.

In the first quarter of fiscal 2014, the Successor Company recorded $2.6 million of bankruptcy related restructuring charges consisting of costs associated with warehouse closures, transportation costs resulting from bankruptcy related backorders and consulting fees.

33-------------------------------------------------------------------------------- Table of Contents Interest Expense Successor Non-GAAP Successor Predecessor Company Combined Company Company Three Months Three Months Seven Weeks Six Weeks Ended Ended Ended Ended July 26, 2014 July 27, 2013 July 27, 2013 June 11, 2013 Interest expense $ 5,275 $ 6,056 $ 2,821 $ 3,235 Interest expense decreased $0.8 million, from $6.1 million for the combined three months ended July 27, 2013 to $5.3 million for the three months ended July 26, 2014.

For the three months ended July 26, 2014, interest expense associated with the Successor Company's New Term Loan was approximately $0.5 million lower than combined term loan interest expense for the three months ended July 27, 2013, primarily due to a lower interest rate under the New Term Loan Credit Agreement as compared to the pre-bankruptcy term loan. For the three months ended July 26, 2014, interest expense associated with the Successor Company's New ABL Facility was approximately $0.3 million lower than combined interest expense for the three months ended July 27, 2013, primarily due to a lower average outstanding balance.

Change in Fair Value of Interest Rate Swap In the second quarter of fiscal 2014, the Company entered into an interest rate swap agreement that effectively fixes the interest payments on a portion of the Company's variable-rate debt. The swap, which has a termination date of September 11, 2016, effectively fixes the LIBOR-based interest rate on the debt in the amount of the notional amount of the swap at 9.985%. The notional amount of the swap at July 26, 2014 was $72.5 million. As of July 26, 2014, the fair value of the derivative increased by less than $0.1 million and, accordingly, a non-cash gain of less than $0.1 million was recorded.

Reorganization Items, Net In the three months ended July 26, 2014, the Company recorded a $0.3 million net reorganization loss. This consists of professional advisory fees and other costs related to the continued implementation of the Reorganization Plan and the resolution of unresolved claims.

In the combined three months ended July 27, 2013, the Company recorded an $83.5 million net reorganization gain. This consists of $161.9 million of cancellation of indebtedness income related to the settlement of prepetition liabilities and changes in the Predecessor's capital structure arising from implementation of the Reorganization Plan, offset by $30.2 million of fresh start adjustments, $21.4 million of cancellation of debt upon the issuance of equity, $14.7 million of professional, financing and other fees, $7.0 million of contract rejections and $5.1 million of other reorganization adjustments.

Included in the $14.7 million of professional and other financing fees are $1.3 million of professional fees incurred after the Effective Date which pertained to post-emergence activities related to the implementation of the Reorganization Plan and other transition costs attributable to the reorganization.

34-------------------------------------------------------------------------------- Table of Contents Provision for (Benefit from) Income Taxes Successor Non-GAAP Successor Predecessor Company Combined Company Company Three Months Three Months Seven Weeks Six Weeks Ended Ended Ended Ended July 26, 2014 July 27, 2013 July 27, 2013 June 11, 2013 Provision for (benefit from) income taxes $ (56 ) $ 1,893 $ 252 $ 1,641 Effective tax rate -0.5 % 2.0 % 1.5 % 2.1 % The benefit from income taxes was $0.1 million for the three months ended July 26, 2014 as compared to a combined provision for income taxes of $1.9 million for the three months ended July 2, 2013.

The effective tax rate for the combined three months ended July 27, 2013 was 2.0%. This rate was significantly lower than the statutory rate because the net reorganization income realized during this period is primarily related to cancellation of indebtedness income. During the six weeks ended June 11, 2013, the Company excluded from taxable income $129,084 of cancellation of indebtedness income as defined under Internal Revenue Code ("IRC") Section 108.

IRC Section 108 excludes from taxable income the amount of indebtedness discharged under a Chapter 11 case. IRC Section 108 also requires a reduction of tax attributes equal to the amount of excluded taxable income. As a result, the Company reduced the available federal and state net operating loss carryforward and adjusted the tax reporting basis of tangible and intangible assets for the discharge of indebtedness income. In addition to the adjustment to the tax reporting basis as described above, the fresh start accounting adjustments also created additional basis differences between income tax and financial reporting.

Because the Company had recorded a full valuation allowance in fiscal 2013, the reduction of tax attributes resulted in a corresponding reduction of the valuation allowance. Thus, the reduction of tax attributes did not result in an increased effective tax rate for the combined three months ended July 27, 2013.

The effective rate for the three months ended July 26, 2014 was -0.5%. The benefit recorded in the three months ended July 26, 2014 is related to foreign tax true-ups. The Company does not expect to have taxable income in fiscal 2015.

Due to the inability to forecast the utilization of net operating losses in future years, the Company did not record a federal tax benefit.

Liquidity and Capital Resources At July 26, 2014, the Company had working capital of $127.9 million. The Company's capitalization at July 26, 2014 was $341.5 million and consisted of total debt of $228.8 million and stockholders' equity of $112.7 million.

For a description of the Predecessor Company's debt, please see the disclosure contained in the Company's Form 10-K for the fiscal year ended April 26, 2014.

On June 11, 2013, in accordance with the Reorganization Plan, the Company entered into a Loan Agreement (the "Asset-Based Credit Agreement") among the Company, Bank of America, N.A, as Agent, SunTrust Bank, as Syndication Agent, Merrill Lynch, Pierce, Fenner & Smith Incorporated and SunTrust Robinson Humphrey, Inc., as Joint Lead Arrangers and Bookrunners, and the Lenders that are party to the Asset-Based Credit Agreement (the "Asset-Based Lenders").

Under the Asset-Based Credit Agreement, the Asset-Based Lenders agreed to provide a revolving senior secured asset-based credit facility (the "New ABL Facility") in an aggregate principal amount of $175 million. Outstanding amounts under the New ABL Facility will bear interest at a rate per annum equal to, at the Company's election: (1) a base rate (equal to the greatest of (a) the prime lending rate, (b) the federal funds rate plus 0.50%, and (c) the 30-day LIBOR rate plus 1.00% per annum) (the "Base Rate") plus an applicable margin (equal to a specified margin based on the interest rate elected by the Company, the fixed charge coverage ratio under the New ABL Facility and the applicable point in the life of the New ABL Facility) (the "Applicable Margin"), or (2) a LIBOR rate plus the Applicable Margin (the "LIBOR Rate"). Interest on loans under the New ABL Facility bearing interest based upon the Base Rate will be due monthly in arrears, and interest on loans bearing interest based upon the LIBOR Rate will be due on the last day of each relevant interest period or, if sooner, on the respective dates that fall every three months after the beginning of such interest period.

35 -------------------------------------------------------------------------------- Table of Contents The New ABL Facility will mature on June 11, 2018. The Company may prepay advances under the New ABL Facility in whole or in part at any time without penalty or premium. The Company will be required to make specified prepayments upon the occurrence of certain events, including: (1) the amount outstanding on the New ABL Facility exceeding the Borrowing Base, and (2) the Company's receipt of net cash proceeds of any sale or disposition of assets that are first priority collateral for the New ABL Facility.

Pursuant to a Guaranty and Collateral Agreement dated as of June 11, 2013 (the "New ABL Security Agreement"), the New ABL Facility is secured by a first priority security interest in substantially all assets of the Company and the guarantor subsidiaries. Under an intercreditor agreement between the Asset-Based Lenders and the Term Loan Lenders, as defined and described below, the Asset-Based Lenders have a first priority security interest in substantially all working capital assets of the Company and the guarantor subsidiaries, and a second priority security interest in all other assets, subordinate only to the first priority security interest of the Term Loan Lenders in such other assets.

The Asset-Based Credit Agreement contains customary events of default and financial, affirmative and negative covenants, including but not limited to a springing financial covenant relating to the Company's fixed charge coverage ratio and restrictions on indebtedness, liens, investments, asset dispositions and dividends and other restricted payments. The Company was in compliance with the financial covenants during the three months ended July 26, 2014.

Also on June 11, 2013, the Company entered into a credit agreement (the "New Term Loan Credit Agreement") among the Company, Credit Suisse AG, as Administrative Agent and Collateral Agent, and the lenders party to the New Term Loan Credit Agreement (the "Term Loan Lenders").

Under the New Term Loan Credit Agreement, the Term Loan Lenders agreed to make a term loan (the "New Term Loan") to the Company in aggregate principal amount of $145 million. The outstanding principal amount of the New Term Loan will bear interest at a rate per annum equal to the applicable LIBOR rate (with a 1% floor) plus 8.50%, or the base rate plus a margin of 7.50%. Interest on loans under the New Term Loan Credit Agreement bearing interest based upon the base rate will be due quarterly in arrears, and interest on loans bearing interest based upon the LIBOR rate will be due on the last day of each relevant interest period or, if sooner, on the respective dates that fall every three months after the beginning of such interest period.

The New Term Loan matures on June 11, 2019. The New Term Loan Credit Agreement requires prepayments at specified levels upon the Company's receipt of net proceeds from certain events, including: (1) certain dispositions of property, divisions, business units or business lines; and (2) other issuances of debt other than Permitted Debt, as defined in the New Term Loan Credit Agreement. The Post-Emergence Term Loan Credit Agreement also requires prepayments at specified levels from the Company's excess cash flow. The Company is also permitted to voluntarily prepay the New Term Loan in whole or in part. Any prepayments are to be made at par, plus an early payment fee calculated in accordance with the terms of the New Term Loan Credit Agreement if prepaid prior to the second anniversary of the New Term Loan Credit Agreement.

Pursuant to a Guarantee and Collateral Agreement dated as of June 11, 2013 (the "New Term Loan Security Agreement"), the New Term Loan is secured by a first priority security interest in substantially all assets of the Company and the guarantor subsidiaries. Under an intercreditor agreement between the Asset-Based Lenders and the Term Loan Lenders, the Term Loan Lenders have a second priority security interest in substantially all working capital assets of the Company and the subsidiary guarantors, subordinate only to the first priority security interest of the Asset-Based Lenders in such assets, and a first priority security interest in all other assets.

The New Term Loan Credit Agreement contains customary events of default and financial, affirmative and negative covenants, including but not limited to quarterly financial covenants that commenced on the fiscal quarter ending October 26, 2013, relating to the Company's (1) minimum interest coverage ratio and (2) maximum net total leverage ratio and restrictions on indebtedness, liens, investments, asset dispositions and dividends and other restricted payments. The Company was in compliance with the financial covenants during the three months ended July 26, 2014.

The Company closely evaluates its expected ability to remain in compliance with the financial covenants under our New ABL Security Agreement and New Term Loan Credit Agreement. Based on current projections, the Company believes it will maintain compliance with these financial covenants through the remainder of fiscal 2015.

36 -------------------------------------------------------------------------------- Table of Contents Net cash used in operating activities was $55.5 million, $41.5 million and $20.0 million for the three months ended July 26, 2014, the seven weeks ended July 27, 2013 (Successor Company) and the six weeks ended June 11, 2013 (Predecessor Company), respectively. The combined decrease of $6.0 million is primarily due to a reduction in bankruptcy-related costs of approximately $8 million for professionals or other financing related fees which were paid in the combined first three months of fiscal 2014 Net cash used in investing activities was $4.3 million, $0.9 million and $0.7 million for the three months ended July 26, 2014, the seven weeks ended July 27, 2013 (Successor Company) and the six weeks ended June 11, 2013 (Predecessor Company), respectively. The combined increase was primarily due to $1.6 million of capital improvements in our distribution center in Mansfield, Ohio as part of the reconfiguration of the distribution network.

Net cash provided by financing activities was $60.1 million, $36.7 million and $15.5 million for the three months ended July 26, 2014, the seven weeks ended July 27, 2013 (Successor Company) and the six weeks ended June 11, 2013 (Predecessor Company), respectively. The combined increase of $7.9 million relates primarily to $9.4 million of debt issuance costs incurred by the Predecessor Company that were not incurred in the first quarter of fiscal 2015.

Outstanding borrowings on the New ABL Facility were $71.9 million as July 26, 2014, while the excess availability on that date for the New ABL Facility was $75.3 million.

We believe that our cash flow from operations, borrowings available from our existing credit facility and other sources of capital will be sufficient to meet our liquidity requirements for operations, including anticipated capital expenditures and our contractual obligations for the foreseeable future.

Fluctuations in Quarterly Results of Operations Our business is subject to seasonal influences. Our historical revenues and profitability have been dramatically higher in the first two quarters of our fiscal year, primarily due to increased shipments to customers coinciding with the start of each school year. Quarterly results also may be materially affected by the variations in our costs for the products sold, the mix of products sold and general economic conditions. Therefore, results for any fiscal quarter are not indicative of the results that we may achieve for any subsequent fiscal quarter or for a full fiscal year.

Inflation Inflation, particularly in energy costs, has had and is expected to have an effect on our results of operations and our internal and external sources of liquidity.

Forward-Looking Statements Statements in this Quarterly Report which are not historical are "forward-looking" statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include: (1) statements made under Item 2, Management's Discussion and Analysis of Financial Condition and Results of Operation, including, without limitation, statements with respect to our Process Improvement Program, internal growth plans, projected revenues, margin improvement, capital expenditures, adequacy of capital resources and ability to comply with financial covenants; and (2) statements included or incorporated by reference in our future filings with the Securities and Exchange Commission. Forward-looking statements also include statements regarding the intent, belief or current expectation of School Specialty or its officers. Forward-looking statements include statements preceded by, followed by or that include forward-looking terminology such as "may," "should," "believes," "expects," "anticipates," "estimates," "continues" or similar expressions.

All forward-looking statements included in this Quarterly Report are based on information available to us as of the date hereof. We do not undertake to update any forward-looking statements that may be made by us or on our behalf, in this Quarterly Report or otherwise. Our actual results may differ materially from those contained in the forward-looking statements identified above. Factors which may cause such a difference to occur include, but are not limited to, the risk factors set forth in Item 1A, "Risk Factors" of our Annual Report on Form 10-K for the fiscal year ended April 26, 2014.

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