School Specialty 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 preK-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 school start dates, the Company views a year-over-year comparison of the first nine months of the fiscal year to be a more meaningful analysis than year-over-year comparative results for quarterly periods on an individual basis.

During the first nine months of fiscal 2009, revenue decreased 2.6% as compared to the first nine months of fiscal 2008. The Essentials segments had revenue growth of 1.0% which was primarily related to strong furniture sales associated with new school construction projects, partially offset by a reduction in consumable orders. The Specialty segment experienced a revenue decline in the nine-month period of 5.4%. The decline in the Specialty segment was attributable primarily to the cyclical nature of state adoption revenues for the Company's curriculum-based products. Our state adoption revenue will continue to have significant variability between years due to the adoption schedules established by individual states. As such, we expect fiscal 2010 adoption revenue will decline as compared to fiscal 2009 adoption revenue. Gross margin was 41.1% for the first nine months of fiscal 2009, down 180 basis points from the comparable period last year. This decline is related to rising vendor and fuel costs during our peak shipping season and the shift in revenue towards lower margin products both within the segments, as well as between the segments.

Selling, general and administrative expenses ("SG&A") increased 60 basis points as a percent of revenues in the first nine months of fiscal 2009 as compared to the first nine months of fiscal 2008. Approximately 30 basis points of this increase is related to restructuring charges of $3.0 million in the first nine months of fiscal 2009 related to a distribution center closing and other severance costs. The remaining increase is related to a combination of the fixed SG&A costs being spread over a lower revenue base as well as increased transportation costs due to higher fuel costs during the Company's seasonally high-volume shipping months.

Operating income was $92.0 million in the first nine months of fiscal 2009, a decrease of $24.2 million from the prior year's comparable period. Earnings from continuing operations were $45.8 million in the first nine months of fiscal 2009, a decrease of $12.7 million from the first nine months of fiscal 2008.

Results of Continuing Operations

The following table sets forth various items as a percentage of revenues for the
three and nine months ended January 24, 2009 and January 26, 2008:



                                              Three Months Ended                    Nine Months Ended
                                        January 24,        January 26,        January 24,       January 26,
                                           2009               2008               2009              2008
Revenue                                       100.0 %            100.0 %            100.0 %           100.0 %
Cost of revenue                                64.4               61.7               58.9              57.1

Gross profit                                   35.6               38.3               41.1              42.9
Selling, general and administrative
expenses                                       60.2               56.8               30.8              30.2

Operating income (loss)                       (24.6 )            (18.5 )             10.3              12.7
Interest expense, net                           3.5                3.3                1.5               1.6
Other expense                                   0.6                1.2                0.3               0.6

Income (loss) before provision for
income taxes                                  (28.7 )            (23.0 )              8.5              10.5
Provision for (benefit from) income
taxes                                         (11.0 )             (8.9 )              3.4               4.1

Earnings (loss) from continuing
operations                                    (17.7 )%           (14.1 )%             5.1 %             6.4 %

Three months Ended January 24, 2009 Compared to Three months Ended January 26, 2008

Revenue

Revenue decreased 9.7% from $134.8 million for the three months ended January 26, 2008 to $121.7 million for the three months ended January 24, 2009.

Specialty segment revenue decreased $8.3 million or 10.6% from $78.3 million for the three months ended January 26, 2008 (which included $1.1 million of intersegment revenues) to $70.0 million for the three months ended January 24, 2009 (which included $0.6 million of intersegment revenues). The decrease was attributable to a combination of reductions and delays in spending by school districts as state budgetary concerns and the ongoing global economic slowdown have resulted in uncertainty as to the education funding levels in the upcoming state budget cycles. This uncertainty also is negatively impacting the smaller orders placed directly by teachers.

Essentials segment revenue decreased $5.3 million, or 9.2%, from $57.5 million for the three months ended January 26, 2008 to $52.2 million for the three months ended January 24, 2009. Both periods are comprised solely of sales to external parties. Consistent with the Specialty segment, the ongoing economic slowdown is negatively impacting Essentials revenue. The impact in the Essentials segment revenue was mainly related to the consumables business. Furniture revenues were relatively flat during the current year quarter compared to last year.

Gross Profit

Gross profit decreased $8.4 million, or 16.2%, from $51.7 million for the three months ended January 26, 2008 to $43.3 million for the three months ended January 24, 2009. The decrease in gross profit was due to a combination of decreased consolidated revenue and gross margin declines in both the Specialty and Essentials segments. Gross margin declined 270 basis points from 38.3% for the three months ended January 26, 2008 to 35.6% for the three months ended January 24, 2009.

Specialty segment gross profit decreased $6.7 million from $34.9 million for the three months ended January 26, 2008 to $28.2 million for the three months ended January 24, 2009 and gross margin decreased from 44.6% to 40.3%. The decrease in gross profit was related primarily to the overall decrease in Specialty revenue, as well as the decreased gross margin. Approximately 160 basis points of the decreased gross margin was related to the lower-margin product mix within the Specialty businesses, especially the reduction in the revenue attributable to curriculum-based products. In addition, product promotions within the science unit in the current year's quarter negatively impacted Specialty segment gross margin by 130 basis points. Finally, the volume decline resulted in an underabsorption of fixed overhead costs which contributed to the gross margin decline.

Essentials segment gross profit decreased $1.8 million from $16.5 million for the three months ended January 26, 2008 to $14.7 million for the three months ended January 24, 2009. This decrease was attributable primarily to the decreased volume in the current quarter. To a lesser extent, a decline of 50 basis points in the gross margin from 28.7% in the third quarter of fiscal 2008 to 28.2% in the third quarter of fiscal 2009 also contributed to the gross profit decline. A shift in the product mix towards lower margin furniture products versus consumable products led to a 90 basis point decline in the current quarter gross margin.

Selling, General and Administrative Expenses

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 include information systems, accounting, legal and human resources; and depreciation and intangible asset amortization expense.

As a percent of revenue, SG&A increased from 56.8% for the three months ended January 26, 2008 to 60.2% for the three months ended January 24, 2009. SG&A decreased $3.3 million from $76.6 million in the third quarter of fiscal 2008 to $73.3 million in the third quarter of fiscal 2009. SG&A attributable to the Specialty and Essentials segments decreased a combined $4.9 million and Corporate SG&A increased $1.6 million, to $12.3 million in the third quarter of fiscal 2009 as compared to $10.7 million last year's third quarter. The increase in Corporate SG&A included severance costs related to the Company's cost reduction efforts, incremental costs associated with the company's direct marketing and product management initiatives, and incremental depreciation related to the ERP phased implementations in recent years.

Specialty segment SG&A decreased $4.0 million from $45.5 million for the three months ended January 26, 2008 to $41.5 million for the three months ended January 24, 2009, and increased 110 basis points as a percent of revenue from 58.2% to 59.3% over this same period. The decrease in SG&A was due primarily to a decline in variable costs such as sales commissions, warehousing and transportation associated with the decreased revenues. In addition, cost reduction efforts undertaken during the quarter contributed to the decline in SG&A. The increase in SG&A as a percent of revenue is primarily attributable to the fixed SG&A costs being absorbed by a smaller revenue base.

Essentials segment SG&A decreased $0.9 million from $20.4 million for the three months ended January 26, 2008 to $19.5 million for the three months ended January 24, 2009, but increased 180 basis points as a percent of revenue from 35.5% to 37.3% over this same period. The decrease in SG&A was related to the decline in variable costs associated with the volume decline. Partially offsetting the decline were increases associated with the segment's marketing initiatives, as well as severance costs associated with headcount reductions made in the third quarter. The increase in SG&A as a percent of revenue was driven by the base of non-variable costs in comparison to decreased revenue partially offset by decreased costs associated with transportation savings and other cost reduction efforts.

Interest Expense

Net interest expense decreased $0.3 million from $4.5 million for the three months ended January 26, 2008 to $4.2 million for the three months ended January 24, 2009. The decrease in interest expense was due to a reduction in the overall effective borrowing rate to 4.6% in the third quarter of fiscal 2009 as compared to an effective borrowing rate of 4.8% in the third quarter of fiscal 2008, along with a $19.5 million decrease in the Company's average outstanding borrowings over the same periods.

Other Expense

Other expense, which primarily consists of the discount and loss on the accounts receivable securitization, was $0.7 million in the third quarter of fiscal 2009, compared to $1.6 million in the third quarter of fiscal 2008. This decrease was due to lower effective discount rates associated with the Company's securitization facility in fiscal 2009 as compared to fiscal 2008.

Provision for (Benefit From) Income Taxes

Benefit from income taxes increased $1.3 million from a benefit of $12.0 million in the third quarter of fiscal 2008 to a benefit of $13.3 million in the third quarter of fiscal 2009. This increase was primarily due to an increased pre-tax loss for the third quarter of fiscal 2009 as compared to the third quarter of fiscal 2008. The effective income tax rate decreased 40 basis points from 38.6% for the three months ended January 26, 2008 to 38.2% for the three months ended January 24, 2009. The change in the effective tax rate is related primarily to an incremental tax benefit in fiscal 2008's third quarter due to the favorable tax treatment of charitable contributions of inventory.

The effective income tax rate of 38.2% exceeds the federal statutory rate of 35% primarily due to foreign income that is taxed at higher rates than domestic income, along with state taxes.

Nine Months Ended January 24, 2009 Compared to Nine Months Ended January 26, 2008

Revenue decreased 2.6% from $914.3 million for the nine months ended January 26, 2008 to $890.8 million for the nine months ended January 24, 2009.

Specialty segment revenue decreased 5.4% from $535.3 million for the nine months ended January 26, 2008 (which included $5.3 million of intersegment revenues) to $506.4 million for the nine months ended January 24, 2009 (which included $3.8 million of intersegment revenues). The decline in Specialty segment revenue was related primarily to a decline of approximately $25 million of state adoption revenue from the Company's curriculum-based products. The remaining reduction is related to the decline in the Specialty segment business associated the global economic slowdown.

Essentials segment revenue increased 1.0% from $383.8 million for the nine months ended January 26, 2008 to $387.7 million for the nine months ended January 24, 2009. Revenue amounts for both periods were comprised solely of sales to external parties. The increase in Essentials segment revenue was due to a combination of stronger furniture orders and the timing of key school building projects. Partially offsetting these revenue gains was a decline in consumable orders, the timing of which coincided with the deteriorating macro-economic conditions in the latter part of the period presented.

Gross Profit

Gross profit decreased 6.7% from $392.6 million for the nine months ended January 26, 2008 to $366.4 million for the nine months ended January 24, 2009. The decrease in gross profit was due to a combination of decreased consolidated revenue and gross margin declines in both the Specialty and Essentials segments. Gross margin declined 180 basis points from 42.9% for the nine months ended January 26, 2008 to 41.1% for the nine months ended January 24, 2009. Approximately 40 basis points of this decline was related to the mix of revenue between segments. The Specialty segment, which generates a higher gross margin than the Essentials, accounted for 58% of the consolidated revenues in the first nine months of fiscal 2008 as compared to 57% of consolidated revenues in the first nine months of fiscal 2009.

Specialty segment gross profit decreased $20.2 million from $270.4 million for the nine months ended January 26, 2008 to $250.2 million for the nine months ended January 24, 2009 and gross margin decreased from 50.5% to 49.4%. The decrease in gross profit was related primarily to the overall decrease in Specialty revenue, as well as the decreased gross margin. The primary cause of the decreased gross margin was the lower margin product mix within the Specialty businesses, especially the reduction in the state adoption revenue from curriculum-based products. To a lesser extent, product cost increases and increased transportation costs on vendor-direct shipments to customers also placed pressure on the Specialty segment gross margins.

Essentials segment gross profit decreased $6.3 million from $121.3 million for the nine months ended January 26, 2008 to $115.0 million for the nine months ended January 24, 2009 and gross margin declined 190 basis points from 31.6% in the first nine months of fiscal 2008 to 29.7% in the first nine months of fiscal 2009. The decrease in gross profit was driven by the gross margin decline. Approximately 60 basis points of the decline in gross margin is related to product mix shifting towards lower margin furniture products versus consumable products. The remaining decline in gross margin is due to a combination of cost increases being passed on to the Company from its vendors, and higher fuel costs increasing inbound freight costs associated with procuring the products. The Company was not able to pass on vendor and transportation cost increases to customers due to current fixed pricing within contract agreements and longer-lived catalogs.

Selling, General and Administrative Expenses

As a percent of revenue, SG&A increased from 30.2% for the nine months ended January 26, 2008 to 30.8% for the nine months ended January 24, 2009. SG&A decreased $2.0 million from $276.4 million in the first nine months of fiscal 2009 to $274.4 million in the first nine months of fiscal 2009. SG&A attributable to the Specialty and Essentials segments decreased a combined $4.3 million and Corporate SG&A increased $2.3 million in the first nine months of fiscal 2009 as compared to last year's first nine months. The increase in Corporate SG&A included $1.7 million for the closing of the Lyons, New York distribution center, severance costs related to headcount reductions, and incremental costs associated with the Company's direct marketing and product management initiatives. Corporate SG&A also includes incremental depreciation associated with the new ERP system. Partially offsetting these additional costs is a reduction in variable performance-based compensation expense, as well as savings from the Company's cost reduction efforts, primarily in compensation and occupancy.

Specialty segment SG&A decreased $6.4 million from $165.0 million for the nine months ended January 26, 2008 to $158.6 million for the nine months ended January 24, 2009, and increased 50 basis points as a percent of revenue from 30.8% to 31.3% over this same period. The decrease in SG&A was due primarily to a decline in variable costs such as sales commissions, warehousing and transportation associated with the decreased revenues. These decreases were partially offset by increased outbound freight costs related to higher fuel prices during the Company's high volume summer months, as well as severance costs associated with headcount reductions. This increase in SG&A as a percent of revenue is primarily attributable to the fixed SG&A costs being absorbed by a smaller revenue base.

Essentials segment SG&A increased $2.1 million from $79.6 million for the nine months ended January 26, 2008 to $81.7 million for the nine months ended January 24, 2009, and increased 40 basis points as a percent of revenue from 20.7% to 21.1% over this same period. The increase in SG&A and SG&A as a percent of revenue was a result of increased outbound transportation costs associated with higher fuel costs, increased costs associated with the segment's marketing initiatives, severance costs related to headcount reductions, and incremental variable costs associated with the volume increase.

Interest Expense

Net interest expense decreased $1.4 million from $14.8 million for the nine months ended January 26, 2008 to $13.4 million for the nine months ended January 24, 2009. The decrease in interest expense was due to a reduction in the overall effective borrowing rate to 4.5% in the first nine months of fiscal 2009 as compared to an effective borrowing rate of 4.9% in the first nine months of fiscal 2008. The reduction in the borrowing rate is attributable to the decreased rates in the overall credit markets. In addition, average outstanding borrowings in fiscal 2009 have decreased by $3.6 million as compared to the first nine months of fiscal 2009. Average outstanding borrowings have decreased over the prior year as cash provided by operating activities in the first nine months of fiscal 2009, partially offset by share repurchases made by the Company since the beginning of fiscal 2008, has been used to reduce debt.

In May 2008, FASB issued FASB Staff Position APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (Including Partial Cash Settlement) ("FSP APB 14-1"). FSP APB 14-1 requires an issuer of certain convertible debt instruments to separately account for the liability and equity components of convertible debt instruments in a manner that reflects the issuer's nonconvertible debt borrowing rate. FSP APB 14-1 will be effective for the Company at the beginning of fiscal 2010 (April 26, 2009) and requires retrospective application to all periods presented during which any such convertible debt instruments were outstanding. The Company expects FSP APB 14-1 to have a negative impact on historical results of operations when applied retrospectively and future operating results as long as the Company continues to have convertible debentures outstanding primarily as a result of the recognition of increased non-cash interest expense. The Company has preliminarily estimated that the adoption of FASB Staff Position APB 14-1 would have reduced diluted earnings per share by approximately $0.34 and $0.19, in fiscal 2008 and fiscal 2007, respectively.

Other Expense

Other expense, which primarily consists of the discount and loss on the accounts receivable securitization, was $2.8 million in the first nine months of fiscal 2009, compared to $5.3 million in the first nine months of fiscal 2008. This decrease was due to lower effective discount rates associated with the Company's securitization facility in fiscal 2009 as compared to fiscal 2008.

Provision for Income Taxes

Provision for income taxes decreased $7.6 million primarily due to lower pre-tax income. The effective income tax rate increased 40 basis points from 39.1% for the nine months ended January 26, 2008 to 39.5% for the nine months ended January 24, 2009. The increase in the effective tax rate is related to the incremental tax benefit realized in fiscal 2008 for the favorable tax treatment of certain inventory donations.

The effective income tax rate of 39.5% exceeds the federal statutory rate of 35% primarily due to foreign income that is taxed at higher rates than domestic income, along with state taxes.

Liquidity and Capital Resources

At January 24, 2009, the Company had working capital of $14.8 million. The Company's capitalization at January 24, 2009 was $865.7 million and consisted of total debt of $361.1 million and shareholders' equity of $504.6 million.

The Company's credit facility matures on February 1, 2011 and provides for $350.0 million of revolving loan availability and $100.0 million incremental term loan availability. The amounts outstanding as of January 24, 2009

under the revolving and incremental term loans were $13.0 million and $0, respectively. The credit facility is secured by substantially all of the Company's assets and contains certain financial and other covenants. During the first nine months of fiscal 2009, the Company borrowed under its credit facility primarily to meet seasonal working capital requirements. The Company's borrowings are usually significantly higher during the first two quarters of its fiscal year to meet the working capital requirements of the Company's peak selling season. As of January 24, 2009, the Company's effective interest rate on borrowings under its credit facility was approximately 1.9%, which excludes amortization of loan origination fee costs and the commitment fees on unborrowed funds. During the nine months ended January 24, 2009, the Company paid commitment fees on unborrowed funds under the credit facility of $0.5 million and amortized loan origination fee costs of $0.2 million related to the credit facility. The credit facility contains certain financial covenants, including a consolidated total and senior leverage ratio, a consolidated fixed charge ratio and a limitation on consolidated capital expenditures. The Company was in compliance with these covenants at January 24, 2009.

The Company's $133.0 million, 3.75% convertible subordinated notes became convertible during the second quarter of fiscal 2006 as the closing price of the Company's common stock exceeded $48.00 for the specified amount of time. As a result, holders of the notes may surrender the notes for conversion at any time from October 1, 2005 until July 31, 2023. The notes are recorded as a current liability. Holders that exercise their right to convert the notes will receive up to the accreted principal amount in cash, with the balance of the conversion obligation, if any, to be satisfied in shares of Company common stock or cash, at the Company's discretion. Holders may require the Company to repurchase the notes for cash on August 1, 2010, 2013 and 2018 at a repurchase price equal to 100% of their accreted principal amount, plus accrued and unpaid interest, if any. No notes have been converted into cash or shares of common stock as of January 24, 2009. The notes are currently redeemable at the option of the Company.

In November 2006, the Company sold $200.0 million of convertible subordinated debentures due 2026. The debentures are unsecured, subordinated obligations of the Company, pay interest at 3.75% per annum on each May 30th and November 30th, and are convertible upon satisfaction of certain conditions. In connection with any such conversion, the Company will deliver cash equal to the lesser of the aggregate principal amount of debentures to be converted and the Company's total conversion obligation, and will deliver, at its option, cash or shares of the Company's common stock in respect of the remainder, if any, of the Company's conversion obligation. The initial conversion rate is 19.4574 shares per $1,000 principal amount of debentures, which represents an initial conversion price of approximately $51.39 per share. The debentures are redeemable at the Company's option on or after November 30, 2011. On November 30, 2011, 2016 and 2021 and upon the occurrence of certain circumstances, holders will have the right to require us to repurchase all or some of the debentures.

Net cash provided by operating activities increased $14.0 million to $104.1 million in the first nine months of fiscal 2009 as compared to $90.1 million provided in the first nine months of fiscal 2008. The increase in cash provided by operating activities was related to improvements in both inventory management and receivables collections, partially offset by the decline in net income.

Net cash used in investing activities for the first nine months of fiscal 2009 was $11.2 million as compared to $25.6 million for the first nine months of fiscal 2008. Additions to property, plant and equipment decreased $4.5 million from the nine months of fiscal 2008 to $7.7 million in the first nine months of fiscal 2009, primarily as a result of decreased spending related to the implementation of the Company's ERP system. Spending on product development decreased by $1.8 million in the first nine months of fiscal 2009 as compared to . . .