Quarterly Overview

School Specialty, 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 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 the finalization of state education budgets, 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.

During the first quarter of fiscal 2010, revenues decreased 12.8% over the first quarter of fiscal 2009. Both the Educational Resources segment and the Publishing segment experienced revenue declines in the quarter of 10.8% and 16.2% respectively. The revenue declines in both the Educational Resources and Publishing segments were attributable to the current macroeconomic conditions which have created uncertainty in the school districts related to state budget funding levels, which, in turn, has led to a cautious spending approach by our customers. Gross margin was 43.2% for the first quarter of fiscal 2010, down 10 basis points from the comparable quarter last year. This decline is related to an unfavorable product mix both between segments and within the Publishing segment which has more than offset gross margin improvements in our Educational Resources segment.

Selling, general and administrative expenses ("SG&A") remained flat as a percentage of revenues in the first quarter of fiscal 2010 as compared to the first quarter of fiscal 2009. The Company has been able to keep SG&A flat as a percentage of sales despite the revenue decline due to its cost cutting initiatives primarily associated with the consolidation of operating activities. The Company's current full-time staffing is down approximately 300 individuals as compared to last year's first quarter.

Operating income was $54.5 million for the first quarter of fiscal 2010, a decrease of $8.4 million from the prior year quarter. Net income was $28.4 million in the first quarter of fiscal 2010, a decrease of $5.0 million from the prior year quarter.

Results of Continuing Operations

The following table sets forth various items as a percentage of revenues on a historical basis concerning the Company's results of operations for the three months ended July 25, 2009 and July 26, 2008:

                                                       Three Months Ended
                                                                 (As Adjusted,
                                                   July 25,       See Note 9)
                                                     2009        July 26, 2008
    Revenues                                          100.0 %            100.0 %
    Cost of revenues                                   56.8               56.7

    Gross profit                                       43.2               43.3
    Selling, general and administrative expenses       26.7               26.7

    Operating income                                   16.5               16.6
    Interest expense, net                               2.3                2.1
    Other expense                                        -                 0.1

    Income before provision for income taxes           14.2               14.4
    Provision for income taxes                          5.6                5.6

    Earnings from continuing operations                 8.6 %              8.8 %

Three Months Ended July 25, 2009 Compared to Three Months Ended July 26, 2008

Revenues

Revenues decreased 12.8% from $378.8 million for the three months ended July 26, 2008 to $330.4 million for the three months ended July 25, 2009.

Educational Resources segment revenue decreased 10.8% from $252.3 million for the three months ended July 26, 2008 to $224.9 million for the three months ended July 25, 2009. Both periods are comprised solely of sales to external parties. The decline in Educational Resources segment revenue was comprised of a decline of approximately $7 million in the administrative supplies category and a decline of approximately $20 million in the furniture and supplemental materials category, which are more discretionary in nature. These declines were most directly attributable to the ongoing weakened economic conditions which we believe have negatively impacted and delayed school purchasing decisions. This has been particularly noticeable in those states which have been more seriously affected by the economic decline, such as California, Florida, Illinois, and Michigan.

Publishing segment revenues decreased 16.2% from $126.8 million for the three months ended July 26, 2008 (which includes $0.5 million of intersegment revenues) to $106.3 million for the three months ended July 25, 2009 (which includes $1.1 million of intersegment revenues). Approximately $10 million of the decline in Publishing segment revenue was due to the decrease in state adoption revenue of the Company's curriculum-based products, primarily in the state of California, which the Company had anticipated would occur. The remaining decrease was attributable to the impact that the downturn in the general economic conditions has had on school districts' spending decisions.

Gross Profit

Gross profit decreased 12.9% from $164.0 million for the three months ended July 26, 2008 to $142.8 million for the three months ended July 25, 2009. The decrease in consolidated revenue resulted in $21.0 million of the decline in gross profit had consolidated gross margin remained constant. The remaining decline of $0.2 million was related to a decline in consolidated gross margin. Gross margin declined 10 basis points from 43.3% for the three months ended July 26, 2008 to 43.2% for the three months ended July 25, 2009. A shift in product mix between the Company's segments accounted for approximately 20 basis points of gross margin decline in the first quarter of fiscal 2010 as compared to the first quarter of fiscal 2009. The Publishing segment, which generates higher gross margin, due to its curriculum-based products, than the Educational Resources segment, accounted for 32% of the consolidated revenue in the first quarter of fiscal 2010 compared to 34% of the consolidated revenue in the first quarter of fiscal 2009.

Educational Resources segment gross profit decreased $6.4 million from $89.1 million for the three months ended July 26, 2008 to $82.7 million for the three months ended July 25, 2009. The decrease in segment revenue resulted in a $9.6 million decline in gross profit had segment gross margin remained constant. The increase in gross margin of 150 basis points from 35.3% in the first quarter

of fiscal 2009 to 36.8% in the first quarter of fiscal 2010 increased gross profit by $3.3 million. Approximately 100 basis points of the increase in gross margin is related to net price increases in excess of product cost increases as the segment executed on its initiative to better align its pricing structure with product costs. Lower direct transportation costs, related to decreases in fuel costs contributed another 30 basis points of gross margin improvement. The remaining increase in gross margin was due to a product mix shift towards more profitable products within the Educational Resources segment.

Publishing segment gross profit decreased $14.5 million from $74.0 million for the three months ended July 26, 2008 to $59.5 million for the three months ended July 25, 2009. The decrease in segment revenue resulted in a $12.0 million decline in gross profit had segment gross margin remained constant. The remaining decline of $2.5 million was related to a decline of 240 basis points in segment gross margin from 58.4% in the first quarter of fiscal 2009 to 56.0% in the first quarter of fiscal 2010. The majority of the decline, approximately 180 basis points, was due to unfavorable product mix within the segment, particularly the decline in adoption revenue of the higher margin curriculum-based products. Approximately 50 basis points of the decline in gross margin is related to product cost increases being passed on to the Company from its vendors.

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

As a percent of revenue, SG&A remained flat at 26.7% for the three months ended July 25, 2009 as compared to the three months ended July 26, 2008. SG&A decreased $12.7 million from $101.0 million in the first quarter of fiscal 2009 to $88.3 million in the first quarter of fiscal 2010. SG&A attributable to the Educational Resources and Publishing segments decreased a combined $11.3 million and Corporate SG&A decreased $1.5 million in the first quarter as compared to last year's first quarter. The decrease in Corporate SG&A was related primarily to the lower compensation and benefit costs, including headcount reductions, associated with the Company's cost reduction efforts.

Educational Resources segment SG&A decreased as a percent of revenues from 23.4% for the three months ended July 26, 2008 to 22.8% for the three months ended July 25, 2009. Educational Resources segment SG&A decreased $7.8 million, or 13.2%, from $59.0 million for the three months ended July 26, 2008 to $51.2 million for the three months ended July 25, 2009. The segment incurred $0.4 million of one-time charges related to cost savings initiatives and approximately $0.6 million of additional costs for marketing initiatives. The segment saw a decrease of approximately $2.9 million in its variable costs such as transportation, warehousing, and selling expenses associated with decreased revenues. In addition, operational improvements in order fulfillment, along with decreased fuel costs, resulted in approximately $2.6 million of decreased warehouse and transportation costs. The remaining decline is related primarily to the compensation savings associated with the headcount reductions associated with operational consolidations and restructuring.

Publishing segment SG&A increased as a percent of revenues from 24.5% for the three months ended July 26, 2008 to 26.0% for the three months ended July 25, 2009. Publishing segment SG&A decreased $3.5 million, or 11.3%, from $31.1 million for the three months ended July 26, 2008 to $27.6 million for the three months ended July 25, 2009. The decrease in Publishing segment SG&A was largely due to a $2.4 million decrease in its variable costs such as transportation, warehousing, and selling expenses associated with decreased revenues. The segment also saw a decrease of $0.8 million in its marketing initiatives as well as $0.2 million compensation savings associated with headcount reductions. The increase in SG&A as a percentage of revenue is due to the base non-variable costs in comparison to decreased revenues.

Interest Expense

On April 26, 2009, the Company adopted FSP APB 14-1, "Accounting for Convertible Debt Instruments that May Be Settled in Cash Upon Conversion (Including Partial Cash Settlement)" ("FSP APB 14-1"). Net interest expense including the impact of the adoption of FSP APB 14-1 was $7.6 million for the three months ended July 25, 2009 compared to $7.8 million for the three months ended July 26, 2008. The non-cash interest related to the adoption of FSP APB 14-1 was $3.2 million in the first quarter of fiscal 2010 as compared to $2.9 million in the first quarter of fiscal 2009, as adjusted for FSP APB 14-1.

Net interest expense excluding the adoption of FSP APB 14-1 decreased $0.5 million from $4.8 million for the three months ended July 26, 2008 to $4.3 million for the three months ended July 25, 2009. Approximately $0.4 million of the decrease in interest expense was due to a reduction in the overall effective borrowing rate of 4.05% in the first quarter of fiscal 2010 as compared to an effective borrowing rate of 4.51% in the first quarter of fiscal 2009. The remaining decrease was related primarily to a reduction of approximately $13 million in average outstanding borrowings in the first quarter of fiscal 2010.

Other Expense

Other expense, which consisted of the discount and loss on the accounts receivable securitization, was zero in the first quarter of fiscal 2010, compared to $0.6 million in the first quarter of fiscal 2009. This decrease was due to the non-renewal of the Company's securitization facility, which expired on January 28, 2009.

Provision for Income Taxes

Provision for income taxes decreased $2.8 million due to lower pre-tax income. The effective income tax rate increased 50 basis points from 39.0% for the three months ended July 26, 2008 to 39.5% for the three months ended July 25, 2009.

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 July 25, 2009, we had working capital of $116.3 million. Our capitalization at July 25, 2009 was $981.1 million and consisted of total debt of $404.3 million and shareholders' equity of $576.8 million.

Our 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 amount outstanding as of July 25, 2009 under the revolving and incremental term loans was $81.5 million and $0, respectively. The credit facility is secured by substantially all of our assets and contains certain financial and other covenants. During the first quarter of fiscal 2010, we borrowed under our credit facility primarily to meet seasonal working capital requirements. Our borrowings are usually significantly higher during the first two quarters of our fiscal year to meet the working capital requirements of our peak selling season. As of July 25, 2009, our effective interest rate on borrowings under our credit facility was approximately 1.3%, which excludes amortization of loan origination fee costs and the commitment fees on unborrowed funds. During the three months ended July 25, 2009, we paid commitment fees on unborrowed funds under the credit facility of $0.1 million and amortized loan origination fee costs of $0.1 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 and places certain limitations on our ability to repurchase our common stock. The Company was in compliance with these covenants and restrictions at July 25, 2009.

While we will continue to monitor our expected ability to remain in compliance with these covenants through the remainder of fiscal 2010, we expect to remain in compliance with these covenants based on our projected financial results for fiscal 2010 and the additional action items available to us. If we are unable to meet these covenants, our ability to access available lines of credit could be limited, our liquidity could be adversely affected and our debt obligations could be accelerated. These circumstances could have a material adverse effect on our future results of operations, financial position and liquidity.

Our $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. The Company's credit facility places certain restrictions on the Company's repurchase of these notes. No notes have been converted into cash or shares of common stock as of July 25, 2009. The notes are currently redeemable at the option of the Company.

In November 2006, we 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, we will deliver cash equal to the lesser of the aggregate principal amount of debentures to be converted and our total conversion obligation, and will deliver, at our option, cash or shares of our common stock in respect of the remainder, if any, of our 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 our 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. The Company's credit facility places certain restrictions on the Company's repurchase of these notes. We used a portion of the proceeds to repurchase approximately 1.1 million shares of our common stock at a cost of $40.0 million. The remaining proceeds were used to pay down a portion of our existing debt under the credit facility.

Net cash used in operating activities improved $22.8 million to $22.3 million in the first quarter of fiscal 2010 as compared to $45.1 million used in the first quarter of fiscal 2009. The net use of cash in operating activities during the first quarter is indicative of the highly seasonal nature of our business, with the majority of purchases and other operating cash outflows occurring in the first and second quarters of the fiscal year and the majority of cash receipts occurring in the second and third quarters of the fiscal year. The decrease in cash used in operating activities between years is due to working capital improvements, primarily in the Company's collections of accounts receivable in the first quarter of fiscal 2010 as compared to the first quarter of fiscal 2009.

Net cash used in investing activities increased $2.8 million to $4.9 million in the first quarter of fiscal 2010 as compared to $2.1 million for the first quarter of fiscal 2009. In the first quarter of fiscal 2009, the Company received $1.7 million attributable to the notes received as part of the School Specialty Media sale. After adjusting for the $1.7 million received in last years first quarter for these note receivables, net cash used in investing activities increased $1.1 million. Additions to property, plant and equipment increased $0.8 million from the first quarter of fiscal 2009 to $2.9 million in the first quarter of fiscal 2010, primarily as a result of increased spending related to the implementation of our ERP system. Product development spending increased by $0.4 million in the first quarter of fiscal 2010 as compared to the first quarter of fiscal 2009. This increase is attributable to the Company's ongoing investment in the development of curriculum-based products.

Net cash provided by financing activities decreased $19.6 million from $48.9 million in the first quarter of fiscal 2009 to $29.3 million in the first quarter of fiscal 2010. The net cash provided by financing activities was primarily used to fund seasonal working capital needs. In the first quarter of fiscal 2009, the Company repurchased $15.3 million of its common stock. There were no stock repurchases in the first quarter of fiscal 2010.

We anticipate 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.

Off Balance Sheet Arrangements

Our accounts receivable securitization facility expired on January 28, 2009 and the Company elected to not renew the agreement due to the significant cost increases in accounts receivable asset-backed securities markets compared to the costs of other sources of liquidity available to the Company. Costs associated with the sale of receivables, primarily related to the discount and loss on sale, for the three months ended July 26, 2008 was $0.6 million. These costs are included in other expenses in our consolidated statements of operations.

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 timing of acquisitions, the timing and magnitude of costs related to such acquisitions, variations in our costs for the products sold, the mix of products sold and general economic conditions. Moreover, the operating margins of companies we acquire may differ substantially from our own, which could contribute to further fluctuation in quarterly operating results. 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 internal growth plans, projected revenues, margin improvement, future acquisitions, capital expenditures and adequacy of capital resources; 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 25, 2009.