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.

Based on current surveys and recently reported results by education companies in the textbook and curriculum markets, school spending trends in 2012 have continued to be challenging across the industry this school season. While overall state budgets appear to be improving, pressure on educational budgets at the state and municipal level has continued in a significant number of states.

We experienced challenges similar to those of the overall industry in the first six months of fiscal 2013 while we continued to implement changes to improve the effectiveness of the organizational structure of our business. Total revenue of $489.0 million in the first six months of fiscal 2013 was a decline of 7.3% compared to the first six months of fiscal 2012. Educational Resources segment reported a decline in revenue of 4.0% to $344.8 million, but gross margin increased due to improved pricing, inventory planning and merchandising and supply chain management. The Accelerated Learning segment reported a decline in revenue of 14.3% to $143.9 million and a decline in gross margin, caused primarily by lower curriculum related sales in our Science division and lower sales of our agenda products. The Company believes that its curriculum business, notably the science business, has been affected the most severely due to delays in the finalization of Next Generation Science Standards which are expected to be issued in spring of 2013.

The challenges related to the continued depressed educational markets have placed and are expected to continue to place in the near term, increasing pressure on our ability to maintain acceptable levels of liquidity and covenant compliance. In response to these challenges, we have closely managed working capital, including trade payables, as we have continued to work with our vendor base on maintaining favorable payment terms. These actions have temporarily improved our cash flows from operations. We cannot assure you, however, that we will be successful in maintaining these favorable terms. In the event we are unable to do so, this would place increased pressure on our liquidity and ability to maintain covenant compliance.

The Company has continued to pursue its ongoing management initiatives, which drove the year to date gross margin improvements in the Educational Resources segment. We have also made progress on our four previously announced immediate priorities of:

• targeting investments that will best capitalize on growth opportunities and increase EBITDA,

• building product management and marketing capabilities to transform the organization,

• identifying and exiting product lines with inadequate returns or which are not synergistic fits with the balance of our product lines, and

• driving a change in culture that focuses on accountability and organic growth.

We intend to continue to take the steps necessary to achieve these priorities and address the challenges posed by current market trends.

SG&A increased as a percentage of revenues was essentially flat at 29.1% in the first six months of fiscal 2013 as compared to 29.0% in the first six months of fiscal 2012. The Company recorded $1.1 million in restructuring charges in the first six months of fiscal 2013. Total permanent headcount is down approximately 10.0% percent in the first six months of fiscal 2013 as compared to the first six months of fiscal 2012. Total SG&A decreased by $10.7 million in the first six months of fiscal 2013 as compared to the first six months of fiscal 2012. The decrease in SG&A is due to a combination of headcount reductions and decreased variable costs, such as transportation, warehouse and selling, associated with the decrease in revenue.

Operating income was $53.8 million for the first six months of fiscal 2013, an increase of $0.6 million from the prior year six month period. Net income was $32.5 million in the first six months of fiscal 2013, an increase of $10.1 million from the prior year six month period, due to lower income taxes.

Results of Continuing Operations

The following table sets forth various items as a percentage of revenues for the
three and six months ended October 27, 2012 and October 29, 2011:



                                              Three Months Ended                           Six Months Ended
                                       October 27,           October 29,           October 27,           October 29,
                                          2012                  2011                  2012                  2011
Revenues                                      100.0 %               100.0 %                100.0 %              100.0 %
Cost of revenues                               60.9                  62.2                   59.9                 60.9

Gross profit                                   39.1                  37.8                   40.1                 39.1
Selling, general and
administrative expenses                        29.0                  29.2                   29.4                 29.0

Operating income                               10.1                   8.6                   10.7                 10.1
Interest expense, net                           3.9                   2.7                    3.9                  3.0

Income before provision for
income taxes                                    6.2                   5.9                    6.8                  7.1
Provision for income taxes                      0.1                   2.4                    0.1                  2.8

Earnings before investment in
unconsolidated affiliate                        6.1 %                 3.5 %                  6.7 %                4.3 %

Three Months Ended October 27, 2012 Compared to Three Months Ended October 29, 2011

Revenue

Revenue decreased 5.8% from $251.4 million for the three months ended October 29, 2011 to $236.9 million for the three months ended October 27, 2012.

Educational Resources segment revenue decreased 1.2% from $173.2 million for the three months ended October 29, 2011 to $171.1 million for the three months ended October 27, 2012. The decline in Educational Resources segment revenue was comprised of a decline of approximately $2.0 million in the supplies category. The decline in the supplies category is related primarily to classroom supplemental products and other specialty brands which schools consider more discretionary than basic school supplies. Sales of basic school supplies and furniture were essentially flat for the three months ended October 29, 2011 compared to the three months ended October 27, 2012.

Accelerated Learning segment revenue decreased by 15.9% from $78.0 million for the three months ended October 29, 2011 to $65.6 million for the three months ended October 27, 2012. Approximately $8 million of the decline was related to decreased school spending for agenda products. The remaining decline was due to continued softness in curriculum purchases related to the Company's science business unit. In addition, the disposition of our SEEDS of Science product in the fourth quarter of fiscal 2012 contributed to the sales decline.

Gross Profit

Gross profit decreased 2.5%, from $95.1 million for the three months ended October 29, 2011 to $92.7 million for the three months ended October 27, 2012. The decrease in consolidated revenue resulted in approximately $5.0 million of the decline in gross profit had consolidated gross margin remained constant. Gross margin increased 130 basis points from 37.8% for the three months ended October 29, 2011 to 39.1% for the three months ended October 27, 2012 primarily due to improvements in Educational Resources gross margin. The Accelerated Learning segment, which generates a higher gross margin due to its curriculum-based products than the Educational Resources segment, accounted for 28% of the consolidated revenue in the second quarter of fiscal 2013 compared to 31% of the consolidated revenue in the second quarter of fiscal 2012. This shift of sales between segments partially offset the increase in consolidated gross margin by approximately 70 basis points.

Educational Resources segment gross profit increased $3.7 million from $53.4 million for the three months ended October 29, 2011 to $57.1 million for the three months ended October 27, 2012. Gross margin increased by 250 basis points from 30.9% in the second quarter of fiscal 2012 to 33.4% in the second quarter of fiscal 2012. Approximately 225 basis points of the increase were related to margin improvements in furniture and supplies associated with product pricing. The remaining increase of 25 basis points was due to favorable product mix.

Accelerated Learning segment gross profit decreased $5.4 million from $40.8 million for the three months ended October 29, 2011 to $35.4 million for the three months ended October 27, 2012 due to the decreased spending on the Company's curriculum products for which demand has continued to soften as schools are delaying purchases. Gross margin increased 170 basis points from 52.3% in the second quarter of fiscal 2012 to 54.0% in the second quarter of fiscal 2013 primarily due to favorable product mix.

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.

SG&A decreased $6.0 million from $73.4 million for the three months ended October 29, 2011 to $67.4 million for the three months ended October 27, 2012. As a percent of revenue, SG&A decreased from 29.2% for the three months ended October 29, 2011 to 28.4% for the three months ended October 27, 2012. SG&A attributable to the Educational Resources and Accelerated Learning segments decreased a combined $8.8 million and Corporate SG&A increased $2.8 million in the three months ended October 27, 2012 compared to the three months ended October 29, 2011. The increase in Corporate SG&A was related primarily to an increase in employee healthcare costs and professional and outside services.

Educational Resources segment SG&A decreased $4.9 million, or 12.1%, from $40.7 million for the three months ended October 29, 2011 to $35.8 million for the three months ended October 27, 2012. The segment had a decrease of $2.2 million in marketing costs primarily associated with a decrease in catalog costs. In addition, the segment had a decrease of approximately $1.7 million in its variable costs such as transportation, warehousing, and selling expenses associated with decreased revenues. Educational Resources segment SG&A decreased as a percent of revenues from 23.5% for the three months ended October 29, 2011 to 20.9% for the three months ended October 27, 2012.

Accelerated Learning segment SG&A decreased $3.9 million, or 16.2%, from $24.2 million for the three months ended October 29, 2011 to $20.3 million for the three months ended October 27, 2012. The segment had a decrease of approximately $3.1 million in its variable costs such as transportation, warehousing, and selling expenses associated with decreased revenues. Accelerated Learning segment SG&A decreased as a percent of revenues from 30.9% for the three months ended October 29, 2011 to 30.8% for the three months ended October 27, 2012.

Impairment of Long-Term Asset

For the three months ended October 27, 2012, the Company recorded a $1.4 million impairment charge related to the note receivable it had recorded on its balance sheet from the divestiture of the School Specialty Media business in fiscal 2008. The Company received proceeds of $3.0 million that was used to pay down the Term Loan and recorded an impairment charge of $1.4 million.

Interest Expense

Interest expense increased $2.4 million from $6.9 million for the three months ended October 29, 2011 to $9.3 million for the three months ended October 27, 2012. The increase in interest expense was partially due to a $1.4 million early payment fee related to the Company's repayment of a portion of its Term Loan during the quarter. The remaining increase was related to higher borrowing costs on the Company's Term Loan as compared with the borrowing costs in the prior year's former Credit Agreement, partially offset by a $0.3 million reduction in non-cash interest expense associated with the Company's convertible debt.

Provision for Income Taxes

Provision for income taxes was $0.3 million for the three months ended October 27, 2012 compared to $6.0 million for the three months ended October 29, 2011. The effective tax rate for the three months ended October 27, 2012 was 2.3% compared to 40.9% for the three months ended October 27, 2011. The Company is forecasting a taxable loss for fiscal 2013. The decline in taxes was related to projected annual tax losses for fiscal 2013 for which tax benefits are not expected to be recognized at this time due to valuation allowances.

Six Months Ended October 27, 2012 Compared to Six Months Ended October 29, 2011

Revenue

Revenue decreased 7.3% from $527.5 million for the six months ended October 29, 2011 to $489.0 million for the six months ended October 27, 2012.

Educational Resources segment revenue decreased 4.0% from $359.3 million for the six months ended October 29, 2011 to $344.8 million for the six months ended October 27, 2012. The decline in Educational Resources segment revenue was comprised of a decline of approximately $9.0 million in the supplies category and a decline of approximately $5.5 million in the furniture category. The decline in the supplies category is related primarily to classroom supplemental products and other specialty brands which schools consider more discretionary than basic school supplies.

Accelerated Learning segment revenues decreased by 14.3% from $167.8 million for the six months ended October 29, 2011 to $143.9 million for the six months ended October 27, 2012. Approximately $13 million of the decline was related to decreased school spending on our science division curriculum and the prior year disposition of our SEEDS of Science product line. While the majority of the decline in the science curriculum was anticipated due to large prior year shipments for science adoptions in Indiana, Nevada and New York City that were not expected to repeat in fiscal 2013, the Company believes that school districts continue to delay spending as the impact from the pending changes to Next Generation Science Standards and general economic conditions remains uncertain. Approximately $11 million of the decline is related to our student planner and agenda products as we believe schools consider agenda products more discretionary in nature.

Gross Profit

Gross profit decreased 4.9% from $206.3 million for the six months ended October 29, 2011 to $196.3 million for the six months ended October 27, 2012. The decrease in consolidated revenue accounted for $15.0 million of the decrease in gross profit had gross margins remained constant. Gross margin increased 100 basis points from 39.1% for the six months ended October 29, 2011 to 40.1% for the six months ended October 27, 2012 primarily due to improvements in Educational Resources gross margin. The Accelerated Learning segment generates higher gross margin due to its curriculum-based products than the Educational Resources segment and accounted for 29.4% of consolidated revenue for the six months ended October 27, 2012 compared to 31.8% of consolidated revenue for the six months ended October 29, 2011. This shift in sales between segments partially offset the increase in consolidated gross margin by approximately 50 basis points.

Educational Resources segment gross profit increased $3.7 million from $113.9 million for the six months ended October 29, 2011 to $117.6 million for the six months ended October 27, 2012. Gross margin increased 240 basis points from 31.7% for the six months ended October 29, 2011 to 34.1% for the six months ended October 27, 2012. Approximately 200 basis points of the increase were related to margin improvements in furniture and supplies associated with product pricing. The remaining 40 basis point increase was due to favorable product mix.

Accelerated Learning segment gross profit decreased $12.7 million from $91.0 million for the six months ended October 29, 2011 to $78.3 for the six months ended October 27, 2012. The decrease in gross profit for the six months ended October 27, 2012 compared to October 29, 2011 is due to decreased spending on the Company's curriculum products for which demand has continued to be soft as schools are delaying purchases. Gross margin increased 20 basis points from 54.2% for the six months ended October 29, 2011 to 54.4% for the six months ended October 27, 2012. Product mix was the primary reason for the increase in gross margin in this segment.

Selling, General and Administrative Expenses

SG&A decreased $10.7 million from $153.2 million for the six months ended October 29, 2011 to $142.5 million for the six months ended October 27, 2012. As a percent of revenue, SG&A increased from 29.0% for the six months ended October 29, 2011 to 29.1% for the six months ended October 27, 2012. SG&A attributable to the Educational Resources and Accelerated Learning segments decreased a combined $14.5 million and Corporate SG&A increased $3.8 million in the first six months of fiscal 2013 as compared to last year's first six months. The increase in Corporate SG&A was related primarily to an increase in professional and outside services.

Educational Resources segment SG&A decreased $9.8 million, or 11.5%, from $85.0 million for the first six months ended October 29, 2011 to $75.2 million for the six months ended October 27, 2012. The segment had a decrease $3.5 million in

marketing costs primarily associated with a decrease in catalog costs related to continued refinements in the Company's circulation strategy. In addition, reduced volume led to an approximate $3.0 million decrease in its variable costs such as transportation, warehousing, and selling expenses. The segment had a reduction in compensation costs of $3.6 million due to reduced headcount and other compensation-related cost saving actions. Educational Resources segment SG&A decreased as a percent of revenues from 23.7% for the six months ended October 29, 2011 to 21.8% for the six months ended October 27, 2012.

Accelerated Learning segment SG&A decreased $4.7 million, or 9.7%, from $48.6 million for the six months ended October 29, 2011 to $43.9 million for the six months ended October 27, 2012. Reduced volume led to a decrease of approximately $2.8 million in its variable costs such as transportation, warehousing, and selling expenses. The remaining reduction is related primarily to segment headcount reductions and other compensation-related cost saving actions. Accelerated Learning segment SG&A increased as a percent of revenues from 29.0% for the six months ended October 29, 2011 to 30.5% for the six months ended October 27, 2012.

Impairment of Long-Term Asset

For the six months ended October 27, 2012, the Company recorded a $1.4 million impairment charge related to the note receivable it had recorded on its balance sheet from the divestiture of the School Specialty Media business in fiscal 2008. The Company received proceeds of $3.0 million that was used to pay down a portion of the Term Loan and recorded an impairment charge of $1.4 million.

Interest Expense

Interest expense increased $4.5 million from $14.8 million for the six months ended October 29, 2011 to $19.3 million for the six months ended October 27, 2012. The increase in interest expense was due primarily to the write-off of $2.5 million of debt issuance costs related to the Company's former revolving credit facility which was refinanced in the first quarter of fiscal 2013. In addition, the current year interest expense includes a $1.4 million early payment fee associated with the Company's repayment of a portion of its Term Loan. The remaining increase was related to higher borrowing costs on the Company's Term Loan as compared with the borrowing costs in the prior year's former Credit Agreement. The increase was partially offset by $0.5 million of a decrease in non-cash interest associated with the Company's convertible notes.

Provision for Income Taxes

The provision for income taxes was $0.6 million for the first six months of fiscal 2013 compared to $15.0 million for the first six months of fiscal 2012. The effective tax rate in the first six months of fiscal 2013 was 1.8% compared to 40.2% for the first six months of fiscal 2012. The Company is forecasting a taxable loss for fiscal 2013. The decline in taxes was related to projected annual tax losses for fiscal 2013 for which tax benefits are not expected to be recognized at this time due to valuation allowances.

Liquidity and Capital Resources

At October 27, 2012, the Company had working capital of $127.9 million. The Company's capitalization at October 27, 2012 was $395.3 million and consisted of total debt of $295.4 million and shareholders' equity of $99.9 million.

On May 22, 2012, the Company entered into an Asset-Based Credit Agreement (the "ABL Facility") and Term Loan Credit Agreement (the "Term Loan"), which replaced the Company's then-existing credit facility. Both the ABL Facility and the Term Loan contain customary events of default and financial, affirmative and negative covenants, including quarterly financial covenants relating to the Company's
(1) maximum secured leverage ratio, (2) maximum total leverage ratio,
(3) maximum term loan ratio, (4) minimum fixed charge coverage ratio and
(5) minimum interest coverage ratio. In addition, the Term Loan contains a minimum liquidity covenant requiring the Company to maintain minimum liquidity levels at the end of each month during the life of the Term Loan (consisting of qualified cash, subject to a $2.0 million cap, plus availability under the ABL Facility).

Under the ABL Facility, the Asset-Based Lenders agreed to provide a revolving senior secured asset-based credit facility in an aggregate principal amount of $200 million. Outstanding amounts under the 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%, or (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 excess availability under the ABL Facility

and the applicable point in the life of the ABL Facility) (the "Applicable Margin"), or (2) a LIBOR rate plus the Applicable Margin (the "LIBOR Rate"). Interest on loans under the 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.

The ABL Facility will mature on September 30, 2014, but may be extended to October 31, 2015 if the Company's indebtedness under its convertible subordinated debentures has been refinanced. Advances under the ABL Facility may be prepaid by the Company 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 ABL Facility exceeding the Borrowing Base; (2) the Company's receipt of net cash proceeds of any sale or disposition of assets that are first priority collateral for the ABL Facility; (3) the Company's receipt of Extraordinary Receipts that would constitute collateral for the ABL Facility; (4) the incurrence by the Company of any indebtedness that is not Permitted Indebtedness; (5) the Company's issuance of certain equity interests; (6) the receipt by the Company of any proceeds of business interruption insurance; and (7) the Company's receipt of cash proceeds in connection with certain asset sales.

Under the Term Loan, the Term Loan Lenders agreed to make a term loan to the Company in aggregate principal amount of $70 million. The outstanding principal amount of the Term Loan will bear interest at a rate per annum equal to the applicable LIBOR rate (calculated as the greater of (1) the current three-month LIBOR rate and (2) 1.5%) plus 11.0%, accruing and paid on a quarterly basis in arrears.

The Term Loan matures on October 31, 2014, but may be extended to December 31, 2015 if the Company's indebtedness under its convertible subordinated debentures has been refinanced. The Term Loan 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, including any Permitted Divestiture; (2) issuances of debt for the refinancing of the Term Loan; (3) other issuances of debt other than Permitted Debt;
(4) issuances of certain equity interests; (5) the Company's receipt of certain Extraordinary Receipts; and (6) any insurance proceeds in respect of business interruption insurance or loss or destruction of collateral property. The Company is also permitted to voluntarily prepay the 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 Term Loan Credit Agreement.

The Company used the proceeds of the ABL Facility and the Term Loan to repay outstanding indebtedness under the Company's previous credit facility.

The covenants for fiscal 2013 are as follows:

                                                     Fiscal 2013 Covenants
         Ratio                              Q1          Q2          Q3          Q4
         Maximum secured leverage ratio     5.12x       3.21x       2.45x       3.09x
         Maximum total leverage ratio       9.52x       7.15x       6.55x       6.99x
         Maximum term loan ratio            2.28x       2.29x       2.32x       2.28x
         Minimum fixed charge ratio         0.82x       0.97x       0.92x       0.96x

In addition, the ABL Facility and Term Loan require that the Company have minimum liquidity of at least $20.0 million at the end of each of its fiscal months.

The Company closely evaluates its expected ability to remain in compliance with the financial covenants under our ABL Facility and Term Loan Credit Agreement. The recent challenges affecting the Company's performance have placed, and are expected to continue to place in the near term, pressure on the Company's . . .