Franklin Covey FC
February 18, 2008 - 3:33pm EST by
zach721
2008 2009
Price: 7.50 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 146 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

In our opinion, FC is radically misunderstood and mispriced by a wide margin trading for less than 50% of what we think the company is realistically worth today. For 2008 the business should generate around 20% returns on equity (ebitda-capex/equity) and 90% returns on tangible equity (ebitda-capex/equity-intangibles), while it is valued at a 5x multiple on trailing EV/EBITDA basis and approximately a 4.3x multiple on forward EV/EBITDA (see below for EV details). CAPEX was distorted in 2007, because the company built their own print facility (the previous 4 years annual CAPEX was $4mn). Covey's annual total sales are $285mn and the brand does over $400mn a year in sales including franchisee sales and royalities sell through. A fundamental shift in Covey’s business model has led to approximately 40%+ of the EBITDA coming from high margin recurring revenue sharing and royalty based agreements which are also the fastest growing segments of their business today. In our opinion, Mr. Market remembers and values the overall business off the Retail store concept which represents only 20% of total revenue. Fundamentally FC is a good business, if you look at the last 18 years good, bad, ugly the average EBITDA margin was 13.8% while CAPEX ran 4% of revenue. We think the company over the next 1-2 years will be in the best position since it was formed in terms of FCF dynamics: EBITDA margins should trend to mid teens and CAPEX should run at about 2.5% of revenue. The margin improvement should be driven by growth of International OSBU (their education/training arm, which is heavily driven by high margin franchisee fees that pay 15% of sales to FC). Management has strong vested interests and incentives to see a substantially higher stock price and from the last two conference calls does not intend to sit idly by for the market to realize the current mispricing of the business's valuation (see below). The company has many bright spots: a sharp capital allocator in Bob Whitman, low cost of capital (LIBOR plus 110 BPS), a long history of aggressive buybacks ($115mn of common and $95mn of preferred's plus $62mn in preferred Dividends on $135mn EV), a hidden asset, and growth in their highest margin revenue streams. Growth in high margin revenue streams comes from: new PlanPlus CRM software, 7 Habits Interactive (online training), International growth, and a wholesale revenue sharing program that has gone from 2,500 stores in 2004 to guidance of 12,000+ by August 2008. While on the surface this appears like a no growth company, underlying high margin elements have been growing as there has been a decline in lower margin segments which has lifted GM's from 47% to low 60%'s over the last several years. In addition, the company recently paid off the last of their preferred's which were disbursing 10% on an after tax basis and currently has a net cash position versus their credit line (as of 1-11-08). The company should be generating Cash Flow in the range of $7mn a quarter on $135mn EV. Management feels $2-3 per share in EBITDA is possible over the next year or two while potentially doubling operating margins to the 13% (explained below).  We value FC's high margin Education/Training business at an 8-12x multiple of EBITDA for a business with decent international growth opportunities, 2008 15% EBITDA margins, 67% gross margins with proprietary content and a decent following from Fortune 500, Governments, and Small Business in 95 countries (40% of education/training is internationally based). Finally, many of their international markets are virtually untapped: one part of India saw 100% growth from $5 to $10mn in 2007.  Looking at comparable education/training companies like SKIL, EPAX, EXBD and NETg they trade at from 1.25-4x sls and 8-17x EV/EBITDA and Franklin acquired Covey (Education/Training) for 1.6x sls and 25x EBITDA in 1998. We value education/training at $10-13 per share 1.6x sls and 8-12x EBITDA which makes up 50% of FC's total revenue and growing. 
 
 
Company   EV/Sales EV/EBITDA

GM%

Corporate Executive Board Co. 2.5x 10.6x

66

Advisory Board Co.   4.6x 22.5x

53

SkillSoft plc   4.5x 18.0x

88

Dolan Media Company   4.3x 17.7x

67

Gartner Inc.   1.8x 12.4x

54

Ambassadors Group Inc. 1.1x 6.7x

35

NETg (acquisition)   1.8x    
Average   2.9x 14.6x

60

FC (trailing)   0.5x 5.5x

60

OSBU Valuation ($mm) 409 244  
per share    $       21.0  $        12.5  
 
Why these comps for OSBU? Their only direct competitor on OSBU is IIR a private company in Europe so its makes this segment more difficult to value. EBITDA margins for OSBU were 12% in 2007 and should be north of 15% in 2008 (driven in part due to the conversion of Brazil and Mexico to Franchisee's).

The high qualtiy of the brands/concepts of FC's education/training business are reflected in 67% GM which should improve over 70% with greater percentage coming from franchisee royalties. Using consulting companies as comps is not appropriate in our opinion because your assets ride up and down in the elevator each morning and are reflected in much lower GM due to compensation and issues of getting utlization right and managing employee turnover. We believe the above comps most accurately reflect the dynamics FC's education/training businesses, which are: high quality brands (7 Habits Series - best selling business book ever, Good to Great, etc),  40% of the EBITDA is recurring, many markets are in early development phase China (1st inning), India (2nd inning), Brazil and others, and has a very diverse customer base in 95 countries. We think FC's OSBU business should be worth at least $12 with plenty of potential upside.

 
What is the business?

FC estimates that the market size for performance skills training should grow from $7bn in 2007 to $8bn in 2008.  “FranklinCovey is engaged in the performance skills segment of the training industry.  Our competitive advantage in this highly fragmented industry stems from our fully integrated training curricula, measurement methodologies and implementation tool offerings to help individuals and organizations measurably improve their effectiveness.  This advantage allows FranklinCovey to deliver not only training to both corporations and individuals, but also to implement the training through the use of powerful behavior changing tools with the capability to then measure the impact of the delivered training and tools.

In fiscal 2007, we provided products and services to 90 percent of the Fortune 100 companies and more than 75 percent of the Fortune 500 companies.  We also provide products and services to a number of U.S. and foreign governmental agencies, including the U.S. Department of Defense, as well as numerous educational institutions.  We provide training curricula, measurement services and implementation tools internationally, either through directly operated offices, or through licensed providers.  On August 31, 2007, we had direct operations in Australia, Canada, Japan and the United Kingdom.  We also had licensed operations in 87 countries and licensed rights in more than 140 countries."

 

FC's Consumer Solutions Business Unit (CSBU) is being valued in the negative range of $2.5-6.50 per share, which does not make any sense.  CSBU does $145mn in annual revenue and EBITDA of $13mn ($9mm with corporate overhead included) with normalized CAPEX of $2-3mn. This business has 4 business lines: Wholesale (which has 40% ebitda margins and high margin revenue sharing), Internet/Catalog, Retail Stores, and recently released CRM Software business called Plan Plus which is growing double digits month over month off small base. It certainly has a positive value, realistically between 5-7x EBITDA or about .40x sls which would come to ~$3 per share. This values the Retail stores at less $0.86 per share or less than 6% of our $15 Target. The sum of the parts valuation is between $13-16 per share or for overall business 8x EV/EBITDA on '08E $13 per share. The retail stores continue to show solid profitability with the average store generating EBITDA of $53,000 which has improved every year since 2002 when the average store lost $6,000. This is due to closing stores that did not have attractive underlying demand, on average 12-15 stores a year are up for lease renewals and can continue to support only their best locations. One nice part of CSBU is the revenue sharing program with over 10,000 retailers including: Target, Walmart, Office Depot, Costco, and Sam's Club. Systemwide revenues for this wholesale channel have grown from $4mn to $60mn over the last 5 years and FC takes approximately 7.5% of the sale in royalties. Management has guided to being in 12,000 locations by August 2008.

Since 1990 (even through downturn of over expanding and selling off businesses) has averaged 13.8% EBITDA margins, and (excluding acquisitions) CAPEX has averaged 4% of revenue. However, this should change going forward where FC should be able to reach the mid teens EBITDA margins and CAPEX should drop to 2.5% of revenue. With an EV of $135 and poised to drop rapidly, the company is set to generated outstanding FCF over the next several years.

Fundamentally Covey has great brands, and while the distribution of the products has changed over time (from just paper planner to paper planner, software products, interactive online products) the underlying CSBU margins should hold with historic averages and Free Cash Flow dynamics should improve with reduced fixed costs. Over the last 10 years FC has had total sales well over $4 billion dollars. The business is in very stable shape given international growth, Client Partner sales growth (sales people booking go up to $1.5mn in the 5th year), new online/software products (Confidant, PlanPlus CRM,  7 Habits Interactive).

In comparing problems faced in 2002 recession with the state of the business today: In 2002 FC had: a) $420mn breakeven b) sold off non-core business c) in debt for $95mn with 10% after tax payments d) had over 200 retail stores that lost on average $6000 per year per store e) and was in survival mode. In 2008, FC has solidified the business: A) breakeven is $260mn b) has been highly focused and substantially improving the businesses they currently operate c) No debt and very low cost of captial d) Cut money losing stores from 200 to 80 and average profitablity is $53K per store e) Created revenue sharing agreeements with retailers where FC gets nearly 7.5% of sales from 10,000 retail locations growing 20% annually f) converted to more licensee's internationally (which creates a significant high margin royality stream that was very small in 2002).

The CEO is ethical, intellectually honest, and a very bright operator that has been successful in the business world. In his free time, Bob is a 7 time Iron Man Triathlete and on the Board of the Iron Man. Previous experience is CFO of Trammell Crow when he was 33 years old and the company had billions in debt which he helped restructure and was named CEO.  Thereafter he joined Private Equity firm Hampstead Group in Dallas from 1992-2000 and became Co-CEO and President. I can tell you from dealing with Bob for 2 years he really understands and thinks like an owner, he is very non-promotional and tells it as he sees it. He refused to hold quarterly conference calls for 5 years and just recently went back to quarterly conference calls. Here are Bob's comments on the situation: 

 NOVEMBER 2007

CEO: "We would love to buy shares, and in fact, slide 17 shows that over the past three years, we have actually taken $95 million of our cash and repurchased shares. Most of that has been preferred because we needed to be able to, under the restructure of the preferred, our rights to buy common were linked to the extent to which we actually repurchased the preferred, and we only had until December of this year to eliminate the preferred altogether." "...We have put ourselves in a position where we could, in fact, buy large amounts of common if we wanted to..." "...Through a combination of continuing to work on reducing assets to generate more cash, some transactions that perhaps can be done in the context of in the course of this year, our hope would be that we would be able to be aggressively in the market for our shares on some basis during the back half of the year (Mar ’08), if not before.

 

CEO: “If the share price continues to not reflect what we think is real value, to purchase back -- either through just an authorization to buy in the market or through some bigger program, to try during the course of this year to raise the capital resources necessary, or to apply them to some version of something that would increase shareholder value. Whether that's stock repurchase or dividending or recap, there are a bunch of different things we're working on. But it's not a passive effort, I can tell you that, any more than these efforts that led to the ultimate repurchase of $95 million of securities were passive.”

 

CEO: “But I think one of the goals is, of course, to try to get the share price to the point where it can reflect the story, which I think the underlying story of which now is one that we are very happy to tell, growth story on one side and the restructuring side on the other. So I would anticipate that during the year, we will be having a public discussion of some kind about something that will affect shareholders.

 

*CEO: “We're trying to work on both sides of the equation, which is having our operating income to sales -- our target is to get to 13% over the next two years, and at the same time to dramatically reduce the number of shares outstanding, if we can. If we can do those two things, the idea of having EBITDA and cash flow per share that's in the $2 and $3 is something that we think could be a realistic target.” (MARGIN EXPANSION: Growth in OSBU/Frachisee fees, Growth in Plan Plus CRM/7 Habits Online, taking $8-10mn out of OPEX)

 

Comments between CEO and an Analyst:

Analyst: "If I may say, I think it would behoove you to consider taking the story and starting to talk to the Street once again. I see no reason at this point why you would want to wait on this, actually.”

 

CEO: “I appreciate the advice on that. Would your advice be to do that before or after we buy a large block of shares?

 

December 2007 Letter to Shareholders:

 

"We expect to increase our return on sales, on capital, and per share of common stock by continuing to improve our business models, optimizing the investment of our capital and human resources, and utilizing excess cash in a way which has the greatest opportunity for increasing shareholder value."

 

January 2008

“….the three key elements obviously to shareholder value creation are, one, continue to grow top line, top and bottom line and the biggest engines behind that right now are our organizational sales, or our organizational Solutions Business Unit and the biggest bets there have been the hiring and ramp up of client partners and the productivity of our existing client partners…..the flow-through from investments that we made years ago in new client partners is now hitting that part of the curve where the biggest increases now occur….” (Company set all time booking's record in December 2007)

“The second element is, of course, the multiple that's applied to our earnings. That's a function of a lot of things. You all will have your own formulas. But certainly one of the issues is the growth rate and we believe we have opportunities for accelerating that growth rate, particularly on the OSBU side and also in CSBU as it relates to these wholesale and international initiatives as well as PlanPlus.”

“Finally, third element of value creation would be in our mind shrinking the outstanding share base. As Steve mentioned, we have now put ourselves in a position where we can pay off our line with remaining cash. We have been -- some cash left in our credit line available and we'll be looking for ways to utilize that. We think one of the opportunities that we've all talked about in the past would be to find ways of shrinking that share base over the -- in the coming quarters.”

 “….we think there's another 8 million to $10 million of costs on top of the $125 million that's come out, that in some of these areas like IT and other things that we should be able to get….”

 

Enterprise Value

- Hidden Asset: Off Balance Sheet reduction of 3.5mn shares outstanding due the the employee loan from 2002, see previous write up for details. We think this is the most convervative method as we do not take the accrued interest which is currently over $13 per share to have the loan forgiven.

- Company stated that their Net Cash position was greater than their line of credit as of January 11, 2008 (we assume net cash is $0)

- What appears to be Long Term debt on the balance sheet is an operating lease ($33.5mm) that is recorded as debt because FC is subleasing part of the space (FC actually only pays 1/3 of the rent as the sub-leases pay the rest), if they weren’t sub-leasing the space the lease debt wouldn’t show on the balance sheet. Therefore we are netting out the sublet part of the $20mn portion and including the $12mn that they lease as debt.

Adjusted EV= (19.7-3.5) = 16.2mn shares * $7.50+ ($12mn in OL debt)= $136mn

Normalized CAPEX $4.5m annually (last year they bought a printing facility) 5 year average $5mn (including print facility)

 

Opportunities to enhance value: 

Hypothetically a $40mn Dutch @ $8.50 takes share count to 15mn with after tax interest cost of $1.6mn annually and EBITDA per share of $2+ for 2008, then the stock should be worth high teens as the company should be able to pay this off and deliver substantial yr/yr per share EBITDA growth. 

If we could simplify the story it would be:
Expanding total end market revenue is growing and is in excess of $400mn total brand sales annually, the concepts/brands are constant what is changing is end market distribution of this content from paper based domestic business to online/software and international growth opportunities, these changes will impact FCF dynamics in a very favorable way: EBITDA margins should improve to the mid teens and CAPEX as percent of revenue should hold around 2%, and finally the capital structure is now set where this excess FCF will fall straight to common holders (versus over the last 8 years: $91mn in preferred’s paid off, $60mn in interest on the preferreds paid, $28mn employee loan made w/recourse, $15mn in common repurchased) .  Gross and Operating Margins should rise, high cost debt is totally paid off, high margin recurring revenue is growing nicely, and management has long history and interest to buyback significant amounts of stock.  We think the stock is very cheap at under 5x ev/ebitda for a business with these dynamics and an EV of $136mn.

The stock in the late 1990's got to $25+ and think there is a chance to revisit those levels over the next few years contingent on $3 per share in EBITDA over the next two years (Likely $45mn EBITDA/15mn shares something like that in terms of numbers)  

Risks:

1Q08 should be weaker than 1Q07: moved around Catalog mailings. But Full year EBITDA should be slightly over $30mn. We are looking for $8mn in EBITDA for 2Q08 (still not bad for the qtr with a 6% EV/EBITDA yield).

Severe prolonged global recession would harm FC's business

 

Disclaimer: This does not constitute a recommendation to buy or sell this stock.  We own shares of the company, and we may buy shares or sell shares at any time without updating the board.

 

Catalyst

Aggressive Share repurchase: Management has long history of repurchasing shares and has clearly stated interest/intent to aggressively repurchase common shares.
Widening Footprint: Wholesale revenue sharing agreements in 10,000 stores growing stores by 20% in 2008, 80 retail stores, operates in 140 countries via licensee’s and company owned locations, total annual brand sales are over $400mn annually with good customer base 90% of Fortune 100 and 75% of Fortune 500.
Gaining Sell Side Coverage, Mgt continues to be more proactive with Wall Street (now does quarterly conference calls and should be more proactive later in the year)
High returns on capital 25-90% ebitda-capex/she and ebitda-capex/(she-intangibles) trading at 6x ev/ebitda-capex and 5x ev/ebitda multiple with business that has critical mass $400mn annual total system revenue.
Strong FCF Dynamics EBITDA margins trend to mid teens and CAPEX should run 2% of revenue. 40% of EBITDA comes from high margin recurring sources
Business operates in 95 countries with no customer concentration and significant international growth opportunities
Opportunity to improve operating margins and possibilty of significant share reduction: Significant EPS power: $285mn dollar business, with 60%+ GM, and 18 year history averaged 13.8% EBITDA margins> Margins should go up and shares should be aggressively repurchased by the company which should get to $2-3+ in EBITDA over the next 18-24 months.
Best balance sheet in 10 years and businesses in good shape overall.
Cheap: $285mn in revenue should operate 13%+ EBITDA margins with 2.5% CAPEX as percent of net revenue on $135mn EV for high return on capital businesses and steady global long term growth prospects.
Mr. Market: is ascribing a tremendous amount of the valuation to the retail store concept and virtually ignoring their other higher quality businesses. The value we ascribe to the Retail stores is $0.85 a share on total value of $15 or 6% of the value of the entire business.
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