Franklin Covey FC
July 11, 2006 - 4:26pm EST by
zach721
2006 2007
Price: 6.82 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 137 P/FCF
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT

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Description

So what would be so interesting about a company that lost $10 a share over the last 5 years while revenue has fallen 40%? Franklin Covey is worth a look due to management simultaneously pulling several levers that should create shareholder value: a) material OPEX reductions b) significant change in revenue mix and margins in the mix c) continued improvement in FCF dynamics reducing inventory and CAPEX and d) a complex capital structure with a hidden asset. We believe these events combined with a non-promotional highly under-followed company with 4 divisions have left investors with a bargain. We think FC is trading at slightly less than 4x EV/EBITDA on August 2007 year end numbers assuming flat revenue.

 

At current prices we think FC has $6 downside (3.4x ‘07E EV/EBITDA-CAPEX, FY year end August). Our upside target is $16 using the mid point of: sum of the parts $15.70 and 10x EV/EBITDA-CAPEX ‘07E $16.20 using what we think are fairly conservative estimates. Our estimates for the next 3 years: EBITDA ’06E $1.40, ’07E $1.75, ’08E $2.25, ‘09E $2.65 (CAPEX 10-14%+/- of EBITDA). In 2009, we think the stock could see $25-30.   

 

First we think FC could get to $2.50 a share in EBITDA-CAPEX in the next 3 years on a $7 stock. Basic blocking and tackling in operating expenses alone should unlock value by paying down debt (in 2005 the Preferred’s cost .40 per share annually in interest, in 2006 cost about .20 a share, by end of 2007 we think this will be -0-). Operating expenses should come down another .20 a share in 2007 from renegotiating the EDS contract in April 2006, (FC out-sources its fulfillment processes to EDS).  So just assuming 2007 revenue is flat from 2006 we could see a 25% rise in EBITDA and significant reduction in debt. We think that revenue should increase at least 5% in 2007 with better margins on both of their divisions, so there could be upside to the 2007E.

 

Description: OSBU: (Organizational Solutions Business Unit): training and consulting, both Domestic and International. International is in 100 countries with 24% EBITDA margins because of royalties from licensees. Domestic is about a 10% EBITDA margin.

CSBU (Consumer Small Business Unit): Retail 90+ stores, Internet-Catalog, and Wholesale business.

 
Where the story gets more interesting is that in the 2005 annual shareholder letter the CEO writes "we expect training and consulting (OSBU) sales to grow to as much as 65% of our total sales (on an increasing revenue base), in the coming years."  Since the OSBU business has 16% EBITDA margins currently, FC will experience considerable margin expansion if OSBU grows from 50% of sales to 65%. To complicate matters further, International OSBU has 24% EBITDA margins and is growing faster than the Domestic side which has 10% EBITDA, so we could see further margin expansion in this division. The training and consulting sales will increase thanks to increased hiring of sales professionals and more experience within the ranks.  More experienced salespeople generate higher sales (see table below).  The average sales person has been on for 3-4 years and voluntary turnover is extremely low.

OSBU Sales Professional Unit Economics
All figures in $000s
Years on the Job Year 2 Year 3 Year 4 Year 5 Year 6
Revenue 365 645 925 1,100 1,200
Gross Margin 246 435 624 743 810
SG&A 184 184 184 184 184
EBITDA 62 251 440 559 626
OSBU Sales Professionals
Year 2003 2004 2005 2006 (E) 2007 (E)
Number  154 123 137 153 165

 

Company has taken its break-even from $500mn in 2002 to $266mn in 2005. This should continue to drop with the recently re-negotiated contract with EDS. From 1996 through 2001 FC generated $14 in cash from operations per share and CAPEX was $8.50 a share, now CAPEX will be a fraction of what it was then with much better Free Cash Flow dynamics. The CEO should apply to be a VIC member, he has an outstanding letter to investors that is extremely clear and concise on exactly move by move he is doing to create shareholder value. Tank481 did an excellent job of identifying FC as an opportunity to buy at a discount to liquid NWC. A great deal has changed since that 2002 write up. Management has sold off five non-core businesses, closed their Provo office, did sale/leaseback of HQs (generated $32mn cash and bought back from $87mn to $37mn of their preferreds last 15 months), closed 80+ retail stores, reducing WC and CAPEX, while driving more business to their Internet Site. We believe that FC total revenue bottomed out in 2004 at $275mn. FC revenue growth on OSBU has been masked by store closings, nearly 50% of total, over last 3 years.  The turnaround is detailed below:

 

2002 $83mn EBITDA loss

 

2003 $17mn EBITDA loss

 

2004 $6.9mn EBITDA

 

2005 $21mn EBITDA

 

Below are revenue and EBITDA estimates using our assumptions of OSBU 55% - CSBU 45% sales split by 2009 and management’s assumptions using 65%-35% sales split by 2009/2010.

 

 

Our Assumptions - 55%-45% Revenue Mix
  2006 2007 2008 2009
Total Revenue 282 296 312 321
CSBU 142 144 145 146
OSBU 140 152 167 175
% of Revenue 50% 51% 54% 55%
CSBU EBITDA  $            7  $        11  $    14  $      16
OSBU EBITDA  $           21  $        24  $    28  $      32
TOTAL EBITDA  $           28  $        35  $    42  $      48

 

Management's Assumptions - 65%-35% Revenue Mix*
  2006 2007 2008 2009
Total Revenue 284 313 345 395
CSBU 142 144 145 146
OSBU 142 169 200 249
% of Revenue 50% 54% 58% 63%
CSBU EBITDA  $            7  $        11  $    14  $      16
OSBU EBITDA  $           21  $        27  $    34  $      45
TOTAL EBITDA  $           28  $        38  $    48  $      61

 

*from 2005 annual shareholder letter
 
The CSBU side should reach run-rate 10%+ EBITDA margins by the end of FY2006 once all planned store closures have been implemented. Store closures don’t result in a 100% loss of sales as ~20% of sales go to either other stores or internet resulting in improved margins (see table below).  The company has closed all stores where they cannot generate 100% ROI on stores, which usually equates to about $800K in annual sales per store.

 

Poor Store Economics
All Figures in $000s   Transitioned  
Poor Store P&L Sales Incremental
Revenue 450 100 (350)
Gross Margin 240 55 (185)
SG&A 235 10 (225)
EBITDA 5 45 40

 

Competition:

 

OSBU offers effectiveness/execution management training and consulting to businesses with over 100 employees.  FC serves 90% of Fortune100 companies and 75%+ of Fortune500 companies but we believe many of these accounts are under-penetrated.  Their newer xQ Survey offering has been very well received in the market (they haven’t seen this level of excitement since the ‘7 Habits of Highly Effective People’ release in the early 90s).  To generate new products/services, FC employs world-renowned thought-leaders such as Stephen Covey and Jim Collins (author book “Good to Great”).  FC also recruits up-and-coming thought-leaders offering to include their concepts in FC’s products and giving them a cut of the business.  Thought-leaders prefer partnering with FC instead of opening up their own consulting firm (well known brand, sales infrastructure, reduced time-to-market, etc.).  FC benefits by outsourcing their R&D.  FC doesn’t compete directly with other management consulting firms (McKinsey, Bain,etc.) because it helps its clients to execute its goals – it doesn’t develop the goals.  Its biggest competitor is IIR, (mainly in Europe) which doesn’t have the connections in the thought-leader circles, and some smaller competitors like Organizational Dynamics, Provant, and Forum Corp.  FC estimates that the total market is worth $6bn in annual revenue and is highly fragmented with biggest companies having between $100-400mn in annual revenue.

For more details on what the OSBU does, check these case studies on FC’s website:

http://www.franklincovey.com/about/investor/stories/index.html

http://www.franklincovey.com/about/investor/stories/investools_cs.html

 

CSBU competitors are DayTimer, At-a-Glance, and Day Runner. We think that FC should be able to do well given 15,000,000 people use Franklin Covey Planners world-wide.  Another way CSBU differentiates itself from the competitors is offering in-store training events for small businesses.  This is a recent initiative with an estimated 5.7mn small businesses in the US.  Franklin Covey has built incredible brand recognition also thanks to Dr. Covey’s book 7 Habits of Highly Effective People (having sold well over 20,000,000 copies worldwide) and numerous other books like "the 8th Habit". FC has frequent symposiums around the country with Jack Welch from GE, Dr. Covey, and other famous motivational speakers.

 

Management

 

Bob Whitman CEO, has been with the company for ten years as board member and six as CEO. When things got tough Bob passed on a salary for three years in exchange for 1.6mn options with a strike of $14 which was ~100% above where the stock was at the time of this deal. Bob is the Co-founder of private equity firm Hampstead Group and has significant expertise in turnaround situations.

 

 

What is the business worth?

 

a) Sum of Parts

 

OSBU: FC paid $160mn cash for this business in 1997, when it had $100mn in revenue and $4mn in EBIT. This business bottomed out in 2004 with $109mn in revenue. Today OSBU should do $140mn in revenue and $14mn in EBIT.

 

Comps NCI, FCN, XPRT, WINS, CRAI trade for about 1.5-2x ev/sls using the low end of this 1.5x times $140mn in OSBU revenue $210-280mn or $10.80-$14 per share. Given the leverage in the very high margin (24%) international business due to the mix of royalties and consulting should make this reasonable.

 

CSBU: Retail: valuing the stores at .3x ev/sls or $1.25 a share

Consumer Direct: Internet and Catalog sales valued at 1.25x sls or $3.45 a share

Wholesale: sells to Target, Wal-mart, and Costco, $20mn at .50x sls or .50 a share

 

FC  has NOL;s of $58mn of which $30mn can be used or  .50 a share in value

  

Sum of parts= $15.70 a share

 

 

b) EBITDA- CAPEX

 
EBITDA-Capex '07  $        32.5
Multiple Valuation Per Share
12x  $         390  $      19.5
10x  $         325  $      16.2
8x  $         260  $      13.0
4x  $         140  $       7.0
  

c) Hidden Asset 

The hidden asset is a management stock loan program implemented in 2001-2002 with which employees borrowed money to purchase FC shares.  Due to the decrease in stock price since then management has renegotiated the terms of the loan so that the debtors will pay the company either a total of $48mn in cash or 3.6mn shares (the latter option is the most likely, debtors just hand their shares back).  It has been fully written down (FY2004) and the debtors will pay FC by earliest of March 2013 or when the stock price reaches ~$13.  The table below details the EV including this loan program shares redemption and fully diluting options and warrants (avg. exercise price $12.4 and $8 respectively):

 

Calculation Diluted and Adjusted EV
figures in MM   Options Warrants Loan
Share (fully diluted) 25.0 2.3 6.2 (3.6)
Market Cap  $     168.4
Cash  $      36.4  $       28.3  $     49.6
Debt  $      33.8
Preferred  $      37.3
EV  $     125.3

 
Current EV without adjustments $172

Risks/why its cheap

 

A) No coverage

 

b) No quarterly conference calls, just one annual conference call.

 

c) Complicated: 4 business lines and many moving parts in capital structure

 

d) Relatively illiquid trades 48K shares average daily volume.

 

 

Key proprietary courses are: The 7 Habits of Highly Effective People, Xq survey, The 4 roles of Leadership, FOCUS: Achieving your Highest Priorities.

 

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.

Catalyst

Cost savings alone in 2007 could approach .40 a share: Preferred down from $88mn to $37mn last 15 months (should have rest paid off by Aug '07 saves .20 a share annually) + Reduction in OPEX of .20 +/- a share from newly re-negotiated EDS.

EBITDA estimates: ’06E $1.40, ’07E $1.75, ’08E $2.25, ‘09E $2.65 (CAPEX 10-14%+/- of EBITDA)

Buyback of common $1.6mn bought 210K shares last quarter at $7.61

Retail stores that are open should generate high returns on capital and closing should reduce WC needs and CAPEX.

Strong name: Covey has sold over 20,000,000 books and 15,000,000 use a FC daily planner worldwide

Critical mass investors should care with $300mn in annual revenue

International is big opportunity with 25% ebitda margins and solid growth prospects

Significant EPS/EBITDA power in model
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