Value Investors Club / SCHOOL SPECIALTY INC (SCOO)

Description

See below link for PDF formatted version of write-up.

https://www.dropbox.com/s/gg5mmpiboaczpoi/SCOO%20Investment%20Thesis%2006-27-2017-1.pdf?dl=0

Leading distributor to public and private schools is nearing the end of a post-bankruptcy turnaround. Near term structural issues prevent wider ownership, which management is rapidly working to alleviate. Investors today get a chance to participate before catalysts make the stock more visible and investible, with nearly 50% upside from current prices.

Overview

We recommend School Specialty (the “Company”, “School Specialty” or “SCOO”) as a long School Specialty is a leading distributor, developer and designer of school supplies, furniture, curriculum and supplemental learning resources to private and public schools. Founded in 1959, SCOO grew from a local education supplier to a large player in the education distribution and supplies industry through decades of acquisitions and organic growth. In 1996, SCOO was acquired by U.S. Office Products, with USOP spinning off the Company in an IPO in 1998. After another decade of growth through aggressive acquisitions, the Company’s leverage peaked just as the Great Recession trimmed school budgets and spending. As school construction and spending fell, SCOO’s finances deteriorated, leading to a Chapter 11 bankruptcy filing in January 2013. Upon emergence from bankruptcy, debtholders received 1,000,004 shares of SCOO which currently trade on the OTC markets. SCOO’s principal offices are located in, Greenville, Wisconsin.

Post-bankruptcy, SCOO has taken many steps to streamline the business, improve operations and rationalize costs, creating a lean platform for profitable growth with the capacity to conduct bolt-on acquisitions to serve increased portions of the market and capture a greater share of wallet. With significant pain already taken, the Company is entering the final steps of the turnaround. Our thesis centers on a few key points

Near-term corporate finance catalysts (refinancing, stock split and up-listing) to increase share ownership and institutional profile
Competent management team executing on plan to streamline operations and grow share of wallet, while focused on increasing shareholder value
Stable, growing end markets with strong positioning among core customer base

Investment Thesis

1. Corporate finance catalysts provide near term upside

In April 2017, the company refinanced its term loan (From LIBOR + 8.50% to LIBOR + 6.50%) with expected annual savings of $3M per year. With the refinancing finished, SCOO’s next area of corporate finance focus is up-listing to the NASDAQ. The final requirement is to have more than 300 listed shareholders. At the end of the year the Company had 106, which has since increased to over 140. In an effort to hasten the process, the Company plans to do a stock split by the end of Q3-2017. By splitting the stock, the Company will broaden its potential investor universe, including retail investors. Once the stock split is complete, the Company expects listing on NASDAQ to follow quickly thereafter, by the end of 2017. The Company has recently become more accessible to investors and plans to actively engage the equity research community post-split, in advance of the up-listing.

2. Radical business improvement driven by exceptional management team, streamlining operations and growing sales

After emerging from bankruptcy, newly appointed CEO Joseph Yorio completely revamped the Company’s operations, rationalizing costs, streamlining processes and reorganizing the sales force. A former US Special Forces Officer and Army Ranger, Mr. Yorio’s career is a history of success in running operations and logistics companies. As CEO of “Xe”, formerly Blackwater, Mr. Yorio reinvented and turned the Company around, cutting fat (firing nearly a dozen senior executives) and growing sales. Xe was acquired by a group of investors in 2011 and is now known as Academi.

On cost rationalizations, the Company has reduced SG&A while increasing sales and EBIT. Since 2014, SCOO has reduced its full time workforce from 1,450 to 1,156, with further cuts expected. At the same time, Yorio and his team have implemented lean Six Sigma programs into each process in the business, squeezing out inefficiencies and increasing inventory turns from 4.3x in 2014 to 5.6x in 2016.

Going deeper on process improvements, the Company has spent aggressively on technology upgrades, updating antiquated ERP and management software with new offerings from IBM and Microsoft. Specifically the Company has invested in a new CRM system (Salesforce), a new phone system, and is revamping its ecommerce offerings and back end. These efforts include a new Product Information Management (PIM) and Transportation Management System (TMS), all of which will be operational by the end of 2017. Currently the Company is using a very complicated instance of Oracle’s ERP system to manage its back office and logistics. This system has been cobbled together over the past decade to accommodate SCOO’s needs, but is inefficient, underpowered and not sustainable. With the revamping of the PIM and TMS to a cloud-based, light weight offering, SCOO’s ERP will be deemphasized, and by the end of 2017, will be solely dedicated to financial reporting. As SCOO grows revenues and rationalizes costs, margins should continue to improve. Increased volumes will allow the Company to “buy-better” with improved negotiating power within their supplier and 3rd party manufacturer network. The Company also intends to increase its proprietary product offering which carry higher margins. The Company reorganized its sales team to focus on “team selling”, viewing a client holistically rather than silo-ing sales people to specific product categories. The goal is to improve penetration within their current customer base, allowing SCOO to increase its share of wallet. While the Company just moved to this sales strategy, early results are encouraging.

3. Attractive, stable, growing end markets with strong positioning among core customer base

The education supplies, school furniture and equipment markets are highly fragmented, with many small players vying for specific contracts. SCOO’s scale, customer base, and broad portfolio of proprietary and third party products are key competitive advantages. 40% of SCOO’s overall revenue comes from proprietary products and over 70% of revenues are generated from “consumable products” like markers, pens and other materials which must be ordered each year. While the Company is perceived as a low growth business, results suggest otherwise, as three of their categories are growing, while just two are shrinking.

The Company splits its business into two segments: Distribution and Curriculum

Distribution

The Distribution segment focuses on five key categories: Supplies, Instructional Solutions, Furniture, Planning and Student Development and A/V Technology.

Supplies: SCOO is the largest marketer of school and classroom supplies in the United States. Sold mostly through catalogs and direct sales, though online is increasingly becoming a key piece of the business, SCOO offers both proprietary and national brands across a wide array of categories from basic supplies to office products, classroom supplies, JanSan equipment, art supplies, physEd, sports equipment and craft paper. Proprietary brands include Sax®Arts & Crafts and SPARK®.

Instructional Solutions: SCOO sells supplies and technology solutions as well as supplemental learning materials for reading comprehension, math and science. These products are designed to help students remain at required proficiencies and aid students who are falling behind or need more challenging material. Proprietary brands include Abilitations®, Integrations® and Childcraft®.

Furniture: SCOO is the most comprehensive provider of school furniture in the United States, offering school specific furniture and equipment for in-classroom and outdoor uses. SCOO can equip entire schools, with products ranging from school desks, to cafeteria tables and gym equipment. SCOO’s propriety brands include Bird-In Hand®, Classroom Select®, Royal Seating® and Korners for Kids®.

Agendas: The planning and student development segment refers to school agendas which are typically distributed to students at the beginning of the school year. This market has declined over the past decade as high schools and middle schools have shifted toward electronic solutions, reducing the demand for physical agendas. At the same time, SCOO lost focus on this area, ceding share to other players. In conversations with management we understand that this business is still very profitable and beginning to stabilize, with SCOO expecting to win back share over the next few years. The K-5 market has steady demand for agendas, as younger children can’t use more advanced technical products and the planner itself serves as a learning tool to teach responsibility, penmanship and organization. SCOO’s brands in agendas are Premier and Hammond & Stephens

A/V Technology: SCOO sells a vast array of multi-media and interactive technology and presentation products. As schools continue to increase their investments in technology, SCOO expects this segment to resume growth. Califone® is the chief proprietary SCOO brand in the A/V Tech market. Other Products: SCOO’s other products are geared toward school safety and the improvement of wellbeing. In school safety, SCOO offers SSI GUARDIAN, a comprehensive curriculum-based

security initiative designed to keep schools and other facilities safe, providing school employees training and security-related products to address safety and risk mitigation. In wellbeing, SCOO offers Soar Life Products which are tailored to address the needs of healthcare organizations, supplying Art, craft and sports supplies to hospitals, long-term care and day care centers, physicians’ offices and clinics.

Curriculum

The Curriculum segment serves two primary markets: Science and Literacy & Intervention Science: SCOO’s Science category is comprised of proprietary products and resources focused on promoting scientific literacy, education and inquiry. Products include lab equipment, furniture, lesson plans and curriculum. Proprietary brands include FOSS®, Frey Scientific ®, Delta Science Modules, Delta Education®, CPO Science, and Neo/SCI ®.

Literacy & Intervention: Labeled as “Reading” on the segmented income statement, SCOO’s L&I segment provides supplemental resources and programs in math and reading for students who are struggling or have special needs. Proprietary brands include Educator’s Publishing Service (EPS), Explode the Code®, Making Connections ® and Making Connections Intervention TM, Path Driver for Math ® and Path Driver for Reading®, Sitton Spelling and WordSkills®, S.P.I.R.E ®, and WordlyWise®.

Customers

SCOO estimates that in 2016 the Company served 63% (nearly 87,000) of schools in the United States. Customers tend to be sticky, with top accounts having relationships lasting over a decade and overall retention rates well over 90%. SCOO’s top 10 school district customers account for just 8% of revenue. The recent reorganization of the sales team along with investments in sales technology is set to dramatically increase salesforce productivity and penetration within SCOO’s existing client base. More and more customers are moving to COOPs, which allow groups of schools to purchase from SCOO at specific, contracted rates. SCOO is the only player that can service these groups

In addition to providing a channel for SCOO to get into schools where they had not been before, COOPs also serve as a marketing partners for existing customers. The Company is rolling out a completely revamped ecommerce tool, making it far easier for teachers, school administrators and parents to order directly from the company. Currently, most customers order through “analog” processes, either through the catalog or over the phone. Technology had been a historical area of weakness, and management is focused on tapping this channel. Internet sales were 27% of revenue in 2016 and are expected to grow going forward. In addition to further penetrating its existing markets, the Company is also looking to expand its customer base by moving into the health care space. There is significant overlap between SCOO’s current product offerings and the needs of hospitals, health clinics and long term care facilities.

4. Rational, highly aligned management team focused on creating shareholder value.

In 2016 and early 2017, the Company underwent a strategic alternatives review and was approached by several “value oriented” buyers.” While the Company did not ultimately find any of the offers compelling, the willingness of management to consider such steps gives us confidence that a deal could happen in the future. The Company has also discussed a willingness to sell underperforming segments and exit product lines which no longer fit with the overall strategy of the business. Management also understands the intense seasonality of the business, which is heavily weighted to the back-to-school season (Q3 is 40% of sales). Such intense

concentration in one quarter gives investors pause, as many would prefer a more diversified, well rounded revenue base. SCOO has commented that they are looking for, and are positioning the business to be able to do, bolt-on acquisitions to drive value by leveraging their current platform and customer base. Once the streamlining of operations and technology initiatives are complete the Company will be in a far better position to conduct and integrate new companies. Management also appears to have a strict, “value oriented” acquisition discipline and understands that paying high multiples of EBITDA when you have a low multiple stock is not “accretive”, even if you used cash. Such an attitude speaks to managements “ownership” mentality, and gives us confidence that their interests are aligned with shareholders.

Industry

The United States PreK-12education market is large and has historically exhibited attractive and stable growth characteristics, despite fluctuations in the U.S. economy. Total expenditures for the K-12 Market were $662 billion through 2014-2015 growing to $675 billion in 2015-2016. Based on industry estimates, spending should increase mid-single digits over the long term. Funding for education comes from three main sources: State, Local and the Federal government, accounting for 44%, 44% and 12% respectively. The key driver of funding is enrollment, which has grown steadily over the past two decades, with NCES estimating growth to continue through 2024 at a 0.5% rate. At the same time, spending per pupil is expected to increase, providing two complementally growth tailwinds for the industry. Industry reports from McGraw-Hill suggest construction spending on K-12 should grow from $24bn in 2014 to $36bn in 2017. Years of delayed maintenance and capital investment paired with increased enrollments is driving the needs for new facilities. The driver for allocable funds is primarily property taxes, which are collected on the basis of property values. Since the recession, property values have increased markedly, boding well for the future school spending environment.

Valuation and Price Target

We believe SCOO is dramatically undervalued at its current share price given the ongoing fundamental business improvements, along with the near-term catalysts and credible growth strategy. We valued SCOO’s two businesses separately, then did a sum-of-the-parts analysis for the combined company, assigning a 7.5X multiple on the low end for the Distribution business and an 9X multiple for the curriculum business given its higher margins and rapid growth. Under this “Bear Case” Scenario, the stock is worth $175, nearly 50% higher than current prices.(Exhibit 3) While there are no good public company comparisons, other distributors (Exhibit 1) tend to trade for 7-9x EBITDA. If SCOO traded at 8.3x (the mid-point blended multiple in our SOTP case) management’s 2017 EBITDA estimate the stock would be $225, over 90% above the current share price.

Please note that given the extreme seasonality of the business, we calculated a normalized cash balance and adjusted the TEV accordingly. The Company builds up working capital in the first three quarters of the year and collects an enormous amount of cash in Q4 as schools pay for their supplies. To correct for this, we made an adjustment based on what we think a “normalized” cash balance would be given the current working capital balance and how that compares to the average over the last 12 months.

Working Capital Analysis

Risks

Amazon: While Amazon does sell school supplies, at its core it is a business-to-consumer company, selling to parents and school teachers vs. schools and school districts. SCOO’s aggregate prices are also often more competitive than Amazon’s. SCOO has a direct relationship with the schools, and can provide certain items at lower prices than Amazon by offering a bundled package. SCOO is also a key vendor for Amazon in the school supplies space by way of SCOO’s leading, proprietary brands.

SPLS and ODP: While Staples and Office Depot do provide some of the same product as SCOO, they service different markets, with SPLS and ODP focusing on the business world and SCOO focusing on the education market and schools.

Other Dedicated School Supplies Competitors: Other distributor competitors include smaller privately-held players like Excelligence ($240M in Revenue) and single line competitors, like furniture and Ed-Tech players. There is no other company of SCOO’s size and scale serving this market. This scale provides an advantage when SCOO negotiates prices with COOPs, as the COOPs know that SCOO can supply the depth and readth of product necessary to meet the needs of their members.

Competitive market for Curriculum: There are many players in the curriculum market, with school districts adopting a “winner-take- most” approach. School districts and states tend to pick one main provider of a specific curriculum offering with other bidders getting small pieces if any. This creates lumpiness in the business. SCOO’s curriculum products are well regarded, particularly in Science, which has been growing over the past few years.

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Near-term corporate finance catalysts (refinancing, stock split and up-listing) to increase share ownership and institutional profile

show sort by

			2017	2018
Price:	118.00	EPS	0	0
Shares Out. (in M):	1	P/E	0	0
Market Cap (in $M):	142	P/FCF	0	0
Net Debt (in $M):	142	EBIT	0	0
TEV (in $M):	305	TEV/EBIT	0	0