Description

School Specialty, the #1 provider of non-textbook educational products to the stable and steadily growing preK-12 market, is currently trading at $34.35/share or 10.3x Free Cash Flow after all capex (14.0x my estimate of 2008 GAAP EPS).  SCHS is poised to grow Free Cash Flow (and GAAP earnings) per share at a low-to-mid-teens annual rate over the next 3+ years through initiatives being driven by the company’s new President and COO Tom Slagle; Tom joined School Specialty 8 months ago from Cardinal Health, where he was Group President with P&L responsibility over $7 billion of annual revenue.  Though School Specialty was bruised by the 2005 failed Bain Capital leveraged buyout (attempted at 11.5x EBITDA versus the company’s current 8.1x EBITDA multiple), the company is beginning to find its groove again under Tom’s leadership.  The company grew Operating Income 15.1% and EPS 25.2% in the most recent 6 month period and is committed to returning the FCF generated to equity shareholders; in fact, SCHS repurchased $121.5 million of shares in the last 18 months relative to its $700 million market cap.  Within 12-18 months, I expect School Specialty shares to trade at 12x my calendar 2009 FCF estimate of $4/share, representing 40% upside from current levels.
 

Company update:

For a company description, see juice835’s write-up from December 2005.

Since juice835’s December 2005 note on School Specialty, three major changes have occurred:

1)      Free Cash Flow per share (defined as Cash Flow from Operations less all Capex) has increased from $2.03 for Fiscal 2006 ending April 2006 to $2.84/share in Fiscal 2007, to guidance of $3.00 to $3.46/share for Fiscal 2008 ending April 2008 (I am modeling $3.33/share, a 10% FCF yield)

2)      In mid-2006, management and the Board re-evaluated the company’s uses of Free Cash Flow and determined share repurchases would generate a better risk-adjusted return for shareholders than complementary acquisitions (which had been the historical use for Free Cash Flow), especially since private equity capital had bid up multiples in the space.  This mindset change further reduces the (already low) risk profile of the company

3)      Tom Slagle joined as President and COO from Cardinal Health where he was a key member of the executive management team that created significant shareholder value during his 11-year tenure at the company.  Tom is bringing much needed sophistication, focus, and discipline to the company’s sales, marketing, and supply chain functions [see below for additional detail]

What is the Opportunity?

From $34.35/share, SCHS has almost no downside risk and 40%+ upside over the next 12-18 months.

1)      Stable industry growth, low geographic, product, and customer concentration, and share repurchases provide a solid foundation and very limited downside risk.

Though preK-12 supplemental education products may not be sexy, the $8 billion market is extremely stable with consistent low-to-mid single digit growth each year; expenditures per student have NEVER decreased.  Even during the recessions of 1991-92 and 2001-2002, preK-12 education funding grew 5.0% and 4.7%, respectively (source: U.S. Department of Education).

SCHS has almost no geographic or customer concentration; its Top 10 districts represent less than 6% of revenues and no one state represents more than 10% of revenues.  In terms of products, SCHS offers nearly 100,000 SKUs with the Top 100 accounting for less than 5% of revenues.

Since mid-2006, the company has remained committed to returning FCF to equity shareholders in the form of share repurchases.  The Board just issued a new $50 million share repurchase authorization and the company is in a position to complete that program by mid-2008.

Given the risk characteristics of the company, the 10% FCF yield valuation, and the company’s repurchase activity, downside risk to SCHS is very limited … even if we enter a recession.

2)      Although School Specialty is the industry leader and is 7x larger than its nearest competitor, the company is in its early innings of development and has a multitude of improvement opportunities ahead.

Until relatively recently, School Specialty was little more than an agglomeration of different niche businesses with limited synergies.  Under Tom Slagle’s leadership, the company is integrating and upgrading its operations which should yield significant rewards in the near- and long-term.  Slagle is driving efforts in 3 areas, in particular:

CATEGORY MANAGEMENT.  To date, School Specialty did not have visibility into what individual customers or school districts purchased across its product portfolio, nor did it maintain data on a common platform to study price elasticity or catalog/SKU productivity.  That is all about to change.  The company has nearly finished rolling out an Oracle ERP system that will allow it to: 1) understand individual customer behavior, 2) rationalize SKUs, 3) refine catalog circulation, and 4) optimize product pricing.  This will not happen overnight, but Tom Slagle brings the relevant experience from Cardinal in these areas and has already put teams in place who are aggressively pursuing these opportunities.  Over the next 2 years, the benefits of these efforts will be seen in tailored customer marketing strategies, faster top-line growth (from cross-selling), greater profitability per customer, lower catalog marketing costs, and less inventory.

OPERATIONAL EXCELLENCE.  School Specialty recently began pursuing lean initiatives across the company.  The company is initially focusing on purchasing and supply chain functions, but sees opportunities in other areas as well.  Early results from the company’s Premier Agenda business bode well.  Considering SCHS has never before undertaken a focused process improvement/efficiency effort, the gains from this initiative are likely to be meaningful over time.  In addition, SCHS continue to increase revenues from internationally sourced and private label products, which carry 300bp higher operating margins.

ORGANIZATIONAL ALIGNMENT.  I am a firm believer in the motto, “what gets measured, gets managed” and am pleased to see management deploying a well thought-out system of metrics, scorecards, and incentives to ensure organizational alignment around the company’s long-term goals.  The company has also implemented more “checks and balances” in the system to manage the business more effectively and create additional accountability, e.g., a disciplined monthly business review process.

Conclusion

School Specialty’s recent efforts to evolve what was an unsophisticated holding company into a best-in-class, integrated operating company (under Tom Slagle’s leadership) give me confidence SCHS can achieve its goal of driving consistent 4-5% organic top-line growth and 200-300bps of margin expansion. 

Final note: I am conservatively modeling 3% top-line growth, 70bps of EBITDA margin improvement, and continued share repurchases to arrive at my $4/share estimate of FCF for calendar 2009.  Significantly higher upside exists if the efforts outlined above bear fruit sooner than anticipated.

Catalyst