| 2007 | 2008 | ||||||
| Price: | 5.85 | EPS | |||||
| Shares Out. (in M): | 0 | P/E | |||||
| Market Cap (in $M): | 100 | P/FCF | |||||
| Net Debt (in $M): | 0 | EBIT | 0 | 0 | |||
| TEV (in $M): | 0 | TEV/EBIT | |||||
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Scientific Learning, blends the best aspects of a very high moat business (backed by 112 patents owned/licensed/pending by some of top scientists in neuroscience) in a software based business model (80% GM/very limited capex) to help significantly improve cognitive skills in K-12 education. The company has been quietly and consistently outgrowing the industry by a factor of 4 over the last several years in booked sales (deferred revenue model). SCIL has been an enormously under followed and illiquid company for the last 6 years which should have changed last Friday, as Warburg Pincus Private equity fund sold 45% of the shares outstanding after owning them since 1994. I heard it was their last investment in the fund. Its Fast ForWord family of products has proven to significantly improve reading grade levels in fairly short time (135 studies and 1200 articles, see
What’s so exciting here? First the company should do +140% ROE in 2007 and +100% ROE 2008. Second, 80% of the 4900 schools renew annually and they are adding 3+ new schools a day. Third, SCIL’s market share gains should accelerate by spending 55% of revenue on sales and marketing and growing 4x as fast as the industry while holding a whopping 4% market share in US K-12 (more on this later). Third the balance sheet is in good shape: Cash and A/r = 26% of market cap. Fourth SCIL is guiding to reaching 17-20% operating margins at approximately $75mn in revenue, in the mean time the company should generate $6-7mn in cash and $3.5mn in net income in 2007 and end 2007 with a $1 per share in net cash. Fifth, SCIL is loaded with embedded call options: a) International VAR’s up 100% last 18 months now only 1.5% of total revenue (mgt feels there are significant international market opportunities, in India/China as many people are learning English in those market as currently speak English in US) b) the company has added nearly 40 new patents last 3 years c) they plan to license their neuroscience IP outside of K-12 and enter new markets over the next few years. The company feels there are 12 potential markets in neuroscience based education and keeping the brain sharp from birth to old age which they estimate today have total annual revenue of $90bn (no idea, if they can succeed in any of them).
Their family product uses web-based Flash technology in interactive software games that uses nearly 15,000 stimuli to improve cognitive learning abilities. The software is improved by SCIL having the largest database in US of how students learn with over 1,000,000 usages of the product that is stored and monitored in real time. The games use positive reinforcement to keep the kids fully engaged and adapts up or down to the child’s skill so they get about 80% of the questions right. Schools that have problems with SCIL are usually related to issues of lack of teacher know how, not enough use, or computers in poor condition. Very simply the software works around concept called MAPS: Memory, Attention, Processing, and Sequencing (see web site for more details).
Progress Tracker provides real time analysis for teachers, school administrators, and parents on students sent via email or web based system. These parties can look at each student’s very specific points of where a student is succeeding or having problems such as phonemic awareness, decoding, vocabulary and comprehension
SCIL has a very successful management team (200 years in the education market from top executives, and the top 4 were part of NCS which sold to Pearson for $2.5BN), excellent board: former CFO of Bear Sterns, 2 National academy of science members one from Harvard and other former Chancellor of UCSF, and former CEO of NCS/Pearson ($12bn market cap). I estimate the company is trading at about 1.9x ev/year end sales (seasonal DSO’s should lead to $16-17mn in cash). The best comp is RNLN and its 3.5x sales, no growth, very broad and narrow product line. In fact, SCIL should reach $50mn in revenue with 4% market penetration versus $106mn for RNLN with 62% market penetration of the 129,000 k-12 school market. SCIL’s addressable software market in K-12 is about $900mn growing at 6-7% a year this is just the software based market in US for K-12. A quick side note, the company seasonally has negative cash flow 1H of the year and significant cash flow in 2H.
In my investment history I have noticed over time that software companies that spend over 50% of revenue on sales and marketing usually do extremely well. Because they feel they have an outstanding product that CAN sell and do not have to invest heavily into R&D to really create or improve existing products. These usually become category killers like Salesforce.com or Mercury Interactive.
Gaining Traction:
High user satisfaction: 83% say hits or exceeds expectations and that is confirmed with 80% annual renewals which are the highest renewal rates in the industry.
Salesmen quota’s have been increasing: +14% to $1mn while growing sales force 48% last two years.
Brain Summits (for school administrators): events are up 32%, attendance is up 66%, which has expanded potential pipeline from $5mn in 1H06 to $18mn for 1H07 or up 260%!
SCIL won the largest contract in company history in May 2007 of $7.4mn.
R&D is tapping some of the best talent understanding how the brain learns from board and R&D team consisting from Harvard and UCSF:
Dr. Merzenich professor, in Neuroscience, Physiology, Biomedical Engineering and Otolaryngology at UCSF. He is currently the Francis A. Sooy Professor of Otolaryngology at UCSF. During 2004, Dr. Merzenich was on sabbatical from UCSF and worked full-time with Posit Science Corporation, which has licensed certain technology from us and is developing neuroscience based products for healthcare applications. Dr. Merzenich is presently the Chief Scientific Officer and a member of the Board of Directors of Posit. Dr. Merzenich has more than 25 years of experience in managing large, multidisciplinary brain science/behavior/engineering research projects that have led to commercial products and numerous publications and awards. In May 1999, Dr. Merzenich was elected a member of the National Academy of Sciences for distinguished and continuing achievements in original research.
Dr. Joseph Martin:
Dr. Martin is the Edward R. and Anne G. Lefler Professor of Neurobiology at
William M. Jenkins, Ph.D.
Senior Vice President, Product Development William M. Jenkins is one of our founders, and is an expert in learning-based brain plasticity, behavioral algorithms, and psychophysical methods, as well as multimedia and Internet technology. He joined the company at inception from a position as an associate professor at the
Dr. Jenkins is an author or co-author on more than 100 publications including 13 commercial software products, 46
Steven L. Miller, Ph.D.
Senior Vice President, Research
Steven L. Miller, a founder of Scientific Learning Corporation, is a neurophysiologist with expertise in the assessment and treatment of developmental language and reading impairments. He joined the company at inception, after serving as a research associate professor at
David Smith:
Former CEO NCS/Pearson ($12bn market cap Ticker: PSO), and current executive chairman of Plato, 30 years in education testing, training, and software.
Bob Bowen
Highly experienced executive in education: 17 years at McGraw Hill, went to NCS and was part of the team that sold to Pearson in 2000 for $2.5bn. He has been CEO of SCIL since 2002.
I hope this shows that this is a very deep team with decades of educational experience and some of the top scientists in the industry.
The company is clearly playing for significant growth spending 55% of revenue on sales and marketing which has allowed the company to grow at 4x the industry growth rate. Yet even with aggressive growth assumptions the company should generate around .40 in cash per share this year. If the company where to slow growth and matched Renaissance Learning in terms of S&M as percent of sales the company’s operating margins would jump to 26% today.
Why is the stock cheap?
The stock has been enormously illiquid since coming public: insiders own 20%+, Warburg Pincus Private Equity owned 46% and hedge fund Trigran owns 10%. WP last investment from 1994 private equity fund was SCIL the stock closed at $6.80 on last Thursday and deal was priced at $5 it for half the company. Clearly investors not involved in the deal voted with their feet for pricing the deal at $5 when the stock closed at $6.85 the day before. For disclosure I bought half my stock at $6.70 and half at $5 for I am down slightly so far. I think a discount for illiquidity should come out of the stock once investors begin to look at this idea now that the company should trade in a fairly liquid manner.
Why I think the company is cheaper than it appears?
55% of revenue spent on sales and marketing, if this were cut to peer RNLN and not playing for growth SCIL operating margin would be 20% today and the company should generate nearly .60 per share in EBIT.
Market penetration: 4,900 schools out of 129,000 or about 4% market penetration in K-2 this was up from 3,800 in 2005. Company should be at nearly $50m in revenue this year.
Comps:
RNLN: the currently have low single digit top line growth, 3.6x sales, 22x ev/ebtida, 50x ’07 eps, very wide and narrow product line, spends 35% of sales on marketing, 8% of market cap in net cash/ar, currently sells into over 72,000 schools out of 129,000 and does $106mn in revenue.
SCIL: 25% top line growth (most recent quarter bookings +28%), 22x ’07 EPS (but there is 30% of market cap in Cash and a/r) cash from operations should run around .40 or 14x or netting out cash about 12x this year’s cash from operations, the company spends 55% of revenue on sales and marketing which is translating into 4x growth of the industry, 4,900 schools less than 4% of total schools up 30% year over year, yet revenue of $50mn. With $50mn in revenue and cash should be around $16-17mn by year end you are only paying 1.9x ev/sls, for a very wide moat company with many embedded call options.
From 10K: “Our patented products are highly differentiated by their neuroscience basis and their focus on the development of learning capacity through improving cognitive skills. While we therefore have little direct competition, we do compete vigorously for available funding against other companies offering educational software and other language and reading programs, as well as with providers of traditional methods of teaching language and reading.”
Upside/Downside:
a) DCF using 25% top line for the next 5 years, falling to 20% for the next 5 years then going to 15%, for 5 years and ultimately 10% for the rest of the 20 year DCF with a 9.5% discount rate. I thought this was reasonable given: 4-5%
I used at 9.5% cost of capital and came to an $17 price target which I think we will reach over the next 18-24 months with extremely limited downside at current prices 10-15% to $4.75-5.00 given our earlier points.
b) Really no good comps on SCIL except: RLRN valuation little no growth company:
RLRN: 3.5x ev/revs = SCIL is $9.50 +65%, so with 4x growth rate and 4-5% market share this should be appreciably higher.
Negative risks: They will pay taxes in 2008 due to loss of part of NOL in change of control with WP.
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.
Catalysts:
A) Strong aspects of both High moat (112 patents owned/licensed/pending based on improving learning based on neuroscience principles) + Software is patent protect with 80% gross margins and very limited capex)
h) Eventual likely acquisition target from Pearson or McGraw Hill
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