VOYAGER LEARNING CO VLCY W
July 15, 2009 - 1:25am EST by
bondinvestor
2009 2010
Price: 3.60 EPS $0.41 $0.65
Shares Out. (in M): 29 P/E 8.8x 5.5x
Market Cap (in $M): 104 P/FCF 8.8x 5.5x
Net Debt (in $M): -58 EBIT 12 29
TEV ($): 46 TEV/EBIT 3.8x 1.6x

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Description

VLCY is a leading publisher of software for the K-12 education market.  The company creates products for three distinct areas: reading, math & sciences, and teacher development.  The market for K-12 educational software is estimated to be a $5B annually.  The primary payers are local school districts which are funded by tax revenues.

VLCY has LTM revenues of $103M.  Longer-term, this is a growth market, since the US has neglected to invest in K-12 education for the better part of a generation.  The Obama administration intends to rectify this, creating a tailwind for VLCY.  Its products are good and its market share is low (2%).  In 1Q, revenues grew y/y at a 20% annual rate, which was the first meaningful growth since the recession began.

VLCY's  margin structure is average for a software company, due to the lack of scale.  Gross margins are 65%.  However, sales & marketing (25% of revenue) and G&A expenses (25% of revenue) are high.  R&D is another 5% per year, resulting in an EBITDA margin of around 10%.  Capex is about 7% of sales, which means that the company generates a small amount of cash at its current revenue run rate.

VLCY has $64M of cash on its balance sheet.  Current assets are $6M less than current liabilities, leaving a net net cash position of $58M.  There are no other meaningful tangible assets; however, the company does have $45M of NOL's and R&D tax credits that can be used to shield future income.

VLCY in and of itself appears to be a reasonable value investment, since most of the market cap is cash and the operating business (which is a classically "good" business) is itself valued at 35% of sales and 3-4x EBITDA on low margins - before taking into consideration the value of NOL's.

What is really interesting about VLCY, though, is its recently announced merger with Cambrian Learning Systems (CLS).  This merger has the potential to dramatically improve the earnings through cost rationalization.  Further, as part of the merger, VLCY's large cash position will be distributed to VLCY shareholders, thereby creating a company with a more optimum capital structure for a growth business.

CLS is a privately held educational software publisher that is owned by Veronis Suhler Stevenson (VSS).   It has roughly $100M in revenues and $170M of net debt.  CLS does not have publicly traded equity, but it has done a syndicated debt deal.  There is talk in the debt market that CLI's EBITDA margins are in the 25% range.  This puts CLS's leverage towards the high end of what would be considered prudent in the current environment (7x).

VSS intends to merge CLS into VLCY.  VSS is valuing VLCY at $6.50/share.  VLCY shareholders have the option of taking the $6.50 in the form of cash or equity in NewCo on a 1:1 basis.  They also will receive a contingent value right (CVR) that will enable them to receive any tax refunds that are paid to NewCo between now and October 2012 based on losses generated by legacy VLCY.  VLCY management estimates these could be worth up to $0.90/share.

VSS will own 55% of the combined company.  SPO (one of VLCY's largest shareholders) will own about 10%.  The rest will be held by other VLCY shareholders.  Post-closing, the company intends to apply for a NASDAQ listing.

The total cash distribution to VLCY shareholders is limited to $65m.  Any remaining consideration will be paid on a pro rata basis in NewCo shares (2/3 share at the maximum acceptance rate).   To ensure that the cash distribution does not leave NewCo undercapitalized, VSS is contributing an additional $25M of equity to NewCo post-transaction.

Based on information provided by VLCY management about CLI, it appears NewCo will have $203M of revenue, $150M of net debt and $50M of EBITDA.  There will be 44m shares outstanding, which suggests that the cash EPS of NewCo will be around $0.65/share out of the gate (assuming NewCo can utilize its NOL's in Year 1).  Note that I have not given NewCo any credit for VLCY's 1Q annualized growth of 20%.

NewCo Pro Forma Earnings

                    VLCY       CLS           Synergy          NewCo

Revenue       $103M   $100M                               $203M

- COGS           (36)       (35)                                  (71)

- Op Ex           (55)       (40)             10                 (85)

EBITDA             12         25              10                   47

- Interest                      (20)              2                 (18)    

Pre Tax            12            5              12                  29

Shares              29          26               (10)              45

Cash EPS          $0.41      $0.19                          $0.64

 

Pro Forma Cap Structure

VLCY Cash                                   $58m

+ VSS Equity Contribution                25

- VLCY Distribution                        (65)

Cash at Closing                              18

CLI Debt                                    $168M

NewCo Net Debt                            150

PF Debt/EBITDA                             3.2x

 

Unlike many corporate mergers, the industrial logic behind this one seems sound.  NewCo will have greater scale than either VLCY or CLI, which should allow for cost rationalization.  VLCY management estimates $10M synergies.  I think there could be more.   It is possible that substantial amounts of the G&A and S&M expense at one of the two companies could be eliminated, which would create approximately $25M of synergies.

NewCo will also be substantially larger than either VLCY or CLI, which will enable it to get off the pink sheets and obtain sell side coverage down the road.  It will also be profitable, which should facilitate the monetization of the tax NOL's at CLI going forward.  Some of the VLCY NOL's will be lost since CLI is the surviving entity - but I have to think that since the deal is being structured with CLI as the surviving entity, the NOL's there are at least as large as VLCY.

The buyer of VLCY at current share prices ($3.50) therefore gets the following things:

   - $2.20 in cash at closing (assumes all shareholders ask for the maximum cash allocation)

   - Up to $0.90/share in CVR's

   - 2/3 share of NewCo

I think the risk reward trade-off here is excellent.  If NewCo and the CVR's are worthless, the downside in VLCY is $2.20 - the cash distribution.  That is -35%, and it is known with 100% certainty.

If the merger works as advertized, there is substantial upside.   It's not difficult to see how NewCo can generate $1.50/share in fully taxed earnings a few years from now with modest top line growth (eg, 5%) some operating leverage (high 20's EBITDA margin) and debt paydown ($5-15M per year).

If these EPS are perceived by the market to be high-quality, recurring earnings the P/E could reach the mid-teens.  That would be a $20 stock, and the 2/3 stub received by VLCY shareholders would be worth $13.50.  Add to that $2/share in cash and up to $0.90 in CVR's, for total value of $16.40/share.

Even if the bull case isn't realized, the stub is trading at 3x EPS after adjusting for the cash distribution.  If the company simply hits my earnings target and maintains a decent level of profitability for a couple of years, the stock should at least double.  The exception would be if the merger failed to close, though there is no reason why it should, given large insider holdings voting in favor and lack of anti-trust issues.

Catalyst

- Filing of the merger documents (including CLI pro formas)

- Closing of the deal

- The NASDAQ listing of NewCo

- The initiation of sell side coverage

- The paying down of the CLI term loan

- Eventual positive earnings surprises if the company can deliver revenue growth and/or cost synergies

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