Every now and then, the market gives you the chance to buy a company whose stock trades like a call option, but actually has a decent chance of survival. School Specialty common stock represents just such an opportunity. With the exception of a plague of locusts, just about everything that could have hit the company has: a 30% reduction is state spending on schools, the housing crash which virtually halted all new construction – decimating the company’s furniture business, a CEO search (now resolved) that drags on for months, a potential second breach of bank covenants, and to top it all off - year end tax loss selling and a beginning of year expulsion from the S & P 600 index which pole axed the shares down to current levels. The company began its life as a spinoff from the now defunct US Office Products and the controversial founder of that company, John Ledecky, who made his (and lost other investors’ fortunes) playing the roll up game. Ledecky is, unfortunately, still on the board but that has been true through various ups and downs at the Company. Unlike the parent company, SCHS has spent the past several years actually integrating their various acquisitions and putting the whole company on ERP. So the sales force, purchasing, financing and logistics functions are all now centralized. Headcount has dropped by almost 1,000 down to 1,800 as part of that effort but also as an attempt to cut non customer facing sales or service functions during this severe downturn. The Company is down to two stand alone divisions: the higher margin technology intensive Accelerated Learning, which is focused on more curriculum, instructional and digital based solutions and Educational Resources, which provides more basic school supplies and furniture to school systems around the country. The company carried 80,000 SKUs of which maybe 2,000 overlap with the Staples and Office Depot’s of the world with whom they compete on commodity supply items. They also have about 3,000 wholesale and retail competitors many of which are mom and pop operations of under $10million in top line. Many of these competitors pick off a category like special needs or sports in which they specialize. Few if any have the breadth, assortment and pricing power of School Specialty. Due to the recent expulsion from the S&P, the stock has traded down to all time lows. At these levels, you are the beneficiary of cost cutting, the ERP implementation, business rationalization, a potential bounce in school spending, and the new CEO who was hired from Houghton Mifflin with both operational expertise from his days at Koch Industries and technology and curriculum expertise needed for the Accelerated Learning division. It is worth spending some time on the new CEO, who was given a large options and restricted stock package struck in the 2s. While he has turnaround experience, he is primarily from the education field. It would be odd for someone to move himself and his family from sunny Florida to chilly Wisconsin just to take a company into bankruptcy.
$50mm of EBITDA is their guidance which was relatively recently reiterated. It could be a bit more or a bit less. Should it be less and cause a covenant breach, I believe they will get a waiver as they did last year for a relatively minor fee. I believe that the major bone of contention between the longs on the shorts is 1) Whether this year's guidance represents some kind of trough. 2) Should SCHS miss that guidance whether or not a covenant breach will be terminal should it occur.
At $3 or so it is a cheap call option on positive outcomes that the shorts seem to believe are impossible.
After years of revenue and gross margin declines, the company sees both trends reversing. The leading industry forecaster sees a 15% increase in school building in 2012. Since schools are funded by muni bonds, they are less likely to be cut or curtailed. This would be a shot in the arm to the moribund furniture side of their business. The company is raising prices after years of cuts and has its workforce down to a place where not much needs to be added should sales return. Their customers have been relatively slow to migrate to the web but that is accelerating as well from 35 to 50% which should again help on the cost side. The company is benefiting as school systems reduce their number of vendors. SCHS also runs a consulting division that helps customers order from the Company more efficiently but also procure other things like cafeteria services more effectively. The combination of all these factors should see about a100basis point pickup in margin each year for the next two years along with some modest revenue growth. In addition, the company has about $5mm to $40mm in noncore zero to low EBITDA producing assets that are in the process of being divested. The high end of that range would yield over $2 a share in value and greatly reduce the balance sheet risk. Valuation is a bit of an art in this case. The company has a $57mm equity cap with about $275mm of net debt for a $332mm EV against $50mm of EBITDA most of which turns to operating cash due to low capital intensity of the business. The Company trades for about 6x EBITDA. The company's average multiple over the past 9 years is 8.4x. If the stock were to trade at that multiple, it would be worth ((8.4 x $50mm) -$275mm in debt)/19mm shares = $8.4 a share. I believe that the company has enough liquidity to handle its debt and that the stock represents a call not only on a return to an average multiple but also a call option that population growth combined with a bottoming on state school spending (down about 30+% since the peak), could create growth in cash flow and appreciation far greater than that offered by mere mere multiple expansion. A more optimistic scenario looks like this: assume the company realizes about $25mm from its non core assets divestitures and net debt drops to $250mm. If revenue were to rebound 10% to about $808mm and gross margin were to improve 200basis points, EBITDA could improve to something more like $102mm. It is worth remembering that these numbers are well below the peak. Taking the EBITDA of $102mm x 8.4 yields $856mm in enterprise value. If you subtract the $250 in net debt and give no credit for cash build and divide by 19mm shares outstanding, the stock is worth almost $32 a share.
Catalysts A rise in school spending and construction and the corresponding increase in revenue and EBITDA. No covenant breach and or a minor payment to the banks like the one they gave last year. Deleveraging and an end to index and tax loss selling (already happening). It could be taken private like Bain tried to do a few years ago in the 40s.
I was just going through last quarter's report and realized that net debt came in at $277mm versus my $275mm, but close enough and that the company reiterated their full year guidance, which has a midpoint EBITDA of $50mm. In other words, the company's performance is so far tracking what I expected. They were in compliance with all of their covenants and the new CEO has some interesting ideas about growing the business. If he can achieve even modest growth, the impact to common equity could be enormous. Just $10mm of incremental EBITDA at a modest 6x multiple is over $3 a share in value or a double from here.