Description

So what would be so interesting about a company that lost $10 a share over the last 5 years while revenue has fallen 40%? Franklin Covey is worth a look due to management simultaneously pulling several levers that should create shareholder value: a) material OPEX reductions b) significant change in revenue mix and margins in the mix c) continued improvement in FCF dynamics reducing inventory and CAPEX and d) a complex capital structure with a hidden asset. We believe these events combined with a non-promotional highly under-followed company with 4 divisions have left investors with a bargain. We think FC is trading at slightly less than 4x EV/EBITDA on August 2007 year end numbers assuming flat revenue.

 

At current prices we think FC has $6 downside (3.4x ‘07E EV/EBITDA-CAPEX, FY year end August). Our upside target is $16 using the mid point of: sum of the parts $15.70 and 10x EV/EBITDA-CAPEX ‘07E $16.20 using what we think are fairly conservative estimates. Our estimates for the next 3 years: EBITDA ’06E $1.40, ’07E $1.75, ’08E $2.25, ‘09E $2.65 (CAPEX 10-14%+/- of EBITDA). In 2009, we think the stock could see $25-30.   

 

First we think FC could get to $2.50 a share in EBITDA-CAPEX in the next 3 years on a $7 stock. Basic blocking and tackling in operating expenses alone should unlock value by paying down debt (in 2005 the Preferred’s cost .40 per share annually in interest, in 2006 cost about .20 a share, by end of 2007 we think this will be -0-). Operating expenses should come down another .20 a share in 2007 from renegotiating the EDS contract in April 2006, (FC out-sources its fulfillment processes to EDS).  So just assuming 2007 revenue is flat from 2006 we could see a 25% rise in EBITDA and significant reduction in debt. We think that revenue should increase at least 5% in 2007 with better margins on both of their divisions, so there could be upside to the 2007E.

 

Description: OSBU: (Organizational Solutions Business Unit): training and consulting, both Domestic and International. International is in 100 countries with 24% EBITDA margins because of royalties from licensees. Domestic is about a 10% EBITDA margin.

CSBU (Consumer Small Business Unit): Retail 90+ stores, Internet-Catalog, and Wholesale business.

 

Company has taken its break-even from $500mn in 2002 to $266mn in 2005. This should continue to drop with the recently re-negotiated contract with EDS. From 1996 through 2001 FC generated $14 in cash from operations per share and CAPEX was $8.50 a share, now CAPEX will be a fraction of what it was then with much better Free Cash Flow dynamics. The CEO should apply to be a VIC member, he has an outstanding letter to investors that is extremely clear and concise on exactly move by move he is doing to create shareholder value. Tank481 did an excellent job of identifying FC as an opportunity to buy at a discount to liquid NWC. A great deal has changed since that 2002 write up. Management has sold off five non-core businesses, closed their Provo office, did sale/leaseback of HQs (generated $32mn cash and bought back from $87mn to $37mn of their preferreds last 15 months), closed 80+ retail stores, reducing WC and CAPEX, while driving more business to their Internet Site. We believe that FC total revenue bottomed out in 2004 at $275mn. FC revenue growth on OSBU has been masked by store closings, nearly 50% of total, over last 3 years.  The turnaround is detailed below:

 

2002 $83mn EBITDA loss

 

2003 $17mn EBITDA loss

 

2004 $6.9mn EBITDA

 

2005 $21mn EBITDA

 

Below are revenue and EBITDA estimates using our assumptions of OSBU 55% - CSBU 45% sales split by 2009 and management’s assumptions using 65%-35% sales split by 2009/2010.

 

 

Our Assumptions - 55%-45% Revenue Mix
	2006	2007	2008	2009
Total Revenue	282	296	312	321
CSBU	142	144	145	146
OSBU	140	152	167	175
% of Revenue	50%	51%	54%	55%
CSBU EBITDA	$            7	$        11	$    14	$      16
OSBU EBITDA	$           21	$        24	$    28	$      32
TOTAL EBITDA	$           28	$        35	$    42	$      48

 

Management's Assumptions - 65%-35% Revenue Mix*
	2006	2007	2008	2009
Total Revenue	284	313	345	395
CSBU	142	144	145	146
OSBU	142	169	200	249
% of Revenue	50%	54%	58%	63%
CSBU EBITDA	$            7	$        11	$    14	$      16
OSBU EBITDA	$           21	$        27	$    34	$      45
TOTAL EBITDA	$           28	$        38	$    48	$      61

 

 

Poor Store Economics
All Figures in $000s		Transitioned
	Poor Store P&L	Sales	Incremental
Revenue	450	100	(350)
Gross Margin	240	55	(185)
SG&A	235	10	(225)
EBITDA	5	45	40

 

Competition:

 

OSBU offers effectiveness/execution management training and consulting to businesses with over 100 employees.  FC serves 90% of Fortune100 companies and 75%+ of Fortune500 companies but we believe many of these accounts are under-penetrated.  Their newer xQ Survey offering has been very well received in the market (they haven’t seen this level of excitement since the ‘7 Habits of Highly Effective People’ release in the early 90s).  To generate new products/services, FC employs world-renowned thought-leaders such as Stephen Covey and Jim Collins (author book “Good to Great”).  FC also recruits up-and-coming thought-leaders offering to include their concepts in FC’s products and giving them a cut of the business.  Thought-leaders prefer partnering with FC instead of opening up their own consulting firm (well known brand, sales infrastructure, reduced time-to-market, etc.).  FC benefits by outsourcing their R&D.  FC doesn’t compete directly with other management consulting firms (McKinsey, Bain,etc.) because it helps its clients to execute its goals – it doesn’t develop the goals.  Its biggest competitor is IIR, (mainly in Europe) which doesn’t have the connections in the thought-leader circles, and some smaller competitors like Organizational Dynamics, Provant, and Forum Corp.  FC estimates that the total market is worth $6bn in annual revenue and is highly fragmented with biggest companies having between $100-400mn in annual revenue.

For more details on what the OSBU does, check these case studies on FC’s website:

http://www.franklincovey.com/about/investor/stories/index.html

http://www.franklincovey.com/about/investor/stories/investools_cs.html

 

CSBU competitors are DayTimer, At-a-Glance, and Day Runner. We think that FC should be able to do well given 15,000,000 people use Franklin Covey Planners world-wide.  Another way CSBU differentiates itself from the competitors is offering in-store training events for small businesses.  This is a recent initiative with an estimated 5.7mn small businesses in the US.  Franklin Covey has built incredible brand recognition also thanks to Dr. Covey’s book 7 Habits of Highly Effective People (having sold well over 20,000,000 copies worldwide) and numerous other books like "the 8th Habit". FC has frequent symposiums around the country with Jack Welch from GE, Dr. Covey, and other famous motivational speakers.

 

Management

 

Bob Whitman CEO, has been with the company for ten years as board member and six as CEO. When things got tough Bob passed on a salary for three years in exchange for 1.6mn options with a strike of $14 which was ~100% above where the stock was at the time of this deal. Bob is the Co-founder of private equity firm Hampstead Group and has significant expertise in turnaround situations.

 

 

What is the business worth?

 

a) Sum of Parts

 

OSBU: FC paid $160mn cash for this business in 1997, when it had $100mn in revenue and $4mn in EBIT. This business bottomed out in 2004 with $109mn in revenue. Today OSBU should do $140mn in revenue and $14mn in EBIT.

 

Comps NCI, FCN, XPRT, WINS, CRAI trade for about 1.5-2x ev/sls using the low end of this 1.5x times $140mn in OSBU revenue $210-280mn or $10.80-$14 per share. Given the leverage in the very high margin (24%) international business due to the mix of royalties and consulting should make this reasonable.

 

CSBU: Retail: valuing the stores at .3x ev/sls or $1.25 a share

Consumer Direct: Internet and Catalog sales valued at 1.25x sls or $3.45 a share

Wholesale: sells to Target, Wal-mart, and Costco, $20mn at .50x sls or .50 a share

 

FC  has NOL;s of $58mn of which $30mn can be used or  .50 a share in value

  

Sum of parts= $15.70 a share

 

 

b) EBITDA- CAPEX

c) Hidden Asset 

The hidden asset is a management stock loan program implemented in 2001-2002 with which employees borrowed money to purchase FC shares.  Due to the decrease in stock price since then management has renegotiated the terms of the loan so that the debtors will pay the company either a total of $48mn in cash or 3.6mn shares (the latter option is the most likely, debtors just hand their shares back).  It has been fully written down (FY2004) and the debtors will pay FC by earliest of March 2013 or when the stock price reaches ~$13.  The table below details the EV including this loan program shares redemption and fully diluting options and warrants (avg. exercise price $12.4 and $8 respectively):

 

Calculation Diluted and Adjusted EV
figures in MM		Options	Warrants	Loan
Share (fully diluted)	25.0	2.3	6.2	(3.6)
Market Cap	$     168.4
Cash	$      36.4	$       28.3	$     49.6
Debt	$      33.8
Preferred	$      37.3
EV	$     125.3

Risks/why its cheap

 

A) No coverage

 

b) No quarterly conference calls, just one annual conference call.

 

c) Complicated: 4 business lines and many moving parts in capital structure

 

d) Relatively illiquid trades 48K shares average daily volume.

 

 

Key proprietary courses are: The 7 Habits of Highly Effective People, Xq survey, The 4 roles of Leadership, FOCUS: Achieving your Highest Priorities.

Catalyst

Cost savings alone in 2007 could approach .40 a share: Preferred down from $88mn to $37mn last 15 months (should have rest paid off by Aug '07 saves .20 a share annually) + Reduction in OPEX of .20 +/- a share from newly re-negotiated EDS.

EBITDA estimates: ’06E $1.40, ’07E $1.75, ’08E $2.25, ‘09E $2.65 (CAPEX 10-14%+/- of EBITDA)

Buyback of common $1.6mn bought 210K shares last quarter at $7.61

Retail stores that are open should generate high returns on capital and closing should reduce WC needs and CAPEX.

Strong name: Covey has sold over 20,000,000 books and 15,000,000 use a FC daily planner worldwide

Critical mass investors should care with $300mn in annual revenue

International is big opportunity with 25% ebitda margins and solid growth prospects

Significant EPS/EBITDA power in model