Description

School Specialty (SCHS) is an attractive long-term investment at current prices. The company’s stock plummeted dramatically this fall as a massively levered deal to go private with Bain Capital fell apart for reasons discussed below. In addition, the company is currently underappreciated for a variety of other reasons including but not limited to 1) the lack of Wall Street sell-side coverage or true comparables, 2) the fact that its stable, recurring cash flows are dramatically in excess of its GAAP earnings and, 3) recent flattish top-line growth due to impairments to state budgets in recent years.

Overview: The company is the largest nationwide provider of school supplies which are classified in two groups: education essentials and specialty products. The essentials products historically represented the bulk of the company’s business and include the sale of a wide range of classic school supplies from pens and crayons to desks and other furniture. The specialty products, which will account for approximately 70% of EBITDA in 2006, are a diversified mix of educational supplements where SCHS typically owns the content or has exclusive rights to distribution. The company has grown dramatically through acquisitions in recent years and is continuing to bulk up its product lines, particularly in the specialty side of the business.

Business Quality: I believe that this is a very high quality business for a few reasons:

1): SCHS is by far the largest distributor of school supplies in this country with sales that are approximately 8x those of its nearest competitor. In fact, the company’s 10K states that SCHS reaches “virtually all of the pre-K-12 schools” and “nearly all of the teachers in the United States.” This is a platform that represents thousands of relationships and distribution points that would be next to impossible to recreate. It gives the company significant economies of scale, an ability to carry by far the greatest number and range of SKUs and a critical ear to the ground of its customer base such that it can monitor and capitalize on regional and national trends before the competition.

2): Demand for the company’s products is very stable and is driven by population growth and funding for schools, which is not something that politicians can easily cut. Funding per student in this country has increased steadily over a long period of time and should continue to do so far out into the future. The company’s 10K actually has good data on these trends if people are interested. Funding did stagnate somewhat in recent years as state budgets collapsed but should pick up as these budgets have gotten healthier in more recent months. We believe over time, the industry should produce annual growth of around 4% top line.

3): The business model is extremely capital light as the company manufactures less than 10% of the products it sells. I don’t know of too many $1bn revenue companies that require maintenance capex of $10-12mm annually like SCHS.


Bain Deal: As mentioned previously, Bain Capital agreed to purchase the company, subject to financing at $49 per share this past summer which equates to about 11.5x EBITDA. The deal, which was to be done at a level of debt / EBITDA of approximately 7x, fell apart this fall for a few reasons. For one, the company had been optimistic that it would return to more normalized levels of organic growth for the calendar 2005 school selling season given the healthier state budgets but instead saw a more flattish top-line year and had to reduce guidance. While this was disappointing to see, I do not believe it indicates any structural impairment of the model but rather a decision on the part of many of the schools to spend their first surpluses in a few years on deferred infrastructure and other projects in addition to increased transportation and energy costs. In addition to the soft season, there was some turmoil in the high yield markets at the time the deal was to get done this summer which made the environment more difficult. Those factors aside, the fact that a buyer like Bain, after a thorough review, thought that the business could support that type of leverage and also that it could generate a sufficient return at $49 share serves as at least a modest positive data point.

Cash Flow / Valuation: SCHS is currently trading at 11x its estimated FY 07 (ending April) recurring FCF per share of $3.36. This number is calculated as follows:

- midpoint of EPS guidance of $2.20-$2.40

- ADD - deferred taxes of $13mm (this is the result of goodwill that is not amortized for GAAP purposes but that is tax deductible over 15 years, note that this includes an increase of $3-5mm going forward related to the recent purchase of Delta Education).

- ADD - expected D&A of $22.5mm

- LESS - maintenance capital expenditures of $10-12mm (note the difference here from D&A is mostly purchased non-goodwill intangibles such as customer lists that do not need replenishment)

- ADD - amortization of development costs of $9mm

- LESS - estimated costs of development of $8mm

Margin Opportunities: Management believes it can achieve margin improvement on an annual basis of 50-80 bps for a long period of time going forward. This will come from a combination of increased sourcing from the far-east which is just getting underway and more private label products which is also an initiative that has recently been ratcheted up. All in, the company is targeting 15% EBITDA margins in the next few years up from the current 11% that SCHS currently enjoys.

Balance Sheet: Pro forma for the recent acquisition of Delta, the company is levered at approximately 3.5x debt / EBITDA (and dropping) which is very conservative given the business quality. This company should be able to easily support 5-6x leverage. Based on their comments, it seems that SCHS is likely to get to such a level primarily by making acquisitions. While I would prefer that they buy back stock at these levels, it is a highly fragmented competitive environment and the company believes it can make high quality acquisitions at the 6-8x EBITDA.

Summary: SCHS represents the opportunity to buy a very stable, high quality business with a solid balance sheet and a leading competitive position at a very attractive free cash flow yield. Although growth as been a bit sluggish this year, the company is poised for steady top line growth with state budgets picking up and should see consistent margin expansion for the medium term.

Catalyst

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