Free NPV

Just updating the status of some positions I haven’t talked about in awhile:

CNRD: I sold out of conrad industries this week, around $20 a share. I recommended it at $13 in June 2011 and since that time they paid a $2 dividend. Net return is thus 70%. Still cheap but not nearly as cheap as before. Id get back in on a pullback, or if my other positions reach full value and I have cash freed up. Id also get back in if John Conrad sr dies, as morbid as that sounds, as that could be a catalyst for a sale or go private deal to materialize.

PBG: I sold the stub as soon as it was spunout in the $1.20 range. THAI has been an utter failure and word on the street is management is just way off to still believe in it. Return on this one depends when you bought it and assumes you hedge but its about breakeven for me.

Urbana: I sold it to make room for some other stuff but still like it at this price. Currently trading at $1.10, NAV now $2.03 so almost a double. The NAV got a nice boost when the NYSE was taken out. Their last major private holding, the Bombay stock exchange, is looking at IPOing. When that happens there is really no longer a reason to keep this company around and the hope is Caldwell would liquidate and shareholders finally get NAV. I might have to get back into this one soon.

School Specialty: Been out of that one for awhile, but filed for bankruptcy this week, with shareholders getting completely wiped out. Deep Value investing is a messy world.

School Specialty (SCHS) reported Q4 and full year results a few weeks ago. While results and forecasts came in lower than I had been expecting, the shares nonetheless rallied on the news. I guess this is a good example of investing with a margin of safety – even though I was wrong on my analysis the price was so cheap that it is still a profitable investment. Anyways, on to the results.

The 4th quarter (ends April 30th ) is historically a weaker one for SCHS. They make the majority of their sales in the 6 month period from May to October as schools plan for the new year. Still, there are important early indications of interest from school boards in late April that can help the company get better visibility on the upcoming year. For this quarter, revenues came in slightly higher, up 2% when adjusting for the extra week yoy. Gross profit was lower as margins dropped due to continuing weak demand. There were also some more non-cash charges relating to asset writedowns. These are not important. SCHS lost $22.6 million in the quarter, $17.2 million excluding the special charges, compared to a loss of $13.7 million in the year ago period.

If you remember my earlier posts, I was confident SCHS could achieve at least $50 million in free cash flow going forward. This year they came in slightly below that, generating $60 million in cash from operations but spending approximately $25 million on PP&E and product development costs. This means free cash flow was only $35 million for the year. However inventories increased by $11 million yoy, meaning adjusting for this increase, free cash was around $46 million, only slightly lower than their forecast. While this increase in inventories decreases free cash flows for the year, it actually bodes well for the future as management has indicated that they saw some opportunities and increased demand from the marketplace.

Looking forward, management went over most segments and the strengths or weaknesses that they are observing in each. At the end of the 4th quarter and looking at the first few weeks of Q1 2012, the CEO stated that they are cautiously optimistic. They are seeing some strength in furniture, which has been the segment most impacted by the recession. Sales have come in slightly above expectations and margins are improving. Supplies have not shown as much improvement. The accelerated learning group grew revenue by 4% in the fourth quarter, and hopefully demand will continue to improve. The debt issue was resolved in the quarter, and the company has financing in place to cover all debt redemptions through 2014.

For the 2012 fiscal year, SCHS announced they are expecting free cash flow to be $5 to $15 million after a one time deferred tax payment of $30 million, or $35 to $45 million normalized. This is weaker than what I thought SCHS would report, but like I mentioned at the top of this post, if you invest with a large enough margin of safety you can be wrong yet still make money. The stock rallied hard on the news, up 20%, but has since come back down to the $13 level. At this price you are getting the company for 6.2x free cash flows in what should be a trough year. With the company able to generate somewhere in the range of $60 to $75 million in a healthy economy, at this current price it’s a steal. I might just take slightly longer than I previously thought to realize full value on this trade.

A few weeks back School Specialty (SCHS) reported Q3 earnings. SCHS does very little business in this quarter as the bulk of revenues and income is generated in the first six months of their calendar year (April through September). Revenues and net income were lower than the prior year period, which was to be expected. When looking at this quarter, the most useful information is derived by looking at management forecasts for the upcoming year and trends in the industry. As well, SCHS provided new information about their $200 million debt coming due in November.

First, the debt. SCHS is a highly levered company thanks to their acquisitions but has been working for the past 3 years to pay off much of their debt. This process continued this quarter with total debt dropping to about $255 million compared to $330 million a year ago. A slight cause for concern was a $200 million convertible note only due in 2026 but with the holders of the note having the option to force the company to buy back the $200 million in November 2011. On the conference call SCHS announced that they have renegotiated their lending facility. The facility now provides financing of $300 million with $175 million dedicated to working capital needs and $125 eligible to pay debt. As well, the covenants on the loan are less restrictive, giving SCHS more flexibility in operations.

Subsequent to the earnings report, management announced they have they agreed to roll over $100 million of the $200 million convertible into new, higher interest debt. This debt cannot be put back to the company until November 2014, buying the company 3 more years. In that time, SCHS should be able to generate approximately $180 million in free cash flow and will have the option to buy back that debt. So, with the $125 million credit facility for debt and only $100 million coming due in the next few years, SCHS will not have any additional financing needs. The company can now focus on its operations where it generates substantial amounts of cash.

SCHS maintained its full year guidance of 50-60 million in free cash flow. They reported that while sales are down year over year in almost all segments, the rate of decline has been slowing. They believe we may be seeing the bottom of the cycle and that calendar 2012 maybe be an improvement. In certain segments, such as school supplies, they have actually seen an increase in sales over the past 7 weeks when compared to the year ago period. Other parts of their business, such as furniture sales, have not seen much of an improvement. Management indicated that most of their sales have been of mostly essential supplies which would explain why furniture will be the slowest segment to rebound. The accelerated learning group has also been showing some signs of improvement.

While much has been made in the news over the past few months of state budget cuts to education, most of these cuts will be towards employee benefits. Thus school specialty`s revenues are relatively safe. This misconception that SCHS would be facing continuing declines in revenue could explain why the share price increased 20% on the back of what at first appeared to be a mundane earnings report. Since the release the price has moved back down somewhat following the overall market pullback but it is still above the $14 a share when the initial recommendation was made. Management has managed their financial risk well and the business looks like it will stabilize while making close to $60 million in free cash flow. At these levels, it still looks undervalued.

The following is a guest post for a new investment idea done by my friend Greg (from AAB and now PBG fame). We bounce a lot of ideas off each other and this is one of his favorite investments. Greg took the time to do a nice write up along with graphs and tables. Unfortunately my limited web skills don’t allow me to publish the file in a pretty format here. But you can download the full file for free here. What follows is most of the information from the report, but I highly suggest you download the word document and read that instead.

SCHS – School Specialty

Ticker NASDAQ: SCHS
Purchase Date October 26th, 2010
Price Paid $13.91
Market Price 14
Target Price $22

Description: North American Education Services Company. Operates in three main segments; consumables, furniture and curriculum plans.

Investment Thesis: In difficult economic times, strong free cash flow yields, the non-discretionary nature of the business and a sustainable competitive advantage make School Specialty attractive from a long term risk reward standpoint.

Catalysts: Using free cash flow to recapitalize, share repurchases, federal stimulus for state education, visibility and reversion of per pupil spending.

Business Environment & Competitive Advantage

School Specialty is the largest distributor of school supplies and distributes to 70% of schools in the United States and Canada. Its strong competitive advantage is derived from brand loyalty, specialty products as well as the fact that School Specialty not only offers the products that school boards need, it is the only company to also offer consultation, installation know-how and product maintenance knowledge. By offering such an integrated service, its reputation with schools and its accreditations with the DOE, SCHS has managed to carve out a strong competitive position for itself. They have a relationship and distribution network that would be nearly impossible to replicate from the ground up. This creates significant barriers to entry and economies of scale. SCHS’ brands are established, well-known, and respected in the education world. If SCHS approaches a new school with their products, the school’s decision makers will likely instantly recognize many of the company’s brands and therefore believe they are of guaranteed quality.

Macro Environment & Valuation

Given the steady nature of the market and the predictable growth, it is suitable to value SCHS based on a 5yr forward average FCF multiple. If state finances stabilize, SCHS can be expected to produce $60mln of FCF a year going forward. Even if you take a bear case scenario with no margin expansion and no growth, SCHS will have a 20% free cash flow yield , relatively high profit margins, generally low volatility of earnings and an unassailable competitive position. If SCHS reverts to an 8% FCF yield, its historical average, it has a target price of $22. Even if the P/E or FCF ratios don’t expand, SCHS can repurchase shares or institute a dividend creating total return in the absence of multiple expansion. Currently, the market is pricing in a long term decline in sales, which Margin of Safety believes to be untenable given the nature of the business.

According to the Digest of Education Statistics, the CAGR of K-12 spending in the United States has been 6.8% over the past 60 years. Further, it has increased in every recession but this one. While SCHS’ earnings were hurt in the short term, it responded by divesting of non-essential capital assets, staff and services and managed to maintain profitability despite a decline in revenues. This demonstrated the flexibility of its cost structure and management’s dedication to remaining profitable.

School expenditures are driven by two factors, per student spending and student enrolment, and both are poised to grow. Student enrolment is expected to increase every year for the next ten years due to population growth. Per student spending will eventually see a reversion to the mean as it has following every recession in the last 60 years. The only risk is how long this process will take. In the meantime, School Specialty will continue to cut non-core costs (they have just gotten rid of their mail-order catalogues in favour of an online service) operate profitability and offer a phenomenal free cash flow yield.

Total K-12 Education Expenditure ($Bn)

Why is the Market Undervaluing SCHS?

SCHS is trading at a discount due to fears over state finances. While state finances are battered, they are starting to show some signs of life. Receipts were actually better than expected in 2010. Further, education spending has increased through every recession except in 2007-2009. Margin of Safety observed that while historically some spending was put-off during recessions, those expenditures are often made as conditions start to improve. This phenomenon, largely ignored by the market, makes this an ideal entry point for SCHS.

For bottoms-up investors, the apparently large current portion of long term debt makes the company appear as though it faces imminent insolvency. This is inaccurate as both tranches mature after 2020. The reason they are classified as current liabilities is that they are convertible debt with a puttable provision which means redemption can be forced at the discretion of investors. The debt is highly unlikely to be put as the puttable price is par and the debt is trading above these levels.  Additionally, this debt can be absorbed by their FCF or their $450mln revolving credit facility (L + 1.75% with a 1.75% floor). In terms of the conversation premium, the debt is convertible at $40 and $51 for the two tranches respectively which means that dilution is not an issue until well after our price target is reached.

The write-down of goodwill from a large acquisition in early 2007 created a bad earnings year and likely forced a lot of selling. The write-down was related to a recent acquisition and was being carried at 7x EBITDA. Admittedly, the acquisition of Delta in 2007, at 7x EBITDA, was at too high multiple as the markets were frothier and it did seem like a good strategic fit.

The major risks are a continued decline in house prices and the subsequent deterioration of state finances. Though primary and secondary education has been spared funding cuts to date, it has seen a widespread freeze. Should this freeze turn into actual cuts, School Specialty’s business may be materially affected in the short term. However, as we mentioned, these expenditures can be put off for up to a year but cannot be canceled indefinitely. Additionally, these concerns are more than priced into the stock meaning that only wholesale collapse of state finances could justify the current stock price.