Investment Thesis: School Specialty is the leading provider of supplies into the preK-12 education market, where is generates a majority of revenue through consumable items and sells into 63% of the total school market and even greater brand visibility on the teacher level. Through proprietary brands, curriculum services and consumable products as well as a consultative sales and product development approach, the Company has entrenched itself with customers. The Company entered bankruptcy in January 2013 with a bloated cost structure and high leverage, and emerged 6 months later with a margin improvement plan which has been successful thus far and much more moderate leverage. The Company has improved margins even while education budgets have remained stagnant and is poised to continue to generate cash if the current environment persists and increase cash generation upon Due to the bankruptcy the Company’s current EV/EBITDA is ~6.33x (lower depending upon acceptance of certain add-backs), of which leverage accounts for ~3.85x (again, lower depending upon add-backs). This 6.3x max valuation is a discount based on the aforementioned strengths which lead to positive cash generation that will enable the Company to continue to delever over time. Furthermore, as the Company continues to delever there could be an opportunity to refinance the high rate ABL revolver (4.00%+) and Term Loan (9.50%). As outline further below, the Company could generate a sufficient equity IRR of ~13% over 5 years solely through the repayment of debt and a constant EV/EBITDA, while in practice a reduction in leverage along with continued cash generation (which has been improving in recent periods) could result in value expansion as well. Please note the stock is very thinly traded and about ~63% is held by the top 5 owners (all hedge funds) and as the equity may not trade rationally over the short term. I have also made various attempts to get into the name and continue to do so however my brokerage has been unable to execute the orders, my order size may be too small so perhaps larger investor with the required risk tolerance would have an easier time.
School Specialty Overview and Background:
School Specialty is the largest provider of non-textbook supplies to the preK-12 education industry in the United States. The Company was founded in 1959 and acquired by US Office Products in 1996 and spun out in 1998. In 2005 the Company had agreed to get purchased by Bain for $1.5Bn, however the deal was terminated due to the termination of certain financing agreements. In January 2013 the Company entered bankruptcy as a result of a bloated cost structure, education budget cuts, a poorly executed new pricing strategy roll-out and overleverage. In June 2013 the Company emerged from bankruptcy with significantly less debt and a plan to right-size the cost structure. Soon after emerging from bankruptcy the Company hired a new Interim CEO and in April 2014 hired current CEO Joseph Yorio. In February of 2016 Steel Partners made a $75/share offer to buy the Company at which time the Company was trading for ~$70/share, the buyout was never consumated. Today, the Company functions through two primary business units:
Distribution (~85% revenue): The Distribution segment supplies products, solutions and services to the preK-12 market, channel partners, and the healthcare market. The Company’s Distribution segment is comprised of the following product groups: Supplies, Furniture, Instructional Solutions, Student Organization and Planning Products, A/V and Security. The Company sells both third party and private label supplies, functioning as a sole source supplier of a number of third party products. This segment includes a classroom/school design and furniture business.
Curriculum (~15% revenue): The Curriculum segment is a publisher of proprietary and nonproprietary core, supplemental and intervention curriculum in the following areas: Science, Math, Comprehension, Vocabulary, Spelling & Grammar, and Reading & Math Intervention. The Curriculum segment designs its products to meet state by state standards and will also work with customers to specialize products.
The Company estimates that ~70% of revenue comes from consumable products and that 90% of business is repeat business from existing customers. Furthermore, the Company estimates that they sold product into 63% of the 137,000 schools in the united states and reached a majority of the 3.1MM teachers in those schools in 2015. The Company’s proprietary products accounted for ~40% of revenue. Both business segments sell digital product options.
- Market Penetration: The Company estimates that in 2015 it sold into 63% of the ~137,000 schools in its market (US preK-12) and reached a majority of the 3.1MM teachers in those schools. The Company is the largest non-textbook supplier to this end-market and entrenches itself within customers via proprietary, consumable and specialized products. The Company’s revenue has been stable since the bankruptcy, growing 1.42% from FYE 2014 to FYE 2015 and 1.93% from FYE 2015 to LTM 9/30/2016.
- Consumables and repeat revenue: Repeat revenue accounts for 90% of revenue and 70% of revenue is generated through the sale of consumable products. This sale of consumables and generation of repeat revenue results in more stable cash flows and further entrenches the Company within a customer’s operations, as the customer must reorder the consumable items each year and can expect consistency through replacing the order with School Specialty. Furthermore, the Curriculum business provides relatively sticky revenue in that it works with customers to specialize curriculum’s to specialized needs.
- Product Breadth and Depth: School Specialty is the largest distributor of non-textbook supplies to the markets they serve, providing supplies ranging from arts and crafts to science to janitorial supplies, creating a comprehensive supply source for an increasingly sole source focused market. The Company provides over 100,000 items, of which 40% are proprietary products (which generate higher margins) and the Company provides certain third party products as a sole supplier.
- Improved Cost Structure leading to Margin Growth and stable cash flow: EBITDA margins have improved in each period since the bankruptcy as the Company has reduced its bloated cost structure through headcount reductions, reorganization/alignment of business units, realigned base compensation vs. performance bonus system, distribution channel improvements and more. EBITDA margins from FYE 2014 to LTM 9/30/2016 have increased 1.66% from 5.44% to 7.09%. Furthermore, throughout this period Free Cash Flow (EBITDA less Interest less Taxers less Capex less Mandatory Debt Amortization) has average ~$9MM. As the Company continues to focus on paying down debt, note $36.5MM net debt reduction from 3Q 15 to 3Q 16, interest expense is expected to decline leading to improved cash flow.
Risks and mitigants:
Competition: The Company operates in a competitive and fragmented market, with a majority of players being family or employee-owned, regional companies. School Specialty is the largest player in this fragmented market with material market penetration and the widest breadth of products. The Company’s scale allows for competitive pricing, supplier power, and increased resources when compared to smaller local players. Approximately 40% (~$255MM) of the Company’s FYE 2015 revenue was generated through the sale of proprietary products, meaning aside from solely distribution, the Company’s proprietary business alone is a material player in the industry.
Leverage: The Company’s 9/30/2016 leverage is ~3.77x Senior and 4.20x total (based on ~$45MM EBITDA), with senior and total debt of $172MM and $192MM which represent a $36.5MM reduction in net debt from 9/30/2015. Additionally the Company refinanced its debt on with better terms in 2015. The Company’s debt levels are significantly below pre-bankruptcy levels of over $300MM while EBITDA has expanded since. The Company has and is expected to continue to prioritize debt paydown going forward, which should result in increased equity value conservatively assuming a constant enterprise value (further discussed in valuation section below). In practice, a meaningful reduction in debt with continued cash flow stability would likely cause valuation multiple expansion.
2013 Bankruptcy: The Company entered bankruptcy due to a combination of factors including state budget cuts, high leverage, and a high cost structure. Since bankruptcy the Company has realigned it’s salesforce model, integrated disparate departments to optimize efficiency and reduced headcount from 1,450 to 1,180 in 2015, all resulting in an annualized SG&A reduction of ~$20MM. The Company’s bankruptcy had a negative effect on the confidence of customers in the Company’s ability to fulfill large projects, which primarily effected the remodeling and construction project revenue, which does not account for a significant portion of total revenue. The Company has proven the ability to maintain its leading position in the market post-bankruptcy through revenue growth and significant market penetration (estimated at 70% of addressable schools FYE 2016 and 63% for a shortened FYE 2015). Furthermore, the Company’s post-bankruptcy performance improvements have come well budgets remain muted, which demonstrates that Company’s ability to withstand end market headwinds under the improved cost structure.
Industry and Budget Overview:
Demand for the Company’s products is a function of preK-12 student population, while expenditures on the Company’s products is driven, in a large part, by education budgets. Historically, this market has been stable and growing, even through historical headwinds in the greater economy (1981-83, 1991-1992, and 2001-2002), while the 2009 recession had a negative impact on education spend. Total expenditures for public elementary and secondary education decline from $610Bn in 2008-09 to $602Bn in 2011-2012.
In 2014-15 public education funding for school districts came from three primary sources: state funding (44%), local funding (44%) and federal funding (12%). While the recession resulted in reduced budgets which affected education spend, budgets are expected to expand going forward. Furthermore, education budget allotment is often tied to the number of pupils which is expected to rise in the coming years, which should positively affect education spend.
While the Company experienced negative performance due in part to the recessions effect on education spend, the post-bankruptcy cost structure and debt levels position the Company for better performance while facing demand headwinds. As the Company has generated improved performance in a stagnant budget environment, the projected increase in elementary and secondary education spend should positively impact School Specialty.
The Company’s current EV/EBITDA of ~7.06x (on LTM 9/30/2016 Adj. EBITDA of $45.8MM) is comprised of ~4.2x total debt and ~2.4x total equity. The below analysis assumes conservative EBITDA growth of ~2% annually from 2017 through 2021, as a result of increased cost savings due to reorganizational strategies as well as projected industry growth, all free cash flow is then assumed to pay down debt, while a constant EV/EBITDA multiple is used to derive an equity value in each period assuming no multiple expansion. As shown this results in relatively material per share equity growth over the projected period, which leads to a ~12.7% equity IRR.
- 2% EBITDA, Capex, Working Capital, and Taxes growth from 2017-2021.
- Constant EV/EBITDA multiple
- Debt paydown converted to equity value
- Constant shares outstanding
Public Comps: The below public comparables universe ranges from school/offices supply companies to curriculum and education content providers. As shown the Mean EV/EBITDA of 9.5x is meaningfully above the 7x SCOO valuation, while SCOO’s leverage of 4.20x is 1.7x above the mean leverage level of the comparables universe.
Ownership and Management: The Company has a concentrated and sophisticated shareholder base (see below for top shareholder breakout). In early 2016 Steel Partners offered to buy all outstanding shares for $75/share when shares were trading ~$70/share, the offer was not accepted. The sophisticated shareholder base should result in a high level of shareholder accountability, however also results in very low traded volume and could result in extraneous factors leading to price swings. The below table breaks out major shareholders:
CEO Joseph Yorio assumed the position in April 2014 and made $1.2MM in cash compensation in 2015. Prior to joining SCOO, Mr. Yorio was CEO and Chairman of NYC Global, a distribution and logistics Company, and CEO of Academi (FKA Blackwater). The Company’s CFO, Ryan Bohr, has been with the Company since 2014 and prior to SCOO co-founded Torch Lake Capital Partners, a special situations private equity fund.
The Chairman of the Board, James Henderson, was a former executive at Steel Partners, served in interim executive roles at SCOO post bankruptcy and is currently the CEO of ModusLink. Mr. Henderson received $133.3k in compensation for his board capacity in FYE 2015.
Given the Company’s ownership structure, lack of equity liquidity and prior bankruptcy, School Specialty would only fit in a portfolio with a high-risk tolerance and patience, however given the aforementioned credit strengths and current valuation, the Company is in a position to create long term shareholder value through the continued generation of cash flow and reduction of debt.
- Continued pay down of debt
- Take Private
- Increase in K-12 spending
- Forced selling from a fund
- Margin Pressure leading to inability to delever
Disclosure: I am long SCOO