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School Specialty (NASDAQ:SCHS) has seen its earnings and stock price been beaten down by one of the worst state budget crisis America has seen. Despite many short-term and temporary negatives, SCHS is still a large and dominant player with a litany of competitive advantages. Because of temporary negatives, SCHS is cheap on both depressed and normalized earnings. For those with the conviction and the stomach to handle some short-term pain, this is an opportunity.

SCHS is one of the largest providers of supplemental educational products and equipment to the preK-12 education market in the United States and Canada. There are 3 broad categories of goods that they sell. The first is a lower margin (gross margin in mid 30s and only 20% products proprietary) supplies segment that sells basic school supplies as well as more specialized supplies that supplement specific curriculums. These goods are consumable, and revenues are more steady. However, these supplies are more of a commodity. SCHS competes with many in this category, including the many large and small direct school suppliers as well as giant retail school supply vendors, such as Office Max, Office Depot, Target and Wal Mart. The company does have advantages over these competitors here, however, which I will get to later.

The second category is a furniture line for schools (which the company groups in with the supplies segment and calls it Educational Resources). This category's revenues and margins are cyclical, and very depressed right now.

The third category is called accelerated learning, and it consists of both core and supplemental curriculum programs. This is a higher margin business (gross margin in mid 50s and 100% of the products are proprietary) that is slightly depressed right now, as customers delay major curriculum purchases (which are bigger ticket) during tough times. SCHS has about 7% market share here, and competitors include textbook publishers and smaller niche providers. The curriculums are alternative, they do not rely on textbooks. It is based on self-paced instruction, and relies on technology, which the marketplace is moving towards.

INDUSTRY

The PreK-12 grade education market is normally very stable. The market grows consistently in the mid- single digits. It grew through every recent recession, except this one, of course. State budget shortfalls and unprecedented reductions in school budgets have caused the industry to contract, and every section of SCHS has contracted. School construction spending, predictably, has been hardest hit, going from a spending level of $20 billion to about $13 billion as of now. Most industry experts under the age of 90 agree that this is the worst the PreK-12 market has been since they have been observing it. However, long-term prospects are bright.

School expenditures are driven by two factors, per student spending and student enrollment, and both are eventually poised to grow. Student enrollment is expected to increase every year for the next ten years, with population growth. Per student spending will eventually see a reversion to the mean. School budgets are squeezed right now, as state budgets are a mess and property tax income has fallen in most areas. Fifty percent of school spending comes from states and 40% comes from property taxes. States get most of their revenue from employment and sales taxes. Both have obviously been weak recently, but taking a long-term view leads me to believe eventually employment will improve at least a little and consumer spending will eventually increase. Admittedly, this may take many years, but SCHS has the cash flow and the wherewithal to wait for the growth to come. It's worth noting that many states saw revenue increases this summer, so a long-term view might not even be necessary.

SCHS INDUSTRY ROLE AND ADVANTAGES

SCHS is by far the largest distributor of school supplies in this country. SCHS reaches nearly 70% of the nations' schools. They have a relationship and distribution network that would be nearly impossible to recreate from the ground up. This creates significant barriers to entry and economies of scale. It also gives them advantage over suppliers and product development partners. On many curriculum products that are developed, the company has little cost until the back end. In other words, they only pay if the product proves successful.

They also have little to no geographic or customer concentration as they operate in nearly every part of the country. Not one state represented 10% of revenues. This also lends them a unique ability to capitalize on both regional and national trends before the competition can recognize them.

Most companies in the market are specialty companies, selling just one or a few products. SCHS sells nearly every non-textbook item a school needs. They offer about 75,000 different products. It is much easier for a school to just buy every or most items from SCHS than to buy dozens of individual supply, curriculum, or furniture sources. 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 companies brands and already know what to expect if products are ordered. This means that many products are easier to market, and this is an advantage that few of the other 3000 competing companies have.

Many SCHS products (mainly furniture and curriculum) benefit from high switching costs. At small schools especially, the schools don't know much about construction and furniture implementation. SCHS comes in with expertise on what schools want and how to handle the process. For a school to switch to a competitor, they are exposing themselves to the risk that both the products and process will be of lower quality. The same goes with the curriculum segment. SCHS's curriculum and educational products are highly successful, and schools have little incentive to switch to another curriculum if the one implemented is already working.

VALUATION

Management has guided $40-50 million in free cash flow for fiscal 2011. This guidance was down, and caused the stock to tank recently. However, this includes a one-time cash $16 million dollar expense that should be added to enterprise value, not subtracted from earnings. The company also spends about $10 million on product development, which isn't included in FCF. We'll assume that the $10 million produces no growth, so we'll expense the total amount. Taking low-end guidance, adding the $16 million one time expense, taxes and interest expenses, and subtracting the $10 in product development million produces an EBIT of about $90-95 million (depending on what interest expense will be).

Apply the company's historical 40% tax rate and you get roughly $55 million in economic earnings. Compare this to the current Enterprise value of about $600 million, and you get a multiple of about 11.

GROWTH

For just 11 times earnings, today's investor gets much growth for free. I expect SCHS's market to grow, as it reverts to the mean and resumes the long-term historical growth rate of about 5%. The federal government recently allocated $10 billion to schools for hiring back teachers. This could be a short-term windfall for SCHS as it frees up school's other funds. Company-specific growth is also very possible, as SCHS expands their product offering, including the higher margin Curriculum products, into more urban areas. Urban areas are a natural fit for SCHS's curriculum products, as they do not rely on reading skills, which many urban students are lacking.

In fiscal year 2008, SCHS generated about $70 million in economic earnings. This was after the furniture business took a hit. Considering that management says they have taken $35 million in fixed costs permanently out, a mere return to pre-crisis conditions could produce a doubling of earnings from today's level.

DEBT AND RISKS

SCHS has much more debt than I like to see. However, SCHS has very steady earnings. It is odd for their industry and revenues to contract this much. But, it is also odd for school spending and state budgets to contract this much. Even on these depressed earnings, SCHS still has a better than 3 times EBIT to interest expense (after product development). SCHS used to have an appetite for acquisitions, which piled up the debt load. Bad acquisitions are probably the biggest risk to investors. However, since 2006 management has minimized acquisitions. In the last 4 years, they have spent $255 million on stock buybacks and debt retirement. Management is now very focused on reducing debt and is doing so at a feverish pace. I wouldn't be surprised if a buyback program also surfaces while the shares are so depressed.

In summary, I believe SCHS is a high quality business going through short-term issues. The stock is cheap and has many growth opportunities ahead.


Author's Disclosure: Long SCHS

Source: School Specialty: A High Quality Business for the Contrarian Investor