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Franklin Covey Co. (NYSE:FC)

F2Q11 Earnings Call (Qtr End February 26, 2011)

March 31, 2011 5:00 p.m. EDT

Executives

Derek Hatch – Corporate Controller

Bob Whitman – Chairman, President and CEO

Steve Young – CFO, EVP of Finance, Chief Accounting Officer, Corporate Secretary

Sean Covey – Head of International Licensee Partners

Analysts

Joe Jansen – Barrington Research

Patrick Retzer – Retzer Capital

James DeYoung – Credit Suisse

Bill Gibson – Anderson & Strudwick

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Franklin Covey Company Earnings Conference Call.

My name is [Derrick] and I'll be your operator for today. At this time all participants are in a listen-only mode. We will facilitate a question-and-answer session at the end of the conference. If at any time you require operator assistance, please press star 0 and an operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Mr. Derek Hatch, Corporate Controller with Franklin Covey. You may proceed.

Derek Hatch

Thank you. Before we begin today, this afternoon's presentation, once again, thank you for joining us. And we will begin with our forward-looking statements.

This presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based upon management's current expectations and are subject to various risks and uncertainties including, but not limited to, the ability of the company to stabilize and grow revenues, the ability of the company to hire productive sales professionals, general economic conditions, competition in the company’s targeted marketplace, market acceptance of new products or services and marketing strategies, changes in the company’s market share, changes in the size of the overall market for the company’s products, changes in the training and spending policies of the company’s clients, and other factors identified and discussed in the company’s most recent annual report on Form 10-K and other periodic reports filed with the Securities and Exchange Commission.

Many of these conditions are beyond our control or influence, any one of which may cause future results to differ materially from the company’s current expectations. And there can be no assurance that the company’s actual future performance will meet management’s expectations. These forward-looking statements are based on management’s current expectations and we undertake no obligation to update or revise these forward-looking statements to reflect events or circumstances after the date of today’s presentation.

With that out of the way, I would like to turn the time over to our Chief Executive Officer and Chairman of the Board, Bob Whitman. Thank you.

Bob Whitman

Thanks, Derek. We're delighted to have the chance to talk with all of you today and appreciate you joining us.

Hopefully each of you had seen the press release that went out about an hour ago. And we're also delighted to report that revenues were up 19% for the quarter and 21% year-to-date and that our adjusted EBITDA for the quarter was up 78% and up 68% year-to-date. So, just hopefully we'll have a more fun call and continue the progress of the last many quarters.

I'd like to organize my comments today around the following core headlines and themes. First, we are very pleased with the company's strong performance and results in the second quarter. Second, we continue to be encouraged by the strong booking trends and momentum we're continuing to see in the business. Third, based on these trends, we expect to achieve significant growth in both revenues and profitability during 2011. And fourth, that we believe we have the opportunity to continue the strong growth in the future. So I'll just maybe give some background on each that contributed to the quarter.

From a revenue perspective, revenue for the second quarter totaled $35.5 million, which is an increase of $5.7 million or 19.2% compared to the $29.8 million in revenue that we achieved in the second quarter of fiscal 2010. This is pretty much as expected because of our strong bookings during the fourth quarter and first quarter we expected to translate into significant revenue growth, and they did.

As shown in Slide 4, we're pleased we've achieved growth in all of our major channels. Revenues in our Government Services Group by $2.6 million in the quarter, reflecting the previously discussed government services contract that we were awarded at the end of last year's third quarter. We also achieved growth in all of our other key channels. In fact, seven of the eight direct offices both domestic and international grew revenue during the second quarter as did three of our four field support practices, our international licensee partners as a group, and all three of our national account practices. And you'll remember from last quarter that we -- the sales performance practice had been down a little bit last quarter, reflecting the lower revenue repeat of the kickoff of the big contract last year. We expected it to come back this quarter and they did.

Revenues in our four geographic direct offices in the U.S. excluding the government services region grew $2.4 million or 20% in the quarter, again reflecting the delivery of the training engagements booked during the fourth and first quarters, and all four of our geographic domestic offices grew revenues during the quarter.

Revenues also grew in our international direct offices by 13%, including Japan, where revenue grew 23%. We also achieved growth in our Australian office. Revenue in the U.K. office was essentially flat for the quarter, a slight decline of $77,000. But based on bookings, we expect U.K.'s revenues to be flat, slightly up, probably slightly up to last year during the third quarter.

Our international licensee partner royalty revenues grew 12% in the quarter with most of our international licensee partners growing over the prior year, including nine of our ten largest partners. And then in our national account practices, our education practice grew, the sales performance practice grew, as did the customer loyalty practice. And so, very broad-based, good bookings in all of our areas, which is encouraging for the future.

From a profitability standpoint, our gross margin dollars increased by $3.8 million or 20% for the quarter and our gross margin percentage increased a little bit to 65.1% versus 64.9% in the second quarter of fiscal 2010. And we are really pleased to be able to maintain or improve our gross margin percentage in all of our major offering categories.

Our SG&A expenses declined to 56.1% of sales during the second quarter compared to 62.1% of sales in the second quarter of 2010. In absolute dollar terms, SG&A expenses increased approximately $1.4 million during the quarter compared to the last year, and this of course is primarily due to an increase in associate costs or commissions, there's always an increased commission on the improved sales, compared to prior year.

So the profitability, as we've said, the strong revenue growth and improvements in gross margin and SG&A percentages resulted in adjusted EBITDA for the quarter being at $3.6 million. It is up $1.6 million or 77% compared to last year's second quarter. Year-to-date, as I noted earlier, we're up 68% year-to-date. We've had a good, strong entire six months.

Income from operations increased $2.6 million during the quarter to $1.5 million. Pretax income of $850,000 was up $2.7 million compared to a loss of $1.85 million during last year's second quarter. So on this first point, we felt very good, really good about the company's second quarter performance on essentially every major metric.

The second point is that we continue to be excited and encouraged by the trends we're seeing in the business. We were very encouraged by the continued strong momentum in our bookings during the second quarter; you can see on Slide 5. One of our key metrics is what we refer to as booked days which are commitments for the future delivery of training engagements onsite at client locations. This metric is tracked primarily for our North American direct offices, and so that these numbers are reflecting only of that group and our domestic practices.

As shown in Slide 5, in last year's second quarter, we booked approximately 2,100 days for future delivery in North America which of course is up a lot versus the prior year, and in this year's second quarter we booked approximately 2,750 days for future delivery which is an increase of just over 30% during the quarter.

As shown in Slide 6, the strong booking momentum and the addition of new contracts during the quarter resulted in our closing the quarter with approximately $12 million more in our pipeline of booked days and awarded contract revenue to be delivered in future months and quarters, primarily in our North American operations where we collect this data, than we had at the end of the second quarter a year ago. We expect as normal that the bulk of these bookings will be delivered over the next two to three quarters.

As it has over the past -- well, as always, of course this pipeline relates to government contracts. Starting at the end of last year's third quarter, as you recall, this pipeline jumped a lot because we had this one very large contract. That continues to be a portion of this but not a majority by far, approximately 20% of this pipeline. But because of this government contract, the exact timing of it any day, we're always hopeful that the government will keep the budget going each day, today they have -- to date they have, and we're hopeful that the government will continue to fund this operation so that this revenue will continue.

As you may also recall, I just noted the large new government contract which first reflected in our pipeline report at the end of last year's third quarter, and this added significantly to both the overall size of our pipeline and to the incremental growth in our pipeline then and since. Although we expect to continue to receive significant revenue from this contract in the future, beginning at the end of the third quarter, the year-over-year growth in the size of our total pipeline related at least to this contract will be much less than it was at the end of the third quarter of last year when the first big bump happened.

On the other hand, the vast majority of our total pipeline relates to non-government operations and a significant portion of any year-over-year growth that we've had in the size of our pipeline also relates to our non-government operations, and we expect this portion of the pipeline to continue their strong growth. And again as noted, we still have $12 million more in revenue already on the books to be delivered in the coming quarters than we had at this same time last year. So we expect our future growth to be strong.

Third point is, based on these trends, we expect to achieve continued improvement in both revenues and profitability during the back half of 2011. As a result of this booking momentum and the strength of other lead measures, we really expect to achieve this growth despite the potential impact of the earthquake and tsunami in the operations of our Japanese office. I'd like to just make a few comments about our Japanese office.

Thankfully all the associates and their families are safe and well and most experienced very little damage to their homes and properties, which is good. Our office shook and we lost a couple of computer monitors that fell to the floor, but otherwise we experience very little damage and all of our employees are back at work full time.

We were very fortunate that -- feel ourselves, among our associates, that obviously feel, like you all do, very deeply for the human loss and devastation and the physical and emotional toll these events have taken on the Japanese people beyond belief. A testament to their resiliency, really the resilience of all the Japanese people, is that -- companies' employees are now back at work, things are moving ahead as much like normal as they can be.

As it relates to our business, obviously in the first 10 days following the earthquake, with electricity and transportation disrupted and the nation focused on the tragedy and many people asked to stay home, some of our training engagements were canceled and rescheduled. But this is notwithstanding, we expect that our March revenue and profit would still be higher than planned than last year, with the tsunami happening kind of mid-month. Encouragingly more than half of the training days that were canceled came from one large insurance client who has currently all of their available people focused on assisting and processing insurance claims, and therefore they had to cancel or delay training. But overall, to date, cancellations have not been widespread.

In terms of our own new bookings, our pace has been consistent with the average booking pace for the year, which was ahead of last year. But in this month it will be below the accelerated pace of the previous two months, which is understandable. As a consequence of these new bookings, this ongoing booking activity, we had more revenue come on the books than had been cancelled to date.

So despite any impact from Japan, based on the strong pipeline of booked days and awarded revenue and on the momentum we have, we continue to expect that we'll achieve our adjusted EBITDA range of between $18 million and $21 million in 2011, and we believe that the opportunity to continue to achieve strong performance in the coming quarters and years remains substantial as each of our operations is gaining strength.

Just maybe note that this growth, in terms of what underpins this potential for growth, over the past several years it's been driven by two key initiatives. One is the growth in the size and productivity of our sales forces, both in our direct offices and in our licensee offices. And the second has been the growth in our practices, both those we call field support practices and our national account practices. As you can see on Slide 7, from 2004 to 2010, driven primarily by the increase in the size and productivity of our sales and delivery forces, revenue in our direct offices grew 28% and EBITDA grew 67%.

In Slide 8, during the same year, you see that royalty revenue for international licensee partners more than doubled from $4.3 million to $9.2 million, reflecting revenue growth in their own operations of $25 million to something like $65 million. During the same year, our national account practice almost doubled revenues from $9.8 million to $19.5 million.

So we believe that our seven practice areas: execution, education, speed of trust, sales performance, customer loyalty and our two newest areas that we designated as practices leadership and productivity, each has the potential in the coming years to achieve at least $50 million in revenue, even at relatively low levels of penetration in our defined markets. And towards this goal, we believe that over the next three to four years revenue in these practices should grow by approximately $40 million, with something like 30% flow-through just from those practices alone.

We also expect to nearly double the size of our sales and delivery forces over the next four years, and we expect this acceleration to produce significant revenue and profit growth in our business.

So in summary, we were very encouraged by our results. The momentum we're seeing in the business is good, continue to be strong. We believe we'll have the potential to achieve strong growth in future quarters and years. And we will look forward to reporting on our continued progress as we go through the year.

When Steve Young and I talk to you and to our other prospective shareholders, there are several questions which seem to come up frequently. And today, rather than ask each of our executive team members to give a report on their areas of responsibility, we thought it might be helpful to address three of the most frequently asked questions that we, that Steve and I get, and we'd like to maybe do that as a kind of three frequently asked questions, and then our executive team will be on the line should you have any specific questions.

And the three questions that Steve and I would like to address are the, one, many of you have asked for a review of how our revenue breaks down by practice area. Steve is going to provide that and discuss that.

Second, we get asked a lot of times how we think about the valuation of the company, knowing everything we know, how do we look at the valuation of the company. And I thought maybe it would be helpful just to share three different lenses through which we look at that question.

And third, which we covered in some other webcasts and we'll just do briefly, what should investors understand about some unusual balance sheet items?

So, following this, we'll open it to answer your general questions. And so I'm now going to turn this on Steve Young to address question one which is how our revenue breaks down by practice area. Steve?

Steve Young

Thank you, Bob, and good afternoon everyone. It's nice to be with you.

So as Bob said, for the first time in our conference call, we are presenting these sales results summarized by practice. So if you look on Page 11, you'll see each practice is listed separately and the results are compared to the prior year. We hope that this information is meaningful to you.

You'll notice on Page 11 that six of the seven practices show significant growth. Only one practice is down due primarily to being compared to a very strong result last year. We expect all of these practices to grow and to grow quite significantly in the future.

For several quarters now we've said that we're investing in practices. This means that we've been investing in the leadership offerings, marketing, et cetera related to these seven practices. We believe that our investments are paying off and that the practice leadership has been and will continue to be a crucial part of our growth strategy. Behind each one of these rows or each one of our practices is a developed and developing leadership team. These practice leaders are the ones who are experts in their subject matter, they're thought leaders, they're business developers and closers. They're the ones who are the business leaders who can create and maintain leveraged business models, and the ones who can keep these practices laser-focused.

So you can see the number there, that there are significant growth in the practices. We're excited about the leadership team that the practice leads over each of these practices. We're excited, and based upon the foundation that has been laid and upon our results so far that you can see, we do expect these practices to grow. So that's just a summary of Page 11.

Bob Whitman

I think that's very helpful. As Steve said, we see the expansion of our EBITDA margins cover those fixed costs, and we plan with these different practices, so to speak, and they have to come up through the ground and get profitable. But each of them now contributes meaningfully on the margin more than 30% incremental margins to the bottom line of this revenue growth. Thanks, Steve.

So the second question that we're going to try to address today, excuse me, is how we think about the valuation of the company, because you've asked us that, we felt we should share the same information with everybody. So I'd like to maybe share three perspectives on valuation, we hope you'll find useful. We know of course that you'll do it your own way and you already do it your own way, but nevertheless, it might be helpful to see it as we see it.

First, maybe it's just three different lenses at which to view valuation, at least that we do. One is that, you know, one way of assessing value, our current, the current market cap reflects only the value of our international licensee business alone. I know that's a bold statement, but that's actually how we see it. In my prior investment experience, in attempting to establish a value for a company, we would try to value each of the company's assets and operations and see how far through the assets or operations you had to go starting from the top before you essentially got the rest of the company for free, so to speak.

At Franklin Covey, that analysis, you might conclude that you only have to go through one operation which is the value of the international licensee business before you might feel that you effectively gain the rest of the company for free. Our licensee business includes licensees, you know, 42 international licensee partners, each of whom pays us royalties equal to approximately 15% of the gross revenues. Last year this business generated EBITDA more than $8 million, and this business has grown significantly during the first two quarters.

Our international licensee partners are tremendously capable people who'll have more than double their business over the next five to six years with their collected revenues growing from approximately $25 million to more than $70 million, and our royalties growing from approximately $4 million to $10 million. Our overhead for running this operation of a couple of million is pretty fixed, as we already have our regional people in place. And we believe the growth of these licensees, are poised to double their operations again in the next four to five years as many are really accelerating their progress.

This business, as you know, is non-capital intensive, it generates straight royalties. Our agreements with most licensee partners require annual increases in their minimum royalty payments to us. And as we evaluate the business, it might be similar, not saying that we're correct, but as we look at it, businesses like this have been -- at reasonable multiple, we think this kind of business is maybe 16 times EBITDA for that particular kind of business. And if you would have valued at this, the value -- there's some that trade above and some below, but this is a unique business, the value of the licensee business alone is arguably higher than the current market cap of the company.

For those who might want to use a lower EBITDA multiple, it might mean they have to add the education practice to the licensee before you get the rest of the company essentially for free. But however one values the licensee business, we believe it's worth a substantial amount. We have no intention of selling it, but this provides a significant -- this underpinning of value provides significant downside protection of value for an investor who purchases a Franklin Covey stock, and we hope that with that foundation underpinning it, you can then focus on growth. So that's one lens.

The second lens -- evaluation is one that depends on the peer group to which we are compared. We believe that investors often struggle with which peers to compare it. Within the corporate training business or related kind of things, on one end of the spectrum there are companies that are sometimes referred to as body shops where most of the training and consulting is customized and conducted or delivered by humans and by consultants and therefore viewed as less scalable. These companies in our analysis tend to trade at around 10 times EBITDA. At the other end of the spectrum are subscription services, consulting light or productized consulting companies who primarily sell products and services with a third or less of their revenues coming from consulting billing. These companies often trade at between 15 and 22 times EBITDA.

We're currently valued at a lower multiple than even the lower end of the body shops. In fact, our mix of business -- in fact, though, our mix of our business is much closer to the subscription services consulting or productized consulting companies. You might be interested to know that more than 60% of our revenues come from training products, subscriptions, training materials, online contracts, et cetera. And our onsite trainers are often just the first step in the training process that ultimately result in companies buying manuals, buying intellectual property, et cetera. So it's more an entry point than it is an endpoint. As you know, we have 9,500 active trainers, certified inside the company, they order materials and deliver training [percent], intellectual property contracts and the like.

If you look at Slide 9, perhaps a good measure for looking at the relative scalability of our business on this scale of body shops on one end to subscription service on the other, as shown on Slide 9, a great company like GP Strategies who provide more consulting services, according to the information from their public filings, generates revenue per employee of approximately $137,000 per employee. And they're a great company, just a different model. At the other end of the spectrum, a great company like Corporate Executive Board who's offering more subscription service generates revenue from an employee of $234,000, or someone like Gartner Group who is also more on the subscription servicing scale -- end of the scale, achieve revenue per employee of $289,000.

As you see in this slide, our revenue per employee is actually much closer to that being achieved by Corporate Executive Board and Gartner than it is with the more consulting-oriented company. But unless you see it in that peer group which probably hasn't done a good job of doing it, you might thing we're more of a body shop than a productized consulting.

So finally then the third view is that rather than valuing Franklin Covey on an EPS basis, we believe that valuing it on a total enterprise value to EBITDA, or perhaps even better, on a total enterprise value to free cash flow, is much more reflective of the true multiple. As you know, some of you know, because of the required accounting for the sale/leaseback of the corporate campus several years ago, our campus real estate still appears on our balance sheet as an asset that's being depreciated even though we haven't owned it for at least five years. On our balance sheet is also the related capitalized lease obligation which is also just a lease obligation.

As a result of this and other factors, we report large non-cash depreciation and amortization charges, and in fact our depreciation and amortization is approximately $8 million a year whereas our ongoing CapEx spending is only a little more than $1 million a year. So that gap in the real economics suggests that the total enterprise value of the EBITDA is a much better metric for valuing us than an EPS multiple.

Even a better measure perhaps is to look at total enterprise value to after-tax free cash flow. Because of the significant profitability of the business and the large, approximately $28 million net operating loss tax carry-forward in the U.S. and approximately $10 million in foreign tax credits, if we were to, say, achieve $20 million in adjusted EBITDA, we would generate approximately $14 million of after-tax free cash flow. So at current trading value, at today's closing price, we're trading at only approximately 10.4 times free cash flow whereas certain of our consulting-wide or subscription services peers are trading at 20 to 25 times free cash flow.

So I think -- we're not saying where we ought to trade, but it seems like -- we think the downside protection in value provided by the underpinning of value that's in the -- that the licensee business represents, that there is perhaps for many a miscategorization or misunderstanding that our business today is really productized training and consulting business, not a human-based consulting business. Most of the revenues come from that.

And third, that therefore, on a relative basis, whether it's EBITDA or free cash flow, we're trading -- there seems to be some real room for multiple expansion in the valuation.

So hopefully that's helpful. We do believe also that we have significant opportunities for continued growth, as I mentioned earlier, that today aren't being factored in very much. And so we believe in that, that the company is currently being valued very conservatively.

So, Steve, I'll turn it back to you to address the third quarter.

Steve Young

Thank you, Bob, again. So the third question we are asked often about our balance sheet uniqueness. So I've entitled this session "Hidden Treasures."

We do still have a $28 million net operating loss carry-forward and $10 million of foreign tax credit that will be very valuable to us in the future. We do have a financing obligation on our balance sheet; it's really the capitalization of our rent.

We do have $50 million plus of notes receivable by the reserve against and don't show on our balance sheet. To me these are all hidden treasures even though they -- our uniqueness is when they're understood, most of the time they're viewed positively. You might be interested to know that in the second quarter we paid a revolving line of credit, down by $9.8 million in the quarter.

Additionally, just to complete the slide, if you look at Page 10, the adjusted EBITDA, this is the reconciliation of net income to adjusted EBITDA, and please note on this schedule that we've included share-based compensation as a non-cash item. Obviously that's listed on this sheet.

We've talked about Page 11. Page 12 is selected cash flow information that we include each time. Page 12 shows that our operations generated $5.9 million of cash in the quarter. And lastly, Page 13 is a page that is new to our webcast and conference call. Page 13 shows that for the trailing 12 months our sales have grown 20% and adjusted EBITDA has grown 80%. And you can see the individual growth numbers there that Bob talked about.

So we believe that this was a very good quarter. Thank you.

Bob Whitman

Thanks, Steve.

At this time we'd like to open the call to questions from you all. And so we'll turn it over to our moderator to do so.

Question-and-Answer Session

Operator

At this time, ladies and gentlemen, if you would like to ask a question, you may do so by pressing star 1 on your phone. If you feel your question has been answered or would like to withdraw your question, press star 2. Questions will be taken in the order received. Please press star 1 to begin.

And our first question is coming from the line of Joe Jansen from Barrington Research. You may proceed.

Joe Jansen – Barrington Research

Hi, good evening. Joe Jansen filling in for --

Bob Whitman

Hi, Joe, how are you?

Joe Jansen – Barrington Research

I'm doing good. I appreciate all the color on the valuation perspective of your company. I think it's an extremely helpful, and I agree with you, I think investors have definitely been asking that question.

If I could take this like one step further, if possible, can I get approximate EBITDA margins by business unit, to help kind of get to that value?

Bob Whitman

Yeah, that's a good question. We don't have it prepared today. We have no issue providing that in a future webcast. If you want me to kind of give you -- I could try to give you kind of a general idea today or we can just wait for the next webcast. What would you like to do, Joe?

Joe Jansen – Barrington Research

Any guidance would be helpful. I mean I know you've mentioned international direct -- excuse me, your license practice is somewhere around 85%, 90% flow-through, but the other ones would be helpful.

Bob Whitman

Yeah, let's look at marginal flow-through by business. Here's basically how you'd look at it. Our domestic direct offices, because we cover -- we have certain central overhead that we cover on, you know, we operate a lot of their functions, collections and so forth centrally, gross margins are in the high 60s, say 68%. Our direct selling costs are about 20% . We have, when we hire new sales people, we have a cost of starting them up that compresses yields by about 5% or so. But you can think of, even when you're growing and spending new money, in some cases we're adding new consultants, et cetera, we would end up in a position where between 40% and 45% of incremental revenue would flow through from our domestic direct offices. And those offices make up say $75 million of our business.

Our international direct offices, because they cover all their own overhead, they all do their own accounting, billing, collections, have IT, et cetera, their overhead is heavier. The marginal contribution for that overhead though is very similar. Margins are actually slightly higher. In some cases like Japan where we have third-party sales agents in some areas, our selling costs may be higher. But on the margin, you'd expect in our international direct offices 30% to 35% flow-through on incremental revenues. And in certain of the offices like Australia and even the U.K., you have something closer to 40% flow-through on those direct offices.

You mentioned international licensee -- excuse me -- business, because we've built the infrastructure already and are covering that overhead, incrementally, not 100% but something very close to 100% flows through on incremental royalty, and we expect at this point, since we have teams in charge of Europe, Middle East and Africa regions, the Americas and Asia, that we will add very little additional costs as those businesses grow because we've already staffed up for that.

I'm sorry. Excuse me. In our practice areas, we have -- they have, as Steve mentioned, each has a team, and so we -- and we've added to those teams over the years. And so the flow-through in some of these has been smaller than it will be going forward. But now that we generally have teams in place, our education business and these other direct practices, let's say, education, sales performance should flow through in the mid-30s on incremental revenue. In customer royalty, it's lower because the portion of our revenue is from data collection which has lower margins. But even with that, the flow-through on incremental revenue is in the 20s at this point.

And so, I don’t know, I hope that's helpful, Joe. Is that responsive to your question?

Joe Jansen – Barrington Research

Yeah. No, it is, I appreciate it. Another modeling question, it looks like in Q2 your tax rate was around 64%, I think bringing your year-to-date tax rate, if my math is correct, somewhat around 69%. I think Steve did a good job highlighting these hidden treasures. Since it's kind of difficult to model, can you -- is there any kind of guidance you can give for Q3, Q4?

Steve Young

The percentage that we're using is an approximate percentage of what we expect for the year. So obviously due to the uniqueness that we have, that will go up and down depending on what the actual result is. But we're using 71% for the year.

Joe Jansen – Barrington Research

On an annual basis? Okay.

Bob Whitman

As you know, that's not the cash tax --

Joe Jansen – Barrington Research

Right, it's non-cash based, right.

Bob Whitman

And it's really not -- a lot of it is not reflective of the base business, and includes interest from this more than $50 million taxable income on the interest from this $50 million of receivable that doesn’t appear on our balance sheet from the employee stock loan program. It includes also when foreign cash gets transferred in and includes at least implied tax on that.

Joe Jansen – Barrington Research

Okay. And then, Bob, if I'm looking one, two years out, margins are high, you talked about a lot of leverage in the business, and it looks like incremental contributions in Q2 are high 20s, like 28%, and overall around 10.2% a quarter. How high can that margin get and like kind of what level of revenue would I need to get to?

Bob Whitman

Well, we think -- our targeted EBITDA to sales margin is 17%, and we believe that another $30 million of sales or so would get you very close to that margin. So we've been moving it up quarter by quarter on a trailing 12-month basis. And so I think, take -- to get to 17%, probably it'll take about another $30 million of annual revenue to get there.

You could argue that above that you can just keep going since you're adding, you know, flowing through 40% and 80%, et cetera, but I think we would choose, if we got 17% or so, to accelerate our growth to try to keep the EBITDA margins in that range. I think you'd be trading off growth for incremental profit if you tried to go much higher.

Joe Jansen – Barrington Research

Great. I'll jump back in queue.

Bob Whitman

Thanks, Joe.

Operator

Your next question comes from the line of Patrick Retzer from Retzer Capital. You may proceed.

Patrick Retzer – Retzer Capital

Hi, guys.

Bob Whitman

Hi, Pat. How are you?

Patrick Retzer – Retzer Capital

Congratulations on a great quarter. I'm good.

Bob Whitman

Great.

Patrick Retzer – Retzer Capital

We've sort of done this the last couple of quarters but now we're looking at very little debt, a company that generates a huge amount of cash, and I agree with all of your valuation methodologies, that the company, the stock is way undervalued. So when can we start buying back some stock here?

Bob Whitman

Maybe I can put an answer almost mathematically. Let's say of around $20 million of EBITDA that you generate $14 million of free cash flow, for us the timing of -- even though the business is not that seasonal, because of our big fourth quarter, a lot of that cash is collected, a lot of the exit cash didn't come in towards the end of the calendar year. And in fact, we used about $12 million of that excess cash in December and early January to pay down our credit facility.

At this point in the year, because sales [build in for our] fourth quarter, we are working capital intensive. We also have, via this earn-out, for the speed of trust practice, it did very well last year, and so we used, yeah, a little over $5 million for the earn-out payment in March. And so for us the next big [slug] of cash given that we have pending working capital and we'll be generating obviously profitable operations and free cash flow but investing it through that free cash flow in working capital for the -- to fund this extra $12 million of sales that's in the pipeline, so I would expect, in an answer to your question, Pat, that in November, December next year would have -- that's when we'd start to see that $14 million of free cash flow. And aside from the $5 million that we invested this year that we have $8 million or $9 million, $10 million that we could start to use at that point to return to shareholders at some point.

Patrick Retzer – Retzer Capital

Okay. But based on where we're going here and the fact that the stock doesn’t trade a lot of volume, wouldn't that make sense to start nibbling away on a gradual basis tomorrow even if we have to excess the line of credit to do that?

Bob Whitman

Probably would, and that will be a topic that we've had on the board. We just didn't know exactly the size of the payout, so we also are going a little faster than we had budgeted for the year, which is more working capital intensive. But we also had some large clients, including government clients who because of the budget, you know, the payable gets stretched or the receivable gets stretched a little bit.

So I think philosophically you know we're not opposed. We've used more than $50 million of excess cash in the last year to buy back stock. And so I think you're -- we feel of course the same way. We see the numbers, we just want to make sure we had plenty of liquidity to be able to grow sales as we got another big -- a few contracts. And so our first investment will be that, is making sure we have plenty of working capital to grow and spend working capital beyond that. That's a pretty knowable amount, it's about 18% to 20% of incremental sales. And so I think with that in mind, I suspect you'll see us in coming quarters begin to put in some kind of a purchase authorization and begin to nibble away at this.

Patrick Retzer – Retzer Capital

Okay. Well, from where I stand, the sooner the better. Other than that, keep up the great work.

Operator

Your next question comes from the line of James DeYoung from Credit Suisse. You may proceed.

Bob Whitman

Hi, Jimmy.

James DeYoung – Credit Suisse

Hi, Bob. Nice quarter.

Bob Whitman

Thank you.

James DeYoung – Credit Suisse

Just had -- just one question I wanted to ask you. So given the free cash flow this year of say $15 million, next year another $20 million, so that gets your enterprise value down to, conservatively, $120 million for the company. And we're already more than two quarters of the way through this fiscal year. Pretty soon I think you're going to get more analyst coverage, but people are going to start looking at valuating this company off of next year's numbers. So anyway you look at it, we're at 5.5, 6 times enterprise value to cash flow for the business and growing top line 20%, bottom line conservatively, 35%, 40%.

So is it fair, building on some of the questions that were asked previously, given that the cash flow comes in towards the back half of the year, I'm less concerned about when we buy back the stock, but given what you talked about with the comps and the company currently trading at less than half of the other comps and more like 25% when we start going off of next year's numbers, it's safe to say that you'd be more than comfortable buying back stock at prices 50%, 60%, 70% higher than where the stock currently trades. If you can't get coverage and other managers don't want to buy, take positions in the company because it's illiquid, you'd just be more than happy to continue to take out the [weak hands] as you continue to grow the business. Am I not correct?

Bob Whitman

You're correct. Yeah, any lack of purchasing has nothing to do with the price of the stock. I mean if we believe in the future we've laid out, the price is a small -- the price at which we buy is a small issue, plus it's just making sure that we have plenty of liquidity. For example, if we'd used all of our cash two years ago to buy back stock, we would not have had the money to do the speed of trust practice which has added $10 million, $12 million of annual revenue to what we're doing, if we had invested all of our excess cash in buybacks. And then won this large government contract which required us to fund a significant working capital for six months, we would have at a point where we would have had to shut down sales in order to fund it.

And so for us, well, we understand and I think have demonstrated an understanding that buying back stock at a discount is a smart thing to do. We are managing a slightly more complex equation than that. That enters into the question, but it's only through excess cash flow that could not possibly hurt the growth of the business, then I'm willing to invest.

And so I appreciate -- but philosophically, yours and Pat's comments are exactly on point. We couldn't agree -- we couldn't be more philosophically aligned, we just have other factors to manage besides what's the share price and how much, you know, we've got to make sure that we can grow the business, so.

James DeYoung – Credit Suisse

If there are accretive acquisitions to be made, that's a better use for the cash, I'm all for it. I'm just sitting here looking at a business that's trading at 3.7 times enterprise value to EBITDA on next year's numbers and 5.5 times free cash flow to enterprise value. So, just makes no sense when you look at the comps and we're growing faster than the comps. So anyway, thanks a lot. Good work.

Bob Whitman

Thanks, Jimmy. Thank you.

Operator

As a reminder, ladies and gentlemen, if you would like to ask a question, you may do so by pressing star 1.

Your next question comes from the line of Bill Gibson from Anderson & Strudwick. You may proceed.

Bill Gibson – Anderson & Strudwick

Thank you for the comments on what's going on in Japan. But could you give us a little more flavor of some of the international licensees, specifically Europe which is having their own troubles and Asia, particularly India and China.

Bob Whitman

Sure. Thanks, Bill. Thanks for your interest.

Europe for us is a picture of about nine different licensee partners. And in each of the markets, we have a very -- I mean even though they've grown, many of them have grown like 5x since their start. For example, in the Central European countries, we received I think in the [first year] they had like 300,000 of revenue, so you had 30,000 in licensing fee. Today, I won't disclose their numbers, but they are a multimillion-dollar business, they're growing rapidly.

So our growth in Europe is really driven more by the strength that the team -- because there's such opportunity. We have such low penetration, and the size and quality of the team is more a determinant in the economy in Europe today.

To give you an example, in Scandinavia where one of our strongest partner is, we have some of our strongest partners, you know, the whole population of Scandinavia is less than California, but they have become this year our second-largest licensee partner. They've got a very strong team, they're focused, they're not in high-growth markets, and yet because of the low penetration they've grown for seven, eight years now. Very strong partners.

I hope that -- that's a useful example maybe in Europe, but what we think, the potential is elsewhere, because we've got other partners who are doing that same thing, some who aren't. But we see Europe actually as a very good growth area for us, more partner-specific issues than it is if they're not growing as rapidly, than it is economy or opportunity.

In India, we just had our partners here last week, were just in our Redwood council meeting, we call them our senior management meeting. We view ourselves not as, hey, we have direct offices and licensee offices. We view ourselves having 50 offices, eight of which are owned by the company 100%, 42% which are licensees, but we view them as our partners.

The growth rate in India is extraordinary. They've moved from having four employees six years ago to I think they reported 187 and expect to have another 100 over the next two years. And so their business is exploding. We have a whole team going there next week and we have a new education opportunity going there, the first 25 schools in our K-through-6 Leader in Me practice going on there. China is one of our fastest-growing areas as well.

So we have strong partners in almost all of the economies you'd want to have -- in which you’d like to have strong partners. We have good partners in some areas that you'd -- who just don't have maybe the capital, whatever, to grow in some smaller markets, but in general these partners have made investments, we've made investments in them in terms of time and money and training and products and so forth. And so we feel like this network is poised to accelerate growth.

I don’t know if that's --

Sean Covey

Hey, Bob. Bob, this is Shawn.

Bob Whitman

Hi, Shawn.

Sean Covey

Hi. Do you want me to add a couple of things here?

Bob Whitman

I knew you were in that beta today, so I didn't know if you were on the call. Thank you.

Sean Covey

Sure, sure. So, hi, this is Sean Covey, and I lead our international licensee partners. And just to echo what Bob has said, I think the growth opportunities is immense in almost every one of these markets. If you just look at where they are compared to most of our U.S. direct offices, they're many years behind, and they're doing very well, but the penetration levels are very low. And so we feel like there's just years and years of growth ahead.

China is our largest operation, as you might expect, and the potential there is just -- I think all of these could be very, very significant businesses. We have operations in Thailand; they're doing extraordinarily well. In Malaysia and Indonesia, all of which have great growth prospects.

Looking to Latin America, we find that our operations in Panama and Mexico, Central America, doing very well. Brazil again is just scratching the surface.

But most of the big, emerging economies like India and China and Brazil and Mexico are all growing at 25% plus with really unlimited potential for the next 10 to 20 years. So it's actually an exciting business. And as Bob mentioned, we have very, very good teams in place, and the quality of the partner is usually the key. But many of these operations have 150 employees, 50 employees, 200 employees, and they basically own the franchise to the whole country.

So we've got a bright future and I think the growth prospects are, you know, it's hard to even put a cap on it.

Bill Gibson – Anderson & Strudwick

Well, thank you, Sean. I came in liking the business and you got me excited here with the nearly 100% incremental margins internationally.

Sean Covey

Yeah. It's a good model.

Bill Gibson – Anderson & Strudwick

Thank you.

Bob Whitman

Thanks, Bill. Any other questions?

Operator

I do have a follow-up question coming from the line of Joe Jansen from Barrington Research. Please proceed.

Joe Jansen – Barrington Research

Hey, Sean, you mentioned low penetrations. Any color on that as to why?

Sean Covey

It's just that they're just new businesses. A lot of them have only been around, most of Europe, most of our partners there, have been around only for five, six years. So they're just starting. It's just a lot of them are entrepreneurial startups, some real quality people that got excited about our content five, six years ago. They get going, and just takes time to build the business.

So for example, in Germany, we have an ex-Arthur Andersen partner that runs Germany, and she started about five years ago, and they've got a few million dollar business that will -- I think could grow to be four, five, ten times as big for the next many years. It just takes time to establish a brand, to get some marquee clients going, to build a team around you, and just traditional startup. Some of our more advanced --

Joe Jansen – Barrington Research

Okay. I can appreciate that.

Sean Covey

Yeah.

Joe Jansen – Barrington Research

And one last question, I think we're probably a little bit over here. Maybe this is for Bob. You talked about in the past, I just kind of want to drill down on your sales force a bit. You've kind of laid out the timeframe and when they become profitable. I was just curious, are you seeing any improvements in that on productivity of new hires?

Bob Whitman

We are. And [inaudible] talked about, our belief that we now -- historically we accepted, we thought it is a good model, that we invest approximately $50,000 or $60,000 kind of a net investment, $50,000, $60,000 in the first year that a sales person came on. They generate $200,000 of revenue, so 68% gross margin, we'd cover their cost, and lose $50,000 or $60,000. But in their second year, we get all that back plus $100,000. And by year five they'd be generating half-a-million dollars of EBITDA or so, a little over that, per each sales person.

We believe that -- that was on a ramp that assumed you went through $200,000 of revenue the first year, $500,000 the second, $800,000 the third, $1 million the fourth and then $1.2 million in the fifth. We've observed over the last two years in our national account practices and in other areas where we have narrowed the focus of the sales force, given them fewer offerings and more practice support, that they've been able to ramp up much faster than that.

So we are hopeful that in our new hires we'll fully cover their costs plus $1 in their first year and be able to ramp maybe a couple of hundred thousand dollars faster at each of those checkpoints. So we have evidence of it over the last three years. We're now accelerating the hires and expect that that will be the new model as we go forward.

Joe Jansen – Barrington Research

Are you still on pace? I think you mentioned 2011 15, 2012 20, and then 30, new hires in 2013, is that correct?

Bob Whitman

Is Shawn Moon on? He's not, okay. He's in Europe with our operations there.

But we affirmed that last week during our Redwood meeting. So those are more or less our target. I mean those aren't -- that's kind of directionally right, to amp this up. And what we're doing is hiring these classes around a more specialized. We'll be hiring a certain number of sales people for our new productivity offering and others in education and others for execution. So they'll come in with a specialty or a major, so to speak, and focus on that one area until they get up to a point where they ramp. We think with the supportive practices, getting more repetitions on a narrower set of offerings and a narrower set of target customers, that we can accelerate the ramp, so.

Joe Jansen – Barrington Research

Great, I appreciate that. And I guess the last thing I'll just say, you guys have done a great job in turning this business into a growing and profitable business. And keep up the good work.

Bob Whitman

Thanks so much, Joe. We sure appreciate your all's support.

We're about out of time. Is there one last question.

Operator

At this time I'm no showing no further questions. I'd like to hand it back to Mr. Bob Whitman for any closing remarks.

Bob Whitman

Great. Well, we'd just like to express our appreciation to each of you for joining the call today, also for your support and guidance throughout the years, and look forward to our report for next quarter. So, thanks very much. We look forward to seeing many of you.

Just note that on June 1st in New York, we'll be having an Investor Day, Investor and Analyst Day, and we'll get more details out on -- that will be in connection with Barrington. But Clayton Christensen, who is one of our board members and who's on the cover, you may have seen him in Forbes Magazine last week, a professor at the Harvard Business School, will also be there. We'll have an investor day but he's going to be giving a luncheon speech on kind of their latest research at the Harvard Business School on the money management industry and the paper that he and some others did to write for the Harvard Business Review. So I thought that'd be interesting for you. So please plan on June 1st, we'd love to see all of you there.

Thanks so much. I appreciate it. Thanks.

Operator

Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.

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