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School Specialty (NASDAQ:SCHS) is an impaired business in an accelerating rate of decline. SCHS sells classroom products such as supplies, furniture and basic learning materials primarily through direct sales reps. Cyclical school budget constraints, increased competition and product obsolescence have made the future of this company very bleak, yet SCHS still trades at 10.5x EBITDA with -$20.3M in earnings and -$27.8M in CF. Unsustainable leverage (8.5x net debt/ EBITDA) and contracting margins on a high fixed cost structure make this stock a likely zero over the six months.

Background

SCHS grew revenue through continuous acquisitions from 2000 until it ran out of borrowing capacity in 2009. These acquisitions saddled the company with debt and have proven to be a failure as returns on capital have incrementally declined from 7.6% in 2005 to 5.5% in 2009 to the present 0.6% LTM. Poor integration and dysfunction across the business led them to take a $411M goodwill impairment last year, effectively writing off the majority of these acquisitions. Earlier this year the CEO announced he was going to leave. Incidentally the company has not been able to find a replacement since. In the last quarterly call, they indicated they are still 60-90 away from making any announcement on this front. This is particularly troubling given the increasing problems within the business.

Operating Segments

SCHS divides its business into two segments: 1) Educational Resources ("ER") that sells basic classroom supplies and office products, supplemental learning materials, physical education equipment and furniture and 2) Accelerated Learning ("AL") that sells planners and curriculum products. ER contributes 71.3% of revenue and 60% of gross profit while AL contributed 28.7% of revenue and 40% of gross profit. AL has historically been a substantially higher margin (54% gross margin), higher-return business for SCHS. This segment was largely driven by the sales of higher price point planners to teachers. As I will discuss below, this business is essentially permanently gone, one of several dynamics that impair School Specialty. (Please note all financial data is presented on the SCHS fiscal year which is one quarter behind the calendar.)

Industry

Unfortunately public education is often the first area to face government spending cuts. Municipal and state budget constraints are increasingly pressuring K-12 school schools. The most discretionary and consequently the hardest hit are classroom supplies and new furniture - precisely the areas in which SCHS focuses. Governors' budgets will be released in early January. Given fiscal situations at the state level, larger reductions in education nationally are inevitable. In anticipation of leaner budgets, teachers and schools have already begun shrinking their expenditures and are trading down to lower priced goods. Research indicated that discretionary classroom allotments for supplies are likely to be $100/school year in 2012 versus $250 just two years ago. These cuts are not yet reflected in SCHS numbers or its stock price.

Borrowing from the practices of KIPP and other charter school models, many public school systems now have internal 'efficiency consultants' that advocate the use of paperless options and simpler hard items that can be purchased at big box stores like Staples and OfficeMax at a fraction of the cost. Lacking scale, SCHS obviously cannot compete here. Further, even in less progressive schools, many teachers now simply use Excel and Outlook for planning purposes. School Specialty sends out 20-30M catalogs a year and positions itself as a one-stop-shop for teachers supplies with ~60k SKUs. This is no longer a differentiator as constrained teachers now segment their purchases (e.g. buy whatever they can from Staples).

For sake of cost and transparency, most school systems are now requiring that all teachers must record grades online. All these developments are catastrophic for SCHS since their highest margin products that drove past performance were planners and grade books, items that are now either obsolete or offered for less by bigger competitors. This loss is estimated to account for approximately 30% of SCHS's 2011 gross profit and 20% of LTM gross profit. It is unlikely that it will make more than a small contribution in 2012 given the rapid adoption of alternatives. The impact of these declines is magnified by the high fixed nature of SCHS's cost structure. So this $20-25M annual decline in gross profit itself would wipe out all EBITDA. Indirectly acknowledging this reality, management noted it has hired a consultant to reevaluate the business and assist with a reorganization.

Valuation & Catalysts

Aside from an appreciation for the declining fundamental of the business, SCHS is also highly levered at 8.5x net debt/LTM EBITDA. In this quarter they will need to pay out $42M to convert holders who are putting the securities back to the company. With only $4.1M in cash this will be funded off its bank line, increasing total debt to $305M at quarter end. They were less than $1M away from tripping an adjusted EBITDA covenant in Q2. The next covenant at the end of Q3 requires them to have a leverage ratio below 5.5x. Clearly this is going to be a big stretch even as cash seasonally accumulates as working capital declines.

Management is estimating it will generate $48-52M in EBITDA in FY2012 (versus $50M in FY 2011 and $36M LTM). Conveniently this is also just slightly above the amount required to keep them in covenant compliance. To achieve this, they will have to add an incremental $8-9M in EBITDA in the second half of the year, a 20% increase over the same period last year. When asked how this would be possible, management said they have plans to cut $2.5M in costs per quarter starting in Q4. It should be noted this is on top of $40M in cost reductions management says it has made over the last three years and the additional expense they will incur if they hire a new CEO. Even if they are given credit for a full $5M in cost cuts on flat comp margins and hit their sales estimate of $735M, that only gets them to $41M for FY2012 EBITDA. This optimistic EBITDA scenario implies an EV/ EBITDA multiple of 9.2x. The likely scenario is EBITDA of $32M based on sales expectations and mix shift, while still giving them credit for cost cuts. This equates to over 12x EV/ EBITDA. Regardless, both scenarios place them in violation of their bank covenant.

To get a sense of the challenges in the space, SCHS's closest comparable in school furniture production Virco Manufacturing (NASDAQ:VIRC) is on the verge of insolvency. SCHS trades at nearly twice the valuation of its closest public peers Scholastic Corp (NASDAQ:SCHL) and Cambrium Learning (NASDAQ:ABCD). If the peer median 6.1x EV/ LTM EBITDA multiple were applied to SCHS, there would be no value to the equity. Even if performance somehow rapidly improved and EBITDA increased 50%, the implied value of the equity based on industry multiples would be $1.00 per share, over 70% below the current price.

Disclosure: I am short SCHS.

Source: SCHS: Impaired Business With Bleak Prospects