Educational Development Corporation: A Low P/E Non-Cyclical Stock With Hyper Growth

| About: Educational Development (EDUC)

Summary

The company increased its sales agents by 61% last quarter from the linked quarter. Sales last quarter increased by 123% year over year.

The majority of sales are through multi-level marketing. The MLM system used does not have most of the abuses other MLMs have and the product is much better.

My earnings estimate is narrowed to $0.75-$0.80 from $0.70-$0.85 for the fiscal year ending February 29, 2016. My November 2016 target remains at $23.00.

This company is not cyclical, making it a good holding in the current economy.

Educational Development This is an update of an article I wrote on Education Development Corporation (NASDAQ:EDUC) on November 12, 2015 found here.

Background

Educational Development Corporation is a distributor and publisher of children's books. Its primary business is as the U.S. distributor for Usborne Books, an English company. EDUC also publishes children's books under the Kane Miller brand. Kane Miller books are books previously published overseas for which the author did not have a U.S. publisher.

Competition is fragmented. Scholastic is probably the largest children's book publisher and it owns 25% of Usborne. Outside of it most children's books are published by companies that focus more on adult books.

Usborne Books have been published since 1973. EDUC has been in business since 1965 and is a long-time U.S. distributor for Usborne Books. Usborne offers around 2,000 titles at any time. EDUC has two methods of marketing its books, the traditional sales method and multi-level marketing (MLM). Sales using the traditional method are to book, toy and other retailers. MLM sales are through sales agents who sell to schools and libraries and to individuals through home shows and the internet.

EDUC has had an MLM system since 1989. Sales grew to $24 million in 2005 but then fell to $14.5 million in FYE 2/15. Management then realized that allowing sales of new books on Amazon was the cause of the decline. Sellers on Amazon were undercutting the other sales agents. After sales of new books through Amazon by EDUC were discontinued, MLM sales took off.

Current Financial Results

Revenues for EDUC totaled $32.5 million in the fiscal year ended February 28, 2015, up from $26.1 million one year earlier. Net income was $859,000 in FYE 2/15, up from $358,000 in FYE 2/14.

Over the past nine months, the MLM portion of the business has increased revenues by 137%. This trend is accelerating as MLM sales are up 174% in the past quarter. There were 7,800 active sales agents on February 28, 2015. The company added 1,862 agents in the first quarter (ended 5/15), 4,800 agents in the second quarter (ended 8/15) and 7,341 in the third quarter (ended 11/15). Sales agents totaled 17,200 on November 30, 2015, more than double that of nine months ago. All of these new agents juiced sales. Sales in the second quarter of 2015 (ended 8/15) totaled $12.6 million, up 85% from one year earlier. Sales in the third quarter of 2015 (ended 11/15) totaled $24.4 million, up 123% from one year earlier. The third quarter is traditionally the busiest quarter. Sales in the third quarter have averaged about 50% higher than the other three quarters each of the past two years. Sales in the other three quarters are traditionally similar to each other. The MLM channel of sales increased to 81% of total sales in the first nine months of fiscal 2015 (ending 2/16) from 64% one year earlier.

How did EDUC get this massive sales growth? Remember Tupperware parties? EDUC sales agents have a 21st century Tupperware party. It's called a Facebook party. The agent meets with a number of her customers together on Facebook and uses YouTube to show videos of the product. Internet sales, which are mostly Facebook parties, increased an astounding 782% in the quarter ended 11/15 and now constitute over half of all MLM sales.

Also increasing rapidly are Kane Miller sales. This business was acquired several years ago when it was doing $1.5 million in sales annually. It now does over $7 million per year. Kane Miller also is sold traditionally and through MLM. Since this is the self-publishing business, margins are higher than on the Usborne books.

Net income was $0.31 per share in the third quarter (ended 11/15), up from $0.13 one year earlier. However, this was lower than management's guidance of $0.34 to $0.37 provided on December 22, 2015, after the quarter ended. Since sales were exactly what management guided, this indicates the earnings shortfall was due to some late expenses or accruals. My guess is there were some non-recurring expenses related to the large real estate deal discussed below.

Particularly exciting was sales for December 2015. Sales for that month totaled $7.9 million, up 144% from $3.2 million one year earlier. This indicates two things. Sales growth is still accelerating and annualized sales are now around $100 million. Sales are seasonal with December part of a traditionally slower quarter than the one just ended. Keep in mind sales were only $32.5 million in the last fiscal year (ended 2/15).

Real Estate Transaction

On December 1, 2015, just after the end of the fiscal third quarter (ended 11/15), the company paid $23.0 million for a 401,000 square foot office/warehouse facility in Tulsa, Oklahoma. The seller is a large international firm which leased back 181,300 square feet for $105,800 per month. The company took out a $18.4 million loan at 4.23% on the property. The tenant rental is sufficient to cover the entire mortgage payment. The company will occupy the remaining space which doubles the company's prior space. While the tenant rent covers the mortgage payments, the company will not have an expense-free situation on its space. It will still have higher property taxes, insurance, repairs and maintenance and utility costs. However, those increased costs will likely be less than half of what it would have to pay if it rented the current space at a market rent. EDUC also announced it had its former facility under contract to sell.

Balance Sheet

The company had $6.7 million of cash on hand and no borrowings on November 30, 2015. The next day it acquired a large office/warehouse using $4.6 million in cash and borrowing $18.4 million. On the same day, it moved its $4.0 million line of credit to the bank that did the real estate financing. This transaction increased liabilities from 91% of net worth on November 30, 2015, to 226% of net worth the next day. However, as noted above, the company has a strong tenant making payments covering the new debt added. The company could potentially sell the property and lease it back for a profit of at least $5 million if it wanted to.

Inventory has declined significantly over the past year. Inventory was 200 days of sales on November 30, 2015, down from 285 days one year earlier. High inventory is needed in this industry due to the need to buy in bulk, usually 5,000 units or more, and the huge amount of titles offered. The company has sufficient capital to carry inventory with very little borrowing. In fact, there was no balance on its line of credit on November 30, 2015.

Why EDUC Has a Better MLM Model

This is not a traditional MLM which sells potions and lotions of dubious value and abuses its sales agents. The product, primarily Usborne Books, is highly regarded and has been around a long time. My wife was a career children's librarian and had good things to say about Usborne. While that is anecdotal, it is corroborated by ratings on Amazon. There are over 10,000 Usborne and Kane Miller titles on Amazon, most of which have 4.5- or 5-star ratings. Most books on Amazon are used, new books are no longer sold there by EDUC. There is no fee or cost to sign up as an agent. Most agents do not carry much paid for inventory. This is because, unlike any other MLM I know, the company ships inventory to the agents without asking for payment until they sell them. Most of the agent's inventory is held this way. Also, the internet sales are shipped directly to the customer from EDUC, so the need for inventory is less. Over $2 million of the inventory currently on EDUC's books is actually with the sales agents. The minimums to get bonuses are much lower than other MLMs, in the hundreds of dollars instead of in the thousands.

The retail price sales agents get is the same as that sold in stores. This differs from MLMs like Herbalife (NYSE:HLF) that sell their product for 2-3 times the price their competitor's product sold in stores. This makes the EDUC MLM model sustainable.

Sales commissions are lower than other MLMs. Sales commissions were 35% of MLM sales in the third quarter of 2015. For Lifevantage, they were 48% in its most recent quarter. For Nu Skin (NYSE:NUS), they were 43% of revenues. This leads to a higher profit margin. The pretax profit margin is currently about 8% of sales and expected to get to 10-11%.

During the third quarter of fiscal 2015 (ended 11/15), sales agent churn was 31%. This is well below the over 50% experienced by other MLMs.

Risks

The MLM model can be volatile. The company itself faced a decade of declining sales through this channel. There will always be a high churn of sales agents. This requires constant recruitment of new agents. The fact that sales are increasing at the speed new agents are acquired indicates many of the new sales agents are getting traction. Also, the company has a lower churn rate than the industry.

There is always the risk that a company getting this kind of growth is not real so I did some checking. On YouTube, there were 13,900 videos related to Usborne. I looked at the first 400. Almost all appeared to be U.S. Those with over 10,000 views totaled 24, and those with over 1,000 views totaled 112. Almost all of these videos were posted one year ago or more recently, with most of those within the past year. On Facebook, Usborne Books and More (EDUC's distributor name) has over 24,000 likes. There were over 250 individual sales agents, mostly American, with their own Usborne websites, about half with over 100 likes. The company has been around since 1965. Randall White has been the Chairman and President since 1986. All of the directors have been with the company since 2012.

The company recently added significant leverage to acquire new headquarters. This is mitigated by payments from a strong tenant covering the mortgage payment. If the tenant were to leave, earnings would be significantly reduced.

With the economy slowing, I took a look at how cyclical this business is. Nu Skin and Herbalife both increased earnings significantly from 2007 to 2009, the period of the last recession. Usana was down about 20%. EDUC itself had an 18% decline in earnings during this period; however, this was during a period when earnings were in decline, from before the recession until several years after the recession. My sense is that a recession will boost sales agents looking for additional income while reducing sales per agent. It will probably be a wash to slightly positive, which makes it a good holding during economic weakness.

Conclusion

The company has hit on something new and exciting with its Facebook parties. This is primarily what has driven the sales increase in the past year.

The stock closed at $9.30 on January 14, 2016. The price is probably depressed due to the bulk of sales being through MLM and there is some doubt if EDUC is for real. MLM is an industry that has a tarnished image. Most MLMs have had negative press in the past year. Herbalife is under attack by hedge fund manager Bill Ackman for being an illegal pyramid. Nu Skin has run into problems in China, its largest market. ViSalus (owned by Blythe) has imploded. Lifevantage, seller of Protandim, has hit a wall. EDUC needs to get the word out how its MLM model is different. Once this happens the stock should increase. My review of activity on Facebook and YouTube indicates this company is for real.

Net income was about 5% of net income in the first nine months of fiscal 2016 (ending 2/16). This percentage is up from last year and should rise as revenues rise more. If you apply a 5% net income to the current run rate of sales at $100 million annually, you get earnings of $5.0 million or about $1.25 per share. That is the current EPS run rate.

The size of the children's books market is limited but I believe the company can probably get sales up to $200 million within 2-3 years. I also expect their profit margin to increase to 7% from the current 5%. Current earnings are reduced by growing pains such as an unusual amount of overtime being paid, and increased scale will help margins. At $200 million in sales and a profit margin of 7%, earnings per share are $3.50. That would probably get the stock up to $50.00.

In my last article, I estimated earnings for the fiscal year ending February 2016 at $0.70 to $0.85 range. I am narrowing my estimate to $0.75 to $0.80.

At the closing price of $9.30 as of January 14, 2016, the P/E ratio is about 11. A stock with this level of growth deserves much higher. My one-year price target was $22.00 when I wrote the last article in November. I subsequently adjusted it up to $23.00 in a comment to my article. I'm reiterating the $23.00 price target for November 2016.

Disclosure: I am/we are long EDUC.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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