It’s early morning and your head is killing you. No caffeine….it’s a painful reminder of your addiction. You should stop, but you probably won’t.
At least once a week, I will head to the grocery store around 11 p.m. because my wife wants chocolate, that’s demand (or love, but probably more demand).
A product’s demand significantly impacts its producer’s pricing power and therefore profits. This is not rocket science.
It is with this introduction that I give you Franklin Covey. Franklin Covey’s products aren’t demanded by your addictive headache or your spouse’s cravings. These products are sold, not bought…and therein lies the rub.
“I’ve found that when valuation is the overriding driver of interest, I’m prone to get involved in challenging businesses or complicated ideas and liable to confuse a statistically cheap price with a margin of safety.” Allan Mecham
The valuation on FC is somewhat attractive, but I am not sure I am comfortable with the business, yet. This post is therefore a lukewarm introduction to a business that may be attractively priced that I do not own.
FC provides training courses to help companies make their employees better employees. There are fancy categories in which these training courses fall: Leadership, Strategy Execution, Productivity, Trust, Customer Loyalty, Sales Performance, but the general idea is that middle management and sales teams could be more effective at what they are doing. Hence, Seven Habits of Highly Effective People split into “30 different training courses.”
My biggest problem with this business is that it is not clear to me the value that FC is providing to the employers. FC has a well-trained salesforce, paid on commission, who have been successful at selling their programs, however, I am still digging around and looking for the customers who wake up in the morning and demand their training course on how to be an “Highly Effective Leader” from FC. If the demand were there, I would see a much higher revenue growth rate, either based on increased customer counts or pricing power by FC with their existing customers.
Franklin Quest acquired Covey Leadership in 1997. Covey Leadership is basically what is left over at FC now, since the Franklin Quest business was mainly “paper-based” planning guides and seminars related to these products. This unit has been divested. Covey Leadership’s sales in FY 1996 were $98m. After accounting for inflation, revenue, since 1996, has grown roughly 1% per year, basically a rounding error. That means: no pricing power and no significant growth in demand. Further to the theme of demand, from FC’s 10-K in 2008:
“In fiscal 2008, we provided products and services to 97 of the Fortune 100 companies and more than 75 percent of the Fortune 500 companies.”
However, in their latest 10-K,
“Over our history, we have provided content, services, and products to 97 of the Fortune 100 companies and more than 75 percent of the Fortune 500 companies.”
The first statement seems to imply that FC is actively providing products and services to 97 of the Fortune 100 companies, but in 2016, it appears that is no longer the case.
The reason a few people have gotten excited about FC recently is a slight shift in business model. This shift is towards a new program called All Access Pass. This program is an all you can eat buffet of all the courses that FC provides. This business model shift is heralded as a way to up-sell the customers. If Microsoft was initially interested in purchasing a training course for 50 employees at $200 per employee, FC can now up-sell the customer by offering all of their training courses to 100 employees for $175 per employee. The cost per employee is slightly lower for Microsoft, and these employees get access to 30 courses instead of just one. The benefit for FC is that there is an incremental sales that otherwise would have not have been made. Additionally, since the courses are delivered online and not live, there is basically no incremental costs to the additional courses being sold. Given the high margins of the underlying training product, this makes sense from a profitability and sales perspective. However, it still begs the question why there is such a need to up-sell the client if there were real demand for the additional training courses.
If you take a quick look at the numbers, I come up with about $23m in free cash flow from 2016. I get that from $32m in operating cash flow plus minus capex ($4m), capitalized curriculum ($2m) and stock compensation ($3m). Typically, I would average out the past 3 years to find a “normalized free cash flow” number, but we will give them the benefit of the doubt here.
At $18 per share, the enterprise is valued at around $245m. (The “financing obligation” on the balance sheet is a lease, so I will ignore it at this time). This valuation looks attractive at around a 10% FCF yield. FC has been reasonably conservative at capital allocation in recent years, buying back over 10% of the stock in a dutch tender offer at around the price the stock is trading now ($17.75). I started with a quote at the beginning regarding valuation vs. underlying business attraction. I don’t think FC is a complicated business, but I do think I am more attracted to the valuation than the underlying business.
One reason I typically like to take the average of the past 3-5 years is to account for the cyclicality of some businesses. I would put FC in that category given that revenues will fall drastically if the economy slumps for an extended period. Between 2000-02, revenues fell 35%. However, during the 2008 credit crisis period, revenues for the seminar business only fell roughly 15%. It is unclear why this dip was so much lower, but I would certainly count on FC’s seminars being one of the first line items cut from a budget in a belt-tightening situation.
So far, I have only been able to get a hold of two former customers. One was a sales manager at a pest control and subsequently at an alarm services company. These are both high pressure sales companies based here in Utah. If you aren’t familiar with these sorts of companies, they hire college-age students to go door to door selling these products over the summer. This individual, Scott, spoke very highly of the seminars. The seminars gave their incoming employees a great sales training program on how to “Build Trust” with the potential customers. Additionally, the sales training provided a framework for shaping the new employees goals going into their summer and how their goal oriented mindsets could influence their results. Scott worked at both companies and was the individual who suggested bringing FC into his second employer because of his past experience with FC at his first employer.
The second individual I spoke to was Leslie, who worked in H.R. at a large Fortune 500 company. One of the executive vice presidents had arranged for a large group of his “direct reports” to attend two seminars over a two year period. She said the employees gave mostly positive feedback, however, after a new vice president replaced the previous one, the seminars stopped.
I am not sure if this anecdotal data is worthwhile at all since it is such a small subset. I did find it relevant that there is usually one person “buying” the product, but that person is not necessarily the end user. In both situations that is the case and I confirmed this with FC directly. This reminds me of the “Bring Your Own Device” to work phenomenon. Blackberry was the dominant provider when the IT people for large corporations was buying the devices for all the end users, but as soon as BYOD became popular, the market share of Blackberry plummeted.
Zooming Out and Looking at Shareholder Returns:
Sometimes a business changes and you can’t look at the record of past performance to judge a company’s future performance. However, sometimes nothing changes and the past can teach you a lot about what the future may look like.
A little more history, Franklin Quest bought Covey Leadership for roughly $140m through a mix of stock and cash or 1.4x sales (roughly $100m in sales). Since that time, FC has grown in value by about 2.5% annualized to its current $240m. Contrast that with Berkshire’s net worth growth of 14% per annual growth. If FC had grown at a similar rate, FC would be about $2.25B or 10x its current value. Alternatively, 30-yr Treasuries were yielding around 6.8% in 1997. If shareholders would have allocated that $140m to Treasuries instead, the current value would be about $575m or about 2.3x the current value of FC. The S&P has returned a little over 7.1% since May 1997, which would make those proceeds around $600m today. Of note, FC has paid no dividends over the past 20 years. Below is a table of the hypothetical growth of the original $140m compared to a few other investments from 1997.
|Franklin Covey||Berkshire||S&P||30 Yr. Treasury|
I don’t think FC has done a lot for shareholders in the past 20 years. Is that because of poor capital allocation, bad underlying business dynamics or management execution problems? I am not completely sure. Has anything changed? The current CEO, Robert Whitman, has been the CEO since 2000 and the CFO, Steve Young has been there since 2001. The biggest change in the past year is the subscription business model, All Access Pass. Color me skeptical. If a steakhouse is charging $20 for a meal and changes to a buffet and charges $25 a meal, but is still serving the same food, there may be some revenues shifting around the edges. However, the underlying food is still the same and I don’t expect the demand to change that much. In our situation, the seminars may or may not be great value-added products, but I just don’t see any evidence that people are lining up around the block for FC’s products.
I am not interested in buying FC here. I don’t think it is as cheap as it looks and I don’t think there is a huge demand for the product. However, I think studying this company crystallizes three great point of emphasis in business analysis.
- Focus on the product demand. Is there tangible evidence people want the product?
- Focus on who is buying the product. Is the buyer the end user or a middleman?
- Shareholder returns over the past 20 years may be indicative of the future if nothing significant has changed.
Post Script: I do think it is helpful to understand in advance where you could be wrong. In this case, I do think the All Access Pass could have the potential to make FC’s customers spend more and become more sticky. If the employees are able to explore the variety of training programs, employers may be willing to spring to pay for more user seats. Additionally, users could want continued refresher courses on the wide variety of seminar programs, thus creating the stickiness in the annual renewal process. I will be on the look out to see if this is happening.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at email@example.com.