Post-Bankruptcy School Specialty Could Double

The finances of school districts nationwide were devastated by the financial crisis.  Local funding for schools, generally based on residential property taxes, collapsed commensurately with property values.  Hundreds of schools were shut down, and tens of thousands of teachers were laid off.   These effects were felt everywhere from public universities to elementary schools.   The collapse of many public pension plans was a nail in the coffin, and many districts did not recover financially or otherwise for years.  School spending across all levels was anemic in the years following the crisis, which had an outsized impact on undiversified upstream vendors and manufacturers.

School Specialty (SCOO:US), a longtime distributor of school supplies, furniture, and technology began to suffer for these reasons during the crisis, ultimately leading to its high profile Chapter 11 bankruptcy in 2013.

However, the company has recently emerged from the fog of bankruptcy, and according to SumZero member Ben Terk, has several near term catalysts that make it a compelling buy.  Ben has been following the company for over five years, and has met with company management past and present.   He is the Co-Founder and Portfolio Manager of Active Owner's Fund, and has over a decade of experience in private equity prior to this current role.

We sat down with Ben to interview him about this and other components of the long idea on SCOO:US he submitted to SumZero in early September.

1. What about SCOO initially caught your eye as a value investor?

At Active Owners Fund, we look for small cap "buy-out" quality companies that are in transition or open to a transaction that have broken stocks, but are not broken companies. 

We invest significant time and resources on due diligence to understand the industry, competitive set and near term opportunity for significant value creation.  We have tracked School Specialty (SCOO) for over five years and have spent time with previous and current SCOO management as well as with various competitors.  As we all come out of private equity, we are constantly speaking with relationships there and exploring potential take private opportunities across our portfolio.  We believed SCOO would make an interesting take private candidate given its cash flow potential, post-bankruptcy shareholder base and similarities with other distribution companies in which we have invested successfully: a market share leader, with a large direct sales force and long term, sticky customers, where the macro –increasing public school budgets –should be a tailwind. The new CEO had also done some large, thoughtful cost reductions while making significant, but non-recurring infrastructure investments. When we did a pro-forma analysis for these operational improvements and normalized for seasonality, the Company was trading for less than 6x EBITDA, looked like it should start growing a little and cash flow a lot over time, with manageable leverage at 3x.  

 2. What is the market missing?  How has the company recovered since its 2013 bankruptcy? 

As an over-the-counter, thinly traded small cap with no analyst coverage, SCOO is easy to miss.    If the Company actually hits an investor’s screen, it doesn’t look pretty unless you do the above pro-forma gymnastics.  However, the Company had communicated its intent to refinance its  term loan , split the stock, both of which are now complete, and also began to actively engage with the Street, with the goal of increasing liquidity and up-listing to the NASDAQ. These “corporate finance” catalysts gave us confidence that, even if with modest operational improvements, the stock should re-rate with improved liquidity. 

We believe these catalysts will also shine a spotlight on the substantial progress the Company has made post bankruptcy: the debt has been refinanced, headcount has been reduced by over 20%, inventory turns have increased from 4.3x to 5.6x and margins have increased 200 bps. The Company has also been investing in and upgrading its ERP, CRM, Product Information Management (PIM), Transportation Management System (TMS), phone systems and ecommerce capability; which will be operational to some degree by the end of 2017.    The Company completed its first bolt on acquisition, Triumph Learning, just last month, which is a strong indicator of the platform’s progress and stability. 

3. What key metrics should investors be paying attention to as your thesis matures?

We expect modest sales growth and EBITDA-margin improvement.  As the Company stabilizes its A/V business and continues to improve is product mix organically and through acquisition, we should begin to see operational leverage. Up-listing will also be a key milestone.

4. What are SCOO’s biggest problems currently?  Do you see Amazon as a threat? What are the biggest risks associated with your thesis? What could go the most wrong?

From a business perspective, there has been a lot of heavy lifting rebuilding the infrastructure and reorganizing the sales force.  We have met with the CEO, Joe Yorio, and he knows his business.  His corporate background (Xe Services/Blackwater turnaround, Scott Worldwide/ Kimberly Clark, Unisource, Corporate Express, DHL) would indicate that he has the required distribution and logistics experience. His highly decorated Special Forces military career would indicate that he will find a way to win. http://military.wikia.com/wiki/Joseph_Yorio.  

Amazon is both an opportunity and risk for the Company. Amazon sells school supplies to parents and school teachers vs. schools and school districts. In addition to selling direct to School and school districts, SCOO is also key vendor for Amazon in the school supplies space by way of SCOO’s leading, proprietary brands. SCOO’s aggregate prices can also be more competitive than Amazon’s through a bundled–package pricing strategy. Staples and Office Depot also provide some of the same products as SCOO, but SPLS and ODP focus on the business world, while SCOO has strong, long term relationships in the education market.

5. What will catalyze the market to see the value in SCOO?  What’s a realistic timeline to see this play out? 

In the very near-term we think the up-listing will happen in the next 6 to 12 months (all dependent upon how quickly the number of round lot shareholders increases). This paired with analyst coverage, which is currently non-existent, should increase interest in the stock. In the mid to long-term, we think the Company will grow organically and make intelligent acquisitions which will create the necessary scale to attract a broader investor base. 

6. Where else do you see value in the market today?

By focusing on the small cap sector that is under-covered, under-followed and for some companies, under-valued, we are always able to find opportunities where we can buy influence at a discount versus control at a premium.  In the sub-billion-dollar market, there are always a whole host of companies going through different types of fundamental events that will unlock value and better reflect the true earnings power of their respective business models. We are currently over 90% invested with a fairly diverse portfolio including 25% in information technology and telecom, 20% in consumer discretionary, and 15% in business services.