In this edition, I talk about PetroChina, Brazil, and Franklin Covey
Hey folks,
In 2002, Warren Buffett read PetroChina’s annual report and decided to buy ~$500mm worth of shares. Five years later he sold that stake for $4bn. Here’s how he did it:
“I read it in the spring of 2002 and I never asked anyone else their opinion. I thought it was worth $100bn after reading the report. I then checked the price, and it was selling for $35bn. What is the sense of talking to management? I doesn’t make any difference. If the market value was $40bn, you would need to refine the analysis. We don’t like things you have to carry out to 3 decimal places. If someone weighed somewhere between 300-350 pounds, I wouldn’t need precision – I would know they were fat. If you can’t make a decision on PetroChina off the figures, you go on to the next one. You weren’t going to learn more if you thought their big oil field was going to decline out slightly faster, etc.”
Like Buffett, I want to find stocks that have a large gap between valuation and price. Value investors call that a margin of safety.
The current market turmoil offers a once-in-ten-years buying opportunity. In this environment, I’m looking for more than a large margin of safety: I also want durable competitive moats and low leverage. I want stocks that can either survive or come out better after this crisis (anti-fragile).
While writing this newsletter, I came across a blog post from Felix Narhi from Pender Fund. I realized that the three elements I mentioned (margin of safety, competitive moats, and low leverage) are part of what Felix calls the Trinity of Risk: Valuation Risk, Business Risk, and Balance Sheet Risk.
Franklin Covey checks all three boxes of the Trinity of Risk. That’s why I’ve bought it. You should check my write-up at the end of this e-mail.
Watchlist and Investment Update
Here’s what I bought over the last two weeks (see watchlist here):
Tesla, Revolve, and Franklin Covey
Tesla @ ~$520/share, Revolve ~@ $7.50/share, and Franklin Covey @ ~$15. I may buy more over the next few weeks depending on where the market leads us. Nothing changed on my investment theses on these three companies.
Brazil
EWZ @ ~$23.50. EWZ is an Exchange Traded-Fund (ETF) which tracks Brazilian stocks. I’m betting on the Brazilian stock market. Ibovespa fell from ~120k points in January to a bottom of ~63k in March. That’s a 50% reduction, but 100% gain if it returns to previous levels. Before that, the index was on a 3-year streak, rising from <40k points in 2016.
How long will it take until it reaches 120k points again? Before the pandemic, Brazil was implementing important economic reforms (labor, pension) and had an ambitious privatization program. The country can return to that agenda after the pandemic is over. Because nothing has fundamentally changed, I think Ibovespa should pass the 100k mark again sometime in the next five years. This article from Nick Maggiulli inspired my EWZ buying decision.
Don’t forget to read my Franklin Covey analysis below. I think it’s a great business at a great price.
And subscribe and share with your friends, because that’s what friends do.
Stay safe,
Fred.
Franklin Covey (FC)
5-Bullet Summary:
Franklin Covey sells performance improvement services to organizations (e.g. courses on sales, leadership, and customer satisfaction). The company is transitioning from a one-at-a-time sale to a subscription-as-a-service model.
The subscription model gives access to a larger share of customers’ wallet at a higher margin. FC can leverage a broad content suite and sell add-on services, making its value proposition more compelling and widening its competitive moat.
The subscription model is a success: more than 90% retention rates, with related sales growing >20% a year.
What’s attractive about that model is that each additional dollar sale flows through to EBITDA at a rate >60%. FC is an operating leverage story: single-digit top-line growth converts to double-digit EBITDA growth.
Despite having low capital requirements, recurring revenues, and a strong balance sheet, FC was caught amid the recent market sell-off, falling >50%.
I estimate that FC’s fair value is $23.50/share. The stock was selling at <$16.00/share last week.
Franklin Covey: An Operating Leverage Story
Franklin Covey provides services to improve the performance of organizations. The company tackles issues such as leadership, sales, execution, productivity, and education through different delivery options which include online subscription offerings, live-online, on-site training, coaching, and consulting services.
FC has two divisions: Enterprise and Education. Within Enterprise, FC offers programs like “The 4 Disciplines of Execution”, “The 7 Habits of Highly Effective People”, or “Helping Clients Succeeds: Closing the Sale” to companies, governments, and non-profits. Within Education, FC provides services to educational institutions with a program called “Leader in Me”, which helps schools build their cultures and enhance student performance. Enterprise has ~76% of sales, and Education ~22% of sales.
The company has direct offices in the US, Canada, Japan, China, the UK, Australia, Germany, Switzerland, and Austria, and works with licensed partners in other regions.
Transitioning Business Model
To understand FC you need to understand its subscription-as-a-service offering. I’ll focus on the Enterprise segment, but it works the same for the Education segment.
Historically, FC sold services one-at-a-time. Here’s how it used to work: FC would sell a program for a company, say, a Sales Leadership Base Camp. The price would include FC’s facilitators, proprietary content, materials, etc. FC would close the deal and provide the service (lectures, printed material, group activities, coaching). Afterward, FC would try to sell the program to another team in that same company, or another program to the same team (maybe now they need one on customer loyalty).
You can see how laborious that is. Every year FC starts from scratch. There is no sales base to build upon.
This kind of arrangement is still part of FC’s business model, but it isn’t the focus anymore.
Since 2016, FC is transitioning to a subscription model. Here’s how it works now: FC sells a company the All-Access Pass (AAP), a subscription to an online platform that gives access to everything FC has to offer across different themes. There are videos (live and recorded), online learning modules, and interactive content. The subscription price includes a fixed payment for access and a variable sum for the number of users accessing the content. FC also sells add-on services on top of the AAP subscription. Customers have the help of implementation specialists to develop customized programs that include those add-on services, like on-site training and consulting.
Now it’s much easier for companies to stay customers: they just have to renew a subscription. AAP has a retention rate greater than 90%. FC starts off the year with some guaranteed revenue. The company can focus on growing by converting new customers, selling more add-on services to the same customers, or increasing the number of users in the same account.
Advantages of Subscription Business Model
Improved Value Proposition
With AAP, customers gain access to more content at the price of one course. That’s more programs at a lower price.
Broadening Competitive Moat
It’s much harder to compete with FC on a subscription model instead of a course-by-course basis. The company has a large breadth of content across areas, available in 21 languages, and a global reach. AAP caters to organizations because they want to standardize their practices and don’t want to rely on many providers. AAP leverages a large content library to increase the value FC offers and puts FC in constant contact with its customers. It’s a win-win situation where the customer gets more content and FC gets to understand the customer better and foster a long-term relationship. This relationship is highly valuable, and only possible because a subscription offering (and all the content that comes with it) has close to no marginal cost per customer.
Higher Lifetime Value of Customer
A subscription model gives FC access to recurring, higher-margin revenue, and a stickier customer base. It’s easier for a customer to renew a subscription than to hire new services. A subscription snicks into a company’s process. Renewal becomes the default option. Moreover, as long as FC delivers good results, it’s easier to sell add-on services. A good indicator of customer satisfaction is this: FC has maintained customer retention of >90% over the last four years, and its service attachment rate has increased to >50%.
Industry and Competitors
The market for Learning and Development (L&D) is estimated at $166bn in North America and $366bn globally (source). Companies spend 40% of that value with outsourced suppliers like FC, and 60% is spent on internal resources (source).
This data could be inaccurate, but L&D is clearly a large market. It’s also fragmented. In my research, I found hundreds of companies providing L&D services. It’s impossible to go through all of them but here are my two observations:
Many competitors are specialized, that is, they focus on one skill, like sales or communication.
Many competitors offer similar services as FC, including some sort of platform for delivering services online. However, I couldn’t find a competitor that offered a subscription service like FC. It’s usually a pay-by-course dynamic. (I realize this might be inaccurate. If you know any competitor that adopts a subscription model, please send me a message).
Bottom line: FC has many competitors and the market is fragmented. But the market is huge, and few, if any, competitors offer a subscription that competes with the AAP.
Financials
FC has a clean balance sheet with a net cash position (~$40mm total liquidity). The company generated ~$19mm in free cash flow over the last year and is growing revenue by single digits and EBITDA by double digits. This growth shows that the subscription strategy is working.
However, FC is down >50% year to date. In my screening, it’s one of the stocks most punished by the COVID-19 crisis. Why is that?
Part of it is the sector. Organizational training is not a priority for companies right now. In 2008/2009, the L&D market experienced a revenue drop of ~10%. During that period FC’s sales in the consumer solutions business dropped by a similar amount.
A 10% drop in sales for a well-capitalized company with low capital requirements isn’t a tragedy. In fact, if 2009 is any proxy for this year, FC may perform well. So far, the company showed resilience. FC’s March 2020 sales increased compared to a year ago.
If COVID-19 is worse than 2009, FC could experience material revenue decrease over the next quarters. The impact should be mitigated by FC’s subscription model and its broad range of content. For example, in times of distress companies may choose to invest in sales training, because sales are what they need the most. During 2009, FC grew revenue from sales performance and customer loyalty courses and lost revenue from traditional leadership courses.
Long-term, nothing changes. The market for organizational performance improvement is not going to disappear. In fact, the crisis might have accelerated the transition to online offerings, which could benefit FC.
I think another reason why FC’s stock is down so much is that it doesn’t screen well. FC had negative earnings over the last three years. At first glance, FC’s income statement doesn’t look attractive, which keeps many investors at bay. We also have to remember this is a small-cap company, with a smaller pool of potential investors.
But to understand FC’s income statement you have to consider two things.
First, FC had to retrain and refocus its sales force to adapt to AAP, as well as explain its new value proposition to customers. That took some time, but tangible results are here (revenue growth, expanding margins, high customer retention).
Second, the subscription model changed FC’s revenue recognition. Revenue is now recognized as services are delivered over a longer period of time. The portion invoiced but not delivered yet goes to the balance sheet (deferred revenue), flowing to the income statement gradually.
These two factors partially explain why (1) FC’s revenue didn’t grow that much from 2016 to 2018, and (2) net income over the last three years was negative, even though FC generated positive cash from operations and positive free cash flow.
As revenues related to subscriptions make up a larger portion of total revenue (it’s now at >50% of total revenue, with a 45% CAGR over the last two years), FC started to realize the main benefit of its new business model: increasing margins through operating leverage.
Economies of scale is a term thrown around often, but it’s tangible for FC. Each marginal sale of AAP flows through to FC’s operating margin at a high rate. The marginal cost of additional customers is low because most of the content was already developed and the infrastructure for the online platform is in place.
Valuation
The market for outsourced organizational L&D is worth hundreds of billions of dollars. FC’s annual revenue is $225mm. There are more than 50k accounts in the US which are not AAP clients yet (from <5k currently). The education division has an even larger untapped market, with more than 140k educational institutions to be reached (from <3k currently).
FC has a large addressable market and many avenues for growth: win more accounts in the US, sell more to current accounts, and expand internationally.
Before the COVID-19 crisis, FC expected to increase free cash flow from ~$20mm in 2019 to >$44mm in 2022, a +30% CAGR obtained through high single-digit growth in revenue. Before COVID-19, that was achievable. Now, there is more uncertainty and management has withdrawn its guidance.
But here is some certainty: FC has a strong balance sheet, low capital requirements, a sticky customer base, recurring revenues, and management with skin in the game (>30% insider ownership). FC will survive.
Most importantly, at the current price, I don’t have to spend much time thinking about management’s previous guidance.
FC is trading at a trailing EV/EBITDA of ~16x and a P/FCF of ~12x. The market is pricing in 2-3% free cash flow (FCF) growth. Consider that FC can increase FCF by 20-30% with single-digit top-line growth. As such, the market is pricing in close to zero top-line growth, or completely disregarding FC’s operating leverage.
Here are my assumptions:
5% average annual revenue growth (with some bumps due to COVID-19).
200 basis points improvement in gross margins and 250 basis points reduction in SG&A over the next 5 years. Consider that over the last twelve months, FC’s gross margin expanded 133 basis points, and SG&A decreased 226 basis points.
~$11mm annual CapEx for the next 5 years (~20% greater than the avg. CapEx for the last 4 years).
No changes in working capital during the period. Note that FC benefits from changes in working capital because of its large and growing deferred revenue balance.
Implied in my valuation is revenue flowing through to EBITDA at 18% on average. FC reported a flow-through of ~90% over its last reported quarter.
My DCF finds a fair value of $23.50/share, assuming a 10% discount rate and a 5% terminal growth rate. That’s an exit EV/EBITDA multiple of ~13.5x, which is lower than where the company currently trades at. As such, I assume no multiple expansion to the company’s valuation.
A final note: I categorize FC as a capital returner. The company doesn’t need to invest much to grow revenues (most of its growth investment is made by hiring more salespeople, an expense that goes into SG&A). I think FC can return almost all of its free cash flows to shareholders whilst growing and compounding its intrinsic value. It’s that rare business that can grow with little additional investment.
Risks and Next Steps
In the long-term, I think FC is a low-risk investment. The balance sheet is clean, management is good and invested in the company, the industry will not disappear anytime soon, the company owns quality content protected by IP, its value proposition to customers is differentiated and compelling, and the addressable market is large and fragmented, with plenty of room for growth. In the short-term, FC will likely experience some pains, as most companies will. My investment horizon is not next year, so I’m good with that.
I’ll keep an eye on the following:
Retention rates, average initial purchase price, and service attachment rate on FC’s AAP offering
Revenue growth in the Enterprise and Education segments
Growth in billed and unbilled deferred revenue balances
Gross margin and EBITDA margin
Flow-through of revenue dollar growth to EBITDA
CapEx evolution (notably capitalized costs for development of new content)