Franklin Covey (NYSE: FC) Investment Thesis - Part 1
Uncovering the Growth Story of Franklin Covey's Transformative Subscription Model
The 7 Habits of Highly Effective People" by Stephen Covey is a book that has resonated with millions of readers worldwide, offering timeless wisdom and guidance for personal and professional success. What many may not realize is that behind this iconic book lies a company that has harnessed and capitalized on its brand value - Franklin Covey. In this two-part blog post, I will explore the captivating journey of Franklin Covey, a company that often flies under the radar but deserves our attention. In Part 1, I will delve into Franklin Covey's strategic pivot towards a subscription-based model and the remarkable benefits it has yielded. Part 2 will uncover the extensive goodwill Franklin Covey has cultivated, as well as shed light on its often-overlooked crown jewel - the Education Division. Additionally, I will conduct a comprehensive assessment of the company's valuation and potential risks.
Executive summary
Franklin Covey presents an attractive investment opportunity following a recent 30% selloff. The company's strong and consistent earnings power, with 77% of revenue coming from recurring or related sources, coupled with low capital expenditure requirements and impressive margins (77% Gross and 16% EBITDA), positions it favorably in the market. It's worth noting that most of the selloff was driven by concerns surrounding potential corporate expense cuts during recessions and the impact of generative AI in the corporate training sector. However, my research indicates that these concerns are exaggerated and do not accurately reflect the company's prospects.
While recessions may have a temporary impact on corporate training budgets, Franklin Covey's transition to a subscription-based model, with nearly 50% of contracts signed for multiple years, helps mitigate short-term effects. This strategic shift provides stability and a recurring revenue stream, reducing the impact of temporary budget constraints during economic downturns.
Regarding generative AI, the perceived negative impact on Franklin Covey's business is overstated. In fact, the integration of generative AI is expected to benefit the company by enhancing its ability to facilitate effective and scalable employee behavior change. The recent acquisition of Strive in 2021 further positions Franklin Covey to leverage the vast amount of data collected through user learning on its platform. With over 600k subscribers and millions of engagements annually, the company has a significant data advantage. The founder of Strive, now EVP of product & platform, has emphasized the potential of generative AI, highlighting its positive impact on the platform's value proposition.
Despite recent challenges, Franklin Covey remains confident in its projected high single-digit growth (~8%) for the 2023 fiscal year, taking into account currency headwinds and the slow recovery in China and Japan. Furthermore, the company expects its EBITDA to grow at a faster rate of ~14%, reaching $47-$49 million, despite higher operating expenses resulting from significant investments in expanding the sales team and branding efforts.
Over the past decade, Franklin Covey has generated substantial free cash flow, enabling it to allocate $200 million for repurchasing 12 million shares. This strategic decision has effectively reduced the total outstanding shares to 14 million, underscoring the management team's adept capital allocation prowess. Notably, despite the aggressive share buyback, Franklin Covey maintains a robust balance sheet with a healthy net cash position of $50 million. This strong cash flow and cash reserves provide the company with financial flexibility to pursue various growth initiatives, including potential acquisitions and organic expansion strategies.
At the current share price of $36/sh, Franklin Covey's valuation stands at under $500 million enterprise value, presenting an appealing free cash flow yield of over 10% (~$50 million FCF). With the successful implementation of the Impact Platform and its unique subscription model, Franklin Covey is well-positioned to capture market share within the fragmented corporate training and K-12 leadership education market. The company has a clear trajectory towards achieving $500 million in revenue and surpassing $100 million in EBITDA over the next five years. Considering these factors, Franklin Covey's intrinsic value is estimated to exceed $1.5 billion (~$107/sh), accounting for future share buybacks that offset potential stock compensation dilution. This compelling investment opportunity offers a projected nearly 25% compound annual growth rate (CAGR) return for investors over the next five years.
Subscription pivoting
Franklin Covey (FC) is a global organization dedicated to driving organizational performance through behavior change. Their expertise lies in leadership, personal effectiveness, productivity, and culture building, catering to both corporate clients and educational institutions.
In 2016, Franklin Covey embarked on a significant business model transformation, shifting from selling individual content and solutions to offering a comprehensive subscription model called the All Access Pass (AAP) in its Enterprise Division, and The Leader in Me program in its Education Division. The AAP provides affordable access to Franklin Covey's extensive content library, including popular programs like "The 7 Habits of Highly Effective People" and "The Four Disciplines of Execution.” It is available in multiple languages, accommodating multinational organizations. Meanwhile, the Leader in Me membership supports educational institutions in enhancing student leadership, school culture, and academic proficiency through online resources. Additionally, Franklin Covey offers add-on services in person or virtually, such as consulting and workshops, to further add value to subscribers.
Currently, Franklin Covey serves around 4,000 corporate clients, achieving an impressive 75% penetration rate among Fortune 500 companies. The Leader in Me program is utilized in over 5,000 schools, with more than 3,300 of them located in the United States and Canada. The pricing structure for these programs is as follows: Each AAP pass costs $150 per year and can increase to $240 or more with add-on services, while The Leader in Me membership costs $8,000 per year per school, potentially rising to above $12,000 with additional features. Typically, corporate clients initially start with a few hundred seats, primarily targeting mid-level or above management positions. If they find the subscription useful, they have the potential to expand their seat count up to 10 times the initial amount. This scalability allows organizations to effectively cater to their workforce's needs as they grow and evolve. Retention rates have been above 90% in both the Enterprise and Education Divisions since 2018, indicating clients’ strong satisfaction and stickiness of the subscription business model.
The transition to the subscription business model encountered initial challenges, leading to a nearly 10% annual decline in revenue during the first two years. However, this was an anticipated effect as subscription revenues are typically deferred and recognized over the contract period. The turning point came in 2018, two years after the launch of the subscription services, when both sales and margins began improving. The table below summarizes Franklin Covey's successful transition to the subscription model:
Since reaching its lowest point in 2017, revenue has increased by 40%, with a remarkable 10-percentage-point improvement in gross margin. EBITDA has seen a five-fold increase, and the most impressive aspect is that subscription and add-on revenues have tripled compared to 2017, accounting for 3/4 of the company's total revenue.
Benefit of Franklin Covey’s subscription business model
Operating on a subscription-based model brings several benefits to Franklin Covey, including the generation of "float" funds, more predictable revenue, increased sales efficiency, shorter sales cycles, higher customer retention and loyalty, upselling opportunities, data-driven insights, and higher overall efficiency and margin. These benefits directly tie back to the key performance indicators (KPIs) of the business. Let’s dive into each of the benefit.
1st, the upfront one-year payment required from clients generates a significant "float" of funds. Franklin Covey can earn interest on these upfront payments while delivering services to clients, particularly advantageous in a high-interest rate environment. This float enhances the company's financial position as evidenced by its $50 million net cash in the balance sheet.
2nd, the subscription model offers a more predictable revenue stream. Franklin Covey can forecast and plan for recurring revenue, improving financial stability and enabling better resource allocation and long-term investment decisions. The company's deferred revenue, currently nearly 150 million (~80 million shows up in the balance sheet), enhances visibility into future revenue and accounts for over 60% of the prior year's total sales.
3rd, the subscription model ensures existing customers generate recurring revenue without constant sales efforts. This allows the sales team to focus on acquiring new customers, expanding the customer base, and driving new revenue streams. Shorter sales cycles are typical in the subscription model, freeing up the sales team to close deals faster and explore new opportunities. The emphasis on customer success and account management strengthens customer satisfaction, adoption, and retention, leading to increased customer lifetime value. Satisfied customers may even refer new customers, generating additional revenue. With more time and resources available, the sales team can actively target and acquire new customers, expanding their reach and diversifying the customer base. This can drive accelerated growth and tap into untapped revenue streams. The subscription business model facilitates sales growth, allowing sales personnel (client partners in Franklin Covey) to ramp up annual sales from $200k in year 1 to $1.3 million in year 5. With 300 client partners currently, the company plans to hire an additional 40 this year to further drive sales growth.
4th, the subscription model enhances customer retention and loyalty among Franklin Covey's AAP and Leader in Me subscribers. The high engagement and continued subscriptions of these customers lead to increased customer lifetime value and reduced churn rates. Remarkably, both the corporate and education divisions of Franklin Covey have achieved retention rates exceeding 90%. With an average annual spend of $77,000 per customer and a gross margin of over 85%, the customer lifetime value (LTV) surpasses $650,000. Considering that the cost to acquire a customer is less than $77,000, the LTV/CAC ratio reaches an impressive 8x, highlighting the strong retention power and return on investment for sales efforts.
5th, the subscription model enables continuous engagement with customers. Through regular updates, new content, and ongoing support, Franklin Covey maintains an active relationship with subscribers, creating opportunities for upselling and cross-selling. This is evident in the increased service attachment rate, rising from 40% to an overall 60%, and the growth of the average AAP plus add-on deal size from $48,000 to $77,000. These statistics reflect both pricing increases and expanded customer seat usage.
6th, subscriptions provide valuable customer data and insights to Franklin Covey. By analyzing subscriber behavior, usage patterns, and feedback, the company gains a deeper understanding of customer needs and preferences. This data-driven approach allows Franklin Covey to tailor its offerings, personalize the customer experience, and continuously improve its products and services. The introduction of the Impact platform, following the Strive acquisition, further enhances data collection capabilities and leverages generative AI, creating a strong competitive advantage.
Lastly, the subscription model offers scalability for Franklin Covey's offerings. As the subscriber base grows, revenue can increase without significant increases in operational costs. This scalability allows the company to efficiently serve a larger customer base and deliver value at scale. Notably, Franklin Covey's gross margin has increased from 67% in 2017 to 77% in 2022, demonstrating a 10-point improvement within five years. Similarly, the EBITDA margin has risen from 5% to 16% over the same period, highlighting the positive impact on profitability.