Franklin Covey (NYSE: FC) Investment Thesis - Part 2

Valuation and potential risks

Intrinsic value of Franklin Covey’s goodwill and intangible asset

Franklin Covey possesses a valuable portfolio of evergreen media materials that continue to generate sales leads. The company's renowned "7 Habits" series, along with other bestselling books authored by Franklin Covey or through partnerships, contribute to its success. Additionally, Franklin Covey leverages the podcast format to enhance its branding and attract authors and content creators. Its flagship podcast, FranklinCovey on Leadership, is ranked among the top 0.5% most popular shows globally, with an impressive rating of 4.9/5 and over 1,000 ratings on Apple Podcasts.

The content assets play a crucial role in Franklin Covey's success, reflected in the balance sheet as goodwill and intangible assets. The recorded value of these assets stands at $70 million, which is likely undervalued considering their significance. The gross carrying amount, which exceeds $160 million, provides a more reasonable estimation of the intrinsic value of Franklin Covey's trade name and acquired content. It's important to note that the intrinsic value of these intangible assets appreciates each year, contrasting with typical accounting treatment. This appreciation is supported by a return on equity (ROE) of over 40%, calculated by dividing the true EBIT of $40 million by the invested capital of $90 million. This signifies the strong value and profitability derived from Franklin Covey's intellectual property and content.

Education division and international business

The Education Division of Franklin Covey is a highly valuable but often overlooked aspect of the business. Over the past nine years, its revenue has more than doubled (as shown in the above table), with a recent growth rate surpassing 20%. The division is expected to generate approximately $70 million in revenue, with over 90% derived from subscriptions and add-on services. Additionally, it boasts a healthy EBITDA margin of 14%. The Education Division has significant untapped potential, with access to nearly $200 billion in government funding related to COVID-19, which can fuel further growth. Currently, Franklin Covey's Leader-in-Me program is utilized by less than 4,000 K-12 schools, representing less than 2% penetration in a total addressable market of over 150,000 schools in the US and Canada. These schools collectively spend $60 billion annually on building school culture and fostering student leadership, presenting a substantial growth opportunity for Franklin Covey. Considering its predictable subscription-based model and the promising future, the Education Division alone could be valued at over $300 million (~$21/sh) using a current EV/EBITDA multiple of 30x.

The international licensing business is another valuable asset that often goes unnoticed by investors. This segment operates with minimal operating expenses and boasts an impressive EBITDA margin of 50% on a run-rate revenue of $10 million. The international licensing business is believed to hold a value of at least $100 million (~$7/sh).

With the current enterprise value of less than $500 million, only approximately $100 million is attributed to the Direct Office business. However, this business is expected to generate over $200 million in revenue with an EBITDA of over $30 million, even if all central costs of the company were allocated to this division. This valuation implies that the Direct Office business, including the AAP subscription, is effectively being valued at 3x to 3.5x EBITDA.

Valuation

In terms of valuation, two different methodologies have been used. The first is the sum of parts, where the business is divided into three segments: education, international licensing, and direct office. The second is a discounted cash flow (DCF) model, which considers key assumptions such as a discount rate of 10% and a terminal multiple of 15x free cash flow. Both methods yield a similar valuation of $1.5 billion. The details are summarized in the table below:

Potential risks

When investing in Franklin Covey, there are four major risks to consider. 

Risk #1: Competition from tech startups leveraging machine learning -  Franklin Covey faces the risk of competition from tech startups that utilize machine learning and generative AI to offer personalized learning and coaching experiences. These AI-powered solutions have the potential to reduce the reliance on traditional training methods provided by Franklin Covey. Additionally, generative AI can simulate human-like interactions and offer virtual coaching or advisory services, directly competing with certain aspects of Franklin Covey's offerings. Furthermore, organizations may choose to leverage internal data analytics and AI capabilities, diminishing their need for external consulting services, including those offered by Franklin Covey.

However, it's important to recognize that human understanding, interpersonal relationships, and nuanced expertise are still valuable aspects that Franklin Covey's consultants bring to their work. Franklin Covey can adapt by incorporating machine learning and AI technologies into their service offerings to enhance data analytics, personalized learning, and coaching solutions. To address the competition from tech startups, Franklin Covey can explore incorporating machine learning and generative AI technologies into its service offerings. By leveraging these advancements, the company can enhance data analytics, provide personalized learning experiences, and develop AI-driven coaching solutions. The recent acquisition of Strive demonstrates Franklin Covey's willingness to adapt and leverage emerging technologies.

Risk #2: Economic cycle risk - Franklin Covey's financial performance can be influenced by economic cycles. During economic downturns, organizations may reduce their spending on leadership training and consulting services, which could impact Franklin Covey's revenue and profitability. One way Franklin Covey has mitigated this risk is through its strategic shift towards a subscription model, which as mentioned earlier provides stability and a recurring revenue stream, reducing the impact of temporary budget constraints during economic downturns.

Furthermore, during economic downturns, organizations often prioritize leadership development and organizational effectiveness to navigate challenging times. Franklin Covey's solutions, which focus on improving leadership skills, building high-performing cultures, and enhancing organizational effectiveness, can be even more relevant during economic downturns. This presents an opportunity for Franklin Covey to capture market share by demonstrating the value of its programs and services to organizations looking to invest in their leadership and workforce during challenging economic conditions.

Risk #3: International market risk - Franklin Covey operates in international markets, which introduces additional risks stemming from cultural differences and fluctuations in foreign exchange rates. In specific, Franklin Covey faces challenges in the markets of China and Japan. These two countries contribute 10% of the company's total revenue but have experienced a slow recovery following the impact of the pandemic. Japan, in particular, is undergoing a transition from a legacy model to a subscription-based model, which creates additional pressure on revenue generation.

In the past twelve months, both China and Japan have witnessed a decline of more than 20% in revenue for Franklin Covey. However, it is anticipated that as these countries fully recover, the challenges they currently pose will transform into opportunities, leading to an improvement in revenue. As economic conditions stabilize and businesses regain momentum, Franklin Covey's operations in China and Japan are expected to rebound.

Risk #4: Talent Recruiting and Retention - Franklin Covey's success depends on its ability to attract and retain talented employees, including consultants, trainers, and content creators. However, in the competitive training industry, there is a challenge in recruiting and retaining top talent, especially in the current tight labor market environment.

To mitigate this risk, Franklin Covey has recognized the significance of talent recruitment, particularly in the client partners segment. The company has prioritized the systematic expansion of its sales team and has established a strong foundation and platform to provide essential training to client partners. In addition, Franklin Covey has taken steps to incentivize and compensate its employees by increasing stock compensation in the past two quarters. While this may have a short-term impact on the bottom line, it provides valuable incentives for employees in the long term.

To further strengthen its human resources capabilities and enhance talent management, Franklin Covey has appointed Meisha Sherman as Chief People Officer. With her extensive experience of over 30 years in creating high-trust, high-performing cultures across various industries, Meisha brings valuable knowledge and leadership in the field of human resources. Her expertise positions her well to support Franklin Covey's efforts in talent acquisition and retention.

Conclusion

In conclusion, Franklin Covey presents an attractive investment opportunity with strong earnings power, a subscription-based model, and impressive margins. Concerns about corporate expense cuts and the impact of generative AI are exaggerated. The company's transition to a subscription model and its acquisition of Strive position it well to leverage data and enhance employee behavior change. Despite recent challenges, Franklin Covey maintains confidence in its projected growth and has a robust balance sheet. With a current valuation below its intrinsic value, the company offers a compelling investment opportunity with a projected CAGR return of nearly 25% over the next five years. The subscription model brings numerous benefits, including a predictable revenue stream, increased sales efficiency, higher customer retention, upselling opportunities, and valuable data insights. The Education Division and international licensing business offer untapped potential. While competition from tech startups utilizing machine learning poses a risk, Franklin Covey can adapt by incorporating these technologies into its service offerings. Overall, Franklin Covey is well-positioned to capture market share and achieve significant growth in the corporate training and education sectors.