Franklin Covey Co. (FC) Q3 2012 Earnings Report, Transcript and Summary

Good day, ladies and gentlemen, and welcome to the third quarter 2012 Franklin Covey earnings conference call. [Operator instructions.] I would now like to turn the presentation over to your host for today, Mr. Derek Hatch. Please proceed sir.

Thank you. Good afternoon everyone, and welcome to our conference call this afternoon to discuss the third quarter financial results. Before we get started this afternoon, I’d like to remind everybody that this presentation contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are based upon management’s current expectations and are subject to various risks and uncertainties including, but not limited to, the ability of the company to stabilize and grow revenues; the ability of the company to hire productive sales professionals; general economic conditions; competition in the company’s targeted marketplace; market acceptance of new products or services and marketing strategies; changes in the company’s market share; changes in the size of the overall market for the company’s products; changes in the training and spending policies of the company’s clients; and other factors identified and discussed in the company’s most recent annual report on Form 10-K and other periodic reports filed with the Securities and Exchange Commission. Many of these conditions are beyond our control or influence, any one of which may cause future results to differ materially from the company’s current expectations, and there can be no assurance the company’s actual future performance will meet management’s expectations. These forward-looking statements are based on management’s current expectations, and we undertake no obligation to update or revise these forward-looking statements to reflect events or circumstances after the date of today’s presentation, except as required by law. With that out of the way, we’d like to turn the tune over to our chairman and chief executive officer, Mr. Bob Whitman.

Thanks Derek. Hello everyone. I’d like to welcome to you our 2012 third quarter conference call, and we really appreciate you joining us. We’re happy to report that we had a very strong third quarter. It turned out to be the strongest third quarter ever for our current business. And we continue to feel very good about the business, about our momentum, and about our outlook for the year and beyond. We also feel confident about the prospects for continued growth in each of our channels and practice areas, and we’ll talk about that a little bit more, and the expected trajectory of our business over the next several years. Consequently, as you may have seen, we recently raised our full year adjusted EBITDA guidance range to $26-27 million from our previous guidance range of between $24 million and $26 million. Today I’d like to just touch on two topics. First, our financial results for the quarter, and second, a review of our momentum, pipeline, and outlook for the year. On the first point, the overview, I’ll start with cash flow. Our cash flow was very strong for the third quarter, and for the trailing four quarters. Our net cash generated, which you see the definition of there in slide three, grew 59% during the third quarter to $5.1 million, which was up from $3.2 million in the third quarter of fiscal 2011, and up from $1.8 million in the third quarter of fiscal ’10. For the trailing four quarters, our net cash generated increased $18.8 million, which is an increase of $2.8 million, or 17%, compared with the $16 million in the trailing four quarters net cash generated for the same period a year ago. This represents net cash generated per outstanding share of approximately $1.06. Second, a high…

Thank you Bob, and good afternoon everyone. It’s nice to be with you. Like Bob, I’m also pleased with this quarter’s results, and look forward very much to the future. Bob has given highlights about our income statement, so let me just say a few words about our balance sheet and cash flows. Our balance sheet remains strong in my opinion, and balances are generally within expected ranges, meaning that we often expect to see fluctuations in these balances a little bit. At this quarter end, as an example, receivables are up a little bit, payables and accrued liabilities are down a little bit, causing our cash balance to be down a little bit. But all materially within expected ranges and what we would think we would see. I think you noticed in our press release we included a balance sheet for the first time. I really don’t see any unusual amounts on that balance sheet, other than our cash balance just being a little bit lower than what we had anticipated. I would say that if you are newer to our story, I would strongly encourage you to call me and talk about the balance sheet. Particularly, our financing obligation, which is really like a capital lease, our tax net operating loss carry-forwards and foreign tax credits, our share count and our real estate operations. Conversations about these items are generally very positive conversations, and shed light on some often misunderstood accounts. So we think our balance sheet continues to be in good shape. As far as cash flows, you’ll continue to see that we continue to generate cash from our operations. We continue to invest cash in our curriculum, and in growth we’ve invested $1.7 million year to date in our world class courses, and we’ll continue to…

Thanks Steve. I think we’re ready to start our Q&A session. What I thought I’d do maybe first is there’s some slides in your deck, starting with slide nine, I believe. One of the questions that we’re asked most frequently is for a deeper understanding of the math behind the ramp up of new sales people and of our existing, what we call alumni sales people. And so we’ve prepared just a few slides here to try to respond to that question first, and that will probably give rise to some others. But this gives you a brief review of this initiative from its inception in 2005 to date, and then kind of lays out why it is we believe that we’ve got a lot of headroom for growth on top of the 117 sales people we have today, the magnitude of the opportunity, which we think is north of 500 sales people, and what our intentions are with respect to that . So I’ll just go quickly through these slides, and maybe it will give you at least a basis for a deeper understanding of this key initiative. As you see on slide nine, in 2005 we began our REACH initiative. We called it REACH, which is expanding our reach around the world. Two key elements of this initiative were to increase the size and productivity of our direct office and education sales forces, at that time. Subsequently we could add to that, and we’re doing similar things in our sales performance practice and customer loyalty. But at that time it in our direct offices. And in this other was to increase the size and productivity of our international licensee network. As you can see in that slide, the growth has been significant in each of these areas. Our…

Thanks Bob. Good afternoon everybody. Good to spend some time with you. As Bob mentioned, this really is our priority as we look at the year ahead. And we’re excited about the traction we have, but we know that there’s lots more effort that is required to really make sure that we hit these ramps and are able to accelerate the hiring of our client partners. So you see that this wheel, if you’re on slide number 16, it starts at step three. Let me just explain what step one and two were, and I’ll walk through step three and step four. At the center of the wheel, you see client partner expectation of face-to-face hours of 500 hours per year. That really represents a redefinition of the client partner’s role, where of all the things they could be doing, we’re saying the thing that is most leverage, most valuable, and most important to your ability to hit your quota is being face-to-face, selling with clients. Not doing administration, not doing administrivia, or prospecting, or cold calling, but actually taking leads while they’re warm and going through the sales discussions and methodology to progress the client. And so that redefinition really represents steps one and two. Step one is to announce the fact that the face-to-face hour focus is really what we’re going to be asking them to do. And step two is then to begin measuring that. And we have done that and seen some progress and improvement as we have put some metrics to it. In order to help leverage that process, however, step three represents sales management. And that’s really providing crystal clarity around what the job is, what our expectations are, and then a weekly accountability and daily accountability process to ensure that A) the right…

Thanks, Shawn. Maybe that was helpful, I hope, for those of you who are wondering kind of how this works. But with these three steps, we believe we’ll have a permanent structure where we can dramatically expand the number of hires and ensure their ramp up and success. And we’ve made most of the investments that will be needed for those, and this year we’ll continue to make investments in new client partners and new sales management jobs. But the other parts we’ve largely been doing this year. Now, with that, I’ll just open it generally to questions and answers.

[Operator instructions.] And our first question comes from the line of Joe Janssen with Barrington Research. Please proceed.

I appreciate the color on the sales force, and I think as we look at it, the growth and the productivity in both new and existing has been materially improved over the past couple of years, which I think is very impressive. Kind of a big picture, I’m curious, from your perspective, is it possible, in terms of efficiency, not like adding more sales, can you accelerate that ramp? Would it become more profitable quicker? Or are you kind of up against the wall, where if you accelerate it too hard, you’ll kind of get diminishing returns?

Well, I suppose there could be some point where you could accelerate beyond that. But no, the actual answer is that we have seen a significant acceleration by doing two things. The more that we narrow the focus of a sales person on the specific set of offerings or a specific set of customers, and the more marketing activity we put in, so that they’re inviting - let’s say if you’re an execution-oriented client partner, around our execution practice, where we’re inviting multiunit operators to your marketing event, a two-hour luncheon where people self-select to come to it, they think they’ve got an issue in their organization, we have a very predictable conversion rate of business that comes from those. And it really helps the sales person. So we’ve seen, in some of these practice areas, where we’ve narrowed the focus on sales people, internally, while our schedule is, you know, two, five, eight and so forth, I think we’re all thinking that a realistic number can be, and our target should be, three, six, nine, and 1.2 million, and get them to that full ramp, where there would be no net investment the first year. And so in some cases, in our education sales force, for example, we’ve had sales people ramp above 1 million in one year, with a narrowly focused offering on a narrow target market like K-6 schools. And that might be one extreme, because you’ve got a very narrow offering to a very narrow target. But as we narrow the target and give marketing support, we hope that we can both accelerate the ramp, increase the end point of the ramp, and allow us to have the confidence to increase the hiring rate.

Bob, I would just add to that the go-to-market approach that we have, with the event strategy and the marketing that we’ve been doing, has also been helpful in the acceleration of that ramp. It gives the clients an opportunity to engage with our content and our material in the sales process quicker than we’ve had in the past, and that’s having an impact.

The slide where we showed that our ramp of the new sales people had been several million ahead of where we thought it would be, a lot of that excess - the $29 million versus the $25 million - a lot of that excess has occurred just in the last two years, and it’s reflecting this narrower focus.

And just switching gears a bit, within the education practice, you’ve had some considerable growth, and what some might characterize as a difficult environment given state budgets, are you seeing any pushback? Any pricing pressure? Or is the value proposition so overwhelming that it doesn’t matter in these conversations?

Sean Covey’s travelling, but I think he’s joined us.

I’m here.

Thanks, Sean. Do you want to respond?

Sure. The environment’s pretty tough in education right now, and we keep hearing about state budgets being slashed and so forth. I think we’ve got such a strong offering, we’re not finding much resistance. And the other thing that’s happening is we have a lot of outside funding coming in. So this year alone we’ll have over $5 million of community funding or chamber of commerce funding, or foundation funding, coming to us. It’s always an issue. [unintelligible] is going right against the grain of it. We’re growing at 39%. We could grow faster, but that’s about as fast as we can go right now to keep the quality high. We find that if we focus on getting great results, it just spreads like wildfire. So that’s been our focus the last couple of years, as we start with two or three schools in a district. We have great success, and they want to do it with 20 other schools. So we feel like we’re swimming upstream, right against the current of what’s happening, and don’t anticipate there being big push back on funding for some time.

That gap funding that you’re kind of talking about, are you helping the schools find that funding? Or is that just the school goes out to its alumni and finds angel investors, for lack of a better word, to help fill that gap? Or are you facilitating that?

We help facilitate a lot of it. A lot of it’s on our website. If you go to our web, it will give schools a whole bunch of ideas on different ways they can go raise funds. Our most successful source has been chambers of commerce, and we have organized events all over the country, all the time, where we get schools and chambers together. It’s very hard for a chamber to turn down a needy school in their backyard. And we find that there’s so much money looking for a good cause, and you’ve just got to have good results and prove it. So we get principals in front of these chambers, and we have great success with it.

And how many schools are you at now?

We have over 800 schools now doing the Leader in Me process, which is a 3-year implementation, and then we consider it a 20-year operating system. So the economics are really good over a long period of time. We also have [800] inside the United States and Canada. We also have another 100 or so in 20 different countries, including we’ve got some big new partnerships going in Brazil and other countries, where we think we can match what we’ve done in the United States in just the next four or five years.

Great. And switching gears, another practice, Speed of Trust, it’s been lagging versus some of the other practices. And I know, Bob, you mentioned the government contract contributing to some of that. Outside of the government contract, the end markets that you serve, like to the C-level and the M&A advisory space, are you seeing any weakness in that?

No, excluding the government contract, year over year comp from the government contract, the trust practice would be up otherwise. And so you’ve seen the practice go from $2.5 million to $8 million to around $11.5 million to $15.6 million, and it will be down a little bit for this year due to the year over year comping, but otherwise, the growth is good, and the success rate of our events there has been very good too. So we don’t see any of the practices that shouldn’t be growing long term.

And our pipeline in the Speed of Trust practice is encouraging.

What was the total pipeline of booked days, the actual dollar amount?

Approximately $37 million of booked days and awarded revenue.

One last question, tax rate for Q4?

If you look at our year to date tax rate, it’s about 45%, and that’s what we expected it to be for the fourth quarter.

For Q4? Or for the full year?

Both.

And our next question comes from the line of Gunnar Hansen with Sidoti & Company. Please proceed. Gunnar Hansen - Sidoti & Company: First off, maybe just kind of talk about some of the success you guys have had, both in the international direct and licensees channels, and I guess if you’re able to attribute that to anything in particular.

Shawn, do you want to speak to licensees?

Sure. The licensee channel - just as a reminder, we’ve got now 37 partners in about 140 countries, and we’re pretty young, you know? So we’re just maturing as an organization. We’re activating. Some of the other countries have not been really activated in terms of having managers that live there, a bunch of sales people, and so forth. And so it’s a combination of selling off countries that don’t currently have licenses, activating countries that have just kind of been sitting by the wayside. If you look at the product mix internationally, with the partners, the majority of it is in leadership. And so as we get into Speed of Trust, and productivity, and education, as those expand, the whole pie expands. So we feel like the growth potential is still very great. We’re still very young, which is encouraging, because it’s kind of like we’re where the U.S. was 10 years ago. And so there’s just a lot of opportunity. Our penetration’s still pretty low still. We’ve also got huge potential in the big BRIC countries, India and China, Brazil. Germany, we haven’t done much there yet. So we’re still pretty young.

Just to maybe piggyback on that, countries like Austria and Switzerland, you have effectively one sales person covering both those countries. One in Chile, effectively one sales person in Russia. And so for us, we invite the largest licensees to our quarterly Redwood Council meetings we call them, our top 35 leaders. And the real focus - these people have not yet had marketing events, which we didn’t have in the U.S. 10 years ago, or even 5 years ago. The sales ramp up process is now being codified for them as well, the same sales kits, the same marketing tools, the same practice involvement, we’re expanding out. And as Shawn mentioned, about 80% of our revenue to date comes from only 35 home countries. And so while we have 100 under license, they’ve - for good reason, understandably - focused primarily in their home country. And so for us, there’s the organic growth, 14.5% a year, compounded over the period of time. But these other things that Shawn spoke to, we think, can accelerate the growth. International Direct you asked about too. Shawn, do you want to speak?

Yeah, the International Direct countries, we’re very encouraged by Japan. Just over a year ago they had the earthquake and tsunami and we weren’t quite sure what that was going to do for us. They ended up having a great quarter, ended up a great year, and they’re up considerably this year. The U.K. is slightly up, and Australia is struggling. We’ve had some turnover with their client partners. We think we’ve corrected that problem and look forward to growth in the coming year.

Again, there, most of these international countries have not done all the marketing and other things that we’ve historically done. They began this last year, but we think seeing each of these countries become bigger than each of our domestic offices a reality. In fact, the Japan office is among the largest offices now. It will step over $20 million revenue this coming year.

And where we’re seeing success is we’re taking the model, the go-to-market model that we have applied and had success with, our North American Direct offices, and ensuring that there’s adherence across the world with consistency. And not buying into the idea that, well, this is a different country, different culture, that won’t work here. We’re actually finding that the go-to-market approach is working, and is working universally. Gunnar Hansen - Sidoti & Company: And then in terms of the $700,000 incremental in new marketing initiatives, maybe talk a little bit about that and if they’re related to any particular practice, and what geographic regions have you guys been targeting?

There are probably two things there. One is the increase in the number of marketing events held, that’s part of it. And we have a predictable return from those. The other is the launch events and activities around our new four disciplines of execution book launch, which came out from Simon and Schuster about six weeks ago, and thankfully hit the number one on Wall Street Journal and Amazon, and a couple of other important lists. We’ve done a significant amount of promotion around that, because for us the book always follows the offering. We’ve had the practice going for nine years, but once you refine it, and have enough case studies, and you really know that it works, we then try to drive the practice forward with a best-selling book that gets thought leadership out there. And we’ve had early returns. Just, for example, from that book, we’ve had nine different CEOs of major companies pick up the book in an airport or have it sent to them call Amazon and order it for the rest of their executive team or in some cases for hundreds of managers, and then invite our practice - just pick up the phone and call our practice and invite them to come. And so it makes sense for us, we think, to spend money investing in these kind of initiatives to get this book positioned well as a thought leadership piece. And also we’ll be sending copies of the book to hundreds of CEOs of our target kinds of companies so that they get a chance to read it and expect that that will be a good early investment in business development for next year and beyond.

And our next question comes from the line of Marco Rodriguez with Stonegate Securities. Please proceed.

I was wondering if you could first talk a little bit about your year to date EBITDA flow through. It was well above the guided range that you guys talked about. I was wondering if you could maybe discuss the dynamics that might have created that.

It was a good year to date. We are experiencing a good result in flow through.

I think the primary drivers of it were these. One, we’ve kind of got the model down now, we think, where our central costs just don’t increase very much. And in fact there are probably 50 different projects that Steve and the team are running to reduce our telephony costs, or our data costs, or other things, 50 different projects that continue to - without reducing staff centrally - chip away at those costs. And so as a result, our central costs have gone down slightly year to date, centrally. Our business model in the field is such that we always say that we want around 40% to flow through, but in fact, with 68% field gross margins and about 15% commissions, and some additional marketing costs, the flow through there has been higher year to date, because of that. We’ve also had, with the significant growth in our licensees and a couple of large intellectual property contracts that have been significant flow through, those have also driven some. But I think basically the cost model’s in place, and so it’s driven by gross margin, which is then driven by the mix. And I think with the mix of licensees have been very strong, particularly the first two quarters, and also had another good quarter this quarter, a couple of big intellectual properties - for us, hundreds of thousands is a good sized contract. We’ve had a number of large intellectual property contracts. And then we’ve also, in our International Direct offices, had increased flow through because there they hadn’t hit their model before we had all the investment in the fixed costs. But now, on the margin the flow through will be more significant for the next couple of years in those offices, because we’ve had fixed investment.

And then switching gears to the international licensing, I was wondering if you could talk a little bit about the major initiatives that you’re targeting there. Specifically, increasing the home country penetration as well as increasing practice offerings. Is there anything you can provide as far as a quantification as to how you’re moving that?

In terms of practices, we’re just doing them practice by practice. You know, right now, again, in the United States and Canada, about 30% is leadership. Internationally it’s about 80%. And so for example we think we can achieve massive growth in education. And we’ve hired a person to focus internationally. So we’re going to take this one country at a time, and try to build up that practice. We’re doing the same with Speed of Trust, with Execution. So what we do is we typically will certify countries to be able to run the practice. And we’re just inching our way forward bit by bit. Our goal and our expectation is to double the network in four years, and to triple it in eight years. And so we think about half of this growth is going to come through organic growth in activating countries and about half of it is going to come through expanding the practices. That’s the basic idea there. I think in terms of what we’re doing to help activate countries is we’re just going to every license and we’re making every partner accountable for each country. So for example, our licensee partner in Panama runs Mexico and Central America, but Chile has been sitting there to the side. It’s a good sized economy. And so we’re basically going to each partner and saying, hey, either get Chile going and moving, and producing, or we’re going to take it away and sell it to someone else. And so if you look at the home countries, it’s just in many cases we’ve got dozens of countries right now that are really not activated yet, and so we’re just going through partner by partner, and negotiating new deals and setting new expectations. And one of the things we do that has worked pretty well so that people don’t sit on opportunities is we require minimum royalty payments. And so we’re redoing those across the board, where we say, okay, great, you can have access to Chile, but here’s a minimum royalty payment you need to make to ensure that you’re not going to sit on this opportunity. Our partnerships are strong. We get along very well. We treat them as if they were direct offices. We don’t want to treat them any differently. So there’s a lot of push and pull back and forth. But I think that’s one of the strengths that we have, is we’ve got really strong partners that feel like they’re treated as partners, and we’re able to push pretty hard if they’re not performing, or if a country’s not kicked in gear, and so forth. I think this is different than where we’ve been in the past. I think we’re maturing as a group. And we’re just not allowing opportunities to sit there.

Then switching over to the direct sales force, and the initiative there to increase the size, just wondering if you might be able to provide a makeup of, maybe percentage-wise, how much is alumni, who’s in that 3-4 year period, and who’s kind of new.

For 2011, going back to the last full year, about 40% of the revenue for 2011, from the U.S. offices - roughly $90 million of the revenue last year, which is kind of what we’ve measured in these slides here, the U.S. sales force plus education - about 40% of that came from people that have been hired under this new initiative, since 2005. We showed this one slide, Marco, and I’m not sure if it’s exactly on point, but the people who are still in ramp, how much incremental revenue we expect them to produce each of these next years. So if you take those who have already ramped up in the U.S., these U.S. offices, which we were just talking about, generate roughly $58-60 million of revenue. So the other is $40 million, so call it $100 million. That $58 million we expect to grow, as we’ve shown here, at $5 million a year, and you’ll lose a little bit of that from retirements and illness, or whatever happens. You know, 5% a year. But that stream will continue to grow. But you’ll then ramp up all the people who are existing ramp, and we’ve kind of shown what that looks like over the next three years. And then you’ll add, hopefully moving toward - for the whole company it’s more than $20 million, but this year, including international offices, let’s say we’re moving toward $30 million next year, and we think that’s our next plateau, and hopefully we can move then to $40 million with this support structure. And so I think if you kind of add it up and say you’ve got $55-60 million growing at 5%, and losing a little bit of that each year from retirement, you’re growing this other very rapidly with the people who are in ramp. Then the new sales people, each class starts its own ramp. You don’t have to hire very many people to hit your 10% growth goal.

Let me rephrase that. What I was trying to get across was I believe you have about 117 sales people. So of those 117, how many of those would you consider your alumni that are five years plus? How many are in that year one, year two phase, and how many are in the year three, year four phase?

Of the 117, there’s 89 that are U.S. Direct and Education. Of those 89, 34 of those have been here more than five years, at the beginning of the year. And then another five of six will go into the alumni goal, beyond their ramp stage this year.

And then just kind of a last housekeeping item here. Just wanted to make sure I understood from your press release, cash flow from operations for the year to date period was $8.7 million, was that correct?

Yep.

And what was capex and capitalized development costs for the year to date period?

$1.4 million. We have not disclosed cap-d yet, but cap-d, $1.8 million.

And our next question comes from the line of Julian Allen with Spitfire Capital. Please proceed.

A quick follow up on the sales force ramp. So it sounds as if there are about 39 or 40 sales people in the ramp process. Could you let us know how many of those have been hired within this fiscal year? So how many of them would be “year-one hires”?

This is 39 of the 89 you’re saying?

Yeah.

Of those, 14 were hired this year, 2012, and maybe 15 depending on how we count it. Because we’ve kind of netted out any that we think might not make it. And 14 from last year. So a significant portion of those are in their earlier part of the ramp.

Okay, so given that plus or minus, let’s say, 14 or so were hired this year, if I look at SG&A year over year this year it’s about $21.4 million, last year $21 million, so about $400,000 difference. About how much of that is due to this cohort of hiring? And how much of that expense have you managed to offset by some of your expense reductions elsewhere?

Roughly roughly $100,000 including benefits, etc. would be related to those 14. So the offset would be the difference.

And then the next question, if I look at capex and curriculum development expense, this year it totals about $500,000. Last year it’s about $1.8 million, so pretty significant fall off. Is that primarily due to the completion of the productivity product refresh a year ago?

Steve, you would have the detail, but the answer would be yes.

Yes, it is the completion of the Five Choices program.

So expectations going forward, is $500,000 a quarter a decent run rate? Or would you expect it to be somewhat higher?

Between $2-3 million I think is what we would expect per year.

And then last question from me, receivables from third parties, up to $6.3 million. I assume that’s the legacy products business. Can you break that down by major category, i.e. lease guarantees, EDS payments, etc.?

Really it all just comes in one receivable. These contingent liabilities, thankfully, are very, very low now. There are hardly any store leases left. As of this coming January, there will only be one left. And so the stores are basically gone. The warehouse liability that we had originally is basically down to $100,000. It relates to that, but some of this is just the seasonal working capital that they, in their off season, haven’t been able to finish paying us, and we think that will all come back to us toward the end of the year. And we expect after that they’ll be pretty much able to fund all their working capital on their own.

And by end of year, Bob, you mean end of calendar year?

Calendar year. For them, that’s their big time.

Ladies and gentlemen, there are no further questions in the queue. This concludes our question and answer session. I would now like to turn the call back over to Mr. Bob Whitman for closing remarks.