Business Context and Reporting Period
Company: Franklin Covey Co.
Filing Type: Form 10-K (Annual Report)
Period Ended: August 31, 2006
Business Overview: FranklinCovey provides integrated learning and performance solutions, including training curricula (e.g., "The 7 Habits of Highly Effective People"), consulting services, and productivity tools (planners, software). The company operates through two segments: the Consumer Solutions Business Unit (CSBU) and the Organizational Solutions Business Unit (OSBU). As of August 31, 2006, the company employed 1,237 associates and operated 89 domestic retail stores.
Key Financial Metrics
| Metric (in thousands) | Fiscal 2006 | Fiscal 2005 |
|---|---|---|
| Net Sales | $278,623 | $283,542 |
| Gross Profit | $167,385 | $168,695 |
| Gross Margin | 60.1% | 59.5% |
| Income from Operations | $14,046 | $8,443 |
| Net Income | $28,573 | $10,186 |
| Net Income Available to Common Shareholders | $24,188 | $(5,837) |
| Earnings Per Share (Basic) | $1.20 | $(0.34) |
| Cash and Cash Equivalents | $30,587 | $51,690 |
| Net Working Capital | $38,672 | $49,858 |
| Total Debt & Financing Obligations | $34,144 | $35,174 |
Material Changes vs. Prior Period
- Revenue Mix Shift: Total sales decreased 2% to $278.6 million. Product sales declined 7% ($11.0 million) primarily due to the closure of 16 underperforming retail stores. Conversely, training and consulting services sales increased 5% ($6.1 million), driven by refreshed "7 Habits" curriculum and international growth.
- Profitability Improvement: Operating income increased 66% to $14.0 million, and Net Income more than doubled to $28.6 million. This improvement was significantly aided by a $20.4 million non-cash benefit from the reversal of valuation allowances on deferred income tax assets.
- Cost Reductions: Operating expenses decreased $6.9 million year-over-year, driven by a $3.6 million reduction in SG&A expenses (due to store closures and reduced executive severance) and a $3.0 million decrease in depreciation.
- Capital Structure: The company redeemed $20.0 million of Series A preferred stock, reducing annual dividend obligations by $5.0 million. The company also repurchased $5.2 million of its own common stock.
Guidance, Outlook, Risks, and Unusual Items
Management Commentary and Outlook
Management expects to continue initiatives to increase sales, improve gross margins, and reduce operating costs to achieve consistent profitability. The company anticipates spending approximately $10.5 million on property and equipment and $3.1 million on curriculum development in fiscal 2007. The effective tax rate is expected to be approximately 55% in future years due to permanent book-tax differences and foreign income.
Unusual Items
- Tax Benefit: A $20.4 million favorable impact on net income resulted from reversing valuation allowances on deferred tax assets, based on improved operating performance and future taxable income expectations.
- Legal Settlement: A $0.9 million gain was recorded from a settlement with World Marketing Alliance, Inc., resolving a breach of contract lawsuit.
- Accounting Error Correction: The company corrected misstatements at its Mexico subsidiary, resulting in a $0.5 million decrease in international sales and a corresponding increase in SG&A expenses.
Risks and Contingencies
- Internal Control Material Weakness: The company identified a material weakness in internal controls regarding the recording of accounts payable for services, leading to misstatements in current liabilities. Management concluded that internal controls were not effective as of August 31, 2006.
- Intangible Asset Impairment: The company holds $79.5 million in intangible assets. Significant declines in cash flows could trigger impairment charges.
- Outsourcing Risks: Significant reliance on Electronic Data Systems (EDS) for warehousing, distribution, and IT services creates operational risks and contractual minimum payment obligations totaling $153.2 million.
- Management Stock Loans: The company is the creditor for a management stock loan program; inability to collect these receivables could adversely impact financial position.
Investor Verification Checklist
- Tax Asset Realization: Verify the sustainability of the $20.4 million tax benefit and the assumptions regarding future taxable income used to reverse the valuation allowance.
- Internal Control Remediation: Review the specific steps management is taking to remediate the material weakness in accounts payable recording and the timeline for effectiveness.
- Retail Store Strategy: Assess the impact of continued retail store closures on long-term revenue stability and the success of the shift toward higher-margin training services.
- Preferred Stock Obligations: Monitor the remaining $37.3 million in preferred stock and the associated 10% annual dividend requirement ($3.7 million/year).
- EDS Contract Terms: Evaluate the financial impact of the $153.2 million minimum payment obligation to EDS and the risks associated with this single-vendor outsourcing model.