Franklin Covey's (NYSE:FC) Q3 earnings saw a return to year over year revenue growth, following the declines seen in prior quarter. Growth however remains weak due to certain ongoing headwinds. Leading indicators points to a potential acceleration of revenue growth in upcoming quarters, led by the Education division. Profitability remains strong with the majority of its cash flows being deployed towards share repurchases. Despite valuation appearing undemanding, I believe the associated risks concerning its growth outlook warrant a neutral stance at present.

Earnings highlights

As depicted above, the company's Q3 revenue and adjusted EBITDA were up 2.8% and 16.8% respectively versus the prior year period. Though revenue growth remained weak, it was a slight improvement compared to the year over year decline seen in Q2. Management highlighted that despite clients continuing to purchase all the company's product offerings, they have been purchasing a smaller amount of them.

Management expects fourth quarter revenue to be approximately $80.5 million, which would represent a year over year growth of 3.2%. Consequently guidance for the full year points to just above $283 million in revenue, with adjusted EBITDA likely to be around $55 million, corresponding to a margin of 19.4%. Although cash flow margins have been stronger than usual in recent quarters, management expects it to roughly settle down somewhere between 70% to 75% of adjusted EBITDA. Assuming the midpoint of this guidance, this would imply that FCF for this year is expected to be close to $40 million.

Future expectations

Uptick in deferred and unbilled subscription revenue

Despite lackluster growth seen in recent quarters, leading indicators disclosed by the company point to a more promising outlook for growth. Deferred revenue was $83.8 million which is 15% higher than a year ago. Unbilled deferred revenue was $69.4 million, up less than 2% from a year ago. In the case of Franklin Covey, deferred revenue growth is a much better indicator of short-term billings. Unbilled deferred revenue is more representative of revenue in the longer, mostly from multi-year agreements. Nonetheless, deferred and unbilled deferred subscription revenue together was $153.2 million, representing a growth of 8.6% compared to Q3 FY 2023. Though the outlook promises a return to solid growth in upcoming quarters, it is still significantly lower than the growth rates of above 20% which was seen in FY 2023 versus FY 2022, as shown below.

During the Q3 earnings call, the company's CEO Paul Walker sounded more positive regarding the environment for signing new deals and extensions, stating:

In fact, I would say if anything, it's maybe getting a little bit better out there, just the environment, certainly not materially worse in any way, maybe a little bit better for us as we come to the end of the year here.

Headwinds in the Education segment

The company's Education division has seen rapid growth in recent quarters. In Q3 revenue increased 18.7% year over year. Invoiced revenue was up a solid 16% in the same period, benefitting from $4.9 million in funding from a state-wide initiative. The Education division has previously seen significant benefits from government funding initiatives such as the Elementary and Secondary School Emergency Relief Fund (ESSER), for its products like Leader in Me. As this funding program runs out this year, the company is expected to have a fairly significant risk of losing some schools that no longer have the funding. The management team has acknowledged this headwind, but expects the negative effects to be partially mitigated by other sources of funding that the schools are expected to receive, in the form of grants from big foundations as well as community initiatives.

Most of the decisions with regard to the purchase and renewal of the company's products by schools are expected to take place in July and August, and the management team remains confident regarding the outlook. This was re-iterated by Sean Cover, President of the Education Division when he said:

So all the signs are really good, you don't know until it happens, but in terms of all the leading indicators, pipeline, new schools to-date, retention to-date. Also, the funding environment is really positive for us right now because of community support, foundation support, grants that we're winning.

Continued weakness in the International segment

The company's international enterprise segment revenue was $8.5 million, down 7% versus the prior year period. This was indeed concerning given the higher margin that comes along with this license revenue from international markets. Management attributed the weakness to the issues in China, and painted a rather uncertain picture regarding the outlook as Jennifer Colosimo, President of the Enterprise Division stated:

They are all Chinese citizens they're working really hard and doing well, but in our particular space, who they are seeing or frankly us even being an American company is currently a challenge. And then of course China has their own economic challenges taking place. So I wouldn't venture a guess, as to whether or not that improves.

Share repurchases supported by solid cash flow generation

The company's strong balance sheet with net cash of $35 million coupled with the highly cash generative nature of the business, gives management a lot of flexibility with respect to capital allocation. Besides continuing to invest in the business at high rates of return, substantial amounts of cash is being returned to shareholders in the form of share repurchases. A new $50 million stock repurchase program was authorized in April. Despite spending $61.4 million during the last two years on share repurchases, total share count has declined just 5% due to dilution from stock based compensation which amounts to approximately $10 million annually.

Thoughts on valuation

Based on management's guidance for FY 2024 that was discussed previously, the company trades at an EV to adjusted EBITDA multiple of 8.4. This figure takes into account the $35 million in net cash, and is based on today's share price of $38. Correspondingly based on the expected FCF in FY2024 that I mentioned earlier, shares trade at a Price/FCF of 12.4.

In my view, this valuation seems undemanding due to the company's high gross margins and its capital-light model with high incremental margins. Gartner (IT) which operates on a similar business model, trades at an EV to adjusted EBITDA multiple of 24, which is almost three times higher. Though investors could argue that the comparison with Gartner is not entirely justified, I chose it as an example to show how high the market tends to value these kinds of businesses. Nevertheless, the discounted valuation multiple given to Franklin Covey by the market, which I believe is justified to a certain extent, is likely due to the stagnation in its growth and the risks associated with it, which I will discuss in the next section.

Risks

The company has seen its growth rates decelerate during FY 2023, with revenues starting to decline in the first two quarters of FY 2024. Though some of its leading indicators point to the company returning to growth in upcoming quarters, it looks unlikely that growth rates will reach prior levels which were in the high double digits. Elongated sales cycles together with headwinds in its Education division and China are likely to suppress growth rates even in FY 2025. Especially for the Education segment, the company is highly dependent on the schools receiving funding or grants for these types of programs. Moreover if the company struggles to scale its business, it is unlikely that profit margins will reach 30%, which seemed attainable based on expectations during the company's investor day last year.

Conclusion

The company has returned to growth following several quarters of revenue declines. Profitability has remained strong, with leading indicators pointing to a potential acceleration in revenue growth in upcoming quarters. Though valuation appears to be quite reasonable for a business of this nature, I believe the presence of certain risks could threaten its future growth. I therefore assign a Neutral rating to the shares.