Softkey
Q2
| Softkey
Q2
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| (FOOL
CONFERENCE
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SYNOPSIS)* By Debora Tidwell (MF Debit) Softkey International UNION CITY, Ca., July 28, 1996/FOOLWIRE/ --- Softkey International reported Q2 earnings on Thursday, July 25th after the market close. The company reported revenues of $76 million. This translated to net income (on a normalized, pre-charge basis) of $13.3 million or $0.34 per share, slightly above analyst estimates of $0.32 per share.
The company had cost of production of about $20 million, sales and marketing costs in the $15.8 million range, G&A at $6.8 million, R&D at $8.85, and an amortization charge of $160 million which included a one-time charge for in-process R&D off the MECC acquisition.
As a result of the charges, the company reported a net loss for the quarter of $144,185,000 or -$3.63 per share.
They started the quarter at approximately $77 million. They paid out close to $10 million in merger-related costs in the quarter (that's before any of the MECC pieces came in) -- these were legal, investment banking, accounting fees, etc. and does not include the Bear Stearns expenses which were paid by issuance of stock. Morgan Stanley was the investment bankers for the Learning Company and they were paid before the deal closed, in cash, from the Learning Company. (A question came up about Morgan Stanley's recently filing to sell stock. The company responded that this happened because they were acting on behalf of someone who had sold in some hold-period stock two years ago off the Aris acquisition, so it was the tail-end of something that was done two years ago and had nothing to do with the recent transactions.) Softkey brought in $21 million from MECC. They paid down approximately $10 million of merger costs. They acquired about $7 million of fixed assets -- they added about $5 million of related computer equipment around the world and then they brought in about $2 million with MECC. They generated close to $10 million in cash from operations. There is a couple million of other related things, but not significant.
The company has lived through an earnings season for a number of the consumer software companies that probably, to put it charitably, has been rocky. Softkey has been able to deliver a revenue line that they are very proud of, especially when viewed on an apples-to-apples basis. They had a growth rate of around 31% on a year-over-year basis. For almost three years now, their consistent growth rate has been in that 30% range and they have been able to keep it going.
There are two major elements behind that. The first one has to do with the diversity of channels. Their retail business represented only about $38.9 million of total revenues. A little more than $7 million came from OEMs, $7 million from the school channel business that is new to the company (as a result of the MECC & Learning Company acquisitions), $7.6 million from their direct mail and direct response business. International did very well, with $11.4 million. And, their Canadian tax business was in for around $3.8 million. One of the things that helped them, beyond just the diversity of the channel was the fact that their strategy of where they put their bets within retail paid off. A breakdown of the sales by channel category is: 20% through superstores, 3% through malls, 20% through office products stores, 6% through consumer products stores, 16% through mass merchants, 9% through a miscellaneous group that includes Price/Costco and warehouse stores, and 26% through distribution. By price point, 22% of revenues come from $20 and less, 5% comes from $20-30, and above $30 was 73% of revenues (up from 66% last quarter).
THE RETAIL CHANNELS
Softkey, as a company, has always had more of an emphasis on the non-traditional channel. If you look at the office products, mass merchants, and the traditional mall chains -- mall chains in this quarter as a percentage of their retail sales were down to 3% and have lost 7 points of their share to the benefit of the office product and mass merchants channels.
In the budget category, PC Data reported that the #1 company was Expert Software. In the numbers Softkey reported, their Platinum line -- their budget line which includes their key kids products -- did about $12 million worth of revenue. That represents almost 100% over what Expert Software as a company did in their most recent quarter, or what they are estimated to do. Softkey thinks that, in the traditional channel, some people are getting an increasing share of a declining market. Softkey has made their bet on different channels and those bets are paying off. This is not a new strategy for Softkey, it really goes to the heritage of the company. They came to the forefront because of what they had done in the office supply store chains and their presence in mass merchants with jewel case product at affordable prices. And they have continued to leverage off that core strength as they have taken on these new product lines and they think it is reflected in the results they reported.
DIRECT RESPONSE AND OTHER CHANNELS
Similarly, the emphasis they have put on a direct response business has been very exciting for them. A new portion of the $7.6 million in direct sales comes from their phone campaign. They have started to move the emphasis away from just the mail into a telemarketing operation that was getting, on average for the 5 products tried, a response rate of 17% and as high as 18 or 19% on some products. That is a phenomenal response rate in direct marketing where you are usually quite happy in the mails with something in the 2-3% response rate.
The reason they are able to do that, is that they have a database of 5 million names that they are able to offer a family of Softkey products to. And, they are starting to build up a brand identification with those end-users that makes it much easier to sell them the second, third, and fourth product. Increasingly, as they develop their database, they are starting to get credit card information and the like that facilitates that sale. That was an exciting experiment that they tried in the quarter. It had very good results and they think it is going to help them drive this business going forward.
As a company, when they look long term and think of the impact of the Internet on their business, they think that the Internet is the ultimate direct marketing tool that exists. They think that with their 5 million and growing database of customers, that they are going to be able to turn that into quite a significant profit center.
If you look at Learning Company, Softkey, and MECC on a standalone basis within retail, while retail has not been growing as fast as Softkey's international business and some other segments have, Softkey is still pleased with the growth they have achieved there. Softkey products have grown about 20%. Learning Company products were in the 24% year-over-year growth range. There was some decline in MECC that was more noticeable in their Q1 and has reversed now since Softkey has improved their distribution and get more of a focus back into that company.
GROSS MARGINS
Softkey saw a gross margin in the 73% range in Q2. They have one of the highest gross margins in the industry. If you are dealing with software companies that are just in the retail business there is often a concern that those margins can come under pricing pressures. Softkey feels that they are somewhat insulated from that because of the diversity of their channels. With the direct response business, cutting out the middle man in terms of the retailer, that improves gross margins substantially and is one of the key factors that helps Softkey reach their 73% number. Similarly, the school business which, for OEMs is probably among the best gross margins anybody has in the industry, is another factor that helps Softkey. And, that is a constant that isn't under pressure because the business model involves a lot of licensing of product (as does the OEM business). So, Softkey is very comfortable with their ability to maintain this gross margin on an ongoing basis because of the diversity of channels that help contribute to that picture.
In addition, they continue to look at the re-engineering of their products and continue to look at improving their basic cost of materials. They have moved to a new arrangement with Sonapress in the Carolinas. They are continuing to work with Stream, who are consolidating a lot of their manufacturing now in Utah. All of this is geared toward continuing to improve their gross margins which gives them a lot of flexibility in pricing. In the last 12 months, Softkey's average selling prices have come down in a period of time when their gross margins have improved. That is a testament to the work being done to manage cost of materials.
SG&A expenses were around 30% in Q2. Last year they were around 40%. That happened because they have been able to successfully consolidate companies together. With the MECC, Learning Company, and Compton's acquisitons behind them they feel they are able to declare victory on the business model side of things. They have successfully combined the sales forces, back-office operations and the finance departments together and have been able to drive some very successful results. So, they are pleased with that. Their operating margins are among the highest in their segment of the industry. They believe they are sustainable and they are a function of the critical mass Softkey has built and are a function of how well they manage their gross margin line and how well they manage their SG&A cost. They have been able to do that without scrimping on the development dollars which are so important in driving the future success of their business.
THE BALANCE SHEET AND THE ACQUISITIONS
The balance sheet has been probably the single most important priority of Softkey in 1996. Going into 1996, having completed the merger of Learning Company and taken on a considerable amount of convertible debt in order to do that, it was very important for them to show the investment community that they could manage not only the integration of the company but manage the growth of the business within a model that did not consume an enormous amount of cash. That is why they are very proud that their DSOs continue to be under 60 days. They set that 60-day hurdle as a very important one and are confident that they will be able to manage the growth of this business at a rate of 30% without having to materially increase DSOs.
They have seen their inventories go down for the second quarter in a row, even though they took on the additional inventory of the MECC acquisition. They are confident that this trend line will continue. They have seen their working capital increase. They have a strong cash position, just shy of $97 million. They think that all of those things point to a company that is able to generate growth but generate it in a responsible financial manner.
They have been able to accomplish those things because they have made it part of the compensation of most of the senior management of the company. For example, the Vice President of Sales is not just compensated on selling product. He is compensated on the DSO record of the company. So, if Softkey sells something and they don't collect the cash in what they think is a timely manner, that is reflected in his compensation and the compensation of his Senior Sales Directors. Similarly, they have put a strong emphasis on inventory forecasting to make sure that their inventories continue to come down. And a number of senior managers are compensated around that as a measure.
CASH POSITION
In the last six months they have grown the business and had operations generate some significant cash. They have used the cash generated to pay down a number of the merger accruals. Now, as they enter the second half of the year, one of the things they will start to focus on is their ability to deal with the debt the company has. They feel fairly confident of their cash flows and will start to look at retiring some of that debt if they can buy some of it at opportunistic values. So, they are very pleased with the way that the balance sheet has shaped up.
There have been some questions about the purchase accounting and they wanted to reiterate that any accruals that are ever made as the result of a purchase of a MECC or Compton's, etc. -- if those accruals are not fully materialized, they do not flow into the P&L, they are simply dealt with as purchase price adjustments and affect the goodwill number. So, any of the numbers that appear in Softkey's P&L this year are totally related to Softkey's ongoing operations and don't reflect any changes as a result of purchase accounting. Similarly, the amortization and acquisition-related charges which amounted to $262 million in this quarter have two elements to them -- $104 million of goodwill in this quarter (the intangible write-off of Learning Company, MECC, and a bit of Compton's) and a $58 million one-time in-process R&D charge related to the acquisition of MECC.
HOW THE INTEGRATIONS OF MECC AND LEARNING COMPANY ARE GOING
They declared victory from a financial perspective in that they are very happy with the way the companies have come together from an operational point of view. Perhaps a greater success for them in the future, especially in the last 90 days, is their ability to begin to tap into the talent base of these companies and get them working on a broader basis. They have assigned two people from the Learning Company to run worldwide R&D and worldwide Marketing for all Softkey products. When they bought Learning Company, what they wanted was not only the wonderful products and processes they brought to bear on development and marketing of those products, they wanted to take that talent and leverage it for products that MECC, Compton's, and Softkey have. And, they have started to organize themselves to do that.
They have also been very pleased at what MECC has been able to do in helping them in the school channel side of their business. They are also very pleased that their direct mail and direct response program was able to quickly take some of MECC's products and some of Compton's products and start getting them into the mix. They are working on tests on Learning Company products now too. One of the big things that MECC brought to the table was $21 million in cash. There was less than $0.5 million in receivables and less than $0.5 million of inventories. There was a total accounts payable of only about $1.5 million as well.
Most mergers and acquisitions don't work and most of them often don't work because the people don't work very well together. Softkey indicated that they have had success building good chemistry between the various management teams to the point where they have come to respect each others' complementary strengths and talents. They think this will pay off in ways that are much more material than what they save on the cost of goods or on accounting clerks.
The company was asked to comment specifically on turnover at the Learning Company. They responded by saying that there has been no abnormal activity in the employment area. They are in a competitive environment in California with other technology companies and they do lose people periodically, but there hasn't been any mass exodus of any nature.
PRODUCTS RELEASED IN Q2
Q2 was, by any measure, Softkey's most prolific quarter in releasing new products under very strong brands. If there is any theme in looking at their business in the last three months, they feel it has been that they have focused on leveraging the key brands that have come to the company through acquiring titles or, in the case of Learning Company and MECC, very strong brand franchises. They think that was a key factor in their success in the retail channel and others as well.
Interactive Math Journey was an extension of the success that was built around positioning very high quality educational content at higher prices, and they brought it out in math with Interactive Math versus Interactive Reading and the product was a success.
They have extended the Children's Bible from the original Bible product that was brought in from Compton's. They extended the encyclopedia business down to a lower age with the Children's Encyclopedia.
They extended their franchise and lifestyle products with new products such as Landscape Architect. They were able to synergize with content that came out of other groups. For example, in the case of the Tribune connection that they got from the Rice Group, a company that the Tribune owns, a new product content called Paint, Write, and Play, branded it under the Learning Company brand and launched it and it was successful. They extended their franchise in Learning Language titles with three new offerings there. The Reading Development Library was also successful in its launch.
These are all in addition to the catalog business that they have already. Softkey has over 500 products. They extended the SAT business (the college prep market) by going into the Macintosh side with a new platform, and probably added 15-20% in the quarter in the sales velocity of that title. Keycap Pro was upgraded and they brought out new lifestyle titles and learning titles such as Leonardo.
NEW PRODUCTS COMING IN Q3 AND Q4
It was clear to them that, in this market, if you have brands that already have franchises you must not only rely on the laurels of existing titles, you have to extend the franchise of those significantly. And that is the same for Q3. In Q3 they will continue this strategy by moving into strong new content categories under brand names. And that will be the philosophy that they go forward from now on with because they have seen what has happened in the overall market by just relying on old catalog titles. While they can provide a good constant sales base, they alone cannot be responsible for growth. And they have focused on their brands to give them that.
In the quarter, as a result of MECC and the Learning Company coming into the mix, Softkey has become an educational and reference purveyor. Over 70% of their business is now in these categories and they are very comfortable with that because those are categories that are growing and have tremendous life in their product cycles. In the cases of Oregon Trail and Reader Rabbit, for example, they are past a decade with consistent sales under those brands.
One of the advantages in this quarter, with Martin Rice and his team working in R&D, is that they have been able to take inventory of their technologies in all of their development facilities. In products coming in Q3 and Q4, Softkey's will see advantages of scale in terms of cost of developing them and maintaining them. They have technologies going into their products today that are being shared by multiple titles and that is a significant advantage. Their text-to-speech, for example, goes not only into one title but across many at a significantly lower cost and yet the quality is cutting-edge. And that is extremely important in being competitive against the new level of products that are coming out in reference and education.
In Q3 and Q4 there are several products that are beginning to build and extend themselves by providing online connections. Most notably is their Compton's Interactive product which will be upgraded in Q3. That product will have an extended connection to the Internet. It will provide content beyond what is on the CD-ROM when it is purchased. And, in addition to that, will connect customers directly to Softkey's own site where they can offer similar products that extend the interest of that person whether it be in medical, lifestyle, or education. They think the Internet is an opportunity for them to grow their business by connecting directly to their customers. And they are at an advantage here because they have 5 million registered end-users that have already purchased them on what is perhaps the lowest bandwidth, direct mail. They have now extended that to telephone lines and, through the Internet soon, they will direct-connect to them to sell them content online or at least register them at a discount so they will be allowed to service them on a direct basis at a lower cost. Everything they send in the mail today costs the company $0.54 and more. What they connect with through the Internet will be significantly less.
Looking forward into the rest of the year, most of Softkey's business will be built around their brands although there will be significant extensions on upgrades in this quarter. Some titles to note on a brand new basis include Logiquest which is their first 3-D educational product. Score Builder for ACT will continue on what they are doing in the college prep market. Other titles will be Ultimate Writing & Creativity Center and Compton's World Atlas. Interactive Reading Journey 2 will be a brand new product focused at children at an older age (5-8 years). Significant upgrades in Q3 will include Amazon Trail 2, The Silver Edition of Oregon Trail, and Compton's Encyclopedia 1997. New products from MECC will include new extensions for Treasure Math Storm and Treasure Mountain. There will also be new Berlitz titles.
INTEGRATING BRANDS
Softkey has some key value creation activities underway. The first is the use of their branding across the company's combined catalog of products. Softkey is a leading publisher in three primary categories -- education, reference, and personal productivity -- and is also a leader in the under-$20 impulse-buy category. As a result of its recent mergers, Softkey owns the most valuable brand franchises in the consumer software world including the Learning Company brand, the MECC brand, and the Compton's brand.
In addition to those product line brands, they also own the digital rights to many well-recognized brands such as Berlitz, Time Almanac, Popular Photography, American Heritage, and Moseby's. They also have some single-product franchises such as Calendar Creator.
Anyone who is a student of maturing consolidating industries will tell you that the branded, quality products are the ones that sustain over time through all of the consolidation and ultimately become the winners in those industries. They feel that the exciting news in that regard is that they are now, as a consolidated company, leveraging those brands and creating value for the end user, the retailer, and for their own business.
For the end user, branded products make it easier to purchase and give comfort and confidence that the purchase decision is a good one. It results in more initial purchases. It results in multiple product purchases as well as repeat purchases. And branded products are typically able to sustain higher prices over a period of time and catalyze more frequent store visits. These are all good attributes that the retailer really likes. Softkey is working very proactively with retailers now to maximize the benefits of having branded products.
CREATING VALUE BY LEVERAGING BRAND STRENGTHS
But, ultimately this has to translate into some benefit for Softkey. For Softkey, the benefit is not that they are the owner of a single brand, but that they are the owner of multiple brands and these brands really create the material to build incredible long-term value in the franchises that they own. As a result of the merger of the four companies, Softkey now uses a very well-honed development process where they are able to solicit a lot of consumer input and select the brand that is most appropriate for any given product that they are going to develop. Because they are not limited to a single brand, they can select a brand that will yield the highest possible number of sales at retail and really create incremental revenue for Softkey as well as incremental value for the brand. They see this as a significant competitive advantage.
As an example, the Ultimate Children's Encyclopedia that was released in Q2 was a product that was developed by Compton's. The assumption all along was that it would be a Compton's branded product because of its origin. But, after doing some study and after looking at the different alternatives, consumers told Softkey that they would have a higher propensity to purchase the product if it was labeled as a Learning Company product instead of a Compton's branded product. Accordingly, the product as it appears today is a combination of the company's efforts -- developed by Compton's, branded as the Learning Company, and distributed through the Softkey distribution system.
Softkey also enjoys benefits from branded product ownership because they can get products organized into brands and get systems of products. This gives them efficiencies in the advertising, promoting, and merchandising of these products. What they see in the industry is a consolidation of a sort that this industry hasn't seen at retail around fewer products that are more heavily promoted as opposed to many products that are not promoted. As such, when they have branded families of products they are in a better position to deliver the level of support that retailers need at a lower cost per revenue and a lower cost per unit of sales than anyone else is because of the diversity of what they have to offer. The distribution network of Softkey ultimately gives value to these brands because if you can't get the products in front of customers, the brand has no awareness and no value.
So, the first value creation activity is the ownership of brands. The second value creation activity they have is the result of their ownership of many products and the organization of those branded products into families. Softkey is now attracting some major corporate partners who want to work with Softkey almost on an exclusive basis. The reason for this is that Softkey can satisfy many needs because they can offer software either as a premium, as a cross-merchandising piece, etc. As an example, they are the exclusive supplier of software for American Express' Membership Awards Program offering some Softkey products. Their flagship product, Oregon Trail, can be found in Famous Footwear stores this Fall. It is sold there with coupons driving customers into retail software stores to buy additional products. AT&T offers Softkey software to its True Rewards members. General Motors is currently using the Compton's Street Guide in a multimedia promotional CD for its Oldsmobile line. Their relationship with the Tribune company has also produced a product that they are now shipping under the Learning Company label and they expect more good things to come of that long-term relationship.
The third major value creating activity is the ability to cross-sell many
of their products to many of their customers. In 1996, they expect to ship
more than 22 million units of their products and these products will reach
many customers. They believe that because of their direct mail skills, their
online technology skills, their relationships with Compuserve and America
Online, that they have the capabilities and skills to increasingly customize
their sales pitch to these customers and leverage customer loyalty in a way
that no other consumer software company can. * A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. | |
Copyright 1996,
The Motley Fool |