EDUC - Educational Development Corp: Closing The Book On This MLM Disaster

2023-05-01 13:00:00 ET

Summary

• EDUC is going to report its fiscal fourth quarter results on or before May 11, and we are confident the numbers are going to be terrible.
• A detailed analysis of publicly-available consultant sales data strongly suggests that MLM revenues in the quarter were abysmal.
• The ongoing deterioration of product sales has amplified the disconnect between revenues and inventory balances, increasing the risk of an inventory write-down.
• Another quarterly operating loss could result in an event of default by EDUC on the company’s credit agreement.
• The addition of an accounting and audit expert to the Board less than two weeks after a forced amendment to EDUC's credit agreement should be very concerning to investors.

As our followers know, we have been fairly consistently negative on the outlook for Educational Development Corporation ( EDUC ) over the past two years. Many investors have saved a tremendous amount of money by considering our analysis and selling their shares, but unfortunately, we believe another grim chapter is about to be written on this investment.

Next month, EDUC will release its earnings report for its fiscal fourth quarter ending February 28, 2023, and will publish its Annual Report on Form 10-K. And unfortunately for those still holding the stock at that time, the results are likely to be breathtakingly terrible. In what will likely be our final treatise on the subject, we will discuss below why we believe existing shareholders would be best served by selling their shares in the near term.

For a helpful background on EDUC and the reasons why its stock price has crumbled almost 90% over the last two years, we would recommend reading our latest tetralogy on the company, beginning with Educational Development Corporation: Rapid Consultant Losses Don't Augur Well , and continuing with these articles in February 2022 , July 2022 , and January of this year .

PaperPie Segment

EDUC's business now consists almost solely of its recently renamed PaperPie (f/k/a Usborne Books & More, or UBAM) segment, now that EDUC's primary supplier Usborne Publishing Limited in the UK has terminated its relationship with EDUC's publishing segment in favor of HarperCollins .

The rapid decline of PaperPie's sales and operating profits have been well documented; however, EDUC's fiscal fourth quarter will demonstrate to investors that there is still absolutely no light at the end of the tunnel. Although the company has made some minor attempts to stem the decline, such as the $658,200 acquisition of SmartLab Toys , the company's fortunes are still completely tied to how many PaperPie Brand Partners (f/k/a UBAM Consultants) they recruit, and how much each of those Brand Partners sell.

Oddly, EDUC makes available to all of its PaperPie Brand Partners the monthly sales numbers of its top salespeople. All one has to do is become a Brand Partner to receive access to this rich dataset which would give any decent analyst the ability to determine how good (or bad) the PaperPie segment's sales are going to be.

To become a PaperPie Brand Partner, all one needs to do is pay $10.00 to activate one's account:

To make getting access to these data even easier, on March 14 of this year, an interested investor could become a Brand Partner for the trivial price of $3.14:

Upon becoming a Brand Partner, one can download all manner of data about how the PaperPie segment is performing on a real-time basis. We believe that the best measures of how much Brand Partners, in aggregate, are selling, are the sales numbers of the top-selling Brand Partners. We therefore downloaded, and added up, the top-50 Brand Partners' sales for each calendar month, and then summed the three months of each fiscal quarter to see how sales were trending.

Consider the below table, which demonstrates how the year-over-year growth in quarterly PaperPie net revenues is completely tied to the year-over-year growth in the average number of PaperPie Brand Partners (or consultants) each quarter, and the year-over-year growth in how much the top 50 Brand Partners sell.

In fact, if you perform a regression of Column C against Columns A and B, you get the following formula, with an R-Squared of 0.97 (i.e., Column C is almost perfectly explained by Columns A and B):

C = -0.92% + 1.51A +0.81B

So, what does this mean for the upcoming fourth fiscal quarter? Well, we know for a fact that the top 50 sellers sold the following amounts in December, January and February, respectively: $198,128, $148,391 and $138,140. In total, this $484,659 is 15% lower than what it was in EDUC's fiscal fourth quarter of 2022 (and 35% lower from EDUC's previous quarter).

Using our proprietary surname analysis that we have discussed in previous articles, we have already concluded that EDUC is likely going to report an average number of PaperPie Brand Partners this quarter of approximately 24,000 (or 36% below what it was a year ago). We think that the actual number of active Brand Partners is dramatically lower than 24,000; however, we also have come to believe that EDUC employs a very liberal definition of "active" in the calculation of this figure, so we are assuming they will do the same thing this quarter.

Using the above formula, then, we conclude that EDUC's net revenues from its PaperPie segment was likely down 52% year-over-year in the quarter, to a mere $9.8 million .

Considering that EDUC lost the rights to distribute Usborne's products to retail customers after January 31, 2023, and that the Publishing segment's net revenues were $2.9 million in EDUC's fiscal fourth quarter of last year, we believe it is reasonable to assume the company generated net revenues of approximately $2.0 million this quarter. This would bring EDUC's total net revenues in the quarter to $11.8 million, the lowest quarterly sales results in almost a decade.

While cost of goods sold, operating and selling and sales commissions expenses all vary with net revenues, general and administrative expenses don't. With G&A averaging $4.3 million per quarter over the first three quarters of EDUC's fiscal year, it is extremely difficult to construct a scenario whereby the company does not report large operating and net losses this quarter.

While another quarterly loss for a company that historically has been able to remain profitable through most economic environments would not be a good thing, the more important issues are what would this revenue shrinkage mean for EDUC's inventory valuation, and how would another loss impact the company's compliance with its recently amended credit agreement .

Inventory Issues Could Exacerbate The Loss

In February 2022, our article Educational Development Corp. And Bloated Inventories: Tulsa, We Have A Problem included a detailed analysis of how EDUC's bloated inventories created the risk of a big provision. Since then, EDUC's net inventories haven't been worked down very much, and still sat at $65 million before inventory valuation allowances on November 30, 2022.

Despite the fact that PaperPie's sales have been falling precipitously and despite the fact that EDUC's Publishing segment appears to be in the process of being almost completely eviscerated, EDUC hasn't yet materially increased its inventory valuation allowance (it has gone from $932,000 on 11/30/21 to only $998,000 on 11/30/22).

We continue to think that a large inventory write-down is likely to occur in the near future, which will not only further impact EDUC's net income, but will quite possibly cause the company to violate the Fixed Charge Coverage Ratio covenant in its credit agreement.

As of November 30, 2022, EDUC's total debt was over $44 million . Its credit agreement specifies that the company is to maintain a fixed charge coverage ratio of at least 1.25 . Simplified, this means that the company needs to generate $1.25 in EBITDA for every $1.00 in fixed charges (e.g., interest expenses and scheduled debt repayments) over each trailing twelve month period. Over the first three quarters of the company's fiscal year, EDUC reported an operating loss of $0.5 million. We believe that even without a large inventory write-down, the company is going to report a significant operating loss in its fourth quarter. As a result, the company could very well be close to being in default.

Interesting Board Appointment

One recent 8-K filing by EDUC that caught our attention, and that we believe might be related to this inventory valuation concern is the announcement on January 11 that EDUC's Board of Directors added well-regarded accounting professional Bradley Stoots to the board . Mr. Stoots was a longtime Grant Thornton Audit partner who served in multiple leadership roles within the firm's Tulsa office for more than 20 years.

Normally, we wouldn't pay too much attention to a company adding an accounting professional to its board. In EDUC's case though, we believe this is very significant, considering the company's history of questionable corporate governance. This is the company, after all, who has a part-time local real estate agent on its board, and has incorrectly presented this director's employment status for almost a decade in its annual proxy statements :

As an aside, on April 23 we actually asked all members of EDUC's current Board of Directors why the company has not been accurately presenting Dr. Neal's background in its proxy statements for almost a decade, but nobody has yet chosen to respond to our inquiry.

So, with EDUC historically having what appears to us to be a fairly easygoing approach to corporate governance, why would the company increase its number of directors and then add a highly-experienced senior accounting professional to its board just weeks prior to the end of EDUC's fiscal year? There is obviously no way for us to know at this point, but the fact that the company felt the need to improve its accounting expertise on its board of directors at this time suggests to us that the company might be facing higher-than-typical accounting challenges.

Conclusion

At roughly $2.00 per share, Educational Development Corp. has experienced a tremendous stock price decline since peaking at $20 at the height of the pandemic. However, we are confident that this is not the end of the value destruction, and think that the future path of EDUC's stock remains crystal clear. We believe investors in the company would be best served selling their stock now before the company demonstrates once again in May just how much its fundamentals have weakened.

While this marks the end of our journey with this company, we look forward to finding other dramatically mispriced securities in the small and microcap universe, and will keep our interested readers apprised of our findings.

Risks To Our Thesis

There exists a number of risks that our thesis is incorrect. For instance:

1. EDUC could find success at recruiting more PaperPie Brand Consultants than it loses.
2. PaperPie Brand Consultants could, on average, increase their sales of EDUC's products.
3. A larger consumer products company could seek to acquire all of EDUC's shares at a premium to the current stock price.

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