Salomon says School Specialty convert looks somewhat pricey

Nashville, Tenn., Nov. 19 - School Specialty Inc.'s stock was punished after the company posted weaker-than-expected earnings and warned it would likely miss expectations over the next few quarters. Thus, Salomon Smith Barney convertible analysts said that they don't necessarily dislike the stock story but that given the low volatility in the stock and the underlying credit, the School Specialty 6% convertible due 2008 looks somewhat pricey.

After the company announcements, School Specialty shares dropped by about 25%, falling from the $30 level just prior to the announcement of October period results, a Salomon report on Monday noted. The convertible analysts noted that the investment firm has lowered its earnings per share estimate for this year to $1.14 from $1.64 to reflect the dilution from the acquisition and the anticipated softness in the core business.

"Considering the small size of the company, we'd say the underlying credit here isn't too bad. Total debt to capital for this $450 million market cap company weighed in at a respectable 38.6% at the end of the October quarter, down from 42.9% at the end of the last fiscal year in April and down even further compared to the year ago 46.1% ratio," said Salomon convertible analyst Stuart Novick in the report. "Given the significant amount of availability on the company's $350 million credit facility, liquidity is not currently an issue even after accounting for the outflow of $152 million for the Premier School Agendas purchase."

School Specialty's interest coverage ratios are likely to remain comfortable and the balance sheet also looks okay as well, the report stated.

"We like the relatively low leverage on the balance sheet, and the outlook for bottom line improvement suggests that interest coverage ratios will remain comfortable through the foreseeable future. On the other hand, tangible book value remains skimpy due to a large amount of goodwill incurred via acquisitions and, maybe more importantly, the company's cash flows and earnings are extremely seasonal in nature adding an element of operational risk and the potential for liquidity management concerns," Novick said in the report. "Also, further acquisition activity - management plans to complete $90 million to $100 million per year in acquisitions going forward - could limit liquidity, increase interest expenses and stretch School's balance sheet."

The School Specialty 6% bonds have traded richly since their issuance back in July, the report stated, and look expensive based on Salomon's assumptions of an appropriate credit spread of 750 basis points, akin to a single-B credit, and assumed 35% volatility in the stock, compared with the actual 100-day stock price volatility of 56%. Those assumptions put the School Specialty 6% converts trading about 6% rich, which have been trading in the past several weeks at 2 points to 7 points over parity with premiums over investment value almost as high as 70%, the report said. The bonds have call protection through August 2004, although the report noted that at the current 32.7% premium, the breakeven period of 4.2 years falls outside of the call protection period.

"Additionally, considering the size and financial condition of the company, we don't believe that the convert's 5.5% yield to maturity is all that compelling," Novick said in the report. The report also pointed out that given the small number of outstanding School Specialty shares, hedgers should keep in mind that it may be difficult to borrow this stock. In fact, short interest already exceeds 2 million shares, which is pretty substantial number considering that there are only 17.5 million shares outstanding.

"On balance then," Novick said in the report, "while we don't necessarily dislike the School Specialty story or the company's underlying financials, we wouldn't advocate paying up for the convertible issue, either."

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