Friday, November 7, 1997

The Learning Company, Inc.
(NYSE: TLC)
Phone: 617-494-1200
Website: http://www.learningco.com
Price (11/6/97): $19 3/8

HOW DID IT DOUBLE?

This educational software firm has been teaching the ABCs of surviving a tough marketplace: Acquire Brand name Competitors. Until last spring, that alphabet left The Learning Company in the soup, as investors found that after ABC came D, for Debt, Decline, and Disappointment. Yet shareholders watching their Ps and Qs have discovered that private placements, preferred stock, and decent earnings reports work as well as a crib sheet.

In late 1995, low-budget software maker Softkey International won a bidding war with BRODERBUND (Nasdaq: BROD) to acquire upscale "edutainment" giant The Learning Company. Softkey eventually took its target's well-respected brand name as its own. The deal was part of the broad industry consolidation, as the industry pattern of big-budget hit or (mostly) miss productions left companies battling for shelf space, with most of them losing out.

The bidding for Learning Co. represented a market peak for edutainment software firms like Broderbund that would be followed a year later by a peak for game distributors such as GT INTERACTIVE (Nasdaq: GTIS). In the first rout, Learning Co. lost half its value from an all-time high above $50 reached in the fall of 1995. In the broader collapse, the company lost another 80% of its value, spinning to a low of $5 1/2 in last spring's correction before rising again.

The rebound has followed a continuing shakeout in the edutainment market, as competitors such as MICROSOFT (Nasdaq: MSFT) have cut back on their titles and DISNEY (NYSE: DIS) has been among those cutting back on in-house publishing, finding that licensing Mickey may prove more profitable. At the same time, Learning Co. has been gaining market share and delivering on the lowered earnings estimates. For the third quarter, the company earned $0.45 per share before amortization charges.

In August, a trio of institutional investors agreed to turn $150 million of the company's $454 million in convertible debt into preferred stock. More recently, Canadian investors put up $62 million in a private placement to buy Learning Co. warrants.

BUSINESS DESCRIPTION

The Learning Company develops and markets premium software for every age group, with an emphasis on educational and reference CD-ROM titles for the consumer market and for schools. In addition to its Reader Rabbit, Oregon Trail, Treasure, and Super Solvers series, the company offers titles devoted to writing and creativity, college prep, and foreign languages. Its reference software includes the Compton's multimedia encyclopedia and Bodyworks medical series.

The company has grown rapidly by acquiring firms such as EduSoft, Minnesota Educational Computing, and Aris Multimedia Entertainment. On October 24, the company announced plans to acquire Creative Wonders, a joint venture of ABC Inc. and ELECTRONIC ARTS (Nasdaq: ERTS), for $40 million. With Creative's Sesame Street line and projected $30 million in FY98 sales, Learning Co. stands to become the market leader in dollar sales of educational software in the U.S.

The Learning Company's products are sold in over 23,000 retail stores, with an increasing presence in mass merchant outlets such as Wal-Mart. Still, U.S. retail sales account for only half of the company's revenues. The rest are generated overseas or through more profitable channels, including schools, online, direct response, and PC manufacturers. In August, Amway signed up to sell Learning Co.'s educational software through its catalog.

The huge amortization charges putting a hit on the company's earnings result from accounting standards related to its acquisitions. The amount by which an acquisition price exceeds the target's hard assets must be chalked up to goodwill. Since a software firm's key assets are primarily intangible (brand names, intellectual property, personnel), goodwill is substantial. Non-cash write-offs of these assets occur over a set period of time, lowering the reported earnings.

FINANCIAL FACTS

Income Statement
12-month sales: $363.4 million
12-month income: $77.5 million*
12-month EPS: $1.67*
Profit margins: 21.3%*
Capitalization: $955.2 million
(*Excludes amortization & acquisition charges and deferred income taxes.)

Balance Sheet*
Cash: $96.6 million
Current Assets: $225.7 million
Current Liabilities: $120.8 million
Long-term Debt: $453.7 million
(*Prior to announced $150 million debt conversion and $62 million private placement)

Ratios
Price-to-earnings: 11.6
Price-to-sales: 2.6

HOW COULD YOU HAVE FOUND THIS DOUBLE?

Last October, Randy Befumo (TMF Templr) offered the pros and cons on Learning Co. in The Lunchtime News, citing good earnings but the threat of market pressures. Foolish synopses of the third quarter '96 and fourth quarter '96 conference calls showed that the company was suffering some from price competition.

But its distribution system left it relatively less exposed than other edutainment software players, including Broderderbund, which had looked promising a year earlier prior to the delay of Riven, the follow-up to its wildly popular Myst fantasy game. Understanding Learning Co.'s strengths in distribution might have nurtured a contrarian's perspective on the stock.

Still, even newcomers had a chance. New analyst recommendations, listed each day in Investor's Business Daily, can serve as potential investment ideas. When Furman Selz initiated coverage of the company July 22 with a "buy" recommendation and a price target of $20 when the stock was around $9, investors might have taken note.

WHERE TO FROM HERE?

The October 6 Business Week offered a useful overview of the consolidating CD-ROM games and educational market. Due to lower selling prices, revenue is expected to increase by just 22% this year, to $1.7 billion, down from the 47% growth last year and the 128% increase the year before. Research firm PC Data estimates that The Learning Company, CUC INTERNATIONAL (NYSE: CU), and Disney have a lock on more than half of retail sales in the education software market.

Learning Co.'s sales have recently picked up, with several of its Reader Rabbit software titles and new American Girls product making the top 10 retail sales list for September. Add the products from Creative Wonders and Learning Co. would have had seven of the top 10 titles. That may be one reason Piper Jaffray recently upgraded the stock from "neutral" to "strong buy" with a 12-month target of $26 to $28.

Plus, the firm's Cyber Patrol software will be the exclusive content filter on Microsoft's Explorer Plus Internet browser. That should boost Learning Co.'s mind-share among concerned parents, the kind likely to buy educational software products.

First Call shows consensus estimates of $1.59 per share this year and $1.51 in FY98. Both numbers are below the $1.77 earnings (before amortization charges) reported last year, making a PEG irrelevant. With three analysts expecting long-term growth of 15%, below the industry average of 23%, YPEG fair value stands at about $22 1/2.

The company remains somewhat risky, though. It has negative shareholders' equity due to a debt burden rarely if ever seen in the software business, and shareholders will eventually experience substantial dilution. The good news is that with trailing earnings before income tax, depreciation, and amortization (EBITDA) of about $126 million, Learning Co. can easily cover its $16 million annual interest payments going forward. Plus, the stock looks about right at 10.2 times its enterprise value of $1,288 million.

Yet skeptics argue that the former Softkey has used acquisitions as a form of product development, so some of those amortization charges really amount to R&D expenses, making the cash flow number suspect. Will the company be able to deliver a steady stream of popular new titles without gobbling up other firms? Investors looking for edutainment should do their homework.

-- Louis Corrigan
(TMFSeymor@aol.com)

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