School Specialty Drops to Neutral

We recently downgraded our recommendation on School Specialty Inc. ( ) to Neutral with a price target of $3.35. Earlier, the education company, offering supplemental educational products and equipment, had been enjoying an Outperform rating.

Where lies the Weakness

The recent economic downturn has resulted in an uncertainty related to state budget funding levels in the school districts, which has led to a cautious spending approach. A continued softness in demand still persists for both curriculum-based products and supplemental materials.

Many districts opted to defer their purchasing as states delayed their traditional adoption cycles for a new curriculum, indicating ambiguity in the marketplace about the school budgets and the alteration in common-core standards.

School Specialty has been witnessing a decline in the top-line. Total revenue decreased 5.1% year over year to $85.3 million in the third quarter of 2012, following a decline of 13.9% in the second quarter, and fell short of the Zacks Consensus Estimate of $97 million.

Looking back, School Specialty registered an increase of 9.1% in the first quarter of 2012 and 8.8% in the fourth quarter of 2011. But it had registered declines of 12.9% in the third quarter, 15.7% in the second quarter and 23.4% in the first quarter of 2011. Management hinted that the third quarter reflects the smallest volume in terms of revenue, in the year.

On the other hand, the company’s bottom line is also suffering. After posting earnings decline of 51% during the second quarter of 2012, the company incurred a loss of 86 cents a share in the third quarter. However, it fared better than the Zacks Consensus Estimate of 91 cents loss per share and also substantially narrowed from a loss of $1.07 delivered in the third quarter of 2011 on the back of effective cost management. But we still remain cautious about the company’s performance going forward.

Competition a Threat

The company operates in a highly fragmented industry with more than 3,000 smaller companies offering supplemental educational products and equipment. Moreover, School Specialty also competes with alternate channel marketers, which include office product contract stationers and office supply superstores, such as Office Depot Inc. ( ODP - Analyst Report ) .

Strength in Store

School Specialty is the leading provider of supplemental educational products for the PreK-12 market in the U.S. and Canada. The company leverages its strong distribution network to offer more than 75,000 items to approximately 91,000 schools in the U.S. This provides a competitive advantage to the company and bolsters its dominant position in the market.

The company remains committed to augment sales through multi-channel and multi-market approach as well as improve margins and market position through cost-containment efforts, effective working capital management, product line-ups and e-commerce systems. The company anticipates saving about $10 million yearly through its cost reduction program.

The company’s selective acquisition strategy and disciplined integration approach have facilitated it to consolidate its leading position within the supplemental educational products and equipment industry, and improve its national marketing and distribution platform.

Consequently, management reiterated its fiscal 2012 guidance, and continues to project loss per share in the range of 50 cents to 65 cents and revenues between $730 million and $740 million.

Zacks Rank Defining Neutral Stance

Currently, School Specialty holds a Zacks #3 Rank that translates into a short-term ‘Hold’ rating and correlates with our long-term recommendation.