Description

Please see below for a summary of our short thesis on Virco Manufacturing Corporation (VIRC). VIRC manufactures furniture for education markets. We believe VIRC is materially over-earning and over-valued. Note: VIRC’s Fiscal Year ends on January 31^st, so already reported FY24 and FY20 was the last full Fiscal Year before CV19.

Profits Are Over-Earning, Mainly Due to Unsustainable Gross Margins (GM)

During the (5) years before CV19, VIRC’s GM averaged 34.6% (tight range 33.8% - 36.1%). During that same timeframe, VIRC’s EBITDA margins never exceeded 6% and VIRC’s EBITDA never exceeded $12mm. CV19 triggered an era of supply chain disruption, a preference for U.S. manufacturers, and a mix shift toward larger (and more service intensive) classroom furniture. As a U.S. manufacturer with relatively less supply chain challenges, VIRC pushed prices higher and VIRC’s GMs expanded. VIRC’s GM expansion culminated with a multi-decade high of 43.1% during last year (FY24). VIRC’s Management has not provided any indication that FY24’s 43.1% GM is sustainable. As supply chains normalize and K-12 budgets tighten, we believe GMs (and thus EBITDA margin) will revert lower. We believe VIRC’s normalized GM is in the ~mid-30s and we believe VIRC’s normalized EBITDA margin is ~MSD (versus 14% in FY24).

Profit Margins Soared During the Late 1990s, But Subsequently Crashed Down

If you study VIRC’s share price (Below, Visual #1), you will see the stock soared in the late 1990s. From FY94-FY96, VIRC earned an average of 7% EBITDA margin. Then, VIRC’s EBITDA margins averaged 12% from FY97-FY00. It was during this era that VIRC’s share price increased from <$7/share (CY96) to >$17/share (CY98). In the late 1990s, VIRC benefited from a relatively less-competitive marketplace. But in 2001, China entered the WTO and put pressure on U.S. manufacturers. Thus, VIRC’s EBITDA margins reverted lower and averaged just 6% from FY01-FY05. Unsurprisingly, VIRC’s share price fell to <$7/share (CY03). We believe history will repeat: as supply chains normalize, the long-standing economic concept of comparative advantage will prevail and VIRC’s industry will return to the 2001-2019 approach of global sourcing.

VIRC Has No Distinguishable or Proprietary Technology On Its Product …

Over its 70+ year history, VIRC has become the largest manufacturer and supplier of moveable educational furniture and equipment for the education market in the U.S. Admittedly, VIRC has excelled due to its full-service capability and efficient delivery process. However, there is nothing fundamentally advantageous about using VIRC’s products. As Visual #2 (Below), VIRC’s products are rudimentary chairs, desks, and tables. The structural simplicity of these products contributes to the fact that VIRC’s historical EBITDA margins are relatively low (~MSD%) and the industry is highly competitive. Said differently, the structural simplicity of the educational furniture products should prevent ‘open-ended’ revenue and margin growth.

… Meanwhile, VIRC Has Numerous Competitors and Price Is Primary Factor

Per VIRC’s FY24 10K, “Virco has numerous competitors in each of its markets.” Also, the number of competitors has grown. VIRC’s FY09 10K listed (10) key competitors (either a manufacturer or large reseller like School Specialty). Fifteen years later, VIRC’s FY24 10K, listed (17) key competitors (either a manufacturer or large resellers like School Specialty and School Outfitters). Competitors’ websites also highlight that chairs, desks, and tables seem comparable in function. Thus, it is unsurprising that, in VIRC’s own words (per FY24 10K): “The educational furniture market is characterized by price competition, as many sales occur on a bid basis.” In sum, the industry’s shear number of competitors and the price-sensitive bidding dynamic are contributing factors to our view that VIRC’s margins are unsustainable.

VIRC Has Anemic Volume Growth and Revenue Growth Due to Pricing

Each year, VIRC provides its revenue growth attribution due to 1) price 2) volume. This data can be found in the Financial Highlights section of VIRC’s 10K. Before CV19 (FY15-FY20), VIRC had +0.3% volume CAGR and +2.8% price CAGR, i.e. ~all VIRC’s revenue CAGR stemmed from pricing. Since CV19, VIRC had -0.3% volume CAGR and a whopping +9.4% price CAGR. Regarding volume, we can conclude that: 1) underlying volume growth is anemic over a long period -and- 2) volume is not currently over/under-earning in a material way, i.e. Pre/Post-CV19 volume CAGRs are similarly ~0%. Regarding price, we can conclude that VIRC benefited from unusually large price CAGR since CV19. For example, Pre-CV19 CPI averaged ~2% and VIRC had 2.8% pricing CAGR. Since CV19, CPI averaged ~4% and VIRC had 9.4% pricing CAGR. As discussed throughout this write-up, we believe macro tailwinds will prove temporary and competitive pressures will increase, thereby rendering VIRC’s pricing CAGR and VIRC’s elevated margins to be unsustainable.  

Industry Offers ‘Worst of Both Worlds’: < GDP Growth and Cyclicality

As discussed above, VIRC’s volume CAGR has been ~0% for the past decade. Stepping back, VIRC’s non-existent volume growth shouldn’t be surprising given that K-12 enrollment increased from ~45mm (1985) to ~56mm (2019), for a paltry < 1% CAGR. Often, slower-growth industries are recession resilient. However, that is not true for the education furniture market or VIRC. First, let’s examine VIRC during the Dot.Com recession. VIRC’s revenue peaked in FY01 (year-end January 2001) and then VIRC’s revenue declined Y/Y for the next (3) years. VIRC’s FY03 10K is very blunt, “The commercial furniture markets, including Virco's core school markets, have suffered from the recent economic recession.” Now, let’s examine the Great Financial Crisis, VIRC’s revenue peaked in FY08 (year-end January 2008) and then revenue declined Y/Y for the next (6) years! Early in the GFC, VIRC said, “In 2008, the budgets of state and local governments were severely impacted by economic events related to the recession.” But many years later (CY12), VIRC was still citing macro challenges in its 10K, “The decrease in sales was caused by continued unfavorable economic conditions that had an adverse impact on budgets for school spending.” To conclude, education furniture is an inherently discretionary component of a school budget because the existing install-base (of furniture) can always ‘last’ one more year. As the data proves, this creates a dynamic where through-cycle volume growth is already < GDP -yet- the industry is also very susceptible to economic downturns.

K-12 Spending Faces Future Challenges That May Limit Furniture Spend

The Elementary and Secondary School Emergency Relief (ESSER) Fund was a series of Federal grants created by Congress in response to CV19 to help schools recover. In totality, K-12 schools received more than $190 billion in ESSER funding (distributed over three ‘rounds’). The distribution of ESSER funds coincided with high inflation. Schools must pay significantly more for utilities, fuel, supplies, health insurance, employee wages, and other operating costs. ESSER funding has helped school districts manage the inflationary costs. But, ESSER funds will cease being allocated in late 2024. Now that ESSER funding is ending, schools still face high costs despite less funding. While we can’t quantify a direct link between ESSER funding and K-12 furniture spend, common sense indicates school districts will be forced to tighten/prioritize spending. As history indicates (Dot.Com and Great Financial Crisis), the furniture market is very sensitive to funding declines and we believe other K-12 operating expenses will be prioritized.  Therefore, we think the expiration of ESSER funding will be a headwind for VIRC.

VIRC’s Long-Tenured Management Team Has Not Sustained Shareholder Value

VIRC’s Management team seems highly respected, both in the education furniture industry and in the southern California community. We commend Management’s ability to employ hundreds of Americans and make quality products that our own children use daily. Notably, the same Management team has been in-place for decades: CEO at VIRC for 60+ years, President at VIRC for 30+ years, CFO at VIRC for 30+ years, COO at VIRC for 30+ years. With that being said, VIRC’s Management team has not created sustainable value for shareholders. For example, let’s look at VIRC’s stock price over multiple decades: January 1995 = ~$6/share, January 2005 = ~$8/share, January 2015 = ~$2/share, January 2020 (just before CV19) = ~$4/share. VIRC’s stock has soared recently; but, even inclusive of the current ‘rally’ to ~$18/share, VIRC’s stock has generated an awful ~4% CAGR since CEO Virtue became Chair & CEO in 1990. The lack of shareholder value creation shouldn’t be surprising given that VIRC’s sustainable revenue growth has been non-existent: FY90 revenue was $189mm and FY20 revenue (just before CV19) was $191mm.

Compensation Structure Lacks Alignment with Shareholder Value Creation  

As its Annual Bonus structure, VIRC uses a “Entrepreneurial Salaried Bonus Plan” (ESBP). Once a minimum EBIT threshold is achieved, 1/3 of any additional earnings by VIRC (more than the minimum target) are available for distribution to the (140) salaried employees participating in the ESBP. The ESBP structure has remained essentially unchanged since the early 1990s. However, the ESBP distributions (and thus all Annual Bonuses) are paid entirely in cash. VIRC doesn’t provide equity as a part of the Annual Bonus opportunity.  Regarding Long-Term Bonuses, VIRC has not granted RSUs since 2020. All RSUs vest at 20% per year for (5) years from the grant date; the RSUs have no performance criteria, like Total Shareholder Return or Return on Invested Capital. We believe VIRC shareholders have suffered decades of underwhelming returns, and it is directly attributable to the lack of alignment between Management compensation and shareholder value creation. Notably, CEO Virtue only beneficially owns ~480K shares, or ~$8mm, despite being a Director since 1956. To conclude, we respect VIRC’s Management team; but, we think they’ve done a poor job for shareholders -and- we see no forthcoming change to Management.

VIRC’s Current Valuation Already 'Prices-In' Hope of 'New Normal' Profitability

As a refresher, VIRC generated $12mm EBITDA in FY20 (just before CV19) and VIRC’s EBITDA was rangebound between $8mm - $12mm in the (5) years prior to CV19. VIRC’s EBITDA has soared to $41mm LTM. At $18/share, the implied EV/LTM EBITDA is now 7.5x. For context, a Peer Composite of Steelcase (SCS), HNI Corp (HNI), Kimball (KBAL), and MillerKnoll (MLKN) averaged a comparable 8.3x from CY15-CY19 (with a range of 7.5x-9.1x). During the same time-frame, VIRC had a 9.3x EV/LTM EBITDA.  As you can see, VIRC’s current 7.5x EV/LTM EBITDA multiple only implies minimal EBITDA normalization from $41mm LTM. As such, we believe VIRC offers attractive asymmetry whereby: 1) a continuation of tailwinds seems largely ‘priced in’ -and- 2) valuation reflects little probability of EBITDA reverting to much lower levels. Ultimately, we believe VIRC is worth ~$8/share today, based on assumptions that: 1) Revenue will decline FY26 & FY27 2) GM will compress to mid-30s by FY27 3) EBITDA margin will compress to ~MSD by FY27 4) VIRC will be valued at its Pre-CV19 level of 9.3x LTM EBITDA and 5) Future value discounted to present value at 10%/year.

Visual 1

Visual 2

Catalyst

GM peaking and earnings starting to decline in FY25

ESSER fund expiration