Berkshire Ruminations

Wednesday, May 03, 2006

Small-Cap Profile: Varsity Group, Inc.

This is a company that recently underwent an operational restructuring that I am confident will prove much more profitable to the firm. The firm started out as selling college textbooks over the internet and employing college students to promote the company on campus. This was at the height of the dot-com bubble and the company targeted any and every university in the country – including mine – but could never penetrate the market. This industry was and is extremely competitive and the firm did fairly poorly. Varsity Group today, however, has identified an altogether different niche, one that will afford them competitive advantages that would have never been possible under the old business model.

Today, the company contracts with private high schools to provide all the textbooks for the school. The key to this model is contracting. Once the company contracts with the school, the individuals purchasing the books or uniforms have little to no buyer power. This is not to say, however, that the company can ignore potential competition, but only that it will be protected by temporary barriers to entry.

The most exciting benefit from the change in business model is the new customer base. As opposed to the stereotypical “starving-college-student,” to which the company previously marketed its product, the company now is selling to affluent parents, parents rich enough to send their kids to private school in the first place. The typical private high school student will visit the school bookstore with his parents, often buying more than he needs, including every accessory that strikes his fancy. It is a highly price-insensitive clientele. This, of course, compares favorably to the college student I often see so strapped for cash that he will forego buying textbooks altogether.

Additionally, just last year Varsity Group began selling uniforms, through its acquisition of a private uniform provider, with great success. Sales of uniforms are equally as profitable as sales of books, so the company can maintain its strong margins while adding to its product mix. More importantly, though, the company will be able to increase sales per school by providing more than just books.

The Varsity Group annual report is presented clearly and comprehensively. I especially like and appreciate how the company presents its financial statements. Varsity presents each source of revenue and expense separately. This makes it really easy to see how profitable each revenue stream is, and where the growth in total sales is coming from.

It is apparent from a glance at the company’s income statements since its IPO in 1999 that this model is dynamite, as its earnings have exploded, from zero around the time of the change in 2002, to over $12 million in 2005, all on the original $88 million of paid-in-capital. The company has yet to use debt financing, and founder and former CEO Eric Kuhn retains 8% of the outstanding shares. The current P/E of only 8 will get your attention, but a DCF valuation with conservative assumptions yields an intrinsic value high above the current price of $5. For this reason I think there is a considerable margin of safety in and investment in this company.

I own quite a bit of this stock. Bought it back in February at $3.85.


  • Am I mistaken, or when I extract the income tax benefit (presumably from losses of prior years), the PE ratio is more like 33, without accounting for potential taxes which would have accrued to this company had it operated profitably in all years past?

    By Blogger Jay Walker, at 20 May, 2006 22:14  

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