Saturday, November 14, 2009

>EDUCOMP SOLUTIONS: Stressed and Streched

Educomp’s core business of Smart Class (50% of revenues and 60% of profits) is seeing deteriorating economics as growth shifts to smaller towns. Both per student realisation as well as number of classrooms wired per school will see a leg down. The new securitization arrangement, and associated upfront revenue and profit booking ensures that this does not show up in reported financials yet, but the trend is concerning, even as Educomp is stretched thin across a multitude of other businesses, most of which are making losses, and others such as ICT are seeing margins erode. EPS Cagr is set to head to the teens over FY10-13, putting downward pressure on PE multiples. We downgrade the stock to Underperform.

The battle comes home: Deteriorating economics in Smart Class
With a near monopoly in its multimedia content for private schools business (Smart Class), we had expected growth to continue unhindered till at least 8,000 schools (1/3rd of target market) were won. Instead, we notice that with just 2,200 schools implemented, Educomp is now shifting increasingly to smaller schools where per student fee will drop to Rs130 (from Rs150 earlier) and classrooms per school will now be 18 (from 25 earlier). This is a 40-45% swing in core assumptions for Smart Class, and even with an accelerated school addition estimate of 2,000 in FY11, the slide in Smart Class economics is clear.

How does the new securitization arrangement help reported financials?
We like the cash flow profile of the new securitization structure for Smart Class, but disagree with the front loaded recognition of revenues and profits. Notably, this accounting choice will likely mask underlying business deterioration in FY11. Profit estimates that would have been cut 20-25% otherwise per new Smart Class assumptions are instead getting a 15-18% boost thanks to the new accounting policy. In fact, with the new accounting policy, Educomp’s reported profits for FY11 would be higher by almost 80% c.f. older accounting method (refer Figure 9). We note that for the current fiscal, Educomp’s net profit guidance has already been effectively cut, if the one time stake sale proceeds from Pearson JV and the benefits from a mid year accounting change in Smart Class are adjusted.

Stretched thin elsewhere
Our March 2008 report on Indian Education argued that the education business opportunity, while large, is skewed towards just a few segments. While Educomp’s leadership position within the sector is laudable, we suspect there are too many businesses vying for attention, with some making losses. The efforts in vocational training, higher education, e-learning, pre-schools, K-12, Smart Class, and ICT are set to expand further with tutoring and public-private partnerships on horizon.

Growth expectations need tempering, and valuations to take a leg down
Even with a revised earnings model including front loaded revenue and profit recognition, Educomp trades at 19xMar11 earnings, even as EPS Cagr will rapidly reduce ahead, hitting the teens over FY10-13. Elevated growth expectations need tempering and valuation multiples are at risk. We rate the stock Underperform.

To read the full report: EDUCOMP SOLUTIONS