Educomp Solutions Equity Research Report Buy Call Jan'09- Fairwealth Securities Private Limited

FAIRWEALTH SECURITIES PVT. LTD. January 22, 2009

India Computers- Education

Reuters

EDSO.BO

Bloomberg

EDSL IB

BSE Code

532696

Educomp Solutions (EDSO.BO) CMP: Rs.1715

Target: Rs.2750

Target price of Rs 2,750 based on 35x FY09E EPS — we are initiating coverage on Educomp with Buy. Share prices of Educomp have corrected by 40% from its one month high of 2775. A lot of this fall has been due to various market rumors regarding allegations about company’s high debtor days, high working capital, profitability, company’s assets and promoters pledging their shares among others. Company has given detailed clarifications on these allegations and same can be found on the company website.

Priced on January 22, 2009 EDUCOMP.BO @

Rs 1715

We consider that markets have oversold this stock and recommend buy at every dip. Currently the share is trading at 22x FY09E EPS. From the operations point Educomp has continued to deliver strong earnings and exponential growth, 50% CAGR in both revenues and Net income, is estimated for next four years.

12M hi/lo

Rs 4799/1,375

12M price target

Rs 2750

±% potential

+80%

Industry Potential

Target set on

22 Jan 09

Shares in issue

17.3m

Free float (est.)

45.0%

Beta

1.4

India has emerged as one of the world’s largest consumer of education services with a target population of more than 445 millions, with public and private spending on educational services in India aggregating approximately $100 billion per annum. Spending on Education in private sector has grown by CAGR of 10.4% since 1994, double the 5.11% CAGR on total spending. Government spending on education has reached 4% of GDP and is expected to rise further as India focuses on reducing its literacy rates.

Market cap, INR Millions: 26532.7

Major shareholders

Promoters

55.0%

FIIs

35.6%

Sovid Gupta Equity Analyst: Fairwealth Securities Pvt. ltd

Company description Educomp Solutions Ltd, formerly Educomp Datamatics Limited, was incorporated in 1994 and is based in New Delhi, India. It is India's largest market-listed educational service provider mainly focused on the K-12 space. Educomp group serves over 19,000 schools and 9.4 million learners and educators across the world. Company operates private schools across various cities and also partners with various state governments. It has 27 offices worldwide. In addition, the Company operates through its various subsidiaries including authorGEN, Threebrix eServices, Learning.com, USA, AsknLearn Pte Ltd, Singapore and via its associates such as Savvica in Canada.

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Page 1

Educomp Solutions - Buy

The company has three primary business segments : Meanwhile, the use of smartclass has grown from 90 private schools in 2006 to 1,200 now,

1.

and Educomp expects it to touch 1,800 by

2.

March 3.

Licensing of tools that help existing education system to Move to a higher standard of delivery. Direct Intervention – running schools, pre-schools and tutoring classes, online delivery etc. Post K-12 initiatives such as vocational and professional education.

Educomp's main business is developing and licensing digital lessons, which are uploaded onto servers and provided to schools. It also trains teachers (75,000 in the last quarter), provides vocational training to students with courses such as accounting and marketing, and offers online and in-person tutoring.

Smartclass provides 49% of revenues for Educomp with 60% EBITDA margins

It runs eight K-12 schools. It has joined up in January with New Delhi real estate developer Ansal Properties & Infrastructure to start 25 private schools in new townships. It aims to start 150 schools over the next three years. Educomp's big money-maker is Smartclass, a range of interactive digital lessons with animation and graphics that's marketed mainly to private schools as they have deeper pockets than public schools. The multimedia lessons-- 16,000 so far--are based on the different curricula in place across the country and use 12 of the country's languages.

Figure 1:

Segmental Revenues Smart Class ICT Solutions Professional Development Retail and Consulting K-12

Product/ Service

Description

Segment

SmartTM Class

Highly animated Instructor-led content for schools delivered inside the classroom as a "teachers aid"

Private Schools

FY06 38% 30%

FY07 44% 28%

FY08 49% 35%

24%

17%

10%

ICT Solutions

Educational Infrastructure and digital content to bridge the digital divide in government Schools

8.00% 0%

11% 0%

6% 0%

Professional Development

Technology aided learning Pedagogy & Cognitive learning workshops for teachers

eTutoring TM Mathguru

Online portal for students of Mathematics

Private and Government Schools Grades 6 to 12 (NCERT Books)

Learning Hour

Retail online eTutoring on all curricular subjects and test prep

US/ India / Middle East

Roots TM Wings

Neighborhood schools for Kindergarten-aged children

Kindergarten aged children

Brick and Mortar Kindergarten to Grade 12 Schools

K-12

Source: Company Reports

Revenue share from Smart Class business has been continuously increasing and is likely to stay in between 47%-50% range.

Millennium TM Schools

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to

Government Schools

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Educomp Solutions - Buy Key Developments during 1HFY2009

Smart Class: Company has covered 27 cities with total plan of 80 cities. EBIT margins for this business more than 50%

Smart Class: This is the multimedia education business of Educomp catering to Private schools. Company charges upwards of 3000 Rs. Per student per month from each school. Company keeps infrastructure (multimedia content) on its books and transfers the content at the end of the contract. Company added 231 schools in Smart Class in 2Q09 taking cumulative number of schools to 334 in 1H09 versus 172 last year. Cumulative number of students under smart class has increased to 1.43 million. Company doesn’t have any major competitors and we expect strong revenue growth of 80%+ for next three years and margins to stay above 55% for this business. This segment will continue to remain main driver of business for the Company. ICT Solutions: This is computer literacy initiative funded by Union/ State Governments. Company manages and installs labs in public schools and bills to government. Highlight of this business is long term contracts (5-year). However, it results to high debtor days of around 180 days.

Margins for ICT improved to 35% from 27% earlier,

however

such

margins

are

unsustainable in the long run, and are likely to settle around 20%.

Company added 1626 schools in 2Q09 at contract value of 110 crores taking cumulative number of schools to 8900+. Margins for ICT have improved to 35% from 27% earlier. Number of states covered till now is 14. This business is likely to face major competition from several regional and national players forcing the margins down. This segment will remain a low growth segment for the business with revenues growing at more than 70% for period FY09-FY11 but margins are expected to decline further to around 20% post FY11. Higher revenue share of this business would hinder company in reducing its working capital requirements down to below 120 days. When company attains steady state (post FY15) this business will constitute less than 15% EBITDA share of the company. Professional Development: Company trained 81000+ teachers in 2Q09 which is less than 7% of its total 1.2 million teachers. Revenues for the segment for 2Q09 increased by 4.3% (YoY) while number of teachers trained increased 51% for the quarter (YoY). Margins for this business shall continue to remain high (abover65%). Revenue growth for this business will remain around 20-25%.

Educomp achieved growth rate of 700% on its education portal Mathguru.com on paying customers. Margins for retail business improved from 41% to 71%.

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Retail and Consulting: Company is putting a lot of stress on its retail business growth by focusing on both organic and inorganic channels. Company’s online education portal MathGuru has witnessed ~700% growth rate. Company is growing its Preschool portfolio (Root to Wings) by expanding through franchisee. Company bought 50% stake in Euro kids taking preschool number under its umbrella to 500. This business will continue to see lot of inorganic growth as company explores new ways to enter retail markets. Company might find some difficulty in raising money under tight credit conditions. However, this business will help company by lowering its debtor days, providing brand value and goodwill to the company.

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Educomp Solutions - Buy

Received financial closure for Rs 725cr of debt for its K-12 business.

Debtor days for company have come down

K-12 Initiatives: Under this company will operate and manage entire schools and provide access to all its intellectual property. Total of 11 schools with 14000+ students have been established in 9 cities. Company targets 24 schools under K-12 initiatives this year. Company has already received financial closure for Rs 725 cr of debt including - Non-Convertible Debentures (Rs 100cr), out of which 250 crore has already been utilized. Company has planned 140 million of capital expenditure per school and expects EBIT of Rs. 45 million (at 60% margins) per year per school. This segment will see around 100% growth rate over FY09-FY12 and margins will remain above 60%. In steady state (FY14) this business will constitute more than 15% of the revenues and with negative debtor days of the company.

from 179 days to 145 days.

Financials

Figure;

Good 2QFY09 results: %age share of revenue among various segments has changed significantly.

Q2 FY08

Q2 FY09

Figure

Source: Company Reports

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nd

2 quarter saw huge increase in contribution from SmartClass and Retail line of business, going forward SmartClass, will continue to remain main driver for growth for next three financial years.

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Educomp Solutions - Buy Figure : Figure: EBIT Margins

Ratios: Profitability Ratios %

Mar-08

Mar-07

Mar-06

Operating Profit Margin

48.2

48.12

50.58

Gross Profit Margin

35.87

39.31

40.44

Net Profit Margin

25.51

25.54

25.89

Inventory Turnover Ratio

185.88

32.75

30.1

Debtor Turnover Ratio

2.29

2.16

2.08

Fixed Ratio

1.27

1.67

2.76

Current Ratio

5.41

4.5

5.33

Debt Equity Ratio

1.28

1.09

0 .11

Interest Covering Ratio

21.69

25.81

37.13

35 18

110 24

na 31

Turnover Ratios

Asset

Turnover

Solvency Ratio

Professional Development segment margins remain high and will continue to remain highest however revenue contribution from this business will remain small. Company closed 2Q FY09 with 60% margins without considering forex losses.

Valuation Ratio P/E adjusted P/BV

Source: Company Reports, Fairwealth Research

Analysis of Ratios: Company’s Debt Equity Ratio has increased significantly from 0.11 in 2006 to 1.27 in 2008. Company has already made financial closure of secured debt for capital expenditure requirement for K-12 business up to the year 2011. Company’ Interest coverage ratio remains comfortable as most of the debt of the company is in the form of FCCB maturing in 2012. Company had high inventory turnover ratio as company has built up inventory of installing computers for its SmartClass and ICT business.

Future Outlook

Future Outlook Year

FY09E

FY10E

FY11E

Company is poised to continue perform exceeding well with more than 70% revenue growth for period FY09-FY11 and margins staying above 45%.

Revenues Other Income

5722 148

11100 60

16400 60

Oper. Expenses EBITDA(Mn)

2977 2745

6125 5235

9050 7510

Net Profits are expected to rise 5 fold from Rs.700 million in 2008 to 3566 million in FY11giving a CAGR of 70%.

EBITDA(%) Depreciation

48% 718

47% 1154

46% 1614

EBIT Finance Charges

2027 217

4081 498

5896 634

PBT Tax

1958 646

3644 1202

5322 1756

Net EPS

1312 77

2441 140

3566 205

P/E@1715

22

12.25

8.4

Company’s P/E to growth ratio is highly discounted for FY10 and FY11, as company is expected to continue its growth trajectory of 30% for several more years.

Source: Fairwealth Securities Analyst Estimates

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Educomp Solutions - Buy

Figure : Revenue & EBIDTA mar. Estimates

Growth Outlook Company is likely to post very high growth rate for a long time. Revenue figures are expected to show a CAGR of 70% for the period 2009-2011, 35% for the period 20112014 and 20% for the period 2014-2016. We forecast strong 65% CAGR in Net Profits over FY09-FY11E and see limited risks to estimates given.

EBITDA margins are likely to improve as revenue share of high margin retail and online business is likely to improve considerably. We expect ROE to double and settle in the range between 30-35%.

Source: Fairwealth Securities Analyst Estimates

Segmental Revenues FY09E

FY10E

FY11E

Smart Class

45%

48%

45%

ICT Solutions Professional Development Retail and Consulting

26%

29%

24%

7%

5%

6%

18%

12%

16%

4%

6%

9%

K-12

Company has forward P/E of 7.5 for FY-2011 on constant prices while growth rate is expected to be upwards of 30% for year FY11-FY14. Company will continue to shine even in downturn as spending on Education and price levels are highly resilient to economic downturns. Another positive for this company is its short payback period on its investment as significant business comes from long term contracts of 5 years.

Company understands its strengths and challenges ahead to deal with these challenges. Company has recognized four areas of opportunities/ strengths as under:

Source: Fairwealth Securities Analyst Estimates Revenues will start coming for K-12 business from 2009 and should contribute more than 10 percent in 3 years. All other segments might see dilution in share to adjust for K-12 business.

1. Large market opportunity(scale) 2. Create barriers of entry for other players through strong IP and product differentiation. 3. High operating margins (50%+) 4. Experience and ability to execute

On segmental basis ICT business will see margin dilution, while new business K-12 and Retail will deliver high margins and growth.

Risks: • • • • •

Due to high margins and nature of business, company might face competition from new entrants. Company is in high growth phase; PEG (P/E to Growth) ratio will be an important consideration for the stock. Any disappointment on Earnings Growth numbers will see a downward price movement. Free cash flows to remain negative for a while; if credit market tightens or company fails to deliver on expectation, raising fresh funds will be a problem. If government reduces spending on education, earnings and growth potential are likely to taper down. Company faces huge execution risks in its Edu-Infra business. Also company has been very aggressive in its growth plans, both Organic and Inorganic, and it would be very difficult to manage such growth plans under unforeseen circumstances (E.g.-Key Man Risk, Death of MD/Promoter)

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Educomp Solutions - Buy Appendix1: Previous year Financials Statements(Balance Sheet, Income Statement and Cash Flow Statement) Figure Balance sheet(All figures in millions) FY06 160 736 895 2

FY07 160 988 1148 128

FY08 172 2629 2884 194

Secured loans Unsecured Loans Deffered Tax Liab Total source of funds Fixed assets

109 0 1021

183 1071 60 2590

622 3150 210 7061

Gross block Net Block Capital work in progress Total Investments Goodwill Current assets, loans and advances

375 185 67 252 21 1

949 723 108 831 102 138

2890 2342 372 2714 36 282

Inventories Sundry Debtors Cash Loans and Advances Total Current assets, loans and advances

17 260 609 49 935

Less current liabilities and provisions Net current assets Total Applications

187 748 1021

33 496 1106 110 1761 242 1519 2590

18 1157 2912 490 4639 610 4029 7061

Shareholders’ funds Figure3: One year stock price movement:

Price fall 1m 3m 1y

30% 10% 60%

Price fall in last one month has been due to various rumors in the markets, company has responded immediately by giving just explanations.

Share capital Reserves and surplus Net worth Minority interests Loan funds

Income Statement

Company Debtor days are high, as both ICT and Smart class segment revenue collection starts post 90 days. It is around 120 days for Smart Class and more than 150 days for ICT. These will take time to reduce as K-12 and retail business are just beginning to pick up. Post FY15, we expect debtor days to come to around 100 days from 150 days presently.

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Rs million Sales Other Income Total Cost of goods sold Personnel Expenses Admin & Other Expenses Total Expenditure EBITDA Depreciation EBIT Finance Charges PBT Total Taxes Profit after tax and before prior period items Balance bought from previous year Amount Available for App Balance Carried to Reserves EPS

FY06 555 14 569 95 91 100 286 269 57 212 6 220 79 141 115.2 254 220 11

FY07 1065 59 1124 304 105 155 564 501 93 408 14 453 170 283 229 512 455 18

FY08 2620 150 2770 798 338 238 1374 1246 322 924 42 1032 330 702 455 1157 1035 41

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Educomp Solutions - Buy

Cash Flow Statement(All figures in millions)

Company has negative free cash flows which are likely to turn positive by FY13.

Key Cash Flow Statement Data

FY06

FY07

FY08

Net Income (Reported)

141

284

711

Depreciation & Amortization

56

96

331

Change in Working Capital

-60

(225)

(730)

NA

NA

Deferred Taxation Charge Other Adjustments, Net

0

10

193

Cash Flow from Operations

137

165

505

Purchase of Fixed Assets

-162

(675)

(2,224)

Purchase of investments

-50

-389

-16

Net Cash used in Investing activities

-212

-719

-2102

Shares Issue / (Repurchase) Proceeds/ repayment of borrowing

557

0

0

53

71

334

1094

3109

long

term

FCCB Raised Temporary Overdraft facility against fixed deposits

75

3

106

Net cash from financing activities

615

1088

3393

Source: Company reports

Why Buy: Valuations at 22x FY09E, 12.25x FY2010E and 8.5x FY2011E, on the lower side look cheap. More over company is expected to post CAGR of 50%+ in revenues for next four years. EBITDA margins for 2QFY09 excluding extraordinary forex losses were around 60%. Earnings have been forecasted keeping EBITDA on the lower side at 45-50%.Higher EBITDA will lead to further revision in Earnings Estimate. Continue recessionary conditions will make this stock more attractive relatively as Education segment remains recession proof. Downside Risks: 1. 2. 3. 4.

Short Term Market sentiments (High beta of 1.4) Lower Earnings than market expectations Execution/Regulatory/Key Man Risks Tight credit conditions will pose difficulty for company to raise more cash at cheaper interest rates.

Disclaimer: This publication has been prepared solely for information purpose and does not constitute a solicitation to any person to buy or sell a security. While the information contained therein has been obtained from sources believed to be reliable, investors are advised to satisfy themselves before making any investments. Fairwealth Sec Pvt Ltd., does not bear any responsibility for the authentication of the information contained in the reports and consequently, is not liable for any decisions taken based on the same. Further, Fairwealth Research Reports only provide information updates and analysis. All opinion for buying and selling are available to investors when they are registered clients of Fairwealth Investment Advisory Services. As a matter of practice, Fairwealth refrains from publishing any individual names with its reports. As per SEBI requirements it is stated that, Fairwealth Sec Pvt Ltd., and/or individuals thereof may have positions in securities referred herein and may make purchases or sale Thereof while this report is in circulation.

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