Educomp's K-12 business Future prospects

Until now, whenever positive or negative news or opinions have been flashed about Educomp, most of the limelight has been hogged by Educomp's SmartClass business. The last 2-3 years have been particularly bad for Educomp's stock because the SmartClass business has gone through two changes in business models & is now back to the original BOOT model. But most analysts or news-makers have ignored the developments of?Educomp's K-12 business, the business which comprises offering education right from Kindergarten to 12th Std, i.e. Junior College level. Educomp has smartly invested in building this K-12 business over the last 4-5 years & it is still a nascent business as there is a long way to go before it reaches it's true potential.

As investors we need to understand the operational limitations to analyse it's potential growth in the coming years. Whenever an organisation / trust / group / corporate opens a new school, as per regulations, it is permitted to start with only upto 5th Std in the first year and then add one higher Std in each following year. That means, if Educomp started a school in the year 2009 with classes from 1st to 5th Std, then added 6th Std in 2010, 7th Std in 2011, 8th Std in 2012 and so on, it will be only in the year 2016 that the school will be fully operational with all classes from 1st to 12th Std. Not just that. Whenever a new School starts, it does not get enough students to fill up 100% capacity of the available classes. The school starts with about 20% to 30% of average capacity utilisation in the available classes with maximum new admissions happening for the 1st Std & lower numbers for 2nd Std to 5th Std. With each passing year, it's average capacity utilisation goes up 10% to 20% as more & more students join the school in the existing classes. That means it will take atleast 5 years to reach capacity utilisation of between 70% to 100% in classes from 1st to 5th Std that the school originally started with. By the end of 5 years, the batch of students that had joined the school in 5th Std in the first year of operations, which must have been a very small batch of students, will have moved up to 9th Std. Hence, even at the end of 5 years of the school's operations, the capacity utilisation in classes from 6th Std and above will be well under 50%.?It will take another 4 to 5 years, i.e. a total of about 10 years from the year the school started operations. for the capacity utilisation of the entire school crossing the 70% mark & getting closer to 100% level of the total available seats in the entire school.

Most schools are planned with minimum capacity of 100 students per Std, comprising of 2 divisions of 50 students each for each Std. So, in the first year of operations, the school starts with just about 100 to 200 students, spread over the first 5 classes (i.e. an average batch size of just about 30 to 50 students) and adds about 100 to 150 new students with every passing year as a new batch of students is added and a few students join higher classes. In about 5 years of operations, the number of students in the school will have reached between 600 to 750 (i.e. an average batch size of 60 to 80), which will be about 50% of the total capacity of 1200 students (12 Stds x 100 students per Std).

With about 50% of the school's operating cost being Fixed Cost, i.e. it will remain more-or-less same irrespective of the number of students in the school, and the remaining 50% of the operating cost being dependent on the number of students in the different classes of the school, the school's profit margins are generally very low or maybe negative in the first couple of years of operations. But the margins improve rapidly as the student number builds up with every passing year. Educomp's management has indicated that a school earns an EBIT margin of just about 5% to 20% in the first couple of years of operations, but the EBIT margins improve rapidly to levels of over 50% by the time the school completes 5 years of operations. ( EBIT stands for Earnings Before Interest & Tax ).?Because of the Interest Cost, a new school will be in Net Loss in the first 2-3 years of operations, and start generating decent levels of Net Profit only from the 5th year onwards.?

At the end of FY'13, Educomp had 51 operational school with over 23000 students, i.e. an average of about 450 students per school, i.e. the average age must about 2 to 3 years. The management has already said that they will be adding atleast 6000 new students to these 51 schools plus a couple of new schools that could get operational for the new academic year, which will take the average to over 500 students per school. Apart from these, Educomp had over 8500 students in it's pre-school division, which operates under the brand name "Little Millenium". Most of the students completing the pre-school years will shift to one of Educomp's schools.?Educomp's K-12 division earned about Rs.190 crores revenue from the 32,000 students in total, translating into an average annual revenue of about Rs.50,000 per student.

So what is the potential of Educomp's K-12 business??Educomp has plans to have more than 90 schools operational by the end of FY'16 or 17. To be on the safer side, let's say they manage to get only 75 schools operational by the end of FY'16. Assuming that each school will have a minimum capacity of 1200 students (when fully operational), Educomp's 75 schools will have a total minimum capacity of 90,000 students. The average age of all 75 schools by then will be about 4 years. That means the overall capacity utilisation will be about 50%, i.e. a total student strength of about 45,000. This is nearly double of the current student number of little over 23,000 (excluding those from the pre-schools). The management has already mentioned that they will be adding over 6,000 students this academic year, i.e. Educomp will have over 29,000 students in their schools by the end of FY'14. With new schools opening during these 3 years, Educomp should be easily be able to add another 15,000 to 17,000 students in FY'15 & FY'16 together, which should take the total student number to 45,000 or more.?This near doubling of students in Educomp schools alone should help take the company's revenues from K-12 segment to between Rs.350 to 400 crores in FY'16, with an EBIT of close to Rs.200 crores and possibly a Net Profit of about Rs.30 crores.?By then debt levels of the K-12 business also would have started coming down at a good pace as the incremental CAPEX then will be low & the company can use the Cash Profit generated towards debt repayment, which will help bring down the annual interest cost & improvement in Net Profit margins.

Remember that the revenues received by a school in terms of course fee are recurring in nature as most of the students taking admission into a school generally remain with the school until they pass out all classes. So a student entering the school in the 1st Std will generally leave the school only after completing 12th Std, i.e. the school will receive fees from that student for 12 years. This recurring & predictability nature of the revenues of school deserve much higher valuations than in normal case.

Between FY'16 to FY'20 or FY'21, even if Educomp does not add any new school, the company's K-12 business can still double it's revenues on the back of increased capacity utilisation in existing schools. Even if Educomp has only about 75 schools operational in FY'20, it could be having close to 90,000 students, generating about Rs.700 crores in revenues, Rs.400 crores in EBIT and nearly Rs.250 crores in Net Profit.?Educomp's K-12 business alone could be commanding a valuation in excess of Rs.5000 crores by FY'20, i.e. a potential per share value of close to Rs.250/- (even after leaving a scope of 30% further equity dilution from now till FY'20).?

Point to Note: Educomp's K-12 business will still remain smaller than it's SMartClass business. By FY'20, i.e. 7 years from now, SmartClass could be active in over 2,50,000 classrooms, could be running via cloud-solutions, and generating well in excess of Rs.1500 crores in annual recurring revenues.

Educomp - Have Patience, this Co. will regain it's Glitter!!!

Educomp Solutions Ltd's stock price movement post the company's announcement of Q4 & FY'2013 results suggests that the ship is sinking rapidly & everyone needs to get out. But I am of the opinion that the worst period in Educomp's history ended at the end of Q3-FY'13. Almost all the troubles for Educomp Solutions are connected to it's SmartClass business. As I have mentioned in my previous reports on Educomp, the troubles started when the company changed the business model for SMartClass. During the Q3-FY'13 result concall, the company's management announced that they are returning back to the BOOT model for SmartClass and this I think is the end of the troubles for the company. This shift back to the BOOT model will lead to increased transparency, improved & consistant Cash-flows and will be liked by most of Educomp's Institutional Investors.

But there are a few Very Important points that Investors need to keep in mind while evaluating Educomp's result post Q3-FY'13. (1) Eventhough Educomp is selling SmartClass Equipment+Content at a price of around Rs.3.70 lakhs per classroom, the Cash-flows will be spread over the term of the Contract with the school. i.e. When Educomp signs up with a school to equip 10 of it's classrooms with SmartClass at a price of Rs.3.70 lakhs per classroom for a period of 5 years, the contract value of Rs.37 lakhs is received by Educomp in 60 Monthly installments of about Rs.62,000 each or 20 Quarterly installments of Rs.1.85 lakhs each. (2) Educomp needs to Invest it's Capital upfront in purchasing Equipment that needs to be installed in those 10 classrooms. The Equipment cost is somewhere around Rs.1 lakh per classroom. That means, Educomp needs to Invest atleast Rs.10 lakhs at the start of the contract and it will take about 6 quarters of payments to recover it's Investments in Hardware. From the 7th Quarter onwards, the money it receives can be considered as towards it's Multimedia Content, i.e. Intellectual Property. (3) Each new classroom addition under SMartClass adds Rs.18,500 to Educomp's quarterly Cash-flows. Until the Q3-FY'2013, Educomp had almost ZERO classrooms under BOOT model, hence there was not recurring Cash-flows from SmartClass until then. Most of the 6500 classrooms that Educomp has added in Q3 & Q4 can be assumed to be added under the BOOT model. In just 2 quarters, 

Educomp's recurring quarterly cash-flow from SmartClass BOOT has crossed the Rs.12 crores mark. I know this figure is very small currently compared to the SmartClass revenue Educomp was reporting on a quarterly basis. Remember, SmartClass is already active in over 1 lakh classrooms as of now, out of which 85,000 classrooms were added in the last 3 years alone. We can expect Educomp to add about 20,000 new classrooms to SmartClass BOOT every year from FY'14 onwards. This will add Rs.37 crores to Educomp's Quarterly Cash-flows every year. Apart from that, there will be renewal of contracts coming up for classrooms where SMartClass was implemented 5 years ago. So we can expect Educomp's SMartClass BOOT revenues to cross the Rs.100 crores quarterly rate in the next 2 years. For the 85000 classrooms that Educomp has added in the last 3 years, Educomp is earning a small trail revenue of about Rs.5,200 per classroom per quarter. This amounts to about Rs.45 crores per quarter for 2 more years after which it will taper off. This revenue will help keep the SmartClass revenue to a respectable figure until the BOOT revenues themselves reach the levels of it's past.

As per my estimates, SmartClass revenues are expected to be low at less than Rs.350 crores for FY'14, but will keep improving substantially with every passing quarter & should be closer to Rs.500 crores for FY'15 and over Rs.650 crores for FY'16. But the biggest positive part is that the EBITDA margins are expected to be much stronger right from FY'14 onwards at levels of over 35%. To arrive at these estimates, I have assumed an addition of 17500 classrooms in FY'14 and a 10% Y-o-Y growth in further years, with pricing remaining around the Rs.3.80 lakhs per classroom mark.

The expected drop in SmartClass revenue for FY'14 by over Rs.100 crores seems to have spiked the market, which has pushed the stock to a series of Lower-Circuits. But there are so many positives that are being ignored at the same time. SmartClass is no more a solo product that Educomp will be offering the thousands of schools it already has tie-ups with. Educomp has launched the SmartClass tablet solution as well as the English Mentor language Lab. Both these products have the potential to become part of hundreds of schools in the very first year. Both the products can offer subscription-type recurring revenues to Educomp. We will get more details on the pricing of these products at the end of the current quarter. On the conservative side, I am expecting these 2 products to add between 20 to 30% incremental revenues to SmartClass revenues in FY'14, i.e. in the range of Rs.60 crores to 100 crores. This could bridge most of the expected drop in SmartClass revenues in FY'14 compared to FY'13.

The other big positives are: Educomp's other three business segments are growing at a good pace. (1) There are over 23,000 students in Educomp's 51 operational schools and another 8000+ students in nearly 225 pre-schools. In it's ConCall, the management has said that they will be adding atleast another 6000 students to it's Schools & is confident of posting a 25% growth in K-12 revenues in FY'14. I think this should be easy. The bigger positive in this is that as more & more schools mature in terms of period of operations, the profits margins are expected to improve. For FY'14 the K-12 division should be reporting a revenue figure of over Rs.240 crores & EBIT of about Rs.120 crores. This 25% growth can continue for the next 4-5 years as the number of students in each school fills up the capacity in stages. The students number in Educomp's schools will cross the 50,000 mark in the next 3 years. (2) The business segment of Educomp to report the strongest growth in FY'13 was the Online & Supplemental, which reported a growth of 56% Y-o-Y & now contributes nearly 25% of Educomp's Total revenues. Since the company is still investing in expanding it's reach & capacity, this business reported an EBIT Loss. But some of the divisions in this business have posted a break-even by the end of FY'13 and the company has shut-down a couple of loss-making slow-growth divisions. So even this segment is expected to post a turnaround with a small EBIT profit in FY'14. On the conservative side we can expect the revenues from this segment to grow by atleast 30% to touch the Rs.400 crores mark from Rs.305 crores in FY'13. Even if this segment manages to bring it's EBIT Loss down to Zero, it will boost Educomp's consolidated profitability by 2 to 3%. (3) Educomp's Higher Learning division, which comprises of 7 Colleges which conduct Undergrad courses in Design as well as Engineering, posted a decent growth of 25% in it's revenues for FY'13. This growth is expected to repeat in FY'14 as well because all these 7 colleges will induct a new batch of students for the new academic year as the existing students continue into the next year of the course. This division's EBIT loss reduced by 20% in FY'13 and is expected to drop another 40% in FY'14 as the incremental revenues will not be accompanied with proportionate increase in operating costs.

Summary: Following are my expectations for FY'14:

The School Learning Solutions division, which includes SmartClass, ICT & the 2 new product launches: SmartClass tablet & English Mentor, is expected to post a Total revenue of about Rs.525 crores with an EBIT of about Rs.150 crores.

The K-12 Division, which includes Schools & the pre-schools, is expected to report a total revenue of about Rs.240 crores & an EBIT of Rs.120 crores.

The Online & Supplemental division, which includes units like Vidyamandir, Gate Forum, WizIQ, Learning.com, etc., is expected to post a revenue of close to Rs.400 crores and Zero EBIT.

The Higher Learning division, which includes the 7 colleges, is expected to post a revenue of close to Rs.100 crores and an EBIT Loss of about Rs.18 crores.

Educomp Solutions Total Income for FY'14 is expected to be in the region of Rs.1300 to 1350 crores on the conservative side, with an EBIT of about Rs.250 crores. Educomp's Net Profit or Loss will then depend on the company's Interest Cost. For FY'13, Educomp's total Interest cost was Rs.249 crores. With Improving Cash-flows from most of Educomp's Business divisions, coupled with lower CAPEX in FY'14, Educomp should be able to contain it's Net Debt to current levels of about Rs.1950 crores or maybe bring it down by Rs.100 crores by the end of FY'14. In any case I am not expecting Educomp's annual Interest cost to be any much lower than Rs.250 crores. Hence there will hardly be any Net Profit for FY'14. But FY'15 will be a far better year, when I am expecting Educomp to post it's highest ever annual Total Income figure of well over Rs.1600 crores and an EBIT of around Rs.400 crores and a Net Profit of over Rs.100 crores. By then Educomp's Net Debt is expected to be down to around Rs.1500 crores, which will bring down it's Interest burden leading to boost in Net Profit margin.