Indian education sector companies, led by Educomp and NIIT, have been significantly de-rated in the past three-four quarters due to factors that are largely company-specific and which have clouded their near-term growth prospects. Notably, despite a four-fold growth in the past five years, listed education companies in India have captured only 2% of the addressable market.
Although we expect future growth to be more measured compared with the past, we forecast it to be at a healthy 20-25% per year over the next three years.
Notably the risks are skewed to the upside. Importantly, our view is that these factors are not fundamental and that current valuations (10-17x) overlook the sector?s long-term potential.
We estimate the Indian education sector to be $28 billion in size, and likely to grow to $47 bn in five-six years. The sector is favoured by encouraging Indian demographics, with 673 million (60%) of the population below 30 years of age. High illiteracy and drop-out rates underline the need for investment in education and the potential opportunity.
Additionally, with robust growth in the service sector (constituting 57% of GDP in FY09) and a burgeoning middle class, we expect further proliferation in demand for quality educational services and growth in this sector. Notwithstanding such a large opportunity, private institutional participation in the sector has been limited so far (Educomp and NIIT together hold about 2% of the addressable market).
Educomp is a market leader in the school learning aids (multimedia) market. Its success is evident in the over 100% revenue and EPS CAGR (earnings per share, compound annual growth rate) over FY06-10 and a stock return of 122% annually from 2006 to 2010.
The stock has materially de-rated in the past few quarters (from a one-year forward historical average of 46x to 17x currently). The underperformance has been driven by weaker guidance (for FY11, which has been factored into valuations) and due to concerns around its strategy to securitise part of its future cash flows.
In our view, securitisation was driven to fund the company?s foray into tier-III/IV cities and lock in schools, and therefore a positive move. Furthermore, the discount rate of 11% is in line with the borrowing cost and securitisation saves on the service tax on hardware, which is now sold upfront.
While SmartClass is likely to see slower growth in FY12 (13% due to securitisation spillover in FY11), we expect growth to rebound thereafter (CAGR of +20% over FY13-15E).
Additionally, we believe the company?s foray into the primary and secondary (K-12 brick-and-mortar) school market, the largest segment in the education space, is a step in the right direction.
This business has a long gestation period, but patience should be rewarded. Our school perception map indicates a strong brand perception rating for Millennium schools and our conservative assumptions still derive 40% revenue CAGR for the next two years.
Overall, we expect revenue and EPS CAGR of 24% and 30% respectively over FY10-13. Our bullcase scenario suggests a 40% potential return to our target valuation. Our one-year target price does not assume multiple expansion, which is possible if execution is better than our expectations. We assume 25% lower long-term growth than the company guidance in terms of the number of schools.
We believe the long-term growth fundamentals of the company are intact and the stock therefore offers an attractive long-term investment opportunity.
The stock is currently trading at a PE of 17x our FY11 EPS (excluding the one-time tax benefit). Historically, the stock has traded at an average of 46x one-year forward and 26x two-year forward earnings.
We value the company at a PE of 17x our FY12 EPS, or Rs 740. We do not expect valuations to expand in the near term and earnings growth is likely to drive the upside. This is at a discount to the historical average as (i) earnings growth has slowed down to a 30% CAGR over FY10-13E, from more than 100% over FY05-10; and (b) high capital requirements and uncertainty around the success of the new ventures, where significant investments are being made, should keep the valuation depressed.