Tree House Education And Accessories - Reaping Educational Dividends

Tree House Education and Accessories has rapidly grown its education services in the pre-school and K12 segments. The company has offered impressive returns to investors since its listing on the bourses, and looks like a good value proposition overall, says Chandrakant Shukla

Until a few years ago, education wasn’t looked upon as a business opportunity in India. That scenario changed with the changing demographics. Educomp, which was listed in 2006, initially managed to create wealth for investors. However, with most of the bigger players that had jumped into this business getting embroiled in corporate governance issues, the sector soon lost its sheen. In the past five years, companies such as Educomp and Everonn have declined by as much as 83 per cent in value on the bourses. So, is education as a sector really worth its salt for those that are operating in it, as also for investors?

Recent IPOs of education companies such as MT Educare and Tree House Education suggest that the sector has a lot more to offer. We believe that the education story is still intact, in fact robust, and continues to offer a large opportunity based on factors such as the diverse nature of our country, increasing spending on education, etc.

We have lately seen many small and medium-sized education companies emerging and entering the primary market to raise money to fund their expansion plans. One such company is the Mumbai-based Tree House Education and Accessories (THEAL), which offers pre-school education services for kids between 1.5 and 6 years. The company was incorporated in 2003 with one pre-school, and today, it has become one of the largest self-operated pre-school companies in India.

We met the management of the company to understand its business and to know more about what the sector has to offer. This company tapped the primary market to raise a total of Rs 113 crore, and got listed on 26th August, 2011 at Rs 132. The current market price of the scrip is Rs 227, which translates into a 71 per cent return from where it was listed. In contrast to this, companies like Educomp and Everonn have lost tremendous value, and are trading almost 55 per cent down over the past one year.

A Strong Business Model

THEAL mainly operates in the pre-school business, which contributes to about 91 per cent of its total revenue. The rest comes from the K12 school business. As on 31st March, 2012, the company had 302 pre-school centres across 37 cities in India, of which 240 are self-operated and only 62 are franchises. The uniqueness of the enterprise is its business model which, unlike its competitors, focusses more on owned centres and less on franchised ones.[PAGE BREAK]

Advantages Of Operating Self-Owned Centres

• Self-operated centres allow the company to execute full control over the costs and revenues.
• Property owners prefer to rent out their property to companies rather than to individuals running a business. Thus, THEAL enjoys relatively more bargaining power as compared to an individual player.
• The company purchases equipment on a much larger scale as compared to any single franchisee, which further reduces THEAL’s operating costs.
• Under the self-operated pre-schools, the company collects tuition fees between Rs 35000-40000 from each student per year. Further, it also collects Rs 1000-2000 through various other offerings and accessories like books, etc.
• All these factors help the company to earn high EBIDTA margins, which range from 45-55 per cent.
• One factor that makes this business a high margin one (EBITDA margin of 50 per cent) is the assetlight model it follows, wherein the company takes up the premises on rental basis and the initial set-up cost is in the range of Rs 25-30 lakh. These costs are recovered within two years from the start of operations. (Each centre can accommodate approximately 20-25 students, and has four classrooms running two batches each. Students are charged an average of Rs 35000-40000 in fees. Assuming a 100 per cent utilisation rate, the company generates Rs 50 lakh in the first year of its operations. Even if we are to consider a 50 per cent utilisation rate, the company can easily recover all its cost in a two-year time frame.)
• Another advantage that the self-operated model has is the number of batches that can be run at each of the centres. According to Rajesh Bhatia, MD, THEAL, the company presently operates only two batches in a day at its own centres. However, if the demand rises in a particular location, the company has the flexibility to increase the number of batches per day from two to three, which will directly contribute to the topline of the company without incurring any additional cost. What this means is that EBITDA margins will be much higher with the addition of a third batch as compared to the normal 45-50 per cent that we stated above.

One may say that the self-operated school model has problems of scalability and management. According to Bhatia though, this is true, and is the reason why THEAL has refrained from scaling up its business in the traditional manner for the sake of acquiring market share like other companies following a franchise-based business model. Rather, it would like to limit itself to the required number of pre-schools at the required places, to provide a reliable educational network.[PAGE BREAK]

Why THEAL Has Stayed Out Of The Franchise-Based Model

• In the franchised model, a company only receives a one-time fee ranging between Rs 15 lakh-Rs 25 lakh. Apart from this, THEAL also gets a 15-20 per cent share in the annual profits of the franchisee.
• A franchisee purchases student’s kits from the parent company, who charges huge margins, adding to the overall cost of operations.
• The parent company has a lower per-branch cost as compared to the franchisee, which enables it to maintain discounted fees without hampering its margins.
• Unlike self-operated centres, the franchise-based business model is a low margin business and also one that faces the risk of a shutdown. Franchise-based education hampers the quality of education if carried out on a larger scale, Bhatia claims.

These are some of the reasons why THEAL does not intend to take to the franchisee model even if that means forgoing mass volumes on the business.

K12 Schools

The other business that THEAL is engaged in is that of K12 schools, which contributes around eight to nine per cent of the overall revenues. The company offers consultancy and teaching services in the school premises under the K12 brand, and charges a fee for that. At present, the company is operating its K12 business under the brick and mortar model, and some of them are self-operated schools as well. However, THEAL has plans to open owned schools under the K12 model, and is in the process of setting up the first of these in Rajasthan and Gujarat respectively. This is an annuity-based business model, which will yield a steady cash flow over a period of time.

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Value Proposition

Apart from the company’s business model, what gives us more confidence in the stock is the stake held by its strategic partners, which entered the company in 2010. Although there were ample opportunities to exit the company at higher valuations at the time of the IPO, they opted to continue with the company for a longer time frame. This indicates the confidence and faith that large strategic partners have in the business model and in the management of the company.

As on 31st March, 2012, the promoters of the company held a 29.60 per cent stake, while three strategic partners held a 38.56 per cent stake. According to the management, these partners do not have any plans of exiting the company in the near future.

Strong Historical Performance

Over the past six months, THEAL has added almost 75 pre-schools, for which the cost has already been incurred. As the year pans out, the classrooms will see a higher utilisation level, thereby contributing directly to the topline and bottomline in FY13.

Historically too, with double- digit growth, the company has done extremely well. The topline of the company in the past five years has witnessed a CAGR of 70 per cent, while the bottomline has seen a CAGR of almost 200 per cent. THEAL has also maintained its EBITDA margin at 40-50 per cent, which is quite commendable. The EBITDA margins expanded from 16 per cent in FY08 to 54 per cent in FY12 due to an increase in the number of students.

On the financial front, for FY2012, the company has outnumbered its FY11 growth. It has maintained its EBITDA margin at 54 per cent to Rs 42 crore.

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Future Outlook

As for the future of the company, its management provided strong ballpark figures, with Bhatia sounding more realistic and optimistic on the growth plans.

The company seeks to increase its presence in the pre-school area all across the Indian geography by adding around 300-400 centres over the next three years, while maintaining an 80:20 ratio of self-operated and franchise-based centres. Bhatia also stated that in the coming years, the company will focus more on tier III and tier IV cities.

The THEAL management’s execution capability is a proven fact, as can be seen from the performance of the company over the past two years. We believe that the management will be able to carry forward this momentum in the future as well. The company has laid out firm plans for opening 120 pre-schools centres over FY13 and FY14. A calculation of revenues based on the company’s plans suggests that it will register a growth of at least 22-25 per cent over the next two years, on both, the topline and the bottomline.

Not only is the company looking for organic growth, but it is also open for acquisitions whereby it can get onto the inorganic growth path. It is in the process of acquiring small individual franchisees and converting them into self-owned centres. In fact, this ratio has increased from 74.7 per cent of the pre-schools in Q3FY12 to 80 per cent at present, and will go up further once the company acquires the six centres from MT Educare as per its plans.

Further, in order to ensure that no centres are shut down, THEAL will convert its franchise outlets into self-owned centres in the event that any franchisees wish to exit.

Valuations

On the valuations front, at the current market price of Rs 227, the stock is available at a PE of 35x its FY12 earnings of Rs 6.43 per share. We believe that the valuation of THEAL looks on the higher side as compared to that of its peers. However, given the growth that company has achieved over the past few years, the higher premium seems justifiable. To see a further upside from here, the company will have to show a strong performance. Therefore we ask investors to buy the stock on declines at levels of Rs 190-Rs 200.