There is little doubt that the Indian education sector offers significant long-term opportunity, illustrated by the widely quoted statistics that Indian consumers spend $40 billion (3 per cent of the GDP) on private educational services and institutions. Then, there is the widespread venture capital and entrepreneurial involvement in the sector. The world’s largest education company Pearson has recently spent $140m for a 76 per cent stake in TutorVista. Also, data from VCCedge, the financial research platform from VCCircle, suggests that from CY08 to CY11YTD, there have been 51 PE investments in the Indian education sector with an investment of $417 million and 9 exits fetching $114 million to the PE players.
What Ails Education Space?
But in spite of such potentials, there are certain issues that ail the Indian education system. The first phase witnessed the dominance of ICT@schools and multimedia content in private schools. Indeed, for a company like Everonn, ICT@schools was the key revenue generator till FY09. However, this space suffers from high upfront capex and debtor days, and has remained FCF negative for companies (at best FCF neutral in some quarters).
When it comes to multimedia content in private schools, the introduction of digital content for those institutions has been a revolutionary step by Educomp and it has definitely enjoyed the first-mover advantage till CY09. However, this model is now faced with several challenges including commoditisation of content, as it is easily replicable, and price wars resulting from this commoditisation, as new and smaller players have come in with new pricing models. On top of that, there is high capital intensity, an area where PE players do not venture often.
Who Can Serve Best
We must look for these five aspects in an education company – the business has to be asset-light; there should be strong competitive advantages and high entry barriers; the business model should be scalable; there should be very little regulatory hassles and there should be tangible benefits to students (in my opinion, this is perhaps the most important aspect as students are the clients of an education services company).
Businesses that fit into any of these criteria include education allied services companies like pre-school companies, test prep andtutoring companies; institutions providing vocational training; companies managing brick-and-mortar K-12 schools and the highereducation segment.
Tangible Benefits Take You Ahead
For education allied services companies, the opportunity is huge, since the market share for a small segment like the pre-school currently stands at $1 billion. Similarly, for the test prep segment, the market size is close to $1.5 billion while the tutoring market is expected to be around $5 billion, thus showcasing huge opportunities for the players. Although the business model is asset-light and there are no regulatory hassles, the companies suffer from lack of competitive advantages and scalability challenges. While pre-school suffers from competition from mom-and-pop shops, test prep and tutoring business is a highly fragmented market with a strong local preference. The vocational training segment is still in a nascent stage and is mostly dominated by low-price point courses like English vocabulary, personality development and a few other which are highly fragmented and suffer from stiff competition.
I have also mentioned above that I look for tangible benefits to students as one of the key criteria for the business to do well in the long term. In a pre-school segment, this tangible benefit means tie-ups with quality K-12 schools. As a result, parents won’t feel hassled to find a good school for their kids when the young ones are out of playschool. In the test prep and tutoring segment, the tangible benefit is the presence of good teachers in that region, as students generally opt for coaching classes based on facultyquality. Similarly, in the vocational training segment, tangible benefit amounts to job guarantee, which can excite students to enrol for high-value course.
While I don’t rule out that most of these companies tend to do well in the initial part of their journey, over a longer term period, overall shareholder value creation will depend on the presence of tangible benefits which can help them tide the competitive landscape.
Building Value In The K-12 Segment
Companies managing K-12 schools and collaborating with well-known brands mostly dominate the education space. In fact, one of the best options to lead the education sector is to own and/or manage K-12 schools. With a significant shortage in quality schools, firms that own, lease or manage schools can benefit directly from defensive recurring fee revenues. As owning land and building leased to schools is often highly capital-intensive, PE firms generally do not invest in companies which plan to raise money and put it in real estate.
As schools need to be run as ‘not-for-profit,’ firms typically monetise schools by leasing infrastructure and land to an independent trust and charging management fees. This is an attractive business as indicated by the relatively high IRRs (28-32 per cent) in setting up schools. Education companies can practically avoid the real estate part of the school and explore the K-12 schools opportunity by partnering with land-owners or real estate developers to manage schools. In this case, the education company doesn’t make capital investments and earns profits based on the profits generated by the school after paying for the cost of the lease and a per cent of profits to the landlord. Moreover, profit margins are significantly higher in such businesses than owning schools. Given that most firms are looking to set up schools, companies such as Educomp, Career Launcher and Everonn have roots as suppliers to schools. Their strength lies in running the schools better rather than managing real estate.
Another thing that I value is the association with well-known brands. While new schools do resort to advertising, long-term patronage is built by word of mouth as parents choose schools based on the trust in the brand name. Setting up and managing K-12 schools is not easy and schools typically need 6-8 years to reach peak capacity from scratch. But this is a long tenure even for long-term investors. As such, we prefer companies who manage schools having a strong brand name, as a school typically starts as K-5, since it is difficult to attract high school students without a good track record. Indeed, Sequoia Capital and Song Advisors invested $15 million in K-12 Techno Services (Gowtham brand of School), which was already running more than 50 schools at the time of first-round investment. Educomp also partnered with Padma Sheshadri Bal Bhavan (PSBB) brand of schools and this helped add more than 7,000 students to its total tally of about 26,000 students.
Educomp owns real estate of around 30 of the 50 K-12 schools that it runs. It did a QIP of Rs 6 billion in FY10 and 57 per cent of that went into buying land and another 25 per cent is expected to go in construction of the building, making the business very asset-heavy. The private equity participation in this case is expected to come in a very late stage when these schools will be operating at 75-80 per cent capacity and listing of Educomp School Management (a subsidiary) after two to three years of PE investment will provide an easy exit for investors.
Higher Education May Ensure High Profits
Another segment that has immense potential is the higher education segment. Of course, there are no listed players in this segment due to regulatory issues. But the below-average performance of the state and the central government in this segment makes me quite optimistic that this segment will open up soon in a much bigger way for private players. Indeed, three of the large four PE deals in the education sector has been in the higher education segment which includes investments by PremjiInvest Fund in Manipal Universal Learning Pvt Ltd and investments by Navis Asia Fund in ITM Trust.
While for PE players and angel investors varied options are available in this sector, depending on what suits their requirements, for retail investors, there are a few ways to play the education theme – notably done by Educomp, NIIT and Everonn. In the early years of their listing, this scarcity benefited the public companies. In the first three years of its listing, Everonn traded at an average P/E of 40x while Educomp has traded at >60x, driven by the hype around exponential growth expectations. The shares of all the listed companies have since underperformed, as inflated expectations were not met with. The sector’s time will come though, as more and better companies come out with IPO, hopefully with scalable businesses having strong competitive advantages.
(Soumitra Chatterjee is a Technology analyst with Execution Noble).