Credit Suisse:: Educomp Solutions-Margin improvement continues

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Educomp Solutions Ltd---------------------------------------------------- Maintain OUTPERFORM
Margin improvement continues; signing up of second Smartclass partner encouraging


● Educomp reported December 2010 results with revenues 9%
below and profits 29% below estimates. The revenue miss was
due to weak ICT business (net reduction in no. of schools QoQ)
while higher other expense lead to profit miss.
● Key Smartclass business metrics continue to remain stable –
average classroom pricing and incremental classrooms per
school. Guidance is for this stability to continue.
● Margins in Smartclass continue to rise – playing on the margin
leverage post the sharp rise in sales force earlier this year.
● Importantly, during the quarter, management announced the
finalisation of a second implementation partner for Smartclass – in
addition to Edusmart. This addresses the execution risks around
reliance on a single partner.
● Post results, we reduce our EPS estimates by 3-7% for FY11-13
to incorporate the quarter’s miss. With key concerns on the
business model getting addresses, we believe that the risk reward
seems favourable, and retain our OUTPERFORM rating.
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Strong margins
Educomp reported December 2010 results with revenues 9% below
estimates, primarily due to weaker-than-expected ICT business where
no schools were added (while contracts on 3,300 schools expired).
Consolidated margins expanded sharply on expected lines. This is the
second successive quarter of strong margin improvement, and the
company has thus added 1,700 bp to EBITDA margins after bottoming
out two quarters ago. Higher non-operating expenses contributed to
profits missing estimates by 29%. Management retained guidance for
FY3/11 at Rs13.0-13.5 bn revenues and Rs3.3 bn profits.
Second partner in Smartclass – reduces execution risk
Key metrics in Smartclass – average classroom pricing and
incremental classrooms per school – remained flattish for the fourth
quarter. Management guided to stability in these metrics even in
coming quarters. Margins in the Smartclass business continued to rise,
and in the December 2010 quarter were aided by increasing margins
in the first year revenues. We believe this follows margin leverage
post the sharp expansion in sales force earlier this year.
An independent hardware implementation/logistics company has been
finalised as the second partner for Smartclass (name to be announced
in April) – in addition to the existing Edusmart entity. This addresses
our lingering concern around Educomp’s reliance on a single
implementation partner for this fast growing business. The terms with
bankers are expected to remain unchanged even with the new partner.
Retain OUTPERFORM
We adjust our model for the profit miss during the quarter, leading to a
3-7% EPS cuts over FY2011-13. We believe that stabilising metrics in
Smartclass and announcements around the business model
(reduction in corporate guarantee earlier, signing up of new partner
this quarter) should help address the concerns around the business.
At 5x FY12 EV/EBITDA and 9.5x FY12 P/E, we find the stock
attractive and retain our OUTPERFORM rating with Rs675 target price.