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Educomp Solutions
Not convinced about overall governance
Educomp’s fortunes appear to be declining fast in light of reduced
funding from banks. We reiterate our view that the SPE will be
consolidated once India converges to IFRS from 2013 onwards which
will lead to negative OCF and FCF and D/E c.2:1. Management now
has admitted this. Our concerns on overall governance policies go
further, principally: a common address of the auditor and the
registered office of Edu Smart; cost allocation of resource
coordinators and high turnover of company secretaries at Edu
Smart. We change corporate governance rating from Amber to Red,
lower our FV from Rs220 to Rs110 and downgrade our stance from
Neutral to Sell.
See no improvement in stretched cash flow situation
We turned our long-running SELL stance on Educomp (since May 2009) to
Neutral in August 2011 citing valuation. Our key thesis then was that an 80%
fall in the stock price was factoring in most of the core business and overall
governance issues. However, we now see growing reasons to question the
sustainability of the core business model and also highlight some new
governance issues which need answering by management. With Educomp’s K-
12 initiative not growing as per expectations and its core business, Smart Class,
likely to falter on growth due to funding requirements, we think that there are
likely to be further earnings downgrades.
• Incremental securitization of smart class difficult – At the start of the
model, Edu Smart used to get Rs60 for every Rs79 securitized from banks
meaning a cost of debt of 10%. This quickly declined to Rs54 for every
Rs79 securitized resulting in cost of debt of 14% and zero cash balance for
Edu Smart at the end of year 1. While we had expected in May 2011 that
this funding would fall to Rs50 due to rising securitization costs, it has
actually declined to 45. Now either Educomp is paying securitization costs
of 22.25% in return for Rs79 securitized or it is securitising only Rs65 to
keep the rate at 14%. The shortfall of Rs14 implies that Edu Smart will find
it incrementally difficult to pay Educomp, thus stretching its cash flows.
• K-12 segment not that strong as perceived – Our channel checks of
Educomp’s K-12 schools in 2012 suggest no major improvement over 2011,
especially in schools which have been operational for more than 3-4 years.
The only segment that could have helped Educomp in offsetting concerns
of its core business is the K-12 segment, but things are not improving
enough to make any meaningful impact.
• Overall governance issues in the SPE are questionable: In our research
we notice that the statutory auditor of Edu Smart and registered address
of Edu Smart is same. We believe this compromises independence,
especially given any sense of excessive closeness between company and
auditor will naturally concern investors given longstanding concerns about
the structure of Edu Smart. Additionally, we are concerned about the cost
allocation of resource coordinators which should have been booked by
Edu Smart but is being booked by Educomp which is negative for minority
shareholders of Educomp. Furthermore, the high turnover of company
secretaries at Edu Smart also makes us uncomfortable on overall
governance policies.
Valuation: structurally declining model of core business
In our opinion, securitisation has always been a precursor to a big downfall
and Educomp must have learnt this by now. Educomp currently trades at a
FY13E P/E of 11.6. Our research indicates that growth in the smart class
segment (60% of revenues and 90% of EBIT) is set to deteriorate as
securitization of smart classes becomes incrementally more difficult.
Moreover we are wary about the corporate governance standards of the
company. We downgrade our EPS estimates by 50%. SELL Educomp.
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