Crash course

Shantanu Prakash is used to convincing people to buy into his ideas. From selling computer labs to schools in the late 1980s when IT was a blip on the radar, to starting Educomp in the early 1990s to eventually hitting on his million-dollar idea of selling digital education content in the late 1990s, Prakash has honed his salesmanship well.

So when the IIM Ahmedabad alumnus finally listed his company on the Indian bourses in January 2006, investors were eating out of his hands. Educomp was the first company from the education sector to tap the capital markets and it listed with a 100% premium to its issue price of Rs.125 and by January 2008, it had touched a mind-boggling Rs.5,530 (pre-split) per share. But that’s history.

Today, in 2012, industry experts and analysts alike have started questioning Educomp’s potential for growth and the viability of its business model. Educomp’s core business, smartclass — which provides multimedia content for schools and accounts for 60% of its revenue and close to 90% of operating margin — has seen margins decline by as much as 27% year-on-year. Players such as Everonn, NIIT and HCL Tech entered the fray with similar offerings and at far cheaper prices, forcing Educomp, too, to cut prices.

In Q1FY12, the company reported an average selling price of Rs.4.04 lakh per smartclass to a new school; that’s now down to Rs.3.2 lakh, a decline of nearly 25%. “These classes have become like a commodity with little scope for differentiation in terms of content,” says Soumitra Chatterjee, lead technology analyst with research firm Espirito Santo. “We expect prices to decline by another 5-7% year on year for the next couple of years as competition gets fiercer,” he explains. The research firm has a sell rating on the stock. 

What further compounds the trouble is that revenue from the K-12 segment, which accounted for 16% of revenue and 56% of capex in Q1FY13, is still to pick up. The company is aggressively expanding its network of schools under the Millennium brand, using a combination of company-owned and -run schools and joint ventures (JV) for school management. Educomp currently runs 69 schools, of which 38 are greenfield and the rest are all run through a JV. Of these, just 4% of the schools yield operating margins of 49% and above, that too from year four.

Analysts aren’t impressed. States an IDFC report: “Our comfort on Educomp’s business model is tested on account of the deterioration in performance of the smartclass segment. The belief was that the smartclass model is a first mover advantage and will sustain over the next three years, which will then be seconded by the catalyst of the ‘more sustainable’ K-12 model. However, the smartclass business is looking extremely susceptible to competitive risks, reflective in lower yields and subdued margin profile.” Prakash, Educomp’s CEO and managing director, disagrees with that view. “Even with so many  new players jumping into the market, we have managed to penetrate only 10% of the smartclass market. We are the No.1 brand and are sure that there will be growth in volumes. The K-12 business is already earning money for us and will earn even more over the next two or three years.” 

Lapse in concentration

Buying land for schools and constructing them, along with a spate of acquisitions such as Vidyamandir and Gateforum in August 2010 and February 2011 to get a foothold in the lucrative supplemental and prep market, has loaded Educomp’s books with Rs.1,909 crore of debt. Interest payment on this, along with forex losses of Rs.45.3 crore in FY12 and Rs.16.2 crore in Q1FY13, has compounded the cash flow troubles. The company also repaid its FCCBs in July by raising $155 million ($70 million of debt, about $10 million of FCCB and the balance in equity). Analysts predict Educomp’s total cost of servicing debt to move up to 12% because of this. The decline in the margins in the core smartclass business, then, could not have come at a worse time. 

Some of this woe can be traced to changes in the business model. Until November 2009, Educomp operated its smartclass business on a five-year, build-operate-own-transfer (BOOT) model. The contract charges were paid by schools over the five-year period, resulting in greater upfront capital intensity for the company. To make its cash flows healthier, lower debtor days and reduce debt for working capital, Educomp decided to securitise its receivables and outsource the execution to a third-party vendor, EduSmart, in which Educomp has a stake.

Educomp transferred all its old contracts to this model between Q2 and Q4FY10. This resulted in its revenues getting a one-time jump of around Rs.600 crore spread over FY10 and FY11 and the model was expected to boost cash flows by removing the time-lag between the company’s expenditure towards cost of equipment and its income from a new contract. 

However, in FY11, Educomp decided to securitise further contracts with a corporate guarantee of 20% instead of the earlier 100%. The change in the guarantee status then made banks follow their own due diligence process, leading to procedural delays and keeping FY12 revenue in check at Rs.1,491 crore.

Moreover, debtor days increased to 277 in Q3FY12 from 240 in Q2. The bank sanctions finally came through in Q4FY12 and lowered debtor days to 252, but it was up again the next quarter, at 288. Prakash expects the situation to gradually improve and points out that even at the lower 34% margin for the smartclass business in Q1FY13, it had much healthier margins than many other businesses in the same segment. “We have added a record 40,000 classrooms in FY12 alone and plan to add even more this year. What we lose in margins we will make up in volumes,” he hopes. 

Growth, governance and all

Prakash is also betting on tablet PCs to spruce up revenues from smartclass. Each tablet is expected to cost about Rs.12,000 and will carry Educomp content. “With this we want to capture the afterschool tutor market,” he says, adding that he has an over 6 million-strong captive audience to sell the tablet to and a target of selling 3 million tablets in three years.

Besides, Prakash is also hopeful of the K-12 schools coming up and making money over the next two to four years, although the company has brought down its capex by 75% to Rs.61 crore in Q1FY13 from Rs.244 crore in Q1FY12. Educomp is also looking beyond India for growth. It has signed a $1 million deal in Saudi Arabia for smartclass, has entered Nigeria and is now looking at China. Over the past year, it has translated all its ICT content into Mandarin and has signed a business arrangement for distributing smartclass in China. 

Since 2009, when the stock came under a bear cartel attack following reports of governance issues, the dirt has stayed stuck. Says Chatterjee, “Our concerns have always been and remain why a third-party vendor is created by Educomp itself. EduSmart doesn’t have any standalone distribution capability.”

Educomp doesn’t hold any common equity in EduSmart and Prakash says Educomp is not involved in the company’s management. But it has invested Rs.45 crore in preferred equity and derives 60% of its revenues and 90% of its EBIT from the entity. Espirito also points out that over the past 12 months, EduSmart has seen four company secretaries resigning.

Playing down the impact, Prakash says, “If we had such problems, I am sure investors like IFC, from who we have raised money to pay off the FCCB, would have declined to invest after doing their due diligence.” While Espirito has a sell on the stock over governance issues, other brokerages are wary of the business meeting its growth objectives. ICICI Securities feels Educomp is unlikely to turn FCF positive over the next two years given that company has a goal of setting up 150 schools in the coming years. Against such a backdrop, it’s not surprising that the stock has crashed 85% from its peak. Clearly, this is a can-do-better report.