The return of kids to school this week made me think about education stocks. That, and a few impending school fees that rise by more than the inflation rate each year.
Education is a great business, in the right hands. High-quality education providers have traits of exceptional companies: a high return on equity, recurring revenue, a “sticky” product with high switching costs, and scalability as the same course is offered to more students.
The sector has several tailwinds: the boom in international education in Australia; parents spending more on their children’s’ education; growth in childcare and early-learning services; and higher demand for ancillary services such as online learning and tutoring.
Education costs are becoming a bigger part of household budgets and pressure to attend good schools and universities is rising. The Age this week reported that some parents are enrolling kids in schools up to an hour from their suburb, in the search for a better education.
That’s the good news. The bad part is that ASX has only a handful of quality listed education providers and a few others scattered across sectors such as property and software. Look overseas if you want more choice in private-sector education companies.
The sector’s chequered history is another problem. The vocational education sector was a landmine as Vocation, Australian Career Networks and Intueri Education Group destroyed shareholder wealth and caught out many analysts and fund managers.
Industry structure and regulatory risks are other challenges. Most education is provided by incumbent not-for-profit organisations that rely fully or partly on government funding. Intense debate on school funding reinforces the sector’s potential regulatory volatility.
Risks aside, there is merit in exposing portfolios to higher-quality small- or mid-cap education companies. For all the setbacks, parts of the sector have solid long-term growth prospects: international education, learning software and early-learning, for example.
Here are four ways to play the sector:
1. International education
Education is one of Australia’s great export success stories, bettered only by iron ore and coal. Some care is needed with overall international education-industry estimates, for they include non-education expenses, such as accommodation. But it’s still a booming sector.
The question is how long it lasts. As Asia builds more universities and its tertiary education standards, fewer international students might attend our universities. That threat is some way off and growth in Indian demand for our education is a long-term driver.
IDP Education and Navitas are the two main ways to play the international education theme. My preference is IDP, a stock I have written about several times for The Switzer Super Report over the past two years and one that has delivered strong returns.
IDP is a leading provider of international student-placement services and English-language testing services. It also owns and operates several English-language schools in South East Asia. The company has a valuable position in Australia’s international education ecosystem as it attracts more students to this country and gets them ready with English-language skills.
Chart 1: IDP Education (IDP)
Source: ASX
2. Technology
Online learning is one of the great opportunities in education. Digitised content is highly scalable and offers bigger profit margins. Like software, the same piece of education content can be licensed to a much larger market for low additional costs and used over and over.
Early hype around Massive Open Online Courses (MOOCs) reinforces the potential of online learning to disrupt the education sector. Offered by mostly large international universities, free MOOC courses are aimed at unlimited participation and open access via the web. Why pay $30,000 for a university degree if you can do a similar course from a higher-ranked university for free?
Meanwhile, 3P Learning, a provider of online education programs such as Mathletics, has been a frustrating small-cap stock. The company has terrific potential as kids worldwide use its programs. But 3P Learning’s $2.50-issued shares from its 2014 float hit 63 cents in early 2016.
I included 3P Learning in The Switzer Report takeover portfolio because it had valuable content that the previous management team was not fully commercialising, and because the company looked like a neat bolt-on acquisition for a larger US education-software firm.
After a disappointing first three years as a listed company, 3P Learning is starting to recover, its shares peaking at $1.62 this year. The business looks more streamlined and focused under new management and is starting to attract market attention. Schroder Management increased its stake in 3P Learning to 7.37% this month.
The company’s strategic priorities to focus on its core literacy and numeracy products, develop a scalable marketing model and grow overseas are working. Group revenue grew 11% (on a constant currency basis) in FY17 and underlying earnings rose 20%.
3P Learning suits experienced investors who are comfortable with small-caps. For all its challenges, 3P Learning has valuable learning content that can be scaled overseas. Having been positive on 3P Learning too early, I’ll keep the faith as it starts to recover.
Chart 2: 3P Learning (3PL)
Source: ASX
3. Property
Australian Real Estate Investment Trusts (A-REITs) are a lower-risk way to benefit from growth in the education sector. One can invest in childcare-centre operators or in the companies that own properties they rent. The latter is the more conservative approach.
Folkestone Education Trust owns more than 400 externally managed childcare centres in Australia and New Zealand and is one of the sector’s better operators.
Folkestone has starred: the five-year annualised total return (assuming distribution reinvestment) is 23% and the 10-year return is 16%. The trust continues to achieve high occupancy rates and solid rental increases when leases expire.
The main risk is tenant concentration: Goodstart Early Learning accounted for 56% of Folkestone’s FY17 rent. ABC Learning Centres’ collapse in 2008-09 led to Folkestone breaching its banking covenants, so the market is rightly concerned by tenant concentration in this sector.
Goodstart’s proportion of Folkestone rent is falling and should continue to do so as the trust opens new properties and secures new tenants.
An oversupply of childcare centres – and falling occupancy rates – is another short-term risk, but any excess supply should be absorbed in the next few years given rising demand for this service and a shortage of childcare places in some suburbs.
Morningstar’s $3.20 valuation for Folkestone looks about right. There’s still value for income investors who are attracted to the trust’s expected 5.5% yield at the current price and long-term capital-growth prospects.
Another option, Arena REIT has also performed strongly with an annualised 19% total return over three years. Arena has been one of this columnist’s preferred small-cap niche REITS for several years. Folkestone had a 4.4% interest in Arena at June 30, 2017.
Arena is focused on social-infrastructure property: mostly property for early-learning centres and the rest in healthcare. Like Folkestone, Arena looks marginally undervalued at the current price and its expected 5.8% yield should appeal to income investors.
Chart 3: Folkestone Education Trust (FET)
Source: ASX
4. Childcare
G8 Education reminds investors of the potential volatility in this sector. G8 rallied from $3.60 in early 2017 to a 52-week high of $4.71, then tumbled to $3.38 after a nasty earnings downgrade that cut forecast profit by about 9%.
Some good judges I know believe the market over-reacted to the downgrade and that investors were itching to sell at the slightest bad news, given past problems in the sector.
At $3.38, G8 is on a forecast Price Earnings (PE) multiple of about 16 times and yielding 7% fully franked, consensus analyst estimates show. An average share-price target of $4.24, based on seven broking firms, suggests G8 is undervalued.
Value is emerging in G8. For all the recent problems, the childcare-centre industry has good growth prospects and G8’s business model is far from broken. But I’ll stand aside for now, in anticipation of better value in the next few months as the market digests the downgrade and looks for greater clarity on G8’s outlook.
Chart 4: G8 Education (GEM)
Source: ASX
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
