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Value Investing Contest Winning Entry #5: Tree House Education

This report was prepared by Maheswar Reddy, as part of the Safal Niveshak Value Investing Contest. None of the facts herein have been validated by Safal Niveshak. Also, please DO NOT treat this report as a “recommendation” from either the author or Safal Niveshak. Do your own homework.



Tree House Education & Accessories Ltd. (Tree House) is the largest self-operated preschool education provider in India. After establishing itself as one of the top brands in pre-school education, Tree House has also entered the K-12 school segment.

Rapid growth – From one center in 2003 to more than 400 in 2014:

  • 2003 – Incorporated first Tree House pre-school in Mumbai
  • 2006 – Established 6 more pre-schools
  • 2007 – Converted to private limited company and launched first franchise
  • 2008 – INR 35 crores investment from Matrix Partners India
  • 2009 – Entered K-12 and day care segments
  • 2010 – INR 15 crores investment from Matrix Partners India
  • 2011 – Converted to public limited company; Successfully completed IPO of INR 112 crores; INR 9 crores investment from Matrix Partners; INR 31crores investment from FC VI India Venture
  • 2012 – Acquired pre-school business “Global Champs”; INR 41 crores investment from ON Mauritius & Aditya Birla Company
  • 2013 – Acquired pre-school business “Brainworks”

Competition

    1. Low entry barrier – Unorganized sector has a high share
    Setting up a preschool requires low investment due to which the Indian preschool market is largely unorganized. Organized sector consists of 6 – 8 big brands and some smaller brands. Due to rapid urbanization and increasing awareness among parents about the importance of quality learning during the early formative years there is a gradual shift happening from unorganized sector to the organized sector.

    2. Huge growth potential for organized sector
    According to Crisil research, the preschool market in India is expected to grow at a CAGR of 20.6% from Rs 4,300 crores in FY10 to Rs 13,300 crores in FY15. The share of organized sector is expected to increase from 11% in FY10 to 34% in FY16 which suggests there is enough space for many players in the organized sector.

    3. Tree House’s advantage over competition
    Tree House is the only major pre-school chain which is primarily based on self-operated model as compared to the other big players who run primarily on a franchise model. Being self-operated gives Tree House advantages in terms of lower operating costs and at the same time maintains quality of education. Tree House also runs teacher training courses which helps the company in meeting its need for qualified teachers to support its rapid expansion and to maintain centralized approach to curriculum and quality of pre-school education.

    Financial Strength
    1. Low Debt: Tree House has a total debt of INR 66 crores which is not high for a company with market cap of about INR 830 crores (Mar’14) and estimated FY 14 PAT of INR 48 crores.

    2. Nearing the end of capex cycle: The major capex for Tree House so far has been in the K-12 segment where they have invested around 200 crores for school management rights, land, building etc. No major capex expected going forward.

    3. Estimated to be FCF positive from FY14: Tree House is now at the end of its capex cycle. Tree House has also put 4 of its school buildings for sale in Dec 2013 so as to become asset light. Income from sale of buildings and earnings from operations should help the company become cash flow positive and possibly debt free from FY14 onwards.

    4. Strong growth in net profit

    Management Effectiveness
    Pre-school:

    • Achieved tremendous growth in the pre-school segment so far
    • Management seems to have fine-tuned the process of setting up new centers and quickly turn them profitable
    • What needs to be watched out for in the next couple of years is how well the “Global Champs” and “Brainworks” acquisitions add value.

    K-12:

    • Heavy investment – almost INR 200 crores – has been made in the K-12 segment in land, buildings and for school management rights. A big portion of this amount – about 100 crores – is given as deposit to trusts that run the schools. This deposit will be refunded to Tree House over a period of time. Tree House will also get school management fees for about 30 years.
    • The fact that 4 of the school buildings have been put up for sale seems to indicate a reversal of plans although Tree House will retain school management rights even after selling the buildings.
    • How well the K-12 investment pays off for Tree House is something that investors need to watch out for in the coming years.

    Risks

    • Geographical risk: As of end March 2013, 50% (191 out of 379) of Tree House pre-schools are located in one state – Maharashtra. Any negatives that may impact Tree House brand or if competitors take away market share in this state could have significant impact on revenues.
    • Low entry barrier: Pre-schools require low capital. Also PE funding seems to be available (Tree House has received PE funding multiple times). Competitors could scale up quickly and capture market share.
    • Govt regulations: As of now there is no govt intervention in the running of pre-schools in the country. Any change in policy that may impact pre-schools could affect Tree House’s business.

    Valuation
    Tree House has three streams of revenue – pre-school, K-12 and teacher training.

    Of these three, pre-school contributes close to 85% of revenues. This could change in future as K-12 returns start increasing. Teacher training revenues are insignificant in the big scheme of things but this is a key aspect of Tree House as it builds a pool of trained teachers which would help in rapid expansion of its pre-schools.

    Focus of the valuation for now is on the pre-school segment.

    Pre-schools turn profitable for Tree House in about 1-2 years from the time they are set up. Profits for a pre-school continue to rise over time as capacity utilization increases.

    Effectively, the average revenue per center continues to rise each year as more and more schools from earlier years become more profitable due to increasing capacity utilization. This can be seen from data below:


    Average revenue per center has gone up from Rs 15 lac in FY10 to Rs 28 lacs in FY13. This number is expected to rise as more and more pre-schools turn profitable.

    About 27-30% of this revenue ends up as PAT. The PAT margins could increase in the future as Tree House achieves cost efficiency through scale.

    For the purpose of valuation, 27% of revenue ending up as PAT is assumed. Tree House is adding on an average 75 new centers every year. Below is the forecasted model based on these factors –


    At the current market price of Rs 220 (as of 7th March 2014), Tree House is trading at FY16E PE of 9.8 and FY17E PE of 7.5. This is based on estimated earnings from pre-school segment only. Any earnings from K-12 segment will be an upside. Based on this, I believe the stock is undervalued.

    Disclosure: I, Maheswar Reddy, own shares in the company.

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About the Author

Vishal Khandelwal is the founder of Safal Niveshak. He works with small investors to help them become smart and independent in their stock market investing decisions. He is a SEBI registered Research Analyst. Connect with Vishal on Twitter.

Comments

  1. Thank you for the analysis.

    This stipulation that a school cannot make a profit (by law, but I may be wrongly informed) and therefore a trust owns a school and the ‘for profit’ entities enter into management contracts (for a management fee) with such Trusts makes it murky and prone to many malpractices.

    In this case the Rs 100 Crore in deposits to such Trusts probably reinforces my belief that it may not be a clean business.

    The rest of the numbers look interesting.

  2. Maheswar Reddy says:

    Thanks for your comment Sudhir.

    Agree with your point about schools in India being not for profit entities and there could be possibility about roundabout ways of profiting from schools. The two tier method of ‘for profit’ entities entering into management contracts with Trusts seems to be within the law.

    It is still early days for Tree House as a public company but they seem to be well on the way to creating a major brand in the education sector.

  3. Nelson Christian says:

    Hello Maheswar,

    Thank you for the report and for choosing such an interesting company. My doubts are: is it possible for revenues to de-grow if not completely then at least at few centers? Also how much of a brand pull does Treehouse have considering that there are very low entry barriers. Also does not opening up of new centers mask de-growth of revenues at the old centers. I know same store growth is for retail stores but is it possible to do a similar analysis for the company. I may be completely wrong but would like to know your views for the same.

    Best Regards,
    Nelson

  4. Maheswar Reddy says:

    Hello Nelson,

    Thanks for your comments. Before I respond please note that as far as investing is concerned I am at the nursery level trying to learn the alphabets of investing. Please treat my analysis of the company and my response below accordingly. I could be completely wrong in all of my analysis and so please do your own calculations.

    Agree with your point about the possibility of revenues de-growing at some of the centers. In my valuation I have taken average revenue across all centers which should take care of some centers de-growing and some centers becoming more profitable. I do not have the centerwise information to come up with same center growth numbers.

    I have also completely left out K-12 revenues from my valuation. K-12 could become a steady and risk free cash cow for Tree House in future for the following reasons:

    Tree House currently has 24 K-12 schools. Assume each school has classes from LKG to 12 which will make it 14 grades per year per school. It is common to find schools in India with multiple sections in each grade. Some of the schools I have seen had sections from A thru I J K…..and so on for a single grade. For Tree House assume conservatively 2 sections per grade with 30 students per section. We end up with

    24 * 14 * 2 * 30 = 20160 students per year. Assume 50% capacity utilization at a conservative level which gives 10080 students per year. There is no clarity from Tree House on what they expect per student in management fees but you can try out a few numbers. Tree House has school management rights for 30 years. What I have used here are very conservative numbers. Most of the schools have more than 2 sections and more than 30 students per section. Also it is possible in about 5 to 6 years from now the capacity utilization at K-12 schools could be much higher than the 50%. Bottom line there is big scope for Tree House to get steady income from K-12 for the next 30 years and possibly beyond. It is also possible they will expand their presence in K-12 in future. I have left out K-12 from my valuations to be on the conservative side. Hope this helps.

  5. Anil Kumar Tulsiram says:

    Good Analysis

    It will be interesting to compare and contrast Tree house with MT educare. Both are majorly present in that segment of education which is not regulated [Coaching vs Pre-school].

    Asset turnover for MT educare is much higher compared to Tree house. [Tree house has asset turnover of around 0.3-0.4x vs MT Educare of more than 2x].EBITA Margins of Tree house is much higher at 50% vs 15% for MT educare. But despite low margins, ROCE of MT educare is at 30% vs 16% for Tree House. Roughly both are running at 50% utilisation levels. The reason for higher asset turnover for MT Educare is, it can make optimum utilization of each leased centre by running 3-4 batches whereas Tree house does not have this advantage, Moreover capex for coaching is much less compared to pre-school [Area required is roughly same for both coaching and pre-school c1,500-2,000 sq ft, but for Tree House max students per centre is around 250 whereas for MT educare its around 1,200. Capex requirements for MT educare is around 30-40 lakhs whereas for Tree house its 50-60 lakshs.]

    I think because of this reason compounding will be much higher in coaching business vs a pre-school centre.
    Risk for scalability, competition from unorganised sector and recruiting talented employees roughly same for both, though entry barriers in coaching is little higher compared to pre-school, location is much more important for pre-school, hence rentals will be higher side and its possible to compromise on location a little bit in case of coaching centers. Branding plays much more important role for coaching centres vis-a vis pre-schools. Having said that I am not too sure of scalability part for both MT Educare and Tree House, but assuming both business are scalable MT educare is a better business, I think.

    [I have completely ignored valuation and K-12 impact for both. Just analysed Pre-school vs Coaching business]

    • In offices of reputed companies, about 100 s ft is budgeted per employee. I would expect that it should not be less for kids. They need more space to play and run around. My guess is that it should not be less than 75-80 s ft per kid. 1500-2000 s ft for 250 kids means 6 to 8 s ft per kid. How is this even possible?

      Even if I take 60-70 kids per school, it implies 25 to 30 s ft per kid. That’s horrible. Can a business survive like this in the long run, or is it an accident waiting to happen?

      This reminds me of pathetic customer service at Mahindra Holidays and how they suffered because of this. A holiday company may go on with this, but a pre-shool company may get in serious business problems. It looks more like a sweatshop for kids.

  6. Maheswar Reddy says:

    Thanks for your comments Anil. I have not looked in detail into MT Educare.

    Tree House ROCE has been less as they have been investing a lot into K-12 the past few years but are now at the end of capex cycle. Also Tree House is selling some of their school buildings but will retain school management rights. Sale of the buildings and expected increase in K-12 revenues should improve Tree House ROCE going forward.

    Agree with rentals for pre-school being higher as compared to coaching centers but Tree House is now on a major push to expand in the Tier-II and Tier-III centers where the rentals are much less. Looking thru Tree House website it seems they have opened 19 new centers in one month in Lucknow.

    As far as scalability is concerned, looking at revenues for the past 5 years, MT Educare has doubled in revenue from about 70 crores to 147 crores while Tree House has gone up 11 times from 10 crores to 114 crores from 2009 to 2013. It looks like Tree House is scaling up faster. Tree House is adding on an average 75 centers per year and continues to maintain the rapid growth rate.

    Coming to the staff, coaching requires slightly more qualified and experienced personnel with higher salaries as compared to pre-schools which do not require specialized qualifications in selected subjects. Also the pre-school staff salaries are much less as compared to coaching centers.

    In my view Tree House with a combination of pre-schools and K-12 are targeting a much larger pool of students across geographies as compared to MT Educare and so Tree House will grow and scale up much faster than MT Educare. This is my view and I could be wrong.

  7. Anil Kumar Tulsiram says:

    Thanks Maheshwar

    Not even Warren Buffet was always right and that’s the part of the investing game. Like you I am too in learning phase and just 24 months in value investing. You could be 100% right on K-12, I don’t have any insight on that. Only suggestion is to do comparison on per unit basis [i.e per center] separately for both MT educare and Tree house.

  8. Tree house @78 rupees
    This major downfall bcoz of three main reasons-
    1. Promotores had reduced it’s percentage from 30 to 20%
    2. SES raises concerns on 42 crs debtor overdue more than 6 months
    3. Low valuation of tree house on merger with zee learn
    The market cap of this stock has fallen to 330 crores from 990 crores.
    The liquidation value of this stock comes to 70 rupees .so there is huge margin of safety and falling of 660 cr market cap due to 42 cr of debtors ., seems like Mr. Market has hugely undervalued this stock .
    So can anybody suggest whether one should make investment in this stock or not?

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