Description

Dadi Early-Childhood Education (“Dadi”) is one of the top three kindergarten brands in mainland China with 324 franchise schools across more than 100 cities. The stock is underfollowed as an orphaned small-cap stock listed in Taiwan and it trades at a nearly 50% discount to listed peers such as Vtron (002308 CH), RYB Education (RYB US), and Bright Scholar Education (BEDU). Dadi has an attractive growth runway with plans to add 50+ new franchise schools per year which should drive 20%+ earnings growth per year with an ROE of more than 20% and a 60% dividend payout ratio. We like Dadi as a quiet compounder in a defensive, secularly growing sector.

The founder Cheng Ti-Kun is Taiwanese with a Doctorate in Education. He started the business in 1985 and the company entered China in 1993. Since 2000, Dadi has been focused exclusively on the China franchise kindergarten business. The founder and his family control ~40% of Dadi while senior management and other board members control an additional 20%. Dadi IPOed in May 2015, in part to provide an exit to pre-IPO private equity investors.

The market for kindergartens in China is an attractive one. The market is growing aided by China’s two-child policy implemented in 2013 which is boosting the national birth rate, as well as governmental policy to increase kindergarten enrollment rates nationwide to 85%. The number of kindergartens increased from 150k in 2010 to 224k in 2015, and this is forecasted to rise to approximately 280k by 2020. The kindergarten market is very fragmented with the top 20 regional or national brands accounting for less than 4% of the total market. This should provide ample room for Dadi to add new franchise schools.

Dadi is positioned as an upper mid-tier branded school with tuition levels above average but below some other international brands such as Eaton. Dadi leverages its Taiwanese roots to create its premium reputation and school materials. We have conducted interviews with numerous competitors to validate Dadi’s good reputation within the industry.

Dadi’s business model is based on providing consulting services, materials, and software to franchise Dadi-branded kindergartens. There are two basic types of Dadi franchisees: ones with decoration and ones without.

Franchise Without Decoration: These are typically existing kindergartens that decide to convert to become a Dadi franchise. Dadi does not provide any decoration or furniture for the school but it does provide the use of the brand and consulting support, as well as preferential pricing for materials and software. This type of franchisee pays franchise and consulting fees of around RMB 300,000-350,000 per year in monthly installments, plus materials for each semester and optional software. The average contract duration for franchises without decoration is 6.5 years (typically 5-8 years).

Franchise With Decoration: These franchise schools typically sign up with Dadi before they open and Dadi provides consultancy services as well as school furniture and playground equipment during the construction phase. These schools are often set-up in new residential developments because of the regulatory requirement to have one kindergarten for every 2,000 household units. This type of franchise typically generates annual franchise and consulting fees of about RMB 150,000-200,000 in the first several years but this ramps-up to RMB 350,000 or more by year five when enrollment increases and the school becomes more profitable. Dadi generates additional revenue from materials each semester and optional software. The average contract duration is 12.5 years with a minimum of 10 years to ensure Dadi recovers the upfront capex for decoration. The upfront capex spent by Dadi averages around RMB 1.75 million.

Currently half of Dadi’s 324 franchise schools are with decoration and half are without. However the company has been more focused in recent years on signing up franchisees with decoration because of the longer contract periods, greater stickiness, and better profits and returns over the life of the contract. Last year 70% of the 50 new franchise schools were with decoration and this ratio is likely to persist in the coming years.

Management believes there is a strong pipeline to add at least 50 new franchise schools per year for the next several years at least. This combined with increased enrollment at existing schools and regular single digit annual price increases should help drive 20%+ annual revenue growth. As a pure franchise operator, Dadi has high operating margins of more than 60%. There is still modest scope for margins to improve with greater scale as more franchisees are added.

Dadi has three major sources of revenue from its franchisees detailed below. The vast majority of this revenue is recurring in nature which provides strong visibility.

• 60% from franchise and consulting fees which average RMB 320,000 (US$50,000) per school per year. Dadi consults kindergarten owners, who in some cases are investors without an educational background, on site selection, certification approval, construction, decoration, curriculum design, teacher hiring and training, student recruitment, and administration.

• 27% from school materials which averages RMB 160,000 (US$25,000) per school per year. Dadi also provides materials to non-franchised schools, although this is not a material source of revenue. Dadi supplies materials to about 500 schools in total.

• 15% from software which averages RMB 90,000 ($14,000) per school per year. 60% of software sales comes from one-time upfront license fees and 40% comes from recurring annual maintenance fees. Maintenance fees are equal to 15% of the upfront license fee. Franchisees can choose from a menu of 21 software modules, which Dadi continues to add to each year.

Valuation: Dadi trades at 25x 2017 P/E and 20x 2018e P/E with a prospective 3.0% dividend yield and a strong net cash balance sheet. Although the stock is not dirt cheap, we believe this is a very reasonable price for a company with a visible growth runway in a defensive, secularly growing industry. Competitors such as Vtron (002308 CH), RYB Education (RYB US), and Bright Scholar Education (BEDU) trade at 30-40x forward earnings.

Risks

Competitor RYB was embroiled in a scandal last year in which a teacher was alleged to have abused children. The government quickly intervened (covered-up?) but the brand has been impaired to some extent and it will be challenging for RYB to find new franchisees. We think that all school operators have increased training and monitoring of teacher behavior which reduces the risk of it happening again, but a similar scandal happening at a Dadi school would clearly be bad news. However, RYB’s misfortune may actually aid Dadi’s ability to sign-up new franchisees in the near-term.

In addition to targeting increased kindergarten enrollment rates, government regulation stipulates that 80% of kindergartens should be affordable. This means that some private for-profit schools have to offer lower-priced tuition to some or all of their students. This regulation has the potential to put pressure on profits for some existing for-profit schools and also to limit the opportunities for new high tuition for-profit schools. On the other hand, there are subsidies available to some schools that offer affordable tuition which helps to maintain profitability. We understand that the exact rules and enforcement of this policy, including the amount of subsidies available, varies significantly from city to city and province to province. While this regulation presents an industry risk to monitor, in some ways it makes the consulting services of national operators with extensive knowledge of local rules and enforcement that much more valuable. Dadi management has recently confirmed that they are not seeing any challenges in finding new franchisees in recent months.

Catalyst

Earnings Growth, Additional Sell-Side coverage as larger market-cap attracts attention