Description

Educate, Inc. (EEEE)

Overview
Educate, Inc. (EEEE) specializes in pre-kindergarten through twelfth grade education products and services. The company is mostly known for owning tutoring provider Sylvan Learning Systems and publisher Hooked On Phonics. EEEE took its present form in 2003 when management along with private equity group Apollo Advisors bought the division from Laureate Education, Inc. (LAUR). They subsequently took the company public in September of 2004.

EEEE is trading at 10X EV/TTM ADJ. EBITDA-Maintenance Capex, admittedly not dirt cheap. However this is a higher multiple business due to the company’s:
• Market leading position. The company dominates its industry (larger by a factor of 5 to 1 over its next largest competitor) and operates in a highly fragmented market
• 30%+ returns on incremental capital employed
• A clear trajectory to 15% to 20% growth for the foreseeable future
• Low capital intensity (TTM Ebit / WC + Fixed Assets = 235%)
• Two consumer brands with extremely high equity and recognition
• The existence of several additional high potential growth options over and above the current drivers of revenue and earnings.
• Distinct competitive advantage given its size and thus its ability to develop new programs and advertise heavily relative to its smaller competitors

Thesis
EEEE is currently out of favor after turning in poor and inconsistent same store sales (most recently in Q3), selling a business that was perceived as a growth engine, modestly reducing ’05 estimates and for analyst concerns regarding increasing dependence on consumer spending due to the sale of an institutional tutoring business. I believe this temporary pessimism is creating a buying opportunity.

After opening 211 learning centers and buying back 144 learning centers from franchisees since 2001, the maturation of these stores as well as continued learning center expansion should substantially increase earnings power excluding other growth initiatives. The negative short term pessimism is masking a good business with higher earnings power.

On a TTM basis, the company had EBITDA-Capex of $39MM, but after adjusting for selling a money-losing division, the planned expansion at Sylvan as well as maturation of recent openings, EBIT should move closer to $70MM in the next two to three years. Using a range of EBIT multiples of 10X to 15X creates a price target of $13.50 to $20. This excludes any contribution from a number of initiatives the company has brewing (described below) or a significant tax shield the company enjoys related to goodwill from the management buyout.

Capital Structure
Price: $11.80
FDSO: 44. 2
Market Cap: $521MM
Current Cash: $12MM
Net Debt: $143MM
EV: $653MM


Recently the company announced its intention to sell Education Station, a business unit serving the No Child Left Behind (NCLB) market. That business was reported to be on $35MM run rate while losing $8MM of EBIT. One analyst estimated the proceeds at around $50MM for the eventual buyer. The proceeds will be used to continue growth initiatives, pay down debt and possibly buy back shares.

Business Description
The business consists of the following segments:

1. Sylvan Learning Centers (234 corporate-owned learning centers and 877 franchised learning centers)

2. Schulerhilfe learning centers in Germany and Austria (226 company owned centers and 738 franchisees)

3. Hooked on Phonics (“HOP”) (publishing business purchased in Q1’05)

4. Catapult Learning (institutional business serving school districts)


Given that Sylvan provides the majority of the EBIT for the company, I will concentrate my efforts here. Sylvan is the leading national provider of tutoring services in the country serving the pre-K through twelfth grades though most of the customer traffic begins in third grade. The tutoring focuses mainly on math, reading and writing skills though they do perform SAT preparation. The curriculum includes extensive diagnostic tests that have been developed and refined over 25 years which play a significant part of the sales and evaluation process. The product offering in the Sylvan centers is compelling. They guarantee that after 36 hours of instruction the student will move up one grade level in a given discipline. The combination of a very strong brand plus a program backed by a guarantee using a highly effective methodology has produced a significant competitive advantage.

Competition is highly fragmented. According to the company, Sylvan has 13% of the total revenue share for premium tutoring services. All other national branded competitors have roughly the same share combined. The two largest competitors are the over 400,000 private tutors who capture 50% of the industry revenue and local centers (those tutors with storefronts) that get approximately 25% market share. Sylvan enjoys extremely high brand awareness which is aided by their $70MM dollars of marketing spend per year. National competitors include Princeton Review, Huntington, Kaplan, Kumon and Score!. Amazingly, corporate does not provide advertising as part of the services it offers for the 8% franchise fee it collects. Instead, there is an association in which all franchise owners contribute to a pool (including corporate contributing their pro rata share for their owned centers). This amount creates the budget for the annual advertising campaign.

Sylvan franchisees tend to be “life style” operators meaning they are not prone to squeezing out the last dollar. They like the income and flexible hours that owning a Sylvan franchise provides. Evidence of this is that the corporate owned stores run at close to $1MM of revenue while the franchisee average is $565K. One of the key differentiators is that corporate stores are open longer which increases revenue.

Franchises have operating margins in the 15%-20% range even after the 8% royalty fee. This means that pre-tax, a franchisee stands to make over $80k for a seasonal business (this is after pay roughly $140k out in salaries which can accrue to the owners if they work there as well). Initial start-up fees and investment costs are in the $140k to $200k range and are cash flow positive within one year according to the company. Not a bad investment.

Strategy
Management categorizes their market as “supplemental” educational products. They estimate that consumers spend between $10 and $12 billion annually (out of the consumers’ pocket, not school districts) in the form of products and services. Their goal is to provide a product and service across the spectrum of needs and price points in the pre-K through twelfth grade arena both directly to the student and in some cases on behalf of the local school district as a contractor.

Sylvan is their flagship product. At $40-50/ hour and programs that generally last 36 – 72 hours or greater, this is tends to be a large investment for students’ families. Management estimates that 1/3 of customers are “aspirational” and 2/3 are remedial.

Two key findings that have affected their strategy came as a result of a study management performed recently. Firstly, most parents try to remediate or push their child with a self-service product before trying Sylvan. At a price tag of over $3,000, who could blame them? Thus a self-service product category at lower price points was born. To bolster this initiative, management purchased Hooked On Phonics earlier this year. It was a $10mm business purchased for approximately $13MM dollars plus an earn-out. HOP was primarily a direct marketing product but Educate is changing the distribution strategy to mass market channels (like Costco and WalMart). Admittedly, this is a competitive category but with two extremely trusted brands, the company should be able to establish a healthy market share and could help further push the introduction of Sylvan for those that want or need premium instruction.

The company sees opportunity in what they call the “fun and affordable” education segment through its brand Hooked On Phonics. The plans call for product introductions in English and Spanish as well as opening HOP learning centers. I was shocked to see that HOP was only a $10MM business. Its brand awareness is off the charts due to the 15 years of skillful direct marketing. Management compares their purchase of HOP to Disney’s purchase of Baby Einstein in 2001. Disney increased sales significantly by adding additional product SKUs and selling in new channels, which management intends to do with HOP.

Secondly, the study found that in some centers were doing a poor job of covering their territory from a well-situated central location. To address the convenience issue, management is pushing “fill-in” centers in existing territories. Originally, they sold franchise territories in increments of populated areas of 20,000 people when the business started over 25 year ago. Given demographic changes and urban sprawl, one location may not serve the area well enough from a commuting perspective. Ask any suburban soccer mom how long it takes to get from activity to activity these days.

In terms of market penetration, the company believes there is capacity to double the number of centers from its current 1,100 to over 2,000 in North America. Also, the disparity in operational metrics between corporate owned and franchise locations has made the distribution of best practices to all franchisees a key focus for the company.

The institutional side of the business has become less of a focus after the announcement to sell Education Station. The No Child Left Behind Act created a bonanza for service providers as schools scrambled to create remedial programs. The company has a 25% return on invested capital requirement that apparently this business did not have a hope of hitting. Additionally, management stated that the way contracts were awarded at the school district level were highly political. The company is retaining its Catapult On Line division which provides the same NCLB tutoring to rural districts to serve that segment.

Macro Factors
I won’t spend a lot of time on this issue, but suffice it to say, current trends bode well for supplemental educational products and services. There is a rising student population due to immigration and the “Echo Boom” generation. College acceptance rates are declining due to more competitive admissions processes. The gap in expected wages between high school and college graduates is growing (~$25k difference) making some form of post secondary education far more important to achieving a decent wage and thus creating more impetus to perform better in school. Standardized test usage has doubled over the last three years and it is expected that by 2008 that 80% of schools will require annual “exit exams” to move up to the next grade. All the stars are lining up to make school performance more stressful for students creating the need for the likes of Sylvan.

Growth Plans
Management’s growth plans can be divided between Sylvan and “Other”. In the Sylvan division, management expects to open up 30-40 greenfield territories, buy back 30-40 franchises and facilitate 40-60 “fill-ins” per year for the next couple of years. Management has prioritized 200 new territories worth pursuing of over 1,000 potential sites. Fill-in centers typically double revenue for the territory meaning they do just as well as a stand alone center.

Buying back franchise locations have played a key role in increasing sales at the company. Corporate has the right of first refusal on all franchise sales which they selectively exercise. As already mentioned, they operate centers more profitably than franchisees and the returns on purchasing them are over 50% pre-tax once they achieve the improved run rate after two years. I view this as a good use of capital and it keeps corporate closer to the customer which makes the company more competitive.

The “Other” growth initiatives are exciting but very difficult to handicap or quantify. I will list a few of them but take the conservative way out and decline to give any guesses on revenue and contribution. The good news is that the Sylvan growth is the tangible growth story here, these other lines of business come for “free”.

• Hooked on Phonics retail products: With the recent acquisition of HOP, management is changing the format from direct marketing to retail channels such as WalMart and Costco as well as Sylvan locations.
• Hooked on Phonics services business (600 locations currently): This business already existed when the company bought HOP, and management plans to open more.
• LeapFrog / WalMart venture: This venture was announced in Q1’05. There is a JV in the works for a shopping drop off center focusing on education.
• Sylvan Online: This product to date is not been a contributor despite the over $50MM investment over the last 5 years. Recently management decided to incorporate it into the Sylvan bricks and mortar product offering instead of competing with it. I think this will help with creating more persistent student usage as well as the potential to create a lower priced product offering.
• Catapult Online: Even though Education Station is on the block, the company has an online product for designed for rural areas which is showing positive early results.

Valuation
Trailing 12 month EBITDA is $52.6MM. Management has said maintenance capex is $10MM per year. Selling Education station alleviates approximately an $8MM EBITDA loss on a TTM Basis. The maturation of the 211 centers opened and the 144 centers bought back should add another $20MM or operating income (approximately) over the next two to three years. This creates an EBITDA - capex earnings power of approximately $70MM. The company enjoys a tax shield of $18MM per year due to the large amounts of goodwill created during the buyout from Laureate (which is to last for the next 15 years if not longer due to the incremental good will that come as a result of center buy-backs). Using the tax effected earnings and current debt load, tax effected EPS should be around $1 per share in approximately two to three years. Using a multiple of 15X to 20X would produce a price target of $15 to $20.

Risks / Issues
1. The consumer: Obviously, $3,000 is a lot of a family’s disposable income to spend on a child. I do worry about an over extended consumer. However, according to the 2002 census there are over 15MM households that have over $100,000 in total household income (Sylvan services approximately 200,000 per year). Secondarily, between Sylvan on Line and the new published material for the retail channel, they are expanding their offering for lower household incomes as well.

2. Big overhang of Apollo’s percentage ownership (53%): Not much that can be said here. I can only assume that Apollo will do what is economically rational for themselves as shareholders. If the company is undervalued, I assume they will not sell their shares. But they could summarily dump it.

3. Execution risk: Given all the moving parts, the company could falter on the Hooked On Phonics roll out or the expansion plans. Additionally, many analysts are concerned about how competitive the children’s learning product market is with companies like Scholastic and LeapFrog.

4. Competition: Education is a hot market. Despite Sylvan’s size and brand recognition, lower cost in home tutors or other local or national players could hinder growth.

5. Buying franchisees: Though this is hardly a rare occurrence in the franchisor market, it could spook franchisees and it is more capital intensive than a straight franchisor business.

6. Inconsistent SSS: Clearly the lack of consistent performance is a problem. Potential causes could be effectiveness of advertising, the lack of a lower price point offering or poor execution on spreading best practices. In any case, it is something of which to be mindful. The opening of fill-in centers in existing territories and the corporate buy back centers all start in the SSS count from day one. This harms comps and few analysts seem to understand this. De Novo branches in existing territories take time to grow their base and bought-back centers actually decline in revenue before it improves because the sellers don’t market heavily before they sell and new management takes a while to improve sales.

Conclusion
Educate is a high quality business. Educational products and services is a growing industry. The shares are attractively priced given the high returns on capital and the growth ahead.

Catalyst

1. Improving comps
2. Increasing earnings
3. Success of one of the non-Sylvan growth initiatives