Description

HumanSoft Holdings Investment Memo

I.                    Executive Summary:

·         Leading private education company in Kuwait which grew earnings over 100% in 2013, over 60% in 2014, and over 100% in 2015 and in 1Q16, all organically. The key drivers of earnings growth have been (1) growth in the number of Kuwaitis entering college age and (2) supply constraints at competitors – both factors should continue at least for the medium term.

·         The stock trades on ~ 7.5x our estimated 2016 earnings and the company maintains a high dividend payout ratio (averaging 96% over the last three years). In our base case scenario, over the next four years, dividends alone could return ~70% of the investment at today’s share price.

·         Peers are trading at 17-20x P/E. If HumanSoft re-rates and earnings grow at a 20% CAGR going forward (much slower than the rate historically), there is 4-5x return potential over four years. We think it is likely earnings will grow faster than 20% per annum.  

·         Best of breed management team in a country with few ‘rock star’ CEOs. HumanSoft’s founder/CEO is known for his ‘fanatical’ work ethic, high integrity, and being a true businessman in an industry where the competitors are typically either run by academicians or government bureaucrats. Involvement of a PE firm on the board with ~ 25% ownership and with control rights helps provide further comfort.

·         Reason for mispricing – micro-caps in Kuwait do not typically attract sophisticated investor attention. Competition is normally local retail investors who are almost always entirely focused on the dividend yield of the stock (which by definition is a trailing measure) and who do not conduct the deep primary work needed to have conviction in future growth.

II.                  Introduction

HumanSoft (BBG ticker Humansft KK) is the leading owner/operator of private tertiary education assets in Kuwait. Earnings have compounded organically at a CAGR of 65% since 2009 (including 112% in 2015 and over 100% in Q1 16) yet the stock is trading only on ~7.5x 2016E earnings. Thus far, the key drivers of the company’s success have been a favorable industry backdrop and a dominant management team that delivers a compelling product to its customers. However, we are still in the early innings of the value creation story. We expect earnings to grow 2-4x over the next 4 years and for ROE, currently at c. 50%, to continue to expand.

HumanSoft is structurally well positioned in a booming sector. In the coming decade, the combination of Kuwaiti demographics and supply constraints at government universities/colleges, will require anywhere from a 4% (base case) to 10%+ (historical trend) CAGR in enrollment in private colleges and universities. While we should theoretically expect to see both greenfield and brownfield expansions from HumanSoft’s competitors aimed at profiting from this growth, their track record in doing so has been poor. Due in part to strict licensure requirements and high cost of land, there has not been a major new private university built since 2008, when HumanSoft launched the American University of the Middle East. Furthermore, as will be discussed, HumanSoft has significant competitive advantages which would require existing players to fundamentally re-imagine their value proposition and re-design their campuses in order to replicate. Indeed, these advantages have resonated to such a degree with the market that HumanSoft’s share of tertiary private education has increased from 15% in 2008 to 75% in 2015[i].

From today’s levels, HumanSoft shares offer a low-teens 1-year return just from the dividend yield. On a four year horizon, HumanSoft offers 2-4x return potential in a base case and 6-8x return potential in an upside case. The components of these returns are as follows:

·       Low-teens dividend yield and growing: Over the last three years, the dividend payout has averaged 96% and the dividend paid for 2015 was the largest possible absolute payout allowed by Kuwaiti accounting rules. Based on our conversations with individuals who are close to the controlling shareholder, the company is likely to continue to distribute nearly all of its earnings as dividends. HumanSoft’s 2015 dividend equates to an 8% yield given today’s share price and, if our earnings and payout assumptions are correct, investors will receive a 13% dividend yield for 2016 and ~ 70% of today’s market cap back in dividends over the next 4 years.

·       Earnings should at least double over the next 4 years but could grow as much as 3-4x: Simply assuming that HumanSoft is able to repeat its 2015 enrollment over the next 4 years (which shouldn’t be a challenge in the context of a growing market) will alone drive over 60% revenue growth over the next 4 years – with operating leverage, this will translate into ~ 2x earnings growth. From there, non-linear potential upside in earnings growth could come from tuition increases (which, historically, have occurred regularly), enrollment growth, and new programs.

·       Multiple Re-rating Potential: Kuwaiti consumer companies like Mezzan Holding and Kuwait Food trade on 17-20x LTM P/E whereas Al Khaleej Training, the second largest education company in MENA (behind HumanSoft), trades on 17.3x LTM P/E. This compares to HumanSoft at 9.6x LTM P/E. While HumanSoft is less liquid than these companies, it is also growing much faster. We think a 15x P/E multiple on current year’s earnings is not unreasonable, which would be ~ 2x the current valuation. 

·       Private Equity Takeout: There is robust interest by MENA private equity investors in education businesses. A due diligence call we conducted with a leading education investment banker in MENA suggested there is a fervor currently for high-quality healthcare, branded consumer, or education assets as these are the three sectors viewed as highly defensive in a falling oil price environment. This banker indicated there would be at least 10-20 funds interested in investing in or buying HumanSoft. Blackstone’s minority investment in GEMS in the UAE (a K-12 private education company) is rumored to have been valued at 18x-19x P/E.  

In summary, there is scope for significant upside potential given earnings compounding of 2-4x and multiple rerating of 2x. At the same time, there is strong downside protection given a 7.5x P/E valuation for a high quality, rapidly growing asset with a near 100% payout ratio.

Kuwait represents the single largest country weight in the MSCI Frontier Market Index (c. 20%) and it’s only a matter of time before developing market investors will discover that this may be one of the most attractive investments within their universe. Minority investors (like ourselves) are for the first time planning to actively educate the investor community about the story, which should help accelerate this discovery process.

HumanSoft’s EPS and DPS will at least double over the next 4 years

Note: Base case above assumes enrollment based on 2015 intake, flat opex/student from 2015 levels (which are elevated because expenses were incurred ahead of capacity ramp-up), and 3% per annum price increase implemented in a one-time upward price revision in 2018/2019.

III.                HumanSoft should continue to be the winner in a booming sector

The Kuwaiti private tertiary education sector is experiencing secular growth in demand. All Kuwaiti high school graduates are promised a fully-funded tertiary education if they are able to fulfill minimum entrance requirements. And with over 70,000 barrels of oil reserves and over $400,000 in sovereign wealth funds per citizen, the Kuwait government can comfortably afford to maintain this promise[ii]. To quantify the demand growth, from 1997 to 2012, the number of Kuwaiti high school graduates grew by a 6% CAGR and, in the coming decade, Kuwait’s demographic dividend should drive at least a 3% growth in high school graduates.

Outside of HumanSoft, both public sector and private sector institutions are struggling to absorb the growth in demand. By the early 2000s, the Kuwaiti government realized that its one public university (Kuwait University) was incapable of meeting the demand for tertiary education by its growing college-aged population.[iii] The government also sought a way to reduce the cost of education – a private university tuition is a third of the price of educating a student at the public university. These factors led to the birth of the private university sector – in return for putting up initial capital, designing a curriculum (with a foreign partner), and launching the college or university, the private operator was granted land and tuition compensation for nearly all Kuwaiti students that chose to attend its institution.

Today, on the public sector side, Kuwait University is capacity constrained and operating at overflow levels. A project intended to relocate the university to a larger site has been ongoing for two decades and current estimates don’t expect it to be completed for another five years, at the earliest. This timeline has already been delayed multiple times in a strong oil price environment and could be stretched further given today’s oil price. Over a three to five year investment horizon, there will be limited impact from public sector expansion on the industry.

The barriers to entry in the private sector are high and rising. Over the last seven years, the regulator has, on average, approved less than one license per year. After approval, each license holder must not only find an international partner (previously only an international curriculum was required) but also then wait nearly three years for land allocation, permits, and construction. Since HumanSoft’s launch of the American University of the Middle East in 2008, no new private universities have come online and, given the lead time required, we currently don’t foresee significant new competition for three years at a minimum. However, in a growing market, supply from competitors will not be constrained forever. When the HumanSoft’s competition does eventually expand capacity, the company will be protected by the competitive advantages described below.

Over the last seven years, HumanSoft has been able to grow its market share in the private university sector from 15% to 75%. This has not come from other private universities losing enrollment, but rather due to capacity constraints at public institutions leading to a boom in the private university sector. With such strong growth in the private university sector, HumanSoft has been able to take dramatic share without causing a large absolute fall in enrollment at its private competitors. 

Private Education Sector Growth Buoyed By Demographics and Share Gains from the Public Sector

Source: Annual Bulletin of Education Statistics in Kuwait. Proprietary Estimates.

HumanSoft’s Share in Private Education Sector Increases Due to Growing Competitive Advantage

Source: Private University Council.

HumanSoft’s success can be attributed to delivering a compelling product to its customers – namely its students and the government which pays for the students’ tuition – as well as fanatical execution by management, especially the company’s founder and CEO, Fahad Al-Othman[iv]. To understand how HumanSoft has been able to achieve such success, we have dedicated over 100 hours conducting interviews with former executives and professors at HumanSoft, former/current students, deans at competing institutions, and regulators. We learned that while other university operators spent time and resources tinkering with their respective curriculums and are primarily academicians (rather than businessmen) by background, Al-Othman understood that, beyond a certain level of education, what most Kuwaiti students actually wanted was a vibrant campus life as well as facilities for athletics and parking. HumanSoft therefore built the most elaborate campus (including a FIFA-sized soccer stadium) and ample parking. At the same time, HumanSoft allocated a budget multiples of the size of its competitors to advertising these features in the local media.

Importantly, HumanSoft was sensitive to the needs of the regulator, the entity that ultimately pays the tuition. Firstly, Al-Othman recognized that the government’s stress point was a fear of failing to fulfill the promise of educating all Kuwaiti high school graduates. HumanSoft, therefore, delivered its capacity on schedule whereas other operators were besieged by self-inflicted delays. Just as importantly, HumanSoft worked with Purdue University to design and implement a curriculum which impressed the regulator. The feedback we received from former and current regulators was that the quality of education at HumanSoft met high standards and was continuously improving.

Below are a sample of comments on Al-Othman and HumanSoft from our due diligence:

·         “Al-Othman loves his job and his company. He is the most dedicated and most driven person I have ever met.” – Former Employee

·         “Al-Othman is a very shrewd business man. Among his initiatives, he invited Purdue University to put together a technology program which included computer science, engineering, and IT. Whatever the faculty at Purdue dreamed of, he implemented at AUM. Within 10 years, AUM’s IT programs will surpass that of many American Universities.” – One of the highest ranking officials in the Kuwaiti Higher Education Sector

·         “AUM is really quite a force in Kuwait. They have the nicest campus of any private university in Kuwait, it almost feels like a resort. It’s also a PR powerhouse. During recruiting season, you can’t go anywhere in Kuwait without seeing their advertisements (newspapers, billboards, prominent location in malls).” – Dean at competing university

HumanSoft’s key insight was that while students wanted quality education, they were likely to be guaranteed a job in the government or in the family business upon graduation. As such, in deciding where to attend college/university, students prioritized having a beautiful campus with great student life, first-rate sports facilities, a convenient location, and overall top-notch amenities. At this juncture, for other private universities and colleges in Kuwait to replicate this model, they would need not only to redesign their campuses from the bottom-up but, more crucially, to embark on a new marketing message that would risk losing their existing customer base. For example, one of the three other private competitors has spent decades building a brand, faculty, and curriculum centered on science education. This university cannot easily adopt HumanSoft’s value proposition (where academics is only part of the experience) without risking alienating what attracts its existing students. Indeed, we have spoken to Humansoft’s main competitors and none have plans to incorporate part of HumanSoft’s value proposition into their own models. To make matters worse, the other three major private competitors have already nearly fully built out their campuses and do not have additional land – this makes building a major new stadium or a large new parking facility structurally problematic.[v]

IV.                Compounding machine with non-linear earnings upside

We believe that HumanSoft’s revenues will increase by at least 60% in the next 4 years on the basis of its current enrollment alone. While we are not privy to management’s forecasts, we are able to estimate HumanSoft’s historic enrollment and intake figures on the basis of data provided by the regulator[vi]. If one simply assumes that HumanSoft is able to repeat its 2015 enrollment, which should not be difficult in the context of a growing market, this alone will drive over 60% revenue growth over the next four years.

Yet there are several factors which may drive non-linear upside potential in earnings.

·       Increased Enrollment – Thus far, HumanSoft’s curriculum mainly focuses on business and engineering, whereas it has licenses to teach liberal arts as well as medicine. HumanSoft is currently completing 3 new additional buildings on its campus (which has driven a 50% increase in Net PP&E over the last two years) as it is the one private player with still significant physical capacity to expand in its campus. To quantify the potential upside, let’s assume HumanSoft builds a medical school. We know from our primary research that the announced increase in scholarships for study at foreign universities was mainly for medicine and dentistry. Assuming a hypothetical HumanSoft medical school can accommodate ¼ of the incremental students the government plans to send abroad, this would increase HumanSoft’s enrollment by about 25% from what we have modeled.

·       Price Increases – The government sets the tuition prices for private universities and typically this price is increased every 5 years. In the last round of tuition prices increases in 2014/2015, the average realized price per student increased over 50% at HumanSoft. Allowing HumanSoft to increase tuition by 25% in 5 years would increase earnings by over 50% from what we have modeled.

·       Operating Leverage – SG&A represents nearly 60% of operating costs and opex per student had been decreasing over the last two years until it jumped nearly 30% in 2015 when HumanSoft began a major ramp up in enrollment and a campus expansion. Assuming opex per student returns to 2014 levels would add an incremental 15% to earnings.

As summarized below, assuming all these factors play out, HumanSoft would be earning KD 0.543/share which implies a 2.5x P/E based on today’s share price.

Note: Analysis above calculates EPS, implied P/E, cumulative FCF/share (and the % this FCF/share is of today’s share price) based on each assumption and those preceding it.         

HumanSoft is a highly FCF generative business with a strong track record of dividend payment. HumanSoft enjoys negative working capital due to the timing of tuition payments and the fact that the business requires limited maintenance capex – this translates into high FCF conversion and high ROE (over 50% in 2015). As is demonstrated below, normalized free cash flow (e.g. excluding growth capex) has exceeded net income in five out of the last six years. (Arguably, we are being conservative by valuing HumanSoft on a P/E multiple rather than a FCF multiple.)

The biggest negative of the company is the lack of transparency and engagement with the capital markets. While HumanSoft is audited by Deloitte, the company only discloses the bare minimum to the investor community. The controlling shareholder and management doesn’t meet minority shareholders and there are no quarterly conference calls. In the view of Al-Othman, the company doesn’t need additional capital and therefore there is no benefit in sharing its financials with competitors whereas minorities can participate in the company’s success through a nearly 100% dividend payout. Indeed, our reference checks on Al-Othman indicated that he is an ethical individual with high integrity. However, he is extremely competitive and has a singular focus on dominating the private education sector. Indeed, Al-Othman’s preference to disclose only what is required by law (and nothing more) is consistent with the descriptions we have heard on him through our reference checks – he doesn’t want to give competitors even the slightest advantage.

Minority interests, however, are well protected by the presence of Al-Imtiaz, a publically-listed Kuwaiti investment company, on HumanSoft’s Board. With nearly a 25% shareholding in HumanSoft, Al-Imtiaz is entitled both to a seat on the board and rights to appeal to the regulator when minority interest are in any way disadvantaged. One such instance occurred in 2015/2016. Following the lead of over two dozen public Kuwaiti companies in the last 3 years, Al-Othman exercised a legal right to delist from the Kuwait Stock Exchange so as to further reduce his disclosure requirements. Given that HumanSoft doesn’t need additional capital and that Al-Othman plans to maintain his stake for the foreseeable future, maintaining a public listing was only hurting his interests in that competitors benefited from his disclosures. Still, the mandates of several minority shareholders, including Al-Imtiaz, precluded them from holding OTC instruments. Al-Imtiaz therefore petitioned the regulator of Kuwait’s Capital Markets to block the delisting on the basis that a delisting without a tender offer (as is allowed in Kuwait) would in this case hurt minority shareholders. Kuwait’s regulator agreed and the delisting was blocked in May 2016.

Outside of disclosure requirements, we don’t see any other ways in which minorities and the controlling shareholder are misaligned. Firstly, it’s worth emphasizing that in attempting to delist HumanSoft, Al-Othman was in no way behaving unethically; instead, it can be assumed he believed that he was acting in the best interest of the company by reducing the data available to competitors. In terms of the more common self-serving actions which are pervasive among companies in developing markets with a controlling shareholder (such as above-market management compensation, significant related party transactions which are not at an arms-length basis, etc.), there have been no such actions at HumanSoft from our research. Meanwhile, HumanSoft’s disclosure and IR efforts are likely to improve. Our conversations with the Kuwaiti regulator suggested that upcoming securities regulations will require more disclosure from listed companies than before, including that all listed companies have an IR department.

Government funding of the private education sector is less of a risk than meets the eye. Any business that is dependent on government funding or government regulation carries risk. However, in discussing this risk with local Kuwait investors, regulators, investment bankers, and other stakeholders, there is wide consensus that education (with the possible exception of healthcare) is the last area of the economy the government will want to reduce funding for; if anything, funding for education could increase. Indeed, even in the context of falling oil prices, the government has recently implemented a 2x increase in scholarships which enable young Kuwaitis studying abroad to receive full tuition reimbursement as well as a stipend. (These scholarships do not pose a direct risk to HumanSoft as students qualifying for these scholarships typically achieve much higher college entrance scores than the average HumanSoft student.) Like other countries in the region, Kuwait has a rapidly growing young population that the government wants to educate and employ not only for the long-term benefit to the country but also to ensure social stability. In addition, the cost to the government of educating a student in the private tertiary private education sector is dramatically cheaper (two-thirds lower, to be precise) than educating the student at Kuwait University, as the latter is widely considered to be bureaucratic and inefficient. For all these reasons, we believe we are likely to see further support and funding for the private higher education sector.

V.                  Valuation: Cheap on any metric

HumanSoft is cheap relative to its peers on any metric, even though it has stronger financials. Below we’ve compared HumanSoft’s fundamentals and valuations to Al Khaleej (the second largest education company in MENA), the three largest Kuwaiti consumer companies, and the MSCI Kuwait Index. As is evident in the table, HumanSoft’s appears at least 2-3x undervalued based on P/E and dividend yield.

Undoubtedly, relatively low liquidity (c. $100,000 per day over the last 30 days) and management’s limited engagement with investors has historically relegated the stock to obscurity within the investment community. However, HumanSoft’s growth and dividend is making it increasingly harder for investors to overlook it. Indeed, the market cap is in excess of $500mn (private market value likely in the billions) and we believe the company will generate over $60mn in net income this year. We also know that Ali Zabeed (HumanSoft’s 3^rd largest shareholder, holding a c. 9% stake) is selling his position in the market gradually, which will also help increase liquidity.

Source: Bloomberg on June 10, 2016.

Owning the stock should be a no-brainer for frontier investors benchmarked to MSCI as well as for Kuwaiti retail/institutional investors, especially now that the only real negative to the story (potential risk of delisting) is no longer a risk and disclosure/IR efforts are likely to improve from here. Indeed, additional disclosure can provide a further catalyst to the story (on top of strong earnings growth and the rising dividend yield). Finally, in the coming months, we will work with other minority investors to actively educate the relevant buy side and sell side community on the story – as far as we know, this is the first concerted effort of this kind for HumanSoft.

Notes

Catalyst

Continued strong earnings growth and continued high payout ratios.