Description

INVESTMENT SUMMARY

Humansoft (HS) is a deeply undervalued Gulf education story that has been overlooked by the investment community.  In less than seven years, this US$240mn Kuwaiti company has grown to become the largest private education provider in Kuwait, based on university enrollment figures.  HS’s growth has been remarkable - from 2009-2014, sales and EPS have increased at CAGRs of 36% and 66%, respectively, while EBITDA margins have tripled to 46% from 16% over the same period.

Trading at only 5.3x cash earnings and offering a 12% dividend yield, this is the most undervalued education stock in the Middle East and Africa region.  HS has a rock solid balance sheet with ample liquidity and a business model that offers large barriers to entry, visible and consistent future cash flows, and attractive returns on equity that we expect to remain in the 35-40% range.  Management has a sterling reputation in the local business community and a deep passion for education. Their significant ownership stake ensures a strong alignment of interests with shareholders.

COMPANY BACKGROUND

HumanSoft was founded in 1995 by its current chairman, Fahad Al Othman, a Kuwait national.  A graduate of Drake University in Iowa, Mr. Al Othman developed a passion for education, technology, and American best practices in his early years.  After 15 years in corporate lending at Kuwait’s Burgan Bank, while spending his evenings lecturing on credit analysis, he decided to open an American education franchise in Kuwait, New Horizons Computer Learning Centers, to promote IT awareness to the country’s young professionals.  What started as one small branch in 1995 has now become a full-scale, multidisciplinary regional education company.  HumanSoft now owns the New Horizon’s franchise rights to Kuwait, UAE and Qatar, while its several other subsidiaries offer eLearning (Track Learning Solutions), job placement (Tawteen), and language training (Expression Institute).

The company’s real success story began however when it entered the higher education space.  After an arduous 5-year statutory licensing process, and the acquisition of 230,000 sqm. of land in Egaila, Kuwait, in 2008 HumanSoft opened the doors to the American University of the Middle East (AUM) and the American College of the Middle East (ACM), in affiliation with Purdue University.  Starting with fewer than 500 students, AUM and ACM now have combined enrollment of about 7,000 students, and in less than seven years have grown to become Kuwait’s largest private university and college, respectively.

EDUCATION’S REGIONAL TAILWINDS

The beauty of a university’s business model is that it is generally recession resistant, enjoys predictable long-term cash flows, and typically runs with a favorable cash conversion cycle. (i.e. tuition fees are all paid upfront at the start of the semester).  There are also high barriers to entry in higher education businesses, given the long licensing processes and large initial capital expenditures.  If an investor has the good fortune to invest at a reasonable price after the daunting setup and construction process, they can then benefit from a future stream of lucrative and consistent free cash flows, as the business model requires low capex on an ongoing basis and has meaningful operating leverage (i.e. very scalable).

An education provider in the Gulf also benefits from very strong tailwinds, given excellent regional demographic trends and high government support.  In Kuwait, for example, the population has grown at a 2.8% rate from 2009-2014, and with a GDP per capita of US$45,000, the country is home to one of the wealthiest populations in the world (IMF).  While Kuwait enjoys the highest literacy rate in the Gulf at 94%, according to the World Bank, its K-12 schools and universities still fall far behind global developed market education standards.  The government has therefore made education spending a high priority, and has grown its budgeted education expenditure at a 15% CAGR since 2010.  Given the Kuwaiti government’s commitment to higher education, its citizens are able to attend university completely free of charge (to both public and private schools).

According to UNESCO, Kuwait’s higher education system had approximately 72,000 students enrolled at both public and private universities in 2013.  Private universities are accredited locally by Kuwait’s Private University Council (PUC), which is also responsible for granting student scholarships.  There are currently nine accredited private universities in Kuwait, while Kuwait University is the country’s sole public institution.  According to a recent study by Booz and Co, there is growing preference in the Middle East for international, English-language curricula, and enrollment in private schools is expected to grow 3x faster than at public schools.

AUM & ACM’s student population has accelerated rapidly since inception, steadily taking share from established competitors since 2009 and recently growing to become the country’s largest university and college.  The table below reveals the historical breakdown of enrollment figures for Kuwait’s largest private universities.

HUMANSOFT: HIGHER EDUCATION

HS’s higher education business (AUM and ACM) accounts for 96% of the company’s earnings as of FY2014, and is therefore the key driver of this investment story. AUM offers undergraduate degrees in Engineering & Technology (6 majors) and Business (5 majors), an MBA program, and an English Preparatory Program (EPP).  ACM is a 2-year college and vocational school that offers degrees in Business, Engineering, and Information Technology.  The two institutions share a beautiful 230,000 sqm campus, considered the largest private campus in Kuwait. 

In order to fully understand the reasons behind AUM’s enrollment success, we spent a substantial amount of time in Kuwait touring the campus and interviewing AUM’s senior faculty and students.  We also met with a government official at the PUC and other senior faculty at competing universities.

Based on our analysis, the university’s success stems from these four main attributes:

·      A large, beautiful campus with modern teaching and extracurricular/sports facilities

·      High quality of education:

¾      High caliber Western-trained professors. The faculty typically have PHDs, receive very attractive compensation packages, and all go through a thorough interview process

¾      An interactive classroom environment, with a low ratio of 30 students per teacher (vs. a student-to-teacher ratio of 100+ at Kuwait University, the country’s sole public university)

·      Purdue University affiliation:  Students and faculty value the link with Purdue, and the fact that AUM’s coursework and materials are guided and approved by an elite American university

·      Abundance of parking:  Parking is a major issue for students at other Kuwaiti institutions, particularly those in downtown Kuwait, like the American University of Kuwait (AUK) for example

As of the 2014 fall semester, AUM and ACM had a total of 6,900 students (5,400 and 1,500, respectively), or about 10% of Kuwait’s higher education market.  According to management, current capacity allows for 7,500 students, or headroom for 9% growth.  However, our onsite visit and interviews with university officials revealed that the university is currently constructing four new buildings on its large land plot to accommodate thousands of additional students in the coming years.  Of the 4 new buildings there will be a multi-story parking garage, a new conference center, and two new education buildings for the Business and Engineering colleges. For the 2015/16 school year, senior faculty is budgeting for at least 1,500 new students (1,000 at AUM and 500 more at ACM), based on internal estimates and the PUC’s approved scholarship applications thus far.  This suggests another 22% growth in enrollments for the next school year.

FINANCIAL REVIEW:

HumanSoft’s attractive returns on capital, balance sheet/liquidity position, and cash flow profile places it in an enviable position to internally fund its expansion efforts (organic and acquisitions) while paying an attractive dividend to shareholders.

·      Overview: US$240mn market cap (KWD73mn),  US$95mn in annual revenues, and US$43mn in EBITDA

Note that the Kuwaiti Dinar (KWD) is currently worth 3.3 USD, and is pegged to a USD dominant hard currency basket.

·      Growth: from 2009-2014, sales and normalized EPS have increased at 36% and 66% CAGRs, respectively, as enrollments (tuition revenue) accelerated and margins expanded due to operating leverage

·      Profitability: HS’s EBITDA margin has almost tripled from 16% in 2009 to 46% today.  In 2014, the company generated a 23% return on assets and a 37% on equity.  We expect these attractive return figures to continue in the coming years. 

The company is now producing a net income margin of 38%, which we think is exceptional.  In other words, for every US$100 of tuition revenue, the company is able to clear US$38 of pure profit. 

·      Leverage & Liquidity: As of 4Q14, HS has a net cash position (cash – total debt) of KWD14.9mn (US$50mn).  Its cash balance stands at KWD12.1mn and is owed KWD12.1mn in receivables by the Kuwaiti government.  Based on historical repayment schedules and the solid balance sheet of this counterparty, these receivables are essentially cash in our view.  Short term and long-term debt now total KWD9.2mn and according to financial statement footnotes there is about KWD6mn of liquidity available on HS’s revolving credit facilities.  All outstanding debt is local bank debt at an average cost of LIBOR +3.0% and secured against the company’s land bank.

·      Cash flows: At the current stock price, HumanSoft is currently generating a free cash flow yield to equity holders of 17%.  When a company is not undergoing a heavy capex cycle, comparing a stock’s historical FCF levels to its net income figures is usually a good way to gauge the quality of its reported earnings (or the aggressiveness of its accounting).  HS’s numbers track each other very closely, when backing out the noise from changes in working capital.  The company’s high free cash flow levels stem from its lucrative margins, low financing costs, minimal tax rate (3-year average of 5%), and its low maintenance capex requirements.

·      Dividends: In March HumanSoft announced that it is doubling its dividend to KWD0.07/share for 2014, resulting in a current dividend yield of 12%. Note that the KWD0.035/share dividend paid for 2013 was also more than doubled from the KWD0.015 paid for 2012.  Management has maintained a policy of paying out about 73% of normalized earnings (i.e. earnings excluding noncash items) since it started paying dividends in 2012.  2014’s announced dividend payout will still leave the company with an abundance of liquidity on its balance sheet.

ADDITIONAL DUE DILIGENCE:

·      Shareholder breakdown: HumanSoft’s shares are very tightly held, with Chairman Al Othman directly and indirectly owning a 59% stake and Al Imtiaz Investment Co, a Kuwait-based investment company, owning a 24% stake.

·      Auditor/accounting standard: Deliotte & Touche, International Financial Reporting Standards (IFRS)

·      Counterparty risk: 88% of HS’s outstanding receivables are owed by the Kuwait government (via the Ministry of Higher Education).  Given Kuwait’s ‘AA’ rating by the three main rating agencies and its massive sovereign wealth fund (US$550bn in assets, ranked 6^th by SWF Institute), we are not concerned about counterparty risk.  While the government’s fiscal budget will surely come under pressure in 2015 due to falling oil prices, it has vast financial reserves and education spending in Kuwait is simply too politically/socially sensitive and high priority to be at risk in the near or medium-term, in our opinion.

·      Cash cycle: Receivables and days-sales-outstanding spike each third quarter, which is the start of the fall semester when tuition payments are due.  From an accounting standpoint, these assets are initially offset on the liability side of the balance sheet by “deferred revenue” (or unearned revenue). These receivables and liabilities are then run down over the following months as they convert to cash and “earned” revenue.

·      Accreditation: AUM and ACM were both accredited by Kuwait’s PUC.  These licenses were recently renewed for another four years (Kuwait uses 4-year cycles).  AUM is in preparations to apply for USA recognized accreditations for its College of Engineering (i.e. ABET accreditation) and for its College of Business (AACSB accreditation).

VALUATION: DIGGING DEEP FOR HIDDEN VALUE

Carefully peeling back accounting layers and paying meticulous attention to detail can often mean the difference between quickly overlooking a potential investment and finding a hidden gem. Humansoft reported earnings of KWD8.3mn in 2014 (up 63% from 2013), implying a price to earnings ratio of 8.9x.  While a P/E of 8.9x for an education stock of this caliber is already dirt cheap, analysts that dig into the financial statement footnotes will notice that there are two noncash items that are understating net income for 2014.   Due to its current expansion project, management used accelerated depreciation accounting in 3Q14 and 4Q14 on a portion of its land bank needed for the four new university buildings.  This extra depreciation is a noncash, nonrecurring charge to the tune of KWD1.1mn.  The company also made an impairment charge of KWD1.6mn to an unprofitable division which was purchased in 2007.  Adding these two noncash items back to reported earnings results in normalized income of KWD11.0mn and EPS of KWD0.096/share. 

A current stock price of KWD0.60 implies a normalized P/E ratio of 6.3x.  Backing out the company’s net cash position (cash minus total debt) of KWD15mn from its market cap of KWD73mn results in HumanSoft’s true P/E falling further to 5.3x.  Thus, uncovering the company’s real earnings power reveals its true mispricing, and should have indicated to the investment community that HS had the ability to significantly boost its dividend for 2014 (which it did in an announcement to the Kuwait Stock Exchange on March 17^th).

At a 5.3x P/E, 12% dividend yield, sustainable ROE of 35-40%, and an unlevered balance sheet, this education company is grossly undervalued on an absolute basis.  While there is a dearth publicly listed education plays in the MEA region, comparing Humansoft to the region’s largest and most visible education stock, Al Khaleej Training & Education (Ticker: ALKHLEEJ AB), makes for some surprising analysis and further helps put HS’s mispricing into perspective.  ALKHLEEJ is based in Saudi Arabia and runs a wide array of education related businesses, including the New Horizons franchise for Saudi. ALKHLEEJ is trading for 24x trailing earnings (almost 5x HUMANSFT’s multiple) and has a current market cap of US$570mn.  What’s interesting here is that ALKHLEEJ’s entire EBITDA for 2014 was only US$26mn, while HumanSoft generated US$43mn in EBITDA over the same period.  So despite HumanSoft producing 65% higher operating income, its market cap is almost 60% lower than Al Khaleej Training.  Further, ALKHLEEJ generates only half the ROE (20%) as HumanSoft. It is also levered at 2.4x EBITDA and offers a paltry dividend yield of only 1.4%.

Education businesses are typically excellent long-term compounding assets.  Given the education industry’s lucrative economics and the region’s strong tailwinds, it is unsurprising that the space has seen a flurry of merger & acquisition activity over the past 5 years, with many local and international private equity houses getting involved.  It is rare to find a publicly listed education stock in the Middle East, and even harder to find one at an appealing valuation.  While HumanSoft is tightly held and often illiquid, our nimble size and the long-term investment horizon of our limited partners allowed us to take a private equity-like approach to building our sizable stake.  We believe our shares in HumanSoft are worth multiples of our average cost, and offer us the opportunity to participate in one of the region’s true success stories for many years to come.

Catalyst

Carefully peeling back accounting layers and paying meticulous attention to detail can often mean the difference between quickly overlooking a potential investment and finding a hidden gem. Humansoft reported earnings of KWD8.3mn in 2014 (up 63% from 2013), implying a price to earnings ratio of 8.9x.  While a P/E of 8.9x for an education stock of this caliber is already dirt cheap, analysts that dig into the financial statement footnotes will notice that there are two noncash items that are understating net income for 2014.   Due to its current expansion project, management used accelerated depreciation accounting in 3Q14 and 4Q14 on a portion of its land bank needed for the four new university buildings.  This extra depreciation is a noncash, nonrecurring charge to the tune of KWD1.1mn.  The company also made an impairment charge of KWD1.6mn to an unprofitable division which was purchased in 2007.  Adding these two noncash items back to reported earnings results in normalized income of KWD11.0mn and EPS of KWD0.096/share. 

A current stock price of KWD0.60 implies a normalized P/E ratio of 6.3x.  Backing out the company’s net cash position (cash minus total debt) of KWD15mn from its market cap of KWD73mn results in HumanSoft’s true P/E falling further to 5.3x.  Thus, uncovering the company’s real earnings power reveals its true mispricing, and should have indicated to the investment community that HS had the ability to significantly boost its dividend for 2014 (which it did in an announcement to the Kuwait Stock Exchange on March 17^th).

At a 5.3x P/E, 12% dividend yield, sustainable ROE of 35-40%, and an unlevered balance sheet, this education company is grossly undervalued on an absolute basis.  While there is a dearth publicly listed education plays in the MEA region, comparing Humansoft to the region’s largest and most visible education stock, Al Khaleej Training & Education (Ticker: ALKHLEEJ AB), makes for some surprising analysis and further helps put HS’s mispricing into perspective.  ALKHLEEJ is based in Saudi Arabia and runs a wide array of education related businesses, including the New Horizons franchise for Saudi. ALKHLEEJ is trading for 24x trailing earnings (almost 5x HUMANSFT’s multiple) and has a current market cap of US$570mn.  What’s interesting here is that ALKHLEEJ’s entire EBITDA for 2014 was only US$26mn, while HumanSoft generated US$43mn in EBITDA over the same period.  So despite HumanSoft producing 65% higher operating income, its market cap is almost 60% lower than Al Khaleej Training.  Further, ALKHLEEJ generates only half the ROE (20%) as HumanSoft. It is also levered at 2.4x EBITDA and offers a paltry dividend yield of only 1.4%.