Description

I am recommending SLVN based on its discount to my sum-of-the parts assessment of intrinsic value and my belief that this coming Thursday’s conference call will provide a catalyst that will eliminate this discount.

Because SLVN has 3 operating segments and a “ventures investment unit”, there is a lot of complexity that surrounds their financial statements. SLVN has attempted to help investors see through this complexity by using pro-forma financials. Starting in the last quarter, controversy started to emerge around two key items. One item argues that the operating losses of their Walden & eSylvan operations which are not part of pro-forma EPS should be included. Some have alleged that they are hiding marketing expenses that contribute to core operations in that breakout. Another item relates to a 2c controversy over their 30c EPS figure in the last quarter. They decided to discontinue their English as a foreign language operation in Spain. Due to a technicality, there were unable to do discontinued ops reporting for GAAP but did so for their pro-forma EPS.

This controversy has distracted investors from strong and accelerating performance in their core ops. SLVN has 3 key segments: K-12 tutoring services, Canter teacher training (a.k.a. Online division), and International Postsecondary Universities (SIU). My sum of the parts valuation below shows how much these operations own in EBIT (note SLVN only owns 80% of SIU) and my view on the multiple these businesses deserve.

As a side note, I want to emphasize that I did my analysis on SLVN with a very skeptical eye. I hate frauds and companies that have accounting issues, and I did everything I could to get comfort around SLVN’s financials. I feel very comfortable with my analysis. I have tried to capture every issue that can impact value in my sum of the parts—earnouts remaining from past acquisitions, additional funding commitments to the ventures unit, operating losses from the 2 ventures units that have essentially become operating units (Walden and eSylvan), etc. I think you will find my sum-of-the-parts to be as honest a presentation as one can make.

K-12, which consists mainly of franchised units but also of company owned ones, has consistently growth same-store sales in the high single digits. Recently, this growth rate has actually accelerated to a stunning 20%. Because history of generating close to 10% same-store growth + unit expansion, I believe this business is worth 20x after tax operating earnings. You can argue for a higher multiple based on high ROIC and consistency.

The teacher training business has a similar high ROIC and has been showing equally strong growth. Thus, a 20x EPS multiple is warranted.

The international universities, which SLVN has purchased in 4-5 large individual acquisitions, are growing very strongly. After acquiring these universities, SLVN is able to dramatically boost the growth rate by improving the marketing effort and applying best practices. Revenue growth for each school is currently running 20-60% y/y. Longer term, I think these schools increase tuition 6-8% (inflation adjusted) and enrollment in the mid single digits for 10%+ same-school revenue growth. Schools with a similar profile in the US can trade at 30-40x EPS. Due to the international aspect of these schools, I accord only a mid 20s NOPAT multiple.

So, the sum of the parts below shows both my conservative and upside valuation analysis. The real kicker here is I think this upside will be realized immediately after Thursday’s conference call.

First, this company is suffering from a credibility issue from the pro-forma reporting issue that emerged last issue. I think the company is going to go a long way to remove this issue. The main reason I believe this is they will probably provide a reconciliation between GAAP and pro-forma EPS in the press release to remove any controversy. After the last conference call, the company put out a very detailed 10Q that I was impressed with, which gave me confidence in their desire to eliminate the controversy by providing more info.

Second, SLVN reports enrollment figures once a year for their international universities. I expect these figures to be good, and if they are it should be a powerful catalyst since they are an important figure and only come out once a year.

Third, the “ventures” unit has created a lot of controversy around SLVN. It has detracted from value by 1) taking cash from the company and putting it into venture capital investments, 2) creating operating losses for the investments where ownership is high enough for consolidation, and 3) creating equity losses for holdings where the equity method applies. I believe that SLVN may use this quarter to more clearly articulate that they will limit additional commitments to no more than $30mm, and the losses running through ventures will be reduced by ½ in 2003 and disappear in 2004. This is important because it will drive eventual convergence between pro-forma EPS and GAAP EPS.

Lastly, SLVN in the past has talked about trying to eliminate the controversy around their stock by spinning off one or more of the units. They actually had plances to spin-off the international universities, and backed off last quarter due to “market conditions”. I think they might put the plans back on the table.

The bottom line is that complexity has hurt this company, and I am convinced they are moving to remove the complexity. With a reasonable case for there being a discount to intrinsic value and the “perceptual” factors moving in the right direction, I think this stock will be a timely winner.

Sum of the parts valuation are as follows:

SLVN Valuation-- Conservative Base Case
LTM % NOPAT EBIT
EBIT Own Mult Tax Rate Mult Per Share
K-12 38943 100% 20.0 30% 14.0 13.59
Online 10587 100% 20.0 30% 14.0 3.70
SIU 30404 80% 20.0 30% 14.0 8.49
Corp -20939 100% 18.0 30% 12.6 (6.58)
Walden & eSylvan
Losses -24000 100% 5.0 30% 3.5 (2.09)
Cash 4.39
Debt (3.52)
Future Venture Commitment/Losses (0.62)
SLVN WSI & LC Earnout (0.40)
UVM Earnout (0.01)
UDLA Earnout (0.75)
Deferred Rev adjustment (1.36)
Potential tax on repatriated Profits (0.64)
Credit for Walden's Upside Potential 1.25

Total $15.44 / SHARE

Upsdie Scenario-- ssing 24x NOPAT mult for K-12, 25x for SIU, 3x for Walden & eSylvan losses (i.e. they disappear in 3 years), you get $22/share instead of $15.

Company Description (from FactSet Database)
Sylvan Learning Systems, Inc. (SLVN) which delivers its services through a network of educational and testing centers worldwide, is an international provider of educational services to families, schools and industry. It operates through five divisions: K-12 Education Services, Online Higher Education, International Universities, English Language Instruction and Sylvan Ventures.

Sylvan Learning Centers provides personalized instructional services to students of all ages. The company's learning centers provide supplemental instruction in course areas, with an extensive series of diagnostic tests, individualized instruction, a student motivational system, and involvement from parents and the child's regular school teachers. As of Dec. 31, 2001, SLVN owned and operated 90 learning centers in eight states and the District of Columbia. Also at that date, a total of 808 Learning Centers in 48 states, 8 Canadian provinces, Puerto Rico, Hong Kong and Guam were operated by SLVN's franchisees; and there were 460 U.S. franchisees operating Sylvan Learning Centers. During 2001, the company acquired five franchisee-owned learning centers. Sylvan Educational Solutions provides supplemental educational services and professional development services through contracts with school systems and other organizations.

The company's Online Higher Education segment provides teacher professional development training in the U.S. in partnership with sixteen colleges and universities. The Sylvan Teacher Institute serves

K-12 schools that offer solutions for organization and professionals seeking to transition their careers to teaching. On the international level, Sylvan's International Universities segment is comprised of a network of private, post-secondary educational institutions located outside the U.S. formed to address the demand for career-oriented education.

At year end 2001, International Universities operated three full-service universities in Spain, Mexico and Chile, and two specialized universities in France and Switzerland.

SLVN also operates Wall Street Institute, a franchisor and operator of learning centers that teach English through computer-based and live instruction.

Catalyst

Company's operating and reporting complexity has created controversy around the stock that has created the current valuation discount. In the short term, I think this Thursday's conference call will go a long way to eliminating the controversy through management's attempt to clearly reconcile pro-forma EPS with GAAP upfront. I also expect strong operating performance in both the K-12 and SIU segment (where a key annual enrollment figure will be released). Management might also talk about plans to spin off 1 or 2 businesses to eliminate complexity. Regardless of whether or not this happens on Thursday's call, management realizes that complexity is hurting them and is committed to eliminating this complexity over the next year.