Nord Anglia Education: Excessive Growth Expectations, Stock Overvalued

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Includes: NORD
by: Andrew Puopolo

Summary

Nord Anglia Education, Inc. operates 42 premium international K-12 private schools in China, South East Asia, the Middle East, Europe (Eastern and Western) and North America.

At $20.82 per share, NORD trades at multiples of 38.5x and 31.1x latest twelve month and FY2016E adjusted EPS, respectively.

NORD’s majority private equity owner will probably need to sell some or all of its shares in the next few years, which will certainly put downward pressure on stock.

Nord Anglia Education, Inc. (NYSE:NORD) operates 42 premium international K-12 private schools in China, South East Asia, the Middle East, Europe (Eastern and Western) and North America.

At $20.82 per share, NORD trades at multiples of 38.5x and 31.1x latest twelve month and FY2016E adjusted EPS, respectively, which are perhaps at a 75-100% premium to the comparable market multiples. Analysts are expecting NORD's revenues and adjusted EPS to grow over the next two years at approximately 29% and 36% per year, respectively (Yahoo Finance).

Given the risks in NORD's business model, financial situation and geographic profile, I don't expect NORD to achieve those growth rates. Hence, I believe that NORD's stock will go down and thus represent a short selling opportunity.

I believe that NORD won't achieve analysts' growth expectations for a combination of one or more of the following reasons:

  1. The economic slowdown in the countries that NORD operates in,
  2. The political risks associated with operating in the countries that NORD operates in,
  3. NORD's historical dependence on acquisitions to achieve growth (and their inherent risks),
  4. The dependence on capital expenditures to maintain and grow the business, and
  5. NORD's large amount of debt

NORD's majority private equity owner will probably need to sell some or all of its shares in the next few years, which will certainly put downward pressure on NORD's stock price.

Investment Considerations

The average of eight Wall Street analysts expects NORD's revenues to grow from $577.0 million in fiscal 2015 to $963.1 million in fiscal 2017 (Yahoo Finance), which represents a growth rate of approximately 29% per year. Those same group of analysts expects adjusted earnings per share to grow from $0.49 in fiscal 2015 to $0.90 in fiscal 2017, which represents a growth rate of approximately 36% per year.

Economic Slowdown and Political Risks

Geographic Analysis

%Revenues

%EBITDA

China

22.7%

31.7%

Europe

25.8%

21.4%

Middle East

10.3%

7.5%

North America

13.6%

12.2%

South America

27.1%

27.5%

Others

0.5%

(0.3)%

Total

100%

100%

Click to enlarge

Based on my estimate of the revenues and EBITDA coming from Eastern Europe, I believe that approximately 60% of NORD's revenues and EBITDA come from emerging and developing countries. I believe that the economic slowdown and political risks in each of those countries (that are specific to those countries) will result in slower growth and possibly even declines in NORD's operating performance. This kind of operating performance will make it very challenging to achieve the analysts' revenues and EPS growth expectations.

For instance, China, which provides approximately 22.7% and 31.7% of NORD's revenues and EBITDA, respectively, is slowing down economically. The Chinese government's official 2016 GDP growth target is approximately 6.5%, which is substantially below the 10% or more that they have experienced over the recent past. My view is that even the 6.5% target is artificially inflated and not a real reflection of the economic environment in China today; China's real GDP growth target may be closer to 0-2%. With slower economic growth, I believe that NORD's Chinese operation will be challenged. Given that NORD's business model is private pay and with slower growth and lower expected incomes, families may decide not to send their children to NORD's "premium" schools. Furthermore, given that 63% of NORD's students company-wide come from expatriate families, NORD's Chinese operation may be particularly hard hit. With slower economic growth, foreign companies may reduce the number of expatriate families that they have in China and thus reduce the need for NORD's services. I believe that there is a reasonable likelihood that NORD's China operation will make hitting the analysts' revenue and EPS growth targets very difficult.

Politically, China is a treacherous place for foreign-owned businesses. Foreign-owned companies can quickly fall out of favor with the authoritarian central and/or local governments, particularly businesses that deal with something as important to the public as education. I'm not saying that is a likelihood for NORD, but it is a distinct possibility. If it were to happen, that would be disastrous for NORD.

In the Middle East, which represents approximately 10.3% and 7.5% of NORD's revenues and EBITDA, respectively, NORD operates schools in Qatar and the UAE. Those economies are suffering from historically low oil prices, which in turn is putting pressure on their economies. As in China, lower incomes will reduce the demand for NORD's premium education. Furthermore, as in China, reduced economic activity will lead to lower numbers of expatriate families and thus reduced demand for NORD's services. I expect NORD's Middle East operations will also contribute to NORD missing the analysts' revenue and EPS growth targets.

Qatar and the UAE are also treacherous places politically. In fact, I believe that one American education company who was running public K-12 on behalf of the Qatar government had their contract unexpectedly terminated by the government and the government took over their operation. I am not suggesting that this is a likelihood, but being pushed out by a government in countries like these is always a distinct possibility.

In South East Asia, which represents approximately 13.6% and 12.2% of NORD's revenues and EBTIDA, respectively, NORD operates schools in Cambodia, Vietnam, Thailand and Singapore. These economies are largely dependent on exporting commodities and natural resources. Currently, commodity and natural resource markets are depressed given the somewhat muted global economic environment and these countries are feeling the effects. As in China and the Middle East, this environment will result in reduced demand for NORD's premium education from both local and expatriate families. Moreover, the political situation in all of these countries is fragile (with the possible exception of Singapore), which could have disastrous results.

Surprisingly, even NORD's "European" operations are somewhat exposed to the kinds of economic and political risks present in NORD's Chinese, Middle Eastern and South East Asian operations. NORD operates schools in Slovakia, Hungary, Poland and the Czech Republic, which I estimate (based on data in NORD's 20-F and the BMO Capital Markets Report, ibid) represent approximately 9.0% and 7.5% of NORD's revenues and EBITDA, respectively.

Historical Dependence on Acquisitions

Over the last three fiscal years, NORD has acquired 27 of its 42 schools (including 10 in fiscal 2015) or 64% of its schools. Growth through acquisition is always risky. Frequently, buyers end up with lower revenues and cash flow than they expected. Because buyers did not operate the business in the time up to the acquisition, they are less likely to know what is really going on and thus less likely to have accurate expectations for revenues and costs. Moreover, sellers have lots of incentive (in particular getting the highest price possible) to lead buyers to expect revenues and cash flow to be as high as possible. Frequently in acquisitions, buyers find problems and costs after the purchase that they were not aware of before (and that sellers did not disclose). Because of NORD's high rate of acquisition and its inherent risk, I expect that some of NORD's acquisitions will have disappointing results over the next few years and make it difficult for NORD to meet the analysts' high growth expectations for revenues and EPS.

Dependence on Capital Expenditures to Maintain and Grow

Premium private K-12 schools require large amounts of capital to maintain and grow. Affluent parents who are paying high tuitions demand that a school's facilities are well maintained and state of the art, which is very expensive to do. To grow a school also requires large amounts of capital because growth requires larger facilities. Over the next couple of years, at least one analyst (BMO Capital Markets ibid) expects NORD to make $100-$110 million in capital expenditures per year to maintain and grow its business. As a general matter, the need for capital expenditures to finance growth will depress NORD's stock price as those capital expenditures reduce cash flow to the shareholders or has to come from the outside, which has a cost to shareholders. Based on fiscal year 2016 estimated adjusted EBTIDA of $215.7 million, estimated taxes of $18.8 million, interest expense of$68.2 million and estimated capital expenditures of $110 million, (BMO Capital Markets, ibid), NORD will have $28.7 million of available cash flow. If NORD misses that estimated EBITDA of $215.7 million by $28.7 million or more (i.e., 13%), which is entirely possible and even likely (given the considerations discussed above), then NORD will have to look to outside capital to finance the shortfall. If NORD has to raise outside capital, that will negatively impact its stock price.

High Levels of Debt

NORD has $1,253.3 million of interest bearing debt, which may be the maximum amount that NORD can borrow. Based on the amount of 2016 estimated EBITDA, taxes and capital expenditures, lenders might not lend NORD any more money. If NORD doesn't meet the analysts' growth expectations (which I don't think it will), then it may have to sell stock to finance capital expenditures, which would have a particularly negative impact on its stock price. If NORD misses EBITDA expectations by a lot, its level of debt might create a fear that NORD can't pay back all its debt, which would really hurt its stock price.

Selling Majority Shareholder

A private equity firm indirectly owns approximately 62% of NORD, which they ultimately will have to sell. The prospect of a sale that large will have a negative effect on NORD's stock price and the actual sale itself may have a greater negative impact on NORD's stock price.

Conclusion

I don't believe that the analysts' expectations for NORD's revenue and EPS growth of 29% and 36% per year for the next couple of years will be met. With NORD trading at 38.5x and 31.1x latest twelve months and fiscal 2016 estimated EPS, respectively, which are high relative to the market, any shortfall in revenue and earnings growth should result in a significant decrease in NORD's stock price. Moreover, NORD's high levels of debt and a selling majority shareholder will be a further negative on NORD's stock price. I believe that NORD represents a short selling opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am submitting this for the VFG Stock Pitch Competition