Overseas Education Ltd
Overseas Education Ltd is a Singaporean small-cap operating the private “Overseas Family School” (OFS), with a total capacity of around 4,800 students. The school offers education from pre-kindergarten all the way to high school for students aged from 2 to 18. The curriculum is based on international standards such as the K-12 International Baccalaureate (IB) program. The school system is hence very different from the local Singaporean public school system, and a majority of the students come from an international background.
The new Pasir Ris campus
After its IPO in 2013, the company built a new five hectare campus in the far-away suburb of Pasir Ris and moved away from its previous run-down, but very central location close to Orchard Road. This was a major change for the company, because the Orchard campus was leased from the government and the new buildings in Pasir Ris had to be paid for using the company’s own balance sheet. The new campus also increased the student capacity from 3,900 to a much higher number. And so the company issued a SG$150 million bond at a 5.2% fixed rate to finance the SG$230 million new campus. On the cost side, this meant that lease expenses were replaced by interest expenses and depreciation. The company did a hell of a deal – a 30 year lease for 5 hectare of land for SG$37 million when much smaller land plots for residential development have sold for hundreds of millions of dollars. The new campus was built by the leading contractor Woh Hup and the construction quality is excellent in my view.
When the campus moved 20km to the east, many kindergarten and elementary school students dropped out as small children have a greater need to be close to their parents. This caused tuition fee revenue to fall for the company and has continued to fall since the move.
We then get to the following picture (major changes highlighted in yellow): tuition fees dropped by roughly SG$7 million, school lease rental expenses dropped by SG$7 million, depreciation expenses rose by SG$7 million and interest expense rose by SG$8 million for a total negative effect of SG$15 million, all else equal.
The financials look like a disaster. But bear in mind that these are one-off effects: a higher cost base due to new property, plant and equipment at the new campus, a business cycle downturn and students switching schools due to its less-attractive location. Meanwhile, the stock fell quite a bit:
The question is what will happen now. Depreciation charges and finance costs won’t increase further, because the new campus has already been built. But tuition fees may either bottom or continue to fall. Key questions in my mind are:
- Will the new modern facilities be able to attract more students to the OFS?
- Will the overall “foreign system school” industry in Singapore grow over time?
- If enrolment numbers don’t improve, will teachers shoulder some of the loss either via lower salary or layoffs?
- If the school’s utilization rate goes from 62% to the industry average of close to 100%, how much will its financials improve?
Overseas Family School vs its competitors
The niche that the Overseas Family School has is the following:
- Very multi-national community, with students from 70 countries, 50% from Asia and teaching in 14 different languages – higher than any other school. There is no dominant nationality
- The campus in Pasir Ris is next to the ocean, near a beautiful beach and has great air quality
- One of only four schools that offer the IB curriculum from primary years to diploma
- Low entry requirements, which might have contributed to the school’s relaxed and friendly atmosphere
A few comments from review sites:
“Apparently the backup or holding school of choice for families with kids waitlisted at other schools”
“We like OFS’s … friendliness and openness of its staff and teachers”
“The curriculum is good and the multicultural environment is fantastic.”
“There is a happy and friendly atmosphere. EVEN the car park attendants are friendly and caring. Amazing school.”
“The quality of the teaching staff – OFS is okay, but it is not great”
“I prefer OFS to say TTS or AIS or SAS because there is no dominant nationality”
So, to summarise: easy entry requirements, a multi-cultural and friendly environment, decent school quality but not as competitive as UWCSEA.
The industry structure is practically an oligopoly where 4-5 schools dominate. Despite very high profitability with unleveraged return on capital of 20-30%, tuitions are broadly the same across the major schools. Schools clearly have a lot of pricing power. Parents are willing to pay up, because who doesn’t want the very best for his or her child?
Tuition fees for Singaporean private schools tend to be around SG$30,000 a year. Tuitions have risen about 23% over the past five years – a CAGR of 4% – but much faster in the prior decade. Tuition levels are about the same as in Hong Kong.
Overseas Family School is now in the far east of Singapore, close to United World College South East Asia (UWCSEA) Tampines campus. While OFS’s campus is much further out from central Singapore than its previous location, the campus is spacious, is easy to get to (traffic is going in the other direction) and only a few minutes away from the airport. During the recent housing boom in Singapore, Pasir Ris was one of the areas with the most residential construction. Once the currently empty condos have been filled up, demand for nearby schools will surely rise as well.
A simple comparison between the major international schools in Singapore:
UWCSEA has tough entry requirements with a waiting list of 2+ years. This may partly or entirely explain the higher-than-average IB scores from its high school students. High-performing Asian parents tend to want to put their children in UWCSEA while more relaxed parents appreciate the “happy, safe and effective” environment at OFS. The other schools tend to be nation-specific, although not exclusive to students of that nation. Singapore American School, Canadian International School and German European School all have good reputations and some parents – for various reasons – prefer a particular culture. But if the student is not from that particular country, he or she may feel left out. Therein lies OFS’s niche – a friendly school that welcomes students from all cultures but places less emphasis on academic achievements than UWCSEA.
Local schools are an option for foreigners, but there are significant challenges for expats wanting to send their children to the public school system. Priority is given to citizens and to children of alumni of a particular school. Expat children wanting to send their children to a local school would therefore have to choose a second-tier school, where the quality of education is presumably worse. In addition, studying the IB programme makes it easier to switch from one school to another – a key consideration for expat families that typically get transferred internationally on a regular basis.
Singaporeans are only able to send their children to international schools with a special exemption from the Ministry of Education (MOE). This is unlikely to change given that the Singaporean government want to teach its citizens Singaporean values and get them to adopt a Singaporean identity. A Singaporean identity is crucial for social cohesion and the willingness of citizens to defend the country in the event of a war. Given the massive interest in foreign schools among Singaporeans, filling the spots would simply be a matter of MOE increasing the number of approvals. More and more local students are joining OFS, but unfortunately there are no signs of MOE relaxing the standards for approving local students to attend foreign schools.
Industry tailwinds and obstacles
The key driver of the business are: 1) total expat population in Singapore and 2) the total capacity of the foreign school system.
On the demand side, the demographics in Singapore are terrible – similar to those in Japan. Given a fertility rate of 1.3 births per woman and a rapid ageing of the population, the only way to stop the trend is to increase immigration. The government understands this, but lax immigration policies do not enjoy public approval. It is not clear whether PAP is willing to sacrifice votes in order to improve the country’s public finances and to maintain GDP growth.
Judging from the history of policy making in Singapore, the government tends to overdo policies in a certain direction and then reverse the policy when the pain is too great to bear. In my view, a reversal would require a change in public attitude or a very weak economy. We are close to seeing the latter. The number of foreigners moving out of Singapore has probably never been greater in relative terms, and therefore I remain sceptical that the government can or will do further damage at this point. The increase in the number of non-residents is now 31,000, a 5-year low – but still positive, which means that on a net basis the expat population is still growing.
It is worth noting though that the total population in Singapore rose every year over the last 50 years, except for two years: 1986 and 2003. My guess is that the short-fall of 300,000 citizens of working age just to keep the working population steady – a bare minimum requirement in my view – will have to come from foreign immigration. Another 300,000 working-age immigrants are bound to have at least quite a few thousand children that will have to enter the foreign school system.
Meanwhile, the Singaporean government has publicly stated that it wants to grow the population from 5.6 million currently to 7.0 million by 2030. The number of foreigners is 1.7 million right now. Resident growth is close to zero and may even turn negative depending on permanent residence approval policies. So the foreign population may have to almost double in the next 15 years – a compound annual growth rate of 7% per year. Not feasible politically perhaps, but the Singaporean government may also be able to influence public opinion through its state-owned media channels.
Two of the most important industries for the expat population are the shipping and the finance industries. The shipping industry has shown signs of picking up recently with the BDI close to a 23-month high and commodity prices in a cyclical upturn. Although overall asset management AUM is still increasing, a lot of banks are laying off employees due to restructurings following a set of industry acquisitions and mergers, as well as a lacklustre market. It is difficult not to be positive about Singapore in the longer-term. A fantastic environment for expats in terms of public transport, tax rates etc, as well as the inevitable integration of Hong Kong into mainland China makes Singapore the top spot for MNC’s wanting a spot for their Asian headquarters.
A number of other trends are also impacting demand for foreign schools:
- The number of marriages with a foreign spouse is on the increase. Locals that have spent time abroad often want their children to continue in an IB, or GCSE system to make the transition as smooth as possible
- The prevalence of “expat packages” seem to be on a decline which may be a threat to international schools
After a period of very tight supply of international schools, the Education Development Board increased the number of international schools from 2008. Dulwich College and GEMS World Academy opened in 2014 with total enrolment capacity of 2,500 and 3,000 students.
What happened since then is that foreigners have been leaving the island in droves. The EDB has not stopped the approval of new international schools so the supply will be fixed for the foreseeable future. Dulwich now has about 1,000 students and GEMS has internal issues which makes it a weak competitor to OFS.
If you take the supply and demand factors together, then in the short-run a further deterioration is likely with an inflection point 2017-2019 with relatively strong growth rates thereafter. Meanwhile, the supply of new schools is currently fixed, which means that a 100% utilisation rate in my view is close to guaranteed in the long run. It is only a matter of time.
How management is dealing with the current situation
The current CEO and Chairman David Perry and Ms Irene Wong started the company in 1991 and continue to play an integral role in the development of business. In my view, they are exactly the type of management team a long-term investor wants. Quarterly results are a secondary concern, while the primary focus is put on student satisfaction and maintaining their current niche of a “happy, safe and effective” student environment.
The reason the business was started was a perceived tight supply of international schools in Singapore in the early 1990s. OFS rode the wave of foreign investment all the way until 2013 when student enrolment peaked. Enrolment rose practically every year except for the years after the Asian Financial Crisis when many Korean and Thai students had to return to their home countries.
The current situation is about as bad as the Asian Financial Crisis, if not worse. Enrolment has dropped from 3800 students at the peak to 2600 currently, and hovers close to a 50% utilisation rate. Thanks to a very capital light business model and high pricing power, cash flows are still great, it’s just a matter of getting through a number of years of falling revenue.
In 2015, the management conducted a survey asking them why departing students chose to leave. About 1/3 said it was due to the new campus, and about 2/3 said it was due to the family moving to another country. The quality of the new campus facilities is fantastic, and according to the management most of the parents visiting the school end up sending their children there. The environment is simply great for children. About 450 students left the school last year due to parent relocation or moving to another school, 200 graduated and 400 new students were recruited for a net loss of 250 or so. Once the exodus of foreigners stops, the student population should be able to grow by a couple of hundred students per year at the very least.
It is clear that enrolment is still shrinking. Management has guided for improvement in 1Q2017 but it is not clear exactly when enrolment will start growing again.
Another way the team is dealing with the current situation is to not renew some of the 2-year employment contracts that most teachers are working on. If the student population continues to decline, the school will stop renewing teacher contracts such that a 10x student-teacher ratio is maintained. Teacher salaries are by far the biggest cost of the business, so EBITDA margins should not fall materially from the current level.
David Perry’s long-term vision is to scale up the school to its full capacity and then expand with new schools in China. How long it will take to get there is anyone’s guess. He appears to be driven by a dream to create quality education where values such as tolerance, accountability and emotional well-being are emphasised.
The company’s capital allocation has not been great historically. The main goal is to repay debt at close to par value, rather than to buy back stock. As is typical in Asia, the management team believes it is working in the best interest of the company rather than its majority shareholders. Dividends are set at 50% of net profit rather than cash flows after maintenance capex.
The future of education
One of the great aspects of the education business is that it is practically insulated from technological disruption. Much has been said about MOOCs taking market share from traditional teaching institutions. Peter Thiel wrote a thought-provoking op-ed in Washington Post in 2014 arguing that our education systems are counter-productive in many respects. What he and other tech luminaries miss about the education debate is that the main purpose of education is to signal that a person is a low risk-hire for a potential employer:
- There is no doubt that a person who goes through an academically demanding curriculum at least has the basic skills needed to perform a job. If the person has the right basic skills (accounting, programming, etc), then the employer does not need to go through the head-ache of giving that person on-the-job training.
- Most middle level managers do not get rewarded for exceptional hires – exceptional hires may even be a threat to them. But they may get punished if the hire is not up to the task. This creates a minimisation-of-risk-at-all-costs attitude, relying on costly signals such as university education to avoid risk.
- Teaching institutions also provide students with a set of beliefs that makes functional in a corporate setting: easy to control, willing to endure pain to reach a certain goal, etc.
- Employers tend to hire people that comes from a similar background – a person he or she identifies with. Choosing to hire a person from the same university as yourself confirms your belief that the quality of that university’s alumni is top-notch, and that you – by consequence – are also top-notch. This phenomenon creates the self-perpetuation of the need to graduate from a certain university – simply because you need to be part of the club whose members control key resources in the economy.
The technology will improve, but in my view the signalling value of education, building belief systems and habits, mid-level manager incentive issues and the impact of cognitive dissonance on hiring decisions will not disappear. At most, technology will dilute the need for brand name education in those fields where skills are easily quantifiable – programming, music, cooking, etc.
For K-12 teaching institutions, future demand is even more secure. Practically all jobs in developed countries require a minimum of high school education. If you choose not to finish your high school education, employers will take it as a signal that you are either unwilling to adapt to a disciplined environment or perhaps mentally inept. Education is one of the few ways that ambitious parents can outperform their peers in the social prestige game.
Taking a longer term view
Brokers are somewhat bearish on the stock. DBS recently ceased coverage. According to Reuters, CIMB is the only broker covering the stock and currently has a “Hold” rating. It estimates flat revenue in the years ahead with EBIT falling somewhat from the latest SG$16m annualised figure and then returning to stay roughly flat.
Narratives circulating among sell-side analysts, that I think reflect current investor sentiment:
“Uncertain company outlook and weak earnings”
“We remain bearish on FSS this year as we expect to see continued downsizing of firms in the expat-concentrated industries like finance and oil & gas”
“36% of OEL’s students are in high school. As such, we think that new enrolments may not be able to offset the number of graduating students”
“MOM announced an increased scrutiny on the employment of foreign professionals. In view of an upcoming election, the trend is not expected to be reversed”
“Two new FSS, Dulwich and GEMS, set foot into Singapore. While OEL saw registration revenue dropped 1.4%, Dulwich enrolled 920 new students for its first academic year.”
Why these narratives are not strictly incorrect, they reflect a short-term outlook which disregards the fantastic quality of assets the potential for operating leverage when one takes a longer-term view.
Overseas Education used to spend less than 3% of revenues of maintenance capex, and that included plenty of retro-fitting of the old campus. The building quality of the new campus I top-notch and the buildings will not need to be refurbished in a major way in the next 50 years or so. The lease should roll-over for another 30 year term, which gives us visibility over the next half a century, at least. Maintenance capex (repairing toilet doors, buying new computers, etc.) may be more than SG$1 million but in any case much less than SG$3 million. So the company is earning in excess of SG$25 million in free cash flow after capex against a market capitalisation of SG$166m, representing a P/FCF multiple of 7x for what I consider to be a great business.
Registration fees – a leading indicator of tuition revenues – are down 10% YoY for 9M2016. Management is guiding for an improvement in the next semester but given how many foreigners are currently looking to move out of Singapore enrolments will probably continue to be negative for at least another year. While uncertainty is scary and no-one knows exactly what will happen, my best guess is that enrolment will bottom in 2018 and grow thereafter with enrolment reaching 5000 students in 2023 and perhaps even more by 2025. The underlying assumption is that the government stands by its plan to reach a 7.0 million population by 2030.
We then reach the last of my four original questions: if the utilisation rate of the current campus reaches 100%, how much will financials improve?
I am assuming a 10x student-teacher ratio and no major inflation in consumer prices while tuition and teacher salaries are expected to rise by 5% per year from 2018 forward. Thanks to strong cash flow available for debt service of roughly SG$30 million, finance costs are expected to fall SG$1.5-2 million per year which will more or less balance out the loss in tuition revenue in the near term. I am expecting net profit to start increasing again from 2018.
Thanks to low maintenance capex since the build-out of the new campus, cash flows are great and the stock looks cheap even on an EV/(EBITDA-MCX) basis. The great benefit of this business is not only an oligopolistic industry structure and product pricing power, but also the leverage in a currently under-utilised asset. The company can easily double in size without taking on much further costs other than salaries. At my 2023 horizon year, net profit margins will be 26% – roughly in line with management guidance. Discounting free cash flows to equity at 10% with a 10x terminal value PE multiple gives you an intrinsic value of SG$1.37 per share. That’s where I see the stock heading in the medium term.
The situation with the Overseas Family School in Singapore is what I call time arbitrage – a long-term investor can exchange negative short-term return for positive long-term returns. When asked if the school will ever reach full capacity again, the management team answered “of course!” It is just a matter of time. The appropriate strategy is therefore to take a position and increase it as either the price continues downward or the company is starting to turn around. The reason I am confident in the long-term prospects of the business is the fact that industry supply is absolutely fixed, the company’s pricing power is very strong and the school’s reputation is decent. I recommend averaging down and hold the stock until it reaches a price of about SG$1.4/share, which I consider to be a medium term target price.