With target price of Rs 3800 based on 35x FY10E EPS — We are initiating coverage on Educomp with Buy. At a price of 3800 company will be trading at 54.1x FY09 Earnings 35x FY10E EPS and 24x FY11E earnings. Company trades at trailing PEG to ratio of .5 for FY09, this ratio will decline further to .4 based on current prices.

Our last call on Educomp was in January, where we initiated a buy call on the stock at CMP 1715 with a target of 2750. Earlier in 2008 stock price fell by a huge percentage in 2008 due to rumors regarding company’s accounting policies.

Company has given detailed clarifications on these allegations and same can be found on the company website.

From the operations point Educomp has continued to deliver strong earnings and exponential growth, 40% CAGR in both revenues and Net income, is estimated for next four years.

Industry Potential

India has emerged as one of the world’s largest consumer of education services with a target population of more than 445 millions, with public and private spending on educational services in India aggregating approximately $100 billion per annum. Spending on Education in private sector has grown by CAGR of 10.4% since 1994, double the 5.11% CAGR on total spending.

Government spending on education has reached 4% of GDP and is expected to rise further as India focuses on reducing its literacy rates.

Company description

Educomp Solutions Ltd, formerly Educomp Datamatics Limited, was incorporated in 1994 and is based in New Delhi, India. It is India's largest educational service provider mainly focused on the K-12 space.

Educomp group serves over 19,000 schools and 9.4 million learners and educators across the world. Company operates private schools across various cities and also partners with various state governments.

It has 27 offices worldwide. In addition, the Company operates through its various subsidiaries including author GEN, Three brix eServices, Learning.com, USA, AsknLearn Pte Ltd, Singapore and via its associates such as Savvica in Canada.

The company has three primary business segments:

1. Licensing of tools that help existing education system to move to a higher standard of delivery.

2. Direct Intervention – running schools, pre-schools and tutoring classes, online delivery etc.

3. Post K-12 initiatives such as vocational and professional education. Educomp's main business is developing and licensing digital lessons, which are uploaded onto servers and provided to schools. It also trains teachers (75,000 in the last quarter), provides vocational training to students with courses such as accounting and marketing, and offers online and in-person tutoring.

It runs eight K-12 schools. It has joined up in January with New Delhi real estate developer Ansal Properties & Infrastructure to start 25 private schools in new townships. It aims to start 150 schools over the next three years.

Educomp's big money-maker is Smartclass, a range of interactive digital lessons with animation and graphics that's marketed mainly to private schools as they have deeper pockets than public schools. The multimedia lessons-- 16,000 so far--are based on the different curricula in place across the country and use 12 of the country's languages.

Smart Class: This is the multimedia education business of Educomp catering to Private schools. Company charges upwards of 3000 Rs. Per student per month from each school. Company keeps infrastructure (multimedia content) on its books and transfers the content at the end of the contract.

Company added 258 schools in Smart Class in 4Q09 taking cumulative number of schools to 1737. Cumulative number of students under smart class has increased to 1.98 million. Company doesn’t have any major competitors and we expect strong revenue growth of 50%+ for next three years and margins to stay above 55% for this business. This segment will continue to remain main driver of business for the Company.

Company has projected that number of Schools will reach 2800-2900 by FY10E, resulting in 60% growth.

ICT Solutions: This is computer literacy initiative funded by Union/ State Governments. Company manages and installs labs in public schools and bills to government. Highlight of this business is long term contracts (5-year). However, it results to high debtor days of around 180 days.

Company added 2042 schools in 4Q09, revenue growth of 2% Y-o-Y, and taking cumulative number of schools to 12000. Margins have fallen sharply by 1000bps and will continue to fall to settle at around 15%.

Number of states covered till now is 14. This business is likely to face major competition from several regional and national players forcing the margins down. This segment will witness high top line but lower bottom line growth as revenues are likely to grow at more than 35% for period FY09-FY11 but margins are expected to decline further to around 15% post FY11.

Higher revenue share of this business would hinder company in reducing its working capital requirements down to below 120 days. When company attains steady state (post FY12) this business will constitute less than 15% EBITDA share of the company.

Professional Development: Company trained 90000+ teachers in 4Q09 which is less than 7% of its total 1.4 million teachers. Revenues for the segment for 4Q09 increased by 12%( Y-o-Y). Margins for this business shall continue to remain high (above 60%).

Revenue growth for this business will remain around 20%.

Retail and Consulting: Company is putting a lot of stress on its retail business growth by focusing on both organic and inorganic channels. Company’s online education portal MathGuru has witnessed ~700% growth rate. Company is growing its Preschool portfolio (Root to Wings) by expanding through franchisee. Company bought 50% stake in Euro kids taking preschool number under its umbrella to 500. This business will continue to see lot of inorganic growth as company explores new ways to enter retail markets.

K-12 Initiatives: Under this company will operate and manage entire schools and provide access to all its intellectual property. Total of 11 schools with 14000+ students have been established in 9 cities. Company targets 24 schools under K-12 initiatives this year. Company has already received financial closure for Rs 725 cr of debt including - Non-Convertible Debentures (Rs 100cr), out of which 250 crore has already been utilized.

Company has planned 140 million of capital expenditure per school and expects EBIT of Rs. 45 million (at 60% margins) per year per school. This segment will see around 100% growth rate over FY09-FY12 and margins will remain above 60%. In steady state (FY14) this business will constitute more than 15% of the revenues and with negative debtor days of the company.

Results Analysis and Outlook

Smart Class revenues grew by 120% contributing 60% of Net income with PBIT witnessing growth of 102 bps at 62.5 crores. Margins for the business stood at 57.2% down 420 bps. For full year revenues were 314 crores up 146% from FY08. Margins of 59.1 % improved 110 bps resulting in PBIT of 185.6 crores.

ICT Business

For FY09, the segment revenues grew 22% at Rs 113.42 Crore contributing 23% of the revenues with PBIT margins of 23.2% down 600bps and PBIT was down 4% at Rs 26.28 Crore.

Future Outlook

Company is poised to continue perform exceeding well with more than 70% revenue growth for the period FY09-FY11 and margins to stay above 45%.

Net Profits are expected to rise 4 fold from Rs.700 million in 2008 to 2800 million in FY11 giving a CAGR of 58%.

Ideal Price Earning to Growth rate for a high growth company should be between 0.8 and 1, which easily justifies a 100% price appreciation form these levels.

Growth Outlook

Company is likely to post very high growth rate for a long time. Revenue figures are expected to show a CAGR of 70% for the period 2009-2011, 35% for the period 2011-2014 and 20% for the period 2014-2016.

We forecast strong 50% CAGR in Net Profits over FY09-FY11E and see limited risks to the estimates given.

Company has forward P/E of for FY-2011 on constant prices while growth rate is expected to be upwards of 30% for year FY11-FY14. Company will continue to shine even in downturn as spending on Education and price levels are highly resilient to economic downturns.

Another positive for this company is its short payback period on its investment as significant business comes from long term contracts of 5 years.

Company understands its strengths and challenges ahead to deal with these challenges. Company has recognized four areas of opportunities/strengths as under:

1. Large market opportunity(scale)
2. Create barriers of entry for other players through strong IP and product differentiation.
3. High operating margins (50%+)
4. Experience and ability to execute

Risks:

- Due to high margins and nature of business, company might face competition from new entrants.

- Company is in high growth phase; PEG (P/E to Growth) ratio will be an important consideration for the stock. Any disappointment on Earnings Growth numbers will see a sharp downward price movement. For FY09 margins for the sectors decreased substantially however strong revenue growth in Smart Class business, improved overall margins for Company, which will ot be the case going forward.

- Free cash flows to remain negative for a while; if credit market tightens or company fails to deliver on expectation, raising fresh funds will be a problem.

- If government reduces spending on education, earnings and growth potential are likely to taper down.

- Company faces huge execution risks in its Edu-Infra business. Also company has been very aggressive in its growth plans, both Organic and Inorganic, and it would be very difficult to manage such growth plans under unforeseen circumstances (E.g.-Key Man Risk, Death of MD/Promoter)

TECHNICAL OUTLOOK EDUCOMP

Educomp is in a long term bullish trend .However the stock is in a short term correction & may touch 2800-2600 levels .this price should be used as a buying opportunity in the stock for a price Target of 3800-4000 in next 5-6 months.