Wednesday, March 23, 2016

Overseas Education Ltd - Part 2

This is a continuation from the previous post.

A quick recap: Overseas Education (OEL) operates one of the largest international schools in Singapore and was listed on SGX in 2013. The stock has since collapsed below its IPO price due to the three issues discussed previously.

1. It move from Orchard to Pasir Ris, a less prestigious location and lost 20% of its enrolment.

2. Competition has increased with now over 70 international schools in Singapore.

3. The global economic woes hit Singapore hard with lots of expats losing jobs and going home.

OFS senior year students

As alluded to in the previous post, these are likely short term issues that would be resolved in a few years. Yes, value investing is a game measured in years. While these issues could persist for say 18 months, it is likely to normalize over years. So for readers looking to play monthly or quarterly games, well, then, this post is not really suitable. Although these same readers would probably not mind ogling at picture of the senior year students provided here. So read on!

Just joking, the above is a pic taken from The Princess Diaries starring Anne Hathaway when she was 18, fifteen years ago. Today, she is more beautiful as Catwoman (shown below) but alas OFS students are even more beautifulier. This hopefully inspires some readers to go kick the tires by doing actual visits to Pasir Ris :) Anyways, back to long term thinking, here's the thing, if we look out in years, not months, enrolment should have bottomed. OFS has managed to grow enrolment steadily for the last 20 odd years. It is likely to keep growing if we are willing to look out a few years. On average, it has experienced net gain of 150-200 students per year over its long history. So hypothetically it should get back to pre-move enrolment of 3,600 in just three or four years.

Anne Hathaway today, looking more beautifulier

As for competition, while there are c.70 schools in Singapore, the top few schools command high market share with their capacity and brand name. These are the numbers: there are c.40,000 students but the top five schools accounts for c.50% of market share. This means that the remaining 65 schools are not actually competitors as they can hold only a few hundred students each. Simply put, they are barely a tenth or a fifth the size of OFS. In fact quite a few of these schools are struggling to survive. If they do close down, OFS stands to benefit from their transferring students.

The world economy has collapsed in 2015 in the aftermath of China's slowdown, the bursting of the commodity super cycle and the bleak recovery in US and Europe. Global expats are moving back to their home countries and Singapore had its fair share of such woes. Despite this, it was surprise to see that the number of employment pass holders actually jumped from 175,000 in 2013 to 188,000 in 2015, a nice 7% increase over two years. This points to Singapore's continued attractiveness as a global hub for expats to come and work. As long as Singapore remains relevant, the number international students will grow and OFS enrolment should grow over time even though current enrolment is still weak.

Next we move to the financials.

As part of its listing requirement, OEL has produced detailed financial statements since 2010. Again, not to be confused, Overseas Family School or OFS is the name of the school and Overseas Education Limited or OEL is the listed entity. We now have five years of detailed financial statements. Analysis of its profit and loss, balance sheet and cashflow is quite straightforward, given the simplicity of the business model. Here's the cheatsheet:

OEL's Cheatsheet

As usual, this cheatsheet plugs out some of the most important no.s from the three statements and put them in a nice format for easy reference. These are numbers not from any single year but a mixture of estimates and actual figures for better analysis. For example: Sales of SGD 100m is an estimate of what OEL can earn in the next 1-2 years while current year sales is only about SGD 94m. Cash and debt are rounded to the nearest 10m based on last reported numbers.

Numbers in blue are derived from other numbers. We can see that the firm has incredible free cashflow or FCF yield (14.6%), Operating margins (24%) and so-so ROE (11%) but likely to increase as its net income normalizes in the next few years. The P&L is simply revenue minus costs, the largest being labour cost which is 58% of sales. The balance sheet has quite a bit of debt (SGD 180m) as a result of the past borrowings to build the new campus but that should decline over time. Free cashflow turned negative as it poured money into building the new campus but that should also normalize and the firm would likely hit 20-25m FCF per year as it did before it moved from Orchard to Pasir Ris.

As part of the drilling in this post, we look closely at these three numbers described above in detail for this cheatsheet, namely:

1. Labour Cost
2. Debt to Equity
3. Free cashflow and dividend

OEL employs international school teachers globally and it pays to get quality. As such, labour cost ie teachers' salaries is the highest cost component and would likely continue to be so. The school has established itself as the employer of choice for the global pool of international school teachers. These teachers usually sign three year contracts and depending on the student enrolment trend of the school, some would not be renewed. Conversely, the school also has a list of potential new hires for it to recruit rapidly when enrolment picks up and it needs more educators. While labour cost by and large will keep increasing over time with inflation, the school can offset this by increasing tuition fees. The school currently keeps slightly more teachers that needed given that enrolment just collapsed but that should pick up as discussed previously. Over the next few years, we can expect labour cost as a percentage of sales to drop closer to 50%. In short the firm has some flexibility in managing labour cost and offsetting it.

Next, we discuss the conversion of its debt enterprise value to equity enterprise value. OEL raised its debt significantly in order to build its new campus, resulting in the current situation of SGD 120m in net debt (180m debt - 60m cash). Its Enterprise value (EV) stands at SGD 299m. EV being simply market cap plus net debt (179m + 120m). Now, the enterprise value of the firm shouldn't change if the business is intact. So this means that as the firm generates cash annually to pay down its debt, eventually paying it to zero and attaining a net cash status as it has done so in the past, its EV should equate its market cap. This means that its market cap should jump from current SGD 179m to 299m ie up by 67% over time.

This is only possible if the firm keeps generating cash to pay down its debt. For OEL, well, it seems to work just perfectly alright. The firm is capable of generating SGD 20-25m of free cash flow per year, in fact, in the cheatsheet, it's even higher at 26m. This translates to an incredible 14.6% FCF yield, something as safe as a school rarely trades so cheaply. Even if we assume a more conservative number, say it can only do SGD 15m, it still translates to a decent 8.4% FCF yield and bearing in mind that it would use this 15m to pay down its debt means its market cap would grow by the same quantum per year ie 15m or 8.4% of 179m.

To sum this up, in a pretty bad scenario where things simply remain the same, OEL grows at a high single digit clip. If our thesis is right ie enrolment comes back, on top of the regular tuition fee increases, OEL is on its way to see its previous peak $1.02 (2.5x vs current price) and meanwhile we also get 4% dividend every year while it grows multifolds!

Disclaimer: this author owns OEL!

Monday, March 14, 2016

Overseas Education Ltd - Part 1

Part 2 is out!

Overseas Education Ltd (Bloomberg Ticker: OEL SP) is an intriguing small cap stock in Singapore listed in 2013 that almost doubled but then crashed spectacularly in the last 1.5 years. It now trades at 12% free cashflow yield, 11x PE and pays a 4% dividend (likely to be more going forward) and earnings are stable and growing barring Singapore's demise (i.e. our beloved little red dot one day becoming irrelevant).

For the uninitiated, OEL operates the largest independent international school in Singapore called Overseas Family School (OFS) providing expatriate kids with quality international education. It started in 1991 and currently has enrolment of 3,000 students. It is the third largest international school in Singapore after the Singapore American School (SAS) and the United World College (UWC). However, as it has no affiliation to any nationality, it is also the school with the most diversity in the world, boasting a record of educating kids from over 70 countries in our little red dot.

Well then, why did the stock collapse in the first place?

This was largely caused by its move from the prime downtown Orchard campus to Pasir Ris in 2015. It lost 20% of its enrolment and together with anxiety in the stock market since the start of 2016, OEL found no buyers for its stock. It is also likely that some large foreigner shareholders could be selling to get out of their positions which put further pressure on the stock price. Now, to me, this looks like the perfect scenario when value investors should pounce and buy when others are fearful and wait for the stock to go 2x (or even 3x) in a few years.

Well, let's not get too excited. To be fair, the bear story has a few valid points:

1. Losing the Orchard location was devastating, it lost 600-800 students with some in their early years which meant a lot of lost future income. But this is now all factored in the price.

2. Singapore has seen a huge increase in international schools and competition is intense. Last count there were over 70 international schools albeit some are quite small. There is now no longer any waiting list even at the top schools, this meant that Overseas Family School is facing a lot more competition.

3. The weakness in the global economy has translated to a lot of expats losing jobs in Singapore, which exacerbated the decline in enrolment numbers that we saw. These jobs include functions in the oil and gas industry, finance and managerial positions that might not be replaced soon. This meant less expats and their families staying in Singapore for the next few years.

We shall come back to these points later. First let's examine the bull case:

Education is one of the most fantastic businesses because the schools have a lot of pricing power. Parents are not about to be stingy when it comes to their children's education. They will pay an arm and a leg for good quality education especially if the school is "branded". Brand is very important and once built, its reputation lasts for decades (think Oxford, Harvard, Qinghua and in Singapore, Raffles and Hwa Chong) which meant that competition is actually largely irrelevant. Costs are relatively stable (teachers and depreciation essentially) and easily managed and offset by rising school fees which meant that marginal profitability is very high once the fixed cost is covered. 

OFS has been slowing building its brand name in Singapore for twenty over years albeit it has always been outshined by the Singapore American School, UWC, Tanglin Trust, Canadian and some others with affiliations to their home countries. Over time, however, it should slowly build stronger reputation given its dedication in hiring the best teachers and its sheer size and outreach in Singapore. It is well-known in the global recruitment of overseas teachers as one of the best employers globally. Hence its should have the ability to grow and retain its talent pool of teachers and continue to build its brand power.

Anecdotally, expat mums also like to share that their kids enjoy and learn a lot in the school and would not want to be transferred to some of the other top brands despite the school's low key profile. As a result of its diligence in hiring good teachers, emphasizing quality and good management of its strong executive team, it's enrolment had grown steadily from 200 students in its second year of operation to over 3,000 students today as shown in the chart below until 2013 (when enrolment peaked at 3,600 students). 

Overseas Family School Enrolment

OFS' test results have also improved over the years as a natural consequence of its focus on providing good holistic education. It has gradually nurtured more and more students getting more than 40 points out of the full marks of 45 in the globally recognized International Baccalaureate (IB) test. While it still has some distance from the three Singapore schools offering IB to Singaporean students (with c.25-50% of students getting 40 points or more), its test results are remarkable considering it does not have the advantage of nurturing most of its students for more than a few years since expats move around a lot to different global cities all the time.

Hence while OFS had seen a dramatic decline in enrolment as a result of its move to Pasir Ris, it should continue to grow as long as Singapore remains relevant economically and can attract global expats to live and work here. OFS should see net enrollment growing by 150-200 students or so which mean that it should take just 3-4 years for it to recover its enrolment to the 2013 level. From there the school could grow to fill up its campus capacity of more than 4,000 students at its new location over time.

One important point is this: even if enrolment growth is slower than expected, education, especially international school education, is a business that would see 5-6% price increase annually. This means that its FCF of S$20m currently should be the bottom because even without increasing enrolment, one should expect a base case scenario of its FCF growing 5-6% on school fees increase alone. Obviously there is quite a good likelihood that Singapore remains a magnet for expats, i.e. the number of students would increase by 5-7% per year (150-200 out of 3,000) and FCF explodes to S$30-40m by growing 10-15% over the next few years. At S$170m market cap today, this stock is a steal!

Next post, we look into more details surrounding its financials and the risks.

Disclaimer: The author of this post owns OEL!

Tuesday, March 01, 2016

Negative interest rates, skyrocketing asset prices!

This is a continuation of the previous post.

Inflation had always been around, so the nominal zero that we saw was never really zero. Inflation of 3% meant that money depreciated value 3% every year, we just didn't see it so we think it's not there. When inflation is 3% and interest rate is 2%, effectively money in the bank is still being burnt. After the Global Financial Crisis (GFC), nominal interest rate became zero, but inflation was around 1% and hence real rate was already negative. But unfortunately our primitive human minds can only think in nominal terms, not real terms. Hence in the long history of financial markets, nominal interest rate  (ie the one that we have been talking all this while, which is the one always quoted on TV and news) didn't need to go subzero since inflation was always positive.

But now that inflation is negative, things are really different, and actually also dangerous. It might make sense for interest rate to go negative. In real terms, we will still be fine though. In negative inflation or deflation, money now appreciates in value, so negative interest rates serve to stop that appreciation which is not normal and actually harmful.

Banana money issued in Singapore during WWII

You see, deflation is a silent killer. It is not as dramatic as hyperinflation when money becomes worthless like how Singapore's own history with banana money showed (pic above). Banana money notes worth $10 might be just $5 a few months later and then dropped to $3 after a year or two. By the end of the war it was not even justified to be used as toilet paper. There was a famous anecdote told by our late founding father Mr Lee Kuan Yew that when he received his salary in banana money, he simply bought anything he could because the money would be worth much less very quickly. So he quickly bought stuff like a billiard table, machines and what not even when he had not much use for them. It turned out to be an important strategy.

When the next global financial crisis hits, it might be worthwhile to learn this because fiat currency and investment assets could become worthless as the global financial system comes to a halt. It would be vital to own hard assets that are useful for sustaining life: land, livestocks, electric vehicle, solar panel and power generator etc. Well, that's story for another day.

The topic of the day is not inflation but deflation.

Deflation, as alluded to in the previous post, causes a different set of problems. First prices to decline, that's by definition. This procrastinates consumption, slows innovation and brings economic growth to a standstill, which exacerbates further price declines. It creates a vicious cycle and leaves the economy in stagnation. It's a slow death process that could trap an economy indefinitely. Again, we have go back to the Ant-Man analogy. It really feels pretty much like being trapped in the subatomic quantum realm.

Quantum realm, or rather, the black hole from Interstellar

Economic theory tells us that interest rate is the key lever to pull to regulate the economy. Inflation is one of the results that we see, the others being employment and growth. In an economy that is growing well, inflation is usually at around 2%. Interest rates could be around 2-3% to be moved up and down accordingly. If the economy is weak, interest rate should be lowered to stimulate growth and vice versa to prevent overheating. However, conventional wisdom put a limit on this powerful interest rate lever. Interest rate cannot go below zero. When the Global Financial Crisis (GFC) happened, interest rates were lowered to zero. But it wasn't enough. Now that China is at the risk of imploding, coupled with the world slowing drastically, the global central bankers are at their wits end.

Drastic times calls for drastic measures. In order to stimulate the global economy which is not growing and having negative inflation, a few countries started with negative interest rates. If zero interest rate is not enough to get people to borrow money, then we pay them to borrow money! In theory, this should work if it's not prolonged. People would wake up, work harder, come up with ideas, create new businesses which would require capital, borrow money, increase consumption, innovate and in no time, the economy is up and running again.

Unfortunately, reality works differently.

If money being deposited into the bank costs money rather than earning interest and if lending to people means I have to pay the borrowers instead of them paying me, then I better do something else with my money. What will happen is asset inflation. For quality assets, it would be massive asset inflation, perhaps even hyper inflation. The most accessible hard asset for most people is property. So negative interest rates also mean that property prices will skyrocket. This has important implications for Singapore's property market.

Stylized chart of Singapore Property Price vs Value

The chart above shows how Singapore property price and value had move over the past 10 years. Essentially prices nearly doubled from 2005 to 2008 but collapsed as a result of the GFC but went on to more than double, peaking at 220% of 2005 prices in 2013. The red line shows my estimation of the true value of Singapore's property. Recall that in value investing doctrine, we buy when price is less than value. Unfortunately, this only happened once in the last 10 years for Singapore property. This was in 2009 when the blue line i.e. price dipped below my estimation of value which is the red line. Well, we might get a chance in 2016 and 2017 if the world hadn't gone into negative interest rates.

In the following chart we try to understand what happens to value and ultimately price in the negative interest rate environment or NIRE. This has nothing to do with basketball shoes. Here we show prices in blue (price) and red (value) again, essentially the same data points from the previous chart but we also added a purple line.

Stylized chart of Singapore Property Price vs Value in NIRE

In the red value curve, I assumed that Singapore property value grew at 4-10% over the past 10 years. (4% growth during the lean years and 10% for the boom years) and should grow around 4% until 2020. Singapore is a mature economy and hence growth at 4% would roughly mirror GDP growth which is fair. This is just simple compounding at work and we see that in 2020, Singapore property value should be around 2.5x of what it was in 2005. In the graph, it reads about 250 on the y-axis. This means that if property prices remain where it is today until 2020, value gets to be higher than price and we would be able to buy Singapore property soon!

Alas, with the reality of NIRE hitting us (NIRE again stands for negative interest rate environment and has nothing to do with basketball shoes), what is likely to happen is that global money will start chasing high quality assets as discussed in the first half of this article. Singapore property is at the forefront of high quality assets. Global rich started buying Singapore around 2005 which caused prices to skyrocket as we had seen. Billionaires from all over the world starting to buy up bungalows. District 9, 10, 11 properties are already used for money parking of rich Chinese, Indians and Indonesians. This is going to further exacerbate.

This is depicted in the purple line in the same chart. While the red line shows a pedestrian growth in value mirroring GDP growth, negative interest rates know no bounds. We know that property value doubles when rental yield drops by half. Now that yield can go negative, it could only mean value can only skyrocket! In the chart, I arbitrary computed that value could shoot up to 600 by 2020 (vs only 250 for the red line).

To put this into better context, let's use some real numbers. In the past, say a good property in a good location (i.e. District 9, 10, 11) have provide a monthly rental income of S$4,000. This comes up to around S$40,000 a year after subtracting the peripheral costs. A property, valued at 4% rental yield means that its value should be S$1,000,000. As global interest rates fell, some of these good properties are being valued at 2% rental yield, which mean S$2,000,000, which is roughly what it is today.  This was more or less what happened with the Singapore property market over the past decade. Then the government stepped in to cool it down, some rationality prevailed and prices finally started falling in 2014 and 2015.

With negative interest rates, it means that money being put in the bank would lose value. The banks will be charging 1% for funds park there. These rich people having 10 million dollars in the bank will not be happy paying that bank $100,000 every year. They will be happy to buy Singapore property at 1% yield or even 0.5% yield. At 1% yield means the same property we talked about is worth S$4,000,000 and at 0.5% it is worth S$8,000,000. We may see Sky Habitat selling at $3,000 psf some day. This is the reality facing us.

Can this prediction be wrong? Of course, and actually it shouldn't be viewed as a prediction.

Nothing is ever cast in stone. The future is always a set of probabilities ascribed to a few scenarios. This could be one future reality. Its probability of actually happening gets higher if more central banks adopt negative interest rates. The big swing factor being the US Fed. There is always the alternative reality that the world finds its growth trajectory again, we move away from NIRE *Phew* and we get one chance to achieve the Singapore 5C dream again!

Let's hope that's the future waiting for us.