Why IDP Education ticks all our boxes

IDP Education (ASX: IEL) places international students into Australia and other key English speaking destinations, while also administering English language proficiency tests. With defensive earnings, a long runway for growth and strong industry tailwinds, we think there’s plenty to like about this Australian-based global business.

IDP Education is a structural growth company which the newly launched Montgomery Small Companies Fund has initiated as a core position within the portfolio. We saw the recent pull back in the shares as an attractive entry point into a high-quality business with defensive-growth characteristics, a strong structural thematic underpinning the medium-term earnings growth profile, and optionality afforded by the net cash balance sheet position.

As one of the largest global providers of English language testing and student placement services, IEL offers investors exposure to the international education and migration theme currently playing out. The rising wealth of Asia’s expanding middle class continues to drive strong growth in demand for tertiary education in English speaking destinations, particularly out of China and India, and into Australia, Canada and the UK. Additionally, education is a valuable export with higher fee paying international students representing an important source of income for both universities and their local economies. IEL is well placed to benefit from these strong industry tailwinds, both via its IELTS (International English Language Testing System) testing segment and its student placement business.

The shares were sold down around 25 per cent after the release of the FY19 results. Although IEL delivered a strong result that met broker estimates (FY19 EBITDA grew 29 per cent to $115 million), the market was concerned with the unexpected slowdown in IELTS testing volumes revealed in the second half (testing volumes slowed from 18 per cent growth in the first half to 7 per cent in the second). This slowdown was solely attributable to India where volumes were negatively impacted by the election as well as some false media reports about the quality of the test. The total volume impact was estimated to be around 50,000. We understand that volumes have since recovered and the business has returned to trend. Adding these volumes back implies 15 per cent testing volume growth in the second half (rather than 7 per cent reported) and lifts FY19 EBITDA by $6 million or 5 per cent to $121 million (so the result would have beaten market expectations by 5 per cent). We are comfortable that the structural growth story remains intact and took advantage of the sell off by establishing a position at attractive prices.

By way of background, the company was founded fifty years ago as a not-for-profit organisation, owned by 38 Australian universities that supported international educational institutions in Asia. In 2006, Seek (SEK) acquired 50 per cent of IEL and subsequently transitioned it into a for-profit business. The company listed on the ASX in 2015 with Seek exiting the register and the foundation universities retaining a 49 per cent stake (strong alignment of interest with the universities a major positive from our perspective). Today, IEL has a market cap of $4 billion and generated $69 million NPAT in FY19 (grew 24 per cent over the year).

English Language Testing is the largest operating segment, accounting for 46 per cent of FY19 Group gross profit with sales growing at a healthy 17 per cent clip. This business distributes around half of the 3.8 million IELTS tests taken throughout the world each year. IELTS is the most internationally accepted English competency test and is typically required for international applicants looking to migrate, study or work in countries where English is the principal language. IEL co-owns the IELTS test along with Cambridge University and the British Council (each own one third share). Cambridge develops the content in exchange for a fixed royalty per test while IEL and the British Council are both responsible for its distribution and administration (exclusively in their respective home countries but in competition elsewhere, except for China where a special agreement exists). IEL and its licensees operate around 500 testing centres in more than 45 countries.

The English Language Testing revenue model involves IEL charging a fee for administering the IELTS test, equivalent to approximately $280 in FY19 (grew 4 per cent year over year). Gross profit margins are solid at 43 per cent.

We see ‘blue sky’ upside potential if IEL were to acquire British Council’s distribution rights to the IELTS test. Material cost synergies would likely arise from rationalising duplicated costs and network infrastructure in markets where IEL and the British Council directly compete. We also think revenue synergies could result from IEL’s more targeted digital investment initiatives.

Student Placement is the other major operating segment, representing 42 per cent of FY19 gross profit. This business provides specialist services to international students looking to study overseas, ranging from initial course counselling, course and visa application assistance, and general pre-departure guidance. IEL has student recruitment services agreements with over 600 educational institutions in five destination countries. Students are sourced through the company’s network of 127 offices across 30 countries, the majority of which are in Asia. In FY19, India was the largest and fastest growing source market (accounting for 37 per cent of IEL’s total student placement volumes and growing at 63 per cent), followed by China (25 per cent growing at 14 per cent). Australia was IEL’s largest destination market (58 per cent of student placements, growing at 10 per cent), followed by Canada (18 per cent growing at 72 per cent) and the UK (18 per cent growing at 41 per cent).

The Student Placement revenue model involves an Application Processing Fee (APF) paid by educational institutions based on successful applicants. In FY19, the APF grew 11 per cent to approximately $3,400 (equivalent to around 13 per cent of A$26,000 which is a typical first year tuition fee for an international university student). Gross profit margins are high at more than 80 per cent.

Having established a dominant position in the key Australian destination market with around 25 per cent of all international student volumes into Australian universities (or 50 per cent of all agency channel placements), IEL has significantly expanded its market opportunity via its multi-destination strategy, broadening its focus to include other large and growing destination markets such as Canada, New Zealand, the UK and the US. We believe Canada and the UK have the potential to be at least as big as Australia for IEL. Consequently, Student Placement is the business unit where we see the most scope for growth and upside surprise over the medium-term horizon. We also like this strategy from a risk perspective – expanding the destination market portfolio reduces the impact from country specific risks like visa processing changes or bottlenecks. IEL’s new digital platform (completed March 2019) is also expected to drive more student leads with higher conversion rates which should meaningfully increase placement volumes over the coming years.

IEL stands out to us as a well-managed, high quality company with defensive earnings, a long runway for growth and strong structural industry tailwinds. We also like the high margin, capital light business model (ROE more than 45 per cent) and the strong balance sheet position (net cash). Based on our forecasts, IEL should continue growing earnings per share at a compound growth rate north of 25 per cent over the medium-term. We expect demand for tertiary education in English speaking destinations to remain strong and back IEL management to successfully execute its multi-destination Student Placement strategy. The shares are trading on 28x FY20 EBITDA (consensus estimates), however this multiple falls to 13x three years further out (on our forecasts).